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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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Quarterly Report Pursuant to Section
13 or 15(d) of the Securities Exchange Act of 1934



For
the Quarterly Period Ended September 30, 2004



Commission
File No. 0-13442



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MENTOR GRAPHICS CORPORATION

(Exact
name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Oregon                                                         |  | 93-0786033                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)
|                                                               | 
|8005 SW Boeckman Road Wilsonville, Oregon                      |  | 97070-7777                       
|(Address of principal executive offices)                       |  | (Zip Code)                       



Registrants
telephone number, including area code: (503) 685-7000



NO
CHANGE

(Former name, former address and former fiscal year, if changed since last report)



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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 an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act).    Yes  x    No ̈



Number of shares of common stock, no par value, outstanding as of November 1, 2004:
76,332,032



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##### Table of Contents

MENTOR GRAPHICS CORPORATION



Index to
Form 10-Q



|                                 |  |                                                                                               |  |                                                                                                        |  |     
|-------------------------------- |  | --------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------ |  | ----
|                                 |  | Page Number                                                                                  
|PART I    
FINANCIAL INFORMATION |  |                                                                                              
|                                 |  |                                                                                              
|                                 |  | Item 1.
Financial Statements                                                                  |  |                                                                                                       
|                                 |  |                                                                                               | 
|                                 |  |                                                                                               |  | Condensed Consolidated Statements of Operations for the three months ended September 30, 2004 and 2003 |  | 3   
|                                 |  |                                                                                               | 
|                                 |  |                                                                                               |  | Condensed Consolidated Statements of Operations for the nine months ended September 30, 2004 and 2003  |  | 4   
|                                 |  |                                                                                               | 
|                                 |  |                                                                                               |  | Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003                   |  | 5   
|                                 |  |                                                                                               | 
|                                 |  |                                                                                               |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003  |  | 6   
|                                 |  |                                                                                               | 
|                                 |  |                                                                                               |  | Notes to Unaudited Condensed Consolidated Financial Statements                                         |  | 7-17
|                                 |  |                                                                                              
|                                 |  | Item 2.
Managements Discussion and Analysis of Results of Operations and Financial Condition |  | 17-36                                                                                                 
|                                 |  |                                                                                              
|                                 |  | Item 3.
Quantitative and Qualitative Disclosures About Market Risk                            |  | 36-37                                                                                                 
|                                 |  |                                                                                              
|                                 |  | Item 4.
Controls and Procedures                                                               |  | 38                                                                                                    
|                                 | 
|PART II    
OTHER INFORMATION    |  |                                                                                              
|                                 |  |                                                                                              
|                                 |  | Item 5.
Other Information                                                                     |  | 39                                                                                                    
|                                 |  |                                                                                              
|                                 |  | Item 6.
Exhibits                                                                              |  | 39                                                                                                    
|                                 | 
|SIGNATURES                       |  | 39                                                                                           



2



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##### Table of Contents

PART I. FINANCIAL INFORMATION



Item 1. Financial Statements



Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)



|                                                                     |  |      |         |   |      |   |         |  
|-------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|Three months ended September 30, In thousands, except per share data |  | 2004 |         |   | 2003 |  
|Revenues:                                                            |  |      |         |   |      |   |         |  
|System and software                                                  |  | $    | 89,933  |   |      | $ | 86,166  |  
|Service and support                                                  |  |      | 72,027  |   |      |   | 70,785  |  
|                                                                     |  |      |         |   |      |   |         |  
|Total revenues                                                       |  |      | 161,960 |   |      |   | 156,951 |  
|                                                                     |  |      |         |   |      |   |         |  
|Cost of revenues:                                                    |  |      |         |   |      |   |         |  
|System and software                                                  |  |      | 2,615   |   |      |   | 5,945   |  
|Service and support                                                  |  |      | 20,320  |   |      |   | 20,344  |  
|Amortization of purchased technology                                 |  |      | 2,672   |   |      |   | 2,319   |  
|                                                                     |  |      |         |   |      |   |         |  
|Total cost of revenues                                               |  |      | 25,607  |   |      |   | 28,608  |  
|                                                                     |  |      |         |   |      |   |         |  
|Gross margin                                                         |  |      | 136,353 |   |      |   | 128,343 |  
|                                                                     |  |      |         |   |      |   |         |  
|Operating expenses:                                                  |  |      |         |   |      |   |         |  
|Research and development                                             |  |      | 50,990  |   |      |   | 46,522  |  
|Marketing and selling                                                |  |      | 63,304  |   |      |   | 57,781  |  
|General and administration                                           |  |      | 18,120  |   |      |   | 18,011  |  
|Amortization of intangible assets                                    |  |      | 916     |   |      |   | 899     |  
|Emulation litigation settlement                                      |  |      |        |   |      |   | 20,264  |  
|Special charges                                                      |  |      | 507     |   |      |   | 4,948   |  
|Merger and acquisition related charges                               |  |      | 7,290   |   |      |   | 60      |  
|                                                                     |  |      |         |   |      |   |         |  
|Total operating expenses                                             |  |      | 141,127 |   |      |   | 148,485 |  
|                                                                     |  |      |         |   |      |   |         |  
|Operating loss                                                       |  |      | (4,774  | ) |      |   | (20,142 | )
|Other income, net                                                    |  |      | 2,479   |   |      |   | 2,096   |  
|Interest expense                                                     |  |      | (4,755  | ) |      |   | (4,525  | )
|                                                                     |  |      |         |   |      |   |         |  
|Loss before income taxes                                             |  |      | (7,050  | ) |      |   | (22,571 | )
|Benefit from income taxes                                            |  |      | (1,304  | ) |      |   | (9,781  | )
|                                                                     |  |      |         |   |      |   |         |  
|Net loss                                                             |  | $    | (5,746  | ) |      | $ | (12,790 | )
|                                                                     |  |      |         |   |      |   |         |  
|Net loss per share:                                                  |  |      |         |   |      |   |         |  
|Basic                                                                |  | $    | (.08    | ) |      | $ | (.19    | )
|                                                                     |  |      |         |   |      |   |         |  
|Diluted                                                              |  | $    | (.08    | ) |      | $ | (.19    | )
|                                                                     |  |      |         |   |      |   |         |  
|Weighted average number of shares outstanding:                       |  |      |         |   |      |   |         |  
|Basic                                                                |  |      | 73,213  |   |      |   | 67,886  |  
|                                                                     |  |      |         |   |      |   |         |  
|Diluted                                                              |  |      | 73,213  |   |      |   | 67,886  |  
|                                                                     |  |      |         |   |      |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



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Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)



|                                                                    |  |      |         |   |      |   |         |  
|------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|Nine months ended September 30, In thousands, except per share data |  | 2004 |         |   | 2003 |  
|Revenues:                                                           |  |      |         |   |      |   |         |  
|System and software                                                 |  | $    | 282,545 |   |      | $ | 265,769 |  
|Service and support                                                 |  |      | 213,462 |   |      |   | 207,990 |  
|                                                                    |  |      |         |   |      |   |         |  
|Total revenues                                                      |  |      | 496,007 |   |      |   | 473,759 |  
|                                                                    |  |      |         |   |      |   |         |  
|Cost of revenues:                                                   |  |      |         |   |      |   |         |  
|System and software                                                 |  |      | 11,800  |   |      |   | 15,541  |  
|Service and support                                                 |  |      | 59,494  |   |      |   | 61,805  |  
|Amortization of purchased technology                                |  |      | 7,642   |   |      |   | 6,797   |  
|                                                                    |  |      |         |   |      |   |         |  
|Total cost of revenues                                              |  |      | 78,936  |   |      |   | 84,143  |  
|                                                                    |  |      |         |   |      |   |         |  
|Gross margin                                                        |  |      | 417,071 |   |      |   | 389,616 |  
|                                                                    |  |      |         |   |      |   |         |  
|Operating expenses:                                                 |  |      |         |   |      |   |         |  
|Research and development                                            |  |      | 147,695 |   |      |   | 133,363 |  
|Marketing and selling                                               |  |      | 191,055 |   |      |   | 175,678 |  
|General and administration                                          |  |      | 55,430  |   |      |   | 54,154  |  
|Amortization of intangible assets                                   |  |      | 2,488   |   |      |   | 2,975   |  
|Emulation litigation settlement                                     |  |      |        |   |      |   | 20,264  |  
|Special charges                                                     |  |      | 4,370   |   |      |   | 6,311   |  
|Merger and acquisition related charges                              |  |      | 7,650   |   |      |   | 1,860   |  
|                                                                    |  |      |         |   |      |   |         |  
|Total operating expenses                                            |  |      | 408,688 |   |      |   | 394,605 |  
|                                                                    |  |      |         |   |      |   |         |  
|Operating income (loss)                                             |  |      | 8,383   |   |      |   | (4,989  | )
|Other income, net                                                   |  |      | 5,699   |   |      |   | 4,508   |  
|Interest expense                                                    |  |      | (13,781 | ) |      |   | (12,499 | )
|                                                                    |  |      |         |   |      |   |         |  
|Income (loss) before income taxes                                   |  |      | 301     |   |      |   | (12,980 | )
|Provision (benefit) for income taxes                                |  |      | 36,665  |   |      |   | (7,863  | )
|                                                                    |  |      |         |   |      |   |         |  
|Net loss                                                            |  | $    | (36,364 | ) |      | $ | (5,117  | )
|                                                                    |  |      |         |   |      |   |         |  
|Net loss per share:                                                 |  |      |         |   |      |   |         |  
|Basic                                                               |  | $    | (.51    | ) |      | $ | (.08    | )
|                                                                    |  |      |         |   |      |   |         |  
|Diluted                                                             |  | $    | (.51    | ) |      | $ | (.08    | )
|                                                                    |  |      |         |   |      |   |         |  
|Weighted average number of shares outstanding:                      |  |      |         |   |      |   |         |  
|Basic                                                               |  |      | 71,045  |   |      |   | 67,554  |  
|                                                                    |  |      |         |   |      |   |         |  
|Diluted                                                             |  |      | 71,045  |   |      |   | 67,554  |  
|                                                                    |  |      |         |   |      |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



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Mentor Graphics Corporation

Condensed Consolidated Balance Sheets

(Unaudited)



|                                                                                                     |  |                          |         |   |                         |   |         |  
|---------------------------------------------------------------------------------------------------- |  | ------------------------ | ------- | - | ----------------------- | - | ------- | -
|In thousands                                                                                         |  | As of September 30, 2004 |         |   | As of December 31, 2003 |  
|Assets                                                                                               |  |                          |         |   |                         |   |         |  
|Current assets:                                                                                      |  |                          |         |   |                         |   |         |  
|Cash and cash equivalents                                                                            |  | $                        | 75,171  |   |                         | $ | 68,333  |  
|Short-term investments                                                                               |  |                          | 25,819  |   |                         |   | 2,991   |  
|Trade accounts receivable, net of allowance for doubtful accounts of $3,862 and $4,149, respectively |  |                          | 211,204 |   |                         |   | 223,670 |  
|Inventory, net                                                                                       |  |                          | 6,259   |   |                         |   | 5,489   |  
|Prepaid expenses and other                                                                           |  |                          | 25,688  |   |                         |   | 21,675  |  
|Deferred income taxes                                                                                |  |                          | 17,566  |   |                         |   | 18,787  |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Total current assets                                                                                 |  |                          | 361,707 |   |                         |   | 340,945 |  
|                                                                                                     |  |                         
|Property, plant and equipment, net                                                                   |  |                          | 88,596  |   |                         |   | 91,350  |  
|Term receivables, long-term                                                                          |  |                          | 106,874 |   |                         |   | 98,207  |  
|Goodwill                                                                                             |  |                          | 333,295 |   |                         |   | 290,352 |  
|Intangible assets, net                                                                               |  |                          | 42,411  |   |                         |   | 35,929  |  
|Deferred income taxes                                                                                |  |                          | 27,231  |   |                         |   | 60,021  |  
|Other assets, net                                                                                    |  |                          | 20,514  |   |                         |   | 23,884  |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Total assets                                                                                         |  | $                        | 980,628 |   |                         | $ | 940,688 |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Liabilities and Stockholders Equity                                                                 |  |                          |         |   |                         |   |         |  
|Current liabilities:                                                                                 |  |                          |         |   |                         |   |         |  
|Short-term borrowings                                                                                |  | $                        | 9,257   |   |                         | $ | 6,910   |  
|Accounts payable                                                                                     |  |                          | 16,734  |   |                         |   | 18,105  |  
|Income taxes payable                                                                                 |  |                          | 38,803  |   |                         |   | 35,122  |  
|Accrued payroll and related liabilities                                                              |  |                          | 59,863  |   |                         |   | 80,484  |  
|Accrued liabilities                                                                                  |  |                          | 38,899  |   |                         |   | 37,719  |  
|Deferred revenue                                                                                     |  |                          | 102,930 |   |                         |   | 74,662  |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Total current liabilities                                                                            |  |                          | 266,486 |   |                         |   | 253,002 |  
|                                                                                                     |  |                         
|Notes payable                                                                                        |  |                          | 285,217 |   |                         |   | 286,768 |  
|Other long-term liabilities                                                                          |  |                          | 19,561  |   |                         |   | 23,161  |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Total liabilities                                                                                    |  |                          | 571,264 |   |                         |   | 562,931 |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Commitments and contingencies (Note 13)                                                              |  |                          |         |   |                         |   |         |  
|Minority interest                                                                                    |  |                          |        |   |                         |   | 3,391   |  
|                                                                                                     |  |                         
|Stockholders equity:                                                                                |  |                          |         |   |                         |   |         |  
|Common stock                                                                                         |  |                          | 361,754 |   |                         |   | 294,180 |  
|Deferred compensation                                                                                |  |                          | (812    | ) |                         |   | (2,601  | )
|Retained earnings                                                                                    |  |                          | 23,903  |   |                         |   | 57,800  |  
|Accumulated other comprehensive income                                                               |  |                          | 24,519  |   |                         |   | 24,987  |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Total stockholders equity                                                                           |  |                          | 409,364 |   |                         |   | 374,366 |  
|                                                                                                     |  |                          |         |   |                         |   |         |  
|Total liabilities and stockholders equity                                                           |  | $                        | 980,628 |   |                         | $ | 940,688 |  
|                                                                                                     |  |                          |         |   |                         |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



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Mentor Graphics Corporation

Condensed Consolidated Statements of Cash Flows

(Unaudited)



|                                                                                          |  |      |         |   |      |   |         |  
|----------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|Nine months ended September 30, In thousands                                              |  | 2004 |         |   | 2003 |  
|Operating Cash Flows:                                                                     |  |      |         |   |      |   |         |  
|Net loss                                                                                  |  | $    | (36,364 | ) |      | $ | (5,117  | )
|                                                                                          |  |     
|Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |  |      |         |   |      |   |         |  
|Depreciation and amortization of property, plant and equipment                            |  |      | 18,367  |   |      |   | 17,300  |  
|Amortization                                                                              |  |      | 13,911  |   |      |   | 18,798  |  
|Deferred income taxes                                                                     |  |      | 29,949  |   |      |   | (2,048  | )
|Changes in other long-term liabilities and minority interest                              |  |      | (3,502  | ) |      |   | (311    | )
|Write-down of assets                                                                      |  |      | 8,408   |   |      |   | 2,166   |  
|Gain on sale of investments                                                               |  |      |        |   |      |   | (2,390  | )
|                                                                                          |  |     
|Changes in operating assets and liabilities, net of effect of acquired businesses:        |  |      |         |   |      |   |         |  
|Trade accounts receivable                                                                 |  |      | 11,606  |   |      |   | (15,210 | )
|Prepaid expenses and other                                                                |  |      | (2,578  | ) |      |   | (2,680  | )
|Term receivables, long-term                                                               |  |      | (9,259  | ) |      |   | 3,184   |  
|Accounts payable and accrued liabilities                                                  |  |      | (23,851 | ) |      |   | (632    | )
|Income taxes payable                                                                      |  |      | 3,863   |   |      |   | (19,925 | )
|Deferred revenue                                                                          |  |      | 27,356  |   |      |   | 471     |  
|                                                                                          |  |      |         |   |      |   |         |  
|Net cash provided by (used in) operating activities                                       |  |      | 37,906  |   |      |   | (6,394  | )
|                                                                                          |  |      |         |   |      |   |         |  
|Investing Cash Flows:                                                                     |  |      |         |   |      |   |         |  
|Proceeds from sales and maturities of short-term investments                              |  |      | 9,954   |   |      |   | 3,857   |  
|Purchases of short-term investments                                                       |  |      | (32,782 | ) |      |   |        |  
|Purchases of property, plant and equipment                                                |  |      | (16,833 | ) |      |   | (14,343 | )
|Purchases of intangible assets                                                            |  |      | (3,334  | ) |      |   |        |  
|Proceeds from sale of investments                                                         |  |      |        |   |      |   | 2,390   |  
|Acquisitions of businesses and equity interests                                           |  |      | (8,039  | ) |      |   | (17,093 | )
|                                                                                          |  |      |         |   |      |   |         |  
|Net cash used in investing activities                                                     |  |      | (51,034 | ) |      |   | (25,189 | )
|                                                                                          |  |      |         |   |      |   |         |  
|Financing Cash Flows:                                                                     |  |      |         |   |      |   |         |  
|Proceeds from issuance of common stock                                                    |  |      | 19,155  |   |      |   | 15,553  |  
|Repurchase of common stock                                                                |  |      |        |   |      |   | (29,785 | )
|Net increase (decrease) in short-term borrowings                                          |  |      | 2,391   |   |      |   | (7,985  | )
|Note issuance costs                                                                       |  |      |        |   |      |   | (4,639  | )
|Proceeds from long-term notes payable                                                     |  |      |        |   |      |   | 110,000 |  
|Repayment of long-term notes payable                                                      |  |      | (1,531  | ) |      |   | (1,146  | )
|                                                                                          |  |      |         |   |      |   |         |  
|Net cash provided by financing activities                                                 |  |      | 20,015  |   |      |   | 81,998  |  
|                                                                                          |  |      |         |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                              |  |      | (49     | ) |      |   | 727     |  
|                                                                                          |  |      |         |   |      |   |         |  
|Net change in cash and cash equivalents                                                   |  |      | 6,838   |   |      |   | 51,142  |  
|Cash and cash equivalents at beginning of period                                          |  |      | 68,333  |   |      |   | 34,969  |  
|                                                                                          |  |      |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                |  | $    | 75,171  |   |      | $ | 86,111  |  
|                                                                                          |  |      |         |   |      |   |         |  
|Supplemental disclosure of cash flow information:                                         |  |      |         |   |      |   |         |  
|Common stock issued in connection with an acquisition                                     |  | $    | 49,576  |   |      | $ |        |  
|                                                                                          |  |      |         |   |      |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



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MENTOR GRAPHICS CORPORATION

Notes to Unaudited Condensed Consolidated Financial Statements

(In thousands, except per share amounts)



|(1) | General - The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the
United States of America and reflect all material normal recurring adjustments. However, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally
accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the condensed consolidated financial statements include
adjustments necessary for a fair presentation of the results of the interim periods presented. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included
in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2003.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of
revenue and expenses during the reporting period. Actual results could differ from those estimates.



|(2) | Summary of Significant Accounting Policies 
|--- | --------------------------------------------



Principles of Consolidation



The condensed consolidated financial statements include the financial statements of the Company and its wholly owned and majority-owned subsidiaries. All
significant intercompany accounts and transactions are eliminated in consolidation.



The Company does not have off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business,
the Company leases certain real properties, primarily field office facilities and equipment, as described in Note 13.



Reclassifications



Certain reclassifications have been made in the accompanying condensed consolidated financial statements for 2003 to conform to the 2004 presentation.



Revenue Recognition



The Company derives system and software revenue from the sale of licenses of
software products and emulation hardware systems. The Company derives service and support revenue from annual support contracts and professional services, which includes consulting services, training services and other services.



For the sale of licenses of software products and related service and
support, the Company recognizes revenue in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions. Revenue from perpetual license arrangements is recognized upon shipment, provided persuasive evidence of an arrangement exists, fees are fixed or determinable and collection is probable. Product revenue from term license
installment agreements is recognized upon shipment and start of the license term, provided persuasive evidence of an arrangement exists, fees are fixed or determinable and collection is probable. The Company uses term license installment agreements
as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. In a term license agreement in which the Company provides the customer with
rights to unspecified or unreleased future products, revenue is recognized ratably over the license term.



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##### Table of Contents

The Company uses the residual method to recognize revenue when a license agreement includes one or more
elements to be delivered at a future date if evidence of the fair value of all undelivered elements exists. If an undelivered element of the arrangement exists under the license arrangement, revenue is deferred based on vendor-specific objective
evidence of the fair value of the undelivered element, as established by the price charged when such element is sold separately. If vendor-specific objective evidence of fair value does not exist for all undelivered elements, all revenue is deferred
until sufficient evidence exists or all elements have been delivered.



Revenue from annual maintenance and support arrangements is deferred and recognized ratably over the term of the contract. Revenue from consulting and training is recognized when the services are performed.



For the sale of emulation hardware systems and related service and support,
the Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, which supercedes SAB No. 101, Revenue Recognition in Financial Statements. Revenue is recognized when the
title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the sales price is fixed or determinable and collection is probable. When the terms of sale
include customer acceptance provisions and compliance with those provisions cannot be demonstrated until customer use, revenue is recognized upon acceptance. A limited warranty is provided on emulation hardware systems generally for a period of
ninety days. The Company maintains an accrued warranty reserve to provide for these potential future costs and evaluates its adequacy on a quarterly basis. Service and maintenance revenues are recognized over the service period.



Accounting for Stock-Based Compensation



Statement of Financial Accounting Standards (SFAS) No. 123, Accounting
for Stock-Based Compensation, defines a fair value based method of accounting for employee stock options and similar equity instruments. As is permitted under SFAS No. 123, the Company has elected to continue to account for its stock-based
compensation plans under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. The Company has computed, for pro forma disclosure purposes, the value of all stock-based
awards granted during the three months and nine months ended September 30, 2004 and 2003 using the Black-Scholes option pricing model as prescribed by SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation 
Transition and Disclosure, using the following assumptions:



|                                      |  |                                 |   |  |                                |   |  |      |   |  |      |  
|------------------------------------- |  | ------------------------------- | - |  | ------------------------------ | - |  | ---- | - |  | ---- | -
|                                      |  | Three months endedSeptember 30, |   |  | Nine months endedSeptember 30, |  
|Stock Option Plans                    |  | 2004                            |   |  | 2003                           |   |  | 2004 |   |  | 2003 |  
|Risk-free interest rate               |  | 3.5                             | % |  | 3.1                            | % |  | 3.5  | % |  | 2.8  | %
|Dividend yield                        |  | 0                               | % |  | 0                              | % |  | 0    | % |  | 0    | %
|Expected life (in years)              |  | 4.4                             |   |  | 4.2                            |   |  | 4.4  |   |  | 4.1  |  
|Volatility                            |  | 45                              | % |  | 68                             | % |  | 45   | % |  | 66   | %
|                                      |  |                                
|                                      |  | Three months endedSeptember 30, |   |  | Nine months endedSeptember 30, |  
|Employee Stock Purchase Plans (ESPPs) |  | 2004                            |   |  | 2003                           |   |  | 2004 |   |  | 2003 |  
|Risk-free interest rate               |  | 2.1                             | % |  | 1.6                            | % |  | 1.8  | % |  | 1.5  | %
|Dividend yield                        |  | 0                               | % |  | 0                              | % |  | 0    | % |  | 0    | %
|Expected life (in years)              |  | 1.25                            |   |  | 1.25                           |   |  | 1.25 |   |  | 1.25 |  
|Volatility                            |  | 45                              | % |  | 86                             | % |  | 45   | % |  | 86   | %



The Company used
expected volatility to estimate volatility for options granted during the three months and nine months ended September 30, 2004, and considers expected volatility to be more representative of prospective trends. Expected volatility is based on the
option feature embedded in the Companys convertible subordinated debentures (see Note 5), which is comparable to employee stock options. In prior years, the Company used historical volatility. Using the Black-Scholes methodology, weighted
average fair value of options granted was $4.59 and $10.35 per share during the three months ended September 30, 2004 and 2003, respectively, and $5.90 and $6.98 per share during the nine months ended September 30, 2004 and 2003, respectively. The
weighted average estimated fair value of purchase rights under the ESPPs was $2.64 and $2.13 during the three months ended September 30, 2004 and 2003, respectively, and $1.98 and $1.86 during the nine months ended September 30, 2004 and 2003,
respectively.



8



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##### Table of Contents

Other than with respect to options assumed through acquisitions, no stock-based employee compensation
cost is reflected in net income, as all options granted under the Companys Stock Option Plans have an exercise price equal to the market value of the underlying common stock on the date of grant and the ESPPs are considered noncompensatory
under APB Opinion No. 25. The Company recorded compensation expense for amortization of deferred compensation related to unvested stock options assumed through acquisitions of $374 and $512 for the three months ended September 30, 2004 and 2003,
respectively, and $1,122 and $1,535 for the nine months ended September 30, 2004 and 2003, respectively. If the Company had accounted for its stock-based compensation plans in accordance with SFAS No. 123, the Companys net loss and net loss
per share would approximate the pro forma disclosures below:



|                                                                                                                                                                                 |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                                                                                 |  | Three months endedSeptember 30, |         |   | Nine months endedSeptember 30, |  
|                                                                                                                                                                                 |  | 2004                            |         |   | 2003                           |   |         | 2004 |  |   | 2003    |  
|Net loss, as reported                                                                                                                                                            |  | $                               | (5,746  | ) |                                | $ | (12,790 | )    |  | $ | (36,364 | ) |  | $ | (5,117  | )
|                                                                                                                                                                                 |  |                                 |         |  
|Less: Total stock-based employee compensation expense determined under fair value based method, for all awards not previously included in net
income, net of related tax benefit |  |                                 | (4,268  | ) |                                |   | (4,689  | )    |  |   | (13,653 | ) |  |   | (15,753 | )
|                                                                                                                                                                                 |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Pro forma net loss                                                                                                                                                               |  | $                               | (10,014 | ) |                                | $ | (17,479 | )    |  | $ | (50,017 | ) |  | $ | (20,870 | )
|                                                                                                                                                                                 |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Basic net loss per share  as reported                                                                                                                                           |  | $                               | (.08    | ) |                                | $ | (.19    | )    |  | $ | (.51    | ) |  | $ | (.08    | )
|Basic net loss per share  pro forma                                                                                                                                             |  | $                               | (.14    | ) |                                | $ | (.26    | )    |  | $ | (.70    | ) |  | $ | (.31    | )
|Diluted net loss per share  as reported                                                                                                                                         |  | $                               | (.08    | ) |                                | $ | (.19    | )    |  | $ | (.51    | ) |  | $ | (.08    | )
|Diluted net loss per share  pro forma                                                                                                                                           |  | $                               | (.14    | ) |                                | $ | (.26    | )    |  | $ | (.70    | ) |  | $ | (.31    | )



|(3) | Net Loss Per Share  Basic net loss per share is computed using the weighted average number of common shares outstanding during the period. Diluted net loss per
share is computed using the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive common shares consist of employee stock options, purchase rights from Employee Stock Purchase Plans and
warrants using the treasury stock method and common shares issued assuming conversion of the convertible subordinated notes and convertible subordinated debentures, if dilutive.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The following provides the computation of basic and diluted net loss per
share:



|                                                                                                 |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |        |  
|------------------------------------------------------------------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                 |  | Three months endedSeptember 30, |        |   | Nine months endedSeptember 30, |  
|                                                                                                 |  | 2004                            |        |   | 2003                           |   |         | 2004 |  |   | 2003    |  
|Net loss                                                                                         |  | $                               | (5,746 | ) |                                | $ | (12,790 | )    |  | $ | (36,364 | ) |  | $ | (5,117 | )
|                                                                                                 |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |        |  
|Weighted average shares used to calculate basic net loss per share                               |  |                                 | 73,213 |   |                                |   | 67,886  |      |  |   | 71,045  |   |  |   | 67,554 |  
|Employee stock options and employee stock purchase plan                                          |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |       |  
|                                                                                                 |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |        |  
|Weighted average common and potential common shares used to calculate diluted net loss per share |  |                                 | 73,213 |   |                                |   | 67,886  |      |  |   | 71,045  |   |  |   | 67,554 |  
|                                                                                                 |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |        |  
|Basic net loss per share                                                                         |  | $                               | (.08   | ) |                                | $ | (.19    | )    |  | $ | (.51    | ) |  | $ | (.08   | )
|                                                                                                 |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |        |  
|Diluted net loss per share                                                                       |  | $                               | (.08   | ) |                                | $ | (.19    | )    |  | $ | (.51    | ) |  | $ | (.08   | )
|                                                                                                 |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |        |  



9



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##### Table of Contents

Options and warrants to purchase 18,288 and 17,575 shares of common stock for the three months ended
September 30, 2004 and 2003, respectively and 18,578 and 17,817 for the nine months ended September 30, 2004 and 2003, respectively, were not included in the computation of diluted earnings per share. The options and warrants were anti-dilutive
either because the Company incurred a net loss or because the exercise price was greater than the average market price of the common shares for the respective periods. The effect of the conversion of the Companys convertible subordinated notes
for the three months and nine months ended September 30, 2004, was anti-dilutive. If the convertible subordinated notes had been dilutive, the Companys net loss per share would have included additional earnings of $2,648 and $7,944 as well as
additional incremental shares of 7,413 for the three months and nine months ended September 30, 2004, respectively. The shares issuable on conversion of the Companys convertible subordinated debentures have been excluded from dilutive common
shares, as the circumstances that allow for conversion were not met. If the circumstances had been met and such conversion had been dilutive, additional earnings of $847 and $2,384 and incremental shares of 4,700 would have been included for the
three months and nine months ended September 30, 2004, respectively.



|(4) | Short-Term Borrowings  In July 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This
facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and
0.75%, based on a pricing grid tied to a financial covenant. As a result, the Companys interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the
unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing grid tied to a financial covenant. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of
specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had no short-term borrowings against the credit facility at September 30, 2004 and December 31, 2003. The Companys credit facility prohibits the payment of
dividends.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Other short-term borrowings include
borrowings on multi-currency lines of credit, capital leases and other borrowings. Interest rates are generally based on the applicable countrys prime lending rate, depending on the currency borrowed. Other short-term borrowings of $9,257 and
$6,910 were outstanding under these facilities at September 30, 2004 and December 31, 2003, respectively.



|(5) | Long-Term Notes Payable  In August 2003, the Company issued $110,000 of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 in a private
offering pursuant to SEC Rule 144A. The Debentures have been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Debentures quarterly in February, May, August and November, at a variable interest rate equal to
3-month LIBOR plus 1.65%. The effective interest rate was 2.92% for the nine months ended September 30, 2004. The Debentures are convertible, under certain circumstances, into the Companys common stock at a conversion price of $23.40 per
share, for a total of 4,700 shares. These circumstances generally include (a) the market price of the Companys common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value
of the common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures or certain other corporate transactions. The conversion price may also be adjusted based on certain future transactions. Some or all of the
Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018. See Note 15, Recent Accounting
Pronouncements for a discussion of EITF No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings Per Share.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In June 2002 the Company issued $172,500 of 67/8% Convertible Subordinated Notes (Notes) due 2007 in a private offering pursuant to SEC Rule 144A. The Notes have been registered with the SEC under the Securities Act of 1933. The Company pays
interest on the Notes semi-annually in June and December. The Notes are convertible into the Companys common stock at a conversion price of $23.27 per share, for a total of 7,413 shares. Some or all of the Notes may be redeemed by the Company
for cash on or after June 20, 2005. The Notes rank pari passu with the Debentures.



10



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##### Table of Contents

Other long-term notes payable include multi-currency notes payable and capital leases. Interest rates are
generally based on the applicable countrys prime lending rate, depending on the currency borrowed. Other long-term notes payable of $2,717 and $4,268 were outstanding under these agreements at September 30, 2004 and December 31, 2003,
respectively.



|(6) | Stock Repurchases -The board of directors has authorized the Company to repurchase shares in the open market. There were no repurchases in the nine months ended
September 30, 2004. In August 2003, the Company used a portion of the proceeds from the sale of the Debentures to repurchase 1,750 shares of common stock for an aggregate purchase price of $29,785. No other shares were repurchased in the first nine
months of 2003. The Company considers market conditions, alternative uses of cash and balance sheet ratios when evaluating share repurchases.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(7) | Supplemental Cash Flow Information-The following provides additional information concerning supplemental disclosures of cash flow activities:
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------



|                                |  |      |       |      |   |      
|------------------------------- |  | ---- | ----- | ---- | - | -----
|Nine months ended September 30, |  | 2004 |       | 2003
|Interest paid                   |  | $    | 9,287 |      | $ | 7,397
|Income tax paid, net            |  | $    | 1,158 |      | $ | 2,874



|(8) | Comprehensive Loss- The following provides a summary of comprehensive loss:
|--- | ---------------------------------------------------------------------------



|                                                    |  |      |         |   |      |   |        |  
|--------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------ | -
|Nine months ended September 30,                     |  | 2004 |         |   | 2003 |  
|Net loss                                            |  | $    | (36,364 | ) |      | $ | (5,117 | )
|Change in unrealized gain on derivative instruments |  |      | 687     |   |      |   | 304    |  
|Change in accumulated translation adjustment        |  |      | (1,155  | ) |      |   | 4,132  |  
|                                                    |  |      |         |   |      |   |        |  
|Comprehensive loss                                  |  | $    | (36,832 | ) |      | $ | (681   | )
|                                                    |  |      |         |   |      |   |        |  



|(9) | Emulation Litigation Settlement and Other Special Charges For the nine months ended September 30, 2004, the Company recorded special charges of $4,370. These
charges primarily consisted of accruals for excess leased facilities and costs incurred for employee terminations.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Excess leased facility costs of $1,240 primarily consist of adjustments to previously recorded non-cancelable lease payments for leases of facilities in
North America and Europe. These adjustments are a result of reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities are located remaining at depressed levels longer than originally
anticipated. Non-cancelable lease payments on these excess leased facilities should be expended over seven years. In addition to the excess leased facility costs, the Company recorded a $758 write-off of leasehold improvements for one of the
facilities in North America.



The Company rebalanced its
workforce by 41 employees during the nine months ended September 30, 2004. The reduction impacted several employee groups. Employee severance costs of $1,997 included severance benefits, notice pay and outplacement services. Termination benefits
were communicated to the affected employees prior to the end of the quarter in which the charge was recorded. The majority of these costs were expended during the first nine months of 2004. There have been no significant modifications to the amount
of these charges.



Other costs of $590 include costs incurred
to restructure the organization other than employee rebalances and excess leased facility costs.



11



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##### Table of Contents

In addition, the Company reversed $215 of the remaining accrual related to the emulation litigation with
Cadence Design Systems, Inc.



For the nine months ended
September 30, 2003, the Company recorded special charges of $26,575. These charges primarily consisted of costs incurred for the settlement of emulation litigation, an accrual for excess leased facility costs and costs incurred for employee
terminations.



Cadence Design Systems, Inc. (Cadence) and the
Company announced in September 2003 that they agreed to settle all outstanding litigation between the companies relating to emulation and acceleration systems. The companies also reached agreement that, for a period of seven years, neither will sue
the other over patented emulation and acceleration technology. In connection with the settlement, the Company recorded emulation litigation settlement costs of $20,264, which included a cash settlement of $18,000 paid to Cadence, an accrual for
expected costs to make available certain of its products to the OpenAccess computing environment as specified in the settlement agreement, and attorneys fees.



Excess leased facility costs of $4,487 primarily consist of adjustments to previously recorded non-cancelable lease payments
for leases of three facilities in North America. These adjustments are a result of reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities are located remaining at depressed levels
longer than originally anticipated. Non-cancelable lease payments on these excess leased facilities should be expended over seven years. In addition, the Company recorded non-cancelable lease payments for two facilities in North America. These
facilities were permanently abandoned and the payments are net of estimated sublease income. Non-cancelable lease payments on these excess leased facilities should be expended within the next 12 months.



The Company rebalanced its workforce by 47 employees during the nine months
ended September 30, 2003. This reduction impacted several employee groups. Employee severance costs of $1,594 included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior
to the end of the quarter in which the charge was recorded. The majority of these costs were expended during the first nine months of 2003. There have been no significant modifications to the amount of these charges.



Accrued special charges are included in accrued liabilities and other
long-term liabilities on the consolidated balance sheets. The following table shows changes in accrued special charges during 2004:



|                                                |  |                                          |        |                                        |   |       |              |  |   |                                                   |   |  |   |       
|----------------------------------------------- |  | ---------------------------------------- | ------ | -------------------------------------- | - | ----- | ------------ |  | - | ------------------------------------------------- | - |  | - | ------
|                                                |  | AccruedSpecialCharges atDecember 31,2003 |        | 2004Charges(excludingasset write-offs) |   |       | 2004Payments |  |   | Accrued Special Charges at September 30, 2004 (1)
|Emulation litigation settlement                 |  | $                                        | 1,536  |                                        | $ | (215  | )            |  | $ | (1,109                                            | ) |  | $ | 212   
|Employee severance and related costs            |  |                                          | 2,681  |                                        |   | 1,997 |              |  |   | (3,719                                            | ) |  |   | 959   
|Lease termination fees and other facility costs |  |                                          | 10,034 |                                        |   | 1,240 |              |  |   | (1,987                                            | ) |  |   | 9,287 
|Other costs                                     |  |                                          |       |                                        |   | 590   |              |  |   | (539                                              | ) |  |   | 51    
|                                                |  |                                          |        |                                        |   |       |              |  |   |                                                   |   |  |   |       
|Total                                           |  | $                                        | 14,251 |                                        | $ | 3,612 |              |  | $ | (7,354                                            | ) |  | $ | 10,509
|                                                |  |                                          |        |                                        |   |       |              |  |   |                                                   |   |  |   |       

---

| | (1) | Of the $10,509 total accrued special charges at September 30, 2004, $6,682 represents the long-term portion of accrued lease termination fees and other facility costs. The remaining
balance of $3,827 represents the short-term portion of accrued special charges.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(10) | Merger and Acquisition Related Charges In September 2004, the Company acquired 0-In Design Automation Inc. (0-In), a provider of electronic design automation
tools for integrated circuit and system-on-chip designs. The acquisition was an investment aimed at expanding the Companys product offering and increasing revenue growth which supported the premium paid over the fair market value of the
individual assets. The outstanding shares of common stock and preferred stock of 0-In were converted into
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



12



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##### Table of Contents

approximately 4,507 shares of the Companys common stock, of which approximately 541 shares have
been deposited in an indemnity escrow account. The shares were valued at the closing price of $11.00 per share as reported on The NASDAQ Stock Market on September 1, 2004. 0-In stockholders and certain employees will receive future contingent
earn-out payments based on the Companys revenues derived from 0-In products and technologies. The total purchase price including acquisition costs was $52,319. The Company recorded severance costs related to 0-In employees of $105 due to the
overlap of employee skill sets as a result of the acquisition. In addition, the Company recorded costs for termination of a distributor contract of $282. The excess of tangible assets acquired over liabilities assumed was $715. The cost of the
acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $6,400, goodwill of $39,357,
technology of $4,400, other identified intangible assets of $5,990, net of related deferred tax liability of $4,156. The technology is being amortized to cost of revenues over three years. The other identified intangible assets are being amortized
to operating expenses over two to five years.



Additionally,
during the nine months ended September 30, 2004, the Company acquired (i) Project Technology Inc., (ii) the remaining 49% ownership interest of its Korean distributor, Mentor Korea Co. Ltd. (MGK) for a total ownership interest of 100%, and (iii) the
parallel and serial ATA IP business division of Palmchip Corporation (Palmchip). The acquisitions were investments aimed at expanding the Companys product offerings and increasing revenue growth. The aggregate purchase price including
acquisition costs for these three acquisitions was $7,750. The aggregate excess of liabilities assumed over tangible assets acquired was $338. The minority interest recorded in connection with the original 51% ownership in MGK was $3,383, less
dividends paid in prior years to minority shareholders of $1,975, reducing the acquisition cost to be allocated by a total of $1,408. The purchase accounting allocations resulted in a charge for in-process R&D of $1,250, goodwill of $3,610,
technology of $1,050 and other identified intangible assets of $770. The technology is being amortized to cost of revenues over two to three years. The other identified intangible assets are being amortized to operating expenses over three years. In
connection with the Palmchip acquisition, the Company concurrently licensed software to Palmchip under term licenses and entered into an agreement to provide services. Payment for these arrangements was incorporated into the purchase price of the
acquisition and resulted in a reduction of cash paid to Palmchip of $1,208. The Company used an independent third party valuation firm to determine the allocation of the purchase price of these acquisitions.



The separate results of operations for the acquisitions for the nine months
ended September 30, 2004 were not material compared to the Companys overall results of operations and accordingly pro-forma financial statements of the combined entities have been omitted. The results of operations are included in the
Companys consolidated financial statements from the date of acquisition forward.



During the nine months ended September 30, 2003, the Company acquired (i) the Technology Licensing Group business of Alcatel (Alcatel), (ii) Translogic Polska Sp z o.o. (Translogic), (iii) the distributorship, Mentor
Italia S.r.l. (Mentor Italia), (iv) the business and technology of DDE-EDA A/S (DDE), and (v) First Earth Limited. The acquisitions were investments aimed at expanding the Companys product offering and increasing revenue growth. The aggregate
purchase price including acquisition costs for these five acquisitions was $13,846. The aggregate excess of tangible assets acquired over liabilities assumed was $456. The purchase accounting allocations resulted in a charge for in-process research
and development (R&D) of $1,710, goodwill of $7,230, technology of $3,910 and other identified intangible assets of $540. The technology is being amortized to cost of revenues over five years. The other identified intangible assets are being
amortized to operating expenses over three years. In connection with the Alcatel acquisition, the Company concurrently licensed software to Alcatel under term licenses and entered into an agreement to provide services. Payment for these arrangements
was incorporated into the purchase price of the acquisition and resulted in a reduction of cash paid to Alcatel of $3,804. The Company used an independent third party valuation firm to determine the allocation of the purchase price of these
acquisitions.



In addition, during the three months ended June
30, 2003, the Company recorded a one-time charge to operations of $150 for the acquisition of the in-process R&D of New Design Paradigm, Limited, a developer and marketer of engineering-design software systems for the automotive and aerospace
industries.



13



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##### Table of Contents

|(11) | Derivative Instruments and Hedging Activities  The Company is exposed to fluctuations in foreign currency exchange rates. To manage the volatility relating to
these exposures, exposures are aggregated on a consolidated basis to take advantage of natural offsets. For exposures that are not offset, the Company enters into short-term foreign currency forward and option contracts to partially offset these
anticipated exposures. The primary exposures that do not currently have natural offsets are the Japanese yen where the Company is in a long position and the Euro where the Company is in a short position. The Company formally documents all
relationships between foreign currency contracts and hedged items as well as its risk management objectives and strategies for undertaking various hedge transactions. All hedges designated as cash flow hedges are linked to forecasted transactions
and the Company assesses, both at inception of the hedge and on an ongoing basis, the effectiveness of the foreign exchange contracts in offsetting changes in the cash flows of the hedged items. The effective portions of the net gains or losses on
foreign currency contracts are reported as a component of accumulated other comprehensive income in stockholders equity. Accumulated other comprehensive income associated with hedges of forecasted transactions is reclassified to the
consolidated statement of operations in the same period as the forecasted transaction occurs. The Company discontinues hedge accounting prospectively when it is determined that a foreign currency contract is not highly effective as a hedge under the
requirements of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Any gain or loss deferred through that date remains in accumulated other comprehensive income until the forecasted transaction occurs at which
time it is reclassified to the consolidated statement of operations. To the extent the transaction is no longer deemed probable of occurring, hedge accounting treatment is discontinued prospectively and amounts deferred are reclassified to other
income or expense.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The fair value of foreign
currency forward and option contracts, recorded in prepaid expenses and other in the consolidated balance sheet, was $2,710 and $11 at September 30, 2004 and December 31, 2003, respectively.



The following provides a summary of activity in accumulated other
comprehensive income relating to the Companys hedging program:



|                                                    |  |      |       |   |      |   |      |  
|--------------------------------------------------- |  | ---- | ----- | - | ---- | - | ---- | -
|Nine months ended September 30,                     |  | 2004 |       |   | 2003 |  
|Beginning balance                                   |  | $    |      |   |      | $ | (171 | )
|Favorable changes in fair value of cash flow hedges |  |      | 1,014 |   |      |   | 621  |  
|Net (gain) loss transferred to earnings             |  |      | (327  | ) |      |   | (317 | )
|                                                    |  |      |       |   |      |   |      |  
|Net unrealized gain                                 |  | $    | 687   |   |      | $ | 133  |  
|                                                    |  |      |       |   |      |   |      |  



The remaining balance
in accumulated other comprehensive income at September 30, 2004 represents a net unrealized gain on foreign currency contracts relating to hedges of forecasted revenues and expenses expected to occur during 2004 and 2005. These amounts will be
transferred to the consolidated statement of operations upon recognition of the related revenue and recording of the respective expenses. The Company expects substantially all of the balance in accumulated other comprehensive income to be
reclassified to the consolidated statement of operations within the next year. The Company transferred a $897 deferred gain and a $443 deferred loss to system and software revenues relating to foreign currency contracts hedging revenues for the nine
months ended September 30, 2004 and 2003, respectively. The Company transferred a $570 deferred loss and a $760 deferred gain to operating expenses relating to foreign currency contracts hedging commission and other expenses for the nine months
ended September 30, 2004 and 2003, respectively.



The Company
enters into foreign currency contracts to offset the earnings impact relating to the variability in exchange rates on certain short-term monetary assets and liabilities denominated in non-functional currencies. These foreign exchange contracts are
not designated as hedges. Changes in the fair value of these contracts are recognized currently in earnings in other income, net to offset the remeasurement of the related assets and liabilities.



In accordance with SFAS No. 133, the Company excludes changes in fair value
relating to time value of foreign currency contracts from its assessment of hedge effectiveness. The Company recorded income relating to time value in other income, net, of $352 and $109 for the three months ended September 30, 2004 and 2003,
respectively, and $737 and $382 for the nine months ended September 30, 2004 and 2003,



14



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respectively. The Company recorded expense related to time value in interest expense of $137 and $188 for
the three months ended September 30, 2004 and 2003, respectively, and $375 and $519 for the nine months ended September 30, 2004 and 2003, respectively.



|(12) | Income Taxes - The income tax benefit was $1,304 for the three months ended September 30, 2004 while the nine months ended September 30, 2004 had a provision of
$36,665, compared to income tax benefits of $9,781 and $7,863 for the comparable periods of 2003. On a quarterly basis, the Company evaluates its expected income tax expense or benefit based on its year to date operations and records an adjustment
in the current quarter. The net tax provision is the result of the mix of profits earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. The provision for income taxes differs from tax computed at the
federal statutory income tax rate primarily due to the impact of a large one-time dividend declared by a foreign subsidiary as well as the impact of state taxes and the amortization of a deferred tax charge recorded in 2002, offset in part by the
impact of the tax rate differential on earnings of foreign subsidiaries. Tax expense of $36,650 was provided on the declaration of a $120,000 dividend from a foreign subsidiary and is reflected in the tax provision for the nine months ended
September 30, 2004. The dividend was declared to increase the Companys future flexibility to marshal the Companys foreign generated cash in the United States for operating and acquisition purposes and to utilize United States deferred
tax assets. Because the Company had sufficient net operating loss and tax credit carryforwards to offset the tax liability for tax return purposes, the Company incurred a federal and state cash tax liability of approximately $3,000 as a result of
the dividend and realized $33,650 of its deferred tax assets.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Company has not provided for United States income taxes on the undistributed earnings of foreign subsidiaries because they are considered permanently invested outside of the United States. Upon repatriation, some
of these earnings would generate foreign tax credits which may reduce the Federal tax liability associated with any future foreign dividend.



|(13) | Commitments and Contingencies 
|---- | -------------------------------



Leases



The Company leases a majority of its field office facilities under non-cancelable operating leases. In addition, the Company leases certain equipment used
in its research and development activities. This equipment is generally leased on a month-to-month basis after meeting a six-month lease minimum.



Indemnifications



The Companys license and services agreements include a limited indemnification provision for claims from third-parties relating to the
Companys intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5, Accounting for Contingencies. The indemnification is generally limited to the amount paid by the customer. At
September 30, 2004, the Company is not aware of any material liabilities arising from these indemnifications.



Legal Proceedings



From time to time the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include
disputes and lawsuits relating to intellectual property rights, licensing, contracts and employee relations matters. The Company believes that the outcome of current litigation, individually and in the aggregate, will not have a material affect on
the Companys results of operations.



|(14) | Segment Reporting- 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. To determine what information to report under SFAS No. 131, the Company reviewed the Chief Operating Decision Makers (CODM) method of
analyzing the operating segments to determine resource allocations and performance assessments. The Companys CODMs are the Chief Executive Officer and the President.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Company operates exclusively in the electronic design automation (EDA) industry. The Company markets its products and
services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. The Company sells and licenses its products through its
direct sales force in North America, Europe, Japan and Pacific Rim, and through distributors where third parties can extend sales reach more effectively or efficiently. The Companys reportable segments are based on geographic area.



15



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##### Table of Contents

All intercompany revenues and expenses are eliminated in computing revenues and operating income (loss).
The corporate component of operating income represents research and development, corporate marketing and selling, corporate general and administration, special charges and merger and acquisition related charges. Corporate capital expenditures and
depreciation and amortization are generated from assets allotted to research and development, corporate marketing and selling and corporate general and administration. Reportable segment information is as follows:



|                        |  |                                 |         |   |                                |   |          |      |  |   |          |   |  |   |          |  
|----------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | -------- | ---- |  | - | -------- | - |  | - | -------- | -
|                        |  | Three months endedSeptember 30, |         |   | Nine months endedSeptember 30, |  
|                        |  | 2004                            |         |   | 2003                           |   |          | 2004 |  |   | 2003     |  
|Revenues                |  |                                 |         |   |                                |   |          |      |  |   |          |   |  |   |          |  
|Americas                |  | $                               | 68,653  |   |                                | $ | 70,740   |      |  | $ | 216,575  |   |  | $ | 227,027  |  
|Europe                  |  |                                 | 47,637  |   |                                |   | 44,120   |      |  |   | 134,757  |   |  |   | 133,380  |  
|Japan                   |  |                                 | 31,337  |   |                                |   | 29,902   |      |  |   | 98,490   |   |  |   | 74,591   |  
|Pacific Rim             |  |                                 | 14,333  |   |                                |   | 12,189   |      |  |   | 46,185   |   |  |   | 38,761   |  
|                        |  |                                 |         |   |                                |   |          |      |  |   |          |   |  |   |          |  
|Total                   |  | $                               | 161,960 |   |                                | $ | 156,951  |      |  | $ | 496,007  |   |  | $ | 473,759  |  
|                        |  |                                 |         |   |                                |   |          |      |  |   |          |   |  |   |          |  
|Operating income (loss) |  |                                 |         |   |                                |   |          |      |  |   |          |   |  |   |          |  
|Americas                |  | $                               | 30,339  |   |                                | $ | 34,920   |      |  | $ | 113,100  |   |  | $ | 120,401  |  
|Europe                  |  |                                 | 26,814  |   |                                |   | 24,497   |      |  |   | 69,740   |   |  |   | 70,883   |  
|Japan                   |  |                                 | 20,544  |   |                                |   | 20,741   |      |  |   | 67,226   |   |  |   | 46,665   |  
|Pacific Rim             |  |                                 | 10,108  |   |                                |   | 8,942    |      |  |   | 33,110   |   |  |   | 28,860   |  
|Corporate               |  |                                 | (92,579 | ) |                                |   | (109,242 | )    |  |   | (274,793 | ) |  |   | (271,798 | )
|                        |  |                                 |         |   |                                |   |          |      |  |   |          |   |  |   |          |  
|Total                   |  | $                               | (4,774  | ) |                                | $ | (20,142  | )    |  | $ | 8,383    |   |  | $ | (4,989   | )
|                        |  |                                 |         |   |                                |   |          |      |  |   |          |   |  |   |          |  



The Company segregates
revenue into three categories of similar products and services. These categories include Integrated Circuit (IC) Design, Systems Design and Professional Services. The IC Design and Systems Design categories include both product and support revenue.
Revenue information is as follows:



|                               |  |                                 |         |                                |   |         |  |      |         |  |   |        
|------------------------------ |  | ------------------------------- | ------- | ------------------------------ | - | ------- |  | ---- | ------- |  | - | -------
|                               |  | Three months endedSeptember 30, |         | Nine months endedSeptember 30,
|                               |  | 2004                            |         | 2003                           |   | 2004    |  | 2003
|Revenues                       |  |                                 |         |                                |   |         |  |      |         |  |   |        
|Integrated Circuit (IC) Design |  | $                               | 108,340 |                                | $ | 106,904 |  | $    | 340,328 |  | $ | 318,781
|Systems Design                 |  |                                 | 47,120  |                                |   | 44,007  |  |      | 135,695 |  |   | 136,962
|Professional Services          |  |                                 | 6,500   |                                |   | 6,040   |  |      | 19,984  |  |   | 18,016 
|                               |  |                                 |         |                                |   |         |  |      |         |  |   |        
|Total                          |  | $                               | 161,960 |                                | $ | 156,951 |  | $    | 496,007 |  | $ | 473,759
|                               |  |                                 |         |                                |   |         |  |      |         |  |   |        



|(15) | Recent Accounting Pronouncements- In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on the remaining portions of EITF No. 03-01, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF No. 03-01 provides new disclosure requirements for other-than-temporary impairments on debt and equity investments. Investors are required to disclose
quantitative information about: (i) the aggregate amount of unrealized losses, and (ii) the aggregate related fair values of investments with unrealized losses, segregated into time periods during which the investment has been in an unrealized loss
position of less than 12 months and greater than 12 months. In addition, investors are required to disclose the qualitative information that supports their conclusion that the impairments noted in the qualitative disclosure are not
other-than-temporary. In September 2004, the Financial Accounting Standards Board (FASB) issued a final FASB Staff Position, (FSP) EITF No. 03-01-1, which indefinitely delays the effective date for the measurement and recognition guidance of EITF
No. 03-01. The adoption of this issue is not expected to have a material impact on the Companys financial position or results of operations.
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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On October 13, 2004, the EITF ratified its consensus on EITF No. 04-08, The Effect of Contingently
Convertible Debt on Diluted Earnings per Share. EITF No. 04-08 requires that contingently convertible debt instruments that become convertible on satisfaction of a market price condition be included in diluted earnings per share using the
if-converted method, regardless of whether the market price condition has been met. The EITF is effective for reporting periods ending after December 15, 2004 and requires the retroactive restatement of earnings per share. Under the provisions of
EITF No. 04-08, the Companys Debentures, which represent 4,700 potential shares of common stock, will be included in the calculation of diluted earnings per share, if dilutive, regardless of whether the contingent requirements have been met
for conversion to common stock. The Company will adopt EITF No. 04-08 in the fourth quarter of 2004 and believes that it will not have a material adverse effect on its diluted earnings per share or earnings per share as stated in prior periods.



Item 2. Managements Discussion and Analysis of Results of Operations and Financial Condition

(All numerical references in
thousands, except for percentages and per share data)



OVERVIEW



The Company



The Company is a supplier of electronic design automation (EDA) systems  advanced
computer software, emulation hardware systems and intellectual property designs and databases used to automate the design, analysis and testing of electronic hardware and embedded systems software in electronic systems and components. The Company
markets its products and services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. Through the diversification of
the Companys customer base among these various customer markets, the Company attempts to reduce its exposure to fluctuations within each market. The Company sells and licenses its products through its direct sales force and a channel of
distributors and sales representatives. In addition to its corporate offices in Wilsonville, Oregon, the Company has sales, support, software development and professional service offices worldwide.



Business Environment



Beginning in late 2000, the electronics industry experienced a broad economic downturn. As a
result of this downturn, many of the Companys customers reduced research and development (R&D) budgets, limited general investment in design tools and reduced engineering staff. Although the overall economy and the electronics industry
have gradually recovered during 2003 and 2004, the Companys customers have in general continued to limit EDA spending. Notwithstanding this general trend, customers still require new innovative EDA tools to solve leading edge design problems
and increase productivity and speed time to market. The Company attempts to fill those demands through its relatively young and diverse product portfolio. As a result, the Company had solid performance in 2003 and the first nine months of 2004.
Strength in system design in the military and aerospace segments helped drive revenue growth for the Company in 2003. As customer demand expanded during this time, the Company was able to leverage its strength in system design relative to its major
competitors. As the semiconductor industry began to stabilize in the second half of 2003 and the first nine months of 2004, newer integrated circuit (IC) design tool sales and verification tools sales increased. For the Company, this resulted in
growth in the second half of 2003 and the first nine months of 2004, led by its IC Design to Silicon and Scalable Verification product flows.



The Companys management believes that EDA spending by semiconductor companies generally lags their economic financial recovery by several quarters for two primary
reasons. First, because of the importance of R&D to the future of semiconductor companies, customers try to moderate R&D spending reductions during downturns in comparison to other expense items. As a result, R&D spending as a percentage
of revenue increases. As revenues grow in the early stages of the recovery, customers constrain spending increases until R&D returns to more typical percentage of revenue levels. Second, as a result of reduced engineering staff, customers may
hold excess software licenses of established tools. Hiring must resume before additional software licenses will be required. The exception is for newer software that customers have not previously purchased or have limited quantities to.



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The Companys management believes that the Company will continue to grow revenue and earnings faster than the
industry because of its heavy mix of relatively new products, many of which are in new types of design methodologies that do not currently have a large EDA installed base. The Company will continue its strategy of attempting to develop best in class
point tools with number one market share potential. This strategy is intended to create a diversified product portfolio for the Company that solves customers critical design problems. The Companys management believes that this product
strategy, in conjunction with a customer diversification strategy, has helped reduce the impact of marketplace fluctuations in the past.



License Model Mix



License model trends can have a material impact on various aspects of the Companys business. See Critical Accounting Estimates  Revenue
Recognition on page 20 for a description of the types of product licenses sold by the Company. As the mix among perpetual licenses, fixed term licenses (term) with upfront revenue recognition and term licenses with ratable revenue recognition
(which include due and payable revenue recognition) shifts, revenues, earnings, cash flow and days sales outstanding (DSO) are either positively or negatively affected. The year ended December 31, 2003 marked the third consecutive year in which, as
a percentage of product revenue, term revenue increased while perpetual revenue decreased. This trend has continued through the first nine months of 2004. This trend was primarily the result of two factors. First, the Companys customers are
moving toward the term license model, which provides the customer with greater flexibility for product usage, including the ability to share the products between multiple locations and reconfigure consumption at regular intervals from a fixed
product list. As such, some of the Companys customers have converted their existing installed base from perpetual to term licenses. Second, the weakness in the United States high-technology economy has disproportionately impacted the
Companys smaller customers. Historically these customers have purchased under the perpetual license model.



Under this ongoing shift from perpetual licenses to term licenses with upfront revenue recognition, which the Companys management views as a positive trend, the
Company expects no measurable impact to earnings, but a negative impact on cash flow and DSO. As customers move away from perpetual licenses and into term licenses, the renewability and repeatability of the Companys business is increased. This
provides opportunity for increased distribution of newer products earlier in their lifecycles.



Product Developments



During
2004, the Company continued to execute its strategy of focusing on new customer problem areas, as well as building upon its well-established product families. The Companys management believes that customers, faced with leading-edge design
challenges, choose the best products in each category to build their design environment. The Company generally has focused its internal development efforts on areas where it believes it can build a number one market position, or extend an existing
number one market position.



New products delivered by the Company in the area
of printed circuit board design included: I/O Designer (a tool that enables large and complex FPGAs to be efficiently incorporated into the design process), TeamPCB (a tool that allows multiple designers to simultaneously work on the same design
without affecting each others work) and advanced high-speed design and analysis software.



In the Design-to-Silicon Division, the Company continued to extend the scope of the Calibre platform, obtaining significant new customer engagements and orders with its resolution enhancement technology. As part of
this platform extension, the Company is continuing the development of new design-for-manufacturing tools, the first of which were announced in October 2004.



In 2003, the Company launched its Scalable Verification Environment featuring a suite of tools designed to solve the verification challenges that design engineers face.
According to Collett International, an industry analysis firm, engineers spend approximately 62% of their design effort verifying their designs. This dominance of verification in the design process has driven many customers to seek new solutions to
enhance their verification abilities.



In 2004, the Company launched Catapult C
Synthesis, a new tool that enables designers to work at a higher level of design abstraction. Using C language rather than traditional hardware design languages can improve design quality as well as designer productivity.



The acquisitions that were completed during 2004 provide the Company with new product
offerings. As a result of the 0-In acquisition, the Company acquired assertion-based verification products that are important to solidifying and expanding the market opportunity for the Scalable Verification platform. With the acquisition of the
Palmchip intellectual property (IP) business, the Company added Parallel and Serial ATA IP cores, which broaden its portfolio of certified, standards-based IP for the storage communications market.



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##### Table of Contents

The Companys management believes that the development and commercialization of EDA software tools is usually a
multi-year process with limited customer adoption in the first years of tool availability. Once tools are adopted, however, their life spans tend to be long and healthy. The Companys management believes that the Companys relatively young
and diverse product lines are positioned for growth over the long-term.



Q3 2004 Financial Performance



| | Total revenues were $161,960 and $496,007 for the three months and nine months ended September 30, 2004, respectively, a 3% and 5% increase over the comparable periods of 2003,
primarily as a result of favorable currency effects from strengthening of the Japanese yen, the Euro and the British pound sterling as well as strength in the Scalable Verification and Integrated System Design product lines.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Product revenues split by license model for the three months ended September 30, 2004 were 47% term with upfront revenue recognition, 34% perpetual and 19% term with ratable revenue
recognition (which include due and payable revenue recognition), compared to product revenues split by license model for the comparable period of 2003 of 43% term with upfront revenue recognition, 40% perpetual and 17% term with ratable revenue
recognition.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Service and support revenues for the three months and nine months ended September 30, 2004 were $72,027 and $213,462, respectively, a 2% and 3% increase over the comparable periods
of 2003 service and support revenues of $70,785 and $207,990, respectively, resulting largely from favorable currency effects from strengthening of the Japanese yen, the Euro and the British pound sterling.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | By geography, in the Americas revenues decreased 3% and 5% for the three months and nine months ended September 30, 2004, respectively, as compared to the comparable periods of
2003. Revenues increased 8% and 1% in Europe, 5% and 32% in Japan due to new term business and 18% and 19% in Pacific Rim for the three months and nine months ended September 30, 2004, respectively. The Americas contributed the largest share of
revenues at 42% and 44% for the three months and nine months ended September 30, 2004, respectively.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Net loss for the three months and nine months ended September 30, 2004 was $5,746 and $36,364, respectively, compared to a net loss of $12,790 and $5,117 in the comparable periods
of 2003. The decreased net loss for the three months ended September 30, 2004 was primarily due to a reduction in special charges as a result of the Quickturn emulation litigation settlement in 2003. The increased net loss for the nine months ended
September 30, 2004 was primarily due to an increase in the tax provision due to the declaration of a $120,000 dividend from a foreign subsidiary. This increase was partially offset by increased revenues for the three months and nine months ended
September 30, 2004 as compared to the comparable periods of 2003.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Trade accounts receivable, net decreased to $211,204 at September 30, 2004, down 6% from $223,670 at December 31, 2003. Average days sales outstanding increased from 100 days at
December 31, 2003 to 117 days at September 30, 2004. The increase in days sales outstanding was primarily due to the seasonal decrease in revenue for the three months ended September 30, 2004 as compared to the three months ended December 31, 2003.
In addition, the product revenue split for term with upfront revenue recognition decreased from 61% for the three months ended December 31, 2003 to 47% for the three months ended September 30, 2004.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Cash generated by operating activities was $37,906 for the nine months ended September 30, 2004 compared to cash used of $6,394 in the comparable period of 2003. The increase in
cash flows from operating activities was primarily due to a decrease in accounts receivable and an increase in deferred revenue. At September 30, 2004, cash, cash equivalents and short-term investments were $100,990, up 42% from $71,324 at December
31, 2003.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



CRITICAL ACCOUNTING ESTIMATES



The Companys discussion and analysis of its financial condition and
results of operations are based upon the Companys consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial
statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities and contingencies as of the date of the financial statements and the reported amounts of revenues and expenses during the
reporting periods. The Company evaluates its estimates on an on-going basis. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes
the following are the critical accounting estimates and judgments used in the preparation of its consolidated financial statements.



19



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##### Table of Contents

Revenue Recognition



The Company reports revenue in two categories based upon how the revenue is generated: (i) system and software and (ii) service and support.



System and software revenue - System and software
revenues are derived from the sale of licenses of software products and emulation hardware systems.



The Company licenses software using two different license types:



| | 1. | Term licenses are for a specified time period, typically three years with payments spread over the license term, and do not provide the customer with the right to use the product
after the end of the term. The Company generally recognizes product revenue from term installment license agreements upon shipment and start of the license term. The Company uses these agreements as a standard business practice and has a history of
successfully collecting under the original payment terms without making concessions on payments, products or services. If the Company no longer had a history of collecting without providing concessions on term agreements, then revenue would be
required to be recognized as the payments become due and payable over the license term. This change would have a material adverse impact on the Companys near-term results of operations. In a situation in which a risk of concession may exist on
a term license agreement, revenue is recognized on a due and payable basis, which is the lesser of the ratable portion of the entire fee or the customer installments as they become due and payable. In a term license agreement where the Company
provides the customer with rights to unspecified or unreleased future products, revenue is recognized ratably over the license term.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | Perpetual licenses provide the customer with the right to use the product in perpetuity and typically do not provide for extended payment terms. The Company recognizes product
revenue from perpetual license agreements upon delivery to the customer when the likelihood of product return is remote. If the agreement provides for customer payment terms that are different than the standard payment terms in the customers
jurisdiction, product revenue is recognized as payments become due and payable.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Service and support revenue- Service and support revenue consist of revenues from support contracts and professional services, which include consulting services, training services and other services. The
Company records service revenue as the services are provided to the customer. Support revenue is recognized over the support term. For multi-element arrangements that include support, support is allocated based on vendor specific objective evidence
(VSOE) of the fair value of support. For term licenses, VSOE is established by the price charged when such support is offered as optional during the license term. For perpetual licenses, VSOE is established by the price charged when such support is
sold separately.



The Company determines whether software product revenue
recognition is appropriate based upon the evaluation of whether the following four criteria have been met:



|1. | Persuasive evidence of an arrangement exists  An agreement signed by the customer and the Company.
|-- | ---------------------------------------------------------------------------------------------------



|2. | Delivery has occurred  The software has been shipped, the customer is in possession of the software or the software has been made available to the customer through electronic
delivery.
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. | Fee is fixed and determinable  The amount of the fee and the due date have been fixed at execution of the arrangement without the possibility of future adjustments or
concessions.
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. | Collectibility is probable  The customer is expected to pay for products or services without the Company providing future concessions to the customer.
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------



Valuation of Trade Accounts Receivable



The Company maintains allowances for doubtful accounts on trade accounts receivable and
term receivables, long-term for estimated losses resulting from the inability of its customers to make required payments. The Company evaluates the collectibility of its trade accounts receivable based on a combination of factors. The Company
regularly analyzes its customer accounts. When it becomes aware of a specific customers inability to meet its financial obligations, such as in the case of bankruptcy or deterioration in the customers operating results or financial
position, a specific reserve for bad debt is recorded to reduce the related receivable to the amount believed to be collectible. The Company also records unspecified reserves for bad debt for all other customers based on a



20



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##### Table of Contents

variety of factors including length of time the receivables are past due, the financial health of the customers, the
current business environment and historical experience. If circumstances related to specific customers change, estimates of the recoverability of receivables would be adjusted resulting in either additional selling expense or a reduction in selling
expense in the period such determination was made.



Valuation of Deferred
Tax Assets



Deferred tax assets are recognized for deductible
temporary differences, net operating loss carryforwards and credit carryforwards if it is more likely than not that the tax benefits will be realized. The Company has considered future taxable income and ongoing prudent and feasible tax planning
strategies in assessing the need for valuation allowances. The Company has recorded a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. In the event the Company was to determine that it
would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase either income or contributed capital, or decrease goodwill, in the period such determination
was made. Also, if the Company was to determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to increase the valuation allowance on such net deferred tax assets would be charged to
expense in the period such determination was made.



Goodwill, Intangible
Assets and Long-Lived Assets



The Company reviews long-lived assets
and the related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Recoverability of an asset is determined by comparing its carrying amount, including any
associated intangible assets, to the forecasted undiscounted net cash flows of the operation to which the asset relates. If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written
down first, followed by the other long-lived assets of the operation, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Goodwill and intangible assets with indefinite
lives are tested for impairment annually and whenever there is an impairment indicator using a fair value approach. In the event that, in the future, it is determined that the Companys goodwill, intangible or other long-lived assets have been
impaired, an adjustment would be made that would result in a charge for the write-down in the period that determination was made.



Inventory



The Company purchases and commits to purchase inventory based upon forecasted shipments of its emulation hardware systems. The Company evaluates, on a quarterly basis, the need for inventory reserves based on
projections of systems expected to ship within six months. Reserves for excess and obsolete inventory are established to account for the differences between forecasted shipments and the amount of purchased and committed inventory.



Restructuring Charges



The Company has recorded restructuring charges in connection with its plans to better align
the cost structure with projected operations in the future. In accordance with Statement of Financial Accounting Standards (SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities, the Company records liabilities
for costs associated with exit or disposal activities when the liability is incurred. Prior to January 1, 2003, in accordance with Emerging Issues Task Force (EITF) No. 94-3, the Company accrued for restructuring costs when management made a
commitment to an exit plan that specifically identified all significant actions to be taken.



The Company has recorded restructuring charges in connection with employee rebalances based on estimates of the expected costs associated with severance benefits. If the actual cost incurred exceeds the estimated
cost, additional special charges will be recognized. If the actual cost is less than the estimated cost, a benefit to special charges will be recognized.



The Company has also recorded restructuring charges in connection with excess leased facilities to offset future rent, net of estimated sublease income that could be
reasonably obtained, of the abandoned office space and to write-off leasehold improvements on abandoned office space. The Company worked with external real estate experts in each of the markets where properties are located to obtain assumptions used
to determine the best estimate of the net loss. The Companys estimates of expected sublease income could change based on factors that affect the Companys ability to sublease those facilities such as general economic conditions and the
real estate market. If the real estate



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markets worsen and the Company is not able to sublease the properties as expected, additional adjustments may be
required, which would result in additional special charges in the period such determination was made. Likewise, if the real estate market strengthens and the Company is able to sublease the properties earlier or at more favorable rates than
projected, a benefit to special charges will be recognized.



RESULTS OF
OPERATIONS



REVENUES AND GROSS MARGINS



System and Software



System and software revenues are derived from the sale of licenses of software products and
emulation hardware systems. System and software revenues for the three months and nine months ended September 30, 2004 totaled $89,933 and $282,545, respectively, representing an increase of $3,767 or 4% and $16,776 or 6% over the comparable periods
of 2003. The increase for the three months ended September 30,2004 was attributable to (i) an increase in Scalable Verification product revenues primarily attributable to the Modelsim product line and (ii) strength in the Integrated System Design
product lines. The increase for the nine months ended September 30, 2004 was attributable to an increase in Scalable Verification product revenues, which was partially offset by a decrease in Design-to-Silicon product revenues. In addition, system
and software revenues were favorably impacted by approximately 2% due to the strengthening of foreign currencies for the three months and nine months ended September 30, 2004.



System and software gross margins were 94% and 93% for the three months and nine months ended September 30, 2004, respectively, compared to
90% and 92% for the comparable periods of 2003. Gross margin was favorably impacted for the three and nine months ended September 30, 2004 primarily due to a reduction in the amount of royalties paid on increased software product revenues and a
greater mix of higher margin software product revenue versus lower margin emulation hardware system revenue. Additionally, gross margin was favorably impacted for the three months ended September 30, 2004 by sales of previously written down
emulation inventory.



Amortization of purchased technology to system and
software cost of goods sold was $2,672 and $7,642 for the three months and nine months ended September 30, 2004, respectively, compared to $2,319 and $6,797 in the comparable periods of 2003. The increase in amortization of purchased technology is
primarily attributable to a full nine months of amortization on 2003 acquisitions and new acquisitions in 2004. Purchased technology costs are amortized over two to five years to system and software cost of revenues.



Service and Support



Service and support revenues consist of revenues from support contracts and professional
services, which include consulting services, training services and other services. Service and support revenues for the three months and nine months ended September 30, 2004 totaled $72,027 and $213,462, respectively, representing an increase of
$1,242 or 2% and $5,472 or 3% over the comparable periods of 2003. The increases in service and support revenues for the three and nine months ended September 30, 2004 were primarily attributable to the strengthening of foreign currencies.



Service and support gross margins for the three months and nine months ended
September 30, 2004 were 72% compared to 71% and 70% for the comparable periods of 2003, respectively. Service and support gross margin increased for the three and nine months ended September 30, 2004 compared to the same period in 2003 primarily due
to higher revenue resulting from the strengthening of foreign currencies and lower costs resulting from headcount reductions.



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Geographic Revenues Information



|                                 |  |      |         |        |    |    |      |   |        
|-------------------------------- |  | ---- | ------- | ------ | -- | -- | ---- | - | -------
|Three months ended September 30, |  | 2004 |         | Change |    |    | 2003
|Americas                         |  | $    | 68,653  |        | (3 | )% |      | $ | 70,740 
|Europe                           |  |      | 47,637  |        | 8  | %  |      |   | 44,120 
|Japan                            |  |      | 31,337  |        | 5  | %  |      |   | 29,902 
|Pacific Rim                      |  |      | 14,333  |        | 18 | %  |      |   | 12,189 
|                                 |  |      |         |        |    |    |      |   |        
|Total                            |  | $    | 161,960 |        |    |    |      | $ | 156,951
|                                 |  |      |         |        |    |    |      |   |        



|                                |  |      |         |        |    |    |      |   |        
|------------------------------- |  | ---- | ------- | ------ | -- | -- | ---- | - | -------
|Nine months ended September 30, |  | 2004 |         | Change |    |    | 2003
|Americas                        |  | $    | 216,575 |        | (5 | )% |      | $ | 227,027
|Europe                          |  |      | 134,757 |        | 1  | %  |      |   | 133,380
|Japan                           |  |      | 98,490  |        | 32 | %  |      |   | 74,591 
|Pacific Rim                     |  |      | 46,185  |        | 19 | %  |      |   | 38,761 
|                                |  |      |         |        |    |    |      |   |        
|Total                           |  | $    | 496,007 |        |    |    |      | $ | 473,759
|                                |  |      |         |        |    |    |      |   |        



Revenues in the Americas decreased
for the three months ended September 30, 2004 as compared to the three months ended September 30, 2003 due to lower emulation hardware system sales. Revenues in the Americas decreased for the nine months ended September 30, 2004 as compared to the
nine months ended September 30, 2003 primarily due to a decrease in Integrated Systems Design product lines. Revenues outside the Americas represented 58% and 56% of total revenues for the three months and nine months ended September 30, 2004,
respectively, compared to 55% and 52% for the comparable periods of 2003. The effects of exchange rate differences from the European currencies to the United States dollar positively impacted European revenues by approximately 2% for the three and
nine months ended September 30, 2004. Exclusive of currency effects, higher revenue for the three months ended September 30, 2004 compared to the comparable period of 2003 was primarily due to higher software product sales, while lower revenue for
the nine months ended September 30, 2004 compared to the comparable period of 2003 was primarily due to lower emulation hardware systems sales, partially offset by increased support revenue. The effects of exchange rate differences from the Japanese
yen to the United States dollar positively impacted Japanese revenues by approximately 7% and 10% for the three months and nine months ended September 30, 2004, respectively. Exclusive of currency effects, lower revenue for the three months ended
September 30, 2004 compared to the comparable period of 2003 was primarily due to lower software product sales, while higher revenues for the nine months ended September 30, 2004 compared to the comparable period of 2003 were primarily attributable
to higher software product sales and an increase in service and support revenue. Revenues in the Pacific Rim increased for the three and nine months ended September 30, 2004 as compared to the comparable periods of 2003 primarily as a result of
higher software product and support sales. Since the Company generates more than half of its revenues outside of the U.S. and expects this to continue in the future, revenue results should continue to be impacted by the effects of future foreign
currency fluctuations.



OPERATING EXPENSES



|                                       |  |                                  |        |                                 |         |    |      |   |        |  |        |         |  |      |    |  |   |        
|-------------------------------------- |  | -------------------------------- | ------ | ------------------------------- | ------- | -- | ---- | - | ------ |  | ------ | ------- |  | ---- | -- |  | - | -------
|                                       |  | Three months ended September 30, |        | Nine months ended September 30,
|                                       |  | 2004                             |        | Change                          |         |    | 2003 |   | 2004   |  | Change |         |  | 2003
|Research and development               |  | $                                | 50,990 |                                 | 10      | %  |      | $ | 46,522 |  | $      | 147,695 |  | 11   | %  |  | $ | 133,363
|Marketing and selling                  |  | $                                | 63,304 |                                 | 10      | %  |      | $ | 57,781 |  | $      | 191,055 |  | 9    | %  |  | $ | 175,678
|General and administration             |  | $                                | 18,120 |                                 | 1       | %  |      | $ | 18,011 |  | $      | 55,430  |  | 2    | %  |  | $ | 54,154 
|Amortization of intangible assets      |  | $                                | 916    |                                 | 2       | %  |      | $ | 899    |  | $      | 2,488   |  | (16  | )% |  | $ | 2,975  
|Emulation litigation settlement        |  | $                                |       |                                 | (100    | )% |      | $ | 20,264 |  | $      |        |  | (100 | )% |  | $ | 20,264 
|Special charges                        |  | $                                | 507    |                                 | (90     | )% |      | $ | 4,948  |  | $      | 4,370   |  | (31  | )% |  | $ | 6,311  
|Merger and acquisition related charges |  | $                                | 7,290  |                                 | (12,050 | )% |      | $ | 60     |  | $      | 7,650   |  | 311  | %  |  | $ | 1,860  



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Research and Development



R&D costs increased for the three months and nine months ended September 30, 2004 over the comparable periods of 2003 primarily due to
increased headcount, including headcount in the systems design and embedded system product lines and due to a weaker United States dollar during 2004 that increased R&D expenses by approximately 2% and 3% for the three months and nine months
ended September 30, 2004, respectively.



Marketing and Selling



Marketing and selling costs increased for the three months and nine
months ended September 30, 2004 over the comparable periods of 2003 primarily due to higher headcount and due to a weaker United States dollar during 2004 that increased marketing and selling expenses by approximately 3% and 4% for the three months
and nine months ended September 30, 2004, respectively.



General and
Administration



General and administration costs increased for the
three months and nine months ended September 30, 2004 over the comparable periods of 2003 primarily due to higher headcount and a weaker United States dollar during 2004 that increased general and administration expenses by approximately 2% and 3%
for the three months and nine months ended September 30, 2004, respectively. These increases were offset by no emulation litigation related costs due to the settlement of the emulation litigation with Cadence Design System, Inc. in 2003.



Amortization of Intangible Assets



Amortization of intangible assets increased for the three months ended September 30, 2004 as
compared to the comparable period of 2003 due to acquisitions during the twelve months ended September 30, 2004, partially offset by the complete amortization of intangible assets related to certain prior year acquisitions. Amortization of
intangible assets decreased for the nine months ended September 30, 2004 as compared to the comparable period of 2003 due to the complete amortization of intangible assets related to certain prior year acquisitions, partially offset by acquisitions
during the twelve months ended September 30, 2004.



Emulation Litigation
Settlement and Other Special Charges



For the nine months ended
September 30, 2004, the Company recorded special charges of $4,370. These charges primarily consisted of accruals for excess leased facilities and costs incurred for employee terminations.



Excess leased facility costs of $1,240 primarily consist of adjustments to previously
recorded non-cancelable lease payments for leases of facilities in North America and Europe. These adjustments are a result of reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities
are located remaining at depressed levels longer than originally anticipated. Non-cancelable lease payments on these excess leased facilities should be expended over seven years. In addition to the excess leased facility costs, the Company recorded
a $758 write-off of leasehold improvements for one of the facilities in North America.



The Company rebalanced its workforce by 41 employees during the nine months ended September 30, 2004. The reduction impacted several employee groups. Employee severance costs of $1,997 included severance benefits, notice pay and
outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the charge was recorded. The majority of these costs were expended during the first nine months of 2004. There have been
no significant modifications to the amount of these charges.



Other costs of
$590 include costs incurred to restructure the organization other than employee rebalances and excess leased facility costs.



In addition, the Company reversed $215 of the remaining accrual related to the emulation litigation with Cadence Design Systems, Inc.



For the nine months ended September 30, 2003, the Company recorded special charges of
$26,575. These charges primarily consisted of costs incurred for the settlement of emulation litigation, an accrual for excess leased facility costs and costs incurred for employee terminations.



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Cadence Design Systems, Inc. (Cadence) and the Company announced in September 2003 that they agreed to settle all
outstanding litigation between the companies relating to emulation and acceleration systems. The companies also reached agreement that, for a period of seven years, neither will sue the other over patented emulation and acceleration technology. In
connection with the settlement, the Company recorded emulation litigation settlement costs of $20,264, which included a cash settlement of $18,000 paid to Cadence, an accrual for expected costs to make available certain of its products to the
OpenAccess computing environment as specified in the settlement agreement, and attorneys fees.



Excess leased facility costs of $4,487 primarily consist of adjustments to previously recorded non-cancelable lease payments for leases of three facilities in North America. These adjustments are a result of
reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities are located remaining at depressed levels longer than originally anticipated. Non-cancelable lease payments on these excess
leased facilities should be expended over seven years. In addition, the Company recorded non-cancelable lease payments for two facilities in North America. These facilities were permanently abandoned and the payments are net of estimated sublease
income. Non-cancelable lease payments on these excess leased facilities should be expended within the next 12 months.



The Company rebalanced its workforce by 47 employees during the nine months ended September 30, 2003. This reduction impacted several employee groups. Employee severance
costs of $1,594 included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the charge was recorded. The majority of these costs were
expended during the first nine months of 2003. There have been no significant modifications to the amount of these charges.



Merger and Acquisition Related Charges



In September 2004, the Company acquired 0-In Design Automation Inc. (0-In), a provider of electronic design automation tools for integrated circuit and system-on-chip
designs. The acquisition was an investment aimed at expanding the Companys product offering and increasing revenue growth which supported the premium paid over the fair market value of the individual assets. The outstanding shares of common
stock and preferred stock of 0-In were converted into approximately 4,507 shares of the Companys common stock, of which approximately 541 shares have been deposited in an indemnity escrow account. The shares were valued at the closing price of
$11.00 per share as reported on The NASDAQ Stock Market on September 1, 2004. 0-In stockholders and certain employees will receive future contingent earn-out payments based on the Companys revenues derived from 0-In products and technologies.
The total purchase price including acquisition costs was $52,319. The Company recorded severance costs related to 0-In employees of $105 due to the overlap of employee skill sets as a result of the acquisition. In addition, the Company recorded
costs for termination of a distributor contract of $282. The excess of tangible assets acquired over liabilities assumed was $715. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed.
The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $6,400, goodwill of $39,357, technology of $4,400, other identified intangible assets of $5,990, net of related deferred tax liability of
$4,156. The technology is being amortized to cost of revenues over three years. The other identified intangible assets are being amortized to operating expenses over two to five years.



Additionally, during the nine months ended September 30, 2004, the Company acquired (i) Project Technology Inc., (ii) the remaining 49%
ownership interest of its Korean distributor, Mentor Korea Co. Ltd. (MGK) for a total ownership interest of 100%, and (iii) the parallel and serial ATA IP business division of Palmchip Corporation (Palmchip). The acquisitions were investments aimed
at expanding the Companys product offerings and increasing revenue growth. The aggregate purchase price including acquisition costs for these three acquisitions was $7,750. The aggregate excess of liabilities assumed over tangible assets
acquired was $338. The minority interest recorded in connection with the original 51% ownership in MGK was $3,383, less dividends paid in prior years to minority shareholders of $1,975, reducing the acquisition cost to be allocated by a total of
$1,408. The purchase accounting allocations resulted in a charge for in-process R&D of $1,250, goodwill of $3,610, technology of $1,050 and other identified intangible assets of $770. The technology is being amortized to cost of revenues over
two to three years. The other identified intangible assets are being amortized to operating expenses over three years. In connection with the Palmchip acquisition, the Company concurrently licensed software to Palmchip under term licenses and
entered into an agreement to provide services. Payment for these arrangements was incorporated into the purchase price of the acquisition and resulted in a reduction of cash paid to Palmchip of $1,208. The Company used an independent third party
valuation firm to determine the allocation of the purchase price of these acquisitions.



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During the nine months ended September 30, 2003, the Company acquired (i) the Technology Licensing Group business of
Alcatel (Alcatel), (ii) Translogic Polska Sp z o.o. (Translogic), (iii) the distributorship, Mentor Italia S.r.l. (Mentor Italia), (iv) the business and technology of DDE-EDA A/S (DDE), and (v) First Earth Limited. The acquisitions were investments
aimed at expanding the Companys product offering and increasing revenue growth. The aggregate purchase price including acquisition costs for these five acquisitions was $13,846. The aggregate excess of tangible assets acquired over liabilities
assumed was $456. The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $1,710, goodwill of $7,230, technology of $3,910 and other identified intangible assets of $540. The technology is being
amortized to cost of revenues over five years. The other identified intangible assets are being amortized to operating expenses over three years. In connection with the Alcatel acquisition, the Company concurrently licensed software to Alcatel under
term licenses and entered into an agreement to provide services. Payment for these arrangements was incorporated into the purchase price of the acquisition and resulted in a reduction of cash paid to Alcatel of $3,804. The Company used an
independent third party valuation firm to determine the allocation of the purchase price of these acquisitions.



In addition, during the three months ended June 30, 2003, the Company recorded a one-time charge to operations of $150 for the acquisition of the in-process R&D of
New Design Paradigm, Limited, a developer and marketer of engineering-design software systems for the automotive and aerospace industries.



Other Income, Net



Other income, net totaled $2,479 and $5,699 for the three months and nine months ended September 30, 2004, respectively, compared to $2,096 and $4,508 for the comparable
periods in 2003. Interest income was $2,230 and $5,722 for the three months and nine months ended September 30, 2004, respectively, compared to $1,473 and $4,136 for comparable periods of 2003. Interest income includes income relating to time value
of foreign currency contracts of $352 and $737 for the three months and nine months ended September 30, 2004, respectively, compared to $109 and $382 for the comparable periods in 2003. Other income, net was impacted by a foreign currency loss of
$311 and $182 in the three months and nine months ended September 30, 2004, respectively, compared to $226 and $1,051 for the comparable periods of 2003. These variances were partially offset by a net gain on sale of investment of $745 in the three
and nine months ended September 30, 2004, respectively, compared to $899 and $2,390 for the comparable periods of 2003.



Interest Expense



Interest expense was $4,755 and $13,781 for the three months and nine months ended September 30, 2004, respectively, compared to $4,525 and $12,499 for comparable periods in 2003. Interest expense is primarily
attributable to the Companys convertible subordinated notes and debentures issued in September 2002 and August 2003, respectively. The Company recorded interest expense relating to the time value of foreign currency contracts of $137 and $375
for the three months and nine months ended September 30, 2004, respectively, compared to $188 and $519 for the comparable periods of 2003.



Provision for Income Taxes



The provision for income taxes was a benefit of $1,304 for the three months ended September 30, 2004 and an expense of $36,665 for the nine months ended September 30,
2004 compared to a benefit of $9,781 and $7,863 for the comparable periods of 2003, respectively. On a quarterly basis, the Company evaluates its expected income tax expense or benefit based on its year to date operations and records an adjustment
in the current quarter. The net tax provision is the result of the mix of profits earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. The provision for income taxes for the nine months ended
September 30, 2004 differs from tax computed at the federal statutory income tax rate primarily due to the impact of a large one-time dividend declared by a foreign subsidiary as well as the impact of state taxes and the amortization of a deferred
tax charge recorded in 2002, offset in part by the impact of the tax rate differential on earnings of foreign subsidiaries. Tax expense of $36,650 was provided on the declaration of a $120,000 dividend from a foreign subsidiary and is reflected in
the tax provision for the nine months ended September 30, 2004. The dividend was declared to increase the Companys future flexibility to marshal the Companys foreign generated cash in the United States for operating and acquisition
purposes and to utilize United States deferred tax assets. Because the Company had sufficient net operating loss and tax credit carryforwards to offset the tax liability for tax return purposes, the Company incurred a federal and state cash tax
liability of approximately $3,000 as a result of the dividend and realized $33,650 of its deferred tax assets.



The Company has not provided for United States income taxes on the undistributed earnings of foreign subsidiaries because they are considered permanently invested outside of the United States. Upon repatriation, some
of these earnings would generate foreign tax credits which may reduce the Federal tax liability associated with any future foreign dividend.



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Under SFAS No. 109, Accounting for Income Taxes, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. SFAS No. 109 provides for the recognition of
deferred tax assets without a valuation allowance if realization of such assets is more likely than not. Based on the weight of available evidence, the Company has provided a valuation allowance against certain deferred tax assets. A portion of the
valuation allowance for deferred tax assets relates to the difference between financial and tax reporting of employee stock option exercises, for which subsequently recognized tax benefits will be applied directly to increase contributed capital. A
portion of the valuation allowance for deferred tax assets relates to certain of the tax attributes acquired from IKOS, for which subsequently recognized tax benefits will be applied directly to reduce goodwill. The remainder of the valuation
allowance was based on the historical earnings patterns within individual taxing jurisdictions that make it uncertain that the Company will have sufficient income in the appropriate jurisdictions to realize the full value of the assets. The Company
will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.



The Company recently settled an examination with the Internal Revenue Service for its U.S. federal income tax returns for the years 2000 and 2001. The results of this exam have been reflected in the deferred tax asset
balances and taxes payable balances as of September 30, 2004. There was no impact on tax expense because, as a result of audit findings, an additional assessment of tax liability for the audit period had been adequately provided for in previous
periods. See Factors that may affect future results and financial condition below. In addition, the Company is currently under examination by the IRS for its 2002 and 2003 federal income tax returns. The Company is subject to income
taxes in the United States and in numerous foreign jurisdictions and in the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain.



Effects of Foreign Currency Fluctuations



More than half of the Companys revenues and approximately two-fifths of its expenses
were generated outside of the United States for the first nine months of 2004. For 2004 and 2003, approximately one-fourth of European and all Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies. Most
large European revenue contracts are denominated and paid to the Company in the United States dollar while the Companys European expenses, including substantial research and development operations, are paid in local currencies causing a short
position in the Euro and the British pound sterling. In addition, the Company experiences greater inflows than outflows of Japanese yen as all Japanese-based customers contract and pay the Company in local currency. While these exposures are
aggregated on a consolidated basis to take advantage of natural offsets, substantial exposure remains. For exposures that are not offset, the Company enters into short-term foreign currency forward and option contracts to partially offset these
anticipated exposures. The option contracts are generally entered into at contract strike rates that are different than current market rates. As a result, any unfavorable currency movements below the strike rates will not be offset by the foreign
currency option contract and could negatively affect operating results. These contracts address anticipated future cash flows for 90-day to one-year periods and do not hedge 100% of the potential exposures related to these currencies. As a result,
the effects of currency fluctuations could have a substantial effect on the Companys overall results of operations.



Foreign currency translation adjustment, a component of accumulated other comprehensive income reported in the stockholders equity section of the consolidated
balance sheets, decreased to $24,767 at September 30, 2004 from $25,922 at December 31, 2003. This reflects the decrease in the value of net assets denominated in foreign currencies as a result of the strengthening of the United States dollar since
year-end 2003.



LIQUIDITY AND CAPITAL RESOURCES



Cash, Cash Equivalents and Short-Term Investments



Total cash, cash equivalents and short-term investments at September 30, 2004 were $100,990
compared to $71,324 at December 31, 2003. Cash provided by operations was $37,906 in the first nine months of 2004 compared to cash used by operations of $6,394 during the same period in 2003. The increase in cash flows from operating activities was
primarily due to a decrease in accounts receivable and an increase in deferred revenue in the first nine months of 2004. This increase was partially offset by payment of payroll and related liabilities in the first nine months of 2004.



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Cash used for investing activities, excluding short-term investments, was $28,206 and $29,046 in the first nine months of
2004 and 2003, respectively. Cash used for investing activities included capital expenditures of $16,833 in the first nine months of 2004 compared to $14,343 during the same period in 2003. Acquisition of businesses and equity interests was $8,039
in the first nine months of 2004 compared to $17,093 for the comparable period in 2003. Purchases of intangible assets were $3,334 for the nine months ended September 30, 2004. There were no purchases of intangible assets for the nine months ended
September 30, 2003.



Cash provided by financing activities was $20,015 and
$81,998 in the first nine months of 2004 and 2003, respectively. Cash provided by financing activities included $110,000 proceeds from long-term notes payable in the first nine months of 2003. Cash and short-term investments were positively impacted
by proceeds from issuance of common stock upon exercise of stock options and employee stock plan purchases of $19,155 and $15,553 during the nine months ended September 30, 2004 and 2003, respectively. During the nine months ended September 30,
2003, the Company repurchased shares of its common stock for $29,785.



Trade Accounts Receivable, Net



Trade accounts
receivable, net decreased to $211,204 at September 30, 2004 from $223,670 at December 31, 2003. Excluding the current portion of term receivables of $122,797 and $119,627, average days sales outstanding were 49 days and 46 days at September 30, 2004
and December 31, 2003, respectively. Average days sales outstanding in total accounts receivable increased from 100 days at December 31, 2003 to 117 days at September 30, 2004. The increase in days sales outstanding was primarily due to the seasonal
decrease in revenue for the three months ended September 30, 2004 as compared to the three months ended December 31, 2003. In the quarters where term contract revenue is recorded, only the first twelve months of the receivable is reflected in
current trade accounts receivable. In the following quarters, the amount due in the next twelve months is reflected in current trade accounts receivable without the corresponding revenue.



Inventory, Net



Inventory, net increased $770 from December 31, 2003 to September 30, 2004. The increase was primarily due to purchases based on forecasted shipments of next generation
emulation hardware systems.



Prepaid Expenses and Other



Prepaid expenses and other increased $4,013 from December 31, 2003 to
September 30, 2004. The increase was primarily due to an increase in the fair value of derivatives, renewals of maintenance contracts and prepayments for income taxes. The increase was partially offset by the receipt of an income tax refund of
$1,494.



Term Receivables, Long-Term



Term receivables, long-term increased to $106,874 at September 30, 2004 compared to $98,207
at December 31, 2003. The balances were attributable to multi-year, multi-element term license sales agreements. Balances under term agreements that are due within one year are included in trade accounts receivable and balances that are due in more
than one year are included in term receivables, long-term. The Company uses term agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments,
products or services. The increase was attributable to new term agreements closed during 2004, primarily in Japan. This increase was partially offset by a reclassification of amounts due in the next twelve months to trade accounts receivable.



Accrued Payroll and Related Liabilities



Accrued payroll and related liabilities decreased $20,621 from December 31, 2003 to
September 30, 2004. The decrease was primarily due to payments of the 2003 annual and fourth quarter incentive compensation.



Deferred Revenue



Deferred revenue consists primarily of prepaid annual software support contracts. Deferred revenue increased $28,268 from December 31, 2003 to September 30, 2004. The increase was primarily due to annual contract
renewals in the first nine months of 2004, higher renewal rates, higher business levels and support contracts moving from quarterly to annual billing cycles.



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Capital Resources



Expenditures for property and equipment increased to $16,833 for the first nine months of 2004 compared to $14,343 for the same period in 2003. Expenditures in the
first nine months of 2004 and 2003 did not include any individually significant projects. In the first nine months of 2004, the Company acquired (i) Project Technology Inc., (ii) a minority equity interest in M2000, a French company, (iii) remaining
49% minority interest in MGK, (iv) 0-In Design Automation Inc. and (v) the parallel and serial ATA IP business division of Palmchip Corporation, which together resulted in total net cash payments of $6,479. Additionally, the Company paid $1,560
relating to holdbacks on prior year acquisitions. The Company also paid $3,334 related to purchases of technology from (i) Atair, (ii) LSI Logic, (iii) Analog Bits and (iv) Rox Software Technology in the first nine months of 2004. In the first nine
months of 2003, the Company acquired (i) the Technology Licensing Group business of Alcatel, (ii) Translogic, (iii) the distributorship, Mentor Italia, (iv) the business and technology of DDE and (v) First Earth Limited, which resulted in total net
cash payments of $13,023. Additionally, the Company paid $4,070 relating to a holdback on a prior year acquisition.



In August 2003, the Company issued $110,000 of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 in a private offering pursuant to SEC Rule 144A for
general corporate purposes and to fund the purchase of 1,750 shares of the Companys stock. The Debentures have been registered with the SEC for resale under the Securities Act of 1933. Interest on the Debentures is payable quarterly at a
variable interest rate equal to 3-month LIBOR plus 1.65%. The effective interest rate for the first nine months of 2004 was 2.92%. The Company pays interest on the Debentures quarterly in February, May, August and November. The Debentures are
convertible, under certain circumstances, into the Companys common stock at a conversion price of $23.40 per share, for a total of 4,700 shares. These circumstances generally include (a) the market price of the Companys common stock
exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures or certain other
corporate transactions. Some or all of the Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018.



In June 2002, the Company issued $172,500 of 67/8% Convertible Subordinated Notes (Notes) due 2007 in a private offering pursuant to SEC Rule 144A to
fund the purchase of Innoveda. The Notes have been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Notes semi-annually in June and December. The Notes are convertible into the Companys common stock at
a conversion price of $23.27 per share, for a total of 7,413 shares. Some or all of the Notes may be redeemed by the Company for cash on or after June 20, 2005.



In July 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This
facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and
0.75%, based on a pricing grid tied to a financial covenant. As a result, the Companys interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the
unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing grid tied to a financial covenant. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of
specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had no short-term borrowings against the credit facility at September 30, 2004.



The Companys primary ongoing cash requirements will be for product development, operating activities, capital expenditures, debt
service and acquisition opportunities that may arise. The Companys primary sources of liquidity are cash generated from operations and borrowings under the revolving credit facility. The Company anticipates that current cash balances,
anticipated cash flows from operating activities, including the effects of financing customer term receivables, and amounts available under existing credit facilities will be sufficient to meet its working capital needs on a short-term and long-term
basis. The Companys sources of liquidity could be adversely affected by a decrease in demand for the Companys products or a deterioration of the Companys financial ratios.



Off-Balance Sheet Arrangements



The Company does not have off-balance sheet arrangements, financings or other relationships
with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business, the Company leases certain real properties, primarily field office facilities, and equipment.



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Outlook for Fourth Quarter 2004



Revenues for the fourth quarter are expected to be approximately $205,000. Earnings per share are expected to be approximately $0.33.



FACTORS THAT MAY AFFECT FUTURE RESULTS AND FINANCIAL CONDITION



The statements contained under Outlook for Fourth Quarter
2004 above and other statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words believes, expects, projections and words of
similar import, constitute forward-looking statements that involve a number of risks and uncertainties that are difficult to predict. Moreover, from time to time, the Company may issue other forward-looking statements. Forward-looking statements
regarding financial performance in future periods, including the statements above under Outlook for Fourth Quarter 2004, do not reflect potential impacts of mergers or acquisitions or other significant transactions or events that have
not been announced as of the time the statements are made. Actual outcomes and results may differ materially from what is expressed or forecast in forward-looking statements. The Company disclaims any obligation to update forward-looking statements
to reflect future events or revised expectations. The following discussion highlights factors that could cause actual results to differ materially from the results expressed or implied by the Companys forward-looking statements.
Forward-looking statements should be considered in light of these factors.



Weakness in the United States and international economies may materially adversely affect the Company.



United States and international economies can experience economic downturns, which may have an adverse affect on the Companys results of operations. Weakness in
these economies may adversely affect the timing and receipt of orders for the Companys products and the Companys results of operations. Revenue levels are dependent on the level of technology capital spending, which include expenditures
for EDA software, hardware and consulting services, in the United States and abroad. In addition, demand for the Companys products and services may be adversely affected by mergers and company restructurings in the electronics industry
worldwide which could result in decreased or delayed capital spending patterns.



The Company is subject to the cyclical nature of the integrated circuit and electronics systems industries and any future downturns may, materially adversely affect the Company.



Purchases of the Companys products and services are highly dependent upon new design
projects initiated by integrated circuit and electronics systems industries are highly cyclical and are subject to constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles and
wide fluctuations in product supply and demand. The integrated circuit and electronics systems industries regularly experience significant downturns, often connected with, or in anticipation of, maturing product cycles of companies in these
industries and their customers products and a decline in general economic conditions. These downturns cause diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. During
such downturns, the number of new design projects generally decreases, which can adversely affect demand for the Companys products and services.



Over the past several years, IC manufacturers and electronics systems companies have experienced a downturn in demand and production, which has resulted in reduced
research and development spending by many of the Companys customers. While many of these companies appear to have experienced a gradual recovery in the second half of 2003 and in 2004, they have continued their focus on cost containment. Any
economic downturn could harm the Companys business, operating results and financial condition.



Fluctuations in quarterly results of operations due to the timing of significant orders and the mix of licenses used to sell the Companys products could hurt the Companys business and the market price
of the Companys common stock.



The Company has experienced, and may
continue to experience, varied quarterly operating results. Various factors affect the Companys quarterly operating results and some of these are not within the Companys control, including the timing of significant orders and the mix of
licenses used to sell the Companys products. The Company receives a majority of its software product revenue from current quarter order performance, of which a substantial amount is usually booked in the last few weeks of each quarter. A
significant portion of the Companys revenue comes from



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multi-million dollar contracts, the timing of the completion of and the terms of delivery of which can have a material
impact on revenue recognition for a given quarter. If the Company fails to receive expected orders in a particular quarter, particularly large orders, the Companys revenues for that quarter could be adversely affected. In such an event, the
Company could fail to meet investors expectations, which could adversely affect the Companys stock price.



The Company uses fixed-term license agreements as a standard business practice. These multi-year, multi-element term license agreements are typically three years in
length, with payments spread over the license term and with customers the Company believes are credit-worthy. These agreements increase the risk associated with collectibility from customers that can arise for a variety of reasons including ability
to pay, product dissatisfaction, disagreements and disputes. If the Company is unable to collect under any of these multi-million dollar agreements, the Companys results of operations could be adversely affected.



The Company uses these fixed-term license agreements as a standard business practice and has
a history of successfully collecting under the original payment terms without making concessions on payments, products or services. If the Company no longer had a history of collecting without providing concessions on term agreements, then revenue
would be required to be recognized as the payments become due and payable over the license term. This change would have a material impact on the Companys results.



The Companys revenue is also affected by the mix of licenses entered into where the Company recognizes software product revenue as
payments become due and payable or ratably over the license term as compared to revenue recognized at the beginning of the license term. The Company recognizes revenue ratably over the license term when the customer is provided with rights to
unspecified or unreleased future products. A shift in the license mix toward increased ratable or due and payable revenue recognition would result in increased deferral of software product revenue to future periods and would decrease current
revenue, possibly resulting in the Company not meeting revenue expectations.



The accounting rules governing software revenue recognition have been subject to authoritative interpretations that have generally made it more difficult to recognize software product revenue at the beginning of the license period. These
new and revised standards and interpretations could adversely affect the Companys ability to meet revenue expectations.



The gross margin on the Companys software products is greater than that for the Companys hardware products, software support and professional services.
Therefore, the Companys gross margin may vary as a result of the mix of products and services sold. Additionally, the margin on software products varies year to year depending on the amount of third-party royalties due to third parties from
the Company for the mix of products sold. The Company also has a significant amount of fixed or relatively fixed costs, such as professional service employee costs and purchased technology amortization, and costs which are committed in advance and
can only be adjusted periodically. As a result, a small failure to reach planned revenue would likely have a relativity large negative effect on resulting earnings. If anticipated revenue does not materialize as expected, the Companys gross
margins and operating results would be materially adversely affected.



Forecasting the Companys tax rates is complex and subject to uncertainty.



Forecasts of the Companys income tax position and resultant effective tax rate are complex and subject to uncertainty as the Companys income tax position for each year combines: (a) the effects of a mix of
profits (losses) earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates (b) benefits from available deferred tax assets and costs resulting from tax audits and (c) changes in tax laws or the
interpretation of such tax laws. In order to forecast the Companys global tax rate, pre-tax profits and losses by jurisdiction are estimated and tax expense by jurisdiction is calculated. If the mix of profits and losses or effective tax rates
by jurisdiction are different than those estimates, the Companys actual tax rate could be materially different than forecast.



Outcome of Internal Revenue Service and other tax authorities examinations could have a material adverse affect on the Company.



The Internal Revenue Service and other tax authorities regularly examine the Companys
income tax returns. Significant judgment is required in determining our provision for income taxes. In determining the adequacy of our income taxes, the Company assesses the likelihood of adverse outcomes resulting from the Internal Revenue Service
and other tax authorities examinations. The ultimate outcome of these examinations cannot be predicted with certainty. Should the Internal Revenue Service or other tax authorities assess additional taxes as a result of



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examinations, the Company may be required to record charges to operations in future periods that could have a material
impact on the results of operations, financial position or cash flows in the applicable period or periods recorded.



Limitations on the effectiveness of controls.



The Company does not expect that its disclosure controls or internal control over financial reporting will prevent all error and all fraud. A control system, no matter
how well designed and operated, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the
benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the
Company have been detected. Failure of the Companys control systems to prevent error or fraud could materially adversely impact the Company.



The lengthy sales cycle for the Companys products and services and delay in customer consummation of projects makes the timing of the Companys revenue
difficult to predict.



The Company has a lengthy sales cycle that
generally extends between three and six months. The complexity and expense associated with the Companys products and services generally requires a lengthy customer evaluation and approval process. Consequently, the Company may incur
substantial expenses and devote significant management effort and expense to develop potential relationships that do not result in agreements or revenue and may prevent the Company from pursuing other opportunities. In addition, sales of the
Companys products and services may be delayed if customers delay approval or commencement of projects because of customers budgetary constraints, internal acceptance review procedures, timing of budget cycles or timing of competitive
evaluation processes.



Any loss of the Companys leadership position in
certain portions of the EDA market could have a material adverse affect on the Company.



The industry in which the Company competes is characterized by very strong leadership positions in specific portions of the EDA market. For example, one company may enjoy a large percentage of sales in the physical
verification portion of the market while another will have a similarly strong position in mixed-signal simulation. These strong leadership positions can be maintained for significant periods of time as the software is difficult to master and
customers are disinclined to make changes once their employees, as well as others in the industry, have developed familiarity with a particular software product. For these reasons, much of the Companys profitability arises from niche areas in
which it is the strong leader. Conversely, it is difficult for the Company to achieve significant profits in niche areas where other companies are the leaders. If for any reason the Company loses its leadership position in a niche, the Company could
be materially adversely affected.



Intense competition in the EDA industry
could materially adversely affect the Company.



Competition in the EDA
industry is intense, which can lead to, among other things, price reductions, longer selling cycles, lower product margins, loss of market share and additional working capital requirements. The Companys success depends upon the Companys
ability to acquire or develop and market products and services that are innovative and cost-competitive and that meet customer expectations.



The Company currently competes primarily with two large companies: Cadence Design Systems, Inc. and Synopsys, Inc. The Company also competes with numerous smaller
companies, a number of which have combined with other EDA companies. The Company also competes with manufacturers of electronic devices that have developed, or have the capability to develop, their own EDA products internally.



The Company may acquire other companies and may not successfully integrate them or the
companies the Company has recently acquired.



The industry in which the
Company competes has seen significant consolidation in recent years. During this period, the Company has acquired numerous businesses, and it is frequently in discussions with potential acquisition candidates and may acquire other businesses in the
future. While the Company expects to carefully analyze all potential transactions before committing to them, the Company cannot assure that any transaction that is completed will result in long-term benefits to the Company or its shareholders or
that the Companys management will be able to manage the acquired businesses effectively. In addition, growth through acquisition involves a number of risks. If



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any of the following events occurs after the Company acquires another business, it could materially adversely affect the
Company:



| |  | difficulties in combining previously separate businesses into a single unit;
| | - | ----------------------------------------------------------------------------



| |  | the substantial diversion of managements attention from day-to-day business when evaluating and negotiating acquisition transactions and then integrating the acquired
business;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the discovery after the acquisition has been completed of liabilities assumed with the acquired business;
| | - | ---------------------------------------------------------------------------------------------------------



| |  | the failure to realize anticipated benefits, such as cost savings and revenue increases;
| | - | ----------------------------------------------------------------------------------------



| |  | the failure to retain key personnel of the acquired business;
| | - | -------------------------------------------------------------



| |  | difficulties related to assimilating the products of an acquired business in, for example, distribution, engineering and customer support areas;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  | unanticipated costs;
| | - | --------------------



| |  | adverse effects on existing relationships with suppliers and customers; and
| | - | ---------------------------------------------------------------------------



| |  | failure to understand and compete effectively in markets in which we have limited previous experience.
| | - | ------------------------------------------------------------------------------------------------------



Acquired businesses may not perform as projected, which could result in impairment of acquisition-related intangible assets. Additional
challenges include integration of sales channels, training and education of the sales force for new product offerings, integration of product development efforts, integration of systems of internal controls and integration of information systems.
Accordingly, in any acquisition there will be uncertainty as to the achievement and timing of projected synergies, cost savings and sales levels for acquired products. All of these factors can impair the Companys ability to forecast, meet
revenue and earnings targets and manage effectively the Companys business for long-term growth. The Company cannot assure that it can effectively meet these challenges.



Risks of international operations and the effects of foreign currency fluctuations can adversely impact the Companys business and
operating results.



The Company realizes more than half of the
Companys revenue from customers outside the United States and approximately two-fifths of the Companys expenses are generated outside of the United States. Significant changes in exchange rates can have an adverse effect on the Company.
For further discussion of foreign currency effects, see Effects of Foreign Currency Fluctuations discussion above. In addition, international operations subject the Company to other risks including longer receivables collection periods,
changes in a specific countrys or regions economic or political conditions, trade protection measures, import or export licensing requirements, loss or modification of exemptions for taxes and tariffs, limitations on repatriation of
earnings and difficulties with licensing and protecting the Companys intellectual property rights.



Delay in production of components or the ordering of excess components for the Companys Mentor Emulation Division hardware products could materially adversely affect the Company.



The success of the Companys Mentor Emulation Division depends on the Companys
ability to:



| |  | procure hardware components on a timely basis from a limited number of suppliers;
| | - | ---------------------------------------------------------------------------------



| |  | assemble and ship systems on a timely basis with appropriate quality control;
| | - | -----------------------------------------------------------------------------



| |  | develop distribution and shipment processes;
| | - | --------------------------------------------



| |  | manage inventory and related obsolescence issues; and
| | - | -----------------------------------------------------



| |  | develop processes to deliver customer support for hardware
| | - | ----------------------------------------------------------



The Companys inability to be successful in any of the foregoing could materially adversely affect the Company.



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The Company commits to purchase component parts from suppliers based on sales forecasts of the Companys Mentor
Emulation Division products. If the Company cannot change or be released from these non-cancelable purchase commitments, or if orders for the Companys products do not materialize as anticipated, the Company could incur significant costs
related to the purchase of excess components which could become obsolete before the Company can use them. Additionally, a delay in production of the components could materially adversely affect the Companys operating results.



The Companys failure to adequately protect the Companys proprietary rights or
to obtain software or other intellectual property licenses could materially adversely affect the Company.



The Companys success depends, in large part, upon the Companys proprietary technology. The Company generally relies on patents, copyrights, trademarks, trade secret laws, licenses and restrictive
agreements to establish and protect the Companys proprietary rights in technology and products. Despite precautions the Company may take to protect the Companys intellectual property, the Company cannot assure that third parties will not
try to challenge, invalidate or circumvent these protections. The companies in the EDA industry, as well as entities and persons outside the industry, are obtaining patents at a rapid rate. As a result, the Company may on occasion be forced to
engage in costly patent litigation to protect the Companys rights or defend our customers rights. The Company may also need to settle these claims on terms that are unfavorable; such settlements could result in the payment of significant
damages or royalties, or force the Company to stop selling or redesign one or more products. The Company cannot assure that the rights granted under the Companys patents will provide it with any competitive advantage, that patents will be
issued on any of the Companys pending applications or that future patents will be sufficiently broad to protect the Companys technology. Furthermore, the laws of foreign countries may not protect the Companys proprietary rights in
those countries to the same extent as United States law protects these rights in the United States.



Some of the Companys products include software or other intellectual property licensed from third parties, and the Company may have to seek new licenses or renew existing licenses for software and other
intellectual property in the future. The Companys failure to obtain software or other intellectual property licenses or rights on favorable terms could materially adversely affect the Company.



Future litigation may materially adversely affect the Company.



Any future litigation may result in injunctions against future product sales and substantial
unanticipated legal costs and divert the efforts of management personnel, any and all of which could materially adversely affect the Company.



Proposed regulations related to equity compensation could cause us to recognize an additional expense, which would result in a reduction in our net income.



On March 31, 2004, the Financial Accounting Standards Board (FASB),
consistent with recent actions of other accounting agencies and entities, issued a proposed statement Share Based Payment, an Amendment of FASB Statements No. 123 and 95 relating to the accounting for equity-based compensation. This
statement proposes changes to United States Generally Accepted Accounting Principles (GAAP) that, if implemented, would require the Company to record a charge to compensation expense for stock option grants. The Company currently accounts for stock
options under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. As permitted by SFAS No. 123, the Company have elected to use the intrinsic value method prescribed by Accounting
Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, to measure compensation expense for stock-based awards granted to employees, under which the granting of stock options is not considered compensation, if
the option exercise price is not less than the fair market value of the common stock at the grant date. Starting in the second half of 2005, the FASBs proposal would require that stock-based awards be accounted for using a fair-value based
method, which would require the Company to measure the compensation expense for all such awards, including stock options, at fair-value at the grant date. The Company cannot predict whether the proposed accounting standard will be adopted, but if
adopted they would have an adverse affect on the Companys results of operations.



Errors or defects in the Companys products and services could expose the Company to liability and harm the Companys reputation.



The Companys customers use the Companys products and services in designing and developing products that involve a high degree of technological complexity and
have unique specifications. Because of the complexity of the systems and products with which the Company works, some of the Companys products and designs can be



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adequately tested only when put to full use in the marketplace. As a result, the Companys customers or their end
users may discover errors or defects in the Companys software or the systems we design, or the products or systems incorporating the Companys designs and intellectual property may not operate as expected. Errors or defects could result
in:



| |  | loss of current customers and loss of, or delay in, revenue and loss of market share;
| | - | -------------------------------------------------------------------------------------



| |  | failure to attract new customers or achieve market acceptance;
| | - | --------------------------------------------------------------



| |  | diversion of development resources to resolve the problems resulting from errors or defects; and
| | - | ------------------------------------------------------------------------------------------------



| |  | increased service costs.
| | - | ------------------------



The Companys failure to attract and retain key employees may harm the Company.



The Company depends on the efforts and abilities of the Companys senior management, the Companys research and development staff and a number of other key
management, sales, support, technical and services personnel. Competition for experienced, high-quality personnel is intense, and the Company cannot assure that it can continue to recruit and retain such personnel. The failure by the Company to hire
and retain such personnel would impair the Companys ability to develop new products and manage the Companys business effectively.



Regulations adopted by the NASDAQ Stock Market require stockholder approval for new stock option plans and significant amendments to existing plans, including increases
in options. These regulations could make it more difficult for the Company to grant equity compensation to employees in the future. To the extent that these regulations make it more difficult or expensive to grant equity compensation to employees,
the Company may incur increased compensation costs or find it difficult to attract and retain employees, which could materially and adversely affect the Company.



Terrorist attacks and other acts of violence or war may materially adversely affect the markets on which the Companys securities
trade, the markets in which the Company operates, the Companys operations and the Companys profitability.



Terrorist attacks may negatively affect the Companys operations and investment in the Companys business. These attacks or armed conflicts may directly impact
the Companys physical facilities or those of the Companys suppliers or customers. Furthermore, these attacks may make travel and the transportation of the Companys products more difficult and more expensive and ultimately affect
the Companys sales.



Any armed conflict entered into by the United States
could have an impact on the Companys sales and the Companys ability to deliver products to the Companys customers. Political and economic instability in some regions of the world may also result from an armed conflict and could
negatively impact the Companys business. The Company currently has operations in Pakistan, Egypt and Israel, countries that maybe particularly susceptible to this risk. The consequences of any armed conflict are unpredictable, and the Company
may not be able to foresee events that could have an adverse effect on the Companys business.



More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy. They also could result
in or exacerbate economic recession in the United States or abroad. Any of these occurrences could have a significant impact on the Companys operating results, revenues and costs and may result in volatility of the market price for the
Companys securities.



The Companys articles of incorporation,
Oregon law and the Companys shareholder rights plan may have anti-takeover effects.



The Companys board of directors has the authority, without action by the shareholders, to designate and issue up to 1,200,000 shares of incentive stock in one or more series and to designate the rights,
preferences and privileges of each series without any further vote or action by the shareholders. Additionally, the Oregon Control Share Act and the Business Combination Act limit the ability of parties who acquire a significant amount of voting
stock to exercise control over the Company. These provisions may have the effect of lengthening the time required for a person to acquire control of the Company through a proxy contest or the election of a majority of the board of directors. In
February 1999, the Company adopted a shareholder rights plan which has the effect of making it more difficult for a person to acquire control of the Company in a transaction not approved by the Companys board of directors. The potential
issuance of incentive stock, the provisions of the Oregon Control Share Act and the Business Combination



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Act and the Companys shareholder rights plan may have the effect of delaying, deferring or preventing a change of
control of the Company, may discourage bids for the Companys common stock at a premium over the market price of the Companys common stock and may adversely affect the market price of, and the voting and other rights of the holders of,
the Companys common stock.



The Companys debt obligations expose
the Company to risks that could adversely affect the Companys business, operating results and financial condition, and could prevent the Company from fulfilling its obligations under such indebtedness.



The Company has a substantial level of indebtedness. As of September 30, 2004, the Company
had $294.5 million of outstanding indebtedness, which includes $172.5 million of 67/8% Convertible Subordinated
Notes (Notes) due 2007 and $110.0 million of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023. This level of indebtedness among other things, could:



| |  | make it difficult for the Company to satisfy its payment obligations on its debt;
| | - | ---------------------------------------------------------------------------------



| |  | make it difficult for the Company to incur additional indebtedeness or obtain any necessary financing in the future for working capital, capital expenditures, debt service,
acquisitions or general corporate purposes;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | limit the Companys flexibility in planning for or reacting to changes in its business;
| | - | ---------------------------------------------------------------------------------------



| |  | reduce funds available for use in the Companys operations;
| | - | -----------------------------------------------------------



| |  | make the Company more vulnerable in the event of a downturn in its business;
| | - | ----------------------------------------------------------------------------



| |  | make the Company more vulnerable in the event of an increase in interest rates if the Company must incur new debt to satisfy its obligations under the Notes and Debentures; or
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | place the Company at a possible competitive disadvantage relative to less leveraged competitors and competitors that have greater access to capital resources.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------



If the Company experiences a decline in revenue due to any of
the factors described in this section entitled Factors That May Affect Future Results and Financial Condition it could have difficulty paying amounts due on its indebtedness. Any default under the Companys indebtedness could have a
material adverse effect on its business, operating results and financial condition.



Item 3. Quantitative And Qualitative Disclosures About Market Risk

(All numerical references in thousands, except for rates and
percentages)



INTEREST RATE RISK



The Company is exposed to interest rate risk primarily through its investment portfolio,
short-term borrowings and long-term notes payable. The Company does not use derivative financial instruments for speculative or trading purposes.



The Company places its investments in instruments that meet high credit quality standards, as specified in the Companys investment policy. The policy also limits
the amount of credit exposure to any one issuer and type of instrument. The Company does not expect any material loss with respect to its investment portfolio.



The table below presents the carrying value and related weighted-average fixed interest rates for the Companys investment portfolio. The carrying value
approximates fair value at September 30, 2004. In accordance with the Companys investment policy, all investments mature in twelve months or less.



|                                                      |  |                 |        |                             |      |  
|----------------------------------------------------- |  | --------------- | ------ | --------------------------- | ---- | -
|Principal (notional) amounts in United States dollars |  | Carrying Amount |        | Average Fixed Interest Rate |     
|Cash equivalents  fixed rate                         |  | $               | 49,159 |                             | 1.86 | %
|Short-term investments  fixed rate                   |  |                 | 25,735 |                             | 1.79 | %
|                                                      |  |                 |        |                             |      |  
|Total fixed rate interest bearing instruments         |  | $               | 74,894 |                             | 1.84 | %
|                                                      |  |                 |        |                             |      |  



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The Company had convertible subordinated notes of $172,500 outstanding with a fixed interest rate of 67/8% at September 30, 2004. For fixed rate debt, interest rate changes affect the fair value of the notes but do not
affect earnings or cash flow.



The Company had floating rate convertible
subordinated debentures of $110,000 outstanding with a variable interest rate of 3-month LIBOR plus 1.65% at September 30, 2004. For variable interest rate debt, interest rate changes affect earnings and cash flow. If the interest rates on the
variable rate borrowings were to increase or decrease by 1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $1,100.



At September 30, 2004, the Company had a three-year revolving credit facility, which
terminates on July 14, 2006, which allows the Company to borrow up to $100,000. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%,
based on a pricing grid tied to a financial covenant. As a result, the Companys interest expense associated with borrowings under this credit facility will vary with market interest rates. The Company had no short-term borrowings against the
credit facility at September 30, 2004.



The Company had other long-term notes
payable of $2,717 and short-term borrowings of $9,257 outstanding at September 30, 2004 with variable rates based on market indexes. For variable rate debt, interest rate changes generally do not affect the fair market value, but do affect future
earnings or cash flow. If the interest rates on the variable rate borrowings were to increase or decrease by 1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by
approximately $120.



FOREIGN CURRENCY RISK



The Company transacts business in various foreign currencies and has established a foreign
currency hedging program to hedge certain foreign currency forecasted transactions and exposures from existing assets and liabilities. Derivative instruments held by the Company consist of foreign currency forward and option contracts. The Company
enters into contracts with counterparties who are major financial institutions and believes the risk related to default is remote. The Company does not hold or issue derivative financial instruments for trading purposes.



The Company enters into foreign currency option contracts for forecasted revenues and
expenses between its foreign subsidiaries. These instruments provide the Company the right to sell/purchase foreign currencies to/from third parties at future dates with fixed exchange rates. As of September 30, 2004, the Company had options
outstanding to sell Japanese yen with contract values totaling $42,990 at a weighted average contract rate of 113.98 and had options outstanding to buy the Euro with contract values totaling $32,087 at a weighted average contract rate of 1.27.



The Company enters into foreign currency forward contracts to protect against
currency exchange risk associated with expected future cash flows and existing assets and liabilities. For further discussion of foreign currency effects, see Effects of Foreign Currency Fluctuations discussion under Item 2.
Managements Discussion and Analysis of Results of Operations and Financial Condition above.



The table provides information as of September 30, 2004 about the Companys foreign currency forward contracts. The information provided is in United States dollar equivalent amounts. The table presents the
notional amounts, at contract exchange rates, and the weighted average contractual foreign currency exchange rates.



|                       |  |                 |         |                               |        |                   |    
|---------------------- |  | --------------- | ------- | ----------------------------- | ------ | ----------------- | ---
|                       |  | Notional Amount |         | WeightedAverage Contract Rate |        | Contract Currency
|Forward Contracts:     |  |                 |         |                               |        |                   |    
|Euro                   |  | $               | 60,121  |                               | 1.22   |                   | USD
|Japanese yen           |  |                 | 53,166  |                               | 106.71 |                   | JPY
|British pound sterling |  |                 | 19,083  |                               | 1.79   |                   | USD
|Indian rupee           |  |                 | 5,733   |                               | 45.69  |                   | INR
|Canadian dollar        |  |                 | 4,696   |                               | 1.29   |                   | CAD
|Swedish krona          |  |                 | 2,537   |                               | 7.43   |                   | SEK
|Taiwan dollar          |  |                 | 1,297   |                               | 33.71  |                   | TWD
|Other                  |  |                 | 4,129   |                               |       |                   |    
|                       |  |                 |         |                               |        |                   |    
|Total                  |  | $               | 150,762 |                               |        |                   |    
|                       |  |                 |         |                               |        |                   |    



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##### Table of Contents

Item 4. Controls and Procedures



The Company
maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Companys Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the
SECs rules and forms, and that such information is accumulated and communicated to the Companys management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control
objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



The Company carried out an evaluation, under the supervision and with the participation of the Companys management, including the Companys Chief Executive
Officer and the Companys Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures were effective.



Internal Control Over Financial Reporting



There has been no change in the Companys internal control over financial reporting that occurred during the last fiscal quarter that has materially affected, or is
reasonably likely to materially affect, the Companys internal control over financial reporting.



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##### Table of Contents

PART II. OTHER INFORMATION



Item 5. Other Information



Executive Severance
Agreements



On November 4, 2004, the Companys Board of Directors
approved amendments to the existing severance agreements between the Company and each of Walden C. Rhines (Chairman and Chief Executive Officer of the Company) and Gregory K. Hinckley (President of the Company). The amendments increase from two to
three the multiple of annual salary and target bonus payable to these officers upon certain terminations of employment following a change in control of the Company.



Item 6. Exhibits

(All numerical references in thousands)



|     |  |                                                                                                                                                                                             
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|31.1 |  | Certification of Chief Executive Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                      
|     | 
|31.2 |  | Certification of Chief Financial Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                      
|     | 
|32   |  | Certification of Chief Executive Officer and Chief Financial Officer of Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.



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.



|                        |  |                            
|----------------------- |  | ---------------------------
|Dated: November 9, 2004 |  | MENTOR GRAPHICS CORPORATION
|                        |  | (Registrant)               
|                        | 
|                        |  | /s/ Gregory K. Hinckley    
|                        |  | Gregory K. Hinckley        
|                        |  | President                  



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