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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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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended July 3, 2005



or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period fromto.



Commission File No.: 0-33213



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MAGMA DESIGN AUTOMATION, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 77-0454924                             
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)



5460 Bayfront Plaza

Santa Clara, California 95054

(Address of principal executive offices)



Telephone: (408) 565-7500

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (l) 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 at least 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 ̈



On August 1, 2005, 35,059,260 shares of Registrants Common Stock,
$.0001 par value were outstanding.



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



FORM
10-Q



QUARTERLY PERIOD ENDED JULY 3, 2005



INDEX



|                              |  |                                                                                                          |  |     
|----------------------------- |  | -------------------------------------------------------------------------------------------------------- |  | ----
|                              |  |                                                                                                          |  | Page
|Part I:
Financial Information |  | 3                                                                                                       
|                              |  |                                                                                                         
|Item 1:                       |  | Financial Statements (unaudited)                                                                         |  | 3   
|                              |  |                                                                                                         
|                              |  | Condensed Consolidated Balance Sheets at July 3, 2005 and March 31, 2005                                 |  | 3   
|                              |  |                                                                                                         
|                              |  | Condensed Consolidated Statements of Operations for the Three Months EndedJuly 3, 2005 and June 30, 2004 |  | 4   
|                              |  |                                                                                                         
|                              |  | Condensed Consolidated Statements of Cash Flows for the Three Months EndedJuly 3, 2005 and June 30, 2004 |  | 5   
|                              |  |                                                                                                         
|                              |  | Notes to Condensed Consolidated Financial Statements                                                     |  | 6   
|                              |  |                                                                                                         
|Item 2:                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                    |  | 19  
|                              |  |                                                                                                         
|Item 3:                       |  | Quantitative and Qualitative Disclosures About Market Risk                                               |  | 49  
|                              |  |                                                                                                         
|Item 4:                       |  | Controls and Procedures                                                                                  |  | 49  
|                              | 
|Part II:
Other Information    |  | 51                                                                                                      
|                              |  |                                                                                                         
|Item 1:                       |  | Legal Proceedings                                                                                        |  | 51  
|                              |  |                                                                                                         
|Item 2:                       |  | Unregistered Sales of Equity Securities and Use of Proceeds                                              |  | 54  
|                              |  |                                                                                                         
|Item 4:                       |  | Submission of Matters to a Vote of Security Holders                                                      |  | 54  
|                              |  |                                                                                                         
|Item 5:                       |  | Other Information                                                                                        |  | 54  
|                              |  |                                                                                                         
|Item 6:                       |  | Exhibits                                                                                                 |  | 55  
|                              | 
|Signatures                    |  | 56                                                                                                      
|                              | 
|Exhibit Index                 |  | 57                                                                                                      



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PART I: FINANCIAL INFORMATION



Item 1. Financial Statements.



MAGMA DESIGN AUTOMATION, INC.



CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                           |  |              |          |   |                |   |          |  
|------------------------------------------ |  | ------------ | -------- | - | -------------- | - | -------- | -
|                                           |  | July 3, 2005 |          |   | March 31, 2005 |  
|ASSETS                                     |  |              |          |   |                |   |          |  
|Current assets:                            |  |              |          |   |                |   |          |  
|Cash and cash equivalents                  |  | $            | 38,545   |   |                | $ | 20,622   |  
|Restricted cash                            |  |              | 274      |   |                |   | 2,950    |  
|Short-term investments                     |  |              | 43,696   |   |                |   | 114,896  |  
|Accounts receivable, net                   |  |              | 35,052   |   |                |   | 33,851   |  
|Prepaid expenses and other current assets  |  |              | 6,347    |   |                |   | 7,088    |  
|                                           |  |              |          |   |                |   |          |  
|Total current assets                       |  |              | 123,914  |   |                |   | 179,407  |  
|Property and equipment, net                |  |              | 22,004   |   |                |   | 21,309   |  
|Intangibles, net                           |  |              | 91,260   |   |                |   | 69,573   |  
|Goodwill                                   |  |              | 43,012   |   |                |   | 43,194   |  
|Restricted cash                            |  |              | 3,543    |   |                |   |         |  
|Other assets                               |  |              | 4,535    |   |                |   | 5,741    |  
|                                           |  |              |          |   |                |   |          |  
|Total assets                               |  | $            | 288,268  |   |                | $ | 319,224  |  
|                                           |  |              |          |   |                |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY       |  |              |          |   |                |   |          |  
|Current liabilities:                       |  |              |          |   |                |   |          |  
|Accounts payable                           |  | $            | 2,201    |   |                | $ | 3,010    |  
|Accrued expenses                           |  |              | 29,724   |   |                |   | 22,321   |  
|Deferred revenue                           |  |              | 21,267   |   |                |   | 20,745   |  
|                                           |  |              |          |   |                |   |          |  
|Total current liabilities                  |  |              | 53,192   |   |                |   | 46,076   |  
|Convertible subordinated notes             |  |              | 105,500  |   |                |   | 150,000  |  
|Other long-term liabilities                |  |              | 5,852    |   |                |   | 1,749    |  
|                                           |  |              |          |   |                |   |          |  
|Total liabilities                          |  |              | 164,544  |   |                |   | 197,825  |  
|Commitments and contingencies (Note 9)     |  |              |          |   |                |   |          |  
|Stockholders equity:                      |  |              |          |   |                |   |          |  
|Common stock                               |  |              | 4        |   |                |   | 4        |  
|Additional paid-in capital                 |  |              | 278,333  |   |                |   | 261,627  |  
|Deferred stock-based compensation          |  |              | (4,984   | ) |                |   | (5,749   | )
|Accumulated deficit                        |  |              | (115,667 | ) |                |   | (115,644 | )
|Treasury stock                             |  |              | (32,651  | ) |                |   | (16,606  | )
|Accumulated other comprehensive loss       |  |              | (1,311   | ) |                |   | (2,233   | )
|                                           |  |              |          |   |                |   |          |  
|Total stockholders equity                 |  |              | 123,724  |   |                |   | 121,399  |  
|                                           |  |              |          |   |                |   |          |  
|Total liabilities and stockholders equity |  | $            | 288,268  |   |                | $ | 319,224  |  
|                                           |  |              |          |   |                |   |          |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)



|                                                                          |  |                            |        |   |               |   |        |  
|------------------------------------------------------------------------- |  | -------------------------- | ------ | - | ------------- | - | ------ | -
|                                                                          |  | For the Three Months Ended |       
|                                                                          |  | July 3, 2005               |        |   | June 30, 2004 |  
|Revenue:                                                                  |  |                            |        |   |               |   |        |  
|Licenses                                                                  |  | $                          | 33,910 |   |               | $ | 30,892 |  
|Services                                                                  |  |                            | 4,922  |   |               |   | 5,137  |  
|                                                                          |  |                            |        |   |               |   |        |  
|Total revenue                                                             |  |                            | 38,832 |   |               |   | 36,029 |  
|                                                                          |  |                            |        |   |               |   |        |  
|Cost of revenue:                                                          |  |                            |        |   |               |   |        |  
|Licenses                                                                  |  |                            | 4,414  |   |               |   | 1,308  |  
|Services*                                                                 |  |                            | 3,857  |   |               |   | 3,734  |  
|                                                                          |  |                            |        |   |               |   |        |  
|Total cost of revenue                                                     |  |                            | 8,271  |   |               |   | 5,042  |  
|                                                                          |  |                            |        |   |               |   |        |  
|Gross profit                                                              |  |                            | 30,561 |   |               |   | 30,987 |  
|                                                                          |  |                            |        |   |               |   |        |  
|Operating expenses:                                                       |  |                            |        |   |               |   |        |  
|Research and development                                                  |  |                            | 10,975 |   |               |   | 9,569  |  
|In-process research and development                                       |  |                            |       |   |               |   | 4,009  |  
|Sales and marketing                                                       |  |                            | 11,202 |   |               |   | 11,267 |  
|General and administrative                                                |  |                            | 8,613  |   |               |   | 3,625  |  
|Amortization of intangible assets                                         |  |                            | 3,588  |   |               |   | 4,475  |  
|Amortization of stock-based compensation**                                |  |                            | 1,672  |   |               |   | 458    |  
|Restructuring charge                                                      |  |                            |       |   |               |   | 502    |  
|                                                                          |  |                            |        |   |               |   |        |  
|Total operating expenses                                                  |  |                            | 36,050 |   |               |   | 33,905 |  
|                                                                          |  |                            |        |   |               |   |        |  
|Operating loss                                                            |  |                            | (5,489 | ) |               |   | (2,918 | )
|                                                                          |  |                            |        |   |               |   |        |  
|Other income (expense):                                                   |  |                            |        |   |               |   |        |  
|Interest income                                                           |  |                            | 660    |   |               |   | 553    |  
|Interest expense                                                          |  |                            | (208   | ) |               |   | (246   | )
|Other income (expense), net                                               |  |                            | 7,450  |   |               |   | (562   | )
|                                                                          |  |                            |        |   |               |   |        |  
|Other income (expense), net                                               |  |                            | 7,902  |   |               |   | (255   | )
|                                                                          |  |                            |        |   |               |   |        |  
|Net income (loss) before income taxes                                     |  |                            | 2,413  |   |               |   | (3,173 | )
|Provision for income taxes                                                |  |                            | (2,436 | ) |               |   | 638    |  
|                                                                          |  |                            |        |   |               |   |        |  
|Net loss                                                                  |  | $                          | (23    | ) |               | $ | (2,535 | )
|                                                                          |  |                            |        |   |               |   |        |  
|Net loss per common share                                                 |  |                            |        |   |               |   |        |  
|Basic                                                                     |  | $                          | (0.00  | ) |               | $ | (0.08  | )
|                                                                          |  |                            |        |   |               |   |        |  
|Diluted                                                                   |  | $                          | (0.00  | ) |               | $ | (0.08  | )
|                                                                          |  |                            |        |   |               |   |        |  
|Shares used in calculation:                                               |  |                            |        |   |               |   |        |  
|Basic                                                                     |  |                            | 34,132 |   |               |   | 33,671 |  
|                                                                          |  |                            |        |   |               |   |        |  
|Diluted                                                                   |  |                            | 34,132 |   |               |   | 33,671 |  
|                                                                          |  |                            |        |   |               |   |        |  
|* Stock-based compensation included in cost of services revenue           |  | $                          |       |   |               | $ | 4      |  
|                                                                          |  |                            |        |   |               |   |        |  
|** Components of stock-based compensation included in operating expenses: |  |                            |        |   |               |   |        |  
|Research and development                                                  |  | $                          | 1,634  |   |               | $ | 290    |  
|Sales and marketing                                                       |  |                            | 8      |   |               |   | 25     |  
|General and administrative                                                |  |                            | 30     |   |               |   | 143    |  
|                                                                          |  |                            |        |   |               |   |        |  
|                                                                          |  | $                          | 1,672  |   |               | $ | 458    |  
|                                                                          |  |                            |        |   |               |   |        |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                |  |                    |         |   |               |   |         |  
|------------------------------------------------------------------------------- |  | ------------------ | ------- | - | ------------- | - | ------- | -
|                                                                                |  | Three Months Ended |        
|                                                                                |  | July 3, 2005       |         |   | June 30, 2004 |  
|Cash flows from operating activities:                                           |  |                    |         |   |               |   |         |  
|Net loss                                                                        |  | $                  | (23     | ) |               | $ | (2,535  | )
|Adjustments to reconcile net loss to net cash provided by operating activities: |  |                    |         |   |               |   |         |  
|Depreciation and amortization                                                   |  |                    | 2,250   |   |               |   | 1,510   |  
|Amortization of intangible assets                                               |  |                    | 7,752   |   |               |   | 5,774   |  
|In-process research and development                                             |  |                    |        |   |               |   | 4,009   |  
|Provision for (recovery from) doubtful accounts                                 |  |                    | (179    | ) |               |   | 116     |  
|Amortization of debt issuance costs                                             |  |                    | 199     |   |               |   | 245     |  
|Impairment of strategic equity investments                                      |  |                    | 390     |   |               |   | 331     |  
|Gain on repurchase of convertible notes, net of debt issuance cost write-off    |  |                    | (8,781  | ) |               |   |        |  
|Loss on sale of short-term investments                                          |  |                    | 661     |   |               |   |        |  
|Amortization of stock-based compensation                                        |  |                    | 1,672   |   |               |   | 462     |  
|Restructuring charge                                                            |  |                    |        |   |               |   | 502     |  
|Deferred income taxes                                                           |  |                    |        |   |               |   | (1,153  | )
|Income tax benefit realized from gain on repurchase of convertible notes        |  |                    | 701     |   |               |   |        |  
|Income tax benefit realized from debt issuance costs                            |  |                    | 21      |   |               |   | 26      |  
|Change in operating assets and liabilities, net of effect of acquisitions:      |  |                    |         |   |               |   |         |  
|Accounts receivable                                                             |  |                    | (878    | ) |               |   | 2,825   |  
|Prepaid expenses and other assets                                               |  |                    | 447     |   |               |   | 835     |  
|Accounts payable                                                                |  |                    | (809    | ) |               |   | 49      |  
|Accrued expenses                                                                |  |                    | 1,890   |   |               |   | (4,651  | )
|Deferred revenue                                                                |  |                    | 522     |   |               |   | 4,041   |  
|Other long-term liabilities                                                     |  |                    | (355    | ) |               |   | 82      |  
|                                                                                |  |                    |         |   |               |   |         |  
|Net cash provided by operating activities                                       |  |                    | 5,480   |   |               |   | 12,468  |  
|                                                                                |  |                    |         |   |               |   |         |  
|Cash flows from investing activities:                                           |  |                    |         |   |               |   |         |  
|Purchase of intangible assets                                                   |  |                    | (9,505  | ) |               |   | (9,092  | )
|Purchase of property and equipment                                              |  |                    | (366    | ) |               |   | (4,797  | )
|Purchase of short-term investments                                              |  |                    | (37,733 | ) |               |   | (52,198 | )
|Proceeds from sale and maturities of short-term investments                     |  |                    | 109,096 |   |               |   | 68,858  |  
|Purchase of strategic equity investments                                        |  |                    |        |   |               |   | (250    | )
|                                                                                |  |                    |         |   |               |   |         |  
|Net cash provided by investing activities                                       |  |                    | 61,492  |   |               |   | 2,521   |  
|                                                                                |  |                    |         |   |               |   |         |  
|Cash flows from financing activities:                                           |  |                    |         |   |               |   |         |  
|Proceeds from issuance of common stock                                          |  |                    | 1,841   |   |               |   | 2,591   |  
|Repurchase of common stock                                                      |  |                    | (16,045 | ) |               |   |        |  
|Repurchase of convertible notes, net                                            |  |                    | (34,668 | ) |               |   |        |  
|Repayment of lease obligation                                                   |  |                    | (131    | ) |               |   |        |  
|                                                                                |  |                    |         |   |               |   |         |  
|Net cash (used in) provided by financing activities                             |  |                    | (49,003 | ) |               |   | 2,591   |  
|                                                                                |  |                    |         |   |               |   |         |  
|Effect of foreign currency translation on cash and cash equivalents             |  |                    | (46     | ) |               |   | 77      |  
|                                                                                |  |                    |         |   |               |   |         |  
|Net increase in cash and cash equivalents                                       |  |                    | 17,923  |   |               |   | 17,657  |  
|Cash and cash equivalents at beginning of period                                |  |                    | 20,622  |   |               |   | 17,634  |  
|                                                                                |  |                    |         |   |               |   |         |  
|Cash and cash equivalents at end of period                                      |  | $                  | 38,545  |   |               | $ | 35,291  |  
|                                                                                |  |                    |         |   |               |   |         |  
|Supplemental disclosure:                                                        |  |                    |         |   |               |   |         |  
|Non-cash investing and financing activities:                                    |  |                    |         |   |               |   |         |  
|Deferred stock-based compensation                                               |  | $                  | (908    | ) |               | $ | (458    | )
|                                                                                |  |                    |         |   |               |   |         |  
|Issuance of common stock in connection with intangible asset purchase           |  | $                  | 12,005  |   |               | $ |        |  
|                                                                                |  |                    |         |   |               |   |         |  
|Issuance of common stock warrant in connection with intangible asset purchase   |  | $                  | 3,080   |   |               | $ |        |  
|                                                                                |  |                    |         |   |               |   |         |  
|Purchase of fixed assets under capital leases                                   |  | $                  | 1,790   |   |               | $ |        |  
|                                                                                |  |                    |         |   |               |   |         |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Note 1. Basis of Presentation



The interim unaudited condensed consolidated financial statements included
herein have been prepared by Magma Design Automation, Inc. (Magma or the Company), pursuant to the rules and regulations of the United States Securities and Exchange Commission (SEC). Certain information and note
disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, pursuant to these rules and regulations. However,
management believes that the disclosures are adequate to ensure that the information presented is not misleading. The interim unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary
(consisting only of normal recurring adjustments) to present a fair statement of results for the interim periods presented. The operating results for any interim period are not necessarily indicative of the results that may be expected for the
entire fiscal year ending April 2, 2006. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Companys Form 10-K for the year ended March 31, 2005, as filed with the SEC on June 14,
2005. The accompanying unaudited condensed consolidated balance sheet at March 31, 2005 is derived from audited consolidated financial statements at that date.



Preparation of 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 and 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.



Principles of Consolidation



The consolidated financial statements of Magma include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Accounts denominated in foreign-currency have
been translated using the U.S. dollar as the functional currency.



Change in Fiscal Year End



On January 26,
2005, the Companys Board of Directors approved a change in Magmas fiscal year end from March 31 to a 52-53 week fiscal year ending on the first Sunday subsequent to March 31. After the fiscal year ended March 31, 2005, Magmas
fiscal years will consist of four quarters of 13 weeks each except for each seventh fiscal year, which will include one quarter with 14 weeks. The current fiscal year ends on April 2, 2006. All references to years or quarters in these notes to
consolidated financial statements represent fiscal years or fiscal quarters, respectively, unless otherwise noted. As a result of this change, the first quarter of Magmas fiscal year 2006 includes three additional days, the results of which
are included in the accompanying condensed consolidated financial statements for the first quarter of fiscal year 2006.



Reclassifications



Certain amounts in the fiscal 2005 financial statements have been reclassified to conform with the fiscal 2006 presentation. Certain auction rate
securities have been reclassified from cash equivalents to short-term investments. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days. Auction rate
securities have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer.
Interest paid during a given period is based upon the interest rate determined during the prior auction.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Although these securities are issued and rated as long-term bonds, they are priced and traded as
short-term instruments because of the liquidity provided through the interest rate reset. Based on the Companys ability either to liquidate the holdings or to roll the investment over to the next reset period, the Company had historically
classified some or all of these instruments as cash equivalents if the period between interest rate resets was 90 days or less.



The Company accounts for our marketable securities in accordance with Statement of Financial Accounting Standards (SFAS) No. 115,
Accounting for Certain Investments in Debt and Equity Securities. Such investments are classified as available for sale and are reported at fair value in the Companys balance sheets. The short-term nature and structure,
the frequency with which the interest rate resets and the ability to sell auction rate securities at par and at our discretion indicates that such securities should more appropriately be classified as short-term investments with the intent of
meeting the Companys short-term working capital requirements.



Based upon the Companys re-evaluation of these securities, Magma reclassified as short-term investments any auction rate securities previously classified as cash equivalents for the fiscal 2005 and 2004 periods. As a result, purchases
and sales of short-term investments included in the consolidated statements of cash flows have been revised to reflect the purchase of $20.6 million and sale of $55.5 million auction rate securities during the first quarter of fiscal 2005. This
resulted in a decrease in cash used in investing activities by $34.9 million for the quarter ended June 30, 2004. These reclassifications had no impact on the previously reported net income or cash flows from operations.



Recently Issued Accounting Pronouncements



In July 2005, the FASB issued an Exposure Draft of a proposed interpretation
Accounting for Uncertain Tax Positionsan interpretation of FASB Statement No. 109. This proposal seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement requirements related to
accounting for income taxes. Specifically, the interpretation requires that an enterprise recognize in its financial statements, the best estimate of the impact of a tax position only if that position is probable of being sustained on audit based
solely on the technical merits of the position. In evaluating whether the probable recognition threshold has been met, this proposed interpretation would require the presumption that the tax position will be evaluated during an audit by taxing
authorities. The interpretation is expected to be effective for Magma beginning with the first quarter of 2006. The Company is currently reviewing the provisions in the Exposure Draft to determine its impact to its consolidated financial statements.



In May 2005, the Financial Accounting Standards Board
(FASB) issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154). This new standard replaces APB Opinion No. 20, Accounting Changes in Interim Financial Statements, and SFAS No. 3,
Reporting Accounting Changes in Interim Financial Statements, and represents another step in the FASBs goal to converge its standards with those issued by the International Accounting Standards Board (IASB). Among other
changes, SFAS 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principle unless it is impracticable. SFAS 154 also provides that (1) a change in method of depreciating or
amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a
restatement. The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Early adoption of this standard is permitted for accounting changes and correction of
errors made in fiscal years beginning after June 1, 2005. Management does not expect the adoption of SFAS 154 to have a material effect on the Companys consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment.
(SFAS 123R) SFAS 123R eliminates the ability to account for share-based compensation transactions using APB 25, and generally requires instead that such transactions be accounted for using a fair-value based method. Companies are
required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. The new rules will be applied on a modified prospective basis as defined in SFAS 123R, and
will be effective for annual periods beginning after June 15, 2005 and, thus, will be effective for us no later than the first quarter of fiscal 2007. The Company is currently evaluating which transition method to use and option valuation
methodologies and assumptions in light of SFAS 123R related to employee stock options and employee stock purchase plans. The adoption of SFAS 123R will have a significant impact on the Companys consolidated statement of operations as the
Company will be required to expense the fair value of its stock option grants and stock purchases under its employee stock purchase plan rather than disclose the impact on its consolidated net income within the footnotes (see Note 2 to the Condensed
Consolidated Financial Statements), as is the Companys current practice.



In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107 Share-Based Payment. SAB 107 provides guidance related to share-based payment transactions with non-employees, the
transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements,
the classification of compensation expense, non-GAAP financial measures, first-time adoption of SFAS 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of
share-based payment arrangements upon adoption of SFAS 123R, the modification of employee share options prior to adoption of SFAS 123R and disclosures in Managements Discussion and Analysis subsequent to adoption of SFAS 123R. The provisions
of SAB 107, as appropriate, will be adopted upon implementation of SFAS 123R in fiscal 2007.



FASB Staff Position (FSP ) No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2),
provides guidance under SFAS No. 109, Accounting for Income Taxes, (SFAS 109) with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act)
on enterprises income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. FSP 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the
Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS 109. The Company has completed evaluating the impact of the repatriation provisions. The adoption of FSP 109-2 did not have any impact on the
Companys results of operations or financial condition. Among other things, the Jobs Act repeals an export incentive and creates a new tax deduction for qualified domestic manufacturing activities. At this time, the Company does not expect that
the deduction will have a material impact on its reported income tax rate.



8



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 2. Stock-Based Compensation



The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, as interpreted by FASB Interpretation No. 44 (FIN 44), Accounting for Certain Transactions Involving Stock
Compensationan Interpretation of APB 25 and Emerging Issues Task Force No. 00-23 (EITF 00-23), Issues related to the Accounting for Stock Compensation under APB 25 and FIN 44, and FASB Interpretation No. 28,
Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, and complies with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosurean
amendment of SFAS 123. Under APB Opinion No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Companys stock and the exercise price. SFAS 123 as amended by SFAS 148
requires a fair-value based method of accounting for an employee stock option or similar equity instrument. Had compensation cost for the Companys stock-based compensation plan been determined using the Black-Scholes option pricing model at
the grant date for awards granted in accordance with the provisions of SFAS 123, the Companys net loss would have been the amounts indicated below (in thousands):



|                                                                                                    |  |                    |        |   |               |   |        |  
|--------------------------------------------------------------------------------------------------- |  | ------------------ | ------ | - | ------------- | - | ------ | -
|                                                                                                    |  | Three Months Ended |       
|                                                                                                    |  | July 3, 2005       |        |   | June 30, 2004 |  
|                                                                                                    |  | (in thousands)     |       
|Net loss:                                                                                           |  |                    |        |   |               |   |        |  
|As reported                                                                                         |  | $                  | (23    | ) |               | $ | (2,535 | )
|Add: Stock-based employee compensation expense included in reported net loss                        |  |                    | 1,672  |   |               |   | 462    |  
|Deduct: Stock-based employee compensation expense determined under fair value method for all awards |  |                    | (5,382 | ) |               |   | (5,573 | )
|                                                                                                    |  |                    |        |   |               |   |        |  
|Pro forma                                                                                           |  | $                  | (3,733 | ) |               | $ | (7,646 | )
|                                                                                                    |  |                    |        |   |               |   |        |  
|Net loss per share, basic and diluted:                                                              |  |                    |        |   |               |   |        |  
|As reported                                                                                         |  | $                  | (0.00  | ) |               | $ | (0.08  | )
|                                                                                                    |  |                    |        |   |               |   |        |  
|Pro forma                                                                                           |  | $                  | (0.11  | ) |               | $ | (0.23  | )
|                                                                                                    |  |                    |        |   |               |   |        |  



Such pro forma
disclosures may not be representative of future compensation cost because options vest over several years and additional grants are made each year.



The weighted-average estimated fair value per share at the date of grant for options granted to employees and for share purchase rights granted under the
employee stock purchase plans was as follows:



|                              |  |                    |      |               |   |     
|----------------------------- |  | ------------------ | ---- | ------------- | - | ----
|                              |  | Three Months Ended
|                              |  | July 3, 2005       |      | June 30, 2004
|Stock options                 |  | $                  | 3.16 |               | $ | 6.16
|Employee stock purchase plans |  | $                  | 1.72 |               | $ | 3.57



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



The fair value of options at the date of grant was estimated using the Black-Scholes option pricing
model, with the following weighted-average assumptions:



|                               |  |                    |   |  |               |  
|------------------------------ |  | ------------------ | - |  | ------------- | -
|                               |  | Three Months Ended |  
|                               |  | July 3, 2005       |   |  | June 30, 2004 |  
|Stock options:                 |  |                    |   |  |               |  
|Risk-free interest rate        |  | 3.78               | % |  | 3.00          | %
|Expected dividend yield        |  | 0                  | % |  | 0             | %
|Volatility                     |  | 55                 | % |  | 44            | %
|Expected life (years)          |  | 3.13               |   |  | 2.78          |  
|                               | 
|                               |  | Three Months Ended |  
|                               |  | July 3, 2005       |   |  | June 30, 2004 |  
|Employee stock purchase plans: |  |                    |   |  |               |  
|Risk-free interest rate        |  | 3.65               | % |  | 1.71          | %
|Expected dividend yield        |  | 0                  | % |  | 0             | %
|Volatility                     |  | 64                 | % |  | 44            | %
|Expected life (years)          |  | 0.25               |   |  | 1.13          |  



The fair value option
valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including
the expected stock price volatility. Because the Companys employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair
value estimate, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the Companys employee stock options.



Note 3. Basic and Diluted Net Income (Loss) Per Share



The Company computes net income (loss) per share in accordance with SFAS 128, Earnings per Share. Basic net
income (loss) per share is computed by dividing net income attributable to common stockholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Diluted net income per share gives effect to all
dilutive potential common shares outstanding during the period including stock options and redeemable convertible subordinated notes using the as-if-converted method.



For the three months ended July 3, 2005 and June 30, 2004, all potential common shares outstanding during the period were
excluded from the computation of diluted net loss per share as their effect would be anti-dilutive. Such shares included the followings:



|                                                                         |  |                    |            |               |   |          
|------------------------------------------------------------------------ |  | ------------------ | ---------- | ------------- | - | ---------
|                                                                         |  | Three Months Ended
|                                                                         |  | July 3, 2005       |            | June 30, 2004
|Shares of common stock if converted under convertible subordinated notes |  |                    | 4,615,000  |               |   | 6,562,000
|Shares of common stock issuable under stock option plans outstanding     |  |                    | 10,330,204 |               |   | 8,415,966
|Weighted average price of shares issuable under stock option plans       |  | $                  | 14.63      |               | $ | 15.55    



10



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 4. Cash equivalents and investments



Cash equivalents and short-term investments are detailed as follows:



|                              |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|----------------------------- |  | -------------- | ------- | ---------------- | - | ----------------- |  | - | -------------------- | - |  | - | -------
|                              |  | Cost           |         | Unrealized Gains |   | Unrealized Losses |  |   | Estimated Fair Value
|                              |  | (In Thousands)
|July 3, 2005                  |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|Classified as current assets: |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|Cash                          |  | $              | 16,239  |                  | $ |                  |  | $ |                     |   |  | $ | 16,239 
|Money market funds            |  |                | 6,972   |                  |   |                  |  |   |                     |   |  |   | 6,972  
|Commercial paper              |  |                | 15,351  |                  |   |                  |  |   | (17                  | ) |  |   | 15,334 
|Auction rate preferreds       |  |                | 1,999   |                  |   | 1                 |  |   |                     |   |  |   | 2,000  
|Government agencies           |  |                | 6,000   |                  |   |                  |  |   | (6                   | ) |  |   | 5,994  
|Corporate bonds               |  |                | 2,554   |                  |   |                  |  |   | (2                   | ) |  |   | 2,552  
|Municipal obligations         |  |                | 33,150  |                  |   |                  |  |   |                     |   |  |   | 33,150 
|                              |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|                              |  | $              | 82,265  |                  | $ | 1                 |  | $ | (25                  | ) |  | $ | 82,241 
|                              |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|March 31, 2005                |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|Classified as current assets: |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|Cash                          |  | $              | 16,979  |                  | $ |                  |  | $ |                     |   |  | $ | 16,979 
|Money market funds            |  |                | 395     |                  |   |                  |  |   |                     |   |  |   | 395    
|Commercial paper              |  |                | 3,249   |                  |   |                  |  |   | (1                   | ) |  |   | 3,248  
|Auction rate preferreds       |  |                | 6,998   |                  |   | 2                 |  |   |                     |   |  |   | 7,000  
|Government agencies           |  |                | 49,499  |                  |   |                  |  |   | (525                 | ) |  |   | 48,974 
|Corporate bonds               |  |                | 37,506  |                  |   |                  |  |   | (316                 | ) |  |   | 37,190 
|Auction rate certificates     |  |                | 19,650  |                  |   |                  |  |   |                     |   |  |   | 19,650 
|Municipal obligations         |  |                | 2,090   |                  |   |                  |  |   | (8                   | ) |  |   | 2,082  
|                              |  |                |         |                  |   |                   |  |   |                      |   |  |   |        
|                              |  | $              | 136,366 |                  | $ | 2                 |  | $ | (850                 | ) |  | $ | 135,518
|                              |  |                |         |                  |   |                   |  |   |                      |   |  |   |        



As of July 3, 2005,
the stated maturities of the Companys current investments (including $15.3 million classified as cash equivalent investments in the table above) are $25.9 million within one year and $33.1 million after ten years.



As of July 3, 2005, $23,000 of the unrealized losses has a duration of less
than twelve months and $2,000 of the unrealized losses has a duration of twelve months or greater. The gross unrealized losses on these investments were primarily due to interest rate fluctuations and market-price movements. The Company reviewed the
investment portfolio and determined that the gross unrealized losses on these investments at July 3, 2005 were temporary in nature. The Company has the ability and intent to hold these investments until recovery of their carrying values. The Company
also believes that it will be able to collect both principal and interest amounts due to the Company at maturity, given the high credit quality of these investments.



In May 2005, the Company liquidated certain investments to repurchase a portion of the convertible subordinated notes,
resulting in a realized loss of approximately $0.7 million. See Note 7 for information regarding the repurchase of convertible subordinated notes.



Note 5. Asset Purchases



Technology License



On June 30, 2005, the Company acquired a technology license from International Business Machines Corporation (IBM) to copyrighted material
pertinent to technology relating to electronic design automation



11



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



(EDA), as well as other intellectual property owned by IBM. Also in connection with the technology license agreement, IBM and Magma entered into
an amendment extending to 2010 the term of Magmas patent license agreement with IBM dated March 24, 2004. These two licenses cover IBMs patents and significant technology with respect to the development of EDA tools and products that
perform physical implementation.



The total fee for the
licenses was $7.0 million paid on June 30, 2005. In connection with the license agreements, the Company also entered into a warrant agreement pursuant to which IBM is entitled to purchase up to 500,000 shares of Magma common stock at an exercise
price of $4.73 per share. The warrant is exercisable immediately and expires on the earlier of June 30, 2010 or immediately prior to a change of control of Magma. The warrant may be exercised by payment of the exercise price in cash or pursuant to a
cashless net exercise provision. The fair value of the warrants was estimated to be $6.16 per share using the Black-Scholes option pricing model, with the following weighted-average assumptions:



|                        |  |      |  
|----------------------- |  | ---- | -
|Risk-free interest rate |  | 3.72 | %
|Expected dividend yield |  | 0    | %
|Volatility              |  | 65   | %
|Expected life (years)   |  | 5.00 |  



The license fee of
$7.0 million and $3.1 million fair value of the 500,000 shares of common stock warrant were included in the intangible asset balance on the Companys unaudited condensed consolidated balance sheet as of July 3, 2005 (see Note 6).



Acquisition-Related Earnouts



For a number of Magmas acquisitions, the asset purchase or merger
agreements, as applicable, included an earnout provision under which the Company may pay contingent consideration in cash and/or stock based on the achievement of certain technology milestones as outlined in the respective asset purchase or merger
agreement.



In the three months ended July 3, 2005, the Company
recorded $19.4 million of intangible assets resulting from contingent consideration that was paid or became payable to stockholders of acquired companies as follows (in thousands):



|                            |  |      |       |                    |   |       
|--------------------------- |  | ---- | ----- | ------------------ | - | ------
|                            |  | Cash |       | Common Stock Value
|Mojave, Inc.                |  | $    | 8,935 |                    | $ | 8,935 
|Aplus Design Technologies   |  |      | 268   |                    |   | 1,081 
|Other                       |  |      | 140   |                    |   |      
|                            |  |      |       |                    |   |       
|Total earnout consideration |  | $    | 9,343 |                    | $ | 10,016
|                            |  |      |       |                    |   |       



In addition, during
the three months ended July 3, 2005 and June 30, 2004, Magma recognized deferred stock-based compensation of $0.8 million and $0.1 million, respectively, related to the Mojave acquisition.



12



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 6. Goodwill and Intangible Assets



The following table summarizes the components of goodwill, intangible assets and related accumulated amortization balances
as of July 3, 2005 and March 31, 2005 (in thousands):



|                              |  |                                |  |                          |         |                |                     |         |                       |  |                          |        |  |                     |        |  |   |         |   |  |   |       
|----------------------------- |  | ------------------------------ |  | ------------------------ | ------- | -------------- | ------------------- | ------- | --------------------- |  | ------------------------ | ------ |  | ------------------- | ------ |  | - | ------- | - |  | - | ------
|                              |  | Weighted Average Life (months) |  | July 3, 2005             |         | March 31, 2005
|                              |  | Gross Carrying Amount          |  | Accumulated Amortization |         |                | Net Carrying Amount |         | Gross Carrying Amount |  | Accumulated Amortization |        |  | Net Carrying Amount
|Goodwill                      |  |                                |  | $                        | 43,012  |                | $                   |        |                       |  | $                        | 43,012 |  | $                   | 43,194 |  | $ |        |   |  | $ | 43,194
|                              |  |                                |  |                          |         |                |                     |         |                       |  |                          |        |  |                     |        |  |   |         |   |  |   |       
|Intangible assets:            |  |                                |  |                          |         |                |                     |         |                       |  |                          |        |  |                     |        |  |   |         |   |  |   |       
|Developed technology          |  | 47                             |  | $                        | 78,302  |                | $                   | (21,261 | )                     |  | $                        | 57,041 |  | $                   | 59,083 |  | $ | (16,488 | ) |  | $ | 42,595
|Licensed technology           |  | 36                             |  |                          | 33,094  |                |                     | (9,688  | )                     |  |                          | 23,406 |  |                     | 23,014 |  |   | (7,668  | ) |  |   | 15,346
|Customer relationship or base |  | 61                             |  |                          | 2,200   |                |                     | (750    | )                     |  |                          | 1,450  |  |                     | 2,200  |  |   | (637    | ) |  |   | 1,563 
|Patents                       |  | 59                             |  |                          | 11,932  |                |                     | (3,993  | )                     |  |                          | 7,939  |  |                     | 11,792 |  |   | (3,355  | ) |  |   | 8,437 
|Acquired customer contracts   |  | 36                             |  |                          | 900     |                |                     | (515    | )                     |  |                          | 385    |  |                     | 900    |  |   | (438    | ) |  |   | 462   
|Assembled workforce           |  | 43                             |  |                          | 1,235   |                |                     | (418    | )                     |  |                          | 817    |  |                     | 1,235  |  |   | (330    | ) |  |   | 905   
|No shop right                 |  | 24                             |  |                          | 100     |                |                     | (86     | )                     |  |                          | 14     |  |                     | 100    |  |   | (73     | ) |  |   | 27    
|Trademark                     |  | 45                             |  |                          | 400     |                |                     | (192    | )                     |  |                          | 208    |  |                     | 400    |  |   | (162    | ) |  |   | 238   
|                              |  |                                |  |                          |         |                |                     |         |                       |  |                          |        |  |                     |        |  |   |         |   |  |   |       
|Total                         |  |                                |  | $                        | 128,163 |                | $                   | (36,903 | )                     |  | $                        | 91,260 |  | $                   | 98,724 |  | $ | (29,151 | ) |  | $ | 69,573
|                              |  |                                |  |                          |         |                |                     |         |                       |  |                          |        |  |                     |        |  |   |         |   |  |   |       



During the three
months ended July 3, 2005, the Company reduced its goodwill by $0.2 million to reflect purchase price adjustments on an acquisition related to tax benefits recognized on net operating loss carryforwards.



For the three months ended July 3, 2005 and June 30, 2004, the amortization
expense related to intangible assets was $7.8 million and $5.8 million, respectively, of which $4.2 million and $1.3 million, respectively, was included in cost of revenue because it related to the products sold, while the remaining $3.6 million and
$4.5 million, respectively, was shown as a separate line item on the Companys unaudited condensed consolidated statement of operations for the respective periods. The expected future annual amortization expense of intangible assets is as
follows (in thousands):



|                                          |  |                              |       
|----------------------------------------- |  | ---------------------------- | ------
|Fiscal Year                               |  | EstimatedAmortizationExpense
|2006 (remaining nine months)              |  | $                            | 26,976
|2007                                      |  |                              | 34,613
|2008                                      |  |                              | 17,561
|2009                                      |  |                              | 11,165
|2010-2020                                 |  |                              | 945   
|                                          |  |                              |       
|Total expected future annual amortization |  | $                            | 91,260
|                                          |  |                              |       



Note 7. Repurchase of Convertible
Subordinated Notes



In May 2005, the Company repurchased,
in privately negotiated transactions, $44.5 million face amount (or approximately 29.7 percent of the total) of the Companys zero coupon convertible subordinated notes due May 2008 at an average discount to face value of approximately 22
percent. The Company spent approximately $34.8 million on the repurchases. The repurchase left approximately $105.5 million principal amount of convertible



13



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



subordinated notes outstanding. In addition, a portion of the hedge and warrant transactions entered into by Magma in 2003 to limit potential dilution from
conversion of the notes was terminated in connection with the repurchase. In the first quarter of fiscal 2006, the Company recorded a gain of $8.8 million on the repurchase of the convertible subordinated notes, which was net of the write-off of
$0.9 million of deferred financing costs associated with the convertible subordinated notes. The net proceeds of $140,000 from the termination of a portion of the hedge and warrant were recorded against additional paid-in capital.



Note 8. Restructuring Charge



During the three months ended June 30, 2004, the Company recorded net
restructuring charges of $0.5 million related to employee termination costs for 7 employees resulting from the Companys realignment to current business conditions. The accrued termination costs of $0.5 million as of June 30, 2004 were paid in
the second quarter of fiscal 2005.



Note 9. Contingencies



Synopsys, Inc. v. Magma Design Automation, Inc., Civil Action No.
C04-03923 (MMC), United States District Court, Northern District of California. In this action, filed September 17, 2004, Synopsys has sued the Company for alleged infringement of U.S. Patent Nos. 6,378,114 (the 114
Patent), 6,453,446 (the 446 Patent), and 6,725,438 (the 438 Patent). The patents-in-suit relate to methods for designing integrated circuits. The Complaint seeks unspecified monetary damages, injunctive
relief, trebling of damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by the Company as a result of its alleged infringement of the
patents-in-suit.



On October 21, 2004, the Company filed its
answer and counterclaims (Answer) to the Complaint. On November 10, 2004 Synopsys filed motions to strike and dismiss certain affirmative defenses and counterclaims in the Answer. On November 24, 2004 the Company filed an Amended Answer
and Counterclaims (Amended Answer). By order dated November 29, 2004, the Court denied Synopsys motions as moot in light of the Amended Answer. On December 10, 2004, Synopsys moved to strike and dismiss certain affirmative defenses
and counterclaims in the Amended Answer. By order dated January 20, 2005, the Court denied in part and granted in part Synopsys motion. In its pretrial preparation order dated January 21, 2005, the Court set forth a schedule for the case
which, among other things, sets trial for April 24, 2006. Discovery is ongoing.



On February 3, 2005, Synopsys filed its Reply to the Amended Answer. On March 17, 2005, Synopsys filed a First Amended Complaint, which asserts seven causes of action against the Company and/or Lukas van Ginneken: (1)
patent infringement (against both defendants), (2) breach of contract (against van Ginneken), (3) inducing breach of contract (against the Company), (4) fraud (against the Company), (5) conversion (against both defendants), (6) unjust
enrichment/constructive trust (against both defendants), and (7) unfair competition (against both defendants). Synopsys seeks injunctive relief, declaratory relief, at least $100 million in damages, trebling of damages, punitive damages, fees and
costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by the Company as a result of its alleged exploitation of the alleged inventions in the patents-in-suit. On
April 1, 2005, the Company filed a motion to dismiss the third through seventh causes of action. This motion was granted in part and denied in part by order dated May 18, 2005.



On April 11, 2005, Synopsys voluntarily dismissed van Ginneken from the lawsuit without prejudice. Also on April 11, 2005,
Synopsys filed against the Company a motion for partial summary judgment establishing unfair competition and a motion for partial summary judgment based on the doctrine of assignor estoppel.



14



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



On June 7, 2005, Synopsys filed a Second Amended Complaint that asserts six causes of action against
the Company: (1) patent infringement, (2) inducing breach of contract/interference with contractual relations, (3) fraud, (4) conversion, (5) unjust enrichment/constructive trust/quasi-contract, and (6) unfair competition. Synopsys seeks injunctive
relief, declaratory relief, at least $100 million in damages, trebling of damages, punitive damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly
obtained by the Company as a result of its alleged exploitation of the alleged inventions in the patents-in-suit. On June 10, 2005, Magma moved for summary judgment as to the second through sixth causes of action in the Second Amended Complaint. On
June 21, 2005, the Company moved to dismiss the third cause of action for fraud in the Second Amended Complaint and moved to strike certain allegations in the Second Amended Complaint. The court granted the Companys motion to dismiss and
strike by order dated July 15, 2005.



On July 1, 2005, the
Court granted Synopsyss motion for partial summary judgment regarding assignor estoppel, dismissing Magmas affirmative defenses and counterclaim alleging the invalidity of the 114 Patent. On July 14, 2005, the court vacated the
hearings on Magmas motion for summary judgment on the second through sixth causes of action in the Second Amended Complaint and Synopyss motion for partial summary judgment establishing unfair competition. The court stated that it would
reset the motions for hearing, if necessary, after the claims construction hearing scheduled for August 15, 2005.



On July 29, 2005, Synopsys moved to preliminarily enjoin the Company from abandoning or dedicating to the public the 446 Patent or the 438
Patent. Also on July 29, 2005, Synopsys moved for partial summary judgment dismissing certain counterclaims and defenses by the Company on the grounds of estoppel by contract. Both motions are scheduled to be heard September 9, 2005.



On August 3, 2005, Synopsys filed a Third Amended Complaint that asserts six
causes of action against the Company: (1) patent infringement, (2) inducing breach of contract/interference with contractual relations, (3) fraud, (4) conversion, (5) unjust enrichment/constructive trust/quasi-contract, and (6) unfair competition.
Synopsys seeks injunctive relief, declaratory relief, at least $100 million in damages, trebling of damages, punitive damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other
benefits allegedly obtained by the Company as a result of its alleged exploitation of the alleged inventions in the patents-in-suit.



The Company intends to vigorously defend against the claims asserted by Synopsys and to fully enforce its rights against Synopsys. However, the results of
any litigation are inherently uncertain and the Company can not assure that it will be able to successfully defend against the Complaint. A favorable outcome for Synopsys could have a material adverse effect on the Companys financial position,
results of operations or cash flows. The Company is currently unable to assess the extent of damages and/or other relief, if any, that could be awarded to Synopsys; therefore, no contingent liability has been recorded on our condensed consolidated
balance sheet as of July 3, 2005.



On April 18, 2005, Synopsys,
Inc. filed an action against the Company in Germany seeking to obtain ownership of the European patent application corresponding to the Companys 446 Patent. The Company has engaged counsel in Germany and this action will be stayed
pending the outcome of the above-referenced Synopsys action filed in the United States.



On July 29, 2005, Synopsys, Inc. filed an action against the Company in Japan seeking to obtain ownership of the Japanese patent application corresponding to the Companys 446 Patent. The Company is in the
process of engaging counsel in Japan and will seek to stay this action pending the outcome of the above-referenced Synopsys action filed in the United States.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



On June 13, 2005, a putative shareholder class action lawsuit captioned The Cornelia I. Crowell
GST Trust vs. Magma Design Automation, Inc., Rajeev Madhavan, Gregory C. Walker and Roy E. Jewell., No. C 05 02394, was filed in U.S. District Court, Northern District of California. The complaint alleges that defendants failed to disclose
information regarding the risk of Magma infringing intellectual property rights of Synopsys, Inc., in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and prays for unspecified damages. The Company is
currently unable to assess the possible range or extent of damages and/or other relief, if any, that could be awarded to the shareholder class; therefore, no contingent liability has been recorded on our condensed consolidated balance sheet as of
July 3, 2005. The ultimate resolution of this matter or other third party assertions could have a material adverse effect on the Companys financial position, results of operations or cash flows.



On July 26, 2005, a putative derivative complaint captionedSusan Willis
v. Magma Design Automation, Inc. et al., No. 1-05-CV-045834, was filed in the Superior Court of the State of California for the County of Santa Clara. The Complaint seeks unspecified damages purportedly on behalf of the Company for alleged
breaches of fiduciary duties by various directors and officers, as well as for alleged violations of insider trading laws by executives during a period between October 23, 2002 and April 12, 2005. The Company is currently unable to assess the
possible range or extent of damages and/or other relief, if any, that could be awarded; therefore, no contingent liability has been recorded on our condensed consolidated balance sheet as of July 3, 2005. The ultimate resolution of this matter or
other third party assertions could have a material adverse effect on the Companys financial position, results of operations or cash flows.



In addition to the above, from time to time, the Company is involved in disputes that arise in the ordinary course of business. The number and
significance of these disputes is increasing as the Companys business expands and it grows larger. Any claims against the Company, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of
management time and result in the diversion of significant operational resources. As a result, these disputes could harm the Companys business, financial condition, results of operations or cash flows.



Indemnification Obligations



The Company enters into standard license agreements in the ordinary course
of business. Pursuant to these agreements, the Company agrees to indemnify its customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect
to the Companys products. These indemnification obligations have perpetual terms. The Companys normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum
amount of indemnification the Company may be required to make may exceed its normal business practices. The Company estimates the fair value of its indemnification obligations as insignificant, based upon its historical experience concerning product
and patent infringement claims. Accordingly, the Company has no liabilities recorded for indemnification under these agreements as of July 3, 2005.



The Company has agreements whereby its officers and directors are indemnified for certain events or occurrences while the officer or director is, or was,
serving at the Companys request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a directors and
officers liability insurance policy that reduces its exposure and enables the Company to recover a portion of future amounts paid. As a result of the Companys insurance policy coverage, the Company believes the estimated fair value of
these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of July 3, 2005.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



In connection with certain of the Companys recent business acquisitions, it has also agreed to
assume, or cause Company subsidiaries to assume, the indemnification obligations of those companies to their respective officers and directors.



Warranties



The Company offers its customers a warranty that its products will conform to the documentation provided with the products. To date, there have been no
payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, the Company has no liabilities recorded for these warranties as of July 3, 2005. The Company assesses the need for a warranty accrual on a quarterly
basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.



Note 10. Comprehensive Income (Loss)



Comprehensive income (loss) includes net income (loss), unrealized gain (loss) on investments and foreign currency translation adjustments as follows (in thousands):



|                                                         |  |                    |     |   |               |   |        |  
|-------------------------------------------------------- |  | ------------------ | --- | - | ------------- | - | ------ | -
|                                                         |  | Three Months Ended |    
|                                                         |  | July 3, 2005       |     |   | June 30, 2004 |  
|Net loss                                                 |  | $                  | (23 | ) |               | $ | (2,535 | )
|Unrealized gain (loss) on available-for-sale investments |  |                    | 823 |   |               |   | (883   | )
|Foreign currency translation adjustments                 |  |                    | 99  |   |               |   | 77     |  
|                                                         |  |                    |     |   |               |   |        |  
|Comprehensive income (loss)                              |  | $                  | 899 |   |               | $ | (3,341 | )
|                                                         |  |                    |     |   |               |   |        |  



Components of
accumulated other comprehensive loss were as follows (in thousands):



|                                                  |  |              |        |   |                |   |        |  
|------------------------------------------------- |  | ------------ | ------ | - | -------------- | - | ------ | -
|                                                  |  | July 3, 2005 |        |   | March 31, 2005 |  
|Unrealized loss on available-for-sale investments |  | $            | (24    | ) |                | $ | (847   | )
|Foreign currency translation adjustments          |  |              | (1,287 | ) |                |   | (1,386 | )
|                                                  |  |              |        |   |                |   |        |  
|Accumulated other comprehensive loss              |  | $            | (1,311 | ) |                | $ | (2,233 | )
|                                                  |  |              |        |   |                |   |        |  



Note 11. Segment Information



The Company adopted the provisions of SFAS No. 131,
Disclosures about Segments of an Enterprise and Related Information, which requires the reporting of segment information using the management approach. Under this approach, operating segments are identified in substantially
the same manner as they are reported internally and used by the Companys management for purposes of evaluating performance and allocating resources. Based on this approach, the Company has one reportable segment as the management reviews
financial information on a basis consistent with that presented in the unaudited condensed consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Revenue from the North America, Europe, Japan and Asia-Pacific region, which includes, India, South
Korea, Taiwan, Hong Kong and the Peoples Republic of China, was as follows (in thousands):



|                               |  |                    |        |               |   |       
|------------------------------ |  | ------------------ | ------ | ------------- | - | ------
|                               |  | Three Months Ended
|                               |  | July 3, 2005       |        | June 30, 2004
|North America*                 |  | $                  | 28,161 |               | $ | 22,977
|Europe                         |  |                    | 4,201  |               |   | 4,850 
|Japan                          |  |                    | 4,236  |               |   | 5,566 
|Asia-Pacific (excluding Japan) |  |                    | 2,234  |               |   | 2,636 
|                               |  |                    |        |               |   |       
|                               |  | $                  | 38,832 |               | $ | 36,029
|                               |  |                    |        |               |   |       



|                               |  |                    |   |  |               |  
|------------------------------ |  | ------------------ | - |  | ------------- | -
|                               |  | Three Months Ended |  
|                               |  | July 3, 2005       |   |  | June 30, 2004 |  
|North America*                 |  | 73                 | % |  | 64            | %
|Europe                         |  | 11                 |   |  | 14            |  
|Japan                          |  | 11                 |   |  | 15            |  
|Asia-Pacific (excluding Japan) |  | 5                  |   |  | 7             |  
|                               |  |                    |   |  |               |  
|                               |  | 100                | % |  | 100           | %
|                               |  |                    |   |  |               |  

---

|* | The Company has substantially all its North America revenue in the United States for all periods presented.
|- | -----------------------------------------------------------------------------------------------------------



Revenue attributable to significant customers, representing 10% or more of
total revenue for at least one of the respective periods, is summarized as follows:



|           |  |                    |   |  |               |  
|---------- |  | ------------------ | - |  | ------------- | -
|           |  | Three Months Ended |  
|           |  | July 3, 2005       |   |  | June 30, 2004 |  
|Customer A |  | 32                 | % |  | 27            | %



The Company has
substantially all of its long-lived assets located in the United States.



Note 12. Stockholders Equity



Repurchase of Common
Stock



On April 13, 2005, the Company announced that its
Board of Directors authorized Magma to repurchase up to 2.0 million shares of its common stock. The stock repurchase was completed in May 2005, with repurchase prices ranging from $7.82 to $8.17 per share. The Company used approximately $16.0
million to repurchase 2.0 million shares of common stock. The repurchased shares are to be used for general corporate purposes.



Option Exchange Program



On April 18, 2005 the Companys Board of Directors authorized Magma to seek stockholder approval of an option exchange program designed to promote
employee retention and reward contributions to stockholder value. Under the program, the company will offer to exchange outstanding options to purchase common stock at exercise prices greater than or equal to $10.50 for a smaller number of new
options at an exercise price equal to fair market value on the date of grant, expected to be August 22, 2005. Directors and executive officers are not eligible to participate in this option exchange program. The exercise prices of outstanding
options that are eligible for the program range from $10.50 to $30.28 per share, and these options are held by approximately 554 employees. The program was approved by the Companys stockholders at a special meeting of stockholders on June 22,
2005.



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



This Managements Discussion and Analysis of Financial Condition and Results of Operation section should be read in conjunction with our unaudited
condensed consolidated financial statements and results appearing elsewhere in this report. Throughout this section, we make forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. You can often identify these and other forward looking statements by terms such as becoming, may, will, should, predicts, potential, continue,
anticipates, believes, estimates, seeks, expects, plans, intends, or comparable terminology. These forward-looking statements include, but are not limited to, our
expectations about revenue and various operating expenses. Although we believe that the expectations reflected in these forward-looking statements are reasonable, and we have based these expectations on our beliefs and assumptions, such expectations
may prove to be incorrect. Our actual results of operations and financial performance could differ significantly from those expressed in or implied by our forward-looking statements. Factors that could cause or contribute to such differences
include, but are not limited to: competition in the EDA market; Magmas ability to integrate acquired businesses and technologies; potentially higher-than-anticipated costs of litigation; potentially higher-than-anticipated costs of compliance
with regulatory requirements, including those relating to internal control over financial reporting; any delay of customer orders or failure of customers to renew licenses; weaker-than-anticipated sales of Magmas products and services;
weakness in the semiconductor or electronic systems industries; the ability to manage expanding operations; the ability to attract and retain the key management and technical personnel needed to operate Magma successfully; the ability to continue to
deliver competitive products to customers; and changes in accounting rules.



Overview



Magma Design Automation provides
electronic design automation (EDA) software products and related services. Our software enables chip designers to reduce the time it takes to design and produce complex integrated circuits used in the communications, computing, consumer
electronics, networking and semiconductor industries. Our products are used in all major phases of the chip development cycle, from initial design through physical implementation. Our focus is on software used to design the most technologically
advanced integrated circuits, specifically those with minimum feature sizes of 0.13 micron and smaller. See Item 1, Business in our Annual Report on Form 10-K for the year ended March 31, 2005 for a more complete description of our
business.



As an EDA software provider, we generate
substantially all our revenue from the semiconductor and electronics industries. Our customers typically fund purchases of our software and services out of their research and development budgets. As a result, our revenue is heavily influenced by our
customers long-term business outlook and willingness to invest in new chip designs.



Beginning in late calendar 2000, the semiconductor industry entered its steepest and longest downturn of the past 20 years, with industry sales dropping significantly from late 2000 to early 2002. As a result, our
customers have focused on controlling costs and reducing risk, lowering research and development (R&D) expenditures, cutting back on design starts, purchasing from fewer suppliers, requiring more favorable pricing and payment terms
from suppliers, and pursuing consolidation within their own industry. Further, during the downturn, many start-up semiconductor design companies failed or were acquired, and the pace of investment in new companies declined. While the semiconductor
industry has experienced a moderate recovery in recent years, our customers have remained cautious. It is not yet clear when improved demand in our own customers electronics end markets will result in significantly increased R&D spending
or design starts, and corresponding spending on EDA tools.



To
support our customers, we have focused on providing the most technologically advanced products to address each step in the integrated circuit (IC) design process, as well as integrating these products into broad platforms, and expanding
our product offerings. Our goal is to be the EDA technology supplier of choice for our customers as they pursue longer-term, broader and more flexible relationships with fewer suppliers.



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Despite the condition of the semiconductor industry described above, we were able to achieve the
following during the first quarter of fiscal 2006:



| |  |  | We achieved record quarterly revenue of $38.8 million during the first quarter of fiscal 2006, up 9% from the prior quarter and up 8% from the same quarter in fiscal 2005. License
sales for the quarter ended July 3, 2005 accounted for approximately 87% of total revenue, compared to 85% in the prior quarter and 86% from the same quarter in the prior year. Revenue increased primarily from sales of additional licenses, services
and contract extensions to existing customers in North America.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We continued to penetrate our market, and during the first quarter of fiscal 2006 we passed the 201-customer threshold.
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | We neared completion of the rollout of new products developed as part of our 18-month-long Cobra initiative. With these products, we further widen our lead in producing the best
quality of results as defined by chip performance, area and manufacturability.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our technology continues to be a top choice among designers working on the most advanced designs. A number of Magma customers are currently using our technology for 90 nanometer and
65 nanometer designs. Several customers have already completed 65 nanometer designs using Magma technology.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We entered into a licensing arrangement with IBM, allowing us to incorporate into our products advanced technology that has been integral to IBMs world-class ASIC design
capabilities for many years.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Critical Accounting Policies and
Estimates



In preparing our financial statements, we make
estimates, assumptions and judgments that can have a significant impact on our revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates,
assumptions and judgments involved in the accounting policies described below have the most significant potential impact on our financial statements, so we consider these to be our critical accounting policies. We consider the following accounting
policies related to revenue recognition, allowance for doubtful accounts, investments, asset purchases and business combinations, income taxes and valuation of long-lived assets to be our most critical policies due to the estimation processes
involved in each.



Revenue recognition



We recognize revenue in accordance with Statement of Position
(SOP) 97-2, as modified by SOP 98-9, which generally requires revenue earned on software arrangements involving multiple elements (such as software products, upgrades, enhancements, maintenance, installation and training) to be allocated
to each element based on the relative fair values of the elements. The fair value of an element must be based on evidence that is specific to us. If evidence of fair value does not exist for each element of a license arrangement and maintenance is
the only undelivered element, then all revenue for the license arrangement is recognized over the term of the agreement. If evidence of fair value does exist for the elements that have not been delivered, but does not exist for one or more delivered
elements, then revenue is recognized using the residual method, under which recognition of revenue for the undelivered elements is deferred and the residual license fee is recognized as revenue immediately.



Our revenue recognition policy is detailed in Note 1 of the Notes to
Consolidated Financial Statements on Form 10-K for the year ended March 31, 2005. Management has made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our products (referred to as an
arrangement in the accounting literature) we must evaluate whether our fee is fixed or determinable and we must assess whether collectibility is probable. These judgments are discussed below.



The fee is fixed or determinable. With respect to each arrangement, we
must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon



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delivery of software (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable, then the revenue recognized in each
period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized ratably.



Except in cases where we grant extended payment terms to a
specific customer, we have determined that our fees are fixed or determinable at the inception of our arrangements based on the following:



| |  |  | The fee our customers pay for our products is negotiated at the outset of an arrangement and is generally based on the specific volume of products to be delivered.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our license fees are not a function of variable-pricing mechanisms such as the number of units distributed or copied by the customer or the expected number of users of the product
delivered.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In order for an arrangement to be
considered fixed or determinable, 100% of the arrangement fee must be due within one year or less from the order date. We have a history of collecting fees on such arrangements according to contractual terms. Arrangements with payment terms
extending beyond 12 months are considered not to be fixed or determinable.



Collectibility is probable. In order to recognize revenue, we must make a judgment about the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis
pursuant to our credit review policy. We typically sell to customers for which there is a history of successful collection. New customers are subjected to a credit review process, which evaluates the customers financial positions and ability
to pay. If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, revenue is recognized on a cash receipts basis (as each payment is collected).



License revenue



We derive license revenue primarily from licenses of our design and
implementation software and, to a much lesser extent, from licenses of our analysis and verification products. We license our products under time-based and perpetual licenses.



We recognize license revenue after the execution of a license agreement and the delivery of the product to the customer,
provided that there are no uncertainties surrounding the product acceptance, fees are fixed or determinable, collection is probable and there are no remaining obligations other than maintenance. For licenses where we have vendor-specific objective
evidence of fair value (VSOE,) for maintenance, we recognize license revenue using the residual method. For these licenses, license revenue is recognized in the period in which the license agreement is executed assuming all other revenue
recognition criteria are met. For licenses where we have no VSOE for maintenance, we recognize license revenue ratably over the maintenance period, or if extended payment terms exist, based on the amounts due and payable.



For transactions in which we bundle maintenance for the entire license term
into a time-based license agreement, no VSOE of fair value exists for each element of the arrangement. For these agreements, where the only undelivered element is maintenance, we recognize revenue ratably over the contract term. If an arrangement
involves extended payment termsthat is, where payment for less than 100% of the license, services and initial post contract support is due within one year of the contract datewe recognize revenue to the extent of the lesser of the
portion of the amount due and payable or the ratable portion of the entire fee.



For our perpetual licenses and some time-based license arrangements, we unbundle maintenance by including maintenance for up to first year of the license term, with maintenance thereafter renewable by the customer at
the substantive rates stated in their agreements with us. In these unbundled licenses, the aggregate renewal period is greater than or equal to the initial maintenance period. The stated rate for maintenance renewal in these contracts is VSOE of the
fair value of maintenance in both our unbundled time-based and perpetual



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licenses. Where the only undelivered element is maintenance, we recognize license revenue using the residual method. If an arrangement involves extended
payment terms, revenue recognized using the residual method is limited to amounts due and payable.



If we were to change any of these assumptions or judgments, it could cause a material increase or decrease in the amount of revenue that we report in a
particular period. Amounts invoiced relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized over time as the applicable revenue recognition criteria are satisfied.



Services revenue



We derive services revenue primarily from consulting and training for our
software products and from maintenance fees for our products. Most of our license agreements include maintenance, generally for a one-year period, renewable annually. Services revenue from maintenance arrangements is recognized on a straight-line
basis over the maintenance term. Because we have VSOE of fair value for consulting and training services, revenue is recognized as these services are performed or completed. Our consulting and training services are generally not essential to the
functionality of the software. Our products are fully functional upon delivery of the product. Additional factors considered in determining whether the revenue should be accounted for separately include, but are not limited to: degree of risk,
availability of services from other vendors, timing of payments and impact of milestones or acceptance criteria on our ability to recognize the software license fee.



Unbilled accounts receivable



Unbilled accounts receivable represent revenue that has been recognized in advance of being invoiced to the customer. In all cases, the revenue and
unbilled receivables are for contracts which are non-cancelable, there are no contingencies and where the customer has taken delivery of both the software and the encryption key required to operate the software. We typically generate invoices 45
days in advance of contractual due dates, and we invoice the entire amount of the unbilled accounts receivable within one year from the contract inception.



Allowances for doubtful accounts



We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We regularly
review the adequacy of our accounts receivable allowance after considering the size of the accounts receivable balance, each customers expected ability to pay and our collection history with each customer. We review significant invoices that
are past due to determine if an allowance is appropriate using the factors described above. We also monitor our accounts receivable for concentration in any one customer, industry or geographic region.



For the quarter ended July 3, 2005, one customer accounted for more than 10%
of total receivables. The allowance for doubtful accounts represents our best estimate, but changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future. If actual losses are
significantly greater than the allowance we have established, that would increase our general and administrative expenses and reported net loss. Conversely, if actual credit losses are significantly less than our allowance, this would decrease our
general and administrative expenses and our reported net income would increase.



Accounting for asset purchases and business combinations



We are required to allocate the purchase price of acquired assets and business combinations to the tangible and intangible assets acquired, liabilities assumed, as well as in-process research and development based on
their estimated fair values. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.



Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from license sales,
maintenance agreements, consulting contracts, customer contracts, acquired



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workforce and acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable
products and estimated cash flows from the projects when completed; the acquired companys brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined
companys product portfolio; and discount rates. Managements estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate,
and unanticipated events and circumstances may occur.



Other
estimates associated with the accounting for these acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed resulting in changes in the purchase price allocation.



Goodwill impairment



Statement of Financial Accounting Standards No. 142, Goodwill and
Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests in certain circumstances. Application
of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting unit, and determining the fair value of the reporting unit. We
have determined that we have one reporting unit (see Note 11 of the Notes to the Condensed Consolidated Financial Statements in this Form 10-Q). Significant judgments required to estimate the fair value of a reporting unit include estimating future
cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for the reporting unit. Any impairment losses recorded in the future could
have a material adverse impact on our financial condition and results of operations.



Valuation of intangibles and long-lived assets



SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, requires that we record an impairment charge on finite-lived intangibles or long-lived assets to be held and used when we determine that the carrying
value of intangible assets and long-lived assets may not be recoverable. Based on the existence of one or more indicators of impairment, we measure any impairment of intangibles or long-lived assets based on a projected discounted cash flow method
using a discount rate determined by our management to be commensurate with the risk inherent in our business model. Our estimates of cash flows require significant judgment based on our historical results and anticipated results and are subject to
many factors.



Income taxes



We account for income taxes in accordance with SFAS 109, Accounting
for Income Taxes. Significant judgment is required in determining our provision for income taxes. In the ordinary course of business, there are many transactions and calculations where the ultimate tax outcome is uncertain. The amount of
income taxes we pay could be subject to audits by federal, state, and foreign tax authorities, which could result in proposed assessments. Although we believe that our estimates are reasonable, no assurance can be given that the final outcome of
these tax matters will not be different than that which is reflected in our historical income tax provisions.



We assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not
likely, we establish a valuation allowance. We consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent fiscal years, future taxable income, and ongoing prudent
and feasible tax planning strategies in assessing the amount of the valuation allowance. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis. Future reversals or increases to our valuation
allowance could have a significant impact on our future earnings.



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Strategic investments in privately-held companies



Our strategic equity investments consist of preferred stock and convertible
notes that are convertible into preferred or common stock of several privately-held companies. As of July 3, 2005, none of the notes have been converted. The carrying value of our portfolio of strategic equity investments in non-marketable equity
securities (privately-held companies) totaled $1.9 million at July 3, 2005. Our ability to recover our investments in private, non-marketable equity securities and to earn a return on these investments is primarily dependent on how successfully
these companies are able to execute on their business plans and how well their products are accepted, as well as their ability to obtain additional capital funding to continue operations. In the current equity market environment, their ability to
obtain additional funding as well as to take advantage of liquidity events, such as initial public offerings, mergers and private sales, may be significantly constrained.



Under our accounting policy, the carrying value of a non-marketable investment is the amount paid for the investment unless
it has been determined to be other than temporarily impaired, in which case we write the investment down to its estimated fair value. We review all of our investments periodically for impairment; however, for non-marketable equity securities, the
fair value analysis requires significant judgment. This analysis includes assessment of each investees financial condition, the business outlook for its products and technology, its projected results and cash flows, the likelihood of obtaining
subsequent rounds of financing and the impact of any relevant contractual equity preferences held by us or others. If an investee obtains additional funding at a valuation lower than our carrying amount, we presume that the investment is other than
temporarily impaired, unless specific facts and circumstances indicate otherwise, such as when we hold contractual rights that give us a preference over the rights of other investors. As the equity markets have declined significantly over the past
few years, we have experienced substantial impairments in our portfolio of non-marketable equity securities. If equity market conditions do not improve, as companies within our portfolio attempt to raise additional funds, the funds may not be
available to them, or they may receive lower valuations, with more onerous investment terms than in previous financings, and the investments will likely become impaired. However, we are not able to determine at the present time which specific
investments are likely to be impaired in the future, or the extent or timing of individual impairments. We recorded impairment charges related to these non-marketable equity investments of $0.4 million and $0.3 million during the first quarter of
fiscal 2006 and 2005, respectively.



Results of Operations



Revenue



Revenue consists of licenses revenue and services revenue. License revenue
consists of fees for time-based or perpetual licenses of our products. Services revenue consists of fees for services, such as post-contract customer support (PCS), customer training and consulting. We recognize revenue based on the
specific terms and conditions of the license contracts with our customer for our products and services as described in detail above in our Critical Accounting Policies and Estimates. For management reporting and analysis purposes we
classify our revenue into the following four categories:



| |  |  | Ratable
| | - |  | -------



| |  |  | Due & Payable
| | - |  | -------------



| |  |  | Cash Receipts
| | - |  | -------------



| |  |  | Turns or Up-front/ Perpetual or Time-Based
| | - |  | --------------------------------------------



We classify our license arrangements as either bundled or unbundled. Bundled license contracts include maintenance with the license fee and do not include
optional maintenance periods. Unbundled license contracts have separate maintenance fees and include optional maintenance periods.



We use this classification of license revenue to provide greater insight into the reporting and monitoring of trends in the components of our revenue and
to assist us in managing our business. It is important to note that the characterization of an individual contract may change over time. For example, a contract originally characterized



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as Ratable may be redefined as Cash Receipts if that customer has difficulty in making payments in a timely fashion. In cases where a contract has been
re-characterized for management reporting purposes, prior periods are not restated to reflect that change. The following table shows the breakdown of license revenue by category as defined for management reporting and analysis purposes:



|                      |  |                      |  |                    |        |             |               |   |         |   |             |  |     |  
|--------------------- |  | -------------------- |  | ------------------ | ------ | ----------- | ------------- | - | ------- | - | ----------- |  | --- | -
|                      |  |                      |  | Three Months Ended |       
|                      |  |                      |  | July 3, 2005       |        |             | June 30, 2004 |  
|                      |  |                      |  | $Amount            |        | % ofRevenue |               |   | $Amount |   | % ofRevenue | 
|Revenue category:     |  |                      |  |                    |        |             |               |   |         |   |             |  |     |  
|License revenue       |  |                      |  |                    |        |             |               |   |         |   |             |  |     |  
|Ratable               |  | Bundled andUnbundled |  | $                  | 5,007  |             | 13            | % |         | $ | 4,863       |  | 13  | %
|Due & Payable         |  | Unbundled            |  |                    | 13,593 |             | 35            | % |         |   | 15,352      |  | 43  | %
|Cash Receipts         |  | Unbundled            |  |                    | 1,876  |             | 5             | % |         |   | 2,577       |  | 7   | %
|Turns                 |  | Unbundled            |  |                    | 13,434 |             | 34            | % |         |   | 8,100       |  | 23  | %
|                      |  |                      |  |                    |        |             |               |   |         |   |             |  |     |  
|Total license revenue |  |                      |  |                    | 33,910 |             | 87            | % |         |   | 30,892      |  | 86  | %
|Services revenue      |  |                      |  |                    | 4,922  |             | 13            | % |         |   | 5,137       |  | 14  | %
|                      |  |                      |  |                    |        |             |               |   |         |   |             |  |     |  
|Total Revenue         |  |                      |  | $                  | 38,832 |             | 100           | % |         | $ | 36,029      |  | 100 | %
|                      |  |                      |  |                    |        |             |               |   |         |   |             |  |     |  



Bundled and
Unbundled Licenses: Ratable.For bundled time-based licenses, we recognize license revenue ratably over the contract term, or as customer payments become due and payable, if less. The revenue for these bundled arrangements for both license and
maintenance is classified as license revenue in our statement of operations. For unbundled time-based with a term of less than 15 months, we recognize license revenue ratably over the license term, or as customer payments become due and payable, if
earlier. For management reporting and analysis purposes, we refer to both these types of licenses generally as Ratable and we generally refer to all time-based licenses recognized on a ratable basis as Long Term, independent
of the actual length of term of the license.



We classify
unbundled perpetual or time-based licenses with a term of fifteen months or greater based on the payment term structure, as Due and Payable, Cash Receipts or Perpetual:



Unbundled Licenses: Due and Payable/Time-Based licenses with long term
payments.For unbundled time-based licenses where the payment terms extend greater than one year from the arrangement effective date, we recognize license revenue on a due and payable basis and we recognize maintenance and services revenue
ratably over the maintenance term. For management reporting and analysis purposes, we refer to this type of license generally as Due and Payable/Long Term Time-Based Licenses.



Unbundled Licenses: Cash Receipts.We recognize revenue from customers who have not met our predetermined credit
criteria on a cash receipts basis to the extent that revenue has otherwise been earned. Such customers generally order short-term time based licenses or separate annual maintenance. We recognize license revenue as we receive cash payments from these
customers. Maintenance is recognized ratably over the maintenance term after the customer has remitted payment. For management reporting and analysis purposes, we refer to this type of license revenue as Cash Receipts.



Unbundled Licenses: Turns/Perpetual License or Time-Based
licenses with short-term payments.For unbundled time-based and perpetual licenses, we recognize license revenue upon shipment as long as the payment terms require the customer to pay 100% of the license fee and the initial period of PCS within
one year from the agreement date and payments are generally linear. We recognize maintenance revenue ratably over the maintenance term. In all of these cases, the contracts are non-cancelable, and the customer has taken delivery of both the software
and the encryption key required to operate the software. For management reporting and analysis purposes, we refer to this type of license generally as Turns, where the license is either perpetual or time-based.



25



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Our license revenue in any given quarter depends upon the mix and volume of perpetual or short term
licenses ordered during the quarter and the amount of long-term ratable or due and payable, and cash receipts license revenue recognized during the quarter. In general, we refer to license revenue recognized from perpetual or time based licenses
during the quarter as Up-front or turns revenue, for management reporting and analysis purposes. All other types of revenue are generally referred to as revenue from backlog. We set our revenue targets for any given period
based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of short term licenses. The precise mix of orders fluctuates substantially from period to period and affects the revenue we recognize in the period.
If we achieve our target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we have more-than-expected long term licenses) or may exceed them (if we have more-than-expected short term or
perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets as described in the risk factors below.



Revenue, cost of revenue and gross profit



The table below sets forth the fluctuations in revenue, cost of revenue and
gross profit data for the three months ended July 3, 2005 and June 30, 2004 (in thousands, except percentage data):



|                      |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|--------------------- |  | ------------ | ------ | ------------ | --- | - | ------------- | - | ------------ |  | --- | ------------- |  | - | -------- | - |  | --- | --
|                      |  | July 3, 2005 |        | % of Revenue |     |   | June 30, 2004 |   | % of Revenue |  |     | Dollar Change |  |   | % Change |  
|Three Months Ended:   |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Revenue:              |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Licenses              |  | $            | 33,910 |              | 87  | % |               | $ | 30,892       |  | 86  | %             |  | $ | 3,018    |   |  | 10  | % 
|Services              |  |              | 4,922  |              | 13  | % |               |   | 5,137        |  | 14  | %             |  |   | (215     | ) |  | (4  | )%
|                      |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Total revenue         |  |              | 38,832 |              | 100 | % |               |   | 36,029       |  | 100 | %             |  |   | 2,803    |   |  | 8   | % 
|                      |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Cost of revenue:      |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Licenses              |  |              | 4,414  |              | 11  | % |               |   | 1,308        |  | 4   | %             |  |   | 3,106    |   |  | 237 | % 
|Services              |  |              | 3,857  |              | 10  | % |               |   | 3,734        |  | 10  | %             |  |   | 123      |   |  | 3   | % 
|                      |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Total cost of revenue |  |              | 8,271  |              | 21  | % |               |   | 5,042        |  | 14  | %             |  |   | 3,229    |   |  | 64  | % 
|                      |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Gross profit          |  | $            | 30,561 |              | 79  | % |               | $ | 30,987       |  | 86  | %             |  | $ | (426     | ) |  | (1  | )%
|                      |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   



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We market our products and related services to customers in four geographic regions: North America,
Europe (Europe, the Middle East and Africa), Japan, and Asia-Pacific. Internationally, we market our products and services primarily through our subsidiaries and various distributors. Revenue is attributed to geographic areas based on the country in
which the customer is domiciled. The table below sets forth geographic distribution of revenue data for the three months ended July 3, 2005 and June 30, 2004 (in thousands, except percentage data):



|                               |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|------------------------------ |  | ------------ | ------ | ------------ | --- | - | ------------- | - | ------------ |  | --- | ------------- |  | - | -------- | - |  | --- | --
|                               |  | July 3, 2005 |        | % of Revenue |     |   | June 30, 2004 |   | % of Revenue |  |     | Dollar Change |  |   | % Change |  
|Three Months Ended:            |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Domestic                       |  | $            | 28,161 |              | 73  | % |               | $ | 22,977       |  | 64  | %             |  | $ | 5,184    |   |  | 23  | % 
|                               |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|International:                 |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Europe                         |  |              | 4,201  |              | 11  | % |               |   | 4,850        |  | 14  | %             |  |   | (649     | ) |  | (13 | )%
|Japan                          |  |              | 4,236  |              | 11  | % |               |   | 5,566        |  | 15  | %             |  |   | (1,330   | ) |  | (24 | )%
|Asia-Pacific (excluding Japan) |  |              | 2,234  |              | 5   | % |               |   | 2,636        |  | 7   | %             |  |   | (402     | ) |  | (15 | )%
|                               |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Total International            |  |              | 10,671 |              | 27  | % |               |   | 13,052       |  | 36  | %             |  |   | (2,381   | ) |  | (18 | )%
|                               |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   
|Total revenue                  |  | $            | 38,832 |              | 100 | % |               | $ | 36,029       |  | 100 | %             |  | $ | 2,803    |   |  | 8   | % 
|                               |  |              |        |              |     |   |               |   |              |  |     |               |  |   |          |   |  |     |   



Revenue



| |  |  | Revenue for the first quarter of fiscal 2006 was $38.8 million, up 8% from the same quarter in the prior year.
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | License revenue increased in the first quarter of fiscal 2006 compared to the same quarter in the prior year primarily due to large orders executed during the first quarter
of fiscal 2006 in North America. These orders came from existing customers who extended license periods and added license capacity due to the continued proliferation of existing and new Magma products, amongst their design group designers. A single
customer accounted for greater than 10% of the revenue for both first quarter of fiscal 2006 and the same quarter in the prior year. License revenue as a percentage of revenue was consistent for both quarters.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Service revenue slightly decreased in the first quarter of fiscal 2006 compared to the same quarter in the prior year was due to a $0.7 million decrease in revenue from
consulting service, partially offset by $0.5 million increase in maintenance revenue. The increase in maintenance revenue was primarily due to our large customers accelerating their deployment of our licenses and placing additional service orders.
Service revenue as a percentage of total revenue was consistent for both quarters.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Domestic revenueincreased in the first quarter of fiscal 2006 compared to the same quarter in the prior year primarily due to a single customer in North America purchasing
additional capacity of existing licenses and licenses to new technology products. Domestic revenue as a percentage of total revenue increased by 9 percent in the first quarter of fiscal 2006 compared to the same quarter in the prior year.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | International revenue decreased in the first quarter of fiscal 2006 compared to the same quarter in the prior year primarily due to our existing customers in Japan and
Asia-Pacific demanding less capacity of existing licenses and licenses to new technology products. International revenue as a percentage of total revenue decreased by 9 percent in the first quarter of fiscal 2006 compared to the same quarter in the
prior year.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Cost of Revenue



| |  |  | Cost of license revenue primarily consists of amortization of acquired developed technology and other intangible assets, software maintenance costs,
royalties and allocated outside sale representative expenses. Cost of license revenue increased by $3.1 million in the first quarter of fiscal 2006 compared to the same quarter in the prior year primarily due to an increase of $2.0 million
amortization relating to
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | licensed technology, as the Company began recognizing revenue from products based on the licensed technology during the quarter. The amortization expense on
this technology was included in operating expense in prior periods. The remainder of the increase in the first quarter of fiscal 2006 compared to the same quarter in the prior year was due to amortization on intangibles purchased subsequent to the
first quarter of fiscal 2005.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Cost of service revenue primarily consists of personnel and related costs to provide product support, consulting services and training. Cost of service revenue also includes
asset depreciation, allocated outside sale representative expenses and amortization of deferred stock-based compensation. Cost of service revenue remained relatively stable during the first quarter of fiscal 2006 compared to the same quarter in the
prior year because the payroll related expenses for application engineers are relatively fixed in nature.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Operating expenses



The table below sets forth operating expense data for the three months ended July 3, 2005 and June 30, 2004 (in thousands, except percentage data):



|                                         |  |              |        |              |    |   |               |   |              |  |    |               |  |   |          |   |  |      |   
|---------------------------------------- |  | ------------ | ------ | ------------ | -- | - | ------------- | - | ------------ |  | -- | ------------- |  | - | -------- | - |  | ---- | --
|                                         |  | July 3, 2005 |        | % of Revenue |    |   | June 30, 2004 |   | % of Revenue |  |    | Dollar Change |  |   | % Change |  
|Three Months Ended:                      |  |              |        |              |    |   |               |   |              |  |    |               |  |   |          |   |  |      |   
|Operating expenses:                      |  |              |        |              |    |   |               |   |              |  |    |               |  |   |          |   |  |      |   
|Research and development                 |  | $            | 10,975 |              | 28 | % |               | $ | 9,569        |  | 27 | %             |  | $ | 1,406    |   |  | 15   | % 
|In-process research and development      |  |              |       |              | 0  | % |               |   | 4,009        |  | 11 | %             |  |   | (4,009   | ) |  | n/a  |   
|Sales and marketing                      |  |              | 11,202 |              | 29 | % |               |   | 11,267       |  | 31 | %             |  |   | (65      | ) |  | (1   | )%
|General and administrative               |  |              | 8,613  |              | 22 | % |               |   | 3,625        |  | 10 | %             |  |   | 4,988    |   |  | 138  | % 
|Amortization of intangible assets        |  |              | 3,588  |              | 9  | % |               |   | 4,475        |  | 12 | %             |  |   | (887     | ) |  | (20  | )%
|Amortization of stock-based compensation |  |              | 1,672  |              | 4  | % |               |   | 458          |  | 1  | %             |  |   | 1,214    |   |  | 265  | % 
|Restructuring costs                      |  |              |       |              | 0  | % |               |   | 502          |  | 1  | %             |  |   | (502     | ) |  | (100 | )%
|                                         |  |              |        |              |    |   |               |   |              |  |    |               |  |   |          |   |  |      |   
|Total operating expenses                 |  | $            | 36,050 |              | 93 | % |               | $ | 33,905       |  | 94 | %             |  | $ | 2,145    |   |  | 6    | % 
|                                         |  |              |        |              |    |   |               |   |              |  |    |               |  |   |          |   |  |      |   



| |  |  | Research and development expense increased in the first quarter of fiscal 2006 compared to the same quarter in the prior year primarily due to an increase in payroll related
expenses of $1.4 million, which included a $0.6 million increase in bonus expense, and, a $0.8 million increase in salaries and related expenses due to the increase of senior and experienced staff in research and development through direct hiring
and business acquisitions. The increase in research and development expense was also caused by higher allocated common expenses (e.g., facility related expenses) of $0.5 million in the first quarter of 2006 compared to the same quarter in the prior
year. The increases were partially offset by a decrease of $0.6 million in software maintenance costs due to the fact that a major software maintenance contract expired in the last quarter of fiscal 2005. The remainder of the fluctuation in research
and development expenses was accounted for by other individually insignificant items. We expect our quarterly research and development expenses in each of the remaining three quarters of fiscal 2006 to be consistent with the amount in the first
quarter of fiscal 2006 as our research and development headcount will remain at approximately the same level.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In-process research and development (IPR&D) expenses of $4.0 million for the first quarter of fiscal 2005 consisted of a charge recorded in connection with
our acquisition of Mojave, Inc. in April 2005. The charge was recorded based on managements final purchase price allocation. There has been no material change to the IPR&D project schedule as of July 3, 2005. Revenue resulting from the
IPR&D project commenced around the end of the first quarter of fiscal 2006.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Sales and marketing expense remained at approximately the same level in the first quarter of 2006 compared to the comparable prior fiscal year quarter. The
headcount in sales and marketing increased slightly by 6% (primarily application engineers) in the first quarter of fiscal 2006 compared to the same
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | quarter in the prior year. There were no material changes in our sales and marketing activities in the first quarter of fiscal 2006 compared to the same
quarter in the prior year. We expect that our quarterly sales and marketing expenses in each of the remaining three quarters of fiscal 2006 to be consistent with the amount in the first quarter of fiscal 2006 as our sales and marketing headcount
growth will be moderate and in line with the revenue growth.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | General and administrative expense increased by $5.0 million in the first quarter of fiscal 2006 compared to the same quarter in the prior year primarily due to increases in
professional service fees of $4.0 million, payroll related expenses of $0.7 million and asset depreciation of $0.7 million, partially offset by an increase in allocated cost of $0.7 million to other functional areas due to higher common expenses in
the first quarter of fiscal 2006 compared to the same quarter in the prior year. The increase in professional service fees for the first quarter of fiscal 2006 was primarily due to legal expenses related to patent litigation with Synopsys, Inc. and
other law suits. The remainder of the fluctuation in general and administrative expenses was accounted for by other individually insignificant items. We expect that our quarterly general and administrative expenses in each of the remaining three
quarters of fiscal 2006 will be consistent with the amount in the first quarter of fiscal 2006 as our general and administrative head count growth will be moderate and legal expenses and professional services related to litigation and compliance
with the requirements of the Sarbanes-Oxley Act of 2002 will remain at approximately the same level.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Restructuring costs in the first quarter of fiscal 2005 consisted of employee termination charges resulting from the Companys realignment to current business
conditions.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Amortization of intangible assets decreased by $0.9 million in the first quarter of fiscal 2006 compared to the same quarter in fiscal 2005 primarily due to the change in
classification of a $2.0 million amortization relating to developed technology to cost of license revenue from operating expenses. The Company began recognizing revenues from products based on the developed technology during the quarter. The
decrease was partially offset by amortization of intangible assets acquired subsequent to the first quarter of fiscal 2005. The intangible assets being amortized include technology licenses, trademarks, customer contracts, customer relationships, no
shop rights and non-competition agreements that were identified in the purchase price allocation for each business combination and asset purchase transaction.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Amortization of deferred stock-based compensation increased by $1.2 million in the first quarter of fiscal 2006 compared to the comparable quarter in fiscal 2005 primarily
due to an increase in amortization of deferred stock-based compensation of $0.8 million and $0.6 million, respectively, related to deferred stock compensation recorded in connection with the Companys 2005 Key Contributor Incentive Plan and the
Mojave acquisition and earnout. The increases were partially offset by decreases in amortization of deferred stock-based compensation of $0.2 million and $0.1 million, respectively, related to deferred stock compensation recorded in connection with
our IPO in November 2001 and the acquisition of VeraTest.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Other items



The table below sets forth
other data for the three months ended July 3, 2005 and June 30, 2004 (in thousands, except percentage data):



|                             |  |              |        |   |              |    |    |               |   |      |              |  |    |               |  |   |          |   |  |     |   
|---------------------------- |  | ------------ | ------ | - | ------------ | -- | -- | ------------- | - | ---- | ------------ |  | -- | ------------- |  | - | -------- | - |  | --- | --
|                             |  | July 3, 2005 |        |   | % of Revenue |    |    | June 30, 2004 |   |      | % of Revenue |  |    | Dollar Change |  |   | % Change |  
|Three Months Ended:          |  |              |        |   |              |    |    |               |   |      |              |  |    |               |  |   |          |   |  |     |   
|Other income (expense), net: |  |              |        |   |              |    |    |               |   |      |              |  |    |               |  |   |          |   |  |     |   
|Interest income              |  | $            | 660    |   |              | 2  | %  |               | $ | 553  |              |  | 2  | %             |  | $ | 107      |   |  | 19  | % 
|Interest expense             |  |              | (208   | ) |              | (1 | )% |               |   | (246 | )            |  | (1 | )%            |  |   | 38       |   |  | (15 | )%
|Other income, net            |  |              | 7,450  |   |              | 19 | %  |               |   | (562 | )            |  | (2 | )%            |  |   | 8,012    |   |  |     |   
|                             |  |              |        |   |              |    |    |               |   |      |              |  |    |               |  |   |          |   |  |     |   
|Total other income, net      |  | $            | 7,902  |   |              | 20 | %  |               | $ | (255 | )            |  | (1 | )%            |  | $ | 8,157    |   |  |     |   
|                             |  |              |        |   |              |    |    |               |   |      |              |  |    |               |  |   |          |   |  |     |   
|Provision for income taxes   |  | $            | (2,436 | ) |              | (6 | )% |               | $ | 638  |              |  | 2  | %             |  | $ | (3,074   | ) |  |     |   
|                             |  |              |        |   |              |    |    |               |   |      |              |  |    |               |  |   |          |   |  |     |   



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| |  |  | Interest income increased in the first quarter of fiscal 2006 compared to the same quarter in fiscal 2005 primarily due to higher interest rate on our cash and investments
balance during the period. Even though we used more than $50 million of cash to repurchase shares of common stock and a portion of the convertible subordinated notes, the higher short term interest rates allowed us continue to generate higher
interest income in the first quarter of fiscal 2006 as compared to the same quarter in fiscal 2005.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest expense primarily represents amortization of debt discount and issuance costs, which were recorded in connection with our convertible subordinated debt offering
completed in May 2003. In May 2005, we repurchased approximately 29.7% of the convertible subordinated debt. In connection with the repurchase, we wrote off $0.9 million of the unamortized debt issuance costs related to the repurchased portion of
the convertible subordinated debt. As a result, amortization of debt issuance costs decreased by $46,000 in the first quarter of fiscal 2006 compared to the same quarter in fiscal 2005.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Other income, net in the first quarter of fiscal 2006 consisted of a $9.7 million gain on repurchase of $44.5 million of the convertible subordinated debt, partially offset
by a $0.9 million write-off of the debt issuance costs related to the repurchase, a $0.7 million loss on sale of short-term investments, a $0.4 million charge associated with other than temporary impairment in our strategic investments and a foreign
exchange loss of $0.3 million. Other expense, net in the first quarter of fiscal 2005 consisted of a $0.3 million charge associated with other than temporary impairment in our strategic investments and $0.2 million of foreign exchange loss. The
impairment charge was determined based on our periodic review of investee company financial performance, financial conditions and near-term prospects. The slight increase of foreign exchange loss in the first quarter of fiscal 2006 was caused by an
unfavorable exchange rate fluctuation between the U.S. Dollar and the Japanese Yen.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Provision for income taxes. The income tax expense of $2.4 million for the three months ended July 3, 2005 primarily consists of the federal and state taxes provided for
certain discrete items, such as gain on the partial retirement of the convertible bond, impairment of certain equity investments and loss on disposal of certain investments, as well as the federal, state and foreign taxes provided for the income
derived from our normal operations. The income tax benefit of $0.6 million for the three months ended June 30, 2004 was comprised of a deferred tax benefit of $1.1 million related to the amortization of intangible assets, current federal income
taxes of $0.2 million, foreign income taxes of $0.2 million, and state income taxes of $0.1 million. Our effective tax rates vary from the U.S. statutory rate primarily due to changes in our valuation allowance, state taxes, foreign income at other
than U.S. rates, deferred compensation, in-process research and development, research and development credits, and foreign withholding taxes.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We are in a net deferred tax asset position, for which a full valuation allowance has been recorded. We will continue to provide a valuation allowance on our net deferred tax assets
until it becomes more likely than not that the deferred tax assets will be realizable. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In the event of a future change in ownership, as defined under federal and state tax laws, our net operating loss and tax credit carryfowards may be subject to an annual limitation.
The annual limitations may result in an increase to our current income tax provision and/or the expiration of the net operating loss and tax credit carryforwards before realization.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Liquidity and Capital Resources



|                                                    |  |              |         |   |                |   |        
|--------------------------------------------------- |  | ------------ | ------- | - | -------------- | - | -------
|                                                    |  | July 3, 2005 |         |   | March 31, 2005
|Cash, cash equivalents and short-term investments   |  | $            | 82,241  |   |                | $ | 135,518
|                                                    |  |             
|For the three months ended:                         |  | July 3, 2005 |         |   | June 30, 2004 
|Net cash provided by operating activities           |  | $            | 5,480   |   |                | $ | 12,468 
|Net cash provided by investing activities           |  | $            | 61,492  |   |                | $ | 2,521  
|Net cash provided by (used in) financing activities |  | $            | (49,003 | ) |                | $ | 2,591  



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During the fourth quarter of fiscal 2005, we reclassified auction rate securities of $20.6 million and
$55.5 million as of June 30, 2004 and March 31, 2004, respectively, from cash and cash equivalents to short-term investments. We have reclassified the purchases and sales of these auction rate securities in our condensed consolidated statements of
cash flows, which decreased our cash used in investing activities by $34.9 million for the three months ended June 30, 2004.



Our cash, cash equivalents and short-term investments, excluding restricted cash, were approximately $82.2 million at July 3, 2005, a decrease of $53.3
million or 39% from March 31, 2005. The decrease primarily reflected cash generated from operations and proceeds from common stock issuances, which in fiscal 2006 were more than offset by cash used for repurchase of a portion of the convertible
subordinated notes, repurchase of common stock, purchases of intangible assets, equity investments and capital investments. Our investment portfolio consists of high-grade fixed-income securities diversified among corporate, US agency and municipal
issuers with maturities of two years or less. A portion of the portfolio is allocated to auction rate securities which provide liquidity at par every 28 days with underlying longer-term maturities.



On April 13, 2005, we announced that our Board of Directors authorized Magma
to repurchase up to 2.0 million shares of our common stock. The stock repurchase program was completed in May 2005. We used approximately $16.0 million to repurchase 2.0 million shares of common stock. The repurchased shares are to be used for
general corporate purposes.



In early May 2005, we repurchased,
in privately negotiated transactions, $44.5 million face amount (or approximately 29.7 percent of the total) of these notes at an average discount to face value of approximately 22 percent. We spent an aggregate of approximately $34.8 million on the
repurchase. The repurchase leaves approximately $105.5 million aggregate principal amount of convertible subordinated notes outstanding. At the same time we terminated a portion (approximately 29.7 percent) of the hedging arrangements.



Net cash provided by operating activities



Net cash provided by operating activities was $5.5 million in the first
quarter of fiscal 2006 compared to $12.5 million in the same quarter in the prior year. The decrease was primarily due to a $7.8 million increase in costs and operating expenses, a $4.1 million decrease in cash from customers and a $1.2 million
change in prepaid and other assets balances. Prepaid and other assets increased by $0.4 million in the first quarter of fiscal 2006 and decreased by $0.8 million in the same quarter in fiscal 2005. These decreases in cash flow were partially offset
by a $5.7 million decrease in payments associated with accounts payable and accrued liabilities and a $0.9 million increase in cash from interest income. The decrease in cash from customers was primarily due to slower cash collection during the
first quarter of fiscal 2006 compared to the same quarter in fiscal 2005. The increase in prepaid expenses during the first quarter of 2006 was primarily caused by an increase of $1.7 million in prepaid software maintenance expense, partially offset
by decreases in prepaid commission expense of $0.3 million and other prepaid expenses of $1.0 million. The decrease in prepaid expenses during the first quarter of 2005 was primarily caused by decreases in prepaid software maintenance expense of
$0.4 million and in prepaid commission expense of $0.3 million. Prepaid commission decreased during the first quarter of fiscal 2006 and 2005 primarily due to orders recorded in fiscal 2003 of approximately $100.0 million for which we paid advance
commissions but where the entire order value has not been recognized as revenue in fiscal 2003. We expect commission paid in advance to decrease during years after fiscal 2003 as these orders are recognized as revenue in subsequent periods. The
payment of accrued liabilities during the first quarter of fiscal 2005 was primarily related to a payout of accrued bonuses during the period.



Net cash provided by investing activities



Net cash provided by investing activities was $61.5 million in the first quarter of fiscal 2006. We had net proceeds of $71.4 million from sales of
marketable securities as we liquidated these investments to repurchase a portion of the convertible subordinated notes. Partially offsetting the cash inflow, we used a total of $9.5 million



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in cash to purchase a technology license and made earnout payments relating to prior asset purchases. In addition, we acquired property and equipment
totaling $0.4 million in cash and $1.8 million through capital leases. We expect to make capital expenditures of approximately $7.8 million for the remainder of fiscal 2006. These capital expenditures will be used to support selling, marketing and
product development activities. We will use capital lease financing as well as our cash and cash equivalents and/or investments to fund these purchases. In addition, we may make additional strategic equity investments in the future by using our
cash, cash equivalents and/or investments.



Net cash provided
by investing activities was $2.5 million in the first quarter of fiscal 2005. We had net proceeds of $16.7 million from maturities of short-term investments. Partially offsetting the cash inflow, we used a total of $9.1 million in cash to complete
the Mojave and Lemmatis transactions during the quarter in order to broaden our product offerings and to incorporate certain key technologies into our existing products. We also made strategic investment of $0.3 million in a privately held
technology companies for business and strategic purposes. In addition, we acquired property and equipment totaling $4.8 million. The property and equipment expenditures were primarily for purchases of computer equipment and research and development
tools to support our growing operations.



Net cash used in financing
activities



Net cash used in financing activities was
$49.0 million in the first quarter of fiscal 2005. We used $34.8 million to repurchase a portion of our convertible subordinated notes and received net proceeds of $140,000 from termination of the related portion of the bond hedge and warrant. In
addition, we used $16.0 million to repurchase 2,000,000 shares of common stock on the open market, as authorized by the board of directors in April 2005, and made payments of $0.1 million on our capital leases. The primary source of cash was $1.8
million in cash received from the exercise of stock options and shares purchased under the employee stock purchase plan during the period.



Net cash provided by financing activities was $2.6 million in the first quarter of fiscal 2005, which consisted of proceeds from issuance of common stock.



Capital resources



We believe that our existing cash and cash equivalents and short-term
investments will be sufficient to meet our anticipated operating and working capital expenditure requirements in the ordinary course of business for at least the next 12 months. If we require additional capital resources to grow our business
internally or to acquire complementary technologies and businesses at any time in the future, we may use cash or need to sell additional equity or debt securities. The sale of additional equity or convertible debt securities may result in more
dilution to our existing stockholders. Financing arrangements may not be available to us, or may not be available in amounts or on terms acceptable to us.



Our acquisition agreements related to certain business combination and asset purchase transactions obligate us to pay certain contingent cash compensation
based on continued employment and meeting certain revenue or project milestones. Total cash contingent compensation that could be paid under our acquisition agreements assuming all contingencies are met is $49.3 million as of July 3, 2005.



Contractual obligations



As of July 3, 2005, our principal commitments consisted of operating leases,
with an aggregated future amount of $12.8 million through fiscal 2011 for office facilities, and repayment of the convertible subordinated notes of $105.5 million due in fiscal 2009. During the three months ended July 3, 2005, other than the
decrease of $44.5 million in the convertible subordinated notes, there were no material changes in our reported payments due under contractual obligations at March 31, 2005. Although we have no material commitments for capital



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expenditures, we anticipate a substantial increase in our capital expenditures and lease commitments with our anticipated growth in operations,
infrastructure, and personnel. In addition, we have other obligations for goods and services entered into in the normal course of business. These obligations, however, either are not enforceable or legally binding or are subject to change based on
our business decisions.



Off-balance Sheet Arrangements



As of July 3, 2005, we did not have any significant
off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K.



Indemnification Obligations



We enter into standard license agreements in the ordinary course of business. Pursuant to these agreements, we agree to indemnify our customers for losses
suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to our products. These indemnification obligations have perpetual terms. Our normal business
practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification we may be required to make may exceed its normal business practices. We estimate the fair value
of its indemnification obligations as insignificant, based on our historical experience concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of July 3, 2005.



We have agreements whereby our officers and directors are
indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is
unlimited; however, we have a directors and officers insurance policy that reduces our exposure and enables us to recover a portion of future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these
indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of July 3, 2005.



In connection with recent business acquisitions, we agreed to assume, or cause our subsidiaries to assume, indemnification obligations to the officers and
directors of acquired companies.



Warranties



We offer our customers a warranty that our products
will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, we have no liabilities recorded for these warranties as of
July 3, 2005. We assess the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.



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FACTORS THAT MAY AFFECT OUR BUSINESS AND FUTURE RESULTS OF OPERATIONS AND FINANCIAL CONDITION



Our business faces many risks. The risks described below may not be the
only risks we face. Additional risks that we do not yet know of or that we currently think are immaterial may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business,
financial condition or results of operations could suffer, and the trading price of our common stock could decline.



Our limited operating history makes it difficult to evaluate our business and prospects.



We were incorporated in April 1997 and introduced our first principal software product, Blast Fusion, in April 1999. We have
a limited history of generating revenue from our software products, and the revenue and income potential of our business and market is still unproven. As a result of our short operating history, we have limited financial data that can be used to
evaluate our business. We have only been profitable for eight of the last thirteen fiscal quarters, and we were not profitable prior to fiscal 2003. Our software products represent a new approach to the challenges presented in the electronic design
automation market, which to date has been dominated by established companies with longer operating histories. Key markets within the electronic design automation industry may fail to adopt our proprietary technologies and software products. Any
evaluation of our business and our prospects must be considered in light of our limited operating history and the risks and uncertainties often encountered by relatively young companies.



We have a history of losses prior to fiscal 2003 and subsequent to fiscal 2004 and have an accumulated deficit of approximately $115.7
million as of July 3, 2005; if we do not increase profitability, the public trading price of our stock would be likely to decline.



We had an accumulated deficit of approximately $115.7 million as of July 3, 2005. Although we achieved profitability in fiscal 2003 and fiscal 2004, we
incurred losses in prior years, in fiscal 2005 and the first quarter of fiscal 2006. If we incur new losses, or do not increase profitability at a level expected by securities analysts or investors, the market price of our common stock is likely to
decline. If we incur net losses, we may not be able to maintain or increase our number of employees or our investment in capital equipment, sales, marketing, and research and development programs, and we may not be able to continue to operate.



Our quarterly results are difficult to predict, and if we miss quarterly
financial expectations, our stock price could decline.



Our quarterly revenue and operating results are difficult to predict, and fluctuate from quarter to quarter. It is likely that our operating results in some periods will be below investor expectations. If this happens, the market price of
our common stock is likely to decline. Fluctuations in our future quarterly operating results may be caused by many factors, including:



| |  |  | size and timing of customer orders, which are received unevenly and unpredictably throughout a fiscal year;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | the mix of products licensed and types of license agreements;
| | - |  | -------------------------------------------------------------



| |  |  | our ability to recognize revenue in a given quarter;
| | - |  | ----------------------------------------------------



| |  |  | higher than anticipated costs in connection with patent litigation with Synopsys, Inc.;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | timing of customer license payments;
| | - |  | ------------------------------------



| |  |  | the relative mix of time-based licenses bundled with maintenance, unbundled time-based license agreements and perpetual license agreements, each of which has different revenue
recognition practices;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | size and timing of revenue recognized in advance of actual customer billings and customers with graduated payment schedules which may result in higher accounts receivable balances
and days sales outstanding (DSO);
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | the relative mix of our license and services revenue;
| | - |  | -----------------------------------------------------



| |  |  | our ability to win new customers and retain existing customers;
| | - |  | ---------------------------------------------------------------



| |  |  | changes in our pricing and discounting practices and licensing terms and those of our competitors;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | changes in the level of our operating expenses, including increases in incentive compensation payments that may be associated with future revenue growth;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in the interpretation of the authoritative literature under which we recognize revenue;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | the timing of product releases or upgrades by us or our competitors; and
| | - |  | ------------------------------------------------------------------------



| |  |  | the integration, by us or our competitors, of newly-developed or acquired products.
| | - |  | -----------------------------------------------------------------------------------



We currently face a patent infringement lawsuit brought by Synopsys, Inc., and we may face additional intellectual property infringement
claims against us or our customers. We are also subject to the ongoing risk of commercial litigation unrelated to intellectual property infringement claims, including that from pending lawsuits. In June 2005 a putative shareholder class action
lawsuit was filed against us, and, in July 2005 a putative shareholder derivative lawsuit was filed against us. Similar lawsuits could follow. Lawsuits can be costly to defend, can take the time of our management and employees away from day-to-day
operations, and could result in our loss of significant rights and/or financial resources.



On September 17, 2004, Synopsys, Inc., filed suit against us for patent infringement in the United States District Court (please see the discussion in
Part II. Item 1.Legal Proceedings below for further detail), and in the future other parties may assert intellectual property infringement claims against us or our customers. We have also acquired or may hereafter acquire software
as a result of our past or future acquisitions, and we may be subject to claims that such software infringes the intellectual property rights of third parties.



Our products may be found to infringe intellectual property rights of third parties, including third-party patents. In addition, many of our contracts
contain provisions in which we agree to indemnify our customers from third-party intellectual property infringement claims that are brought against them based on their use of our products. Also, we may be unaware of filed patent applications that
relate to our software products. We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent
infringement or settle through patent cross-licenses.



Due to
intellectual property litigation, including the pending Synopsys, Inc. litigation, we could lose critical proprietary rights and incur substantial unexpected operating costs. Intellectual property litigation is expensive and time-consuming and could
divert managements attention from our business. If there is a successful claim of infringement, we may be ordered to pay substantial monetary damages (including punitive damages), we may be prevented from distributing all or some of our
products, and we may be required to develop non-infringing technology or enter into royalty or license agreements, which may not be available on acceptable terms, if at all. Our failure to develop non-infringing technologies or license the
proprietary rights on a timely basis would harm our business.



On April 18, 2005, Synopsys, Inc. filed an action against us in Germany seeking to obtain ownership of the European patent application corresponding to Magmas 446 Patent (as defined in Item II, Part I -Legal
Proceedings). We have engaged counsel in Germany and this action will be stayed pending the outcome of the above-referenced Synopsys action filed in the United States.



On July 29, 2005, Synopsys, Inc. filed an action against us in Japan seeking to obtain ownership of the Japanese patent
application corresponding to Magmas 446 Patent (as defined in Item II, Part I - Legal Proceedings). We are in the process of engaging counsel in Japan and will seek to stay this action pending the outcome of the
above-referenced Synopsys action filed in the United States.



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In June 13, 2005, a putative shareholder class action lawsuit was filed against us in federal court as
further identified in Part II, Item 1.Legal Proceedings. Generally, the complaint in this lawsuit alleges that defendants (Magma, Rajeev Madhavan, Gregory C. Walker and Roy E. Jewell) failed to disclose information regarding the
risk of Magma infringing intellectual property rights of Synopsys, Inc., in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and prays for unspecified damages.



On July 26, 2005, a putative derivative lawsuit was filed against us in state
court as further identified in Part II, Item 1.Legal Proceedings. The Complaint in this lawsuit seeks unspecified damages purportedly on behalf of the Company for alleged breaches of fiduciary duties by various directors and
officers, as well as for alleged violations of insider trading laws by executives.



With respect to the above-referenced Synopsys, Inc. lawsuit, the June 13, 2005 lawsuit and the July 26, 2005 lawsuit, we are currently unable to assess the possible extent of damages and/or other relief, if any, that
could be awarded against us, therefore, with respect to the Synopsys, Inc. lawsuit and the June 13, 2005 lawsuit, no contingent liability has been recorded on our condensed consolidated balance sheet as of July 3, 2005.



Publicly announced developments in our litigation matters that are perceived
to be adverse to us, have caused, and, may in the future cause our stock price to decline sharply and suddenly. In addition, the stock market has historically experienced significant price and volume fluctuations that have adversely affected the
market prices of common stock of technology companies. These broad market fluctuations may reduce the market price of our common stock. Accordingly, we are subject to ongoing risk of securities class action litigation related to volatility in the
market price for our securities. In addition, there is the possibility that additional lawsuits related to the above-referenced June 13, 2005 and July 26, 2005 lawsuits will be filed against us.



In addition to the above matters, we are often involved in or threatened with
commercial litigation unrelated to intellectual property infringement claims such as labor litigation and contract claims, and we may acquire companies that are actively engaged in such litigation.



We may not be successful in defending some or all claims that may be brought
against us. Regardless of the outcome, litigation can result in substantial expense and could divert the efforts of our management and technical personnel from our business. In addition, the ultimate resolution of the above-referenced lawsuits or
other third party assertions could have a material adverse effect on our financial position, results of operations and cash flows and harm our ability to execute our business plan.



We may not be able to hire and/or retain the number of qualified personnel required for our business, particularly engineering personnel,
which would harm the development and sales of our products and limit our ability to grow.



Competition in our industry for senior management, technical, sales, marketing and other key personnel is intense. If we are unable to retain our existing personnel, or attract and train additional qualified
personnel, our growth may be limited due to a lack of capacity to develop and market our products.



In particular, we continue to experience difficulty in hiring and retaining skilled engineers with appropriate qualifications to support our growth
strategy. Our success depends on our ability to identify, hire, train and retain qualified engineering personnel with experience in integrated circuit design. Specifically, we need to continue to attract and retain field application engineers to
work with our direct sales force to technically qualify new sales opportunities and perform design work to demonstrate our products capabilities to customers during the benchmark evaluation process. Competition for qualified engineers is
intense, particularly in Silicon Valley where our headquarters is located.



Retaining our employees has become more challenging due to the decline in our stock price over the past several years. Many of the stock options held by our employees have an exercise price that is significantly
higher than the current trading price of our stock, and these underwater options do not serve their purpose as



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incentives for our employees to remain with Magma. Although, as discussed below, we are attempting to address this problem in part via a stock option
exchange program that will allow eligible employees to exchange existing underwater options for options exercisable for a smaller number of shares at the current trading price, we cannot guarantee that this program will satisfy our employees. In
addition, the increased volatility of our stock price due to the pendency of, and developments in, the Synopsys litigation and above-referenced shareholder litigation may affect employee morale. If we lose the services of a significant number of our
employees and/or if we cannot hire additional employees, we will be unable to increase our sales or implement or maintain our growth strategy.



Our success is highly dependent on the technical, sales, marketing and managerial contributions of key individuals, and we may be unable to recruit and retain these
personnel.



We depend on our senior executives and certain
key research and development and sales and marketing personnel, who are critical to our business. We do not have long-term employment agreements with our key employees, and we do not maintain any key person life insurance policies. Furthermore, our
larger competitors may be able to offer more generous compensation packages to executives and key employees, and therefore we risk losing key personnel to those competitors. If we lose the services of any of our key personnel, our product
development processes and sales efforts could be slowed. We may also incur increased operating expenses and be required to divert the attention of our senior executives to search for their replacements. The integration of our new executives or any
new personnel could disrupt our ongoing operations.



Customer payment
defaults may cause us to be unable to recognize revenue from backlog, and changes in the type of orders comprising backlog could affect the proportion of revenue recognized from backlog each quarter, which could have a material adverse effect on our
financial condition and results of operations and on investor expectations.



A portion of our revenue backlog is variable based on volume of usage of our products by the customers or includes specific future deliverables or is recognized in revenue on a cash receipts basis. Management has
estimated variable usage based on customers forecasts, but there can be no assurance that these estimates will be realized. In addition, it is possible that customers from whom we expect to derive revenue from backlog will default and as a
result we may not be able to recognize expected revenue from backlog. If a customer defaults and fails to pay amounts owed, or if the level of defaults increases, our bad debt expense is likely to increase. Any material payment default by our
customers could have a material adverse effect on our financial condition and results of operations.



Our lengthy and unpredictable sales cycle, and the large size of some orders, makes it difficult for us to forecast revenue and increases the magnitude of quarterly fluctuations, which could harm our stock price.



Customers for our software products typically commit
significant resources to evaluate available software. The complexity of our products requires us to spend substantial time and effort to assist potential customers in evaluating our software and in benchmarking it against our competition. As the
complexity of the products we sell increases, we expect the sales cycle to lengthen. In addition, potential customers may be limited in their current spending by existing time-based licenses with their legacy vendors. In these cases, customers delay
a significant new commitment to our software until the term of the existing license has expired. Also, because our products require a significant investment of time and cost by our customers, we must target those individuals within the
customers organization who are able to make these decisions on behalf of their companies. These individuals tend to be senior management in an organization, typically at the vice president level. We may face difficulty identifying and
establishing contact with such individuals. Even after initial acceptance, the negotiation and documentation processes can be lengthy. Our sales cycle typically ranges between three and nine months, but can be longer. Any delay in completing sales
in a particular quarter could cause our operating results to fall below expectations.



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We rely on a small number of customers for a significant portion of our revenue, and our revenue could decline due to
delays of customer orders or the failure of existing customers to renew licenses or if we are unable to maintain or develop relationships with current or potential customers.



Our business depends on sales to a small number of customers. We had one customer that accounted for 32% of our revenue in
the first quarter of fiscal 2006, as compared to 27% in the same quarter of prior year.



We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenue for the foreseeable future. If we fail to sell sufficient quantities of our products and
services to one or more customers in any particular period, or if a large customer reduces purchases of our products or services, defers orders, or fails to renew licenses, our business and operating results will be harmed.



Most of our customers license our software under time-based licensing
agreements, with terms that typically vary from 15 months to 48 months. Most of our license agreements automatically expire at the end of the term unless the customer renews the license with us or purchases a perpetual license. If our customers do
not renew their licenses, we may not be able to maintain our current revenue or may not generate additional revenue. Some of our license agreements allow customers to terminate an agreement prior to its expiration under limited
circumstancesfor example, if our products do not meet specified performance requirements or goals. If these agreements are terminated prior to expiration or we are unable to collect under these agreements, our revenue may decline.



Some contracts with extended payment terms provide for payments which are
weighted toward the later part of the contract term. Accordingly, as the payment terms are extended, the revenue from these contracts is not recognized evenly over the contract term, but is recognized as the lesser of the cumulative amounts due and
payable or ratably for bundled agreements, and as amounts become due and payable for unbundled agreements, at each period end. Revenue recognized under these arrangements will be higher in the later part of the contract term, which puts our revenue
recognition in the future at greater risk of the customers continuing credit-worthiness. In addition, some of our customers have extended payment terms, which creates additional credit risk.



We compete against companies that hold a large share of the electronic design automation
market and competition is increasing among EDA vendors as customers tightly control their EDA spending and use fewer vendors to meet their needs. If we cannot compete successfully, we will not gain market share and our revenue could decline.



We currently compete with companies that hold dominant
shares in the electronic design automation market, such as Cadence and Synopsys. Each of these companies has a longer operating history and significantly greater financial, technical and marketing resources than we do, as well as greater name
recognition and larger installed customer bases. Our competitors are better able to offer aggressive discounts on their products, a practice they often employ. Our competitors offer a more comprehensive range of products than we do; for example, we
do not offer logic simulation, full-feature custom layout editing, analog or mixed signal products, which can sometimes be an impediment to our winning a particular customer order. In addition, our industry has traditionally viewed acquisitions as
an effective strategy for growth in products and market share and our competitors greater cash resources and higher market capitalization may give them a relative advantage over us in buying companies with promising new chip design products or
companies that may be too large for us to acquire without a strain on our resources.



Competition in the EDA Market has increased as customers rationalized their EDA spending by using products from fewer EDA vendors and continued consolidation in the electronic design automation market could intensify
this trend. Also, many of our competitors, including Cadence and Synopsys, have established relationships with our current and potential customers and can devote substantial resources aimed at preventing us from establishing or enhancing our
customer relationships. Competitive pressures may prevent us from obtaining new customers and gaining market share, may require us to reduce the price of products and services or cause us to lose existing customers, which could harm our business. To
execute our business strategy successfully, we must continue our efforts to increase our sales worldwide. If we fail to do so in a timely manner or at all, we may not be able to gain market share and our business and operating results could suffer.



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Also, a variety of small companies continue to emerge, developing and introducing new products. Any of
these companies could become a significant competitor in the future. We also compete with the internal chip design automation development groups of our existing and potential customers. Therefore, these customers may not require, or may be reluctant
to purchase, products offered by independent vendors.



Our
competitors may develop or acquire new products or technologies that have the potential to replace our existing or new product offerings. The introduction of these new or additional products by competitors may cause potential customers to defer
purchases of our products. If we fail to compete successfully, we will not gain market share and our business will fail.



We may not be successful in integrating the operations of acquired companies and acquired technology.



We expect to continuously evaluate the possibility of accelerating our
growth through acquisitions, as is customary in the electronic design automation industry. Achieving the anticipated benefits of past and possible future acquisitions will depend in part upon whether we can integrate the operations, products and
technology of acquired companies with our operations, products and technology in a timely and cost-effective manner. The process of integrating with acquired companies and acquired technology is complex, expensive and time consuming, and may cause
an interruption of, or loss of momentum in, the product development and sales activities and operations of both companies. In addition, the earnout arrangements we use, and expect to continue to use, to consummate some of our acquisitions, pursuant
to which we agreed to pay additional amounts of contingent consideration based on the achievement of certain revenue, bookings or product development milestones, can sometimes complicate integration efforts. We cannot be sure that any part or all of
the integration will be accomplished on a timely basis, or at all. Assimilating previously acquired companies such as Silicon Metrics Corporation and Mojave, Inc., or any other companies we may seek to acquire in the future, involves a number of
other risks, including, but not limited to:



| |  |  | adverse effects on existing customer relationships, such as cancellation of orders or the loss of key customers;
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | difficulties in integrating or an inability to retain key employees of the acquired company;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | the risk that earnouts based on revenue will prove difficult to administer due to the complexities of revenue recognition accounting;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the risk that actions incentivized by earnout provisions will ultimately prove not to be in Magmas best interest as its interests may change over time;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | difficulties in integrating the operations of the acquired company, such as information technology resources, manufacturing processes, and financial and operational data;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | difficulties in integrating the technologies of the acquired company into our products;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | diversion of management attention;
| | - |  | ----------------------------------



| |  |  | potential incompatibility of business cultures;
| | - |  | -----------------------------------------------



| |  |  | potential dilution to existing stockholders if we have to incur debt or issue equity securities to pay for any future acquisitions; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | additional expenses associated with the amortization of intangible assets.
| | - |  | --------------------------------------------------------------------------



Our operating results may be harmed if our customers do not adopt, or are slow to adopt, 65-nanometer design geometries.



Many Magma customers are currently working on 90-nanometer designs. Magma
continues to work toward developing and enhancing its product line in anticipation of increased customer demand for 65-nanometer (sub-90 nanometer) design geometries. Similarly, Magma has acquired Mojave personnel and technology to better address
customers needs for designing and verifying semiconductors that are manufacturable with higher yield and performance, which is a key design parameter when moving to 65-nanometer geometries. Notwithstanding



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our efforts to support 65-nanometer geometries, customers may fail to adopt or may be slower to adopt 65-nanometer geometries and we may be unable to
convince our customers to purchase our related software products. Accordingly, any revenues we receive from enhancements to our products or acquired technologies may be less than the development or acquisition costs. If customers fail to adopt
65-nanometer design geometries or are slow to adopt 65-nanometer design geometries, our operating results may be harmed.



Our operating results will be harmed if chip designers do not adopt Blast Fusion and products released under our Cobra initiative.



Blast Fusion has accounted for a significant majority of our revenue since
our inception and we believe that revenue from Blast Fusion and related products will account for most of our revenue for the foreseeable future. In addition, we have dedicated significant resources to developing and marketing products developed
under our Cobra development initiative. We must gain market penetration of Blast Fusion and products released under our Cobra initiative in order to achieve our growth strategy and financial success. Moreover, if integrated circuit designers do not
continue to adopt Blast Fusion, our operating results will be significantly harmed.



If the industries into which we sell our products experience recession or other cyclical effects affecting our customers research and development budgets, our revenue would be likely to decline.



Demand for our products is driven by new integrated circuit design projects.
The demand from semiconductor and systems companies is uncertain and difficult to predict. Slower growth in the semiconductor and systems industries, a reduced number of design starts, reduction of electronic design automation budgets or continued
consolidation among our customers would harm our business and financial condition. We have experienced slower growth in revenue than we anticipated as a result of the prolonged downturn and decreased spending by our customers in the semiconductor
and systems industries.



The primary customers for our products
are companies in the communications, computing, consumer electronics, networking and semiconductor industries. Any significant downturn in our customers markets or in general economic conditions that results in the cutback of research and
development budgets or the delay of software purchases would likely result in lower demand for our products and services and could harm our business. For example, the United States economy, including the semiconductor industry, experienced a
slowdown starting in 2000, which negatively impacted and may continue to impact our business and operating results. While the semiconductor industry experienced a moderate recovery in recent years, our customers have remained cautious, and it is not
yet clear when increased R&D spending will occur. The continuing threat of terrorist attacks in the United States, the ongoing events in Iraq and other worldwide events including those in the Middle East have increased uncertainty in the United
States economy. If the economy declines as a result of this economic, political and social turmoil, existing customers may delay their implementation of our software products and prospective customers may decide not to adopt our software products,
either of which could negatively impact our business and operating results.



In recent years, some Asian countries have experienced significant economic difficulties, including devaluation and instability, business failures and a depressed business environment. These difficulties triggered a
significant downturn in the semiconductor market, resulting in reduced budgets for chip design tools, which, in turn, negatively impacted us. We have experienced delayed orders and slower deployment of our products under new orders as a result of
reduced budgets for chip design tools. In addition, the electronics industry has historically been subject to seasonal and cyclical fluctuations in demand for its products, and this trend may continue in the future. These industry downturns have
been, and may continue to be, characterized by diminished product demand, excess manufacturing capacity and subsequent erosion of average selling prices.



Difficulties in developing and achieving market acceptance of new products and delays in planned release dates of our software products and upgrades may harm our
business.



To succeed, we will need to develop innovative
new products. We may not have the financial resources necessary to fund all required future innovations. Expanding into new technologies or extending our product line



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into areas we have not previously addressed may be more costly or difficult than anticipated. Also, any revenue that we receive from enhancements or new
generations of our proprietary software products may be less than the costs of development. If we fail to develop and market new products in a timely manner, our reputation and our business will suffer.



Our costs of customer engagement and support are high, so our gross margin may decrease if
we incur higher-than-expected costs associated with providing support services in the future or if we reduce our prices.



Because of the complexity of our products, we typically incur high field application engineering support costs to engage new customers and assist them in
their evaluations of our products. If we fail to manage our customer engagement and support costs, our operating results could suffer. In addition, our gross margin may decrease if we are unable to manage support costs associated with the services
revenue we generate or if we reduce prices in response to competitive pressure.



Product defects could cause us to lose customers and revenue, or to incur unexpected expenses.



Our products depend on complex software, both internally developed and licensed from third parties. Our customers may use our products with other
companies products, which also contain complex software. If our software does not meet our customers performance requirements, our customer relationships may suffer. Also, a limited number of our contracts include specified ongoing
performance criteria. If our products fail to meet these criteria, it may lead to termination of these agreements and loss of future revenue. Complex software often contains errors. Any failure or poor performance of our software or the third-party
software with which it is integrated could result in:



| |  |  | delayed market acceptance of our software products;
| | - |  | ---------------------------------------------------



| |  |  | delays in product shipments;
| | - |  | ----------------------------



| |  |  | unexpected expenses and diversion of resources to identify the source of errors or to correct errors;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | damage to our reputation;
| | - |  | -------------------------



| |  |  | delayed or lost revenue; and
| | - |  | ----------------------------



| |  |  | product liability claims.
| | - |  | -------------------------



Our product functions are often critical to our customers, especially because of the resources our customers expend on the design and fabrication of
integrated circuits. Many of our licensing agreements contain provisions to provide a limited warranty, which provides the customer with a right of refund for the license fees if we are unable to correct errors reported during the warranty period.
If our contractual limitations are unenforceable in a particular jurisdiction or if we are exposed to claims that are not covered by insurance, a successful claim could harm our business. We currently carry insurance coverages and limits that we
believe are consistent with similarly situated companies within the EDA industry.



Much of our business is international, which exposes us to risks inherent to doing business internationally that could harm our business. We also intend to expand our international operations. If our revenue from this expansion does not
exceed the expenses associated with this expansion, our business and operating results could suffer.



We generated 27% of our total revenue from sales outside North America for the first quarter of fiscal 2006, compared to 36% for our same quarter in the
prior year. While most of our international sales to date have been denominated in U.S. dollars, our international operating expenses have been denominated in foreign currencies. As a result, a decrease in the value of the U.S. dollar relative to
the foreign currencies could increase the relative costs of our overseas operations, which could reduce our operating margins.



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The expansion of our international operations includes the maintenance of sales offices in Europe, the
Middle East, and the Asia Pacific region. If our revenue from international operations does not exceed the expense of establishing and maintaining our international operations, our business could suffer. Additional risks we face in conducting
business internationally include:



| |  |  | difficulties and costs of staffing and managing international operations across different geographic areas;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | changes in currency exchange rates and controls;
| | - |  | ------------------------------------------------



| |  |  | uncertainty regarding tax and regulatory requirements in multiple jurisdictions;
| | - |  | --------------------------------------------------------------------------------



| |  |  | the possible lack of financial and political stability in foreign countries, preventing overseas sales growth;
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | on-going events in Iraq; and
| | - |  | ----------------------------



| |  |  | the effects of terrorist attacks in the United States and any related conflicts or similar events worldwide.
| | - |  | ------------------------------------------------------------------------------------------------------------



Future changes in accounting standards, specifically changes affecting revenue
recognition, could cause adverse unexpected revenue fluctuations.



Future changes in accounting standards for interpretations thereof, specifically those changes affecting software revenue recognition, could require us to change our methods of revenue recognition. These changes could result in deferral of
revenue recognized in current periods to subsequent periods or in accelerated recognition of deferred revenue to current periods, each of which could cause shortfalls in meeting the expectations of investors and securities analysts. Our stock price
could decline as a result of any shortfall. Implementation of internal controls reporting and attestation requirements, as further described below, will impose additional financial and administrative obligations on us and will cause us to incur
substantial implementation costs from third party consultants, which could adversely affect our results.



Changes in laws and regulations that affect the governance of public companies have increased our operating expenses and will continue to do so.



Recently enacted changes in the laws and regulations affecting public companies, including the provisions of the Public
Company Accounting Reform and Investor Protection Act of 2002 (the Sarbanes-Oxley Act of 2002) and the listing requirements for The Nasdaq Stock Market have imposed new duties on us and on our executives, directors, attorneys and
independent registered public accounting firms. In order to comply with these new rules, we have hired additional personnel and use additional outside legal, accounting and advisory services, all of which have increased and may continue to increase
our operating expenses over time. In particular, we have incurred and will continue to incur additional administrative expenses relating to the implementation of Section 404 of the Sarbanes-Oxley Act of 2002, which requires the implementation and
maintenance of an effective system of internal control over financial reporting, and, annual certification of Section 404 compliance by our independent registered public accounting firm. For example, we have incurred significant expenses and will
continue to incur expenses in connection with the implementation, documentation and continued testing of our internal control systems. Management time associated with these compliance efforts necessarily reduces time available for other operating
activities, which could adversely affect operating results. For the year ended March 31, 2005, our independent registered public accounting firm certified that we were in compliance with the provision of Section 404 relating to effective
internal control over financial reporting, however, our internal control obligations are ongoing and subject to continued review and testing. If we are unable to maintain full and timely compliance with the foregoing regulatory requirements, we
could be required to incur additional costs, expend additional management time on remedial efforts and make related public disclosures that could adversely affect our stock price and result in securities litigation.



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



Management must make significant assumptions, judgments and estimates to
determine our current provision for income taxes, deferred tax assets and liabilities, and any valuation allowance that may be recorded against our deferred tax assets. These assumptions, judgments and estimates are difficult to make due to their
complexity and the relevant tax law is often changing. Our future effective tax rates could be adversely affected by the following:



| |  |  | an increase in expenses not deductible for tax purposes, including deferred stock-based compensation and write-offs of acquired in-process research and development;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in the valuation of our deferred tax assets and liabilities;
| | - |  | --------------------------------------------------------------------



| |  |  | future changes in ownership as defined by Internal Revenue Code Sections 382 and 383 which may limit realization of certain assets;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in forecasts of pre-tax profits and losses by jurisdiction used to estimate tax expense by jurisdiction;
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | assessment of additional taxes as a result of federal, state, or foreign tax examinations; or
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | changes in tax laws or interpretations of such tax laws.
| | - |  | --------------------------------------------------------



Our success will depend on our ability to keep pace with the rapidly evolving technology standards of the semiconductor industry. If we are unable to keep pace with
rapidly changing technology standards, our products could be rendered obsolete, which would cause our operating results to decline.



The semiconductor industry has made significant technological advances. In particular, recent advances in deep sub-micron technology have required
electronic design automation companies to continuously develop or acquire new products and enhance existing products. The evolving nature of our industry could render our existing products and services obsolete. Our success will depend, in part, on
our ability to:



| |  |  | enhance our existing products and services;
| | - |  | -------------------------------------------



| |  |  | develop and introduce new products and services on a timely and cost-effective basis that will keep pace with technological developments and evolving industry standards;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | address the increasingly sophisticated needs of our customers; and
| | - |  | ------------------------------------------------------------------



| |  |  | acquire other companies that have complementary or innovative products.
| | - |  | -----------------------------------------------------------------------



If we are unable, for technical, legal, financial or other reasons, to respond in a timely manner to changing market conditions or customer requirements,
our business and operating results could be seriously harmed.



If we fail to
offer and maintain competitive stock option packages for our employees, or if our stock price declines materially for a protracted period of time, we might have difficulty retaining our employees and our business may be harmed.



In todays competitive technology industry, employment decisions of
highly skilled personnel are influenced by stock option packages, which offer incentives above traditional compensation only where there is a consistent, long-term upward trend over time of a companys stock price. Our stock price has declined
significantly over the past several years due to market conditions and has recently been negatively affected by uncertainty surrounding the outcome of our patent litigation with Synopsys, Inc. (discussed below under Part II, Item 1, Legal
Proceedings). As a result, many of the options held by our non-executive employees have an exercise price significantly above the current trading price of our stock; on July 3, 2005 approximately 86% of the options held by our non-executive
employees were underwater.



On June 22, 2005, our
stockholders approved a stock option exchange program (Exchange Program) allowing non-executive employees holding options to purchase our common stock at exercise prices greater than



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or equal to $10.50 to exchange those options for a smaller number of new options at an exercise price equal to fair market value on the date of grant. The
date of grant is expected to be August 22, 2005. If the closing trading price of our stock on August 22, 2005 or the terms of the Exchange Program are not satisfactory to employees who participate in the Exchange Program, or, if our stock price
drops after August 22, 2005, our ability to retain employees could be affected.



If our stock price continues to decline in the future due to market conditions, investors perceptions of the technology industry or managerial or performance problems we have, we may be forced to grant
additional options to retain employees. This in turn could result in:



| |  |  | immediate and substantial dilution to investors resulting from the grant of additional options necessary to retain employees; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | compensation charges against the company, which would negatively impact our operating results.
| | - |  | ----------------------------------------------------------------------------------------------



In addition, the new accounting requirements for employee stock options discussed below may adversely affect our option
grant practices and our ability to recruit and retain employees.



When the
accounting treatment for employee stock options changes, our reported results of operations will likely be adversely affected and we may be forced to change our employee compensation and benefits practices.



We currently account for the issuance of employee stock options under
principles that do not require us to record compensation expense for options granted at fair market value. In December 2004, the FASB issued SFAS 123R, Share-Based Payment, which eliminates the ability to account for share-based
compensation transactions using APB 25, and generally requires instead that such transactions be accounted for using a fair-value based method. Under SFAS 123R, companies are required to recognize an expense for compensation cost related to
share-based payment arrangements including stock options and employee stock purchase plans. We will be required to adopt the new rules no later than the first quarter of our fiscal year 2007. We are currently assessing the impact of the adoption of
SFAS 123R on our business practices; however, this change in accounting treatment will likely adversely affect our reported results of operations and hinder our ability to achieve profitability. Accordingly, we may consider changing our employee
compensation practices, and those changes could make it harder for us to retain existing employees and attract qualified candidates.



If our sales force compensation arrangements are not designed effectively, we may lose sales personnel and resources.



Designing an effective incentive compensation structure for our sales force
is critical to our success. We have experimented, and continue to experiment, with different systems of sales force compensation. If our incentives are not well designed, we may experience reduced revenue generation, and we may also lose the
services of our more productive sales personnel, either of which would reduce our revenue or potential revenue.



Fluctuations in our growth place a strain on our management systems and resources, and if we fail to manage the pace of our growth our business could be harmed.



Periods of growth followed by efforts to realign costs
when revenue growth is slower than anticipated have placed a strain on our management, administrative and financial resources. For example, in fiscal year 2005 and the third quarter of fiscal year 2003, we decreased our workforce by 23 and 32
employees, respectively. Over time we have significantly expanded our operations in the United States and internationally, and we plan to continue to expand the geographic scope of our operations. To pace the growth of our operations with the growth
in our revenue, we must continue to improve administrative, financial and operations systems, procedures and controls. Failure to improve our internal procedures and controls could hinder our efforts to adequately manage our growth, disrupt
operations, lead to deficiencies under the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, and ultimately harm to our business.



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If chip designers and manufacturers do not integrate our software into existing design flows, or if other software
companies do not cooperate in working with us to interface our products with their design flows, demand for our products may decrease.



To implement our business strategy successfully, we must provide products that interface with the software of other electronic design automation software
companies. Our competitors may not support our or our customers efforts to integrate our products into their existing design flows. We must develop cooperative relationships with competitors so that they will work with us to integrate our
software into a customers design flow. Currently, our software is designed to interface with the existing software of Cadence, Synopsys and others. If we are unable to convince customers to adopt our software products instead of those of
competitors offering a broader set of products, or if we are unable to convince other software companies to work with us to interface our software with theirs to meet the demands of chip designers and manufacturers, our business and operating
results will suffer.



We may not obtain sufficient patent protection, which
could harm our competitive position and increase our expenses.



Our success and ability to compete depends to a significant degree upon the protection of our software and other proprietary technology. We currently have a number of issued patents in the United States, but this number is relatively few in
relation to our competitors.



These legal protections afford
only limited protection for our technology. In addition, rights that may be granted under any patent application that may issue in the future may not provide competitive advantages to us. Further, patent protection in foreign jurisdictions where we
may need this protection may be limited or unavailable. It is possible that:



| |  |  | our pending U.S. and non-U.S. patents may not be issued;
| | - |  | --------------------------------------------------------



| |  |  | competitors may design around our present or future issued patents or may develop competing non-infringing technologies;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | present and future issued patents may not be sufficiently broad to protect our proprietary rights; and
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | present and future issued patents could be successfully challenged for validity and enforceability.
| | - |  | ---------------------------------------------------------------------------------------------------



We believe the patent portfolios of our competitors are far larger than ours, and this may increase the risk that they may
sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses.



We rely on trademark, copyright and trade secret laws and contractual restrictions to protect our proprietary rights, and if these rights are not sufficiently
protected, it could harm our ability to compete and generate income.



To establish and protect our proprietary rights, we rely on a combination of trademark, copyright and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses. Our ability to
compete and grow our business could suffer if these rights are not adequately protected. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software
pursuant to agreements, which impose certain restrictions on the licensees ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary
information to execute confidentiality agreements. Our proprietary rights may not be adequately protected because:



| |  |  | laws and contractual restrictions in U.S. and foreign jurisdictions may not prevent misappropriation of our technologies or deter others from developing similar technologies;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | competitors may independently develop similar technologies and software code;
| | - |  | -----------------------------------------------------------------------------



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| |  |  | for some of our trademarks, federal U.S. trademark protection may be unavailable to us;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | our trademarks may not be protected or protectable in some foreign jurisdictions;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | the validity and scope of our U.S. and foreign trademarks could be successfully challenged; and
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we may be unable to determine the extent of this unauthorized use.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The laws of some countries in which we market
our products may offer little or no protection of our proprietary technologies. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technologies could enable third parties to benefit from our technologies without
paying us for it, which would harm our competitive position and market share.



Our directors, executive officers and principal stockholders own a substantial portion of our common stock and this concentration of ownership may allow them to elect most of our directors and could delay or prevent a change in control
of Magma.



Our directors, executive officers and
stockholders who currently own over 5% of our common stock beneficially own a substantial portion of our outstanding common stock. These stockholders, in a combined vote, will be able to significantly influence all matters requiring stockholder
approval. For example, they may be able to elect most of our directors, delay or prevent a transaction in which stockholders might receive a premium over the market price for their shares or prevent changes in control or management.



We may need additional capital in the future, but there is no assurance that funds would
be available on acceptable terms.



In the future we may
need to raise additional capital in order to achieve growth or other business objectives. This financing may not be available in sufficient amounts or on terms acceptable to us and may be dilutive to existing stockholders. If adequate funds are not
available or are not available on acceptable terms, our ability to expand, develop or enhance services or products, or respond to competitive pressures would be limited.



Our certificate of incorporation, bylaws and Delaware corporate law contain anti-takeover provisions which could delay or prevent a
change in control even if the change in control would be beneficial to our stockholders. We could also adopt a stockholder rights plan, which could also delay or prevent a change in control.



Delaware law, as well as our certificate of incorporation and bylaws,
contain anti-takeover provisions that could delay or prevent a change in control of our company, even if the change of control would be beneficial to the stockholders. These provisions could lower the price that future investors might be willing to
pay for shares of our common stock. These anti-takeover provisions:



| |  |  | authorize the Board of Directors without prior stockholder approval to create and issue preferred stock that can be issued increasing the number of outstanding shares and deter or
prevent a takeover attempt;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | prohibit stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  |  | establish a classified Board of Directors requiring that not all members of the board be elected at one time;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | prohibit cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | limit the ability of stockholders to call special meetings of stockholders; and
| | - |  | -------------------------------------------------------------------------------



| |  |  | require advance notice requirements for nominations for election to the Board of Directors and proposals that can be acted upon by stockholders at stockholder meetings.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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In addition, Section 203 of the Delaware General Corporation Law and the terms of our stock option plans
may discourage, delay or prevent a change in control of our company. That section generally prohibits a Delaware corporation from engaging in a business combination with an interested stockholder for three years after the date the stockholder became
an interested stockholder. Also, our stock option plans include change-in-control provisions that allow us to grant options or stock purchase rights that will become vested immediately upon a change in control of us.



The board of directors also has the power to adopt a stockholder rights plan,
which could delay or prevent a change in control even if the change in control appeared to be beneficial to stockholders. These plans, sometimes called poison pills, are sometimes criticized by institutional investors or their advisors
and could affect our rating by such investors or advisors. If the board were to adopt such a plan it might have the effect of reducing the price that new investors are willing to pay for shares of our common stock.



We are subject to risks associated with changes in foreign currency exchange rates.



We transact some portions of our business in various
foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to operating expenses in the United Kingdom, Europe and Japan, which are denominated in the
respective local currencies. As of July 3, 2005, we had no hedging contracts outstanding. We do not currently use financial instruments to hedge operating expenses denominated in Euro, British Pounds and Japanese Yen. We assess the need to utilize
financial instruments to hedge currency exposures on an ongoing basis.



The
convertible notes we issued in May 2003 are debt obligations that must be repaid in cash in May 2008 if they are not converted into our common stock at an earlier date, which is unlikely to occur if the price of our common stock does not exceed the
conversion price.



In May 2003, we issued $150.0 million
principal amount of our zero coupon convertible notes due May 2008. In May 2005, we repurchased, in privately negotiated transactions, $44.5 million face amount (or approximately 29.7 percent of the total) of these notes at an average discount to
face value of approximately 22 percent. Magma spent an aggregate of approximately $34.8 million on the repurchases. The repurchase leaves approximately $105.5 million aggregate principal amount of convertible subordinated notes outstanding. We
will be required to repay that principal amount in full in May 2008 unless the holders of those notes elect to convert them into our common stock before the repayment date. The conversion price of the notes is $22.86 per share. If the price of our
common stock does not rise above that level, conversion of the notes is unlikely and we would be required to repay the principal amount of the notes in cash. There have been previous quarters in which we have experienced shortfalls in revenue and
earnings from levels expected by securities analysts and investors, which have had an immediate and significant adverse effect on the trading price of our common stock. In addition, the stock market in recent years has experienced extreme price and
trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may adversely affect the price of our stock, regardless of our operating
performance. Because the notes are convertible into shares of our common stock, volatility or depressed prices for our common stock could have a similar effect on the trading price of the notes.



Hedging transactions and other transactions may affect the value of our common stock and
our convertible notes.



We entered into hedging
arrangements with Credit Suisse First Boston International at the time we issued our convertible notes, with the objective of reducing the potential dilutive effect of issuing common stock upon conversion of the notes. At the time of our May 2005
repurchase of our zero coupon convertible notes, a portion of the hedging arrangements were retired. These hedging arrangements are likely to have caused Credit Suisse First Boston International and others to take positions in our common stock in
secondary market transactions or to enter into derivative transactions at or after the sale of the notes. Any market participants entering into hedging arrangements are likely to modify their hedge positions from time to time prior to conversion or
maturity of the



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notes by purchasing and selling shares of our common stock or other securities, which may increase the volatility and reduce the market price of our common
stock.



Our convertible notes are subordinated and there are no financial
covenants in the indenture.



Our convertible notes are
general unsecured obligations of Magma and are subordinated in right of payment to all of our existing and future senior indebtedness, which we may incur in the future. In the event of our bankruptcy, liquidation or reorganization, or upon
acceleration of the notes due to an event of default under the indenture and in certain other events, our assets will be available to pay obligations on the notes only after all senior indebtedness has been paid. As a result, there may not be
sufficient assets remaining to pay amounts due on any or all of the outstanding notes. In addition, we will not make any payments on the notes in the event of payment defaults or other specified defaults on our designated senior indebtedness.



Neither we nor our subsidiaries are restricted under the
indenture for the notes from incurring additional debt, including senior indebtedness. If we or our subsidiaries incur additional debt or other liabilities, our ability to pay our obligations on the notes could be further adversely affected. We
expect that we and our subsidiaries from time to time will incur additional indebtedness and other liabilities.



We may be unable to meet the requirements under the indenture to purchase our convertible notes upon a change in control.



Upon a change in control, which is defined in the indenture to include some
cash acquisitions and private company mergers, note holders may require us to purchase all or a portion of the notes they hold. If a change in control were to occur, we might not have enough funds to pay the purchase price for all tendered notes.
Future credit agreements or other agreements relating to our indebtedness might prohibit the redemption or repurchase of the notes and provide that a change in control constitutes an event of default. If a change in control occurs at a time when we
are prohibited from purchasing the notes, we could seek the consent of our lenders to purchase the notes or could attempt to refinance this debt. If we do not obtain a consent, we could not purchase the notes. Our failure to purchase tendered notes
would constitute an event of default under the indenture, which might constitute a default under the terms of our other debt. In such circumstances, or if a change in control would constitute an event of default under our senior indebtedness, the
subordination provisions of the indenture would possibly limit or prohibit payments to note holders. Our obligation to offer to purchase the notes upon a change in control would not necessarily afford note holders protection in the event of a highly
leveraged transaction, reorganization, merger or similar transaction involving us.



Failure to obtain export licenses could harm our business by preventing us from transferring our technology outside of the United States.



We are required to comply with U.S. Department of Commerce regulations when shipping our software products and/or transferring our technology outside of
the United States or to certain foreign nationals. We believe we have complied with applicable export regulations, however, these regulations are subject to change, and, future difficulties in obtaining export licenses for current, future developed
and acquired products and technology could harm our business, financial conditions and operating results.



Our business operations may be adversely affected in the event of an earthquake or other natural disaster.



Our corporate headquarters and much of our research and development operations are located in Silicon Valley, California, which is an area known for its
seismic activity. An earthquake, fire or other significant natural disaster could have a material adverse impact on our business, financial condition and/or operating results.



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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Interest Rate Risk



Our
exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is
accomplished by investing in widely diversified short-term and long-term investments, consisting primarily of investment grade securities, substantially all of which mature within the next twenty-four months. As of July 3, 2005, a hypothetical 100
basis point increase in interest rates would result in approximately a $26,000 decline in the fair value of our available-for-sale securities.



The fair value of our fixed rate long-term debt is sensitive to interest rate changes. Interest rate changes would result in increases or decreases in the
fair value of our debt, due to differences between market interest rates and rates in effect at the inception of our debt obligation. Changes in the fair value of our fixed rate debt have no impact on our cash flows or consolidated financial
statements.



Credit Risk



We completed an offering on May 22, 2003 of $150.0 million principal amount
of convertible subordinated notes due May 15, 2008. Concurrent with the issuance of the convertible notes, we entered into convertible bond hedge and warrant transactions with respect to our common stock, the exposure for which is held by Credit
Suisse First Boston International. Both the bond hedge and warrant transactions may be settled at our option either in cash or net shares and expire on May 15, 2008. The transactions are expected to reduce the potential dilution from conversion of
the notes. Subject to the movement in the share price of our common stock, we could be exposed to credit risk in the settlement of these options in our favor. Based on a review of the possible net settlements and the credit strength of Credit Suisse
First Boston International and its affiliates, we believe that we do not have a material exposure to credit risk arising from these option transactions.



In April 2005, the Company repurchased $44.5 million face value of its convertible notes for $34.8 million. In doing so, the Company liquidated
investments that generated a realized loss of approximately $0.7 million. A portion of the hedge and warrant transactions entered into by Magma in 2003 was terminated in connection with the repurchase. The Company believes that it was in the best
interests of the stockholders to reduce the balance sheet debt despite the one-time loss resulting from the liquidation of marketable securities.



Foreign Currency Exchange Rate Risk



A majority of our revenue, expense, and capital purchasing activities are transacted in U.S. dollars. However, we transact some portions of our business
in various foreign currencies, primarily related to a portion of revenue in Japan and operating expenses in Europe, Japan and Asia-Pacific. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. As of July
3, 2005, we had no currency hedging contracts outstanding. We do not currently use financial instruments to hedge revenue and operating expenses denominated in foreign currencies. We assess the need to utilize financial instruments to hedge currency
exposures on an ongoing basis.



ITEM 4. CONTROLS AND PROCEDURES



Evaluation of disclosure controls and procedures.We maintain disclosure controls and procedures, as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act), that
are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission
rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing
and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can



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provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure
controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in
part upon assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. However, our disclosure controls and procedures have been
designed to meet, and management believes that they meet, reasonable assurance standards.



Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures
were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being
prepared. Although our principal executive officer and principal accounting officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report, we continue to enhance our controls by
hiring qualified personnel in key functional areas, implementing a new computerized system to automate a number of procedures related to quarterly and year-end close processes, and creating procedures to address the impact of acquisitions on a
timely basis.



Changes in Internal Control over Financial
Reporting.There were no changes in our internal control or to our knowledge, in other factors that could significantly affect our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred
during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART II. OTHER INFORMATION



ITEM 1.  LEGAL PROCEEDINGS



Synopsys, Inc. v. Magma Design Automation, Inc., Civil Action No. C04-03923 (MMC), United States District Court, Northern District of California. In this action, filed September 17, 2004, Synopsys has sued the Company for
alleged infringement of U.S. Patent Nos. 6,378,114 (the 114 Patent), 6,453,446 (the 446 Patent), and 6,725,438 (the 438 Patent). The patents-in-suit relate to methods for designing integrated
circuits. The Complaint seeks unspecified monetary damages, injunctive relief, trebling of damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly
obtained by the Company as a result of its alleged infringement of the patents-in-suit.



On October 21, 2004, the Company filed its answer and counterclaims (Answer) to the Complaint. On November 10, 2004 Synopsys filed motions to strike and dismiss certain affirmative defenses and
counterclaims in the Answer. On November 24, 2004 the Company filed an Amended Answer and Counterclaims (Amended Answer). By order dated November 29, 2004, the Court denied Synopsys motions as moot in light of the Amended Answer.
On December 10, 2004, Synopsys moved to strike and dismiss certain affirmative defenses and counterclaims in the Amended Answer. By order dated January 20, 2005, the Court denied in part and granted in part Synopsys motion. In its pretrial
preparation order dated January 21, 2005, the Court set forth a schedule for the case which, among other things, sets trial for April 24, 2006. Discovery is ongoing.



On February 3, 2005, Synopsys filed its Reply to the Amended Answer. On March 17, 2005, Synopsys filed a First Amended
Complaint, which asserts seven causes of action against the Company and/or Lukas van Ginneken: (1) patent infringement (against both defendants), (2) breach of contract (against van Ginneken), (3) inducing breach of contract (against the Company),
(4) fraud (against the Company), (5) conversion (against both defendants), (6) unjust enrichment/constructive trust (against both defendants), and (7) unfair competition (against both defendants). Synopsys seeks injunctive relief, declaratory
relief, at least $100 million in damages, trebling of damages, punitive damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by the Company as
a result of its alleged exploitation of the alleged inventions in the patents-in-suit. On April 1, 2005, the Company filed a motion to dismiss the third through seventh causes of action. This motion was granted in part and denied in part by order
dated May 18, 2005.



On April 11, 2005, Synopsys voluntarily
dismissed van Ginneken from the lawsuit without prejudice. Also on April 11, 2005, Synopsys filed against the Company a motion for partial summary judgment establishing unfair competition and a motion for partial summary judgment based on the
doctrine of assignor estoppel.



On June 7, 2005, Synopsys filed
a Second Amended Complaint that asserts six causes of action against the Company: (1) patent infringement, (2) inducing breach of contract/interference with contractual relations, (3) fraud, (4) conversion, (5) unjust enrichment/constructive
trust/quasi-contract, and (6) unfair competition. Synopsys seeks injunctive relief, declaratory relief, at least $100 million in damages, trebling of damages, punitive damages, fees and costs, and the imposition of a constructive trust for the
benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by the Company as a result of its alleged exploitation of the alleged inventions in the patents-in-suit. On June 10, 2005, Magma moved for summary judgment as to the
second through sixth causes of action in the Second Amended Complaint. On June 21, 2005, the Company moved to dismiss the third cause of action for fraud in the Second Amended Complaint and moved to strike certain allegations in the Second Amended
Complaint. The court granted the Companys motion to dismiss and strike by order dated July 15, 2005.



On July 1, 2005, the Court granted Synopsyss motion for partial summary judgment regarding assignor estoppel, dismissing Magmas affirmative
defenses and counterclaim alleging the invalidity of the 114 Patent. On July 14, 2005, the court vacated the hearings on Magmas motion for summary judgment on the second



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through sixth causes of action in the Second Amended Complaint and Synopyss motion for partial summary judgment establishing unfair competition. The
court stated that it would reset the motions for hearing, if necessary, after the claims construction hearing scheduled for August 15, 2005.



On July 29, 2005, Synopsys moved to preliminarily enjoin the Company from abandoning or dedicating to the public the 446 Patent or the 438
Patent. Also on July 29, 2005, Synopsys moved for partial summary judgment dismissing certain counterclaims and defenses by the Company on the grounds of estoppel by contract. Both motions are scheduled to be heard September 9, 2005.



On August 3, 2005, Synopsys filed a Third Amended Complaint that asserts six
causes of action against the Company: (1) patent infringement, (2) inducing breach of contract/interference with contractual relations, (3) fraud, (4) conversion, (5) unjust enrichment/constructive trust/quasi-contract, and (6) unfair competition.
Synopsys seeks injunctive relief, declaratory relief, at least $100 million in damages, trebling of damages, punitive damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other
benefits allegedly obtained by the Company as a result of its alleged exploitation of the alleged inventions in the patents-in-suit.



The Company intends to vigorously defend against the claims asserted by Synopsys and to fully enforce its rights against Synopsys. However, the results of
any litigation are inherently uncertain and the Company can not assure that it will be able to successfully defend against the Complaint. A favorable outcome for Synopsys could have a material adverse effect on the Companys financial position,
results of operations or cash flows. The Company is currently unable to assess the extent of damages and/or other relief, if any, that could be awarded to Synopsys; therefore, no contingent liability has been recorded on our condensed consolidated
balance sheet as of July 3, 2005.



On April 18, 2005, Synopsys,
Inc. filed an action against the Company in Germany seeking to obtain ownership of the European patent application corresponding to the Companys 446 Patent. The Company has engaged counsel in Germany and this action will be stayed
pending the outcome of the above-referenced Synopsys action filed in the United States.



On July 29, 2005, Synopsys, Inc. filed an action against the Company in Japan seeking to obtain ownership of the Japanese patent application corresponding to the Companys 446 Patent. The Company is in the
process of engaging counsel in Japan and will seek to stay this action pending the outcome of the above-referenced Synopsys action filed in the United States.



On June 13, 2005, a putative shareholder class action lawsuit captioned The Cornelia I. Crowell GST Trust vs. Magma Design Automation, Inc., Rajeev
Madhavan, Gregory C. Walker and Roy E. Jewell., No. C 05 02394, was filed in U.S. District Court, Northern District of California. The complaint alleges that defendants failed to disclose information regarding the risk of Magma infringing
intellectual property rights of Synopsys, Inc., in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and prays for unspecified damages. The Company is currently unable to assess the possible range or extent
of damages and/or other relief, if any, that could be awarded to the shareholder class; therefore, no contingent liability has been recorded on our condensed consolidated balance sheet as of July 3, 2005. The ultimate resolution of this matter or
other third party assertions could have a material adverse effect on the Companys financial position, results of operations or cash flows.



On July 26, 2005, a putative derivative complaint captionedSusan Willis v. Magma Design Automation, Inc. et al., No. 1-05-CV-045834, was filed in
the Superior Court of the State of California for the County of Santa Clara. The Complaint seeks unspecified damages purportedly on behalf of the Company for alleged breaches of fiduciary duties by various directors and officers, as well as for
alleged violations of insider trading laws by executives during a period between October 23, 2002 and April 12, 2005. The Company is currently unable to assess the possible range or extent of damages and/or other relief, if any, that could be
awarded; therefore, no contingent liability has been recorded on our condensed consolidated balance sheet as of July 3, 2005. The



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ultimate resolution of this matter or other third party assertions could have a material adverse effect on the Companys financial position, results of
operations or cash flows.



In addition to the above, from time
to time, the Company is involved in disputes that arise in the ordinary course of business. The number and significance of these disputes is increasing as the Companys business expands and it grows larger. Any claims against the Company,
whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these disputes could harm the
Companys business, financial condition, results of operations or cash flows.



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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



Recent Sales Of Unregistered Securities



Magma previously reported its issuance of a warrant to IBM in its Form 8-K filing dated June 30, 2005. The warrant is also discussed under Note 5 to the Companys Consolidated Financial Statements.



Issuer Purchases of Equity Securities



ISSUER PURCHASES OF EQUITY SECURITIES



|                         |  |                                  |  |                              |      |                                                                                |           |                                                                                       |  
|------------------------ |  | -------------------------------- |  | ---------------------------- | ---- | ------------------------------------------------------------------------------ | --------- | ------------------------------------------------------------------------------------- | -
|Period                   |  | Total Number of Shares Purchased |  | Average Price Paid per Share |      | Total Number ofShares Purchased asPart of PubliclyAnnounced Plans orPrograms * |           | Approximate Dollar Value ofShares that May Yet BePurchased Under the Plansor Programs
|April 1  April 30, 2004 |  | 0                                |  |                              | N/A  |                                                                                | 0         |                                                                                       | 0
|May 1  May 31, 2005     |  | 2,000,000                        |  | $                            | 7.99 |                                                                                | 2,000,000 |                                                                                       | 0
|June 1  July 3, 2005    |  | 0                                |  |                              | N/A  |                                                                                | 0         |                                                                                       | 0
|Total                    |  | 2,000,000                        |  | $                            | 7.99 |                                                                                | 2,000,000 |                                                                                       | 0

---

|* | On April 13, 2005, the Company announced that its Board of Directors had authorized a share repurchase program of up to 2,000,000 shares of Company common stock, as further
described in Note 12 to the condensed consolidated financial statements. The repurchase program was completed during the quarter ended July 3, 2005.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.



A Special Meeting of Stockholders (the Special Meeting) was held on June 22, 2005 in order for stockholders to vote on whether to approve a stock option exchange program (the Exchange Program)
that allows Magma employees (other than executive officers) to exchange stock options with an exercise price per share of $10.50 or greater for options to purchase a lesser number of shares at an exercise price equal to the fair market value of
Magmas common stock on the date such new options are granted*. The results of the vote were as follows:



|           |  |           |  |        
|---------- |  | --------- |  | -------
|For        |  | Against   |  | Abstain
|21,729,578 |  | 3,233,723 |  | 5,629  

---

|* | Exchange Program is currently ongoing and new options are expected to be granted on August 22, 2005.
|- | ----------------------------------------------------------------------------------------------------



ITEM 5. OTHER INFORMATION



Departure and Appointment of Directors



On
June 10, 2005, Wade Meyercord resigned as a member of the Companys Board of Directors (the Board). Mr. Meyercord had served on the Board since January 2004. Mr. Meyercords resignation was not due to any disagreement with the
Company known to an executive officer of the Company on any matter relating to the Companys operations, policies or practices.



The Board appointed Susumu Kohyama as a member of the Board, effective upon his acceptance of that appointment on June 10, 2005. Dr. Kohyama has not yet
been appointed to any committees of the Board. There is no arrangement between Dr. Kohyama and any other person pursuant to which he was selected as a director. There is no family relationship between Dr. Kohyama and any other Company executive
officer or director. In connection with his appointment, Dr. Kohyama is entitled to the Companys standard director compensation arrangements.



The foregoing events were reported in the Companys Form 8-K filing dated June 10, 2005.



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ITEM 6. EXHIBITS



The following documents are filed as Exhibits to this report:



|               |  |                                                                                                                                                |  |                           |  |                |  |             |  |                   |  |  
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- |  | -------------- |  | ----------- |  | ----------------- |  | -
|Exhibit Number |  | Exhibit Description                                                                                                                            |  | Incorporated by Reference |  | Filed Herewith
|               |  | Form                                                                                                                                           |  | File No.                  |  | Exhibit        |  | Filing Date | 
|               |  |                                                                                                                                                |  |                           |  |               
|4.1            |  | Amended and Restated Certificate of Incorporation                                                                                              |  | 10-K                      |  | 000-33213      |  | 3.1         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.2            |  | Certificate of Correction to the Amended and Restated Certificate of Incorporation                                                             |  | 10-K                      |  | 000-33213      |  | 3.2         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.3            |  | Amended and Restated Bylaws                                                                                                                    |  | 10-K                      |  | 000-33213      |  | 3.3         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.4            |  | Amended and Restated Investors Rights Agreement dated July 31, 2001, by and among the Registrant and the parties that are signatories thereto |  | 10-K                      |  | 000-33213      |  | 4.2         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.5            |  | Form of Common Stock Certificate                                                                                                               |  | S-1/A                     |  | 333-60838      |  | 4.1         |  | November 15, 2001 |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|10.1           |  | Warrant Agreement                                                                                                                              |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|31.1           |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer                                                                          |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|31.2           |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer                                                                          |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|32.1           |  | Section 1350 Certification of Principal Executive Officer                                                                                      |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|32.2           |  | Section 1350 Certification of Principal Financial Officer                                                                                      |  |                           |  |                |  |             |  |                   |  | X



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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.



|                       |  |                               |  |                                                                                                                                                       
|---------------------- |  | ----------------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------
|                       |  | MAGMA DESIGN AUTOMATION, INC.
|                       |  |                              
|Dated: August 11, 2005 |  | By                            |  | /s/    GREGORY C.
WALKER                                                                                                                              
|                       |  |                               |  | Gregory C. Walker Senior Vice PresidentFinance and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Signatory)



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EXHIBIT INDEX



TO



MAGMA DESIGN AUTOMATION, INC.



QUARTERLY REPORT ON FORM 10-Q



FOR THE QUARTER ENDED JULY 3, 2005



|               |  |                                                                                                                                                |  |                           |  |                |  |             |  |                   |  |  
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- |  | -------------- |  | ----------- |  | ----------------- |  | -
|Exhibit Number |  | Exhibit Description                                                                                                                            |  | Incorporated by Reference |  | Filed Herewith
|               |  | Form                                                                                                                                           |  | File No.                  |  | Exhibit        |  | Filing Date | 
|               |  |                                                                                                                                                |  |                           |  |               
|4.1            |  | Amended and Restated Certificate of Incorporation                                                                                              |  | 10-K                      |  | 000-33213      |  | 3.1         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.2            |  | Certificate of Correction to the Amended and Restated Certificate of Incorporation                                                             |  | 10-K                      |  | 000-33213      |  | 3.2         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.3            |  | Amended and Restated Bylaws                                                                                                                    |  | 10-K                      |  | 000-33213      |  | 3.3         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.4            |  | Amended and Restated Investors Rights Agreement dated July 31, 2001, by and among the Registrant and the parties that are signatories thereto |  | 10-K                      |  | 000-33213      |  | 4.2         |  | June 28, 2002     |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|4.5            |  | Form of Common Stock Certificate                                                                                                               |  | S-1/A                     |  | 333-60838      |  | 4.1         |  | November 15, 2001 |  |  
|               |  |                                                                                                                                                |  |                           |  |               
|10.1           |  | Warrant Agreement                                                                                                                              |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|31.1           |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer                                                                          |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|31.2           |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer                                                                          |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|32.1           |  | Section 1350 Certification of Principal Executive Officer                                                                                      |  |                           |  |                |  |             |  |                   |  | X
|               |  |                                                                                                                                                |  |                           |  |               
|32.2           |  | Section 1350 Certification of Principal Financial Officer                                                                                      |  |                           |  |                |  |             |  |                   |  | X



57