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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 December 31, 2003



or



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



For the transition period from  to
.



Commission File 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 February 11, 2004, 33,675,414 shares of Registrants Common Stock, $.0001 par value were outstanding.



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MAGMA DESIGN AUTOMATION, INC.



FORM 10-Q



FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2003



INDEX



|                              |  |                                                                                                                       |  |     
|----------------------------- |  | --------------------------------------------------------------------------------------------------------------------- |  | ----
|                              |  |                                                                                                                       |  | Page
|                              | 
|Part I: Financial Information |  | 1                                                                                                                    
|                              |  |                                                                                                                      
|Item 1:                       |  | Financial Statements (unaudited)                                                                                      |  | 1   
|                              |  |                                                                                                                      
|                              |  | Condensed Consolidated Balance Sheets at December 31, 2003 and March 31, 2003                                         |  | 1   
|                              |  |                                                                                                                      
|                              |  | Condensed Consolidated Statements of Operations for the Three Months and Nine Months Ended December 31, 2003 and 2002 |  | 2   
|                              |  |                                                                                                                      
|                              |  | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2003 and 2002                  |  | 3   
|                              |  |                                                                                                                      
|                              |  | Notes to Condensed Consolidated Financial Statements                                                                  |  | 4   
|                              |  |                                                                                                                      
|Item 2:                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                 |  | 17  
|                              |  |                                                                                                                      
|Item 3:                       |  | Quantitative and Qualitative Disclosures About Market Risk                                                            |  | 36  
|                              |  |                                                                                                                      
|Item 4:                       |  | Controls and Procedures                                                                                               |  | 37  
|                              | 
|Part II: Other Information    |  | 37                                                                                                                   
|                              |  |                                                                                                                      
|Item 1:                       |  | Legal Proceedings                                                                                                     |  | 37  
|                              |  |                                                                                                                      
|Item 2:                       |  | Changes in Securities or Use of Proceeds                                                                              |  | 38  
|                              |  |                                                                                                                      
|Item 5:                       |  | Other Information                                                                                                     |  | 38  
|                              |  |                                                                                                                      
|Item 6:                       |  | Exhibits and Reports on Form 8-K                                                                                      |  | 39  
|                              | 
|Signatures                    |  | 40                                                                                                                   
|                              | 
|Exhibit Index                 |  | 41                                                                                                                   



i



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PART I: FINANCIAL INFORMATION



|Item 1. | Financial Statements.
|------- | ---------------------



MAGMA DESIGN AUTOMATION, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)



|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ------------- | - | -------- | -
|                                                                                                                                                                                                          |  | December 31,2003 |          |   | March 31,2003 |  
|ASSETS                                                                                                                                                                                                    |  |                  |          |   |               |   |          |  
|Current assets:                                                                                                                                                                                           |  |                  |          |   |               |   |          |  
|Cash and cash equivalents                                                                                                                                                                                 |  | $                | 68,563   |   |               | $ | 64,756   |  
|Short-term investments                                                                                                                                                                                    |  |                  |         |   |               |   | 3,059    |  
|Accounts receivable, less allowance for doubtful accounts of $293 at December 31, 2003 and $531 at March 31, 2003,
respectively                                                                           |  |                  | 25,399   |   |               |   | 19,223   |  
|Prepaid expenses and other current assets                                                                                                                                                                 |  |                  | 8,091    |   |               |   | 3,627    |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|Total current assets                                                                                                                                                                                      |  |                  | 102,053  |   |               |   | 90,665   |  
|Property and equipment, net                                                                                                                                                                               |  |                  | 13,853   |   |               |   | 5,808    |  
|Intangibles, net                                                                                                                                                                                          |  |                  | 29,471   |   |               |   | 1,352    |  
|Goodwill                                                                                                                                                                                                  |  |                  | 32,663   |   |               |   |         |  
|Long-term investments                                                                                                                                                                                     |  |                  | 112,694  |   |               |   | 27,882   |  
|Other assets                                                                                                                                                                                              |  |                  | 5,666    |   |               |   | 1,771    |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|Total assets                                                                                                                                                                                              |  | $                | 296,400  |   |               | $ | 127,478  |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                      |  |                  |          |   |               |   |          |  
|Current liabilities:                                                                                                                                                                                      |  |                  |          |   |               |   |          |  
|Accounts payable                                                                                                                                                                                          |  | $                | 2,312    |   |               | $ | 1,384    |  
|Accrued expenses                                                                                                                                                                                          |  |                  | 15,387   |   |               |   | 7,711    |  
|Deferred revenue                                                                                                                                                                                          |  |                  | 18,113   |   |               |   | 12,539   |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|Total current liabilities                                                                                                                                                                                 |  |                  | 35,812   |   |               |   | 21,634   |  
|Convertible subordinated notes                                                                                                                                                                            |  |                  | 150,000  |   |               |   |         |  
|Deferred income taxes                                                                                                                                                                                     |  |                  | 4,640    |   |               |   |         |  
|Other long-term liabilities                                                                                                                                                                               |  |                  | 461      |   |               |   | 72       |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|Total liabilities                                                                                                                                                                                         |  |                  | 190,913  |   |               |   | 21,706   |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|Commitments and contingencies (Note 4)                                                                                                                                                                    |  |                  |          |   |               |   |          |  
|Stockholders equity:                                                                                                                                                                                     |  |                  |          |   |               |   |          |  
|Preferred Stock, $.0001 par value; 5,000,000 shares authorized and no shares issued and outstanding                                                                                                       |  |                  |         |   |               |   |         |  
|Common stock, $.0001 par value; 150,000,000 shares authorized and 33,330,840 and 31,210,030 shares issued and 33,330,840 and 31,172,888
outstanding at December 31, 2003 and March 31, 2003, respectively |  |                  | 3        |   |               |   | 3        |  
|Additional paid-in capital                                                                                                                                                                                |  |                  | 218,885  |   |               |   | 228,400  |  
|Deferred stock-based compensation                                                                                                                                                                         |  |                  | (1,031   | ) |               |   | (1,638   | )
|Notes receivable from stockholders                                                                                                                                                                        |  |                  |         |   |               |   | (2,037   | )
|Accumulated deficit                                                                                                                                                                                       |  |                  | (111,289 | ) |               |   | (118,538 | )
|Treasury stock at cost, 0 and 37,142 shares at December 31, 2003 and March 31, 2003, respectively                                                                                                         |  |                  |         |   |               |   | (408     | )
|Accumulated other comprehensive loss                                                                                                                                                                      |  |                  | (1,081   | ) |               |   | (10      | )
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|Total stockholders equity                                                                                                                                                                                |  |                  | 105,487  |   |               |   | 105,772  |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  
|Total liabilities and stockholders equity                                                                                                                                                                |  | $                | 296,400  |   |               | $ | 127,478  |  
|                                                                                                                                                                                                          |  |                  |          |   |               |   |          |  



See accompanying notes
to unaudited condensed consolidated financial statements.



1



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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 December 31, |        |   | For the Nine Months Ended December 31, |  
|                                                                                                                                                                                                           |  | 2003                                    |        |   | 2002                                   |   |        | 2003 |  |   | 2002   |  
|Revenue:                                                                                                                                                                                                   |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Licenses                                                                                                                                                                                                   |  | $                                       | 27,472 |   |                                        | $ | 17,243 |      |  | $ | 70,826 |   |  | $ | 45,310 |  
|Services                                                                                                                                                                                                   |  |                                         | 3,580  |   |                                        |   | 1,426  |      |  |   | 8,856  |   |  |   | 9,253  |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Total revenue                                                                                                                                                                                              |  |                                         | 31,052 |   |                                        |   | 18,669 |      |  |   | 79,682 |   |  |   | 54,563 |  
|Cost of revenue (including $2 and $10 of stock-based compensation for the three months ended December 31, 2003 and 2002 and $8 and $52 for the
nine months ended December 31, 2003 and 2002, respectively) |  |                                         | 4,741  |   |                                        |   | 2,754  |      |  |   | 11,879 |   |  |   | 8,968  |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                                                                                                                                                                                               |  |                                         | 26,311 |   |                                        |   | 15,915 |      |  |   | 67,803 |   |  |   | 45,595 |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Operating expenses:                                                                                                                                                                                        |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Research and development                                                                                                                                                                                   |  |                                         | 7,510  |   |                                        |   | 4,299  |      |  |   | 18,537 |   |  |   | 14,077 |  
|Sales and marketing                                                                                                                                                                                        |  |                                         | 10,038 |   |                                        |   | 6,113  |      |  |   | 25,441 |   |  |   | 19,027 |  
|General and administrative                                                                                                                                                                                 |  |                                         | 2,961  |   |                                        |   | 3,938  |      |  |   | 7,798  |   |  |   | 8,269  |  
|Restructuring costs                                                                                                                                                                                        |  |                                         |       |   |                                        |   | 727    |      |  |   |       |   |  |   | 727    |  
|In-process research and development                                                                                                                                                                        |  |                                         | 200    |   |                                        |   |       |      |  |   | 200    |   |  |   |       |  
|Amortization of intangible assets                                                                                                                                                                          |  |                                         | 584    |   |                                        |   |       |      |  |   | 584    |   |  |   |       |  
|Amortization of stock-based compensation*                                                                                                                                                                  |  |                                         | 923    |   |                                        |   | 1,467  |      |  |   | 6,656  |   |  |   | 4,060  |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                                                                                                                                                                                   |  |                                         | 22,216 |   |                                        |   | 16,544 |      |  |   | 59,216 |   |  |   | 46,160 |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Operating income (loss)                                                                                                                                                                                    |  |                                         | 4,095  |   |                                        |   | (629   | )    |  |   | 8,587  |   |  |   | (565   | )
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Other income (expense):                                                                                                                                                                                    |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Interest income                                                                                                                                                                                            |  |                                         | 691    |   |                                        |   | 419    |      |  |   | 1,934  |   |  |   | 1,447  |  
|Interest expense                                                                                                                                                                                           |  |                                         | (404   | ) |                                        |   | (42    | )    |  |   | (727   | ) |  |   | (45    | )
|Other income                                                                                                                                                                                               |  |                                         | 379    |   |                                        |   |       |      |  |   | 45     |   |  |   |       |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Other income (expense), net                                                                                                                                                                                |  |                                         | 666    |   |                                        |   | 377    |      |  |   | 1,252  |   |  |   | 1,402  |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss) before income taxes                                                                                                                                                                      |  |                                         | 4,761  |   |                                        |   | (252   | )    |  |   | 9,839  |   |  |   | 837    |  
|Income taxes                                                                                                                                                                                               |  |                                         | (1,000 | ) |                                        |   | (80    | )    |  |   | (2,590 | ) |  |   | (411   | )
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)                                                                                                                                                                                          |  | $                                       | 3,761  |   |                                        | $ | (332   | )    |  | $ | 7,249  |   |  | $ | 426    |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss) per common share                                                                                                                                                                         |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                                                                                                                                                                      |  | $                                       | 0.12   |   |                                        | $ | (0.01  | )    |  | $ | 0.23   |   |  | $ | 0.01   |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                                                                                                                                                                                    |  | $                                       | 0.09   |   |                                        | $ | (0.01  | )    |  | $ | 0.18   |   |  | $ | 0.01   |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Weighted average shares:                                                                                                                                                                                   |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                                                                                                                                                                      |  |                                         | 32,184 |   |                                        |   | 30,587 |      |  |   | 31,438 |   |  |   | 30,427 |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                                                                                                                                                                                    |  |                                         | 42,035 |   |                                        |   | 30,587 |      |  |   | 41,075 |   |  |   | 32,134 |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|* Operating expense classification of stock-based compensation amortization is as follows:                                                                                                                 |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Research and development                                                                                                                                                                                   |  | $                                       | 572    |   |                                        | $ | 1,120  |      |  | $ | 3,478  |   |  | $ | 1,721  |  
|Sales and marketing                                                                                                                                                                                        |  |                                         | 74     |   |                                        |   | 153    |      |  |   | 254    |   |  |   | 1,298  |  
|General and administrative                                                                                                                                                                                 |  |                                         | 277    |   |                                        |   | 194    |      |  |   | 2,924  |   |  |   | 1,041  |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|                                                                                                                                                                                                           |  | $                                       | 923    |   |                                        | $ | 1,467  |      |  | $ | 6,656  |   |  | $ | 4,060  |  
|                                                                                                                                                                                                           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  



See accompanying notes
to unaudited condensed consolidated financial statements.



2



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MAGMA DESIGN AUTOMATION, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, unaudited)



|                                                                                               |  |                               |          |   |      |   |        |  
|---------------------------------------------------------------------------------------------- |  | ----------------------------- | -------- | - | ---- | - | ------ | -
|                                                                                               |  | Nine Months EndedDecember 31, |         
|                                                                                               |  | 2003                          |          |   | 2002 |  
|Cash flows from operating activities:                                                          |  |                               |          |   |      |   |        |  
|Net income                                                                                     |  | $                             | 7,249    |   |      | $ | 426    |  
|Adjustments to reconcile net income to net cash used in operating activities:                  |  |                               |          |   |      |   |        |  
|Depreciation and amortization                                                                  |  |                               | 5,473    |   |      |   | 3,676  |  
|Provision for doubtful accounts                                                                |  |                               | (258     | ) |      |   | 550    |  
|Amortization of debt issuance costs                                                            |  |                               | 589      |   |      |   |       |  
|In-process research and development                                                            |  |                               | 200      |   |      |   |       |  
|Loss on disposal of fixed assets                                                               |  |                               | 153      |   |      |   |       |  
|Loss on investments                                                                            |  |                               | (741     | ) |      |   |       |  
|Accrued interest on note receivable from stockholders                                          |  |                               | 8        |   |      |   | (196   | )
|Amortization of stock-based compensation                                                       |  |                               | 6,664    |   |      |   | 4,112  |  
|Changes in operating assets and liabilities, net of effect of acquisitions:                    |  |                               |          |   |      |   |        |  
|Accounts receivable                                                                            |  |                               | (1,286   | ) |      |   | 193    |  
|Prepaid expenses and other current assets                                                      |  |                               | (3,072   | ) |      |   | (315   | )
|Other assets                                                                                   |  |                               | 3        |   |      |   |       |  
|Accounts payable                                                                               |  |                               | 928      |   |      |   | (409   | )
|Accrued expenses                                                                               |  |                               | 3,240    |   |      |   | (1,698 | )
|Deferred revenue                                                                               |  |                               | 2,522    |   |      |   | (1,525 | )
|Other long-term liabilities                                                                    |  |                               | 389      |   |      |   | (34    | )
|                                                                                               |  |                               |          |   |      |   |        |  
|Net cash provided by operating activities                                                      |  |                               | 22,061   |   |      |   | 4,780  |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Cash flows from investing activities:                                                          |  |                               |          |   |      |   |        |  
|Purchase of property and equipment                                                             |  |                               | (10,997  | ) |      |   | (2,637 | )
|Purchase of long-term investments                                                              |  |                               | (100,643 | ) |      |   |       |  
|Acquisitions, net of cash acquired                                                             |  |                               | (46,255  | ) |      |   |       |  
|Proceeds from the sale of investments                                                          |  |                               | 21,548   |   |      |   | 13,468 |  
|Change in restricted cash                                                                      |  |                               | (2,899   | ) |      |   |       |  
|Other assets                                                                                   |  |                               | 487      |   |      |   | (2,460 | )
|                                                                                               |  |                               |          |   |      |   |        |  
|Net cash provided by (used in) investing activities                                            |  |                               | (138,759 | ) |      |   | 8,371  |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Cash flows from financing activities:                                                          |  |                               |          |   |      |   |        |  
|Net proceeds from issuance of convertible subordinated notes                                   |  |                               | 144,734  |   |      |   |       |  
|Repurchase of common stock                                                                     |  |                               | (19,980  | ) |      |   | (3     | )
|Proceeds from issuance of common stock                                                         |  |                               | 18,924   |   |      |   | 4,352  |  
|Purchase of hedging instruments                                                                |  |                               | (56,154  | ) |      |   |       |  
|Payments for notes payable                                                                     |  |                               | (2,099   | ) |      |   |       |  
|Proceeds from issuance of warrant                                                              |  |                               | 35,904   |   |      |   |       |  
|Proceeds from repayment of notes receivable from stockholder                                   |  |                               | 214      |   |      |   | 20     |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Net cash provided by financing activities                                                      |  |                               | 121,543  |   |      |   | 4,369  |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Effect of exchange rate changes on cash and cash equivalents                                   |  |                               | (1,038   | ) |      |   | 230    |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Increase in cash and cash equivalents                                                          |  |                               | 3,807    |   |      |   | 17,750 |  
|Cash and cash equivalents at beginning of period                                               |  |                               | 64,756   |   |      |   | 78,478 |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Cash and cash equivalents at end of period                                                     |  | $                             | 68,563   |   |      | $ | 96,228 |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Supplemental disclosure:                                                                       |  |                               |          |   |      |   |        |  
|Non-cash investing and financing activities:                                                   |  |                               |          |   |      |   |        |  
|Deferred stock-based compensation                                                              |  | $                             | (6,043   | ) |      | $ | (948   | )
|                                                                                               |  |                               |          |   |      |   |        |  
|Settlement of note receivable from stockholder in connection with the purchase of common stock |  | $                             | (3,566   | ) |      | $ |       |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Repurchase of common stock by reducing note receivable from stockholder                        |  | $                             |         |   |      | $ | 813    |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Offset of notes receivable from stockholders against amounts owed to stockholder               |  | $                             |         |   |      | $ | 16     |  
|                                                                                               |  |                               |          |   |      |   |        |  
|Cash paid for:                                                                                 |  |                               |          |   |      |   |        |  
|Taxes                                                                                          |  | $                             | 350      |   |      | $ | 411    |  
|                                                                                               |  |                               |          |   |      |   |        |  



See accompanying notes
to unaudited condensed consolidated financial statements.



3



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Note 1. The Company and Summary of Significant Accounting Policies



Basis of presentation



The interim condensed consolidated financial statements included herein have
been prepared by Magma Design Automation, Inc. (Magma or the Company) without audit, 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 condensed consolidated financial statements reflect, in the opinion of management, all adjustments (consisting only of
normal recurring adjustments) necessary 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 March 31, 2004. The accompanying condensed consolidated financial statements should be read in conjunction with the Companys Form 10-K, as filed with the SEC on June 20, 2003. The accompanying condensed consolidated balance sheet
at March 31, 2003 is derived from audited consolidated financial statements at that date. Certain amounts in the fiscal 2003 condensed consolidated financial statements have been reclassified to conform to the fiscal 2004 presentation.



Use of estimates



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.



Revenue recognition



The Company recognizes revenue in accordance with the American Institute of Certified Public Accountants Statement of Position SOP 97-2, Software
Revenue Recognition (SOP 97-2), as modified by SOP 98-9, Modifications of SOP 97-2, Software Revenue Recognition, with respect to certain transactions. SOP 97-2, as modified, generally requires revenue earned on
software arrangements involving multiple elements such as software products, upgrades, enhancements, post contract customer support (PCS), 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 the vendor. If evidence of fair value does not exist for all elements of a license agreement and PCS is the only undelivered element, then all revenue for the
license agreement is recognized ratably over the term of the agreement. If evidence of fair value of all undelivered elements exists but evidence of fair value does not exist for one or more delivered elements, then revenue is recognized using the
residual method. Under the residual method, the fair value of the undelivered elements is deferred, and the remaining portion of the arrangement fee is recognized as revenue. Revenue from licenses that include a right to specified upgrades is
deferred until the upgrades are delivered because there is no vendor specific objective evidence for the specific upgrade.



The Companys standard license agreement includes PCS for a specified period of time for its software products. Through June 30, 2001, the Company
bundled PCS into its agreements for the entire license term. As a result, vendor-specific objective evidence of fair value did not exist for each element of the arrangement. Accordingly, revenue from all license agreements entered into through June
30, 2001, has been recognized ratably over the contract term after 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 the
Company has no remaining obligations other than the delivery of PCS. If an arrangement involves extended payment terms, revenue is recognized to the extent of the lesser of the portion of the fee presently due and payable or the ratable portion of
the entire fee. The Company considers arrangements where less than 100% of the license, services and initial period PCS fee is due within one year of the agreement date to have extended payment terms. Payments received from customers in advance of
revenue being recognized are presented as deferred revenue in the accompanying consolidated balance sheets.



In addition to continuing to offer time-based licenses for its products bundled with PCS, beginning in the quarter ended December 31, 2001, the Company
began offering time-based and perpetual licenses with PCS bundled for the first year of the license term. Thereafter, PCS can be renewed annually for an additional fee stated in the agreement. The Company uses the PCS renewal rate as evidence of
fair value of PCS. Therefore, where the only undelivered element is PCS, license revenue from these contracts is recognized using the residual method. Under the residual method, the fair value of PCS is recognized over the PCS term and the



4



---

remaining portion of the arrangement fee is recognized 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 the Company has no remaining obligations other than the delivery of PCS. If an agreement involves extended payment terms,
revenue recognized on the residual method is limited to amounts due and payable.



License revenue is comprised of software licenses and PCS where the Company does not have vendor specific objective evidence of fair value of PCS. Service revenue is comprised of PCS on licenses where the Company has
vendor specific evidence of fair value of PCS, and consulting and training on all products. The Company has vendor specific objective evidence of fair value for consulting and training services. Therefore, revenue from such services is recognized
when such services are performed. The consulting and training services are generally not essential to the functionality of the software. Our products are fully functional upon delivery of the product. 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 the realizability of the software license
fee.



Unbilled receivables



Unbilled receivables represent revenue that has been recognized in the
financial statements in advance of being invoiced to the customer. The Company will invoice all of the unbilled receivables within one year. As of December 31, 2003 and March 31, 2003, unbilled receivables were approximately $10.9 million and $6.8
million, respectively, and are included in accounts receivable on the condensed consolidated balance sheets at each of these dates.



Commission expense



The Company recognizes sales commission expense as it is earned by its employees. For orders recorded in fiscal year 2003, commissions were earned and
expensed as revenue from the respective order was recognized. For orders recorded in fiscal year 2004, commissions are earned by the employee over a period of time, typically over two to six quarters, depending on the size of the respective orders.
As a result, the commission expense for the fiscal 2004 plan is recorded when the employee has earned the commission which coincides with the timing of the payment to the employee. These payments are spread evenly over two to six quarters, depending
on the size of the respective orders. Commissions advanced to employees under the fiscal year 2002 and fiscal year 2003 compensation plans, in excess of amounts earned and which are considered recoverable, are reflected as prepaid expenses in the
accompanying condensed consolidated financial statements. Net prepaid commissions on orders received during fiscal year 2002 and fiscal year 2003 totaled $3.2 million at December 31, 2003 and $0.6 million at March 31, 2003.



Trade accounts receivable



Trade accounts receivable are recorded at the invoiced amount and do not
bear interest. The allowance for doubtful accounts is the Companys best estimate of the amount of probable credit losses in the Companys existing accounts receivable. The Company determines the allowance based on historical write-off
experience, current market trends and for larger accounts, the ability of the customer to pay outstanding balances. Past due balances over 90 days and other higher risk amounts are reviewed individually for probability of collection. Account
balances are charged off against the allowance after collection efforts have been exhausted and the potential for recovery is considered remote.



Strategic investments



The Company invests in debt and equity of private companies as part of its business strategy. The investments are carried at cost and are included in
other assets in the consolidated balance sheets.



The Company
has investments in two companies that are classified under the cost method. These investments have been written down to $0. The Company also has investments in three companies that are accounted for under the equity method. For its investments
classified under each of these methods, the Company regularly reviews the assumptions underlying the operating performance and cash flow forecasts based on information requested from these privately held companies. Assessing each investments
carrying value requires significant judgment by management as this financial information may be more limited, may not be as timely and may be less accurate than information available from publicly traded companies. If the Company determines that an
other-than-temporary decline exists in the fair value of an investment, the Company writes down the investment to its fair value and records the related write-down as an investment loss in other income (expense) in its consolidated statements of
operations.



The Company has consolidated the operating
results of one of its equity investments based on the effective control that the Company exerts over the investee and the risk of loss associated with this investment.



5



---

During the three months ended December 31, 2003, the Company wrote down two of its strategic investments
by $0.3 million. For the nine months ended December 31, 2003, the Company wrote down its strategic investments by $1.1 million. At December 31, 2003 and March 31, 2003, the carrying value of the strategic investments was $1.7 million and $0.9
million, respectively.



Stock-based compensation



The Company accounts for employee stock-based
compensation in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Deferred compensation is recorded on the date of grant if the exercise price of the stock award is less than the market
value of the underlying common stock on the date of grant. Deferred compensation is expensed on an accelerated basis over the vesting period of the stock award.



In December 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS)
148, Accounting for Stock-Based CompensationTransition and Disclosure, an Amendment of FASB Statement No. 123 (SFAS 148). SFAS 148 provides alternative methods of transition for companies making a voluntary change to
fair value-based accounting for stock-based employee compensation. Effective for interim periods beginning after December 15, 2002, SFAS 148 also requires disclosure of pro-forma results on a quarterly basis as if the company had applied the fair
value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation.



As the exercise price of all options granted under the 1997, 1998 and 2001 stock incentive plans was equal to the market price of the underlying common stock on the grant date, no stock-based employee compensation
cost, other than acquisition-related compensation, is recognized in net income. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of SFAS 123, as amended,
to employee options granted under the stock option plans and under the Companys Employee Stock Purchase Plan, collectively called options. For purposes of this pro-forma disclosure, the estimated value of the options is amortized
ratably to expense over the options vesting periods. Because the estimated value is determined as of the date of grant, the actual value ultimately realized by the employee may be significantly different.



|                                                                                                    |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|--------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                    |  | Three MonthsEnded December 31, |        |   | Nine Months Ended December 31, |  
|                                                                                                    |  | 2003                           |        |   | 2002                           |   |        | 2003 |  |   | 2002    |  
|                                                                                                    |  | in thousands                   |       
|Net income (loss):                                                                                  |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|As reported                                                                                         |  | $                              | 3,761  |   |                                | $ | (332   | )    |  | $ | 7,249   |   |  | $ | 426    |  
|Add: Stock-based employee compensation expense included in reported net income (loss)               |  |                                | 925    |   |                                |   | 1,477  |      |  |   | 6,664   |   |  |   | 4,112  |  
|Deduct: Stock-based employee compensation expense determined under fair value method for all awards |  |                                | (5,082 | ) |                                |   | (3,322 | )    |  |   | (16,705 | ) |  |   | (6,354 | )
|                                                                                                    |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma                                                                                           |  | $                              | (396   | ) |                                | $ | (2,177 | )    |  | $ | (2,792  | ) |  | $ | (1,816 | )
|                                                                                                    |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net income (loss) per share, basic:                                                                 |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|As reported                                                                                         |  | $                              | 0.12   |   |                                | $ | (0.01  | )    |  | $ | 0.23    |   |  | $ | 0.01   |  
|                                                                                                    |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma                                                                                           |  | $                              | (0.01  | ) |                                | $ | (0.07  | )    |  | $ | (0.09   | ) |  | $ | (0.06  | )
|                                                                                                    |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net income (loss) per share, diluted:                                                               |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|As reported                                                                                         |  | $                              | 0.09   |   |                                | $ | (0.01  | )    |  | $ | 0.18    |   |  | $ | 0.01   |  
|                                                                                                    |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma                                                                                           |  | $                              | (0.01  | ) |                                | $ | (0.07  | )    |  | $ | (0.09   | ) |  | $ | (0.06  | )
|                                                                                                    |  |                                |        |   |                                |   |        |      |  |   |         |   |  |   |        |  



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 fair value per option at the date of grant for options granted to employees during the three months ended December 31, 2003 and 2002,
was $8.62 and $4.99, respectively. The weighted average fair value per option at the date of grant for options granted to employees during the nine months ended December 31, 2003 and 2002, was $8.69 and $6.93, respectively. The Black-Scholes option
pricing model was used to calculate the fair value of options at the date of grant using the following assumptions:



|                        |  |                                 |   |  |                                |   |  |            |   |  |            |  
|----------------------- |  | ------------------------------- | - |  | ------------------------------ | - |  | ---------- | - |  | ---------- | -
|                        |  | Three Months Ended December 31, |   |  | Nine Months Ended December 31, |  
|                        |  | 2003                            |   |  | 2002                           |   |  | 2003       |   |  | 2002       |  
|Stock options:          |  |                                 |   |  |                                |   |  |            |   |  |            |  
|Risk-free interest      |  | 2.83                            | % |  | 1.93                           | % |  | 2.44       | % |  | 2.53       | %
|Expected life           |  | 3.39 years                      |   |  | 4.75 years                     |   |  | 3.12 years |   |  | 4.75 years |  
|Expected dividend yield |  | 0                               | % |  | 0                              | % |  | 0          | % |  | 0          | %
|Volatility              |  | 52                              | % |  | 79                             | % |  | 70         | % |  | 79         | %



6



---

|                               |  |                                |   |  |                               |   |  |           |   |  |           |  
|------------------------------ |  | ------------------------------ | - |  | ----------------------------- | - |  | --------- | - |  | --------- | -
|                               |  | Three MonthsEnded December 31, |   |  | Nine MonthsEnded December 31, |  
|                               |  | 2003                           |   |  | 2002                          |   |  | 2003      |   |  | 2002      |  
|Employee stock purchase plans: |  |                                |   |  |                               |   |  |           |   |  |           |  
|Risk-free interest             |  | 1.21                           | % |  | 1.42                          | % |  | 1.23      | % |  | 1.58      | %
|Expected life                  |  | .81 years                      |   |  | .25 years                     |   |  | .61 years |   |  | .30 years |  
|Expected dividend yield        |  | 0                              | % |  | 0                             | % |  | 0         | % |  | 0         | %
|Volatility                     |  | 49                             | % |  | 79                            | % |  | 62        | % |  | 79        | %



Cash equivalents,
short-term and long-term investments



The Company
considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. As of December 31, 2003 and March 31, 2003, cash equivalents consisted primarily of corporate bonds, municipal bonds and money
market funds.



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



|                                  |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|--------------------------------- |  | -------------- | ------- | ------------------ | - | ------------------- |  | - | ------------------- | - |  | - | -------
|                                  |  | Cost           |         | NetUnrealizedGains |   | NetUnrealizedLosses |  |   | EstimatedFair Value
|                                  |  | (in thousands)
|March 31, 2003                    |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Classified as current assets:     |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Cash                              |  | $              | 3,452   |                    | $ |                    |  | $ |                    |   |  | $ | 3,452  
|Money market funds                |  |                | 2,854   |                    |   |                    |  |   |                    |   |  |   | 2,854  
|Municipal obligations             |  |                | 58,450  |                    |   |                    |  |   |                    |   |  |   | 58,450 
|Corporate bonds                   |  |                | 3,058   |                    |   | 1                   |  |   |                    |   |  |   | 3,059  
|                                  |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|                                  |  |                | 67,814  |                    |   | 1                   |  |   |                    |   |  |   | 67,815 
|Classified as non-current assets: |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Debt securities                   |  |                | 27,864  |                    |   | 18                  |  |   |                    |   |  |   | 27,882 
|                                  |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Total                             |  | $              | 95,678  |                    | $ | 19                  |  | $ |                    |   |  | $ | 95,697 
|                                  |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|                                  |  |                |         |                   
|                                  |  | Cost           |         | NetUnrealizedGains |   | NetUnrealizedLosses |  |   | EstimatedFair Value
|                                  |  | (in thousands)
|December 31, 2003                 |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Classified as current assets:     |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Cash                              |  | $              | 15,513  |                    | $ |                    |  | $ |                    |   |  | $ | 15,513 
|Money market funds                |  |                | 3,350   |                    |   |                    |  |   |                    |   |  |   | 3,350  
|Municipal obligations             |  |                | 46,700  |                    |   |                    |  |   |                    |   |  |   | 46,700 
|Auction preferred                 |  |                | 3,000   |                    |   |                    |  |   |                    |   |  |   | 3,000  
|                                  |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|                                  |  |                | 68,563  |                    |   |                    |  |   |                    |   |  |   | 68,563 
|Classified as non-current assets: |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Debt securities                   |  |                | 112,708 |                    |   |                    |  |   | (14                 | ) |  |   | 112,694
|                                  |  |                |         |                    |   |                     |  |   |                     |   |  |   |        
|Total                             |  | $              | 181,271 |                    | $ |                    |  | $ | (14                 | ) |  | $ | 181,257
|                                  |  |                |         |                    |   |                     |  |   |                     |   |  |   |        



Restricted cash



Included in other current and non-current assets on the
condensed consolidated balance sheets at December 31, 2003 and March 31, 2003 is restricted cash of $2.6 million and $0.5 million, respectively. As of December 31, 2003, restrictions on cash related to $0.3 million for letters of credit for security
deposits on leased facilities. The deposits are required for the five-year and seven-year terms of the leases. The remaining $2.6 million included in long-term investments related to the Silicon Metrics acquisition to secure certain indemnification
obligations of the Silicon Metrics stockholders and bonus plan participants. Restricted cash is included in other current assets, other non-current assets and long-term investments based on the expected term for the release of the restriction.



7



---

Foreign currency



The financial statements of foreign subsidiaries are measured using the local currency of the subsidiary as the functional
currency. Accordingly, assets and liabilities of the subsidiaries are translated at the current rates of exchange at the applicable balance sheet date, and revenue and expense items are translated using average exchange rates during the period.



Comprehensive income (loss)



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



|                                                  |  |                               |       |   |                              |   |      |      |  |   |        |   |  |   |     |  
|------------------------------------------------- |  | ----------------------------- | ----- | - | ---------------------------- | - | ---- | ---- |  | - | ------ | - |  | - | --- | -
|                                                  |  | Three MonthsEndedDecember 31, |       |   | Nine MonthsEndedDecember 31, |  
|                                                  |  | 2003                          |       |   | 2002                         |   |      | 2003 |  |   | 2002   |  
|Net income (loss)                                 |  | $                             | 3,761 |   |                              | $ | (332 | )    |  | $ | 7,249  |   |  | $ | 426 |  
|Unrealized loss on available-for-sale investments |  |                               | (170  | ) |                              |   | (30  | )    |  |   | (33    | ) |  |   | (30 | )
|Foreign currency translation adjustments          |  |                               | (721  | ) |                              |   | 334  |      |  |   | (1,038 | ) |  |   | 260 |  
|                                                  |  |                               |       |   |                              |   |      |      |  |   |        |   |  |   |     |  
|Comprehensive income (loss)                       |  | $                             | 2,870 |   |                              | $ | (28  | )    |  | $ | 6,178  |   |  | $ | 656 |  
|                                                  |  |                               |       |   |                              |   |      |      |  |   |        |   |  |   |     |  



Newly adopted and
recently issued accounting pronouncements



In December
2002, the FASB issued SFAS 148, Accounting for Stock-Based CompensationTransition and Disclosurean Amendment of FASB Statement No. 123. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide
alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require disclosures in both annual
and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The annual disclosure provisions are effective for fiscal years ending after December 15,
2002. The Company adopted the disclosure requirements of this standard in fiscal 2003 and the adoption of SFAS 148 did not have a material effect on its consolidated financial statements.



In November 2002, the FASB issued Interpretation 45, Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45). For guarantees issued or modified after December 31, 2002, a liability shall be recognized for the fair value of the obligation undertaken in issuing the
guarantee. The disclosure requirements are effective for interim and annual financial statements for periods ending after December 15, 2002. In June 2003, the FASB issued a FASB Staff Position, which indicated that indemnification clauses in
software agreements related to intellectual property infringement are subject to disclosure requirements of FIN 45, but not the initial recognition or measurement provisions. The adoption of FIN 45 did not have a material effect on the
Companys consolidated financial statements.



In January
2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No 51 (FIN 46). FIN 46 requires certain variable interest entities to be consolidated by the primary
beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated
financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. The original effective date of FIN 46 was delayed to the first reporting period ending after
December 15, 2003 (December 31, 2003 for the Company) for any variable interest entities or potential variable interest entities created before February 1, 2003. The adoption of FIN 46 did not have a material effect on the Companys
consolidated financial statements.



In April 2003, the
Financial Accounting Standards Board (FASB) issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends and clarifies financial accounting and reporting for derivative
instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 requires that contracts with
comparable characteristics be accounted for similarly and clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component. SFAS No. 149 also
amends the definition of an underlying to conform it to language used in FIN No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. SFAS No. 149 is
effective for contracts entered into or modified after June 30, 2003, with certain exceptions. The adoption of SFAS No. 149 did not have an impact on the Companys financial position or results of operations.



8



---

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity, which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer
classify a financial instrument that falls within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the
beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a material impact on the Companys financial position or results of operations.



Note 2. 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 warrants using the treasury stock method and convertible debt using the as if-converted method.



9



---

The following is a reconciliation of the weighted average common shares used to calculate basic net
income (loss) per share to the weighted average common and potential common shares used to calculate diluted net income (loss) per share for the three and nine months ended December 31, 2003 and 2002 (in thousands):



|                                                                                                          |  |                                |  |                               |  |        |  |       
|--------------------------------------------------------------------------------------------------------- |  | ------------------------------ |  | ----------------------------- |  | ------ |  | ------
|                                                                                                          |  | Three MonthsEnded December 31, |  | Nine MonthsEnded December 31,
|                                                                                                          |  | 2003                           |  | 2002                          |  | 2003   |  | 2002  
|Weighted average common shares used to calculate basic net income (loss) per share                        |  | 32,184                         |  | 30,587                        |  | 31,438 |  | 30,427
|Options outstanding using the treasury method                                                             |  | 3,011                          |  |                              |  | 2,933  |  | 1,661 
|Redeemable convertible subordinated notes using the as-if-converted method                                |  | 6,562                          |  |                              |  | 6,562  |  |      
|Warrants using the treasury method                                                                        |  |                               |  |                              |  |       |  | 17    
|Options exercised and unvested                                                                            |  | 278                            |  |                              |  | 142    |  | 29    
|                                                                                                          |  |                                |  |                               |  |        |  |       
|Weighted average common and potential common shares used to calculate diluted net income (loss) per share |  | 42,035                         |  | 30,587                        |  | 41,075 |  | 32,134
|                                                                                                          |  |                                |  |                               |  |        |  |       



For the three and nine
months ended December 31, 2003, 402,358 and 1,139,432 shares, respectively, of common stock issuable under stock option plans were excluded from the computation of diluted net income per share because their option exercise prices were greater than
the average market price, which would result in antidilution under the treasury stock method. For the three and nine months ended December 31, 2002, 2,889,963 and 247,276 shares, respectively, of common stock issuable under stock option plans were
excluded from the computation of diluted net income per share. The weighted-average exercise price of such shares was $26.44 and $23.57 for the three and nine months ended December 31, 2003, respectively. The weighted-average exercise price of such
shares was $10.88 and $21.21 for the three and nine months ended December 31, 2002, respectively.



Note 3. Intangible Assets



|                              |  |                       |        |                          |   |        |                       |  |                       |        |                          |   |       |                       |   |      |   |  |   |      
|----------------------------- |  | --------------------- | ------ | ------------------------ | - | ------ | --------------------- |  | --------------------- | ------ | ------------------------ | - | ----- | --------------------- | - | ---- | - |  | - | -----
|                              |  | December 31, 2003     |        | March 31, 2003          
|                              |  | Gross Carrying Amount |        | Accumulated Amortization |   |        | Net Intangible Assets |  | Gross Carrying Amount |        | Accumulated Amortization |   |       | Net Intangible Assets
|Developed technology          |  | $                     | 16,963 |                          | $ | (1,832 | )                     |  | $                     | 15,131 |                          | $ | 1,570 |                       | $ | (218 | ) |  | $ | 1,352
|Customer relationship or base |  |                       | 2,200  |                          |   | (91    | )                     |  |                       | 2,109  |                          |   |      |                       |   |     |   |  |   |     
|Patents                       |  |                       | 11,201 |                          |   | (468   | )                     |  |                       | 10,733 |                          |   |      |                       |   |     |   |  |   |     
|Acquired customer contracts   |  |                       | 900    |                          |   | (62    | )                     |  |                       | 838    |                          |   |      |                       |   |     |   |  |   |     
|Assembled workforce           |  |                       | 200    |                          |   | (14    | )                     |  |                       | 186    |                          |   |      |                       |   |     |   |  |   |     
|No shop right                 |  |                       | 100    |                          |   | (10    | )                     |  |                       | 90     |                          |   |      |                       |   |     |   |  |   |     
|Trademark                     |  |                       | 400    |                          |   | (16    | )                     |  |                       | 384    |                          |   |      |                       |   |     |   |  |   |     
|                              |  |                       |        |                          |   |        |                       |  |                       |        |                          |   |       |                       |   |      |   |  |   |      
|Total intangible assets       |  | $                     | 31,964 |                          | $ | (2,493 | )                     |  | $                     | 29,471 |                          | $ | 1,570 |                       | $ | (218 | ) |  | $ | 1,352
|                              |  |                       |        |                          |   |        |                       |  |                       |        |                          |   |       |                       |   |      |   |  |   |      



Amortization of
intangible assets was approximately $1.6 million and $0.1 million for the three months ended December 31, 2003 and 2002, respectively and approximately $2.3 million and $0.1 million for the nine months ended December 31, 2003 and 2002, respectively.
The expected amortization expense related to identifiable intangible assets is approximately $1.7 million for the fourth quarter of fiscal 2004. (See note 8 for information regarding amortization periods)



10



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Note 4. Commitments and Contingencies



Commitments



On July 10, 2003 the Company entered into an agreement to purchase $1.0 million in convertible notes from a private company. The notes are convertible
into preferred or common stock of the private company. The Company has paid $250,000 in July and December 2003 and will pay $250,000 for each of the next two quarters.



Legal proceedings



On February 6, 2003, the Company entered into a definitive agreement to settle a lawsuit initially filed in Santa Clara County, California Superior Court
in August of 2001 by Prolific, Inc. The settlement agreement provided for two installment payments by the Company in the aggregate amount of $1.85 million. The first payment of $0.925 million was made in February 2003 and the second payment of
$0.925 million was made in July 2003. There are no continuing obligations by the parties to each other.



From time to time, the Company is involved in other 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 the Company 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 and financial statements.



Note 5. Segment Information



The Company follows 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 President and Chief
Operating Officer (COO) for purposes of evaluating performance and allocating resources. Based on this approach, the Company has one reportable segment as the COO reviews financial information on a basis consistent with that presented in
the condensed consolidated financial statements.



11



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Revenue from North America, Europe, Japan and the 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 EndedDecember 31, |        | Nine Months EndedDecember 31,
|              |  | 2003                           |        | 2002                          |   | 2003   |  | 2002
|North America |  | $                              | 14,411 |                               | $ | 10,578 |  | $    | 39,553 |  | $ | 34,471
|Europe        |  |                                | 10,556 |                               |   | 4,960  |  |      | 19,056 |  |   | 11,694
|Japan         |  |                                | 4,778  |                               |   | 2,014  |  |      | 18,616 |  |   | 6,527 
|Asia Pacific  |  |                                | 1,307  |                               |   | 1,117  |  |      | 2,457  |  |   | 1,871 
|              |  |                                |        |                               |   |        |  |      |        |  |   |       
|              |  | $                              | 31,052 |                               |   | 18,669 |  | $    | 79,682 |  | $ | 54,563
|              |  |                                |        |                               |   |        |  |      |        |  |   |       



|              |  |                               |   |  |                              |   |  |      |   |  |      |  
|------------- |  | ----------------------------- | - |  | ---------------------------- | - |  | ---- | - |  | ---- | -
|              |  | Three MonthsEndedDecember 31, |   |  | Nine MonthsEndedDecember 31, |  
|              |  | 2003                          |   |  | 2002                         |   |  | 2003 |   |  | 2002 |  
|North America |  | 47                            | % |  | 57                           | % |  | 50   | % |  | 63   | %
|Europe        |  | 34                            |   |  | 26                           |   |  | 24   |   |  | 22   |  
|Japan         |  | 15                            |   |  | 11                           |   |  | 23   |   |  | 12   |  
|Asia Pacific  |  | 4                             |   |  | 6                            |   |  | 3    |   |  | 3    |  
|              |  |                               |   |  |                              |   |  |      |   |  |      |  
|              |  | 100                           | % |  | 100                          | % |  | 100  | % |  | 100  | %
|              |  |                               |   |  |                              |   |  |      |   |  |      |  



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



|           |  |                               |   |  |                              |   |  |      |   |  |      |  
|---------- |  | ----------------------------- | - |  | ---------------------------- | - |  | ---- | - |  | ---- | -
|           |  | Three MonthsEndedDecember 31, |   |  | Nine MonthsEndedDecember 31, |  
|           |  | 2003                          |   |  | 2002                         |   |  | 2003 |   |  | 2002 |  
|Customer A |  | 25                            | % |  |                             | % |  | 12   | % |  |     | %
|Customer B |  | 13                            |   |  | 4                            |   |  | 15   |   |  | 5    |  
|Customer C |  | 11                            |   |  |                             |   |  | 12   |   |  | 2    |  
|Customer D |  | 6                             |   |  | 11                           |   |  | 8    |   |  | 11   |  
|Customer E |  | 5                             |   |  | 14                           |   |  | 6    |   |  | 9    |  
|Customer F |  | 2                             |   |  | 29                           |   |  | 4    |   |  | 19   |  
|Customer G |  | 8                             |   |  | 6                            |   |  | 12   |   |  | 7    |  



Substantially all of
the Companys long-lived assets are located in the United States.



Note
6. Restructuring Charge



The Company incurred
restructuring charges in the third quarter ended December 31, 2002 in the amount of $0.7 million related to employee termination costs of 32 technical, sales, marketing and administrative employees. As of December 31, 2003, all 32 employees were
terminated and the Company paid $0.6 million in termination costs. As of December 31, 2003, $85,000 relating to the remaining termination costs is included in accrued expenses in the condensed consolidated financial statements.



Note 7. Asset Purchases



VeraTest, Inc.



On November 1, 2002, the Company completed an acquisition of VeraTest, Inc., a private California corporation (VeraTest), primarily for the
purpose of acquiring VeraTests chip design verification software.



The Company previously acquired 18.0% of VeraTest, Inc. on April 10, 2002 for $0.2 million, which was charged to research and development. On November 1, 2002, the Company acquired the remaining outstanding common stock held by certain
shareholders for approximately $1.6 million in cash, including the cancellation of indebtedness of $0.3 million of certain VeraTest stockholders to the Company. The Company accounted for this acquisition as an asset purchase. The valuation was
performed using a



12



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discounted cash flow methodology. The purchase price was allocated to developed technology, which has an estimated life of three years.



Under SFAS 86, Accounting for Costs of Computer Software to be Sold,
Leased, or Otherwise Marketed, amortization is based on the greater of the ratio of current gross revenue of the related product to current and anticipated future gross revenues or on a straight-line method over the remaining estimated
economic life. As of December 31, 2003, the Company has amortized $0.6 million of the value of the capitalized software on a pro-rated straight-line basis and the remaining unamortized balance of $1.0 million is included in intangible assets in the
accompanying consolidated balance sheet as of December 31, 2003.



In connection with the November 2002 acquisition, the Company entered into an earn-out arrangement and employment and consulting agreements with the former VeraTest common stockholders. Under the terms of the earn-out arrangement, these
individuals have the right to receive 272,998 shares of the Companys common stock upon the completion of certain milestones. Of these shares of common stock, 171,646 shares were placed in escrow, to be released upon completion of three
milestone achievements: 20% for completion of the first milestone (no later than December 15, 2002), 40% for completion of the second milestone (no later than September 15, 2003), and 40% for the completion of the third milestone (no later than
September 15, 2004). The remaining 101,352 shares were issued pursuant to a restricted stock grant and will vest on the same basis as the shares placed in escrow. The milestones are based upon testing and integration of certain current features, as
well as the development of additional working features of the software tool. If it is determined that any milestone has not been attained, the shares will be cancelled. The first milestone was completed on November 30, 2002 and the second milestone
was completed on September 15, 2003 which resulted in a compensation expense of $2.8 million. The Company expects that the remaining milestone will be met and accordingly has remeasured the value of the contingent consideration for the three months
ended December 31, 2003 and recorded $0.5 million in additional stock-based compensation expense.



Other Asset Purchases



For the nine months ended December 31, 2003, the Company completed two acquisitions for an aggregate consideration of $9.5 million in upfront payments and
contingent consideration totaling $.35 million based on the achievement of a certain technical milestone as outlined in the asset agreements. The earn-out, if achieved, would be recorded as compensation expense in the third quarter of fiscal 2005.
The purchase prices were allocated as follows: patents totaled $9.2 million, assembled workforce totaled $0.2 million from the hiring of six employees and no shop rights totaled $0.1 million. These acquisitions are not considered material to the
Companys balance sheet and results of operations.



A
summary of the purchase price allocations pertaining to the above asset purchases and the amortization periods of the intangible assets acquired is as follows:



|                                                 |  |                |       |                         |   |       |  |   |       
|------------------------------------------------ |  | -------------- | ----- | ----------------------- | - | ----- |  | - | ------
|2003 and 2004 Asset Purchases                    |  | 2003 Veratest  |       | 2004 Other Acquisitions |   | Total
|                                                 |  | (In Thousands)
|Approximate purchase price                       |  | $              | 1,570 |                         | $ | 9,200 |  | $ | 10,770
|Transactions and other direct acquisition costs: |  |                |      |                         |   | 317   |  |   | 317   
|                                                 |  |                |       |                         |   |       |  |   |       
|Purchase price                                   |  | $              | 1,570 |                         | $ | 9,517 |  | $ | 11,087
|                                                 |  |                |       |                         |   |       |  |   |       
|Allocation of purchase price                     |  |                |       |                         |   |       |  |   |       
|Other current assets                             |  |                |      |                         |   | 16    |  |   | 16    
|                                                 |  |                |       |                         |   |       |  |   |       
|Historical net tangible assets acquired          |  | $              |      |                         | $ | 16    |  | $ | 16    
|Intangible assets acquired:                      |  |                |       |                         |   |       |  |   |       
|Developed technology                             |  |                | 1,570 |                         |   |      |  |   | 1,570 
|Patents                                          |  |                |      |                         |   | 9,201 |  |   | 9,201 
|Assembled workforce                              |  |                |      |                         |   | 200   |  |   | 200   
|No shop right                                    |  |                |      |                         |   | 100   |  |   | 100   
|                                                 |  |                |       |                         |   |       |  |   |       
|                                                 |  | $              | 1,570 |                         | $ | 9,517 |  | $ | 11,087
|                                                 |  |                |       |                         |   |       |  |   |       
|Amortization period of intangibles (in years)    |  |                |       |                         |   |       |  |   |       
|Developed technology                             |  |                | 4     |                         |   |      |  |   |       
|Patents                                          |  |                |      |                         |   | 3-5   |  |   |       
|Assembled workforce                              |  |                |      |                         |   | 3     |  |   |       
|No shop right                                    |  |                |      |                         |   | 2     |  |   |       



13



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Note 8. Business Combinations



Aplus Design Technologies, Inc.



On June 10, 2003, the Company entered into an agreement (the Aplus Agreement) to acquire Aplus Design
Technologies, Inc. (Aplus). Aplus designs and develops physical synthesis and physical prototyping solutions for programmable structured logic devices. The Company expects an increase in the number of embedded programmable devices on
large ASIC devices and that the integration of the Aplus technology with Magma tools will allow the customers to address these embedded programmable structured logic devices in a single tool flow. The transaction was completed on July 1, 2003 and
the results of operations from Aplus have been included in Magmas results of operations thereafter.



In accordance with the Aplus Agreement, the Company acquired all the outstanding shares of Aplus and may issue up to 1,079,420 shares of the
Companys common stock and may make up to $4.5 million in cash payments, if all the earn-out milestones set forth in the Aplus Agreement are achieved by fiscal year 2005. To date, Aplus has met two bookings and two technology earn-outs, and the
Company has paid approximately $1.8 million in cash and issued 476,635 shares of the Companys common stock. Under the Aplus Agreement, the remaining balance of the purchase consideration is payable pursuant to earn-out arrangements under which
an additional 7% of the total merger consideration is subject to payment based upon Aplus bookings in fiscal 2004, 35% is subject to payment upon completion of certain technology milestones, and 30% is subject to payment based on operating income
targets for fiscal year 2005. Upon achievement of the milestones, the Company will recognize a higher purchase price equal to the cash paid and the fair value Companys common stock issued to Aplus shareholders on the date the milestones are
achieved.



The acquisition was accounted for under the purchase
method of accounting. The purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. The valuation was performed using a discounted cash flow methodology. As a result of this analysis of the
acquired assets and liabilities, the Company determined that there was no acquired in process research and development and that all of the future cash flows were attributable to the acquired completed software technology.



Acquisition of Silicon Metrics Corporation (Silicon Metrics)



On October 17, 2003, the Company acquired Silicon
Metrics, pursuant to an Agreement and Plan of Merger and Reorganization dated October 16, 2003. Silicon Metrics develops characterization and modeling software for chip design. Silicon Metrics library characterization tool suite will allow the
Company to provide additional characterization and models of standard cell libraries to enable better quality and results and run time for customers.



The Company agreed to pay $18.0 million in cash to Silicon Metrics security holders, including approximately $2.0 million payable to participants in
a Silicon Metrics acquisition bonus plan. In addition, the Company may be required to pay up to $14.0 million in contingent cash consideration pursuant to an earn-out schedule, a portion of which may become payable to participants in the Silicon
Metrics acquisition bonus plan and when paid will be included in goodwill. The earn-outs are based on revenue milestones and if met will be paid in September 2004 and March 2005. Pursuant to the terms of the Silicon Metrics merger agreement, $2.6
million of the consideration was retained by the Company in a segregated bank account to collateralize certain indemnification obligations of the Silicon Metrics stockholders and bonus plan participants and is included in long-term investments on
the Companys consolidated financial statements. The acquisition of Silicon Metrics was accounted for as a purchase and the results of operations are included in the Companys consolidated financial statements from the date of acquisition.



The valuation was performed using a discounted cash flow
methodology. The purchase price was allocated as follows: customer relationships totaling $2.1 million, trademarks totaling $0.3 million, acquired customer contracts totaling $0.3 million, developed technology totaling $1.8 million, patents totaling
$1.2 million and in-process research and development totaled $0.2 million which was charged against operating expense.



Acquisition of Random Logic Corporation (Random Logic)



On October 20, 2003, the Company acquired Random Logic, pursuant to an Agreement and Plan of Merger (the RLC Merger
Agreement) dated October 18, 2003. Random Logic is a developer of the parasitic extraction software product QuickCap.Random Logic brings industrys Gold Standard Resistance and Capacitance extraction technology to the Company, which allows the Company to significantly reduce correlation efforts of its
customers.



The Company paid $20.0 million in cash to Random
Logic security holders in October 2003. Pursuant to the terms of the RLC Merger Agreement, $5.0 million of that consideration was withheld and placed in an escrow account to secure the indemnification obligations of the Random Logic shareholders
which is included in goodwill. The acquisition of Random Logic will be accounted for



14



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as a purchase and the results of operations are included in the Companys consolidated financial statements from the date of acquisition.



The valuation was performed using a discounted cash flow methodology. The
purchase price was allocated as follows: developed technology totaled $4.1 million, patents totaled $0.8 million, trademarks totaled $0.1 million, acquired customer contracts totaled $0.6 million, customer relationships totaled $0.1 million and
goodwill totaled $16.0 million.



A summary of the purchase
price allocations pertaining to the above acquisitions and the amortization periods of the intangible assets acquired is as follows:



|                                                      |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|----------------------------------------------------- |  | -------------- | ----- | - | --------------- | - | ------ | ------------ |  | - | ------ | - |  | - | ------ | -
|2004 Business combinations                            |  | Aplus          |       |   | Silicon Metrics |   |        | Random Logic |  |   | Total  |  
|                                                      |  | (In Thousands) |      
|Cash                                                  |  | $              | 1,671 |   |                 | $ | 17,800 |              |  | $ | 20,000 |   |  | $ | 39,471 |  
|Equity                                                |  |                | 7,955 |   |                 |   |       |              |  |   |       |   |  |   | 7,955  |  
|                                                      |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Approximate Purchase Price                            |  |                | 9,626 |   |                 |   | 17,800 |              |  |   | 20,000 |   |  |   | 47,426 |  
|Transactions and other direct acquisition costs:      |  |                | 158   |   |                 |   | 900    |              |  |   | 76     |   |  |   | 1,134  |  
|                                                      |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Purchase price                                        |  | $              | 9,784 |   |                 | $ | 18,700 |              |  | $ | 20,076 |   |  | $ | 48,560 |  
|                                                      |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Allocation of purchase price                          |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Current assets                                        |  |                | 292   |   |                 |   | 4,907  |              |  |   | 629    |   |  |   | 5,828  |  
|Deferred income taxes                                 |  |                |      |   |                 |   | (2,360 | )            |  |   | (2,280 | ) |  |   | (4,640 | )
|Current liabilities                                   |  |                | (75   | ) |                 |   | (8,660 | )            |  |   |       |   |  |   | (8,735 | )
|Other                                                 |  |                | 74    |   |                 |   | 2,277  |              |  |   |       |   |  |   | 2,351  |  
|                                                      |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Historical net tangible assets (liabilities) acquired |  | $              | 291   |   |                 | $ | (3,836 | )            |  | $ | (1,651 | ) |  | $ | (5,196 | )
|Intangible assets acquired:                           |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Customer relationship or base                         |  |                |      |   |                 |   | 2,100  |              |  |   | 100    |   |  |   | 2,200  |  
|Developed technology                                  |  |                | 9,493 |   |                 |   | 1,800  |              |  |   | 4,100  |   |  |   | 15,393 |  
|Patents                                               |  |                |      |   |                 |   | 1,200  |              |  |   | 800    |   |  |   | 2,000  |  
|Acquired customer contracts                           |  |                |      |   |                 |   | 300    |              |  |   | 600    |   |  |   | 900    |  
|Trademark                                             |  |                |      |   |                 |   | 300    |              |  |   | 100    |   |  |   | 400    |  
|In-process research and development                   |  |                |      |   |                 |   | 200    |              |  |   |       |   |  |   | 200    |  
|Goodwill                                              |  |                |      |   |                 |   | 16,636 |              |  |   | 16,027 |   |  |   | 32,663 |  
|                                                      |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|                                                      |  | $              | 9,784 |   |                 | $ | 18,700 |              |  | $ | 20,076 |   |  | $ | 48,560 |  
|                                                      |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Amortization period of intangibles (in years)         |  |                |       |   |                 |   |        |              |  |   |        |   |  |   |        |  
|Customer relationship or base                         |  |                |      |   |                 |   | 5      |              |  |   | 6      |   |  |   |        |  
|Developed Technology                                  |  |                | 4     |   |                 |   | 5      |              |  |   | 6      |   |  |   |        |  
|Patents                                               |  |                |      |   |                 |   | 5      |              |  |   | 6      |   |  |   |        |  
|Acquired customer contracts                           |  |                |      |   |                 |   | 3      |              |  |   | 3      |   |  |   |        |  
|Trademark                                             |  |                |      |   |                 |   | 5      |              |  |   | 6      |   |  |   |        |  



The following
unaudited pro forma summary presents the consolidated results of operations as if the acquisitions had occurred at the beginning of the three and nine month periods ended December 31, 2003 and for the year ended March 31, 2003. This does not purport
to be indicative of the results that would have been achieved had the acquisition been made as of those dates nor of the results which may occur in the future.



|                                      |  |                                   |        |                                   |   |        |                                  |  |                                  |        |  |        |  
|------------------------------------- |  | --------------------------------- | ------ | --------------------------------- | - | ------ | -------------------------------- |  | -------------------------------- | ------ |  | ------ | -
|(in thousands, except per share data) |  | Three MonthsEndedDecember 31,2003 |        | Three MonthsEndedDecember 31,2002 |   |        | Nine MonthsEndedDecember 31,2003 |  | Nine MonthsEndedDecember 31,2002 |       
|Net revenue                           |  | $                                 | 31,797 |                                   | $ | 21,054 |                                  |  | $                                | 86,673 |  | 59,240 |  
|Net income                            |  | $                                 | 2,069  |                                   | $ | (1,564 | )                                |  | $                                | 3,488  |  | (2,557 | )
|Net income per sharebasic            |  | $                                 | 0.06   |                                   | $ | (0.05  | )                                |  | $                                | 0.11   |  | (0.08  | )
|Net income per sharediluted          |  | $                                 | 0.04   |                                   | $ | (0.05  | )                                |  | $                                | 0.08   |  | (0.08  | )



Note 9. Convertible Subordinated
Notes



On May 22, 2003, the Company completed an offering
of $150.0 million principal amount of Zero Coupon Convertible Subordinated Notes due May 15, 2008 (the Notes) to qualified buyers pursuant to Rule 144A under the Securities Act of 1933, resulting in net proceeds to the Company of
approximately $145.2 million. The Notes do not bear coupon interest and are convertible



15



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into shares of the Companys common stock at a conversion price of $22.86 per share, for an aggregate of 6,561,680 shares. The Notes are subordinated to
the Companys existing and future senior indebtedness and effectively subordinated to all indebtedness and other liabilities of the Companys subsidiaries. The Company may not redeem the Notes prior to their maturity date. The Company paid
approximately $4.5 million in transaction fees to the underwriters of the offering and approximately $0.3 million in other debt issuance costs. The Company is amortizing the transaction fees and issuance costs over the life of the Notes using the
effective interest method. As of December 31, 2003, approximately $0.6 million of transaction fees had been amortized. The shares issuable on the conversion of the Notes are included in fully diluted shares outstanding under the
as-if-converted method of accounting for purposes of calculating diluted earnings per share.



In order to minimize the dilutive effect from the issuance of the Notes, the Company undertook the following additional transactions concurrent with the issuance of the Notes:



| |  | The Company repurchased approximately 1.1 million shares of its common stock at a price of $18.00 per share, or approximately $20.0 million, from one of the initial purchasers of
the Notes, and those shares were retired as of May 30, 2003.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Company and Credit Suisse First Boston International (CSFB International) entered into convertible bond hedge and warrant transactions with respect to the
Companys common stock, the exposure for which is held by CSFB International. Under the convertible bond hedge arrangement, CSFB International agreed to sell to the Company, for $22.86 per share, up to 6,561,680 shares of Magma common stock to
cover the Companys obligation to issue shares upon conversion of the Notes. In addition, the Company issued CSFB International a warrant to purchase up to 6,561,680 shares of common stock for a purchase price of $31.50 per share. Purchases and
sales under this arrangement may be made only upon expiration of the Notes or their earlier conversion (to the extent thereof). Both transactions may be settled at the Companys option either in cash or net shares, and will expire on the
earlier of a conversion event or the maturity of the convertible debt on May 15, 2008. The transactions are expected to reduce the potential dilution from conversion of the Notes. The net cost incurred in connection with these arrangements was
approximately $20.3 million, which is presented in stockholders equity as a reduction of additional paid-in-capital, in accordance with the guidance in Emerging Issues Task Force Issue No. 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Companys Own Stock. That net cost consists of the $56.2 million cost of the convertible bond hedge, offset in part by the $35.9 million proceeds from the issuance of the warrant.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Note 10. Stockholders Equity Transactions and
Additional Paid in Capital Reconciliation



As previously
discussed in detail in other notes to these condensed financial statements, the following is a summary of the significant transactions which were recorded in additional paid-in-capital for the nine months ended December 31, 2003 (in thousands):



|                                                                                                             |  |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | - | ------- | -
|Balance at April 1, 2003                                                                                     |  | $ | 228,400 |  
|Issuance of common stock under stock incentive plans                                                         |  |   | 18,925  |  
|Retirement of treasury stock                                                                                 |  |   | (408    | )
|Purchase of hedging instrument (Note 9)                                                                      |  |   | (56,154 | )
|Proceeds from issuance of warrant (Note 9)                                                                   |  |   | 35,904  |  
|Repurchase of stockholder note                                                                               |  |   | (1,800  | )
|Repurchase of common stock (Note 9)                                                                          |  |   | (19,980 | )
|Issuance of common stock in connection with Aplus acquisition (Note 8)                                       |  |   | 7,955   |  
|Effect of stockholder note repurchase                                                                        |  |   | 2,828   |  
|Issuance and remeasurement of unvested restricted stock in connection with the Veratest acquisition (Note 7) |  |   | 3,349   |  
|Reversal of stock-based compensation for terminated employees                                                |  |   | (134    | )
|                                                                                                             |  |   |         |  
|Balance at December 31, 2003                                                                                 |  | $ | 218,885 |  
|                                                                                                             |  |   |         |  



Note 11. Subsequent Events



Asset Purchase



On February 5, 2004, Magma acquired assets of a private company for $11.0
million, pursuant to an asset purchase agreement (Purchase Agreement), and concurrently entered into a license agreement for certain of Magmas products. Purchased assets include



16



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patents, software products and other intellectual property that can be used to dynamically analyze and resize cells to provide custom performance in a
standard cell ASIC design flow.



The Company paid cash of $7.65
million on February 5, 2004. Pursuant to the terms of the Purchase Agreement, Magma may be required to pay up to $2.5 million in contingent cash consideration pursuant to certain product integration milestones which will be included in the purchase
price. Pursuant to the terms of the purchase agreement, Magma retained 10% of the contingent consideration, or $250,000, and a further $850,000 in a separate interest-bearing account to secure certain indemnification obligations of the private
company and its stockholders.



|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 Selected Consolidated Financial Data and our 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 and 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 the
negative of such words, 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: increasing competition in the electronic design automation market; the continuing impact of
the economic recession; effects that terrorist activities or events in the Middle East may have on Magma, its customers and industry; 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 successfully manage Magmas 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 to help them get their products to market; and changes in accounting rules.



Overview



Our focus is on software used to design technologically advanced integrated circuits, which are typically those with a measurement of 0.13 micron and
smaller.



Magma Design Automation provides electronic design
automation, or EDA, products and related services. We provide design and implementation software that 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 technologically
advanced integrated circuits, which are typically those with a measurement of 0.13 micron and smaller.



An important technical foundation of our software products is our patented FixedTiming methodology, which allows our customers to reduce iterations that
are often required in conventional integrated circuit design processes. Our single data model architecture is a key enabler for this methodology and for our delivery of automated signal integrity detection and correction. Our single data model
architecture contains logical and physical information about the design and is resident in core memory during execution, which makes it possible to analyze the design and make rapid tradeoff decisions during the physical design process.



Our FixedTiming methodology and single data model architecture in our
software products enable chip designers to meet critical time-to-market objectives, improve chip performance and handle chip designs involving millions of components. Our key products include Blast Create, Blast Plan, Blast Fusion, Blast Fusion APX
and Blast Noise. Blast Create enables logic designers to visualize, evaluate and improve code quality, design constraints, testability and analysis. Blast Create, Blast Fusion and Blast Fusion APX combine into one integrated chip design flow what
traditionally had been separate logic design and physical design processes. Our integrated flow significantly reduces iterations used in the design process, allowing our customers to accelerate the time it takes to design and produce deep submicron
integrated circuits. Blast Plan enables hierarchical planning and partitioning of a design into blocks that can be designed separately and later combined into a complex chip or system-on-a-chip. Blast Noise detects and corrects signal interference,
or crosstalk, in physical designs. Blast Rail detects and corrects power distribution within the chip design and causes optimization within physical design flow.



17



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The majority of our revenues come from licensing our software to semiconductor manufacturers and
electronics companies. We provide consulting, training and services to help our customers more rapidly adopt the use of our products. In the past, we have provided integrated circuit design services including assisting our customers in the
utilization of our products for complex chip design challenges. However, beginning in December 2002, we have largely withdrawn from the sale of design services. We also provide post-contract support, or maintenance, for our products.



We were incorporated in Delaware in 1997. Our principal executive offices are
located at 5460 Bayfront Plaza, Santa Clara, California 95054 and our telephone number is (408) 565-7500.



Recent Acquisitions



We
have recently acquired companies and purchased technologies to enable us to expand our served available markets into sign-off quality tool sets for chip timing and parasitic extraction and in library model generation and development. These
acquisitions were intended to support our leading technology position in the EDA industry. We believe that these acquisitions are a significant factor in Magma being able to compete successfully in the EDA industry and we expect to complete similar
acquisitions in the future. These acquisitions increased our headcount by approximately 40 people and increased our research and development expenses. These acquisitions may decrease our liquidity in the short term.



On October 17, 2003, we acquired Silicon Metrics, which develops
characterization and modeling software for chip design. We agreed to pay $18.0 million to Silicon Metrics security holders, including approximately $2.0 million payable to participants in a Silicon Metrics bonus plan. In addition, we may be required
to pay up to $14.0 million in contingent cash consideration pursuant to an earn-out schedule, a portion of which may become payable to participants in the Silicon Metrics bonus plan. The earn-outs will be based upon revenue contribution at September
30, 2004 and March 31, 2005. Pursuant to the terms of the agreement, we retained $2.6 million of the consideration in a segregated bank account to secure certain indemnification obligations of the Silicon Metrics stockholders and bonus plan
participants.



On October 20, 2003, we acquired Random Logic, a
developer of the parasitic extraction software product QuickCap. We paid $20.0 million to Random Logic security holders, $5.0 million of which was withheld and placed in an escrow account to secure certain indemnification obligations of Random Logics shareholders.



During the quarter ended December 31, 2003, the Company acquired assets of
two private companys totaling $9.5 million in cash.



On
February 5, 2004, we entered into an asset purchase agreement with a private company. Under the terms of the asset purchase agreement, we will pay up to $11.0 million which includes $2.5 million in contingent consideration. The Company paid $7.65
million on February 5, 2005.



Critical Accounting Policies and Estimates



In preparing our financial statements, we make estimates,
assumptions and judgments that can have a significant impact on our net 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 greatest 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, deferred 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 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.



18



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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, or
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 lower of amounts due and payable or ratably over the contract period.



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 in one year from the contract datewe recognize revenue to the extent of the lesser of the portion
of the amount presently 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 renewable by the customer at the 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 licenses. In the fourth quarter of fiscal 2003, we changed our business practice for pricing of maintenance renewals from a fixed percentage of annual list price to a fixed percentage of the
annual net license fee. We believe these new pricing policies better reflect the underlying economics of our software license agreements we enter into larger scale license arrangements with our customers, which include substantial discounts from our
list prices. 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. 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 the realizability of the software license fee.



Allowance 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 to any one customer,
industry or geographic region.



To date our receivables have
not had any particular concentrations that, if not collected, would have a significant impact on our operating income. 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 reserve we have established, that would increase our general and administrative expenses and reduce our reported net income.
Conversely, if actual credit losses are significantly less than our reserve, this would eventually decrease our general and administrative expenses and increase our reported net income.



19



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Investments



We invest in debt and equity of privately held technology companies for business and strategic purposes. These companies are
typically in the early stage of development and are expected to incur substantial losses in the near-term. Therefore, these companies may never become publicly traded. Even if they do, an active trading market for their securities may never develop
and we may never realize any return on these investments. Further, if these companies are not successful, we could incur charges related to write-downs or write-offs of these investments.



We also invest in companies that may be classified as variable interest entities. These companies would then be included in
our consolidated statement of operations.



We review the
assumptions underlying the operating performance and cash flow forecasts based on information requested from these privately held companies on at least a quarterly basis. Assessing each investments carrying value requires significant judgment
by management. If we determine that an other-than-temporary decline in fair value exists in a strategic investment, we write-down the investment to its fair value and record the related expense in other income (expense) in our consolidated statement
of operations.



During the second quarter of fiscal 2004, we
entered into an agreement to purchase a $1.0 million convertible note that is convertible into preferred or common stock in a private company. We paid $250,000 in July 2003 and December 2003 and will pay $250,000 for each of the next two quarters.
In addition, during the first half of fiscal 2004, we determined that the decline in value of certain strategic investments was other-than-temporary and recorded write-downs of these investments totaling $1.1 million. The carrying value of all
strategic investments at December 31, 2003 was $1.7 million.



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. We engage independent third-party appraisal firm to assist us in the determining the fair values of assets acquired and liabilities assumed. 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 workforce and acquired
developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimating 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 preliminary purchase price accounting.



Deferred Tax Asset Valuation Allowance



We account for income taxes in accordance with SFAS 109, Accounting for Income Taxes. 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 future taxable income and ongoing prudent and feasible tax planning strategies in assessing
the amount of the valuation allowance. However, adjustments could be required in the future if we determine that the amount to be realized is greater or less than the amount we have recorded.



Valuation of Long-Lived Intangible Assets



As we acquire intangible assets through acquisitions, we will review
long-lived assets for impairment in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be
recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the fair value of the underlying business or asset, a significant decrease in the benefits realized from the acquired business, difficulty and
delays in integrating the business or a significant change in the operations of the acquired business or use of an asset.



Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, different assumptions and estimates could
materially affect our reported financial results. More conservative assumptions of the anticipated future benefits from these businesses could result in greater impairment charges, which would decrease reported net income and result in lower asset
carrying values on our balance sheet. Conversely, less conservative assumptions could result in smaller or no impairment charges, which would result in higher reported net income and higher asset carrying values. At December 31, 2003, we had $29.5
million in intangible assets and $32.7 million of goodwill included on our balance sheet.



20



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Results of Operations



The following table sets forth, for the periods indicated, selected financial data as a percentage of total revenue:



|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|---------------------------------------- |  | ------------------------------- | - |  | ------------------------------ | -- |  | ---- | - |  | ---- | -
|                                         |  | Three Months Ended December 31, |   |  | Nine Months Ended December 31, |   
|                                         |  | 2003                            |   |  | 2002                           |    |  | 2003 |   |  | 2002 |  
|Revenue:                                 |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Licenses                                 |  | 88                              | % |  | 92                             | %  |  | 89   | % |  | 83   | %
|Services                                 |  | 12                              |   |  | 8                              |    |  | 11   |   |  | 17   |  
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Total revenue                            |  | 100                             |   |  | 100                            |    |  | 100  |   |  | 100  |  
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Cost of revenue                          |  | 15                              |   |  | 15                             |    |  | 15   |   |  | 17   |  
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Gross profit                             |  | 85                              |   |  | 85                             |    |  | 85   |   |  | 83   |  
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Operating expenses:                      |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Research and development                 |  | 24                              |   |  | 23                             |    |  | 23   |   |  | 26   |  
|Sales and marketing                      |  | 32                              |   |  | 32                             |    |  | 32   |   |  | 35   |  
|General and administrative               |  | 10                              |   |  | 21                             |    |  | 10   |   |  | 15   |  
|Restructuring costs                      |  |                                |   |  | 4                              |    |  |     |   |  | 1    |  
|In-process research and development      |  | 1                               |   |  |                               |    |  | 0    |   |  |     |  
|Amortization of intangibles              |  | 2                               |   |  |                               |    |  | 1    |   |  |     |  
|Amortization of stock-based compensation |  | 3                               |   |  | 8                              |    |  | 8    |   |  | 7    |  
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Total operating expenses                 |  | 72                              |   |  | 88                             |    |  | 74   |   |  | 84   |  
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Operating income (loss)                  |  | 13                              |   |  | (3                             | )  |  | 11   |   |  | (1   | )
|Other income (expense), net              |  | 2                               |   |  | 2                              |    |  | 1    |   |  | 3    |  
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Net income (loss) before income taxes    |  | 15                              |   |  | (1                             | )  |  | 12   |   |  | 2    |  
|Income taxes                             |  | (3                              | ) |  | (1                             | )  |  | (3   | ) |  | (1   | )
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  
|Net income (loss)                        |  | 12                              | % |  | (2                             | )% |  | 9    | % |  | 1    | %
|                                         |  |                                 |   |  |                                |    |  |      |   |  |      |  



Revenue



Revenue increased 66%, from $18.7 million for the
three months ended December 31, 2002 to $31.1 million for the three months ended December 31, 2003, primarily due to an increase in license revenue. Of the $31.1 million of revenue recognized during the quarter ended December 31, 2003, approximately
72% represents revenue recognized from orders signed before the quarter commenced and the balance represents revenue recognized from new orders signed in the third quarter of fiscal 2004. Revenue increased 46% from $54.6 million for the nine months
ended December 31, 2002 to $79.7 million for the nine months ended December 31, 2003 due to sales to new customers, sales of additional licenses and sales of new products to our existing customers. For the three-month period ended December 31, 2003,
revenue from outside North America represented 53% of total revenue compared with 43% in the comparable year ago period. For the nine-month period ended December 31, 2003, revenue from outside North America represented 50% of total revenue compared
with 37% in the comparable year ago period as a result of signing unbundled multi-year agreements with a single Japanese and European customer during the second and third quarter of fiscal 2004, respectively.



Our revenue consists of license fees for perpetual licenses and for bundled
and unbundled time-based license agreements. Some recent contracts with extended payment terms entered into in recent quarters provide for payments weighted towards the latter part of the contract term. If the payment terms are extended, the revenue
from these contracts will be recognized as amounts become due and payable. Revenue recognized under these arrangements will be higher later in the contract term. Our ability to recognize revenue in the future on contracts with extended payment terms
will be subject to the customers continuing credit-worthiness. Although we plan to enter into both bundled and unbundled time-based license agreements and perpetual license agreements in the future, we expect to derive the majority of our
revenue in the foreseeable future from unbundled time-based license agreements.



License revenue



License revenue increased 59%, from $17.2 million for the three months ended December 31, 2002 to $27.5 million for the three months ended December 31, 2003. License revenue increased 56%, from $45.3 million for the nine months ended
December 31, 2002 to $70.8 million for the nine months ended December 31, 2003. The increases were primarily due to increased license revenue from our design and implementation software products. Specifically, our license revenue benefited from the
introduction of Blast Fusion APX as well as from existing products, such as Blast Fusion, Blast Plan and Blast Noise and to a lesser extent from new products (Blast Create and Blast RTL). We expect license revenue to increase in absolute dollars,
but to remain flat or slightly decrease as a percentage of total revenue.



21



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Services revenue



Services revenue increased 151%, from $1.4 million for the three months ended December 31, 2002 to $3.6 million for the three months ended December 31,
2003. For the nine months ended December 31, 2003, service revenue decreased 4% to $8.9 million, from $9.3 million for the nine months ended December 31, 2002, primarily due to fewer new customer design services engagements. For the three months
ended December 31, 2003, we had two significant engagements to provide design services. We have generally withdrawn from the sale of design services, except when we pass those sales on to approved third party design centers. We expect service
revenue to increase in absolute dollars due to increases in maintenance revenue, but to remain flat or slightly increase as a percentage of total revenue.



Cost of Revenue



Cost of revenue consists primarily of salary and related costs for engineers associated with technical services, including quality assurance, and
associated with post-contract customer support and consulting services. Cost of revenue increased from $2.8 million for the three months ended December 31, 2002, to $4.7 million, for the three months ended December 31, 2003; however, the cost of
revenue as a percentage of total revenue remained constant at 15%. Cost of revenue increased in absolute dollars but decreased as a percentage of total revenue, from $9.0 million, or 17% of total revenue, for the nine months ended December 31, 2002
to $11.9 million, or 15% of total revenue, for the nine months ended December 31, 2003. These absolute dollar increases were primarily due to costs associated with additional support personnel required by our expanding customer base. In
addition, amortization of intangibles accounted for $1.0 million and $1.7 million for the three and nine months ended December 31, 2003, respectively, compared to $0.1 million for the three and nine months ended December 31, 2002. Although we expect
cost of revenue to increase in absolute dollars and that these costs will fluctuate as a percentage of total revenue, our objective is to reduce these costs as a percentage of total revenue.



Operating Expenses



Research and development



Research and development expense consists primarily of salaries, bonuses and
benefits of engineering personnel, along with depreciation of engineering equipment, and outside engineering services from contractors and consultants. Research and development expense increased from $4.3 million, or 23% of total revenue, for the
three months ended December 31, 2002 to $7.5 million, or 24% of total revenue, for the three months ended December 31, 2003. Of this increase, $1.6 million represents payroll related expense partly due to our recent acquisitions and $1.2 million
represents higher headcount and corporate support services. Research and development expenses increased from $14.1 million, or 26% of total revenue, for the nine months ended December 31, 2002 to $18.5 million, or 23% of total revenue, for the nine
months ended December 31, 2003. The nine-month increase of $4.4 million reflects a $3.0 million increase in corporate support services, $2.0 million increase in payroll related expenses related in part to our acquisitions and $0.4 million spent an
equity investment expense. These increases were partially offset by decreases in professional services of $1.0 million as our focused has moved from using outside consulting services. Although we expect research and development expense to increase
in absolute dollars and that these expenses will fluctuate as a percentage of total revenue, our objective is to reduce these expenses as a percentage of total revenue over time.



Sales and marketing



Sales and marketing expense consists primarily of salaries, sales commissions, bonuses, benefits and related costs of sales and marketing personnel, trade
shows and other marketing activities. Sales and marketing expense increased from $6.1 million for the three months ended December 31, 2002 to $10.0 million for the three months ended December 31, 2003; however, the sales and marketing expenses as a
percentage of total revenue remained constant at 32%. The increase was primarily due to a $4.9 million increases in payroll related expense, which included $1.6 million of commission expense. The increase was partially offset by a $1.2 million
decrease in corporate support services. Sales and marketing expenses increased from $19.0 million, or 35% of total revenue, for the nine months ended December 31, 2002 to $25.4 million, or 32% of total revenue, for the nine months ended December 31,
2003. Of this increase, $9.3 million represents increases in net payroll related expenses from additional personnel and commission expense and $0.8 million represents increases in travel expenses from the additional headcount increase. These
increases were partially offset by a decrease of $3.5 million in our corporate support services and $0.2 million in our office related expenses. Although we expect sales and marketing expense to increase in absolute dollars and that these expenses
will fluctuate as a percentage of total revenue, our objective is to reduce these expenses as a percentage of total revenue over time.



General and administrative



General and administrative expense consists primarily of salaries, bonuses, benefits and related costs of finance and administrative personnel and outside
service expenses including legal, accounting and recruiting services. General and administrative expense decreased from $3.9 million, or 21% of total revenue, for the three months ended December 31, 2002 to $3.0 million, or 10% of total revenue, for
the three months ended December 31, 2003. Of this decrease, $1.4 million represents decreases in professional services, especially in legal expenses and $1.0 million represents decreases in corporate support services. These decreases were partially
offset by an increase of $1.2 million in office related expenses. General and administrative expenses decreased from $8.3 million, or 15% of total revenue, for the nine months ended December 31, 2002 to $7.8 million, or 10% of total revenue, for the
nine months



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ended December 31, 2003. The net nine-month decrease of $0.5 million was attributable to decreases in payroll related expense of $0.7 million and
professional services of $1.9 million. These decreases were offset by increases of $0.5 million in support service expenses and office-related expenses of $1.6 million. Although we expect general and administrative expense to generally increase in
absolute dollars and that these expenses will fluctuate as a percentage of total revenue, our objective is to reduce these expenses as a percentage of total revenue over time.



Amortization of stock-based compensation



Stock-based compensation expense consists of the amortization of deferred stock-based compensation resulting from the grant
of stock options at exercise prices less than the fair value of the underlying common stock on the grant date. Options granted to officers and employees generally vest over four years, with 25% vesting after one year and the remainder ratably over
the remaining 36 months. Amortization of stock-based compensation was $1.5 million, or 8%of total revenue, for the three months ended December 31, 2002 and $0.9 million, or 3% of total revenue, for the three months ended December 31, 2003.
Amortization of stock-based compensation was $6.7 million, or 8% of total revenue, for the nine months ended December 31, 2003 and $4.1 million, or 7% of total revenue, for the nine months ended December 31, 2002. For the three months ended December
31, 2003, stock-based compensation included $0.5 million of expense related to the acquisition of VeraTest. For the nine months ended December 31, 2003, stock-based compensation included $3.3 million of expense related to the acquisition of VeraTest
and $2.4 million related to a stock grant issued to our President and director, Roy Jewell.



Amortization of intangible assets



We account for business combinations and asset acquisitions in accordance with SFAS 141. We allocate purchase price to intangible assets and liabilities based on fair values, with the excess of purchase price amount
being allocated to goodwill. The fair values of these intangible assets were assigned, using the discounted cash flow method, which discounts the present value of the free cash flows expected to be generated by the assets. Fair value allocated to
in-process research and development was expensed in the period of acquisition while fair value allocated to developed technology, patents, acquired customer contracts, assembled workforce, no shop rights, trademarks and customer relationships was
capitalized and is amortized over the estimated economic useful life of the asset. The excess of the purchase price over the identified tangible and intangible assets was recorded as goodwill.



We account for amortization of intangibles in accordance with SFAS 142. We
amortize identifiable intangible assets on a straight-line basis over their expected useful lives ranging from two to six years. Amortization of intangible assets amounted to $0.6 million for the nine months ended December 31, 2003. There was no
amortization of intangibles for fiscal year 2003. It is likely that we will continue to expand our business both through acquisitions and internal development. Additional acquisitions could result in incremental expense from additional merger and
acquisition related expenses, amortization of other intangibles and any impairment of goodwill and other intangible assets.



Other Income (Expense), Net



Other income (expense), net was $0.7 million for the three months ended December 31, 2003 and $0.4 million for the three months ended December 31, 2002.
For the nine months ended December 31, 2003 and 2002, other income (expense), net was $1.3 million and $1.4 million, respectively. For the three months ended December 31, 2003 and 2002, interest income was $0.7 and $0.4 million, respectively. For
the nine months ended December 31, 2003 and 2002, interest income was $1.9 million and $1.4 million, respectively. Interest expense increased from ($42,000) for the three months ended December 31, 2002 to ($0.4) million for the three months ended
December 31, 2003. For the nine months ended December 31, 2003 and 2002, interest expense was ($0.7) million and ($45,000), respectively. Interest expense for the nine months ended December 31, 2003 included $0.6 million of amortization for the
transaction fee related to our offering of $150 million principal amount of convertible subordinated notes. Other income (expense) for the three months ended December 31, 2003 and 2002 was $0.4 million and $0, respectively. For the nine months ended
December 31, 2003 and 2002, other income (expense) was $45,000 and $0, respectively. Other income (expense) included impairment charges of $1.1 million related to three of our strategic investments and $1.3 million for foreign exchange gains for the
nine months ended December 31, 2003.



Income Taxes



From inception through December 31, 2003, we incurred
a cumulative net loss for federal and state tax purposes. We are in a net deferred tax asset position, which has been fully reserved. We will continue to provide a valuation allowance for our net deferred tax asset until it becomes more likely than
not that the net deferred tax asset will be realizable. For the three months ended December 31, 2003, the tax provision of $1.0 million included $0.9 million for foreign taxes and $0.5 million for federal income taxes, offset by a decrease of $0.4
million for state income taxes. For the three months ended December 31, 2002, the tax provision of $80,000 included $65,000 for foreign taxes and $15,000 for state income taxes. For the nine months ended December 31, 2003, the tax provision of $2.6
million included $2.0 million for foreign income taxes, $0.4 million for federal income taxes, and $0.2 million for state income taxes. For the nine months ended December 31, 2002, the tax provision of $0.4 million included foreign income taxes of
$0.2 million and state income taxes of $0.2 million.



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Liquidity and Capital Resources



As of December 31, 2003, cash and cash equivalents were $68.6 million, and working capital was $66.2 million.



Net cash provided by operating activities was $22.1 million for the nine
months ended December 31, 2003, compared to net cash provided of $4.8 million for the nine months ended December 31, 2002. For the nine months ended December 31, 2003, cash provided from operating activities included increases in cash from deferred
revenue of $2.5 million due to our increase in revenue, accounts payable of $0.9 million, other long-term liabilities of $0.4 million and accrued expenses of $3.2 million partially due to accrued income taxes. These increases in cash were offset by
decreases in cash from accounts receivable of $1.3 million due to the increase in revenue and prepaid expenses of $3.1 million partially due to prepaid commission. For the nine months ended December 31, 2002, cash flow from operating activities
included an increase in cash from accounts receivable of $0.2 million. This increase was offset by decreases of $1.7 million in cash from accrued expenses, $0.3 million in prepaid expenses and $1.5 million in deferred revenue. In addition,
significant non-cash related adjustments for the nine months ended December 31, 2003 and 2002 included depreciation and amortization of $5.5 million and $3.7 million, amortization of stock-based compensation of $6.7 million and $4.1 million and
provisions for doubtful accounts of ($0.3) million and $0.6 million, respectively.



Net cash used by investing activities was $138.8 million for the nine months ended December 31, 2003, compared to net cash provided of $8.4 million for the nine months ended December 31, 2002. Of the cash used by
investing activities for the nine months ended December 31, 2003, we used $100.6 million to purchase investments, $11.0 million to purchase property and equipment, $2.6 million was used for our Silicon Metrics escrow amount and $0.3 million was used
in connection with our building leases. These purchases were offset by the cash provided from our investing activities, which included $21.5 million in proceeds from sale of investments and $0.5 million provided from other assets. During the nine
months ended December 31, 2003, we have acquired five companies that used cash of $46.3 million. During the nine months ended December 31, 2002, we received $13.5 million in cash as proceeds from our sale of short-term investments. These proceeds
were offset by our purchases of property and equipment for $2.6 million and our purchases of other assets for $2.5 million.



Cash provided by financing activities was $121.5 million and $4.4 million for the nine months ended December 31, 2003 and December 31, 2002, respectively.
Cash provided by financing activities for the nine months ended December 31, 2003 consisted of net proceeds of $144.7 million from our issuance of convertible subordinated notes and of $18.9 million received from our issuance of common stock. This
incoming cash was partially offset by the 1,110,000 shares that we repurchased at $18 per share for an aggregate amount of $20.0 million. In addition, we used $20.3 million in connection with a hedge instrument and a warrant that were related to our
issuance of convertible subordinated notes. During the nine months ended December 31, 2002, $4.4 million was proceeds from issuance of common stock.



On May 22, 2003, we completed an offering of our $150.0 million aggregate principal amount of Zero Coupon Convertible Subordinated Notes due May 15, 2008
to qualified buyers pursuant to Rule 144A under the Securities Act of 1933, resulting in net proceeds to Magma of approximately $145.2 million. We paid approximately $4.5 million in fees to the underwriters of the offering and approximately $0.3
million in other debt issuance costs. We are amortizing the transaction fees and issuance costs over the life of the notes using the interest-rate method. As of December 31, 2003, approximately $0.6 million of the transaction fees have been
amortized. The shares issuable on the conversion of the notes are included in fully diluted shares outstanding under the as-if-converted method of accounting for purposes of calculating diluted earnings per share.



In order to minimize the dilutive effect from the issuance of the notes, we
entered into the following transactions concurrent with the issuance of the notes:



| |  | We repurchased approximately 1.1 million shares of our common stock at a price of $18.00 per share, or approximately $20.0 million, from one of the initial purchasers of the notes,
and those shares were retired as of May 30, 2003.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We and CSFB International, an affiliate of one of the initial purchasers of the notes, entered into convertible bond hedge and warrant transactions with respect to
our common stock, the exposure for which is held by CSFB International. Under the convertible bond hedge arrangement, CSFB International agreed to sell to us, for $22.86 per share, up to 6,561,680 shares of Magma common stock to cover our obligation
to issue shares upon conversion of the notes. In addition, we issued CSFB International a warrant to purchase up to 6,561,680 shares of common stock for a purchase price of $31.50 per share. Purchases and sales under this arrangement may be made
only upon expiration of the notes or their earlier conversion. Both transactions may be settled at our option either in cash or net shares, and will expire on the earlier of the conversion of the notes or the maturity of the convertible debt on May
15, 2008. The transactions are expected to reduce the potential dilution from conversion of the notes. The net cost incurred in connection with these arrangements was approximately $20.3 million, which is presented in shareholders equity as a
reduction of additional paid in capital, in accordance with the guidance in Emerging Issues Task Force Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | Settled in, a Companys Own Stock. That net cost consists of $56.2 million costs of the convertible bond hedge, offset in part by the $35.9
million proceeds from the issuance of the warrant.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of December 31, 2003, our principal source of liquidity consisted of $68.6 million in cash and cash equivalents. We believe that our existing cash and cash equivalents 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.



The following summarizes our contractual obligations at December 31, 2003 and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in millions):



|                              |  |                        |       |                 |   |          |  |          |     |              |   |       |  |   |    
|----------------------------- |  | ---------------------- | ----- | --------------- | - | -------- |  | -------- | --- | ------------ | - | ----- |  | - | ---
|                              |  | Payments due by period
|Contractual Obligations       |  | Total                  |       | Less than1 year |   | 1-3Years |  | 4-5Years |     | After 5Years
|Operating lease obligations   |  | $                      | 12.0  |                 | $ | 1.5      |  | $        | 3.6 |              | $ | 3.8   |  | $ | 3.1
|Convertible subordinated note |  | $                      | 150.0 |                 | $ |         |  | $        |    |              | $ | 150.0 |  | $ |   
|Investment commitment         |  | $                      | 0.5   |                 | $ | 0.5      |  | $        |    |              | $ |      |  | $ |   



We recently acquired
Silicon Metrics Corporation, Pleiades Design and Test Technologies, Inc., Random Logic Corporation, and licensed certain intellectual property from Circuit Semantics, Inc. The aggregate purchase price of these acquisitions is up to approximately $61
million, including $14.4 million in contingent deferred consideration. We have paid approximately $46.3 million, net of cash acquired for the acquisitions to date. The remaining $14.4 million in contingent deferred consideration will be paid as
certain milestones are achieved, if any. These acquisitions have been funded from our cash reserves.



Newly Adopted and Recently Issued Accounting Pronouncements



In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based CompensationTransition and Disclosurean Amendment of FASB
Statement No. 123. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the
method used on reported results. The annual disclosure provisions are effective for fiscal years ending after December 15, 2002. We adopted the disclosure requirements of this standard in fiscal 2003 and the adoption of SFAS 148 did not have a
material effect on our consolidated financial statements.



In
November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. For guarantees issued or modified after December 31,
2002, a liability shall be recognized for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements are effective for interim and annual financial statements for periods ending after December 15, 2002. In June
2003, the FASB issued a FASB Staff Position, which indicated that indemnification clauses in software agreements related to intellectual property infringement are subject to disclosure requirements of FIN 45, but not the initial recognition or
measurement provisions. The adoption of FIN 45 did not have a material effect on our consolidated financial statements.



In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No 51. FIN
46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at
risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. The original
effective date of FIN 46 was delayed to the first reporting period after December 15, 2003 (December 31, 2003 for us) for any variable interest entities or potential variable interest entities created before February 1, 2003. We are studying the
impact of FIN 46 on our consolidated financial position, results of operations and cash flows.



In April 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends and clarifies
financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities. SFAS No. 149 requires that contracts with comparable



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characteristics be accounted for similarly and clarifies under what circumstances a contract with an initial net investment meets the characteristic of a
derivative and when a derivative contains a financing component. SFAS No. 149 also amends the definition of an underlying to conform it to language used in FIN No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, with certain exceptions. The adoption of SFAS No. 149 did not have an impact on our financial
position or results of operations.



In May 2003, the FASB
issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, which establishes standards for how an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that falls within its scope as a liability (or an asset in some circumstances). SFAS No. 150 is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a material impact on our financial position or results of
operations.



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. Our business model is still emerging, and the revenue and income potential of our business and market is unproven. We have a limited history of generating revenue from our software products. As a result
of our short operating history, we have limited financial data that can be used to evaluate our business. 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 have an accumulated deficit of approximately $111.3 million as of December 31, 2003; if we do not increase
profitability, the public trading price of our stock price would be likely to decline.



We had an accumulated deficit of approximately $111.3 million as of December 31, 2003. Although we achieved profitability in fiscal 2003 and fiscal 2004, we incurred losses in prior years. 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;
| | - | ----------------------------------------------------



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



| |  | time-based license agreements with graduated payment schedules that reflect phased deployment of our software and lower relative payments in the first years;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | 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;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | 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;
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| |  | 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.
| | - | -----------------------------------------------------------------------------------



Customer payment defaults may cause us to be unable to recognize revenue from backlog and may have a material adverse effect on our
financial condition and results of operations.



As of
December 31, 2003, we had approximately $241 million in backlog, which we define as non-cancelable contractual commitments by our customers, through purchase orders or contracts that have no contingencies other than our performance. We expect that
we will ultimately be able to recognize this backlog as revenue. However, if a customer defaults and fails to pay amounts owed, we may not be able to recognize expected revenue from backlog. In the current economic environment it is possible that
customers from whom we expect to derive revenue from backlog will default or that the level of defaults will increase. Any material payment default by our customers could reduce the amount of backlog we recognize as revenue and 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.



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. In the nine months ended December 31, 2003, we had four customers that each accounted for more than 10% of our revenue and that together accounted for approximately 51% of our revenue. In the nine months ended December
31, 2002, we had two customers that each accounted for more than 10% of our revenue and that together accounted for approximately 30% of our revenue.



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 licensing agreements automatically expire at the end of the term unless the customer renews the



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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 licensing 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. If we cannot compete successfully, we will not gain market share.



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, formal verification, 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. Examples of acquisitions by our competitors include Synopsys acquisition of Avant! and Cadences acquisitions of Get2Chip,
Silicon Perspective, Plato, Simplex, K2 Technologies, Verplex and Cadmos. Further consolidation in the electronic design automation market could result in an increasingly competitive environment. Competitive pressures may prevent us from gaining
market share, 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 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.



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. We cannot assure you 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, 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 the employees of the acquired company;
| | - | --------------------------------------------------------------------------------------------



| |  | 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;
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| |  | 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.
| | - | --------------------------------------------------------------------------



We may not be able to hire the number of qualified engineering personnel required for our business, particularly field application engineering personnel, which would
harm our ability to grow.



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 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 are located. If we lose the services of a significant number of our engineers or we cannot hire
additional engineers, we will be unable to increase our sales or implement or maintain our growth strategy.



Because many of our current competitors have pre-existing relationships with our current and potential customers, we might not be able to gain market share, which could harm our operations.



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. These existing relationships can make it difficult for us to obtain
additional customers due to the substantial investment that these potential customers have already made in their current design flows. If we are unable to gain market share due to these relationships with our potential customers, our operating
results could be harmed.



Our operating results will be significantly harmed
if chip designers do not adopt Blast Fusion and Blast Fusion APX.



Blast Fusion and Blast Fusion APX have accounted for a significant majority of our revenue since our inception and we believe that revenue from Blast Fusion and Blast Fusion APX and related products will account for most of our revenue for
the foreseeable future. If integrated circuit designers do not adopt Blast Fusion and Blast Fusion APX, our operating results will be significantly harmed. We must continue market penetration of Blast Fusion and Blast Fusion APX to achieve our
growth strategy and financial success.



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 be likely to result in lower demand for our products and services and could harm our business. For example, the United States economy, including the semiconductor industry, is currently experiencing a slowdown, which has
negatively impacted and may continue to impact our business and operating results. Terrorist attacks in the United States, the aftermath of war with Iraq and other worldwide events including in the Middle East have increased uncertainty in the
United States economy. If the economy continues to decline as a result of the 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 addition, the markets for semiconductor products are cyclical. 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



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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. 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 productsin 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 mix of license and 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 product liability claims that are not covered by insurance, a successful claim could harm our business. We currently do not carry product liability
insurance.



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 50% of our
total revenue from sales outside North America for the nine months ended December 31, 2003, compared to 37% in the nine months ended December 31, 2002. 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;
| | - | --------------------------------------------------------------------------------------------------------------



| |  | the aftermath of war 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. Future implementation of internal controls reporting and attestation requirements will impose additional financial and administrative obligations on us that could adversely affect our results.



Changes in effective tax rates could affect our results of operations.



Our future effective tax rates could be adversely affected by the
following:



| |  | earnings being lower than anticipated in countries where we are taxed at lower statutory rates as compared to the U.S. tax rate;
| | - | --------------------------------------------------------------------------------------------------------------------------------



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



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



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Because competition for qualified personnel is intense in our industry, we may not be able to recruit necessary
personnel, which could impact the development or sales of our products.



Our success will also depend on our ability to attract and retain senior management, sales, marketing and other key personnel. Because of the intense competition for such personnel, it is possible that we will fail to
retain key technical and managerial personnel. If we are unable to retain our existing personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products. This
could harm the markets perception of our business and our ability to achieve our business goals.



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 our research and development, 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. If we lose the services of any of these key executives,
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 other senior executives to search for their replacements. The integration of our new
executives or any new personnel could disrupt our ongoing operations.



If we
fail to 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. If our stock price declines
due to market conditions, investors perceptions of the technology industry or managerial or performance problems we have, our stock option incentives may lose value to key employees, and we may lose these employees or be forced to grant
additional options to retain them. This in turn could result in:



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



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



In addition, if we were required to account for stock options as an operating expense, our net income would be reduced or
net losses increased. Accordingly, our financial results would be adversely affected, particularly relative to companies that grant fewer stock options. If we reduce our level of stock option grants, our ability to recruit and retain employees may
be adversely affected.



If our sales force compensation arrangements are
designed poorly, 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 revenues or potential revenues.



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 the third quarter
of fiscal year 2003, we laid off 32 employees. 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 result in a disruption of our operations
and harm to our business. If we are unable to manage our growth the execution of our business plan could be delayed.



We may have difficulty assimilating technology, personnel and operations from acquisitions, and these difficulties may disrupt our business and divert
managements attention.



We have made acquisitions
and we may continue to pursue acquisitions that we believe may complement our business. If we do acquire additional companies, the integration of the separate operations of our company and an acquisition partner may result in problems related to
integration of technology and management teams, either of which could divert managements attention from day-to-day operations. We may not realize all of the anticipated benefits of acquisitions, and we may not be able to retain key



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management, technical and sales personnel after an acquisition. Our products incorporate software licensed from third parties, and if we lose or are unable
to maintain any of these software licenses, our product shipments could be delayed or reduced.



We use software, such as front-end language processing, license keying software and schematic viewing software that we license from third parties. We have also licensed the rights to some technologies from various
universities, including the Technical University of Eindhoven, Delft University and the University of California, Berkeley. These third-party software licenses may not continue to be available on commercially reasonable terms, or at all. If we
cannot maintain existing third-party technology licenses or enter into licenses for other existing or future technologies needed for our products, we could be required to cease or delay product shipments while we seek to develop alternative
technologies.



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 semiconductor 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;
| | - | -----------------------------------------------------------------------------



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



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| |  | 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.



We may face intellectual property infringement or other claims against us or our customers that could be costly to defend and result in our loss of significant rights.



Many of our contracts contain provisions in which we agree to indemnify our customers from third-party intellectual property
infringement claims. Other parties may assert intellectual property infringement claims against us or our customers, and our products may infringe the intellectual property rights of third parties. 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. If we become involved in litigation, we could lose our 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 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. Our products may infringe
third-party patents that may relate to 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.



We may also become involved in litigation unrelated to intellectual property infringement claims. For example, in August 2001, a complaint was filed
against us alleging breach of contract, among other things. This litigation was recently settled. We may not be successful in defending other claims that may be made against us. Regardless of the outcome, litigation can result in substantial expense
and could divert the efforts of our management and technical personnel.



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, if they vote together, 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.



Our stock price may decline significantly because of stock market fluctuations that affect
the prices of technology stocks. A decline in our stock price could result in securities class action litigation against us, that could divert managements attention and harm our business.



The stock market has 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. In the past, securities class action litigation has often been brought against a
company after periods of volatility in the market price of securities. We may in the future be a target of similar litigation. Securities litigation could result in substantial costs and divert managements attention and resources, which could
harm our ability to execute our business plan.



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.



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



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 December 31, 2003, we had no hedging contracts outstanding. We do not currently use financial instruments to hedge operating expenses in the United Kingdom and Japan
denominated in the respective local currency. 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 million principal amount of our zero coupon convertible notes due May 2008. 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.



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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. 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 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 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, as to 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.



|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. A hypothetical 100 basis point decrease
in interest rates would result in an approximate $1.5 million decline in the fair value of our available-for-sale securities.



Market Risk



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 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



36



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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.



Foreign Currency
Exchange Risk



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 and Japan, which are denominated in the
respective local currency. As of December 31, 2003, we had no currency hedging contracts outstanding. We do not currently use financial instruments to hedge operating expenses in the United Kingdom and Japan denominated in the respective local
currency. 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



The Securities and Exchange Commission defines the term disclosure controls and procedures to mean a companys controls and other procedures that are designed to ensure that information required to be disclosed in the
reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Commissions rules and forms. Our chief executive officer and our chief
financial officer, based on their evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report, have concluded that our disclosure controls and procedures were effective for this
purpose.



Internal Control over Financial Reporting



Regulations under the Securities and Exchange Act of 1934 require public
companies, including our company, to evaluate any change in our internal control over financial reporting, which is defined as a process to provide reasonable assurance regarding the reliability of financial reporting and the preparation
of financial statements for external purposes in accordance with generally accepted accounting principles.



In connection with their evaluation of our disclosure controls and procedures as of December 31, 2003, our chief executive officer and chief financial
officer did not identify any change in our internal control over financial reporting during the period that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting, except that we have:



| |  | continued to improve upon our plan and program to update and further automate our financial reporting procedures which we initiated in the quarter ended June 30, 2003. As a result,
we have continued to improve our financial closing processes and financial reporting procedures, and made significant improvement to our consolidation process; and
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | hired two individuals in finance and accounting that are responsible for handling expense accounting accrual and revenue recognition accounting practices.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------



We intend to continue to enhance our financial controls and reporting
procedures, by hiring additional accounting and finance personnel and further formalizing our financial reporting controls and procedures through the remainder of the fiscal year.



PART II. OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------



Magmas quarterly report on Form 10-Q for the period ended June 30, 2003 provides information regarding a settlement agreement between Magma and Prolific, Inc.



From time to time, we are involved in disputes that arise in the ordinary course of business. The number and significance of
these disputes is increasing as our business expands and our company grows larger. Any claims against us, 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 our business.



37



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|Item 2. | Changes in Securities or Use of Proceeds
|------- | ----------------------------------------



Recent Sales Of Unregistered Securities



During the quarter ended December 31, 2003, we issued an aggregate of 4,388 shares of our common stock in connection with the acquisition of Aplus Design Technologies, Inc., for a total of 476,635 shares issued to date in connection with
that acquisition. We may issue up to 602,785 additional shares of our common stock upon the achievement of the earn-out milestones set forth in the Aplus acquisition agreement. The securities were issued in reliance upon the exemption from the
registration requirements of the Securities Act of 1933 provided by Section 4(2) and Regulation D thereof.



|Item 5. | Other Information
|------- | -----------------



Appointments
to Board of Directors



On December 12, 2003, Magma
appointed Kevin (Casey) Eichler to its board of directors. Mr. Eichler, who was appointed as a Class III director to serve until Magmas 2004 Annual Meeting of Stockholders, will also serve on Magmas audit and compensation committees.



On January 28, 2004, Magma appointed Wade Meyercord to its
board of directors. Mr. Meyercord, who was appointed as a Class II director to serve until Magmas 2006 Annual Meeting of Stockholders, will also serve on Magmas compensation committee.



Asset Purchase



On February 5, 2004, Magma acquired assets of a private company for $11.0 million, pursuant to an asset purchase agreement
(purchase agreement), and concurrently entered into a license agreement for certain of Magmas products. Purchased assets include patents, software products and other intellectual property that can be used to dynamically analyze and
resize cells to provide custom performance in a standard cell ASIC design flow.



The Company paid cash of$7.65 million on February 5, 2004. Pursuant to the terms of the purchase agreement, Magma may be required to pay up to $2.5 million in contingent cash consideration pursuant to certain product
integration milestones which will be included in the purchase price. Pursuant to the terms of the purchase agreement, Magma retained 10% of the contingent consideration, or $250,000, and a further $850,000 in a separate interest-bearing account to
secure certain indemnification obligations of the private company and its stockholders.



38



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|Item 6. | Exhibits and Reports on Form 8-K.
|------- | ---------------------------------



(a) Exhibits.



|              |  |                                                                                                                                                                                                                                                                                                                                                 
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                                                                                                                                                                                                             
|              | 
|2.1           |  | Agreement and Plan of Merger and Reorganization, dated as of October 16, 2003, among the Company, Silicon Metrics Corporation, Silicon Correlation, Inc., and Vess Johnson and Austin Ventures
V, L.P., as Stockholder Agents (incorporated by reference to the exhibit of the same number to the Companys Form 8-K filed on October 31, 2003).
|              | 
|3.1           |  | Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Companys Form 10-K for the year ended March 31, 2002 filed on June
28, 2002).                                                                                                                                            
|              | 
|3.2           |  | Certificate of Correction to Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Companys Form 10-K for the year ended
March 31, 2002 filed on June 28, 2002).                                                                                                               
|              | 
|3.3           |  | Amended and Restated Bylaws (incorporated by reference to the exhibit of the same number to the Companys Form 10-K for the year ended March 31, 2002 filed on June 28,
2002).                                                                                                                                                                  
|              | 
|4.1           |  | Form of Common Stock Certificate (incorporated by reference to the exhibit of the same number to Amendment No. 6 to the Companys Registration Statement on Form S-1 (File No.
333-60838)).                                                                                                                                                     
|              | 
|4.2           |  | Amended and Restated Investors Rights Agreement, dated July 31, 2001, by and among the Companys and the parties who are signatories thereto (incorporated by reference to the
exhibit of the same number to the Companys Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).                                                
|              | 
|31.1          |  | Rule 13a-14(a) Certification.                                                                                                                                                                                                                                                                                                                   
|              | 
|31.2          |  | Rule 13a-14(a) Certification.                                                                                                                                                                                                                                                                                                                   
|              | 
|32.1          |  | Certification pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                                                                                                                                               
|              | 
|32.2          |  | Certification pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                                                                                                                                               



(b)
Reports on Form 8-K.



On October 31, 2003, Magma filed a
current report on Form 8-K to report under Item 2 Magmas acquisition of Silicon Metrics Corporation.



On November 4, 2003, Magma furnished a current report on Form 8-K to provide under Item 12 Magmas press release and conference call transcript in
connection with its results of operations and financial condition for its fiscal quarter ended September 30, 2003. This Form 8-K is not filed for purposes of Section 18 of the Securities Exchange Act of 1934 or incorporated into this or any other
filing of the Company.



On December 30, 2003, Magma filed an
amended current report on Form 8-K to provide financial statements of Silicon Metrics Corporation and pro forma financial information reflecting the purchase combination of Silicon Metrics Corporation.



39



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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: February 17, 2004 |  |                               |  | 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)



40



---

EXHIBIT INDEX



TO



MAGMA DESIGN AUTOMATION, INC.



QUARTERLY REPORT ON FORM 10-Q



FOR THE QUARTER ENDED DECEMBER 31, 2003



|              |  |                                                                                                                                                                                                                                                                                                                                                 
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                                                                                                                                                                                                             
|              | 
|2.1           |  | Agreement and Plan of Merger and Reorganization, dated as of October 16, 2003, among the Company, Silicon Metrics Corporation, Silicon Correlation, Inc., and Vess Johnson and Austin Ventures
V, L.P., as Stockholder Agents (incorporated by reference to the exhibit of the same number to the Companys Form 8-K filed on October 31, 2003).
|              | 
|3.1           |  | Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Companys Form 10-K for the year ended March 31, 2002 filed on June
28, 2002).                                                                                                                                            
|              | 
|3.2           |  | Certificate of Correction to Amended and Restated Certificate of Incorporation (incorporated by reference to the exhibit of the same number to the Companys Form 10-K for the year ended
March 31, 2002 filed on June 28, 2002).                                                                                                               
|              | 
|3.3           |  | Amended and Restated Bylaws (incorporated by reference to the exhibit of the same number to the Companys Form 10-K for the year ended March 31, 2002 filed on June 28,
2002).                                                                                                                                                                  
|              | 
|4.1           |  | Form of Common Stock Certificate (incorporated by reference to the exhibit of the same number to Amendment No. 6 to the Companys Registration Statement on Form S-1 (File No.
333-60838)).                                                                                                                                                     
|              | 
|4.2           |  | Amended and Restated Investors Rights Agreement, dated July 31, 2001, by and among the Companys and the parties who are signatories thereto (incorporated by reference to the
exhibit of the same number to the Companys Form 10-K for the year ended March 31, 2002 filed on June 28, 2002).                                                
|              | 
|31.1          |  | Rule 13a-14(a) Certification.                                                                                                                                                                                                                                                                                                                   
|              | 
|31.2          |  | Rule 13a-14(a) Certification.                                                                                                                                                                                                                                                                                                                   
|              | 
|32.1          |  | Certification pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                                                                                                                                               
|              | 
|32.2          |  | Certification pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                                                                                                                                               



41