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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, 2006



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 a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):    Large Accelerated Filer ̈Accelerated Filer  x    Non-accelerated
Filer ̈



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



On February 1, 2007, 38,407,636 shares of Registrants Common
Stock, $.0001 par value were outstanding.



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MAGMA DESIGN AUTOMATION, INC.



FORM 10-Q



QUARTERLY PERIOD ENDED DECEMBER 31, 2006



TABLE OF CONTENTS



|                              |  |                                                                                                                           |  |     
|----------------------------- |  | ------------------------------------------------------------------------------------------------------------------------- |  | ----
|                              |  |                                                                                                                           |  | Page
|Part I: Financial Information |  | 4                                                                                                                        
|                              |  |                                                                                                                          
|Item 1:                       |  | Financial Statements (unaudited)                                                                                          |  | 4   
|                              |  |                                                                                                                          
|                              |  | Condensed Consolidated Balance Sheets at December 31, 2006 and April 2, 2006                                              |  | 4   
|                              |  |                                                                                                                          
|                              |  | Condensed Consolidated Statements of Operations for the Three and Nine Months Ended December 31, 2006 and January 1, 2006 |  | 5   
|                              |  |                                                                                                                          
|                              |  | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2006 and January 1, 2006           |  | 6   
|                              |  |                                                                                                                          
|                              |  | Notes to Condensed Consolidated Financial Statements                                                                      |  | 7   
|                              |  |                                                                                                                          
|Item 2:                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                     |  | 32  
|                              |  |                                                                                                                          
|Item 3:                       |  | Quantitative and Qualitative Disclosures about Market Risk                                                                |  | 50  
|                              |  |                                                                                                                          
|Item 4:                       |  | Controls and Procedures                                                                                                   |  | 50  
|                              | 
|Part II: Other Information    |  | 52                                                                                                                       
|                              |  |                                                                                                                          
|Item 1:                       |  | Legal Proceedings                                                                                                         |  | 52  
|                              |  |                                                                                                                          
|Item 1A:                      |  | Risk Factors                                                                                                              |  | 58  
|                              |  |                                                                                                                          
|Item 2:                       |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                               |  | 73  
|                              |  |                                                                                                                          
|Item 6:                       |  | Exhibits                                                                                                                  |  | 74  
|                              | 
|Signatures                    |  | 75                                                                                                                       
|                              | 
|Exhibit Index                 |  | 76                                                                                                                       



Cautionary Note Regarding Forward-Looking Statements



In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements subject to the safe harbor protection offered by Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. These statements relate to future events and involve known and unknown risks and uncertainties that may cause actual outcomes to be materially different from those indicated by any forward-looking statements. You can
often identify these and other forward-looking statements by terms such as becoming, may, will, should, predicts, potential, continue, anticipates,
believes, estimates, seeks, expects, plans, intends, or comparable terminology. These forward-looking statements include, but are not limited to, our expectations about revenue
and various operating expenses. Although we believe that the expectations reflected in these forward-looking statements are reasonable, and we have based these expectations on our beliefs and assumptions, such expectations may prove to be incorrect.
Our actual results of operations and financial performance could differ significantly from those expressed in or implied by our forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to:
competition in the electronic design automation (EDA) market; Magmas ability to integrate acquired businesses and technologies; potentially higher-than-anticipated costs of litigation; uncertainty surrounding the outcome of the
Synopsys litigation; potentially higher-than-anticipated costs of compliance with regulatory requirements, including those relating to internal control over financial reporting; any delay of customer orders or failure of customers to renew licenses;
adoption of products by customers; weaker-than-anticipated sales of Magmas products and services; weakness in the semiconductor or



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electronic systems industries; the ability to manage expanding operations; the ability to attract and retain the key management and technical personnel
needed to operate Magma successfully; the ability to continue to deliver competitive products to customers; and changes in accounting rules. For a discussion of these and other risk factors, see Part I, Item 1A, Risk Factors of our
Annual Report on Form 10-K for the fiscal year ended April 2, 2006 and Part II, Item 1A, Risk Factors of this Form 10-Q. All of the forward-looking statements are qualified in their entirety by reference to the risk factors
discussed therein. These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. Management cannot predict such new risk factors, nor can it assess the impact, if
any, of such new risk factors on our business or events described in any forward-looking statements after the date of this report to conform them to actual results. Over time, our actual results, performance or achievements will likely differ from
the anticipated results, performance or achievements that are expressed or implied by our forward-looking statements, and such differences might be significant and materially adverse.



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PART I: FINANCIAL INFORMATION



|ITEM 1. | FINANCIAL STATEMENTS
|------- | --------------------



MAGMA DESIGN AUTOMATION, INC.



CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                           |  |                   |          |   |               |   |          |  
|------------------------------------------ |  | ----------------- | -------- | - | ------------- | - | -------- | -
|                                           |  | December 31, 2006 |          |   | April 2, 2006 |  
|ASSETS                                     |  |                   |          |   |               |   |          |  
|Current assets:                            |  |                   |          |   |               |   |          |  
|Cash and cash equivalents                  |  | $                 | 45,049   |   |               | $ | 58,550   |  
|Restricted cash                            |  |                   | 4,600    |   |               |   | 58       |  
|Short-term investments                     |  |                   | 6,650    |   |               |   | 38,608   |  
|Accounts receivable, net                   |  |                   | 31,623   |   |               |   | 33,849   |  
|Prepaid expenses and other current assets  |  |                   | 4,301    |   |               |   | 4,096    |  
|                                           |  |                   |          |   |               |   |          |  
|Total current assets                       |  |                   | 92,223   |   |               |   | 135,161  |  
|Property and equipment, net                |  |                   | 17,840   |   |               |   | 20,062   |  
|Intangibles, net                           |  |                   | 66,554   |   |               |   | 75,735   |  
|Goodwill                                   |  |                   | 48,810   |   |               |   | 43,985   |  
|Restricted cash                            |  |                   | 200      |   |               |   | 3,841    |  
|Other assets                               |  |                   | 4,750    |   |               |   | 5,280    |  
|                                           |  |                   |          |   |               |   |          |  
|Total assets                               |  | $                 | 230,377  |   |               | $ | 284,064  |  
|                                           |  |                   |          |   |               |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY       |  |                   |          |   |               |   |          |  
|Current liabilities:                       |  |                   |          |   |               |   |          |  
|Accounts payable                           |  | $                 | 3,143    |   |               | $ | 2,479    |  
|Accrued expenses                           |  |                   | 36,042   |   |               |   | 31,833   |  
|Deferred revenue                           |  |                   | 22,688   |   |               |   | 24,622   |  
|                                           |  |                   |          |   |               |   |          |  
|Total current liabilities                  |  |                   | 61,873   |   |               |   | 58,934   |  
|Convertible subordinated notes             |  |                   | 65,155   |   |               |   | 105,500  |  
|Other long-term liabilities                |  |                   | 2,440    |   |               |   | 5,727    |  
|                                           |  |                   |          |   |               |   |          |  
|Total liabilities                          |  |                   | 129,468  |   |               |   | 170,161  |  
|Commitments and contingencies (Note 12)    |  |                   |          |   |               |   |          |  
|Stockholders equity:                      |  |                   |          |   |               |   |          |  
|Common stock                               |  |                   | 4        |   |               |   | 4        |  
|Additional paid-in capital                 |  |                   | 304,582  |   |               |   | 286,336  |  
|Deferred stock-based compensation          |  |                   |         |   |               |   | (2,020   | )
|Accumulated deficit                        |  |                   | (173,286 | ) |               |   | (136,581 | )
|Treasury stock                             |  |                   | (29,301  | ) |               |   | (32,650  | )
|Accumulated other comprehensive loss       |  |                   | (1,090   | ) |               |   | (1,186   | )
|                                           |  |                   |          |   |               |   |          |  
|Total stockholders equity                 |  |                   | 100,909  |   |               |   | 113,903  |  
|                                           |  |                   |          |   |               |   |          |  
|Total liabilities and stockholders equity |  | $                 | 230,377  |   |               | $ | 284,064  |  
|                                           |  |                   |          |   |               |   |          |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)



|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|------------------------------------------------------------------------------------------------------- |  | ------------------ | ------- | - | ----------------- | - | ------ | ----------------- |  | - | --------------- | - |  | - | ------- | -
|                                                                                                        |  | Three Months Ended |         |   | Nine Months Ended |  
|                                                                                                        |  | December 31, 2006  |         |   | January 1, 2006   |   |        | December 31, 2006 |  |   | January 1, 2006 |  
|Revenue:                                                                                                |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Licenses                                                                                                |  | $                  | 34,006  |   |                   | $ | 34,889 |                   |  | $ | 103,405         |   |  | $ | 101,503 |  
|Services                                                                                                |  |                    | 11,088  |   |                   |   | 6,431  |                   |  |   | 24,611          |   |  |   | 18,535  |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Total revenue                                                                                           |  |                    | 45,094  |   |                   |   | 41,320 |                   |  |   | 128,016         |   |  |   | 120,038 |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Cost of revenue:                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Licenses                                                                                                |  |                    | 8,358   |   |                   |   | 6,702  |                   |  |   | 23,444          |   |  |   | 17,598  |  
|Services                                                                                                |  |                    | 5,661   |   |                   |   | 4,183  |                   |  |   | 16,352          |   |  |   | 12,566  |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Total cost of revenue                                                                                   |  |                    | 14,019  |   |                   |   | 10,885 |                   |  |   | 39,796          |   |  |   | 30,164  |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Gross profit                                                                                            |  |                    | 31,075  |   |                   |   | 30,435 |                   |  |   | 88,220          |   |  |   | 89,874  |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Operating expenses:                                                                                     |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Research and development                                                                                |  |                    | 15,660  |   |                   |   | 11,643 |                   |  |   | 46,716          |   |  |   | 36,794  |  
|In-process research and development                                                                     |  |                    | 1,300   |   |                   |   | 450    |                   |  |   | 1,300           |   |  |   | 450     |  
|Sales and marketing                                                                                     |  |                    | 14,919  |   |                   |   | 11,500 |                   |  |   | 43,333          |   |  |   | 33,436  |  
|General and administrative                                                                              |  |                    | 9,660   |   |                   |   | 11,267 |                   |  |   | 29,667          |   |  |   | 29,796  |  
|Amortization of intangible assets                                                                       |  |                    | 2,923   |   |                   |   | 2,682  |                   |  |   | 8,735           |   |  |   | 9,152   |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Total operating expenses                                                                                |  |                    | 44,462  |   |                   |   | 37,542 |                   |  |   | 129,751         |   |  |   | 109,628 |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Operating loss                                                                                          |  |                    | (13,387 | ) |                   |   | (7,107 | )                 |  |   | (41,531         | ) |  |   | (19,754 | )
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Other income:                                                                                           |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Interest income                                                                                         |  |                    | 623     |   |                   |   | 795    |                   |  |   | 2,181           |   |  |   | 2,042   |  
|Interest expense                                                                                        |  |                    | (141    | ) |                   |   | (197   | )                 |  |   | (449            | ) |  |   | (629    | )
|Other income (expense), net                                                                             |  |                    | (326    | ) |                   |   | (776   | )                 |  |   | 3,884           |   |  |   | 6,322   |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Other income (expense), net                                                                             |  |                    | 156     |   |                   |   | (178   | )                 |  |   | 5,616           |   |  |   | 7,735   |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Net loss before income taxes                                                                            |  |                    | (13,231 | ) |                   |   | (7,285 | )                 |  |   | (35,915         | ) |  |   | (12,019 | )
|Provision for income taxes                                                                              |  |                    | 330     |   |                   |   | 783    |                   |  |   | 1,100           |   |  |   | 2,692   |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Net loss before cumulative effect of change in accounting principle                                     |  |                    | (13,561 | ) |                   |   | (8,068 | )                 |  |   | (37,015         | ) |  |   | (14,711 | )
|Cumulative effect of change in accounting principle                                                     |  |                    |        |   |                   |   |       |                   |  |   | 321             |   |  |   |        |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Net loss                                                                                                |  | $                  | (13,561 | ) |                   | $ | (8,068 | )                 |  | $ | (36,694         | ) |  | $ | (14,711 | )
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Net loss per common share before cumulative effect of change in accounting principle, basic and diluted |  | $                  | (0.37   | ) |                   | $ | (0.23  | )                 |  | $ | (1.02           | ) |  | $ | (0.43   | )
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Net loss per common share, basic and diluted                                                            |  | $                  | (0.37   | ) |                   | $ | (0.23  | )                 |  | $ | (1.01           | ) |  | $ | (0.43   | )
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Shares used in calculation, basic and diluted                                                           |  |                    | 37,072  |   |                   |   | 34,470 |                   |  |   | 36,289          |   |  |   | 34,237  |  
|                                                                                                        |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                                                |  |                   |         |   |                 |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | --------------- | - | ------- | -
|                                                                                                                |  | Nine Months Ended |        
|                                                                                                                |  | December 31, 2006 |         |   | January 1, 2006 |  
|Cash flows from operating activities:                                                                           |  |                   |         |   |                 |   |         |  
|Net loss                                                                                                        |  | $                 | (36,694 | ) |                 | $ | (14,711 | )
|Adjustments to reconcile net loss to net cash provided by operating activities:                                 |  |                   |         |   |                 |   |         |  
|Cumulative effect of change in accounting principle                                                             |  |                   | (321    | ) |                 |   |        |  
|Depreciation and amortization                                                                                   |  |                   | 7,845   |   |                 |   | 7,054   |  
|Amortization of intangible assets                                                                               |  |                   | 31,434  |   |                 |   | 26,103  |  
|In-process research and development                                                                             |  |                   | 1,300   |   |                 |   | 450     |  
|Provision for (recovery from) doubtful accounts                                                                 |  |                   | 148     |   |                 |   | (349    | )
|Amortization of debt issuance costs                                                                             |  |                   | 354     |   |                 |   | 544     |  
|Loss on strategic equity investments                                                                            |  |                   | 440     |   |                 |   | 854     |  
|Gain on repurchase of convertible notes, net of debt issuance cost write-off                                    |  |                   | (4,809  | ) |                 |   | (8,781  | )
|Loss on sale of short-term investments                                                                          |  |                   | 3       |   |                 |   | 661     |  
|Loss on disposal of fixed assets                                                                                |  |                   | 12      |   |                 |   |        |  
|Stock-based compensation                                                                                        |  |                   | 12,308  |   |                 |   | 3,910   |  
|Income tax benefit realized from gain on repurchase of convertible notes                                        |  |                   |        |   |                 |   | 853     |  
|Income tax benefit realized from debt issuance costs                                                            |  |                   | 259     |   |                 |   | 65      |  
|Change in operating assets and liabilities, net of effect of acquisitions:                                      |  |                   |         |   |                 |   |         |  
|Accounts receivable                                                                                             |  |                   | 2,120   |   |                 |   | 6,267   |  
|Prepaid expenses and other assets                                                                               |  |                   | 980     |   |                 |   | 768     |  
|Accounts payable                                                                                                |  |                   | 438     |   |                 |   | (1,105  | )
|Accrued expenses                                                                                                |  |                   | (1,999  | ) |                 |   | 9,639   |  
|Deferred revenue                                                                                                |  |                   | (1,934  | ) |                 |   | (1,960  | )
|Other long-term liabilities                                                                                     |  |                   | (171    | ) |                 |   | (440    | )
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Net cash provided by operating activities                                                                       |  |                   | 11,713  |   |                 |   | 29,822  |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Cash flows from investing activities:                                                                           |  |                   |         |   |                 |   |         |  
|Purchase of intangible assets                                                                                   |  |                   | (22,631 | ) |                 |   | (25,333 | )
|Purchase of property and equipment                                                                              |  |                   | (2,505  | ) |                 |   | (3,240  | )
|Purchase of short-term investments                                                                              |  |                   | (13,397 | ) |                 |   | (83,746 | )
|Proceeds from sale and maturities of short-term investments                                                     |  |                   | 45,416  |   |                 |   | 162,289 |  
|Purchase of strategic equity investments                                                                        |  |                   | (900    | ) |                 |   | (750    | )
|Restricted cash                                                                                                 |  |                   | (200    | ) |                 |   |        |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Net cash provided by investing activities                                                                       |  |                   | 5,783   |   |                 |   | 49,220  |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Cash flows from financing activities:                                                                           |  |                   |         |   |                 |   |         |  
|Proceeds from issuance of common stock, net                                                                     |  |                   | 5,031   |   |                 |   | 4,617   |  
|Repurchase of common stock                                                                                      |  |                   |        |   |                 |   | (16,045 | )
|Repurchase of convertible notes, net                                                                            |  |                   | (35,000 | ) |                 |   | (34,668 | )
|Repayment of capital lease obligation                                                                           |  |                   | (1,018  | ) |                 |   | (556    | )
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Net cash used in financing activities                                                                           |  |                   | (30,987 | ) |                 |   | (46,652 | )
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Effect of foreign currency translation on cash and cash equivalents                                             |  |                   | (10     | ) |                 |   | (127    | )
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Net (decrease) increase in cash and cash equivalents                                                            |  |                   | (13,501 | ) |                 |   | 32,263  |  
|Cash and cash equivalents at beginning of period                                                                |  |                   | 58,550  |   |                 |   | 20,622  |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Cash and cash equivalents at end of period                                                                      |  | $                 | 45,049  |   |                 | $ | 52,885  |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Supplemental disclosure:                                                                                        |  |                   |         |   |                 |   |         |  
|Non-cash investing and financing activities:                                                                    |  |                   |         |   |                 |   |         |  
|Deferred stock-based compensation                                                                               |  | $                 | 514     |   |                 | $ | 1,089   |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Issuance of common stock in connection with asset purchase                                                      |  | $                 | 6,327   |   |                 | $ | 11,747  |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Issuance of common stock warrant in connection with intangible asset purchase                                   |  | $                 |        |   |                 | $ | 3,080   |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Purchase of fixed assets under capital leases                                                                   |  | $                 | 2,328   |   |                 | $ | 2,048   |  
|                                                                                                                |  |                   |         |   |                 |   |         |  
|Common stock received from termination of hedge and warrants in connection with repurchase of convertible notes |  | $                 | 102     |   |                 | $ |        |  
|                                                                                                                |  |                   |         |   |                 |   |         |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



Note 1. Basis of Presentation



The interim unaudited condensed consolidated financial statements included
herein have been prepared by Magma Design Automation, Inc. (Magma or the Company), pursuant to the rules and regulations of the United States Securities and Exchange Commission (SEC). Certain information and note
disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, pursuant to these rules and regulations. However,
management believes that the disclosures are adequate to ensure that the information presented is not misleading. The interim unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary
(consisting only of normal recurring adjustments) to present a fair statement of results for the interim periods presented. The operating results for any interim period are not necessarily indicative of the results that may be expected for the
entire fiscal year ending April 1, 2007 (fiscal year 2007). The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Companys Form 10-K for the year ended April 2, 2006
(fiscal year 2006), as filed with the SEC on June 15, 2006. The accompanying unaudited condensed consolidated balance sheet at April 2, 2006 is derived from audited consolidated financial statements at that date.



Preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date
of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Management periodically evaluates such estimates and assumptions for continued reasonableness. Appropriate adjustments, if any, to
the estimates used are made prospectively based upon such periodic evaluation. Actual results could differ from those estimates.



Principles of Consolidation



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



Reclassifications



Certain amounts in the prior year financial statements have been reclassified to conform with the current year presentation. Specifically, the Company has
reclassified certain prior year amounts relating to stock-based compensation as detailed in the statements of operations and in Note 2.



Change in Fiscal Year End



On January 26, 2005, the Companys Board of Directors approved a change in Magmas fiscal year end from March 31 to a 52-53 week
fiscal year ending on the first Sunday subsequent to March 31. After the fiscal year ended March 31, 2005, Magmas fiscal years consist of four quarters of 13 weeks each except for fiscal year 2008 and each fifth or sixth fiscal year
after fiscal year 2008, which includes one quarter with 14 weeks. All references to years or quarters in these notes to consolidated financial statements represent fiscal years or fiscal quarters, respectively, unless otherwise noted. As a result of
this change, the first quarter of Magmas fiscal year 2006 included three additional days, the results of which were included in Magmas Form 10-Q for that quarter.



7



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Treasury Stock



Shares of common stock repurchased by the Company are recorded at cost as treasury stock and result in a reduction of
stockholders equity in the Companys Consolidated Balance Sheets. From time to time, treasury shares may be reissued as part of the Companys stock-based compensation programs. When shares are reissued, we use the weighted average
cost method for determining cost. If the issuance price is higher than the cost, the excess of the issuance price over cost is credited to additional paid-in capital (APIC). If the issuance price is lower than the cost, the difference is
first charged against any credit balance in APIC from treasury stock and the balance is charged to retained earnings (accumulated deficit). During the three and nine months ended December 31, 2006, the Company recorded $11,000 of such charges
to accumulated deficit.



Recently Issued Accounting
Pronouncements



In September 2006, the Financial
Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157 Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies only to other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years
beginning after November 15, 2007. The Company is currently evaluating the impact of the adoption of SFAS 157 on its consolidated financial position or results of operations.



In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (SAB 108) addressing how the effects of
prior-year uncorrected financial statement misstatements should be considered in current-year financial statements. SAB 108 requires registrants to quantify misstatements using both balance-sheet and income-statement approaches in evaluating whether
or not a misstatement is material. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company does not anticipate the adoption of SAB 108 will have a material impact on its consolidated financial position or results of
operations.



In July 2006, the FASB issued FASB Interpretation
No. 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (FIN 48). Under FIN 48, companies are required to apply the more likely than not threshold to the
recognition and derecognition of tax positions. FIN 48 also provides guidance on the measurement of tax positions, balance sheet classification, interest and penalties, accounting in interim periods, disclosure and transition. The new guidance
will be effective for the Company on April 2, 2007, the beginning of its fiscal year 2008. The Company is currently evaluating the provisions in FIN 48, however, at the present time, it does not anticipate that the adoption of FIN 48 will
have a material impact on its consolidated financial position or results of operations.



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



8



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 2. Stock-based Compensation



Adoption of SFAS 123R



Effective April 3, 2006, the Company accounts for stock-based employee compensation arrangements under SFAS No. 123 (revised 2004),
Share-Based Payment (SFAS 123R) which supersedes the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and requires the
fair value recognition of share-based payment arrangements, including stock options, restricted stock, restricted stock units and shares issued under the Employee Stock Purchase Plan (ESPP). Prior to April 3, 2006, the Company
accounted for its stock based compensation plans using the intrinsic value method under the provisions of APB 25 and related guidance. The Company adopted SFAS 123R using the modified-prospective-transition method and accordingly prior periods have
not been restated to reflect the impact of SFAS 123R. Under the modified-prospective-transition method, the results of operations include compensation costs of unvested options and awards granted prior to April 3, 2006, and options and
awards granted subsequent to that date. Additionally, the Company elected to use the straight-line method to recognize its stock-based compensation expenses over the option and awards vesting periods. For options and awards granted prior to
adoption of SFAS 123R, the Company continues to record stock-based compensation expenses under the accelerated attribution method. As required by SFAS 123R, on April 3, 2006, the Company eliminated the unamortized deferred stock
compensation of $2.0 million and reduced the Companys additional paid-in capital by the same amount, which had been included in stockholders equity in the Companys condensed consolidated balance sheet as of April 2, 2006.



Unlike APB 25, which allows adjustments to compensation costs
for actual forfeitures, SFAS 123R requires the rate of forfeiture to be estimated and recorded during the option term. Accordingly, during the first quarter of fiscal 2007, the Company recorded a credit of $321,000, reflecting the cumulative effect
of the change in accounting principle for forfeitures primarily related to unvested restricted stock that had previously been recognized as stock-based compensation expense without consideration of forfeitures. No income tax benefit related to the
cumulative effect of the change in accounting for stock option forfeitures was recorded as the Company has provided full valuation allowance against its net deferred tax assets.



In March 2005, the Commission issued Staff Accounting Bulletin (SAB) No. 107, which provided supplemental
implementation guidance for SFAS 123R. SAB 107 requires stock-based compensation to be classified in the same expense line items as cash compensation. Accordingly, the Company recorded stock-based compensation for the three and nine months ended
December 31, 2006 and reclassified stock-based compensation for the three and nine months ended January 1, 2006 as follows (in thousands):



|                                       |  |                   |       |                  |   |                   |  |                 |        |  |   |      
|-------------------------------------- |  | ----------------- | ----- | ---------------- | - | ----------------- |  | --------------- | ------ |  | - | -----
|                                       |  | Three MonthsEnded |       | Nine MonthsEnded
|                                       |  | December 31, 2006 |       | January 1, 2006  |   | December 31, 2006 |  | January 1, 2006
|Cost of revenue                        |  | $                 | 288   |                  | $ | 4                 |  | $               | 974    |  | $ | 51   
|Research and development expense       |  |                   | 1,150 |                  |   | 813               |  |                 | 4,757  |  |   | 3,608
|Sales and marketing expense            |  |                   | 804   |                  |   | 13                |  |                 | 3,058  |  |   | 89   
|General and administrative expense     |  |                   | 1,053 |                  |   | 88                |  |                 | 3,520  |  |   | 162  
|                                       |  |                   |       |                  |   |                   |  |                 |        |  |   |      
|Total stock-based compensation expense |  | $                 | 3,295 |                  | $ | 918               |  | $               | 12,309 |  | $ | 3,910
|                                       |  |                   |       |                  |   |                   |  |                 |        |  |   |      



9



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



The Company has not provided an income tax benefit for stock-based compensation expense for current
and prior year periods, since it is more likely than not that the deferred tax assets associated with this expense will not be realized. To the extent the Company realizes the deferred tax assets associated with the stock-based compensation expense
in the future, the income tax effects of such an event may be recognized at that time. Prior to the adoption of SFAS 123R, the Company presented all tax benefits for deductions resulting from the exercise of stock options as operating cash flows on
its statement of cash flows. SFAS 123R requires the cash retained as a result of tax benefits for tax deductions in excess of the compensation expense recorded for those options to be classified as cash from financing activities. The Company
recorded no excess tax benefits for the three and nine months ended December 31, 2006.



The adoption of SFAS 123R has had a material effect on the Companys financial results since April 3, 2006. The Companys operating loss for the three and nine months ended December 31, 2006
increased by $2.9 million and $9.6 million, respectively, and net loss by $2.9 million and $9.3 million, respectively, than if the Company had continued to account for stock-based compensation under APB 25. Basic and diluted net loss per share
for the three and nine months ended December 31, 2006 was $0.08 and $0.27, respectively, higher than if the Company had continued to account for stock-based compensation under APB 25. For the three and nine months ended January 1, 2006,
the Company recognized $0.9 million and $3.9 million, respectively, of stock-based compensation expense under the intrinsic value method.



Stock-based compensation expense by type of awards during the three and nine months ended December 31, 2006 was as follows (in thousands):



|                                            |  |                                     |       |                                    |   |       
|------------------------------------------- |  | ----------------------------------- | ----- | ---------------------------------- | - | ------
|                                            |  | Three Months EndedDecember 31, 2006 |       | Nine Months EndedDecember 31, 2006
|Stock options                               |  | $                                   | 2,371 |                                    | $ | 8,117 
|Restricted stock and restricted stock units |  |                                     | 607   |                                    |   | 2,607 
|Employee stock purchase plan                |  |                                     | 317   |                                    |   | 1,585 
|                                            |  |                                     |       |                                    |   |       
|Total stock-based compensation expense      |  | $                                   | 3,295 |                                    | $ | 12,309
|                                            |  |                                     |       |                                    |   |       



The Company has
adopted several stock incentive plans providing stock-based awards to employees, directors, advisors and consultants, including stock options, restricted stock and restricted stock units. The Company also has an Employee Stock Purchase Plan, which
enables employees to purchase shares of the Companys common stock. As of December 31, 2006, 1.4 million and 2.4 million shares of common stock were available for issuance under the Companys stock incentive plans and ESPP,
respectively.



Stock Options



The Companys stock incentive plans require that stock options be
granted at the market price of the Companys common stock on the date of grant. Option grants vest over two to four years subject to the employees continuing service to the Company and expire no later than five or ten years from the grant
date. The Company uses the Black-Scholes option pricing model to determine the fair value of its stock options, which is consistent with what was used for pro forma disclosures under SFAS 123, Accounting for Stock-Based Compensation,
prior to the adoption of SFAS 123R. The Black-Scholes option pricing model was developed to estimate the fair value of short lived exchange-traded options that have no vesting restrictions and are fully transferable. In addition, the Black-Scholes
option-pricing model incorporates various highly subjective assumptions including expected future stock price volatility and expected terms of instruments. The weighted average grant date fair value of options granted during the three and nine
months ended December 31, 2006 was



10



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



$3.77 per share and $3.60 per share, respectively. The weighted average assumptions used in the model for the three and nine months ended December 31,
2006 were as follows:



|                        |  |                                     |  |                                   
|----------------------- |  | ----------------------------------- |  | ----------------------------------
|                        |  | Three Months EndedDecember 31, 2006 |  | Nine Months EndedDecember 31, 2006
|Expected life (years)   |  | 4.10                                |  | 4.15                              
|Volatility              |  | 47%                                 |  | 47-50%                            
|Risk-free interest rate |  | 4.49 - 4.73%                        |  | 4.49 - 5.15%                      
|Expected dividend yield |  | 0%                                  |  | 0%                                



In refining estimates
used in the adoption of SFAS 123R, the Company established the expected life assumption for employee options and awards, as well as expected forfeiture rates, based on the historical settlement experience, while giving consideration to vesting
schedules and options that have life cycles less than the contractual terms. Assumptions for option exercises and pre-vesting terminations of options were stratified for employee groups with sufficiently distinct behavior patterns. Expected
volatility under SFAS 123R was developed based on the average historical weekly stock price volatility and average implied volatility. The risk-free interest rate for the period within the expected life of the option is based on the yield of United
States Treasury notes at the time of grant.



A summary of the
changes in stock options outstanding and exercisable under the Companys stock incentive plans during the three and nine months ended December 31, 2006 is as follows (in thousands, except year and per share amount):



|                                                 |  |                  |   |  |                                 |       |                                                   |      |                         |   |      
|------------------------------------------------ |  | ---------------- | - |  | ------------------------------- | ----- | ------------------------------------------------- | ---- | ----------------------- | - | -----
|                                                 |  | Number of Shares |   |  | Weighted Average Priceper Share |       | Weighted Average RemainingContractual Term(Years) |      | AggregateIntrinsicValue
|Options outstanding at April 2, 2006             |  | 8,979            |   |  | $                               | 10.64 |                                                   |      |                         | $ | 2,940
|Granted                                          |  | 2,153            |   |  | $                               | 7.77  |                                                   |      |                         |   |      
|Exercised                                        |  | (1               | ) |  | $                               | 6.08  |                                                   |      |                         |   |      
|Cancelled and forfeited                          |  | (324             | ) |  | $                               | 14.13 |                                                   |      |                         |   |      
|                                                 |  |                  |   |  |                                 |       |                                                   |      |                         |   |      
|Options outstanding at July 2, 2006              |  | 10,807           |   |  | $                               | 9.96  |                                                   | 5.60 |                         | $ | 1,194
|                                                 |  |                  |   |  |                                 |       |                                                   |      |                         |   |      
|Granted                                          |  | 460              |   |  | $                               | 8.31  |                                                   |      |                         |   |      
|Exercised                                        |  | (14              | ) |  | $                               | 6.73  |                                                   |      |                         |   |      
|Cancelled and forfeited                          |  | (142             | ) |  | $                               | 10.29 |                                                   |      |                         |   |      
|                                                 |  |                  |   |  |                                 |       |                                                   |      |                         |   |      
|Options outstanding at October 1, 2006           |  | 11,111           |   |  | $                               | 9.89  |                                                   | 5.34 |                         | $ | 7,186
|                                                 |  |                  |   |  |                                 |       |                                                   |      |                         |   |      
|Granted                                          |  | 385              |   |  | $                               | 9.10  |                                                   |      |                         |   |      
|Exercised                                        |  | (44              | ) |  | $                               | 5.78  |                                                   |      |                         |   |      
|Cancelled and forfeited                          |  | (150             | ) |  | $                               | 12.26 |                                                   |      |                         |   |      
|                                                 |  |                  |   |  |                                 |       |                                                   |      |                         |   |      
|Options outstanding at December 31, 2006         |  | 11,302           |   |  | $                               | 9.84  |                                                   | 5.09 |                         | $ | 6,202
|                                                 |  |                  |   |  |                                 |       |                                                   |      |                         |   |      
|Vested and expected to vest at December 31, 2006 |  | 10,883           |   |  | $                               | 9.90  |                                                   | 5.10 |                         | $ | 5,954
|Exercisable at December 31, 2006                 |  | 6,316            |   |  | $                               | 10.76 |                                                   | 5.45 |                         | $ | 3,290



The total intrinsic
value of options exercised was $149,843 and $165,364, respectively, during the three and nine months ended December 31, 2006, and $27,511 and $260,616, respectively, during the three and nine months ended January 1, 2006. As of
December 31, 2006, there was approximately $14.3 million of



11



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



unrecognized stock-based compensation expense, net of estimated forfeitures, related to stock option grants, which will be recognized over the remaining
weighted average vesting period of approximately 1.47 years.



Restricted
Stock and Restricted Stock Units



Restricted stock and
restricted stock units were granted to employees at par value under the Companys stock incentive plans and Key Contributor Long-Term Incentive Plan, or assumed in connection with an acquisition. In general, restricted stock and restricted
stock unit awards vest over two to four years and are subject to the employees continuing service to the Company. The cost of restricted stock and restricted stock unit awards is determined using the fair value of the Companys common
stock on the date of the grant, and compensation expense is recognized over the vesting period.



A summary of the changes in restricted stock outstanding during the three and nine months ended December 31, 2006 is presented below (in thousands,
except per share amount):



|                                      |  |                  |   |  |                                                  |      
|------------------------------------- |  | ---------------- | - |  | ------------------------------------------------ | -----
|                                      |  | Number of Shares |   |  | Weighted Average Grant Date Fair
Value per Share
|Shares nonvested at April 2, 2006     |  | 389              |   |  | $                                                | 11.87
|Granted                               |  | 307              |   |  | $                                                | 7.11 
|Vested                                |  | (129             | ) |  | $                                                | 12.04
|Forfeited                             |  |                 |   |  | $                                                |     
|                                      |  |                  |   |  |                                                  |      
|Shares nonvested at July 2, 2006      |  | 567              |   |  | $                                                | 9.26 
|                                      |  |                  |   |  |                                                  |      
|Granted                               |  | 50               |   |  | $                                                | 9.50 
|Vested                                |  | (72              | ) |  | $                                                | 7.84 
|Forfeited                             |  | (7               | ) |  | $                                                | 7.11 
|                                      |  |                  |   |  |                                                  |      
|Shares nonvested at October 1, 2006   |  | 538              |   |  | $                                                | 9.49 
|                                      |  |                  |   |  |                                                  |      
|Granted                               |  | 5                |   |  | $                                                | 10.99
|Vested                                |  | (46              | ) |  | $                                                | 7.76 
|Forfeited                             |  | (46              | ) |  | $                                                | 11.61
|                                      |  |                  |   |  |                                                  |      
|Shares nonvested at December 31, 2006 |  | 451              |   |  | $                                                | 9.43 
|                                      |  |                  |   |  |                                                  |      



As of December 31,
2006, there was $2.3 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to restricted stock awards, which will be recognized over the remaining weighted average vesting period of approximately 1.24 years.



12



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



A summary of the changes in restricted stock units outstanding during the three and nine months ended
December 31, 2006 is presented below (in thousands, except year and per share amount):



|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    
|------------------------------------------------ |  | ---------------- | - |  | -------------------------------- | ------ | ------------------------------------------------- | ---- | ----------------------- | - | ---
|                                                 |  | Number of Shares |   |  | Weighted Average Price per Share |        | Weighted Average RemainingContractual Term(Years) |      | AggregateIntrinsicValue
|Shares nonvested at April 2, 2006                |  |                 |   |  | $                                |       |                                                   |      |                         |   |    
|Granted                                          |  | 51               |   |  | $                                | 0.0001 |                                                   |      |                         |   |    
|Vested                                           |  |                 |   |  | $                                |       |                                                   |      |                         |   |    
|Forfeited                                        |  | (1               | ) |  | $                                | 0.0001 |                                                   |      |                         |   |    
|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    
|Shares nonvested at July 2, 2006                 |  | 50               |   |  | $                                | 0.0001 |                                                   | 4.94 |                         | $ | 369
|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    
|Granted                                          |  |                 |   |  | $                                |       |                                                   |      |                         |   |    
|Vested                                           |  | (9               | ) |  | $                                | 0.0001 |                                                   |      |                         |   |    
|Forfeited                                        |  | (1               | ) |  | $                                | 0.0001 |                                                   |      |                         |   |    
|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    
|Shares nonvested at October 1, 2006              |  | 40               |   |  | $                                | 0.0001 |                                                   | 4.69 |                         | $ | 362
|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    
|Granted                                          |  |                 |   |  | $                                |       |                                                   |      |                         |   |    
|Vested                                           |  | (6               | ) |  | $                                | 0.0001 |                                                   |      |                         |   |    
|Forfeited                                        |  | (1               | ) |  | $                                | 0.0001 |                                                   |      |                         |   |    
|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    
|Shares nonvested at December 31, 2006            |  | 33               |   |  | $                                | 0.0001 |                                                   | 4.44 |                         | $ | 299
|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    
|Vested and expected to vest at December 31, 2006 |  | 32               |   |  | $                                | 0.0001 |                                                   | 4.23 |                         | $ | 285
|                                                 |  |                  |   |  |                                  |        |                                                   |      |                         |   |    



As of
December 31, 2006, there was $0.2 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to restricted stock unit awards, which will be recognized over the remaining weighted average vesting period of
approximately 1.26 years.



The total fair value of restricted
stock and restricted stock units that were vested was $0.5 million and $2.7 million, respectively, during the three and nine months ended December 31, 2006, and was $0.2 million and $1.1 million, respectively, during the
three and nine months ended January 1, 2006.



Employee Stock Purchase
Plan



The 2001 Employee Stock Purchase Plan provides for a
series of overlapping offering periods with a duration of 24 months, with new offering periods beginning in February, May, August, and November of each year. The 2001 ESPP allows employees to purchase common stock through payroll deductions of up to
15% of their eligible compensation. Such deductions will accumulate over a three-month accumulation period without interest. After such accumulation period, shares of common stock will be purchased at a price equal to 85% of the fair market value
per share of common stock on either the first day preceding the offering period or the last date of the accumulation period, whichever is less. In the event that the fair market value on the last date of the accumulation period is lower than the
fair market value at the beginning of the offering period, participants are automatically re-enrolled in a new 24-month offering period at the lower fair market value. During the three and nine months ended December 31, 2006, a total of 304,043
and 951,949, respectively, shares were issued under the 2001 ESPP at an average price of $5.40 and $5.38 per share, respectively. As of December 31, 2006, a total of 2,418,029 shares of common stock remained available for issuance under the
2001 ESPP.



13



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Compensation expense for ESPP is calculated using the fair value of the employees purchase
rights under the Black-Scholes option pricing model. The weighted average estimated grant date fair value of purchase rights granted under the ESPP during the three and nine months ended December 31, 2006 was $2.64 and $2.65 per share,
respectively. The weighted average assumptions used in the model for the three and nine months ended December 31, 2006 were as follows:



|                        |  |                                     |  |                                   
|----------------------- |  | ----------------------------------- |  | ----------------------------------
|                        |  | Three Months EndedDecember 31, 2006 |  | Nine Months EndedDecember 31, 2006
|Expected life (years)   |  | 1.13                                |  | 1.13                              
|Volatility              |  | 47%                                 |  | 47 - 51%                          
|Risk-free interest rate |  | 4.93%                               |  | 4.93 - 5.11%                      
|Expected dividend yield |  | 0%                                  |  | 0%                                



Expected volatility
under SFAS 123R was developed based on the average of Magmas historical weekly stock price volatility and average implied volatility. The expected life assumption is based on the average exercise date for the eight purchase periods in each
24-month offering period. The risk-free interest rate for the period within the expected life of the purchase right is based on the yield of United States Treasury notes in effect at the time of grant.



As of December 31, 2006, the Company had $1.6 million of total
unrecognized compensation expense, net of estimated forfeitures, related to ESPP, which will be recognized over the remaining weighted average vesting period of 0.51 years.



Tax Effects of Stock-Based Compensation Awards



In November 2005, FASB issued Financial Statement Position (FSP), on SFAS No. 123R-3, Transition
Election Related to Accounting for Tax Effects of Stock-Based Payment Awards. Effective upon issuance, FSP 123R-3 provides for an alternative transition method for calculating the tax effects of stock-based compensation pursuant to
SFAS No. 123R. The alternative transition method provides simplified approaches to establish the beginning balance of a tax benefit pool comprised of the additional paid-in capital, or APIC, related to the tax effects of employee
stock-based compensation, and to determine the subsequent impact on the APIC tax benefit pool and the statement of cash flows of stock-based awards that were outstanding upon the adoption of SFAS No. 123R. Companies have one year from the later
of the adoption of SFAS No. 123R or the effective date of the FSP to evaluate their transition alternatives and make a one-time election. Upon adoption of SFAS No. 123R, the Company elected to calculate its historical pool of
windfall tax benefits using the long-form method provided in paragraph 81 of SFAS 123R, which resulted in an APIC windfall pool of tax benefits position.



Stock-Based Compensation for the Three and Nine Months Ended January 1, 2006



During the three and nine months ended January 1, 2006, the Company
accounted for its stock-based employee compensation arrangements in accordance with the provisions of APB 25 and related guidance. The Company recognized in its unaudited condensed consolidated statements of operations $1.3 million and $3.0
million, respectively, of stock-based compensation expense primarily for the intrinsic value of restricted stock awarded during the three and nine months ended January 1, 2006.



14



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



During the three and nine months ended January 1, 2006, the Company complied with the
disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as amended. Had compensation cost for the Companys stock-based compensation plan been determined using the Black-Scholes option pricing
model at the grant date for awards granted in accordance with the provisions of SFAS 123, the Companys net loss would have been the amounts indicated below (in thousands, except per share amount):



|                                                                                                    |  |                                   |         |   |                                  |   |         |  
|--------------------------------------------------------------------------------------------------- |  | --------------------------------- | ------- | - | -------------------------------- | - | ------- | -
|                                                                                                    |  | Three Months EndedJanuary 1, 2006 |         |   | Nine Months EndedJanuary 1, 2006 |  
|Net loss:                                                                                           |  |                                   |         |   |                                  |   |         |  
|As reported                                                                                         |  | $                                 | (8,068  | ) |                                  | $ | (14,711 | )
|Add: Stock-based employee compensation expense included in reported net loss                        |  |                                   | 918     |   |                                  |   | 3,910   |  
|Deduct: Stock-based employee compensation expense determined under fair value method for all awards |  |                                   | (6,124  | ) |                                  |   | (18,552 | )
|                                                                                                    |  |                                   |         |   |                                  |   |         |  
|Pro forma                                                                                           |  | $                                 | (13,274 | ) |                                  | $ | (29,353 | )
|                                                                                                    |  |                                   |         |   |                                  |   |         |  
|Net loss per share, basic and diluted:                                                              |  |                                   |         |   |                                  |   |         |  
|As reported                                                                                         |  | $                                 | (0.23   | ) |                                  | $ | (0.43   | )
|                                                                                                    |  |                                   |         |   |                                  |   |         |  
|Pro forma                                                                                           |  | $                                 | (0.39   | ) |                                  | $ | (0.86   | )
|                                                                                                    |  |                                   |         |   |                                  |   |         |  



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



|                              |  |                                   |      |                                  |   |     
|----------------------------- |  | --------------------------------- | ---- | -------------------------------- | - | ----
|                              |  | Three Months EndedJanuary 1, 2006 |      | Nine Months EndedJanuary 1, 2006
|Stock options                 |  | $                                 | 3.94 |                                  | $ | 3.85
|Employee stock purchase plans |  | $                                 | 3.50 |                                  | $ | 2.63



The fair value of
options at the date of grant and share purchase rights granted under the employee stock purchase plans was estimated using the Black-Scholes option pricing model, with the following weighted-average assumptions:



|                               |  |                                   |   |  |                                  |  
|------------------------------ |  | --------------------------------- | - |  | -------------------------------- | -
|                               |  | Three Months EndedJanuary 1, 2006 |   |  | Nine Months EndedJanuary 1, 2006 |  
|Stock options:                 |  |                                   |   |  |                                  |  
|Risk-free interest rate        |  | 4.33                              | % |  | 3.99                             | %
|Expected dividend yield        |  | 0                                 | % |  | 0                                | %
|Volatility                     |  | 61                                | % |  | 62                               | %
|Expected life (years)          |  | 3.45                              |   |  | 3.02                             |  
|                               |  |                                  
|Employee stock purchase plans: |  |                                   |   |  |                                  |  
|Risk-free interest rate        |  | 4.34                              | % |  | 4.25                             | %
|Expected dividend yield        |  | 0                                 | % |  | 0                                | %
|Volatility                     |  | 61                                | % |  | 62                               | %
|Expected life (years)          |  | 1.13                              |   |  | 1.16                             |  



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 3. Comprehensive Income (Loss)



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



|                                                         |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|-------------------------------------------------------- |  | ------------------ | ------- | - | ----------------- | - | ------ | ----------------- |  | - | --------------- | - |  | - | ------- | -
|                                                         |  | Three Months Ended |         |   | Nine Months Ended |  
|                                                         |  | December 31, 2006  |         |   | January 1, 2006   |   |        | December 31, 2006 |  |   | January 1, 2006 |  
|Net loss                                                 |  | $                  | (13,561 | ) |                   | $ | (8,068 | )                 |  | $ | (36,694         | ) |  | $ | (14,711 | )
|Unrealized gain (loss) on available-for-sale investments |  |                    | 42      |   |                   |   | (9     | )                 |  |   | 64              |   |  |   | 808     |  
|Foreign currency translation adjustments                 |  |                    | 85      |   |                   |   | 109    |                   |  |   | 32              |   |  |   | 289     |  
|                                                         |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  
|Comprehensive loss                                       |  | $                  | (13,434 | ) |                   | $ | (7,968 | )                 |  | $ | (36,598         | ) |  | $ | (13,614 | )
|                                                         |  |                    |         |   |                   |   |        |                   |  |   |                 |   |  |   |         |  



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



|                                                  |  |                   |        |   |               |   |        |  
|------------------------------------------------- |  | ----------------- | ------ | - | ------------- | - | ------ | -
|                                                  |  | December 31, 2006 |        |   | April 2, 2006 |  
|Unrealized loss on available-for-sale investments |  | $                 | (8     | ) |               | $ | (72    | )
|Foreign currency translation adjustments          |  |                   | (1,082 | ) |               |   | (1,114 | )
|                                                  |  |                   |        |   |               |   |        |  
|Accumulated other comprehensive loss              |  | $                 | (1,090 | ) |               | $ | (1,186 | )
|                                                  |  |                   |        |   |               |   |        |  



Note 4. 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 (loss) attributable to common stockholders (numerator) by the weighted average number of common shares
outstanding (denominator) during the period. Diluted net income per share gives effect to all dilutive potential common shares outstanding during the period including stock options and redeemable convertible subordinated notes using the
as-if-converted method.



For the three and nine months ended
December 31, 2006 and January 1, 2006, all potential common shares outstanding during the period were excluded from the computation of diluted net loss per share as their effect was anti-dilutive. Such shares included the following (in
thousands, except per share data):



|                                                                                         |  |                             |        |                 |   |      
|---------------------------------------------------------------------------------------- |  | --------------------------- | ------ | --------------- | - | -----
|                                                                                         |  | Three and Nine Months Ended
|                                                                                         |  | December 31, 2006           |        | January 1, 2006
|Shares of common stock upon full conversion of convertible subordinated notes            |  |                             | 2,850  |                 |   | 4,615
|Shares of common stock issuable for all outstanding instruments under stock option plans |  |                             | 11,302 |                 |   | 8,995
|Weighted average price of shares issuable under stock option plans                       |  | $                           | 9.84   |                 | $ | 10.72



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 5. Cash Equivalents and Investments



Cash, cash equivalents and short-term investments are detailed as follows (in thousands):



|                                   |  |      |        |                  |   |                   |  |   |                      |   |  |   |       
|---------------------------------- |  | ---- | ------ | ---------------- | - | ----------------- |  | - | -------------------- | - |  | - | ------
|                                   |  | Cost |        | Unrealized Gains |   | Unrealized Losses |  |   | Estimated Fair Value
|December 31, 2006                  |  |      |        |                  |   |                   |  |   |                      |   |  |   |       
|Cash (U.S. and international)      |  | $    | 13,544 |                  | $ |                  |  | $ |                     |   |  | $ | 13,544
|Money market funds (U.S.)          |  |      | 10,148 |                  |   |                  |  |   |                     |   |  |   | 10,148
|Money market funds (International) |  |      | 8,653  |                  |   |                  |  |   |                     |   |  |   | 8,653 
|Commercial paper                   |  |      | 12,712 |                  |   |                  |  |   | (8                   | ) |  |   | 12,704
|Auction rate preferred             |  |      | 6,650  |                  |   |                  |  |   |                     |   |  |   | 6,650 
|                                   |  |      |        |                  |   |                   |  |   |                      |   |  |   |       
|                                   |  | $    | 51,707 |                  | $ |                  |  | $ | (8                   | ) |  | $ | 51,699
|                                   |  |      |        |                  |   |                   |  |   |                      |   |  |   |       
|April 2, 2006                      |  |      |        |                  |   |                   |  |   |                      |   |  |   |       
|Cash (U.S. and international)      |  | $    | 5,457  |                  | $ |                  |  | $ |                     |   |  | $ | 5,457 
|Money market funds (U.S.)          |  |      | 4,898  |                  |   |                  |  |   |                     |   |  |   | 4,898 
|Money market funds (International) |  |      | 7,711  |                  |   |                  |  |   |                     |   |  |   | 7,711 
|Commercial paper                   |  |      | 40,556 |                  |   |                  |  |   | (72                  | ) |  |   | 40,484
|Auction rate preferred             |  |      | 3,250  |                  |   |                  |  |   |                     |   |  |   | 3,250 
|Government agencies                |  |      | 158    |                  |   |                  |  |   |                     |   |  |   | 158   
|Auction rate certificates          |  |      | 35,200 |                  |   |                  |  |   |                     |   |  |   | 35,200
|                                   |  |      |        |                  |   |                   |  |   |                      |   |  |   |       
|                                   |  | $    | 97,230 |                  | $ |                  |  | $ | (72                  | ) |  | $ | 97,158
|                                   |  |      |        |                  |   |                   |  |   |                      |   |  |   |       



As of
December 31, 2006, the stated maturities of the Companys current investments (including $12.7 million classified as cash equivalent investments in the table above) are $12.7 million within one year and $6.7 million after ten years.



As of December 31, 2006, all unrealized losses related to
instruments with durations of less than twelve months. The gross unrealized losses on these investments were primarily due to interest rate fluctuations and market-price movements. The Company reviewed the investment portfolio and determined that
the gross unrealized losses on these investments at December 31, 2006 were temporary in nature. The Company has the ability and intent to hold these investments until recovery of their carrying values. The Company also believes that it will be
able to collect both principal and interest amounts due to the Company at maturity, given the high credit quality of these investments.



In May 2005, the Company liquidated certain investments to repurchase a portion of the convertible subordinated notes, resulting in a realized loss of
approximately $0.7 million. There were no significant losses realized in connection with the convertible subordinated note repurchases in May 2006. See Note 10 for information regarding the repurchases of convertible subordinated notes.



Note 6. Business Combination



Knights Technology, wholly owned subsidiary of FEI Company(Knights)



On November 20, 2006,
the Company acquired all of the outstanding stock of Knights, a wholly owned subsidiary of FEI Company. Knights is a provider of yield management and failure analysis software solutions to the semiconductor industry. The acquisition broadens the
Companys product portfolio and should allow the Company to tighten the link between design and manufacturing.



17



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



The Company acquired Knights for total consideration of approximately $8.0 million in cash. The
Company retained $250,000 of the initial consideration in a segregated bank account to secure certain indemnification obligations of FEI Company, and this $250,000 was recorded as restricted cash and is separately disclosed on the Companys
consolidated balance sheet as of December 31, 2006. The results of operations from Knights have been included in Magmas results of operations from the acquisition date. The Company does not consider the Knights acquisition material to its
results of operations and therefore is not presenting pro forma statements of operations for the three and nine months ended December 31, 2006.



The acquisition was accounted for as a business combination. The purchase price was allocated to the assets acquired and liabilities assumed based on
their respective fair values. A summary of the purchase price allocations pertaining to the Knights acquisition and the amortization periods of the intangible assets acquired is as follows (in thousands):



|                                              |  |   |        |  
|--------------------------------------------- |  | - | ------ | -
|Cash consideration paid                       |  | $ | 8,000  |  
|Transaction costs                             |  |   | 140    |  
|                                              |  |   |        |  
|Total purchase price                          |  | $ | 8,140  |  
|                                              |  |   |        |  
|Allocation of purchase price:                 |  |   |        |  
|Current assets                                |  | $ | 1,262  |  
|Non-current assets                            |  |   | 99     |  
|Current liabilities                           |  |   | (1,121 | )
|                                              |  |   |        |  
|Net tangible assets acquired                  |  |   | 240    |  
|Intangible assets acquired:                   |  |   |        |  
|Customer relationship or base                 |  |   | 1,000  |  
|Developed technology                          |  |   | 2,600  |  
|Trademarks                                    |  |   | 500    |  
|Acquired customer contracts                   |  |   | 300    |  
|Non-competition agreements                    |  |   | 200    |  
|In-process research and development           |  |   | 1,300  |  
|Goodwill                                      |  |   | 2,000  |  
|                                              |  |   |        |  
|Total assets acquired                         |  | $ | 8,140  |  
|                                              |  |   |        |  
|Amortization period of intangibles (in years) |  |   |        |  
|Customer relationship or base                 |  |   | 7      |  
|Developed technology                          |  |   | 4-5    |  
|Trademarks                                    |  |   | 7      |  
|Acquired customer contracts                   |  |   | 3      |  
|Non-competition agreements                    |  |   | 3      |  



The excess of the
purchase price over the estimated value of the net tangible assets acquired was allocated to various intangible assets, consisting primarily of developed technology, trademarks and customer and contract-related assets, in-process research and
development (IPR&D) and goodwill. The purchase price of $1.3 million allocated to IPR&D was recognized as a charge to operating expenses on the acquisition date.



The values assigned to developed technologies were based upon future discounted cash flows related to the existing
products projected income streams using a discount rate of 11%. The Company believes these rates were appropriate given the business risks inherent in marketing and selling these products. Factors considered in estimating the discounted cash
flows to be derived from the existing technology include risks related to the



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



characteristics and applications of the technology, existing and future markets and an assessment of the age of the technology within its life span.



Other intangibles include the value of an existing customer
relationship or base, trademarks, non-competition agreements and existing customer contracts. The cash flows generated by these intangible assets were valued using discount rates ranging from 13% to 14%.



The in-process technologies acquired from Knights are at a stage of
development that require further research and development to determine technical feasibility and commercially viability and they have no future alternative use. The valuation method used to value IPR&D is a form of discounted cash flow method
commonly known as the excess earnings method. This approach is a widely recognized appraisal method and is commonly used to value technology assets. The value of the in-process technology is the sum of the discounted expected future cash flows
attributable to the in-process technology, taking into consideration the costs to complete the products utilizing this technology, utilization of pre-existing technology, the risks related to the characteristics and applications of the technology,
existing and future markets and the technological risk associated with completing the development of the technology. The cash flows derived from the in-process technology projects were discounted at rates ranging from 15% to 16%. The Company
believes the rate used was appropriate given the risks associated with the technologies for which commercial feasibility had not been established and there was no alternative use. The percentage of completion for in-process technology projects
acquired ranged from 48% to 60%, and was an average of the percentage of completion based on costs and time. The cost-based percentage of completion was determined by identifying the total expenses incurred to date for the project as a ratio of the
total expenses expected to be incurred to bring the project to technical and commercial feasibility. The time-based percentage of completion was determined by identifying the elapsed time invested in the project as a ratio of the total time required
to bring the project to technical and commercial feasibility. Schedules were based on managements estimate of tasks completed and the tasks to be completed to bring the project to technical and commercial feasibility. The in-process technology
projects are expected to be completed during the first quarter of fiscal year 2008.



Development of in-process technology remains a substantial risk to the Company due to a variety of factors including the remaining effort to achieve technical feasibility, rapidly changing customer requirements and
competitive threats from other companies and technologies. Additionally, the value of other intangible assets acquired may become impaired. The value of the in-process research and development, as well as the value of other intangible assets, was
estimated by the management with the assistance of an independent appraisal firm, based on input from the Company and the acquired companies management, using valuation methods that are in accordance with the generally accepted accounting
principles.



ACAD Corporation(ACAD)



On November 29, 2005, the Company acquired ACAD, a
privately-held company that develops circuit simulation software, for an initial consideration of approximately $453,000 in cash and assumption of its net liabilities of approximately $3.9 million. The Company also agreed to pay up to $5.65 million
of cash in contingent consideration to the ACAD shareholders upon achieving or exceeding certain financial and technical milestones. As of December 31, 2006, $2.8 million of the contingent consideration, which was in connection with achievement
of certain financial and technical milestones during the second and third quarter of fiscal 2007, has been earned (of which $1.5 million has been paid) and was recorded as an addition to goodwill on the Companys unaudited condensed
consolidated balance sheet.



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 7. Asset Purchases



Technology Licenses



On October 6, 2006, the Company acquired a technology license and certain other information from another company for a total fee of $2.0 million. The
licensed technology will be integrated into the Companys current product offerings and various other products under development. Under the license agreement, the Company obtained a perpetual, fully-paid, royalty-free worldwide license. The
Company also agreed to pay up to $6.0 million of cash in additional license fees based upon achievement of certain milestones. As of December 31, 2006, none of the additional license fees has been earned.



On May 3, 2006, the Company acquired a license to technology relating to
electronic design automation from Stabie-Soft, Inc. The Company paid $2.5 million for the license in May 2006 and, upon the completion and delivery of technology meeting certain milestones, the Company paid additional fees of $0.5 million in the
second quarter of fiscal 2007.



On June 30, 2005, the
Company acquired a technology license from International Business Machines Corporation (IBM) and extended the term of Magmas patent license with IBM to 2010. Both arrangements cover IBMs patents and significant technology
with respect to the development of EDA tools and products that perform physical implementation. Included in intangible assets were license fees of $7.0 million and $3.1 million fair value of a warrant to purchase 500,000 shares of Magma common stock
at $4.73 per share. In August 2006, IBM exercised the warrant on a cashless exercise basis. In connection with the exercise, 149,005 shares of the Companys common stock were issued to IBM.



Acquisition-Related Earnouts



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



For the three and nine months
ended December 31, 2006, the Company recorded $3.8 million and $12.3 million, respectively, approximately half in cash and half in stock, of intangible assets resulting from contingent consideration that was paid or became payable to
stockholders of Mojave, Inc.



20



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 8. Goodwill and Intangible Assets



The following table summarizes goodwill and the components of intangible assets and related accumulated amortization
balances as of December 31, 2006 and April 2, 2006 (in thousands):



|                              |  |                                |  |                          |         |               |                     |         |                       |  |                          |        |  |                     |         |  |   |         |   |  |   |       
|----------------------------- |  | ------------------------------ |  | ------------------------ | ------- | ------------- | ------------------- | ------- | --------------------- |  | ------------------------ | ------ |  | ------------------- | ------- |  | - | ------- | - |  | - | ------
|                              |  | Weighted Average Life (months) |  | December 31, 2006        |         | April 2, 2006
|                              |  | Gross Carrying Amount          |  | Accumulated Amortization |         |               | Net Carrying Amount |         | Gross Carrying Amount |  | Accumulated Amortization |        |  | Net Carrying Amount
|Goodwill                      |  |                                |  | $                        | 48,810  |               | $                   |        |                       |  | $                        | 48,810 |  | $                   | 43,985  |  | $ |        |   |  | $ | 43,985
|                              |  |                                |  |                          |         |               |                     |         |                       |  |                          |        |  |                     |         |  |   |         |   |  |   |       
|Intangible assets:            |  |                                |  |                          |         |               |                     |         |                       |  |                          |        |  |                     |         |  |   |         |   |  |   |       
|Developed technology          |  | 40                             |  | $                        | 104,445 |               | $                   | (57,435 | )                     |  | $                        | 47,010 |  | $                   | 89,192  |  | $ | (37,824 | ) |  | $ | 51,368
|Licensed technology           |  | 39                             |  |                          | 38,093  |               |                     | (26,703 | )                     |  |                          | 11,390 |  |                     | 33,093  |  |   | (17,962 | ) |  |   | 15,131
|Customer relationship or base |  | 42                             |  |                          | 3,310   |               |                     | (1,455  | )                     |  |                          | 1,855  |  |                     | 2,310   |  |   | (1,086  | ) |  |   | 1,224 
|Patents                       |  | 58                             |  |                          | 12,690  |               |                     | (7,989  | )                     |  |                          | 4,701  |  |                     | 12,690  |  |   | (5,934  | ) |  |   | 6,756 
|Acquired customer contracts   |  | 25                             |  |                          | 1,390   |               |                     | (1,037  | )                     |  |                          | 353    |  |                     | 1,090   |  |   | (782    | ) |  |   | 308   
|Assembled workforce           |  | 45                             |  |                          | 1,235   |               |                     | (916    | )                     |  |                          | 319    |  |                     | 1,235   |  |   | (675    | ) |  |   | 560   
|No shop right                 |  | 24                             |  |                          | 100     |               |                     | (100    | )                     |  |                          |       |  |                     | 100     |  |   | (100    | ) |  |   |      
|Non-competition agreements    |  | 22                             |  |                          | 500     |               |                     | (114    | )                     |  |                          | 386    |  |                     | 300     |  |   | (33     | ) |  |   | 267   
|Trademarks                    |  | 20                             |  |                          | 900     |               |                     | (360    | )                     |  |                          | 540    |  |                     | 400     |  |   | (279    | ) |  |   | 121   
|                              |  |                                |  |                          |         |               |                     |         |                       |  |                          |        |  |                     |         |  |   |         |   |  |   |       
|Total                         |  |                                |  | $                        | 162,663 |               | $                   | (96,109 | )                     |  | $                        | 66,554 |  | $                   | 140,410 |  | $ | (64,675 | ) |  | $ | 75,735
|                              |  |                                |  |                          |         |               |                     |         |                       |  |                          |        |  |                     |         |  |   |         |   |  |   |       



The Company has
included the amortization expense on intangible assets that relate to products sold in cost of license revenue, while the remaining amortization is shown as a separate line item on the Companys unaudited condensed consolidated statement of
operations. For the three and nine months ended December 31, 2006 and January 1, 2006, the amortization expense related to intangible assets was as follows (in thousands):



|                                               |  |                    |        |                   |   |                  |  |                |        |  |   |       
|---------------------------------------------- |  | ------------------ | ------ | ----------------- | - | ---------------- |  | -------------- | ------ |  | - | ------
|                                               |  | Three Months Ended |        | Nine Months Ended
|                                               |  | December 31,2006   |        | January 1,2006    |   | December 31,2006 |  | January 1,2006
|Amortization of intangible assets included in: |  |                    |        |                   |   |                  |  |                |        |  |   |       
|Cost of revenuelicenses                       |  | $                  | 7,964  |                   | $ | 6,524            |  | $              | 22,699 |  | $ | 16,951
|Operating expenses                             |  |                    | 2,923  |                   |   | 2,682            |  |                | 8,735  |  |   | 9,152 
|                                               |  |                    |        |                   |   |                  |  |                |        |  |   |       
|Total                                          |  | $                  | 10,887 |                   | $ | 9,206            |  | $              | 31,434 |  | $ | 26,103
|                                               |  |                    |        |                   |   |                  |  |                |        |  |   |       



The expected future
annual amortization expense of intangible assets is as follows (in thousands):



|                                          |  |                                |       
|----------------------------------------- |  | ------------------------------ | ------
|Fiscal Year                               |  | Estimated Amortization Expense
|2007 (remaining three months)             |  | $                              | 10,691
|2008                                      |  |                                | 27,871
|2009                                      |  |                                | 21,400
|2010                                      |  |                                | 3,760 
|2011 and thereafter                       |  |                                | 2,832 
|                                          |  |                                |       
|Total expected future annual amortization |  | $                              | 66,554
|                                          |  |                                |       



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Note 9. Segment Information



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



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



|                               |  |                    |        |                   |   |                   |  |                 |         |  |   |        
|------------------------------ |  | ------------------ | ------ | ----------------- | - | ----------------- |  | --------------- | ------- |  | - | -------
|                               |  | Three Months Ended |        | Nine Months Ended
|                               |  | December 31, 2006  |        | January 1, 2006   |   | December 31, 2006 |  | January 1, 2006
|North America*                 |  | $                  | 31,596 |                   | $ | 20,939            |  | $               | 84,197  |  | $ | 78,443 
|Europe                         |  |                    | 4,858  |                   |   | 15,407            |  |                 | 15,245  |  |   | 24,103 
|Japan                          |  |                    | 5,930  |                   |   | 3,210             |  |                 | 18,728  |  |   | 11,185 
|Asia-Pacific (excluding Japan) |  |                    | 2,710  |                   |   | 1,764             |  |                 | 9,846   |  |   | 6,307  
|                               |  |                    |        |                   |   |                   |  |                 |         |  |   |        
|                               |  | $                  | 45,094 |                   | $ | 41,320            |  | $               | 128,016 |  | $ | 120,038
|                               |  |                    |        |                   |   |                   |  |                 |         |  |   |        



|                               |  |                    |   |  |                   |   |  |                   |   |  |                 |  
|------------------------------ |  | ------------------ | - |  | ----------------- | - |  | ----------------- | - |  | --------------- | -
|                               |  | Three Months Ended |   |  | Nine Months Ended |  
|                               |  | December 31, 2006  |   |  | January 1, 2006   |   |  | December 31, 2006 |   |  | January 1, 2006 |  
|North America*                 |  | 70                 | % |  | 51                | % |  | 65                | % |  | 65              | %
|Europe                         |  | 11                 |   |  | 37                |   |  | 12                |   |  | 20              |  
|Japan                          |  | 13                 |   |  | 8                 |   |  | 15                |   |  | 9               |  
|Asia-Pacific (excluding Japan) |  | 6                  |   |  | 4                 |   |  | 8                 |   |  | 6               |  
|                               |  |                    |   |  |                   |   |  |                   |   |  |                 |  
|                               |  | 100                | % |  | 100               | % |  | 100               | % |  | 100             | %
|                               |  |                    |   |  |                   |   |  |                   |   |  |                 |  

---

|* | Substantially all its North America revenue related to the United States for all periods presented.
|- | ---------------------------------------------------------------------------------------------------



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



|           |  |                    |   |  |                   |   |  |                   |   |  |                 |  
|---------- |  | ------------------ | - |  | ----------------- | - |  | ----------------- | - |  | --------------- | -
|           |  | Three Months Ended |   |  | Nine Months Ended |  
|           |  | December 31, 2006  |   |  | January 1, 2006   |   |  | December 31, 2006 |   |  | January 1, 2006 |  
|Customer A |  | 14                 | % |  | 11                | % |  | *                 | * |  | 18              | %
|Customer B |  | *                  | * |  | 17                | % |  | *                 | * |  | *               | *

---

|** | Less than 10% of total revenue.
|-- | -------------------------------



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



Note 10. Repurchases of Convertible Subordinated Notes



In May 2006, the Company repurchased, in privately negotiated transactions, $40.3 million face amount (or approximately
38.2% of the remaining principal) of the Companys zero coupon convertible subordinated notes



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



due May 2008 at an average discount to face value of approximately 13%. The Company spent approximately $35.0 million on the repurchases. The repurchase left
approximately $65.2 million principal amount of convertible subordinated notes outstanding. In addition, a portion of the hedge and warrant transactions entered into by Magma in 2003 to limit potential dilution from conversion of the notes was
terminated in connection with the repurchase. In the first quarter of fiscal 2007, the Company recorded a pre-tax gain of $5.3 million on the repurchase, which was partially offset by the write-off of $0.5 million of deferred financing costs
associated with the convertible subordinated notes. The Company received 14,467 shares of Magma common stock, valued at approximately $102,000, as settlement for termination of a portion of the hedge and warrant in connection with the repurchase.
The amount was recorded against additional paid-in-capital.



In
May 2005, the Company repurchased, in privately negotiated transactions, $44.5 million face amount (or approximately 29.7% of the total) of the Companys zero coupon convertible subordinated notes due May 2008 at an average discount to face
value of approximately 22%. The Company spent approximately $34.8 million on the repurchases. The repurchase left approximately $105.5 million principal amount of convertible subordinated notes outstanding. In addition, a portion of the hedge and
warrant transactions was terminated in connection with the repurchase. In the first quarter of fiscal 2006, the Company recorded a pre-tax gain of $9.7 million on the repurchase, which was partially offset by the write-off of $0.9 million of
deferred financing costs associated with the convertible subordinated notes. The net cash proceeds of $140,000 from the termination of a portion of the hedge and warrant were recorded against additional paid-in capital.



Note 11. Line of Credit



In November 2006, the Company established a $5.0 million revolving line of credit facility with Wells Fargo Bank, N.A. The
credit facility is available through November 2011 and bears an interest rate equal to the banks prime rate less 1.60% or LIBOR plus 0.60%. The Company is required to make interest only payments monthly and the outstanding principal amount
plus all accrued but unpaid interest is payable in full at the expiration of the credit facility. As of December 31, 2006, there were no borrowings outstanding under the credit facility. The credit facility is secured by deposits held with the
bank.



In addition, the credit facility allows letters of
credit to be issued on behalf of the Company, provided that the aggregate outstanding amount of the letters of credit shall not exceed the available amount for borrowing under the credit facility. As of December 31, 2006, two letters of credit
totaling $350,000 were outstanding under the credit facility.



Note 12.
Commitments and Contingencies



Commitments



The Company leases its facilities under non-cancelable
operating leases expiring at various dates through March 2013. In December 2006, the Company entered into several new leases for its corporate headquarters as well as its new operation facilities in India. Approximate future minimum lease payments
under the operating leases at December 31, 2006 are as follows (in thousands):



|                              |  |   |       
|----------------------------- |  | - | ------
|Fiscal Year                   |  |  
|2007 (remaining three months) |  | $ | 1,474 
|2008                          |  |   | 6,763 
|2009                          |  |   | 6,477 
|2010                          |  |   | 5,994 
|2011 and thereafter           |  |   | 5,809 
|                              |  |   |       
|                              |  | $ | 26,517
|                              |  |   |       



23



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Contingencies



The Company is subject to the legal proceedings described below and from time to time, the Company is also involved in other
disputes that arise in the ordinary course of business. The number and significance of these litigation matters and disputes is increasing as the Companys business expands and it grows larger. Any claims against the Company, whether
meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. As a result, these litigation matters and disputes could harm
the Companys business and have an adverse effect on the Companys consolidated financial statements. However, the results of any litigation or dispute are inherently uncertain and, at this time, no estimate could be made of the loss or
range of loss, if any, from these litigation matters and disputes. Accordingly, the Company has not recorded any liabilities relating to these contingencies as of December 31, 2006. Legal fees are expensed in the period in which they are
incurred.



Litigation with Synopsys



Synopsys California Case



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



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



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



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



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



On April 18, 2005, Synopsys, Inc. filed an action against the Company in Germany at the
Landgericht München I (District Court in Munich) seeking to obtain ownership of the European patent application corresponding to the Companys 446 Patent. The action has been stayed pending the outcome of the above-referenced
Synopsys action filed in the United States.



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



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



On July 29, 2005, Synopsys moved to preliminarily enjoin the Company from abandoning or dedicating to the public the 446 Patent or the 438 Patent. Also on July 29, 2005, Synopsys moved for
partial summary judgment seeking dismissal of certain counterclaims and defenses asserted by the Company on the grounds of estoppel by contract. On September 16, 2005, Synopsys filed a revised motion for preliminary injunction. On
September 30, 2005, the Company filed its oppositions to Synopsyss preliminary injunction motion and estoppel by contract motion.



On July 29, 2005, Synopsys, Inc. filed an action against the Company in Japan in Civil Department No. 40 of the Tokyo District Court seeking to
obtain ownership of the Japanese patent application corresponding to the Companys 446 Patent. The court has entered a defacto stay pending the outcome of the above-referenced Synopsys action filed in the United States. The Japanese Court
held hearings on January 18, 2006, March 6, 2006, July 11, 2006, October 23, 2006, and December 26, 2006, and set a further hearing for February 28, 2007.



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



On August 30, 2005, the Court issued a temporary restraining order against the Company restraining and enjoining the Company from taking any steps in
the United States Patent and Trademark Office (USPTO) to abandon, suspend or disclaim the 446 and 438 Patents, failing or refusing to pay the maintenance fees for the



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



446 and 438 Patents, or seeking reexamination of the 446 and 438 Patents. The temporary restraining order was scheduled to remain in
effect until the hearing on Synopsyss motion for a preliminary injunction that was scheduled for December 2, 2005. On December 1, 2005, the Court vacated the hearing and granted Synopsyss motion for preliminary injunction. The
Court entered the preliminary injunction enjoining the Company from abandoning, dedicating to the public or seeking reexamination in the USPTO of the 446 Patent or the 438 Patent.



On September 2, 2005, the Company filed an Answer and Counterclaims to
Synopsyss Third Amended Complaint. In that pleading, the Company alleges, inter alia, that IBM is a joint owner of the patents-in-suit and that, as a result, the Company cannot be liable for infringement because (1) Synopsys lacks
standing to assert the patents-in-suit against Magma, and (2) IBM has granted the Company a license under the patents-in-suit.



On September 26, 2005, Synopsys, Inc. filed an action against the Company in the Superior Court of the State of California in and for the County of
Santa Clara, entitled Synopsys, Inc. v. Magma Design Automation, Inc., et al., Case Number 105 CV 049638. Synopsys alleges that Magma committed unfair business practices by asserting defenses of non-infringement and invalidity to patent
infringement allegations brought by Synopsys in the patent infringement action already pending against Magma in the Northern District of California. The Complaint seeks unspecified monetary damages, an unspecified restitutionary/disgorgement award,
injunctive relief, fees and costs, and an accounting of all revenues and profits derived from licensing the technology at issue. On October 19, 2005, the Company removed the action to the United States District Court for the Northern District
of California. On October 26, 2005, the Company moved to strike and dismiss the complaint. On October 27, 2005, the Court granted the Companys motion to relate the removed action with the preexisting patent infringement action, and
both actions are now assigned to Judge Maxine M. Chesney. The Court vacated the hearing on the Companys motion to strike and dismiss the complaint and has taken the matter under submission.



On October 14, 2005, the Court granted Synopsyss request for
permission to file an amended opposition to Magmas motion for summary judgment on the second through sixth causes of action in the Second Amended Complaint. Synopsys filed its amended opposition on December 20, 2005, and the Company filed
its reply on January 13, 2006. The motion was set for hearing on January 27, 2006, but the Court vacated the hearing date and took the matter under submission.



On October 19, 2005, the Court granted in part and denied in part Synopsyss motion to strike certain affirmative
defenses and to dismiss certain counterclaims in the Companys Answer and Counterclaims to Synopsyss Third Amended Complaint. The Court dismissed without leave to amend the Companys counterclaims seeking correction of inventorship
of the 446 and 438 Patents. The Court also struck without leave to amend the Companys affirmative defenses of (1) invalidity of the 446 and 438 Patents based on failure to name all inventors,
(2) unenforceability of the 446 and 438 patents due to inequitable conduct, and (3) unclean hands. The Court struck with leave to amend the Companys affirmative defenses of invalidity of the 446 and 438
Patents based on 35 U.S.C. §§ 102, 103 and 112, as well as the Companys affirmative defense that Synopsys is not the owner of any invention defined by the claims of the 446 and 438 Patents. On October 24,
2005, the Company filed a motion for summary judgment as to the first cause of action (for patent infringement) in Synopsyss Third Amended Complaint on the grounds that IBM is an owner of all the patents-in-suit. Also on October 24, 2005,
Synopsys filed (1) a motion for partial summary judgment to dismiss the Companys joint ownership defenses and counterclaims, and (2) a motion for partial summary judgment to dismiss allegations of co-ownership based on judicial and
quasi-estoppel.



On November 2, 2005, the Company filed a
motion for leave to file an amended answer and counterclaims to Synopsyss Third Amended Complaint, requesting leave to amend the Companys answer to add affirmative



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



defenses of invalidity of the 446 and 438 Patents based on 35 U.S.C. §§ 102, 103 and 112. The Companys motion was set
for hearing on December 16, 2005, but the Court vacated the hearing date and took the matter under submission.



On November 8, 2005, Synopsys filed a motion for sanctions against the Company based on the Companys assertion of non-infringement defenses and
counterclaims in the litigation. The Company opposed the motion, which was set for hearing on December 16, 2005. The hearing was vacated and the motion was taken under submission by the Court.



On November 8, 2005, the Company filed a motion seeking leave to file a
motion for reconsideration of the Courts October 19, 2005 Order striking certain of the Companys defenses without leave to amend. The Court granted the Companys request on November 21, 2005. On December 9, 2005, the
Company filed a motion for reconsideration of the Courts October 19, 2005 Order striking the Companys affirmative defense of unclean hands and for leave to amend the Companys answer to assert an unclean hands defense. The
motion was set for hearing on January 13, 2006, but the Court vacated the hearing and took the matter under submission.



On December 23, 2005, Synopsys filed a motion for partial summary judgment regarding the Companys statute of limitations defense. The Company
opposed the motion, which was set for hearing on January 27, 2006. The hearing was vacated and the motion taken under submission by the Court.



On December 29, 2005, the Company filed a notice of interlocutory appeal to the Court of Appeals for the Federal Circuit of the Courts
December 1, 2005, preliminary injunction against the Company. By agreement of the parties, Magma has dismissed the appeal.



On January 20, 2006, the Company filed a motion to bifurcate the trial into issues of patent ownership and all other issues. The parties subsequently
stipulated to bifurcate the case with patent ownership to be tried first.



Fact and expert discovery relating to patent ownership have closed. By stipulation so-ordered on March 13, 2006, the parties have agreed to schedule any remaining discovery after the patent ownership trial is
resolved.



By order dated March 30, 2006, the Court denied
Magmas motion for summary judgment regarding patent ownership, as well Synopsyss motions (1) for partial summary judgment based on estoppel by contract, (2) for partial summary judgment to dismiss the Companys joint
ownership defenses and counterclaims, and (3) for partial summary judgment to dismiss allegations of co-ownership based on judicial and quasi-estoppel. The parties subsequently stipulated (a) that Magma would withdraw its claim to
ownership of the 446 and 438 Patents on the basis that the buckets claims (i.e., Claims 17, 18, 31, and 32 of the 446 Patent and Claims 17 and 18 of the 438 Patent) were conceived by Magma engineers
after Lukas van Ginneken left Synopsys and (b) that Synopsys would withdraw its assertion that Magma would be foreclosed from arguing that the inventions in the 446 and 438 Patents were reduced to practice after van Ginneken left
Synopsys.



The ownership case was tried to the Court, without a
jury, from April 24, 2006 through May 10, 2006. The parties opening post-trial briefs and findings of fact and conclusions of law were filed June 9, 2006. The parties reply post-trial briefs were filed June 30, 2006.



On August 8, 2005, the Company filed a request for ex parte
reexamination of the 114 Patent. On September 22, 2005, the USPTO instituted a reexamination proceeding, indicating that a substantial new question of patentability was raised by the request. On August 5, 2006, the USPTO rejected all
pending claims (1-15) of the 114 Patent. In response to that office action, Synopsys canceled all the independent claims of the patent.



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



On August 18, 2006, a third party submitted requests for ex parte reexamination of the 446
and 438 Patents to the USPTO. The USPTO received those requests on August 23, 2006.



On September 1, 2006, Synopsys filed a motion for preliminary injunction that sought to require the Company (1) to seek a stay of reexamination of the 446 and 438 Patents or transfer ownership of
the 446 and 438 Patents to Synopsys so that Synopsys may participate in the reexamination proceedings, and (2) to refrain from filing a patent owners statement in any reexamination proceedings for the 446 and 438
Patents. On September 14, 2006, the Company filed an opposition to Synopsyss motion. On September 29, 2006, the Court issued an order denying the motion, without prejudice to Synopsyss refiling the motion if and when the USPTO
issues an order for reexamination of the 446 or 438 Patent.



On November 25, 2006, the PTO granted a request for reexamination of the 438 Patent. On December 1, 2006, Synopsys moved for a preliminary injunction seeking an order that the Company (1) withdraw its claims of
ownership of the 446 and 438 Patents and execute a quitclaim assignment transferring title in the patents to Synopsys, or, alternatively, (2) seek a stay in the PTO of any reexamination proceedings of the 446 and 438
Patents.



On December 26, 2006, Magma filed a second
request for reexamination of the 114 Patent.



On
January 3, 2007, the court ordered the Company to withdraw its claim of ownership of the 446 and 438 Patents and to execute a quitclaim assignment transferring title in the 446 and 438 Patents to Synopsys. On
January 5, 2007, Magma executed a Quitclaim Assignment of the 446 and 438 Patents to Synopsys and recorded the assignment with the PTO. On January 10, 2007, the PTO granted the request for reexamination of the 446 Patent.
Thus, all three patents-in-suit are in reexamination.



On
January 29, 2007, the Company filed a motion to stay the action pending the conclusion of the reexaminations of the 114, 446 and 438 Patents.



On January 31, 2007, the Court issued its Memorandum of Decisions and Findings of Fact and Conclusions of Law Regarding
Ownership Trial. The Court concluded that IBM and Synopsys are joint owners of the 446 and 438 Patents, and ordered Synopsys to take all steps necessary to add IBM as a joint owner of record of the 446 and 438 Patents. The
Court also concluded that IBM and Synopsys are joint owners of certain foreign and continuation applications based on the 446 and 438 Patents, namely, United States Patent Applications Nos. 10/828,547, 11/245,530, and 11/246, 451;
Japan Patent Application No. JP20000526885T; Israel Patent Application No. IL136709D; Canada Patent Application No. CA2317538; European Patent Application No. EP1040435; and International Patent Application No. WO9934310. The
Court ordered Magma to take all necessary steps to transfer those applications to Synopsys and IBM. The Court also concluded that Synopsys is the sole owner of the 114 Patent.



On February 6, 2007, the Court issued an order denying Magmas motion for leave to amend its answer to assert
defenses alleging the invalidity of the 446 and 438 Patents. The Court based its decision on a finding that Magma is barred from asserting the invalidity of those patents by the doctrine of assignor estoppel. Also on February 6,
2007, the Court issued an order denying the Companys motion for reconsideration and for leave to amend its answer to assert an unclean hands defense. One of the Companys bases for moving for leave to assert this defense was an argument
that Synopsys improperly withheld evidence that the 446 and 438 patents were invalid under the on-sale bar. The Court rejected this argument, holding that because assignor estoppel bars the Company from asserting the invalidity of the
446 and 438 Patents, the Company may not circumvent this doctrine by asserting invalidity arguments (which include the on-sale bar) in the guise of an unclean hands defense.



28



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##### Table of Contents

MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Synopsys Delaware Case



On September 26, 2005, Synopsys, Inc. filed an action against the Company in Delaware federal court, Synopsys, Inc.
v. Magma Design Automation, Inc., Civil Action No. 05-701. The Complaint alleges infringement of U.S. Patent Nos. 6,434,733 (the 733 Patent), 6,766,501 (the 501 Patent), and 6,192,508 (the
508 Patent). The patents-in-suit relate to methods for designing integrated circuits. The Complaint seeks unspecified monetary damages, injunctive relief, trebling of damages, fees and costs, and the imposition of a constructive trust
for the benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by the Company as a result of its alleged infringement of the patents-in-suit.



On October 19, 2005, the Company filed its answer and counterclaims (Answer) to Synopsyss Complaint.
The Answer asserts that the Companys products do not infringe the patents-in-suit, that the patents-in-suit are unenforceable, and that the 733 Patent and the 501 Patent were fraudulently obtained by Synopsys and are therefore
unenforceable. The Answer also asserts antitrust and unfair competition counterclaims based on Synopsyss anti-competitive behavior, monopolistic tactics, and its assertion of the 733 and 501 Patents, as well as claims for product
disparagement, trade libel, and tortious interference with business relations. The counterclaims seek treble damages and other equitable relief for Synopsyss anticompetitive and tortuous conduct.



On October 25, 2005, the Company filed an Amended Answer, adding a
counterclaim for infringement of U.S. Patent No. 6,505,328 (the 328 Patent). The 328 Patent relates to methods for designing integrated circuits. The Company seeks treble damages and an injunction against Synopsys for
the sale and manufacture of products the Company alleges infringe the 328 Patent.



On November 22, 2005, Synopsys filed a motion to dismiss the Companys antitrust and other commercial counterclaims. The Company opposed that motion on December 7, 2005. Synopsys filed its reply brief
on December 14, 2005. The Court denied Synopsyss motion on May 25, 2006.



On January 9, 2006, Synopsys filed a request for the United States Patent and Trademark Office to reexamine its 733 and 501 Patents in light of two prior art references that it had not previously
disclosed to the Patent Office. On January 23, 2006, Synopsys filed a motion with the Court to bifurcate and stay its claims for infringement of its 733 and 501 Patents and the Companys counterclaims except for its claim for
infringement of the 328 Patent, based in part on Synopsyss having filed the request for patent reexamination. The Companys opposition to that motion was filed on February 6, 2006. The Court denied Synopsyss motion on
May 25, 2006.



On March 24, 2006, the Company filed a
motion for leave to file a Second Amended Answer and Counterclaims, to add counterclaims for infringement of U.S. Patent Nos. 6,519,745 (the 745 Patent), 6,931,610 (the 610 Patent), 6,854,093 (the 093
Patent), and 6,857,116 (the 116 Patent). All four patents relate to methods for designing integrated circuits. Synopsys opposed the motion on April 7, 2006. The Company filed its reply brief on April 14, 2006. The
Court granted the Companys motion on May 25, 2006, and the Company filed its Second Amended Answer and Counterclaims on May 31, 2006.



On June 13, 2006, the parties held a conference with the Court at which, among other things, Synopsys requested that the trial be delayed until late
2007. The Court denied Synopsyss request. Fact discovery is ongoing and is currently scheduled to close on February 28, 2007, and trial is scheduled for June 11, 2007.



On August 25, 2006, the Company dropped its allegation that Synopsys infringes the 610 Patent. On
September 15, 2006, Synopsys dropped its claims that the Company infringes the 733 and 501 Patents. On



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



October 13, 2006, Synopsys filed a second motion to bifurcate the trial as to the antitrust claims and to stay antitrust discovery, based in part on the
fact that the 733 and 501 Patents are no longer being asserted. The Company filed its opposition to that motion on October 27, 2006, and the Court denied that motion on January 22, 2007.



A claim construction hearing before the Court was held on November 29,
2006. Trial remains scheduled for June 11, 2007.



The
Company intends to vigorously defend against all claims asserted by Synopsys and to fully enforce its rights against Synopsys. However, the results of any litigation are inherently uncertain and the Company can not assure that it will be able to
successfully defend against the Synopsys claims. A favorable outcome for Synopsys could have a material adverse effect on the Companys financial position, results of operations or cash flows. The Company is currently unable to assess the
extent of damages and/or other relief, if any, that could be awarded to Synopsys.



Other Litigation



On June 13, 2005, a putative shareholder class action lawsuit captioned The Cornelia I. Crowell GST Trust vs. Magma Design Automation, Inc., Rajeev Madhavan, Gregory C. Walker and Roy E. Jewell., No. C 05 02394, was filed in
U.S. District Court, Northern District of California. The complaint alleges that defendants failed to disclose information regarding the risk of Magma infringing intellectual property rights of Synopsys, Inc., in violation of Section 10(b) of
the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and prays for unspecified damages. In March 2006, defendants filed a motion to dismiss the consolidated amended complaint. Plaintiff filed a further amended complaint in June 2006, which
defendants again moved to dismiss. Defendants motion was granted in part and denied in part by an order dated August 18, 2006, which dismissed claims against two of the individual defendants. The case is now proceeding on the remaining
claims.



On July 26, 2005, a putative derivative complaint
captioned Susan Willis v. Magma Design Automation, Inc. et al., No. 1-05-CV-045834, was filed in the Superior Court of the State of California for the County of Santa Clara. The Complaint seeks unspecified damages purportedly on behalf
of the Company for alleged breaches of fiduciary duties by various directors and officers, as well as for alleged violations of insider trading laws by executives during a period between October 23, 2002 and April 12, 2005. Defendants have
demurred to the Complaint, and the action has been stayed pending further developments in the putative shareholder class action referenced above.



Narpat Bhandari v. Magma Design Automation, Inc. Cadence Design Systems, Inc., Dynalith Systems, Inc., Altera Corp., Mentor Graphics, Corp. and Aldec,
Inc., Case No. 6:06-CV-480, United States District Court, Eastern District of Texas, Tyler Division. On November 8, 2006, a complaint was filed alleging that Magma and several other named defendants infringe United States Patent
No. 5,663,900. The complaint identifies Magmas FineSim software, and other unidentified devices or programs, as the products accused of infringement. Magma has extended the time to answer the complaint until February 12, 2007. The
complaint seeks unspecified monetary damages, attorneys fees, and costs. The Company intends to vigorously defend against the claims asserted by Bhandari. However, the results of any litigation are inherently uncertain and the Company can not
assure that it will be able to successfully defend against Bhandaris claims. The Company is currently unable to assess the extent of damages and/or other relief, if any, that could be awarded to Bhandari.



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MAGMA DESIGN AUTOMATION, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(unaudited)



Indemnification Obligations



The Company enters into standard license agreements in the ordinary course of business. Pursuant to these agreements, the
Company agrees to indemnify its customers for losses suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to the Companys products. These
indemnification obligations have perpetual terms. The Companys normal business practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification the Company
may be required to make may exceed its normal business practices. The Company estimates the fair value of its indemnification obligations as insignificant, based upon its historical experience concerning product and patent infringement claims.
Accordingly, the Company has no liabilities recorded for indemnification under these agreements as of December 31, 2006.



The Company has agreements whereby its officers and directors are indemnified for certain events or occurrences while the officer or director is, or was,
serving at the Companys request in such capacity. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a directors and
officers liability insurance policy that reduces its exposure and enables the Company to recover a portion of future amounts paid. As a result of the Companys insurance policy coverage, the Company believes the estimated fair value of
these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of December 31, 2006.



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



Warranties



The Company
offers its customers a warranty that its products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, the
Company has no liabilities recorded for these warranties as of December 31, 2006. The Company assesses the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the
future.



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



This Managements Discussion and Analysis of Financial Condition and Results of Operations section should be read in
conjunction with our unaudited condensed consolidated financial statements and results appearing elsewhere in this report. Throughout this section, we make forward-looking statements subject to the safe harbor protection of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements in the following discussion that are not reports of historical information or descriptions of current accounting policy are forward-looking
statements. You can often identify these and other forward-looking statements by terms such as becoming, may, will, should, predicts, potential, continue,
anticipates, believes, estimates, seeks, expects, plans, intends, or comparable terminology. Please consider our forward-looking statements in light of the risks
referenced in this reports introductory cautionary note. We undertake no additional obligation to update these forward-looking statements.



Overview



We provide electronic design automation, or EDA, software products and related services. Our software enables chip designers to reduce the time it takes
to design and produce complex integrated circuits, or ICs, used in the communications, computing, consumer electronics, networking and semiconductor industries. Our products are used in all major phases of the chip development cycle, from initial
design through physical implementation. Our focus is on software used to design the most technologically advanced ICs, specifically those with minimum feature sizes of 0.13 micron and smaller.



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



The semiconductor industry is highly volatile and cost-sensitive. Our customers focus on controlling costs and reducing risk, lowering R&D expenditures, decreasing design starts through chip integration,
purchasing from fewer suppliers, and requiring more favorable pricing and payment terms from suppliers. In addition, intense competition among suppliers of EDA products has resulted in pricing pressure on EDA products.



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



Our accomplishments during the third quarter of fiscal 2007:



| |  |  | We achieved quarterly revenue of $45.1 million during the third quarter of fiscal 2007, up 7% from the prior quarter and up 9% from the same quarter in fiscal
2006. License revenue for the third quarter of fiscal 2007 accounted for approximately 75% of total revenue, compared to 83% in the prior quarter and 84% in the same quarter in the prior year.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our total number of employees increased to 805 as of December 31, 2006 up from 639 as of April 2, 2006. Most of the increase represents additions to our
R&D and application engineering organizations. Our investments in these organizations are expected to enable us to continue to provide leading-edge design solutions for our customers in all key areas of chip design.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | During the first three quarters of fiscal 2007, cash flows generated from operations were $11.7 million, or 9% of revenue for the same period of fiscal 2007.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We strive to offer the best products for delivering the best quality of results as defined by chip performance, area and manufacturability.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------



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Critical Accounting Policies and Estimates



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



Revenue recognition



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



Our revenue recognition policy is detailed in Note 1 of the Notes to
Consolidated Financial Statements on Form 10-K for the year ended April 2, 2006. Management has made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our products (referred to as
an arrangement in the accounting literature) we must evaluate whether our fee is fixed or determinable and we must assess whether collectibility is probable. These judgments are discussed below.



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



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



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



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



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



Collectibility is probable. In order to recognize revenue, we must make a judgment about the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis
pursuant to our credit review policy. We typically sell to customers for which there is a history of successful collection. New



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customers are subjected to a credit review process, which evaluates the customers financial positions and ability to pay. If it is determined from the
outset of an arrangement that collectibility is not probable based upon our credit review process, revenue is recognized on a cash receipts basis (as each payment is collected).



License revenue



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



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



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



For our perpetual licenses and some time-based license
arrangements, we unbundle maintenance by including maintenance for up to the first year of the license term, with maintenance thereafter renewable by the customer at the substantive rates stated in their agreements with us. In these unbundled
licenses, the aggregate renewal period is greater than or equal to the initial maintenance period. The stated rate for maintenance renewal in these contracts is VSOE of the fair value of maintenance in both our unbundled time-based and perpetual
licenses. Where the only undelivered element is maintenance, we recognize license revenue using the residual method. If an arrangement involves extended payment terms, revenue recognized using the residual method is limited to amounts due and
payable.



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



Services revenue



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



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Stock-based compensation



Effective from the first quarter of fiscal 2007, we account for stock-based employee compensation arrangements under SFAS
No. 123 (revised 2004), Share-Based Payment (SFAS 123R) and no longer apply the intrinsic value method to recognize deferred compensation of fixed and variable awards. We adopted SFAS 123R using the
modified-prospective-transition method, resulting in the inclusion in our operating results of compensation costs related to unvested options granted prior to April 3, 2006, and options granted subsequent to that date. Under the
modified-prospective-transition method of SFAS 123R, prior periods were not restated for comparative purposes to reflect the impact of SFAS 123R.



Adoption of SFAS 123R has had a material effect on our financial results since April 3, 2006, increasing total stock-based compensation expenses from
$0.9 million and $3.9 million, respectively, for the three and nine months ended January 1, 2006 using the intrinsic value method to $3.3 million and $12.3 million, respectively, for the three and nine months ended December 31, 2006
using the SFAS 123R fair value method. We continue to evaluate the terms of our stock-based compensation arrangements to provide appropriate incentives to recruit and retain our employees. We expect our quarterly stock-based compensation
expense in the fourth quarter of fiscal 2007 to be consistent with the amount in the third quarter of fiscal 2007. In March 2005, the Commission issued Staff Accounting Bulletin (SAB) No. 107, which provided supplemental
implementation guidance for SFAS 123R. SAB 107 requires stock-based compensation to be classified in the same expense line items as cash compensation as provided in Note 2 to the unaudited condensed consolidated financial statements.



We use the Black-Scholes option pricing model to determine the
fair value of stock options and employee stock purchase plan awards. The Black-Scholes option pricing model was developed for use in estimating the fair value of short lived exchange-traded options that have no vesting restrictions and were fully
transferable. In addition, the Black-Scholes option-pricing model incorporates various highly subjective assumptions including expected future stock price volatility and expected term of instruments. In developing estimates used in the adoption of
SFAS 123R, we established the expected term for employee options and awards, as well as forfeiture rates, based on the historical settlement experience, while giving consideration to vesting schedules and to options that have life cycles less than
the contractual terms. Assumptions for option exercises and prevesting terminations of options were stratified for employee groups with sufficiently distinct behavior patterns. Expected volatility under SFAS 123R was developed based on the average
of our historical weekly stock price volatility and average implied volatility.



Additionally, SFAS 123R requires the rate of forfeiture to be estimated and recorded during the option term unlike previous accounting guidance which allowed adjustments to stock compensation when forfeitures
occurred. Consequently, during the first quarter of 2007, we recorded a credit of $321,000 reflecting the cumulative effect of the change in accounting principle for forfeitures primarily related to unvested restricted stock that had previously been
recognized as stock-based compensation expense without consideration of forfeitures. No income tax benefit related to the cumulative effect of the change in accounting for stock option forfeitures was recorded as we have provided full valuation
allowance against our net deferred tax assets.



Unbilled accounts
receivable



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



Allowances for doubtful accounts



We maintain allowances for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We regularly review the adequacy of our accounts receivable allowance



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after considering the size of the accounts receivable balance, each customers expected ability to pay and our collection history with each customer. We
review significant invoices that are past due to determine if an allowance is appropriate using the factors described above. We also monitor our accounts receivable for concentration in any one customer, industry or geographic region.



As of December 31, 2006, none of our customers accounted for more than
10% of total receivables. The allowance for doubtful accounts represents our best estimate, but changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future. If actual losses are
significantly greater than the allowance we have established, that would increase our general and administrative expenses and reported net loss. Conversely, if actual credit losses are significantly less than our allowance, this would decrease our
general and administrative expenses and our reported net income would increase.



Accounting for asset purchases and business combinations



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



Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from license sales,
maintenance agreements, consulting contracts, customer contracts, acquired workforce and acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimated
cash flows from the projects when completed; the acquired companys brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined companys product
portfolio; and discount rates. Managements estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated
events and circumstances may occur.



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



Goodwill impairment



Statement of Financial Accounting Standards No. 142, Goodwill and
Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests in certain circumstances. Application
of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting unit, and determining the fair value of the reporting unit. We
have determined that we have one reporting unit (see Note 9 to the unaudited condensed consolidated financial statements). Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining
appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for the reporting units. Any impairment losses recorded in the future could have a material adverse
impact on our financial condition and results of operations.



Valuation
of intangibles and long-lived assets



SFAS
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, requires that we record an impairment charge on finite-lived intangibles or long-lived assets to be held and used when we determine that the carrying value of
intangible assets and long-lived assets may not be recoverable. If one or more indicators of impairment exist, we will measure any impairment of intangibles or long-lived assets based on a projected



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discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our business model. Our estimates
of cash flows require significant judgment based on our historical results and anticipated results and are subject to many factors.



Income taxes



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



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



Strategic investments in privately-held companies



Our strategic equity investments consist of preferred stock and convertible notes that are convertible into preferred or
common stock of several privately-held companies. As of December 31, 2006, $0.6 million of the notes has been converted into an investee companys preferred stock. The carrying value of our portfolio of strategic equity investments in
non-marketable equity securities (privately-held companies) and convertible notes totaled $2.3 million at December 31, 2006. Our ability to recover our investments in private, non-marketable equity securities and convertible notes, and to earn
a return on these investments is primarily dependent on how successfully these companies are able to execute on their business plans and how well their products are accepted, as well as their ability to obtain additional capital funding to continue
operations. In the current equity market environment, their ability to obtain additional funding as well as to take advantage of liquidity events, such as initial public offerings, mergers and private sales, may be constrained.



Under our accounting policy, the carrying value of a non-marketable
investment is the amount paid for the investment unless it has been determined to be other than temporarily impaired, in which case we write the investment down to its estimated fair value. For equity investments where our ownership interest is
between 20% to 50%, we record our share of net equity income (loss) of the investee based on our proportionate ownership. We review all of our investments periodically for impairment; however, for non-marketable equity securities, the fair value
analysis requires significant judgment. This analysis includes assessment of each investees financial condition, the business outlook for its products and technology, its projected results and cash flows, the likelihood of obtaining subsequent
rounds of financing and the impact of any relevant contractual equity preferences held by us or others. If an investee obtains additional funding at a valuation lower than our carrying amount, we presume that the investment is other than temporarily
impaired, unless specific facts and circumstances indicate otherwise, such as when we hold contractual rights that give us a preference over the rights of other investors. As the equity markets have experienced volatility over the past few years, we
have experienced substantial impairments in our portfolio of non-marketable equity securities. If certain equity market conditions do not improve, as companies within our portfolio attempt to raise additional funds, the funds may not be available to
them, or they may receive lower valuations, with more onerous investment terms than in previous financings, and the investments will likely become impaired. However, we are not able to determine at the present time which specific investments are
likely to be impaired in the future, or the extent or timing of individual impairments. We recorded impairment charges and share of equity loss related to these



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non-marketable equity investments of $0.1 million and $0.4 million, respectively, during the three and nine months ended December 31, 2006. Similarly,
we recorded impairment charges and share of equity loss related to these non-marketable equity investments of $0.3 million and $0.9 million, respectively, during the three and nine months ended January 1, 2006.



Results of Operations



Revenue overview



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



| |  |  | Ratable
| | - |  | -------



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



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



| |  |  | Up-Front / Perpetual or Time-Based
| | - |  | ----------------------------------



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



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We use this classification of license revenue to provide greater insight into the reporting and
monitoring of trends in the components of our revenue and to assist us in managing our business. It is important to note that the characterization of an individual contract may change over time. For example, a contract originally characterized as
Ratable may be redefined as Cash Receipts if that customer has difficulty in making payments in a timely fashion. In cases where a contract has been re-characterized for management reporting purposes, prior periods are not restated to reflect that
change. The following table shows the breakdown of license revenue by category as defined for management reporting and analysis purposes (in thousands, except for percent data):



|                      |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|--------------------- |  | -------------------- |  | ---------------- | ------- | ----------- | --- | - | -------------- | - | ----------- |  | --- | -
|                      |  |                      |  | December 31,2006 |         | % ofRevenue |     |   | January 1,2006 |   | % ofRevenue | 
|Revenue category:     |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Three Months Ended:   |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|License revenue       |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Ratable               |  | Bundled andUnbundled |  | $                | 5,644   |             | 12  | % |                | $ | 7,428       |  | 18  | %
|Due & Payable         |  | Unbundled            |  |                  | 16,482  |             | 37  | % |                |   | 15,188      |  | 37  | %
|Cash Receipts         |  | Unbundled            |  |                  | 1,805   |             | 4   | % |                |   | 1,515       |  | 3   | %
|Up-Front*             |  | Unbundled            |  |                  | 10,075  |             | 22  | % |                |   | 10,758      |  | 26  | %
|                      |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Total license revenue |  |                      |  |                  | 34,006  |             | 75  | % |                |   | 34,889      |  | 84  | %
|Services revenue      |  |                      |  |                  | 11,088  |             | 25  | % |                |   | 6,431       |  | 16  | %
|                      |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Total Revenue         |  |                      |  | $                | 45,094  |             | 100 | % |                | $ | 41,320      |  | 100 | %
|                      |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Nine Months Ended:    |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|License revenue       |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Ratable               |  | Bundled andUnbundled |  | $                | 14,586  |             | 11  | % |                | $ | 18,692      |  | 16  | %
|Due & Payable         |  | Unbundled            |  |                  | 49,739  |             | 39  | % |                |   | 43,320      |  | 36  | %
|Cash Receipts         |  | Unbundled            |  |                  | 6,256   |             | 5   | % |                |   | 6,004       |  | 5   | %
|Up-Front              |  | Unbundled            |  |                  | 32,824  |             | 26  | % |                |   | 33,487      |  | 28  | %
|                      |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Total license revenue |  |                      |  |                  | 103,405 |             | 81  | % |                |   | 101,503     |  | 85  | %
|Services revenue      |  |                      |  |                  | 24,611  |             | 19  | % |                |   | 18,535      |  | 15  | %
|                      |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  
|Total Revenue         |  |                      |  | $                | 128,016 |             | 100 | % |                | $ | 120,038     |  | 100 | %
|                      |  |                      |  |                  |         |             |     |   |                |   |             |  |     |  

---

|* | Included $9,097 of revenue from new contracts for the quarter ended December 31, 2006.
|- | --------------------------------------------------------------------------------------



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



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



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



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



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



Our license revenue in any given quarter depends upon the mix
and volume of perpetual or short term licenses ordered during the quarter and the amount of long-term ratable or due and payable, and cash receipts license revenue recognized during the quarter. In general, we refer to license revenue recognized
from perpetual or time-based licenses during the quarter as Up-Front revenue, for management reporting and analysis purposes. All other types of revenue are generally referred to as revenue from backlog. We set our revenue targets for
any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of short term licenses. The precise mix of orders fluctuates substantially from period to period and affects the revenue we
recognize in the period. If we achieve our target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we have more-than-expected long term licenses) or may exceed them (if we have
more-than-expected short term or perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets as described in the risk factors in Part II, Item 1A
of this Form 10-Q.



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Revenue, cost of revenue and gross profit



The table below sets forth the fluctuations in revenue, cost of revenue and
gross profit data for the three and nine months ended December 31, 2006 and January 1, 2006 (in thousands, except for percent data):



|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|--------------------- |  | ----------------- | ------- | ------------ | --- | - | --------------- | - | ------------ |  | --- | ------------- |  | - | -------- | - |  | -- | --
|                      |  | December 31, 2006 |         | % of Revenue |     |   | January 1, 2006 |   | % of Revenue |  |     | Dollar Change |  |   | % Change |  
|Three Months Ended:   |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Revenue:              |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Licenses              |  | $                 | 34,006  |              | 75  | % |                 | $ | 34,889       |  | 84  | %             |  | $ | (883     | ) |  | (3 | )%
|Services              |  |                   | 11,088  |              | 25  | % |                 |   | 6,431        |  | 16  | %             |  |   | 4,657    |   |  | 72 | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Total revenue         |  |                   | 45,094  |              | 100 | % |                 |   | 41,320       |  | 100 | %             |  |   | 3,774    |   |  | 9  | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Cost of revenue:      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Licenses              |  |                   | 8.358   |              | 19  | % |                 |   | 6,702        |  | 16  | %             |  |   | 1,656    |   |  | 25 | % 
|Services              |  |                   | 5,661   |              | 13  | % |                 |   | 4,183        |  | 10  | %             |  |   | 1,478    |   |  | 35 | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Total cost of revenue |  |                   | 14,019  |              | 31  | % |                 |   | 10,885       |  | 26  | %             |  |   | 3,134    |   |  | 29 | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Gross profit          |  | $                 | 31,075  |              | 69  | % |                 | $ | 30,435       |  | 74  | %             |  | $ | 640      |   |  | 2  | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Nine Months Ended:    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Revenue:              |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Licenses              |  | $                 | 103,405 |              | 81  | % |                 | $ | 101,503      |  | 85  | %             |  | $ | 1,902    |   |  | 2  | % 
|Services              |  |                   | 24,611  |              | 19  | % |                 |   | 18,535       |  | 15  | %             |  |   | 6,076    |   |  | 33 | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Total revenue         |  |                   | 128,016 |              | 100 | % |                 |   | 120,038      |  | 100 | %             |  |   | 7,978    |   |  | 7  | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Cost of revenue:      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Licenses              |  |                   | 23,444  |              | 18  | % |                 |   | 17,598       |  | 15  | %             |  |   | 5,846    |   |  | 33 | % 
|Services              |  |                   | 16,352  |              | 13  | % |                 |   | 12,566       |  | 10  | %             |  |   | 3,786    |   |  | 30 | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Total cost of revenue |  |                   | 39,796  |              | 31  | % |                 |   | 30,164       |  | 25  | %             |  |   | 9,632    |   |  | 32 | % 
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   
|Gross profit          |  | $                 | 88,220  |              | 69  | % |                 | $ | 89,874       |  | 75  | %             |  | $ | (1,654   | ) |  | (2 | )%
|                      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |          |   |  |    |   



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We market our products and related services to customers in four geographic regions: North America,
Europe (Europe, the Middle East and Africa), Japan, and Asia-Pacific (India, South Korea, Taiwan, Hong Kong and China). Internationally, we market our products and services primarily through our subsidiaries and various distributors. Revenue is
attributed to geographic areas based on the country in which the customer is domiciled. The table below sets forth geographic distribution of revenue data for the three and nine months ended December 31, 2006 and January 1, 2006 (in
thousands, except for percent data):



|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|------------------- |  | ----------------- | ------- | ------------ | --- | - | --------------- | - | ------------ |  | --- | ------------- |  | - | ------- | - |  | --- | --
|                    |  | December 31, 2006 |         | % of Revenue |     |   | January 1, 2006 |   | % of Revenue |  |     | Dollar Change |  |   | %Change |  
|Three Months Ended: |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Domestic            |  | $                 | 31,596  |              | 70  | % |                 | $ | 20,939       |  | 51  | %             |  | $ | 10,657  |   |  | 51  | % 
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|International:      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Europe              |  |                   | 4,858   |              | 11  | % |                 |   | 15,407       |  | 37  | %             |  |   | (10,549 | ) |  | (68 | )%
|Japan               |  |                   | 5,930   |              | 13  | % |                 |   | 3,210        |  | 8   | %             |  |   | 2,720   |   |  | 85  | % 
|Asia-Pacific        |  |                   | 2,710   |              | 6   | % |                 |   | 1,764        |  | 4   | %             |  |   | 946     |   |  | 54  | % 
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Total International |  |                   | 13,498  |              | 30  | % |                 |   | 20,381       |  | 49  | %             |  |   | (6,882  | ) |  | (34 | )%
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Total revenue       |  | $                 | 45,094  |              | 100 | % |                 | $ | 41,320       |  | 100 | %             |  | $ | 3,774   |   |  | 9   | % 
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Nine Months Ended:  |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Domestic            |  | $                 | 84,197  |              | 65  | % |                 | $ | 78,443       |  | 65  | %             |  | $ | 5,753   |   |  | 7   | % 
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|International:      |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Europe              |  |                   | 15,245  |              | 12  | % |                 |   | 24,103       |  | 20  | %             |  |   | (8,858  | ) |  | (37 | )%
|Japan               |  |                   | 18,728  |              | 15  | % |                 |   | 11,185       |  | 9   | %             |  |   | 7,543   |   |  | 67  | % 
|Asia-Pacific        |  |                   | 9,846   |              | 8   | % |                 |   | 6,307        |  | 6   | %             |  |   | 3,539   |   |  | 56  | % 
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Total International |  |                   | 43,819  |              | 35  | % |                 |   | 41,595       |  | 35  | %             |  |   | 2,224   |   |  | 5   | % 
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   
|Total revenue       |  | $                 | 128,016 |              | 100 | % |                 | $ | 120,038      |  | 100 | %             |  | $ | 7,978   |   |  | 7   | % 
|                    |  |                   |         |              |     |   |                 |   |              |  |     |               |  |   |         |   |  |     |   



Revenue



| |  |  | Revenue for the three and nine months ended December 31, 2006 was $45.1 million and $128.0 million, respectively, up 9% and 7%, respectively, from the
same periods in the prior year.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | License revenue decreased by 3% in the third quarter of fiscal 2007 compared to the same quarter of fiscal 2006 and increased by 2% in the nine months ended
December 31, 2006 compared to the same period in fiscal 2006. There were large orders executed during the fiscal 2007 periods within the U.S., Japan and Asia-Pacific (excluding Japan). These orders came from existing customers who extended
license periods and added license capacity due to the continued proliferation of existing and new Magma products, among their design group designers. The increase in license revenue from these regions was partially offset by a decrease in license
revenue from Europe for the nine months ended December 31, 2006 compared to the same period in the prior year, and was more than offset by a decrease in revenue from Europe for the third quarter of fiscal 2007 compared to the same quarter of
fiscal 2006. One customer accounted for greater than 10% of the revenue for the quarter ended December 31, 2006 and no customer accounted for greater than 10% of the revenue for the nine months ended December 31, 2006. License revenue as a
percentage of revenue decreased 9% and 4%, respectively in the three and nine months ended December 31, 2006 as compared to the same periods in fiscal 2006.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Service revenue increased by 72% and 33%, respectively, in the three and nine months ended December 31, 2006 compared to the same periods in the prior
year. The increase in service revenue during the three and nine months ended December 31, 2006 as compared to the same periods in fiscal 2006 was primarily due to our growth in customer base and increased penetration into our major customers.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Domestic revenueincreased by 51% and 7%, respectively, in the three and nine months ended December 31, 2006 compared to the same periods in the prior
year primarily due to revenue recognized as a result of increased penetration into our major U.S. customers. Domestic revenue as a percentage of total revenue increased by 19% in the third quarter of fiscal 2007 compared to the same quarter in
fiscal 2006 and remained the same for the nine months ended December 31, 2006 compared to the same period in the prior year.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | International revenue decreased by 34% in the third quarter of fiscal 2007 compared to the same quarter in fiscal 2006 primarily due to lower revenue from
Europe. International revenue increased by 5% in the nine months ended December 31, 2006 compared to the same period in the prior year primarily due to an increase in purchases of new technology products and additional license capacity by our
existing customers in Japan and Asia-Pacific (excluding Japan).
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Cost of Revenue



| |  |  | Cost of license revenue primarily consists of amortization of acquired developed technology and other intangible assets, software maintenance costs,
royalties and allocated outside sales representative expenses. Cost of license revenue increased by $1.7 million and $5.8 million, respectively, in the three and nine months ended December 31, 2006 as compared to the same periods in the prior
year. The increase was primarily due to amortization charges related to new acquired intangible assets and to several existing acquired technology licenses, as we began recognizing revenue from such products that were based on these acquired
technologies during the periods. Amortization expenses on these existing technology assets were included in the operating expense for prior periods.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Cost of service revenue primarily consists of personnel and related costs to provide product support, consulting services and training. Cost of service
revenue also includes stock-based compensation expenses, asset depreciation and allocated outside sales representative expenses. Cost of service revenue increased by $1.5 million and $3.8 million, respectively, in the three and nine months ended
December 31, 2006 compared to the same periods in the prior year primarily due to an increase of personnel and related costs for application engineers that corresponded to higher consulting and maintenance activities in the fiscal 2007 periods.
Additionally, stock-based compensation expense accounted for a $0.3 million and $0.9 million, respectively, increase in the cost of service revenue for the three and nine months ended December 31, 2006 compared to the same periods in the prior
year.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Operating expenses



The table below sets forth operating expense data for the three and nine months ended December 31, 2006 and
January 1, 2006 (in thousands, except for percent data):



|                                    |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|----------------------------------- |  | ----------------- | ------- | ------------ | --- | - | --------------- | - | ------------ |  | -- | ------------ |  | - | ------- | - |  | ---- | --
|                                    |  | December 31, 2006 |         | % of Revenue |     |   | January 1, 2006 |   | % of Revenue |  |    | DollarChange |  |   | %Change |  
|Three Months Ended:                 |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|Operating expenses:                 |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|Research and development            |  | $                 | 15,660  |              | 35  | % |                 | $ | 11,643       |  | 28 | %            |  | $ | 4,017   |   |  | 35   | % 
|In-process research and development |  |                   | 1,300   |              | 3   | % |                 |   | 450          |  | 1  | %            |  |   | 850     |   |  | 189  | % 
|Sales and marketing                 |  |                   | 14,919  |              | 33  | % |                 |   | 11,500       |  | 28 | %            |  |   | 3,419   |   |  | 30   | % 
|General and administrative          |  |                   | 9,660   |              | 21  | % |                 |   | 11,267       |  | 27 | %            |  |   | (1,607  | ) |  | (14  | )%
|Amortization of intangible assets   |  |                   | 2,923   |              | 6   | % |                 |   | 2,682        |  | 6  | %            |  |   | 241     |   |  | 9    | % 
|                                    |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|Total operating expenses            |  | $                 | 44,462  |              | 99  | % |                 | $ | 37,542       |  | 91 | %            |  | $ | 6,920   |   |  | 18   | % 
|                                    |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|                                    |  |                   |         |              |     |  
|                                    |  | December 31, 2006 |         | % of Revenue |     |   | January 1, 2006 |   | % of Revenue |  |    | DollarChange |  |   | %Change |  
|Nine Months Ended:                  |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|Operating expenses:                 |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|Research and development            |  | $                 | 46,716  |              | 36  | % |                 | $ | 36,794       |  | 31 | %            |  | $ | 9,922   |   |  | 27   | % 
|In-process research and development |  |                   | 1,300   |              | 1   | % |                 |   | 450          |  | 3  | %            |  |   | 850     |   |  | 189  | % 
|Sales and marketing                 |  |                   | 43,333  |              | 34  | % |                 |   | 33,436       |  | 28 | %            |  |   | 9,897   |   |  | 30   | % 
|General and administrative          |  |                   | 29,667  |              | 23  | % |                 |   | 29,796       |  | 25 | %            |  |   | (129    | ) |  | (0.4 | )%
|Amortization of intangible assets   |  |                   | 8,735   |              | 7   | % |                 |   | 9,152        |  | 8  | %            |  |   | (417    | ) |  | (5   | )%
|                                    |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   
|Total operating expenses            |  | $                 | 129,751 |              | 101 | % |                 | $ | 109,628      |  | 91 | %            |  | $ | 20,123  |   |  | 18   | % 
|                                    |  |                   |         |              |     |   |                 |   |              |  |    |              |  |   |         |   |  |      |   



| |  |  | Research and development expense increased by 35% and 27%, respectively, in the three and nine months ended December 31, 2006 compared to the same
periods in the prior year primarily due to an increase in payroll-related expenses of $3.4 million and $7.6 million, respectively, an increase in stock-based compensation charges of $0.3 million and $1.1 million, respectively, and increases in other
individually insignificant items. The increases in payroll related expenses in the three and nine months ended December 31, 2006 were principally attributable to an increase in bonus expense of $0.9 million and $1.2 million, respectively, and
an increase in salaries and related expenses of $2.1 million and $5.1 million, respectively, due to increases in the number of employees and annual wage increases. Stock-based compensation expense for fiscal 2007 periods was based on the SFAS 123R
fair value method, while stock-based compensation expense for fiscal 2006 periods was based on the intrinsic value method. We expect our quarterly research and development expense in the last quarter of fiscal 2007 to increase moderately and to
remain at approximately the same percentage of sales as the third quarter of fiscal 2007. Growth in the number of employees in our research and development will be the primary factor driving up both fixed and variable compensation levels.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In-process research and development (IPR&D) expense of $1.3 million for the three and nine months ended December 31, 2006 consisted of a
charge recorded in connection with our acquisition of Knights in November 2006. IPR&D expense of $450,000 for the three and nine months ended January 1, 2006 consisted of a charge recorded in connection with our acquisition of ACAD in
November 2005. The charges were recorded based on managements final purchase price allocation and were related to acquired technologies for which commercial feasibility had not been established and had no alternative future uses. ACADs
in-process technology projects were completed in the second quarter of fiscal 2007 and we expect to bring Knights in-process products to completion during the first quarter of fiscal 2008.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Sales and marketing expense increased by 30% in both the three and nine months ended December 31, 2006 compared to the same periods in the prior year
due principally to an increase in payroll related expenses of $2.3 million and $6.5 million, respectively, an increase in stock-based compensation charges of $0.8 million and $3.0 million, respectively, and increases in other individually
insignificant items such as marketing and travel expenses. The increases in payroll related charges were primarily due to increases in the number of employees and merit-based compensation. The number of employees in sales and marketing increased by
22% over the comparable period primarily due to growth in the number of application engineer employees. Stock-based compensation expense for fiscal 2007 periods was based on the SFAS 123R fair value method, while stock-based compensation expense for
fiscal 2006 periods was based on the intrinsic value method. There were no material changes in our other sales and marketing activities in fiscal 2007 compared to the same periods in the prior year. We expect our quarterly sales and marketing
expenses in the last quarter of fiscal 2007 to increase moderately compared to the third quarter of fiscal 2007, primarily due to increased variable compensation cost driven by growth in the number of employees, bookings and revenue.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | General and administrative expense decreased by 14% and 0.4%, respectively, in the three and nine months ended December 31, 2006 compared to the same
periods in the prior year primarily due to a decrease of $3.9 million and $7.9 million, respectively, in legal fees related to patent litigation with Synopsys, Inc. and other legal expenses. The decrease was partially offset by increases in
stock-based compensation expenses of $1.0 million and $3.4 million, respectively, payroll related expenses of $0.9 million and $2.2 million, respectively, and asset depreciation of $0.4 million and $0.9 million, respectively. Stock-based
compensation expense for fiscal 2007 periods was based on the SFAS 123R fair value method, while stock-based compensation expense for fiscal 2006 periods was based on the intrinsic value method. The remainder of the fluctuation in general and
administrative expense was accounted for by other individually insignificant items. We expect that our general and administrative expenses in the last quarter of fiscal 2007 will increase materially compared to the third quarter of fiscal 2007. We
will incur moving expenses and write-off unamortized leasehold improvements relating to the existing lease when we relocate our corporate headquarters in March 2007. In addition, legal expenses and professional services related to litigation may
increase moderately, variable compensation will grow moderately in proportion to increases in the number of employees, and professional fees related to compliance with the requirements of the Sarbanes-Oxley Act of 2002 will increase moderately over
third quarter levels. However, litigation expense has the potential to vary significantly from quarter to quarter dependent upon the level of activity incurred in the respective cases during the quarter.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Amortization of intangible assets increased by 9% in the three months ended December 31, 2006 compared to the same period in the prior year primarily
due to amortization charges related to new acquired intangible assets in fiscal 2007. Amortization of intangible assets decreased by 5% in the nine months ended December 31, 2006 compared to the same period in the prior year primarily due to
the change in classification of amortization charges relating to developed technology from operating expenses to cost of license revenue as we began recognizing revenues from products based on the developed technology during fiscal 2007.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Other items



The table below sets forth other data for the three and nine months ended December 31, 2006 and January 1, 2006
(in thousands, except for percent data):



|                                  |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|--------------------------------- |  | ----------------- | ----- | -- | ------------ | -- | -- | --------------- | - | ----- | ------------ |  | -- | ------------ |  | - | -------- | - |  | ---- | --
|                                  |  | December 31, 2006 |       |    | % of Revenue |    |    | January 1, 2006 |   |       | % of Revenue |  |    | DollarChange |  |   | % Change |  
|Three Months Ended:               |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Other income (expense), net:      |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Interest income                   |  | $                 | 623   |    |              | 1  | %  |                 | $ | 795   |              |  | 2  | %            |  | $ | (172     | ) |  | (22  | )%
|Interest expense                  |  |                   | (141  | )) |              |    |    |                 |   | (197  | )            |  |    |              |  |   | 56       |   |  | (28  | )%
|Other expense, net                |  |                   | (326  | )) |              | (1 | )% |                 |   | (776  | )            |  | (2 | )%           |  |   | 450      |   |  | (58  | )%
|                                  |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Total other income (expense), net |  | $                 | 156   |    |              |    |    |                 | $ | (178  | )            |  |    |              |  | $ | 334      |   |  | (188 | )%
|                                  |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Provision for income taxes        |  | $                 | 330   | )  |              | 1  | %  |                 | $ | 783   |              |  | 2  | %            |  | $ | (453     | ) |  | (58  | )%
|                                  |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Nine Months Ended:                |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Other income (expense), net:      |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Interest income                   |  | $                 | 2,181 |    |              | 2  | %  |                 | $ | 2,042 |              |  | 2  | %            |  | $ | 139      |   |  | 7    | % 
|Interest expense                  |  |                   | (449  | )) |              |    |    |                 |   | (629  | )            |  | (1 | )%           |  |   | 180      |   |  | (29  | )%
|Other income, net                 |  |                   | 3,884 |    |              | 3  | %  |                 |   | 6,322 |              |  | 5  | %            |  |   | (2,438   | ) |  | (39  | )%
|                                  |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Total other income, net           |  | $                 | 5,616 |    |              | 4  | %  |                 | $ | 7,735 |              |  | 6  | %            |  | $ | (2,119   | ) |  | (27  | )%
|                                  |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   
|Provision for income taxes        |  | $                 | 1,100 |    |              | 1  | %  |                 | $ | 2,692 |              |  | 2  | %            |  | $ | (1,592   | ) |  | (59  | )%
|                                  |  |                   |       |    |              |    |    |                 |   |       |              |  |    |              |  |   |          |   |  |      |   



| |  |  | Interest income decreased by 22% in the three months ended December 31, 2006 compared to the same period in the prior year primarily due to our lower
cash and investments balance resulting from our use of cash to acquire intangible assets and to repurchase a portion of our outstanding convertible subordinated notes during fiscal 2007. The decrease was partially offset by higher interest rates on
our cash and investments balance during the period. Interest income increased by 7% in the nine months ended December 31, 2006 compared to the same period in the prior year primarily due to higher interest rates on our cash and investments
balance during the period, notwithstanding our lower cash and investments balance resulting from our use of cash to acquire intangible assets and to repurchase a portion of our outstanding convertible subordinated notes.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Interest expense primarily represents amortization of debt discount and issuance costs, which were recorded in connection with our convertible subordinated
debt offering completed in May 2003. During the first quarter of fiscal 2007, we wrote off $0.5 million of the unamortized debt issuance costs in connection with the portion of the convertible subordinated notes repurchased in May 2006, resulting in
less amortization on debt issuance costs for fiscal 2007 periods.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Other income (expense), net in the nine months ended December 31, 2006 and January 1, 2006 consisted primarily of net gains of $4.8 million and
$8.1 million, respectively, associated with repurchases of convertible subordinated notes during the periods. The remaining fluctuation in other income (expense), net during the three and nine months ended December 31, 2006 compared to the same
periods in the prior year relates primarily to our share of equity loss on strategic investments and fluctuation in currency exchange rates.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Provision for income taxes. We recorded an income tax expense of $330,000 and $1.1 million, respectively, for the three and nine months ended
December 31, 2006, compared to income tax expense of $783,000 and $2.7 million, respectively, for the three and nine months ended January 1, 2006. The tax provision consists primarily of the federal, state and foreign taxes provided for
the income derived from
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | our normal operations as well as certain discrete items, including but are not limited to, impairment of certain equity investments and write-off of
in-process research and development related to acquisitions. Our effective tax rates vary from the U.S. statutory rate primarily due to changes in our valuation allowance, state taxes, foreign income taxed at other than U.S. rates, stock
compensation expense, in-process research and development, research and development credits, and foreign withholding taxes.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



Liquidity and Capital Resources



The table below sets forth certain cash flow data as of
December 31, 2006 and April 2, 2006, and for the nine months ended December 31, 2006 and January 1, 2006 (in thousands):



|                                                  |  |                   |        |               |   |       
|------------------------------------------------- |  | ----------------- | ------ | ------------- | - | ------
|                                                  |  | December 31, 2006 |        | April 2, 2006
|Cash, cash equivalents and short-term investments |  | $                 | 51,699 |               | $ | 97,158



|                                          |  |                   |         |   |                 |   |         |  
|----------------------------------------- |  | ----------------- | ------- | - | --------------- | - | ------- | -
|For the nine months ended:                |  | December 31, 2006 |         |   | January 1, 2006 |  
|Net cash provided by operating activities |  | $                 | 11,713  |   |                 | $ | 29,822  |  
|Net cash provided by investing activities |  | $                 | 5,783   |   |                 | $ | 49,220  |  
|Net cash used in financing activities     |  | $                 | (30,987 | ) |                 | $ | (46,652 | )



Our cash, cash
equivalents and short-term investments, excluding restricted cash, were approximately $51.7 million on December 31, 2006, a decrease of $45.5 million or 47% from April 2, 2006. The decrease primarily reflected the use of cash to repurchase
a portion of outstanding convertible subordinated notes, the purchases of intangible assets, capital investments and equity investments, partially offset by cash generated from operations and proceeds from common stock issuances. Our investment
portfolio consists of high-grade fixed-income securities diversified among corporate, U.S. agency and municipal issuers with maturities of two years or less. A portion of the portfolio is allocated to auction rate securities which provide liquidity
at par every 28 days with underlying longer-term maturities.



In May 2006, we repurchased, in privately negotiated transactions, $40.3 million face amount (or approximately 38.2% of the remaining principal) of these notes at an average discount to face value of approximately 13%. We spent an aggregate
of approximately $35.0 million on the repurchase. The repurchase left approximately $65.2 million aggregate principal amount of convertible subordinated notes outstanding. At the same time we terminated a portion of a related hedging arrangement.



Net cash provided by operating activities



Net cash provided by operating activities was $11.7 million in the nine
months ended December 31, 2006 compared to $29.8 million in the same period in the prior year. The $18.1 million decrease was primarily due to a $13.0 million increase in costs and expenses and a $10.1 million increase in payments associated
with accounts payable and accrued liabilities. These decreases in cash flow were partially offset by a $4.4 million increase in cash from customers and a $1.1 million decrease in payments associated with prepaid expenses. The increase in cash from
customers was primarily due to higher cash collection on accounts receivable during the nine months ended December 31, 2006 compared to the same period in fiscal 2006. The increase in payments associated with accrued liabilities was primarily
related to a $3.8 million increase in accrued bonuses payment and a $5.9 million increase in legal expenses payment during the first three quarters of fiscal 2007.



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Net cash provided by investing activities



Net cash provided by investing activities was $5.8 million in the nine months ended December 31, 2006. We had net
proceeds of $32.0 million from sales of marketable securities as we liquidated these investments to repurchase a portion of the convertible subordinated notes. Partially offsetting the cash inflow, we used a total of $22.6 million in cash to acquire
Knights, purchase technology licenses and make earnout payments relating to prior asset purchases. We also made an investment of $0.9 million in a privately held technology company for business and strategic purposes. We may make additional
strategic equity investments in the future by using our cash, cash equivalents and/or short-term investments. In addition, we acquired property and equipment totaling $2.5 million in cash and $2.3 million through capital leases. We expect to make
capital expenditures of approximately $3.9 million for the remainder of fiscal 2007. We expect that these capital expenditures will be used primarily to support selling, marketing and product development activities. We expect to use capital lease
financing as well as our cash and cash equivalents and/or investments to fund these purchases.



Net cash provided by investing activities was $49.2 million in the nine months ended January 1, 2006. We had net proceeds of $78.5 million from sales of marketable securities as we liquidated these investments to
repurchase a portion of the convertible subordinated notes. Partially offsetting the cash inflow, we used a total of $25.3 million in cash to acquire ACAD, purchase a technology license and make earnout payments relating to prior asset purchases. We
also made an investment of $0.8 million in a privately held technology company for business and strategic purposes. In addition, we acquired property and equipment totaling $3.2 million in cash and $2.2 million through capital leases.



Net cash used in financing activities



Net cash used in financing activities was $31.0 million in the nine months
ended December 31, 2006. We used $35.0 million to repurchase a portion of our convertible subordinated notes. The primary source of cash was $5.0 million in net cash received from the exercise of stock options and purchases of shares under the
employee stock purchase plan during the period. The remaining uses of $1.0 million related to payment of capital lease obligations.



Net cash used in financing activities was $46.7 million in the nine months ended January 1, 2006. We used $34.7 million to repurchase a portion of
our convertible subordinated notes and received net proceeds of $140,000 from termination of the related portion of the bond hedge and warrant. In addition, we used $16.0 million to repurchase 2,000,000 shares of common stock on the open market, as
authorized by the board of directors in April 2005, and made payments of $0.6 million on our capital leases. The primary source of cash was $4.6 million in cash received from the exercise of stock options and purchases of shares under the employee
stock purchase plan during the period.



Capital resources



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



Contractual obligations



As of December 31, 2006, our principal commitments consisted of operating leases, with an aggregated future amount of
$26.6 million through fiscal 2014 for office facilities, and repayment of the convertible subordinated notes of $65.2 million due in fiscal 2009. During the nine months ended December 31, 2006, our operating lease commitment increased by $14.3
million due to our entering of leases for our new corporate headquarters in California and our new operation facilities in India. In addition, we repurchased $40.3 million face amount of the convertible subordinated notes in May 2006. There were no
other material changes in our reported payments due under contractual obligations at April 2, 2006. Although we have no material



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



Our acquisition
agreements related to certain business combination and asset purchase transactions obligate us to pay certain contingent cash considerations based on meeting certain financial or project milestones and continue employment. Total amount of cash
contingent consideration that could be paid under our acquisition agreements, assuming all contingencies are met, was $48.9 million as of December 31, 2006.



Line of Credit



In November 2006, we established a $5.0 million revolving line of credit facility with Wells Fargo Bank, N.A. The credit facility is available through
November 2011 and bears an interest rate equal to the banks prime rate less 1.60% or LIBOR plus 0.60%. We are required to make interest only payments monthly and the outstanding principal amount plus all accrued but unpaid interest is payable
in full at the expiration of the credit facility. As of December 31, 2006, there were no borrowings outstanding under the credit facility. The credit facility is secured by deposits held with the bank.



In addition, the credit facility allows letters of credit to be issued on
behalf of us, provided that the aggregate outstanding amount of the letters of credit shall not exceed the available amount for borrowing under the credit facility. As of December 31, 2006, two letters of credit totaling $350,000 were
outstanding under the credit facility.



Off-balance Sheet
Arrangements



As of December 31, 2006, we did not
have any significant off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K.



Indemnification Obligations



We enter into standard license agreements in the ordinary course of business. Pursuant to these agreements, we agree to indemnify our customers for losses
suffered or incurred by them as a result of any patent, copyright, or other intellectual property infringement claim by any third party with respect to our products. These indemnification obligations have perpetual terms. Our normal business
practice is to limit the maximum amount of indemnification to the amount received from the customer. On occasion, the maximum amount of indemnification we may be required to make may exceed our normal business practices. We estimate the fair value
of our indemnification obligations as insignificant, based on our historical experience concerning product and patent infringement claims. Accordingly, we have no liabilities recorded for indemnification under these agreements as of
December 31, 2006.



We have agreements whereby our
officers and directors are indemnified for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these
indemnification agreements is unlimited; however, we have a directors and officers insurance policy that reduces our exposure and enables us to recover a portion of future amounts paid. As a result of our insurance policy coverage, we believe the
estimated fair value of these indemnification agreements is minimal. Accordingly, no liabilities have been recorded for these agreements as of December 31, 2006.



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



Warranties



We offer our customers a
warranty that our products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, we have no liabilities recorded
for these warranties as of December 31, 2006. We assess the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future.



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|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. As
of December 31, 2006, a hypothetical 100 basis point increase in interest rates would result in approximately a $9,000 decline in the fair value of our available-for-sale securities.



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



Credit Risk



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



In May 2006 and May 2005, we repurchased $40.3 million and $44.5 million, respectively, face value of its convertible notes
for $35.0 million and $34.8 million, respectively. In doing so, we liquidated investments that generated a realized loss of approximately $3,000 and $0.7 million, respectively, related to the repurchases. Certain portions of the hedge and warrant
transactions entered into by us in 2003 were terminated in connection with the repurchases. We believe that it was in the best interests of the stockholders to reduce the balance sheet debt despite the one-time loss resulting from the liquidation of
marketable securities.



Foreign Currency Exchange Rate Risk



A majority of our revenue, expense, and capital purchasing activities are
transacted in U.S. dollars. However, we transact some portions of our business in various foreign currencies, primarily related to a portion of revenue in Japan and operating expenses in Europe, Japan and Asia-Pacific. Accordingly, we are subject to
exposure from adverse movements in foreign currency exchange rates. As of December 31, 2006, we had approximately $14.0 million of cash and money market funds in foreign bank accounts. At this time, we have not deemed it to be cost effective to
engage in a program of hedging the effect of foreign currency fluctuations on our operating results using derivative financial instruments. 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



Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we
conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act), as
of the end of the period covered by this



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report (the Evaluation Date). Based on this evaluation, our principal executive officer and principal financial officer concluded as of the
Evaluation Date that our disclosure controls and procedures were effective such that information relating to us, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (SEC) reports
(i) is recorded, processed, summarized and reported within the periods specified in SEC rules and forms and (ii) is accumulated and communicated to our management, including our principal executive officer and principal financial officer,
as appropriate to allow timely decisions regarding required disclosure, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.



Changes in Internal Control over Financial Reporting



Under the supervision and with the participation of our management, including our principal executive officer and principal
financial officer, we conducted an evaluation of any changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during our most recently completed fiscal
quarter. Based on that evaluation, we concluded that there has not been any change in our internal control over financial reporting during that quarter that has materially affected, or is reasonably likely to materially affect, our internal control
over financial reporting.



Inherent Limitations on Effectiveness of Controls



In designing and evaluating our disclosure controls and
procedures, our management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met.
Further, the design of a control system must take into account the benefits of controls relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control
issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls
can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any disclosure controls and procedures also is based in part upon assumptions about the
likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. However, our disclosure controls and procedures have been designed to meet, and our
management believes that they meet, reasonable assurance levels.



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PART II. OTHER INFORMATION



|ITEM 1. | LEGAL PROCEEDINGS
|------- | -----------------



We are subject to some legal proceedings described below and from time to time, we are also involved in other disputes that arise in the ordinary course
of business. The number and significance of these litigation and disputes is increasing as our business expands and we grow 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 litigation and disputes could harm our business and have an adverse effect on our consolidated financial statements. However,
the results of any litigation or dispute are inherently uncertain and, at this time, no estimate could be made of the loss or range of loss, if any, from these litigation matters and disputes. Accordingly, we have not recorded any liabilities
relating to these contingencies as of December 31, 2006. Legal fees are expensed in the period in which they are incurred.



Litigation with Synopsys



Synopsys California Case



Synopsys, Inc. v. Magma Design Automation, Inc., Civil Action No. C04-03923, United States District Court, Northern District of California. In this
action, filed September 17, 2004, Synopsys has sued us for alleged infringement of U.S. Patent Nos. 6,378,114 (the 114 Patent), 6,453,446 (the 446 Patent), and 6,725,438 (the 438 Patent).
The patents-in-suit relate to methods for designing integrated circuits. The Complaint seeks unspecified monetary damages, injunctive relief, trebling of damages, fees and costs, and the imposition of a constructive trust for the benefit of Synopsys
over any profits, revenues or other benefits allegedly obtained by us as a result of our alleged infringement of the patents-in-suit. In addition to the below discussion, this case was also discussed in our Annual Report on Form 10-K for the fiscal
year ended April 2, 2006 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended July 2, 2006 and October 1, 2006.



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



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



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



On April 18, 2005, Synopsys, Inc. filed an action against us in Germany at the Landgericht München I (District Court in Munich) seeking to
obtain ownership of the European patent application corresponding to our



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446 Patent. The action has been stayed pending the outcome of the above-referenced Synopsys action filed in the United States. This action was also
discussed in our Annual Report on Form 10-K for the fiscal year ended April 2, 2006 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended July 2, 2006 and October 1, 2006.



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



On July 1, 2005, the Court granted Synopsyss motion for partial summary judgment regarding assignor estoppel, dismissing our affirmative
defenses and counterclaim alleging the invalidity of the 114 Patent.



On July 14, 2005, the Court vacated the hearings on our motion for summary judgment on the second through sixth causes of action in the Second Amended Complaint and Synopsyss motion for partial summary
judgment establishing unfair competition. The Court stated that it would reset the motions for hearing, if necessary, after the claims construction hearing scheduled for August 15, 2005.



On July 29, 2005, Synopsys moved to preliminarily enjoin us from
abandoning or dedicating to the public the 446 Patent or the 438 Patent. Also on July 29, 2005, Synopsys moved for partial summary judgment seeking dismissal of certain counterclaims and defenses asserted by us on the grounds of
estoppel by contract. On September 16, 2005, Synopsys filed a revised motion for preliminary injunction. On September 30, 2005, we filed our oppositions to Synopsyss preliminary injunction motion and estoppel by contract motion.



On July 29, 2005, Synopsys, Inc. filed an action against
us in Japan in Civil Department No. 40 of the Tokyo District Court seeking to obtain ownership of the Japanese patent application corresponding to our 446 Patent. The court has entered a defacto stay pending the outcome of the
above-referenced Synopsys action filed in the United States. The Japanese Court held hearings on January 18, 2006, March 6, 2006, July 11, 2006, October 23, 2006, and December 26, 2006, and set a further hearing for
February 28, 2007. This action was also discussed in our Annual Report on Form 10-K for the fiscal year ended April 2, 2006 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended July 2, 2006 and October 1,
2006.



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



On August 30, 2005, the Court issued a temporary restraining order against us restraining and enjoining us from taking
any steps in the United States Patent and Trademark Office (USPTO) to abandon, suspend or disclaim the 446 and 438 Patents, failing or refusing to pay the maintenance fees for the 446 and 438 Patents, or seeking
reexamination of the 446 and 438 Patents. The temporary restraining order was scheduled to remain in effect until the hearing on Synopsyss motion for a preliminary injunction that was scheduled for December 2,



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2005. On December 1, 2005, the Court vacated the hearing and granted Synopsyss motion for preliminary injunction. The Court entered the
preliminary injunction enjoining us from abandoning, dedicating to the public or seeking reexamination in the USPTO of the 446 Patent or the 438 Patent.



On September 2, 2005, we filed an Answer and Counterclaims to Synopsyss Third Amended Complaint. In that
pleading, we allege, inter alia, that IBM is a joint owner of the patents-in-suit and that, as a result, we cannot be liable for infringement because (1) Synopsys lacks standing to assert the patents-in-suit against us, and (2) IBM
has granted us a license under the patents-in-suit.



On
September 26, 2005, Synopsys, Inc. filed an action against us in the Superior Court of the State of California in and for the County of Santa Clara, entitled Synopsys, Inc. v. Magma Design Automation, Inc., et al., Case Number 105 CV
049638. Synopsys alleges that we committed unfair business practices by asserting defenses of non-infringement and invalidity to patent infringement allegations brought by Synopsys in the patent infringement action already pending against Magma in
the Northern District of California. The Complaint seeks unspecified monetary damages, an unspecified restitutionary/disgorgement award, injunctive relief, fees and costs, and an accounting of all revenues and profits derived from licensing the
technology at issue. On October 19, 2005, we removed the action to the United States District Court for the Northern District of California. On October 26, 2005, we moved to strike and dismiss the complaint. On October 27, 2005, the
Court granted our motion to relate the removed action with the preexisting patent infringement action, and both actions are now assigned to Judge Maxine M. Chesney. The Court vacated the hearing on our motion to strike and dismiss the complaint and
has taken the matter under submission. This action was also discussed in our Annual Report on Form 10-K for the fiscal year ended April 2, 2006 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended July 2, 2006 and
October 1, 2006.



On October 14, 2005, the Court
granted Synopsyss request for permission to file an amended opposition to our motion for summary judgment on the second through sixth causes of action in the Second Amended Complaint. Synopsys filed its amended opposition on December 20,
2005, and we filed our reply on January 13, 2006. The motion was set for hearing on January 27, 2006, but the Court vacated the hearing date and took the matter under submission.



On October 19, 2005, the Court granted in part and denied in part
Synopsyss motion to strike certain affirmative defenses and to dismiss certain counterclaims in our Answer and Counterclaims to Synopsyss Third Amended Complaint. The Court dismissed without leave to amend our counterclaims seeking
correction of inventorship of the 446 and 438 Patents. The Court also struck without leave to amend our affirmative defenses of (1) invalidity of the 446 and 438 Patents based on failure to name all inventors,
(2) unenforceability of the 446 and 438 patents due to inequitable conduct, and (3) unclean hands. The Court struck with leave to amend our affirmative defenses of invalidity of the 446 and 438 Patents based on 35
U.S.C. §§ 102, 103 and 112, as well as our affirmative defense that Synopsys is not the owner of any invention defined by the claims of the 446 and 438 Patents. On October 24, 2005, we filed a motion for summary judgment
as to the first cause of action (for patent infringement) in Synopsyss Third Amended Complaint on the grounds that IBM is an owner of all the patents-in-suit. Also on October 24, 2005, Synopsys filed (1) a motion for partial summary
judgment to dismiss our joint ownership defenses and counterclaims, and (2) a motion for partial summary judgment to dismiss allegations of co-ownership based on judicial and quasi-estoppel.



On November 2, 2005, we filed a motion for leave to file an amended
answer and counterclaims to Synopsyss Third Amended Complaint, requesting leave to amend our answer to add affirmative defenses of invalidity of the 446 and 438 Patents based on 35 U.S.C. §§ 102, 103 and 112. Our motion
was set for hearing on December 16, 2005, but the Court vacated the hearing date and took the matter under submission.



On November 8, 2005, Synopsys filed a motion for sanctions against us based on our assertion of non-infringement defenses and counterclaims in the
litigation. We opposed the motion, which was set for hearing on December 16, 2005. The hearing was vacated and the motion was taken under submission by the Court.



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On November 8, 2005, we filed a motion seeking leave to file a motion for reconsideration of the
Courts October 19, 2005 Order striking certain of our defenses without leave to amend. The Court granted our request on November 21, 2005. On December 9, 2005, we filed a motion for reconsideration of the Courts
October 19, 2005 Order striking our affirmative defense of unclean hands and for leave to amend our answer to assert an unclean hands defense. The motion was set for hearing on January 13, 2006, but the Court vacated the hearing and took
the matter under submission.



On December 23, 2005,
Synopsys filed a motion for partial summary judgment regarding our statute of limitations defense. We opposed the motion, which was set for hearing on January 27, 2006. The hearing was vacated and the motion taken under submission by the Court.



On December 29, 2005, we filed a notice of interlocutory
appeal to the Court of Appeals for the Federal Circuit of the Courts December 1, 2005, preliminary injunction against us. By agreement of the parties, we have dismissed the appeal.



On January 20, 2006, we filed a motion to bifurcate the trial into
issues of patent ownership and all other issues. The parties subsequently stipulated to bifurcate the case with patent ownership to be tried first.



Fact and expert discovery relating to patent ownership have closed. By stipulation so-ordered on March 13, 2006, the parties have agreed to schedule
any remaining discovery after the patent ownership trial is resolved.



By order dated March 30, 2006, the Court denied our motion for summary judgment regarding patent ownership, as well Synopsyss motions (1) for partial summary judgment based on estoppel by contract, (2) for partial
summary judgment to dismiss our joint ownership defenses and counterclaims, and (3) for partial summary judgment to dismiss allegations of co-ownership based on judicial and quasi-estoppel. The parties subsequently stipulated (a) that we
would withdraw our claim to ownership of the 446 and 438 Patents on the basis that the buckets claims (i.e., Claims 17, 18, 31, and 32 of the 446 Patent and Claims 17 and 18 of the 438 Patent) were conceived by
Magma engineers after Lukas van Ginneken left Synopsys and (b) that Synopsys would withdraw its assertion that we would be foreclosed from arguing that the inventions in the 446 and 438 Patents were reduced to practice after van
Ginneken left Synopsys.



The ownership case was tried to the
Court, without a jury, from April 24, 2006 through May 10, 2006. The parties opening post-trial briefs and findings of fact and conclusions of law were filed June 9, 2006. The parties reply post-trial briefs were filed
June 30, 2006.



On August 8, 2005, we filed a request
for ex parte reexamination of the 114 Patent. On September 22, 2005, the USPTO instituted a reexamination proceeding, indicating that a substantial new question of patentability was raised by the request. On August 5, 2006, the USPTO
rejected all pending claims (1-15) of the 114 Patent. In response to that office action, Synopsys canceled all the independent claims of the patent.



On August 18, 2006, a third party submitted requests for ex parte reexamination of the 446 and 438 Patents to the USPTO. The USPTO
received those requests on August 23, 2006.



On
September 1, 2006, Synopsys filed a motion for preliminary injunction that sought to require the Company (1) to seek a stay of reexamination of the 446 and 438 Patents or transfer ownership of the 446 and 438
Patents to Synopsys so that Synopsys may participate in the reexamination proceedings, and (2) to refrain from filing a patent owners statement in any reexamination proceedings for the 446 and 438 Patents. On
September 14, 2006, we filed an opposition to Synopsyss motion. On September 29, 2006, the Court issued an order denying the motion, without prejudice to Synopsyss refiling the motion if and when the USPTO issues an order for
reexamination of the 446 or 438 Patent.



On
November 25, 2006, the PTO granted a request for reexamination of the 438 Patent. On December 1, 2006, Synopsys moved for a preliminary injunction seeking an order that we (1) withdraw our claims of



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ownership of the 446 and 438 Patents and execute a quitclaim assignment transferring title in the patents to Synopsys, or, alternatively,
(2) seek a stay in the PTO of any reexamination proceedings of the 446 and 438 Patents.



On December 26, 2006, we filed a second request for reexamination of the 114 Patent.



On January 3, 2007, the court ordered us to withdraw our claim of
ownership of the 446 and 438 Patents and to execute a quitclaim assignment transferring title in the 446 and 438 Patents to Synopsys. On January 5, 2007, we executed a Quitclaim Assignment of the 446 and 438
Patents to Synopsys and recorded the assignment with the PTO. On January 10, 2007, the PTO granted the request for reexamination of the 446 Patent. Thus, all three patents-in-suit are in reexamination.



On January 29, 2007, we filed a motion to stay the action pending the
conclusion of the reexaminations of the 114, 446 and 438 Patents.



On January 31, 2007, the Court issued its Memorandum of Decisions and Findings of Fact and Conclusions of Law Regarding Ownership Trial. The Court concluded that IBM and Synopsys are joint owners of the 446
and 438 Patents, and ordered Synopsys to take all steps necessary to add IBM as a joint owner of record of the 446 and 438 Patents. The Court also concluded that IBM and Synopsys are joint owners of certain foreign and continuation
applications based on the 446 and 438 Patents, namely, United States Patent Applications Nos. 10/828,547, 11/245,530, and 11/246, 451; Japan Patent Application No. JP20000526885T; Israel Patent Application No. IL136709D; Canada Patent
Application No. CA2317538; European Patent Application No. EP1040435; and International Patent Application No. WO9934310. The Court ordered us to take all necessary steps to transfer those applications to Synopsys and IBM. The Court also concluded
that Synopsys is the sole owner of the 114 Patent.



On
February 6, 2007, the Court issued an order denying our motion for leave to amend our answer to assert defenses alleging the invalidity of the 446 and 438 Patents. The Court based its decision on a finding that Magma is barred from
asserting the invalidity of those patents by the doctrine of assignor estoppel. Also on February 6, 2007, the Court issued an order denying our motion for reconsideration and for leave to amend our answer to assert an unclean hands defense. One
of our bases for moving for leave to assert this defense was an argument that Synopsys improperly withheld evidence that the 446 and 438 patents were invalid under the on-sale bar. The Court rejected this argument, holding that because
assignor estoppel bars us from asserting the invalidity of the 446 and 438 Patents, we may not circumvent this doctrine by asserting invalidity arguments (which include the on-sale bar) in the guise of an unclean hands defense.



Synopsys Delaware Case



On September 26, 2005, Synopsys, Inc. filed an action against us in
Delaware federal court, Synopsys, Inc. v. Magma Design Automation, Inc., Civil Action No. 05-701. The Complaint alleges infringement of U.S. Patent Nos. 6,434,733 (the 733 Patent), 6,766,501 (the 501
Patent), and 6,192,508 (the 508 Patent). The patents-in-suit relate to methods for designing integrated circuits. The Complaint seeks unspecified monetary damages, injunctive relief, trebling of damages, fees and costs, and
the imposition of a constructive trust for the benefit of Synopsys over any profits, revenues or other benefits allegedly obtained by us as a result of our alleged infringement of the patents-in-suit. In addition to the below discussion, this case
was also discussed in our Annual Report on Form 10-K for the fiscal year ended April 2, 2006 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended July 2, 2006 and October 1, 2006.



On October 19, 2005, we filed our answer and counterclaims
(Answer) to Synopsyss Complaint. The Answer asserts that our products do not infringe the patents-in-suit, that the patents-in-suit are unenforceable, and that the 733 Patent and the 501 Patent were fraudulently
obtained by Synopsys and are therefore unenforceable. The Answer also asserts antitrust and unfair competition counterclaims based on Synopsyss anti-competitive



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behavior, monopolistic tactics, and its assertion of the 733 and 501 Patents, as well as claims for product disparagement, trade libel, and
tortious interference with business relations. The counterclaims seek treble damages and other equitable relief for Synopsyss anticompetitive and tortuous conduct.



On October 25, 2005, we filed an Amended Answer, adding a counterclaim for infringement of U.S. Patent
No. 6,505,328 (the 328 Patent). The 328 Patent relates to methods for designing integrated circuits. We seek treble damages and an injunction against Synopsys for the sale and manufacture of products we allege infringe
the 328 Patent.



On November 22, 2005, Synopsys
filed a motion to dismiss our antitrust and other commercial counterclaims. We opposed that motion on December 7, 2005. Synopsys filed its reply brief on December 14, 2005. The Court denied Synopsyss motion on May 25, 2006.



On January 9, 2006, Synopsys filed a request for the
United States Patent and Trademark Office to reexamine its 733 and 501 Patents in light of two prior art references that it had not previously disclosed to the Patent Office. On January 23, 2006, Synopsys filed a motion with the
Court to bifurcate and stay its claims for infringement of its 733 and 501 Patents and our counterclaims except for its claim for infringement of the 328 Patent, based in part on Synopsyss having filed the request for patent
reexamination. Our opposition to that motion was filed on February 6, 2006. The Court denied Synopsyss motion on May 25, 2006.



On March 24, 2006, we filed a motion for leave to file a Second Amended Answer and Counterclaims, to add counterclaims for infringement of U.S.
Patent Nos. 6,519,745 (the 745 Patent), 6,931,610 (the 610 Patent), 6,854,093 (the 093 Patent), and 6,857,116 (the 116 Patent). All four patents relate to methods for designing
integrated circuits. Synopsys opposed the motion on April 7, 2006. We filed our reply brief on April 14, 2006. The Court granted our motion on May 25, 2006, and we filed our Second Amended Answer and Counterclaims on May 31,
2006.



On June 13, 2006, the parties held a conference
with the Court at which, among other things, Synopsys requested that the trial be delayed until late 2007. The Court denied Synopsyss request. Fact discovery is ongoing and is currently scheduled to close on February 28, 2007, and trial
is scheduled for June 11, 2007.



On August 25, 2006,
we dropped our allegation that Synopsys infringes the 610 Patent. On September 15, 2006, Synopsys dropped its claims that we infringes the 733 and 501 Patents. On October 13, 2006, Synopsys filed a second motion to
bifurcate the trial as to the antitrust claims and to stay antitrust discovery, based in part on the fact that the 733 and 501 Patents are no longer being asserted. We filed our opposition to that motion on October 27, 2006, and the
Court denied that motion on January 22, 2007.



A claim
construction hearing before the Court was held on November 29, 2006. Trial remains scheduled for June 11, 2007.



We intend to vigorously defend against all claims asserted by Synopsys and to fully enforce our rights against Synopsys. However, the results of any
litigation are inherently uncertain and we can not assure that we will be able to successfully defend against the Synopsys claims. A favorable outcome for Synopsys could have a material adverse effect on our financial position, results of operations
or cash flows. We are currently unable to assess the extent of damages and/or other relief, if any, that could be awarded to Synopsys.



Other Litigation



On June 13, 2005, a putative shareholder class action lawsuit captioned The Cornelia I. Crowell GST Trust vs. Magma Design Automation, Inc.,
Rajeev Madhavan, Gregory C. Walker and Roy E. Jewell., No. C 05 02394, was filed in U.S. District Court, Northern District of California. The complaint alleges that defendants failed to disclose information regarding the risk of Magma infringing
intellectual property rights of Synopsys, Inc., in



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violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and prays for unspecified damages. In March 2006,
defendants filed a motion to dismiss the consolidated amended complaint. Plaintiff filed a further amended complaint in June 2006, which defendants again moved to dismiss. Defendants motion was granted in part and denied in part by an order
dated August 18, 2006, which dismissed claims against two of the individual defendants. The case is now proceeding on the remaining claims. This lawsuit was also discussed in our Annual Report on Form 10-K for the fiscal year ended
April 2, 2006 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended July 2, 2006 and October 1, 2006.



On July 26, 2005, a putative derivative complaint captioned Susan Willis v. Magma Design Automation, Inc. et al., No. 1-05-CV-045834, was
filed in the Superior Court of the State of California for the County of Santa Clara. The Complaint seeks unspecified damages purportedly on behalf of us for alleged breaches of fiduciary duties by various directors and officers, as well as for
alleged violations of insider trading laws by executives during a period between October 23, 2002 and April 12, 2005. Defendants have demurred to the Complaint, and the action has been stayed pending further developments in the putative
shareholder class action referenced above. This lawsuit was also discussed in our Annual Report on Form 10-K for the fiscal year ended April 2, 2006 and in our Quarterly Reports on Form 10-Q for the quarterly periods ended July 2, 2006 and
October 1, 2006.



Narpat Bhandari v. Magma Design
Automation, Inc. Cadence Design Systems, Inc., Dynalith Systems, Inc., Altera Corp., Mentor Graphics, Corp. and Aldec, Inc., Case No. 6:06-CV-480, United States District Court, Eastern District of Texas, Tyler Division. On November 8,
2006, a complaint was filed alleging that we and several other named defendants infringe United States Patent No. 5,663,900. The complaint identifies our FineSim software, and other unidentified devices or programs, as the products accused of
infringement. We have extended the time to answer the complaint until February 12, 2007. The complaint seeks unspecified monetary damages, attorneys fees, and costs. We intend to vigorously defend against the claims asserted by Bhandari.
However, the results of any litigation are inherently uncertain and we can not assure that we will be able to successfully defend against Bhandaris claims. We are currently unable to assess the extent of damages and/or other relief, if any,
that could be awarded to Bhandari.



|ITEM 1A. | RISK FACTORS
|-------- | ------------



A restated description of the risk factors associated with our business is set forth below. This description includes any material changes to and
supersedes the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended April 2, 2006.



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 major software product, Blast Fusion, in April 1999. We have a
limited history of generating revenue from our software products, and the revenue and income potential of our business and market is still unproven. As a result of our short operating history, we have limited financial data that can be used to
evaluate our business. We have only been profitable in fiscal 2003 and fiscal 2004. Our software products represent a new approach to the challenges presented in the electronic design automation, or EDA, 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 use our 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.



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We have a history of losses, except for fiscal 2003 and fiscal 2004, and had an accumulated deficit of approximately
$173.3 million as of December 31, 2006; if we continue to incur losses, the trading price of our stock would likely decline.



We had an accumulated deficit of approximately $173.3 million as of December 31, 2006. Except for fiscal 2003 and fiscal 2004, we incurred losses in
all other fiscal years. If we continue to incur losses, or if we fail to achieve profitability at levels 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 is likely to decline.



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



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



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



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



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



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



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



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



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



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



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



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



| |  |  | variability in stock-based compensation charges related to our option exchange program;
| | - |  | ---------------------------------------------------------------------------------------



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



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



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



We currently face lawsuits brought by Synopsys, Inc. related to patent infringement and other claims, and we may face additional
intellectual property infringement claims or other litigation. Lawsuits can be costly to defend, can take the time of our management and employees away from day-to-day operations, and could result in our losing important rights and paying
significant damages.



Synopsys, Inc. has filed various
suits, including for patent infringement, against us (please see the discussion in Part II, Item 1, Legal Proceedings.) In addition, a putative shareholder class action lawsuit and a putative derivative lawsuit have been filed
against us (please see the discussion in Part II, Item 1, Legal



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Proceedings.) Other related litigation may follow. In the future other parties may assert intellectual property infringement claims against us or our
customers. We may have acquired or may in the future acquire software as a result of our acquisitions, and we could be subject to claims that such software infringes the intellectual property rights of third parties. In addition, we are often
involved in or threatened with commercial litigation unrelated to intellectual property infringement claims such as labor litigation and contract claims, and we may acquire companies that are actively engaged in such litigation.



Our products may be found to infringe intellectual property rights of third
parties, including third-party patents. In addition, many of our contracts contain provisions in which we agree to indemnify our customers from third-party intellectual property infringement claims that are brought against them based on their use of
our products. Also, we may be unaware of filed patent applications that relate to our software products. We believe that patent portfolios of our competitors are far larger than ours. This disparity between our patent portfolio and the patent
portfolio of our competitors 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.



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



Publicly announced developments in our litigation matters may cause our stock
price to decline sharply and suddenly. Other factors may reduce the market price of our common stock, and we are subject to ongoing risks of securities class action litigation related to volatility in the market price for our common stocks.



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



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



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



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



Retaining our employees has become more challenging due to the decline in our stock price over the past several years. Many of the stock options held by our employees may have an exercise price that is significantly



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higher than the current trading price of our stock, and these underwater options do not serve their purpose as incentives for our employees to
remain with Magma. Although, as discussed below, we have attempted to address this problem in part via a stock option exchange program that allowed eligible employees to exchange existing underwater options for options exercisable for a smaller
number of shares at the price of $9.20 per share, we cannot guarantee that this program will satisfy our employees. In addition, the increased volatility of our stock price due to the pendency of, and developments in, the Synopsys litigation and the
above-referenced shareholder litigation may affect employee morale. Furthermore, in light of our adopting SFAS 123R Share-Based Payment in the first quarter of our fiscal year 2007, we have changed our employee compensation practices,
and those changes could make it harder for us to retain existing employees and attract qualified candidates. If we lose the services of a significant number of our employees and/or if we cannot hire additional employees of the same caliber, we will
be unable to increase our sales or implement or maintain our growth strategy.



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



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



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



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



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



Customers for our software products typically commit significant resources to evaluate available software. The complexity of
our products requires us to spend substantial time and effort to assist potential customers in evaluating our software and in benchmarking it against our competition. As the complexity of the products we sell increases, we expect the sales cycle to
lengthen. In addition, potential customers may be limited in their current spending by existing time-based licenses with their legacy vendors. In these cases, customers delay a significant new commitment to our software until the term of the
existing license has expired. Also, because our products require a significant investment of time and cost by our customers, we must target those individuals within our 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



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below expectations. Furthermore, technological changes, litigation risk or other competitive factors could cause some customers to shorten the terms of their
licenses significantly, and such shorter terms could in turn have an impact on our total results for orders for this fiscal year.



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. For the nine months ended December 31, 2006, our top three customers together accounted
for approximately 19% 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 could be harmed.



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



Some contracts with extended payment terms provide for payments which are weighted toward the later part of the contract
term. Accordingly, for bundled agreements, 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
unbundled agreements, as the payment terms are extended, the revenue from these contracts is recognized as amounts become due and payable. 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 EDA market and competition is
increasing among EDA vendors as customers tightly control their EDA spending and use fewer vendors to meet their needs. If we cannot compete successfully, we will not gain market share and our revenue could decline.



We currently compete with companies that hold dominant shares in the
electronic design automation market, such as Cadence, Synopsys and Mentor. 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. Competition and corresponding pricing pressures among EDA vendors or other factors might be causing
or might cause in the future the overall market for EDA products to have low growth rates, remain relatively flat or even decrease in terms of overall dollars. Our competitors offer a more comprehensive range of products than we do; for example, we
do not offer logic simulation, full-feature custom layout editing, analog or mixed signal implementation 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 and liquidity.



Competition in the EDA market has increased as customers rationalized their EDA spending by using products from fewer EDA vendors. Continued consolidation
in the electronic design automation market could



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



Also, a variety of small companies continue to emerge, developing and introducing new products which may compete with our 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 either cause potential customers to defer purchases of
our products or cause potential customers to decide against purchasing our products. If we fail to compete successfully, we will not gain market share, or our market share may decrease, and our business may fail.



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



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



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



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



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



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



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



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



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



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



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



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



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



Many of our customers are currently working
on 90-nanometer designs. We continue to work toward developing and enhancing our product line in anticipation of increased customer demand for 65-nanometer (sub-90 nanometer) design geometries. Similarly, we have acquired Mojave personnel and
technology to better address the needs of potential or existing customers to design and verify semiconductors that are manufacturable with higher yield and performance, which is a key design parameter when moving to 65-nanometer geometries.
Notwithstanding our efforts to support 65-nanometer geometries, customers may fail to adopt or may be slower to adopt 65-nanometer geometries and we may be unable to convince our customers to purchase our related software products. Accordingly, any
revenues we receive from enhancements to our products or acquired technologies may be less than the development or acquisition costs. If customers fail to adopt 65-nanometer design geometries or are slow to adopt 65-nanometer design geometries, our
operating results may be harmed. In addition, if customers are not able successfully to make profits as they adopt smaller geometries, demand for our products may be adversely affected, and our operating results may be harmed.



Our operating results will be harmed if chip designers do not adopt Blast Fusion, Talus,
FineSim, Quartz family of products or our other current and future products.



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



In the event that the
changes we made to our organizational structure in fiscal 2006 result in ineffective interoperability between our products or ineffective collaboration among our employees, then our operating results may be harmed.



We changed our organizational structure in fiscal 2006 to establish major
business units that are responsible for our various products. If this new organizational structure results in ineffective interoperability between our products or ineffective collaboration among our employees, then our operating results may be
harmed. For example, if this new organizational structure is not successful, we could experience delays in new product development that could cause us to lose customer orders, which could harm our operating results.



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 consolidation among our customers would harm our business and financial
condition.



The primary customers for our products are
companies in the communications, computing, consumer electronics, networking and semiconductor industries. Any significant downturn in our customers markets or in general economic conditions that results in the cutback of research and
development budgets or the delay of software purchases would likely result in lower demand for our products and services and could harm our business. For example, the United States economy, including the semiconductor industry, experienced a
slowdown starting in 2000 which negatively impacted and may continue to negatively impact our business and operating results. While the semiconductor industry experienced a recovery in recent years, our customers have remained cautious. The
continuing threat of terrorist attacks in the United States, the ongoing events in Iraq and North Korea and other worldwide events including those in the Middle East have increased uncertainty in the



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United States economy. If the economy declines as a result of this economic, political and social turmoil, existing customers may delay their implementation
of our software products and prospective customers may decide not to adopt our software products, either of which could negatively impact our business and operating results.



The electronics industry has historically been subject to seasonal and cyclical fluctuations in demand for its products, and
this trend may continue in the future. These industry downturns have been, and may continue to be, characterized by diminished product demand, excess manufacturing capacity and subsequent erosion of average selling prices. Any such seasonal cyclical
industry downturns could harm our operating results.



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



To succeed, we will need to develop innovative new products. We may not have the financial resources necessary to fund all required future innovations.
Expanding into new technologies or extending our product line into areas we have not previously addressed may be more costly or difficult than we presently anticipate. Also, any revenue that we receive from enhancements or new generations of our
proprietary software products may be less than the costs of development. If we fail to develop and market new products in a timely manner, or if new products do not meet performance features as marketed, our reputation and our business could suffer.



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



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



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



Our products depend on complex software, both internally developed and acquired or 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 or meet the performance features as marketed, 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, some of which agreements provide the customer with a right of refund for the license fees if we are unable to correct errors reported during the
warranty period. If our contractual limitations are unenforceable in a particular jurisdiction or if we are exposed to claims that are not covered by insurance, a



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successful claim could harm our business. We currently carry insurance coverage and limits that we believe are consistent with similarly situated companies
within the EDA industry, however, our insurance coverage may prove insufficient to protect against any claims that we experience.



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 30% of our total revenue from sales outside North America during the first three quarters of fiscal 2007,
compared to 33% for fiscal year 2006 and 43% for fiscal year 2005. 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.



As we expand our international operations, we will need to maintain sales offices in Europe, the Middle East, and the Asia
Pacific region. If our revenue from international operations does not exceed the expense of establishing and maintaining our international operations, our business could suffer. Additional risks we face in conducting business internationally
include:



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



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



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



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



| |  |  | on-going events in Iraq and the Middle East;
| | - |  | --------------------------------------------



| |  |  | 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 unexpected adverse revenue fluctuations.



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



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



Recently enacted changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and the
listing requirements for The Nasdaq Stock Market have imposed duties on us and on our executives, directors, attorneys and independent registered public accounting firms. In order to comply with these new rules, we have hired additional personnel
and use additional outside legal, accounting and advisory services, all of which have increased and may further increase our operating expenses over time. In particular, we have incurred and will continue to incur additional administrative expenses
relating



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to the implementation of Section 404 of the Sarbanes-Oxley Act, which requires that we implement and maintain an effective system of internal controls
and annual certification of our compliance by our independent auditor. For example, we have incurred significant expenses and will continue to incur expenses in connection with the implementation, documentation and continued testing of our internal
control systems. Management time associated with these compliance efforts necessarily reduces time available for other operating activities, which could adversely affect operating results. For the years ended April 2, 2006 and
March 31,2005, our independent registered public accounting firm certified that we were in compliance with the provision of Section 404 relating to effective internal control over financial reporting; however, our internal control
obligations are ongoing and subject to continued review and testing. If we are unable to maintain full and timely compliance with these and other regulatory requirements, we could be required to incur additional costs, expend additional management
time on remedial efforts and make related public disclosures that could adversely affect our stock price and result in securities litigation. Further, a failure to comply with Section 404 could cause us to delay filing our public reports,
potentially resulting in de-listing by the Nasdaq Stock Market.



The
effectiveness of disclosure controls is inherently limited.



We do not expect that our disclosure controls and procedures, or our internal control over financial reporting, will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable,
not absolute, assurance that the control system objectives will be met. The design of a control system must also reflect applicable resource constraints, and the benefits of controls must be considered relative to their costs. As a result of these
inherent limitations, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. Failure of the control systems to prevent error or fraud could materially
adversely impact our financial results and our business.



Forecasting our
tax rates is complex and subject to uncertainty.



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



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



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



| |  |  | future changes in ownership that may limit realization of certain assets;
| | - |  | -------------------------------------------------------------------------



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



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



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



Our success will depend on our ability to keep pace with the rapidly evolving technology standards of the semiconductor industry; if we are unable to keep pace, 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;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



If we fail to offer and maintain competitive equity compensation 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 equity compensation packages, which offer incentives above traditional compensation only where there is a consistent, long-term upward trend over
time of a companys stock price. Our stock price has declined significantly over the past several years due to market conditions and has recently been negatively affected by uncertainty surrounding the outcome of our litigation with Synopsys,
Inc. discussed above under Part II, Item 1, Legal Proceedings.



On June 22, 2005, our stockholders approved a stock option exchange program (Exchange Program) allowing non-executive employees holding options to purchase our common stock at exercise prices greater
than or equal to $10.50 to exchange those options for a smaller number of new options at an exercise price equal to fair market value on the date of grant. We implemented this Exchange Program, and the date of grant was August 22, 2005, at
which date the closing trading price of our stock was $9.20 per share. Therefore, the exercise price for new options under this Exchange Program is $9.20 per share. If this exercise price of $9.20 per share or the terms of the Exchange Program are
not satisfactory to employees who participate in the Exchange Program, our ability to retain employees could be affected.



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



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



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



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



Due to changes in the accounting treatment for employee stock options, we have changed our employee compensation practices, and our reported results of operations have
been and will likely continue to be adversely affected.



Until April 2, 2006, we accounted for the issuance of employee stock options under principles that do not require us to record compensation expense for options granted at fair market value. In December 2004, the FASB issued SFAS 123R,
Share-Based Payment, which eliminates the ability to account for share-based compensation transactions using APB 25, and generally requires instead that such transactions be accounted for using a fair-value based method. Under SFAS 123R,
companies are required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. We adopted the new rules in the first quarter of our fiscal year 2007. This
change in accounting treatment has resulted and will continue to result in significant additional compensation expense compared to prior periods and has adversely affected and will likely continue to adversely affect our reported results of
operations and hinder our ability to achieve profitability. We are continuing to assess the full impact of the adoption of SFAS 123R on our business practices and, as part of that assessment, have changed our employee compensation practices by, for
example, issuing more restricted stock and less stock options. These changes could make it harder for us to retain existing employees and attract qualified candidates.



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



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



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



Periods of growth followed by efforts to realign costs
when revenue growth is slower than anticipated have placed a strain on our management, administrative and financial resources. For example, in fiscal year 2005 we decreased our workforce by 23 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 hinder our efforts to adequately manage our growth, disrupt operations, lead to deficiencies in our internal controls and financial
reporting and ultimately harm our business.



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 customers design flow. Currently, our software is designed to interface with the existing software of Cadence, Synopsys and others. If we are unable
to convince customers to adopt our software products instead of those of competitors offering a broader set of products, or if we are unable to convince other software companies to work with us to interface our software with theirs to meet the
demands of chip designers and manufacturers, our business and operating results will suffer.



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



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



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



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



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



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



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



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



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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;
| | - |  | ------------------------------------------------------------------------



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



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



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



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



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



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



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



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



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



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



Delaware law, as well as our certificate of incorporation and bylaws,
contain anti-takeover provisions that could delay or prevent a change in control of our company, even if the change of control would be beneficial to



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the stockholders. These provisions could lower the price that future investors might be willing to pay for shares of our common stock. These anti-takeover
provisions:



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



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



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



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



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



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



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 a portion of revenue in Japan and operating
expenses in Europe, Japan and Asia-Pacific, which are denominated in the respective local currencies. As of December 31, 2006, we had approximately $14.0 million of cash and money market funds in foreign bank accounts. At this time, we have not
deemed it to be cost effective to engage in a program of hedging the effect of foreign currency fluctuations on our operating results using derivative financial instruments. While we assess the need to utilize financial instruments to hedge currency
exposures on an ongoing basis, our assessments may prove incorrect.



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



In May 2003, we issued $150.0 million
principal amount of zero coupon convertible notes due May 2008. In May 2005, we repurchased, in privately negotiated transactions, $44.5 million face amount (or approximately 29.7% of the total) of these notes at an average discount to face value of
approximately 22%. In addition, in May 2006, we repurchased another $40.3 million face amount (approximately 38.2% of the remaining principal) of these notes at an average discount to face value of approximately 13%. We spent an aggregate of
approximately $34.8 million and $35.0 million, respectively, on the repurchases in May 2005 and May 2006. The repurchases leave approximately $65.2 million aggregate principal amount of convertible subordinated notes outstanding. We will be required
to repay that principal amount in full in May 2008 unless the holders of those notes elect to convert them into our common stock before the repayment date. The conversion price of the notes is $22.86 per



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share. If the price of our common stock does not rise above that level, conversion of the notes is unlikely and we would be required to repay the principal
amount of the notes in cash. There have been previous quarters in which we have experienced shortfalls in revenue and earnings from levels expected by securities analysts and investors, which have had an immediate and significant adverse effect on
the trading price of our common stock. In addition, the stock market in recent years has experienced extreme price and trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual
companies. These broad market fluctuations may adversely affect the price of our stock, regardless of our operating performance. Because the notes are convertible into shares of our common stock, volatility or depressed prices for our common stock
could have a similar effect on the trading price of the notes.



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



We entered into hedging arrangements with Credit Suisse First Boston International at the time we issued our convertible notes, with the objective of
reducing the potential dilutive effect of issuing common stock upon conversion of the notes. At the time of our May 2005 and May 2006 repurchases of our zero coupon convertible notes, portions of the hedging arrangements were retired. These hedging
arrangements are likely to have caused Credit Suisse First Boston International and others to take positions in our common stock in secondary market transactions or to enter into derivative transactions at or after the sale of the notes. Any market
participants entering into hedging arrangements are likely to modify their hedge positions from time to time prior to conversion or maturity of the 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.



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



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



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



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



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



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



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



Recent Sales of Unregistered Securities



During the third quarter of fiscal 2007, we issued 514,793 shares of our common stock as part of the contingent consideration in connection with our
acquisition of Mojave, Inc. pursuant to a definitive agreement signed on February 23, 2004. The contingent share consideration was based on Mojaves achievement of certain technology milestones and product orders. We may issue additional
contingent share consideration of up to $37.8 million based on additional product orders over the period ending March 31, 2009. These securities were issued in reliance upon the exemption from the registration requirements of the Securities Act
of 1933 provided by Section 3(a)(10) thereof.



Purchases of Equity
Securities by the Issuer



The following table shows
repurchases of shares of our common stock in the third quarter of fiscal 2007:



|                               |  |                                  |   |  |                              |       |                                                                              |   |                                                                                       |    
|------------------------------ |  | -------------------------------- | - |  | ---------------------------- | ----- | ---------------------------------------------------------------------------- | - | ------------------------------------------------------------------------------------- | ---
|Period                         |  | Total Number of Shares Purchased |   |  | Average Price Paid per
Share |       | Total Number ofShares Purchased asPart of PubliclyAnnounced Plans orPrograms |   | Approximate Dollar Value ofShares that May Yet BePurchased Under the Plansor Programs
|October 2  October 31, 2006   |  | 40,110                           |   |  | $                            | .0001 |                                                                              | 0 |                                                                                       | N/A
|November 1  November 30, 2006 |  | 16,312                           |   |  | $                            | 7.25  |                                                                              | 0 |                                                                                       | N/A
|December 1  December 31, 2006 |  | 2,436                            |   |  | $                            | .0001 |                                                                              | 0 |                                                                                       | N/A
|                               |  |                                  |   |  |                              |       |                                                                              |   |                                                                                       |    
|Total                          |  | 58,858                           | * |  | $                            | 2.01  |                                                                              | 0 |                                                                                       | N/A

---

|* | Includes 13,099 shares repurchased at $9.03, the fair market value on the repurchase date, in order to satisfy tax withholding obligations associated with the vesting of restricted
shares. The remaining shares that were repurchased were forfeitures of restricted stock as a result of employee terminations.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|ITEM 6. | EXHIBITS
|------- | --------



The following documents are filed as Exhibits to this report:



|               |  |                                                                                                                                                                                                    |  |                           |  |                |  |             |  |                  |  |  
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- |  | -------------- |  | ----------- |  | ---------------- |  | -
|Exhibit Number |  | Exhibit Description                                                                                                                                                                                |  | Incorporated by Reference |  | Filed Herewith
|               |  | Form                                                                                                                                                                                               |  | File No.                  |  | Exhibit        |  | Filing Date | 
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|2.1            |  | Agreement and Plan of Reorganization, dated February 23, 2004, by and among the Registrant, Motorcar Acquisition Corp., Auto Acquisition Corp., Mojave, inc. and Vivek Raghavan, as
Representative |  | 8-K                       |  | 000-33213      |  | 2.1         |  | May 14,2004      |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|3.1            |  | Amended and Restated Certificate of Incorporation                                                                                                                                                  |  | 10-K                      |  | 000-33213      |  | 3.1         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|3.2            |  | Certificate of Correction to the Amended and Restated Certificate of Incorporation                                                                                                                 |  | 10-K                      |  | 000-33213      |  | 3.2         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|3.3            |  | Amended and Restated Bylaws                                                                                                                                                                        |  | 10-K                      |  | 000-33213      |  | 3.3         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|4.1            |  | Amended and Restated Investors Rights Agreement dated July 31, 2001, by and among the Registrant and the parties that are signatories thereto                                                     |  | 10-K                      |  | 000-33213      |  | 4.2         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|4.2            |  | Form of Common Stock Certificate                                                                                                                                                                   |  | S-1/A                     |  | 333-60838      |  | 4.1         |  | November 15,2001 |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|10.1           |  | Office Lease Agreement between Registrant and CA-Skyport I Limited Partnership dated December 28, 2006                                                                                             |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|10.2           |  | Sub-Sub Lease Agreement between Registrant and Siemens Communications Inc. dated November 15, 2006 and becoming effective on December 28, 2006                                                     |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|31.1           |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                 |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|31.2           |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                 |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|32.1           |  | Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*                                       |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|32.2           |  | Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*                                       |  |                           |  |                |  |             |  |                  |  | X

---

|* | As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Quarterly Report on Form 10-Q and are not deemed filed with the Securities and Exchange
Commission and are not incorporated by reference in any filing of Magma Design Automation, Inc. under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general
incorporation language in any filings.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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 8, 2007 |  |  |  | By |  | /s/    PETER S. TESHIMA      
|                        |  |  |  |    |  |                               |  | Peter S. Teshima, Corporate Vice PresidentFinance and Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Signatory)



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EXHIBIT INDEX



TO



MAGMA DESIGN AUTOMATION, INC.



QUARTERLY REPORT ON FORM 10-Q



FOR THE QUARTER ENDED DECEMBER 31, 2006



|               |  |                                                                                                                                                                                                    |  |                           |  |                |  |             |  |                  |  |  
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- |  | -------------- |  | ----------- |  | ---------------- |  | -
|Exhibit Number |  | Exhibit Description                                                                                                                                                                                |  | Incorporated by Reference |  | Filed Herewith
|               |  | Form                                                                                                                                                                                               |  | File No.                  |  | Exhibit        |  | Filing Date | 
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|2.1            |  | Agreement and Plan of Reorganization, dated February 23, 2004, by and among the Registrant, Motorcar Acquisition Corp., Auto Acquisition Corp., Mojave, inc. and Vivek Raghavan, as
Representative |  | 8-K                       |  | 000-33213      |  | 2.1         |  | May 14,2004      |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|3.1            |  | Amended and Restated Certificate of Incorporation                                                                                                                                                  |  | 10-K                      |  | 000-33213      |  | 3.1         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|3.2            |  | Certificate of Correction to the Amended and Restated Certificate of Incorporation                                                                                                                 |  | 10-K                      |  | 000-33213      |  | 3.2         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|3.3            |  | Amended and Restated Bylaws                                                                                                                                                                        |  | 10-K                      |  | 000-33213      |  | 3.3         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|4.1            |  | Amended and Restated Investors Rights Agreement dated July 31, 2001, by and among the Registrant and the parties that are signatories thereto                                                     |  | 10-K                      |  | 000-33213      |  | 4.2         |  | June 28,2002     |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|4.2            |  | Form of Common Stock Certificate                                                                                                                                                                   |  | S-1/A                     |  | 333-60838      |  | 4.1         |  | November 15,2001 |  |  
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|10.1           |  | Office Lease Agreement between Registrant and CA-Skyport I Limited Partnership dated December 28, 2006                                                                                             |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|10.2           |  | Sub-Sub Lease Agreement between Registrant and Siemens Communications Inc. dated November 15, 2006 and becoming effective on December 28, 2006                                                     |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|31.1           |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                 |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|31.2           |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                 |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|32.1           |  | Certification of Chief Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*                                       |  |                           |  |                |  |             |  |                  |  | X
|               |  |                                                                                                                                                                                                    |  |                           |  |               
|32.2           |  | Certification of Chief Financial Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*                                       |  |                           |  |                |  |             |  |                  |  | X

---

|* | As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Quarterly Report on Form 10-Q and are not deemed filed with the Securities and Exchange
Commission and are not incorporated by reference in any filing of Magma Design Automation, Inc. under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general
incorporation language in any filings.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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