ITEM 1. BUSINESS
Overview
We are a leading provider of physical intellectual property components for the design and manufacture of integrated circuits, including those known as system-on-a-chip integrated circuits. Our products include embedded memory, standard cell, input/output components and analog and mixed-signal products, which are designed to achieve the best combination of performance, density, power and yield for a given manufacturing process. Our intellectual property components are pre-tested by producing them in silicon to ensure that they perform to specification. This enables designers to reduce the risk of design failure and gain valuable time to market. We license our products to customers for the design and manufacture of integrated circuits used in complex, high volume applications such as portable computing devices, communication systems, cellular phones, consumer multimedia products, automotive electronics, personal computers and workstations.
We derive a substantial majority of our revenue from integrated circuit manufacturers who pay license fees and royalties to us to use our intellectual property components in the products they manufacture. These integrated circuit manufacturing customers work with integrated circuit designers who incorporate our intellectual property components in their designs. Our customers include the following: foundries, which are independent manufacturing facilities; integrated circuit companies that design and manufacture their own integrated circuit products; system manufacturers which are integrated circuit companies that design and manufacture integrated circuits for use in their electronic products; integrated circuit companies that manufacture products for their customers; and fabless integrated circuit companies, which do not have their own manufacturing facilities, but use our intellectual property components in their integrated circuit designs.
Integrated circuit designers use our intellectual property components to help ensure that integrated circuits will work to specification before they are manufactured. These integrated circuit designers are customers of our integrated circuit manufacturing customers. We serve as an interface layer between integrated circuit designers and manufacturers. This manufacturing process interface layer is important since every integrated circuit design must be mapped into a given manufacturing process to achieve specified performance and desired yield. The use of our intellectual property components by integrated circuit designers encourages integrated circuit manufacturers to license our intellectual property components. We believe that integrated circuit designers view intellectual property components as an important link between the design of an integrated circuit and the manufacturing process.
We have licensed our intellectual property components to over a thousand companies involved in integrated circuit design. We make the core set of our products available to licensed integrated circuit designers at no charge. We also provide customized intellectual property components and services to our licensed customers on a separate fee basis.
We license our intellectual property components on a nonexclusive, worldwide basis to major integrated circuit manufacturers. We charge manufacturers a license fee that gives them the right to manufacture integrated circuits containing intellectual property components we have developed for their manufacturing process. With limited exceptions, manufacturers also agree to pay us royalties based on the selling prices of integrated circuits or wafers that contain our intellectual property components. Generally, we credit a portion of the royalty payments to the manufacturer’s account to be applied against license fees for future orders placed with us, if any, payable by the manufacturer. The portion of the royalty payment that is credited to a manufacturer’s account to be applied against future license fees, if any, is based on negotiations at the time the license arrangement is signed.
We incorporated in California in April 1991 as VLSI Libraries Incorporated, changed our name to Artisan Components, Inc. in March 1997 and reincorporated in Delaware in January 1998. Our principal executive offices are located at 141 Caspian Court, Sunnyvale, California 94089-1013, our telephone number is (408) 734-5600 and our website is www.artisan.com, which includes links to reports that we have filed with the Securities and Exchange Commission or SEC. However, the contents of our website are not incorporated by reference in this Annual Report on Form 10-K. Our trademarks include Artisan, Process-Perfect, SAGE and the Artisan logo. This Annual Report on Form 10-K also includes our and other organizations’ product names, trade names and trademarks.
WHERE YOU CAN FIND MORE INFORMATION
We file annual, quarterly and special reports, proxy statements, and other information with the SEC, in accordance with the Exchange Act. You may read and copy any document we file with the SEC at the following public reference room:
Public Reference Room
450 Fifth Street, N.W.
Room 1024
Washington, D.C. 20549
1-800-SEC-0330
Please call the SEC at 1-800-SEC-0330 for further information about the public reference room. Our reports, proxy statements and other information filed with the SEC are also available to the public over the Internet at the SEC’s World Wide Web site that at http://www.sec.gov.
INDUSTRY BACKGROUND
Evolution of the integrated circuit industry
The integrated circuit industry has undergone a drastic change over the past three decades that has led to the proliferation of intellectual property components used in complex integrated circuits including those known as system-on-a-chip integrated circuits. In its infancy, the industry was vertically integrated with integrated circuit manufacturers performing all aspects of production, including electronic design, manufacturing and marketing. The development of the commercial market for third party intellectual property components used in complex integrated circuits resulted from continuing specialization in the integrated circuit industry. This trend was driven by a growth in design complexity due to improvements in manufacturing technology and an increasing focus on core competencies. By the 1980s, integrated circuit manufacturers began purchasing software design tools from commercial suppliers in order to focus on their core competencies. One driver was the capability of personal computers and the resulting escalation of integrated circuit design complexity. During the 1980s, application specific integrated circuit manufacturers developed a new approach that allowed their customers to perform the logic design of an integrated circuit while the application specific integrated circuit manufacturers performed the detailed physical implementation of the design and manufactured the integrated circuit. The development of the application specific integrated circuit industry led to the emergence of a number of integrated circuit design companies in the early 1990s. The integrated circuit design companies chose to focus on specific design expertise, take advantage of the availability of excess integrated circuit manufacturing capacity and avoid the capital expenditures necessary to build manufacturing facilities. Throughout this period, integrated circuit
manufacturers continued to focus on their core competencies in manufacturing processes. Due to the greatly increased complexity of integrating multiple functions on a single integrated circuit, integrated circuit manufacturers began to outsource the design of particular intellectual property components critical to the successful development of integrated circuits.
The productivity gap
Today, it is possible to place tens of millions of transistors on a single integrated circuit. State of the art manufacturing facilities of the 1980s produced integrated circuits using process geometries of one millionth of a meter, or 1.0-micron. Current state of the art manufacturing facilities use 0.13-micron process geometries, and many integrated circuit manufacturers have begun the transition to facilities using 90 nanometer, or 0.09-micron, processes. The development of design tools has not kept pace with the development of manufacturing processes. Advances in integrated circuit manufacturing processes have enabled the transistor density on integrated circuits to double approximately every 18 months. The integrated circuit design industry has struggled to improve design productivity as fast as the increases in transistor density. The need to close this productivity gap has furthered the development of the market for commercial intellectual property components.
Integration of digital and analog on the same chip
Independent manufacturing facilities and integrated circuit companies may invest billions of dollars designing and building semiconductor manufacturing facilities. In order to generate the high volume production required to realize a return on their investment, these manufacturers rely in large part on semiconductor products targeted to the consumer market. Today, the consumer electronics market is dominated by communications and computing applications and these applications are increasingly delivered via hand-held devices. These hand-held computing devices require the integration of digital computing and analog communications components in addition to analog power management. The market advantage created by analog and digital integration is a significant reduction in the number of components. However, integrating analog components together with digital components often presents difficult technical challenges for integrated circuit designers. If such integration is accomplished efficiently, it can lower material and test costs that in turn may help reduce overall costs of manufacturing, enhance performance and improve reliability.
The system-on-a-chip
The improvement in process technologies combined with the continuing trend to sub-micron feature sizes has enabled the integration of multiple functions into a single integrated circuit. These highly complex integrated circuits are known as system-on-a-chip integrated circuits that combine all of the functionality of printed circuit boards onto a single integrated circuit. System-on-a-chip integrated circuits improve overall system cost, speed, function and power consumption. These integrated circuits are optimal for use in complex, high volume applications such as portable computing devices, cellular phones, consumer multimedia products, automotive electronics, personal computers and workstations.
As shown above, in both a printed circuit board system and in a system-on-a-chip, the building blocks typically include memory, standard cell, input/output, microprocessor, digital signal processor, mixed-signal and analog components. However, integration of these components into system-on-a-chip integrated circuits at process geometries of 0.25-micron or below is far more complex and time consuming than the design of a traditional printed circuit board system. Integrated circuit manufacturers are finding it increasingly difficult to develop these components internally and integrate them due to reduced product development budgets and given shorter product life cycles and the importance of reducing time to market. We believe the use of commercial intellectual property components to leverage design and manufacturing capabilities can be a significant competitive advantage to integrated circuit manufacturers.
Market opportunity for integrated circuit intellectual property components
Commercial intellectual property components have enabled integrated circuit designers to reduce the risk of design failures; reduce design time for system-on-a-chip integrated circuits; decrease the overall cost of integrated circuit design; and more effectively address design and productivity issues associated with process geometries of 0.25-micron and below. Integrated circuit manufacturers require intellectual property components that are designed to achieve the best combination of performance, speed, density and yield for a given manufacturing process while reducing time to market. Although the electronic design automation tool industry has successfully developed partial solutions to increase design productivity and performance, electronic design automation tools have not completely overcome the challenges of creating intellectual property components tailored to a particular manufacturing process within an increasingly compressed time to market window. In addition, integrated circuit manufacturers have increased their internal design resources to produce intellectual property components for themselves and for their customers. However, the use of intellectual property components supplied by a specific integrated circuit manufacturer does not allow integrated circuit designers the flexibility they desire to enable them to use an alternative manufacturer. Many of these same integrated circuit manufacturers use commercial intellectual property components in order to harness the strengths of their manufacturing processes, increase the performance of their manufactured products, accelerate time to market for themselves and their customers and gain access to integrated circuit designers that utilize commercial intellectual property components.
OUR SOLUTION
We provide physical intellectual property components for the design and manufacture of complex integrated circuits. Our intellectual property components are developed and delivered using a proprietary methodology that includes a set of commercial and proprietary electronic design automation tools and design expertise. This methodology enables us to automate our production process and deliver high quality intellectual property components in a short period of time. These components and our methodology are our core technology. Our intellectual property components are designed to optimize the combination of performance, density, power and yield for a given manufacturing process. Our intellectual property components offer customers the benefits described below.
Significant time to market advantages
We enable integrated circuit design companies to reduce the time required to bring new integrated circuits to market by:
• eliminating our customers’ need to design intellectual property components and prove them in silicon; and
• delivering intellectual property components that are highly compatible with industry-standard integrated circuit design tools.
Long-term product development commitment
Our ability to adapt, customize and build on our core technology for use in new processes and designs provides each integrated circuit design customer with a ready source of reliable intellectual property components for future processes and designs. This enables integrated circuit designers to standardize on our intellectual property components, accelerate their product development and focus internal engineering resources on their core competencies.
Cost effective solutions
As integrated circuit manufacturing process geometries shrink and the complexity of integrated circuit designs increases, the cost to design system-on-a-chip integrated circuits increases significantly. By providing reliable intellectual property components with significant time to market benefits, we enable customers to reduce design costs, minimize integration costs and optimize manufacturing yield. Moreover, by using our intellectual property components, integrated circuit companies avoid the cost of recruiting and training and employing a significant group of engineers dedicated to intellectual property component design.
OUR STRATEGY
Our goals are to establish Artisan as a globally recognized brand for intellectual property components and methodology within the integrated circuit design and manufacturing industry and to further expand our customer base. Our customer base includes over a thousand companies involved in integrated circuit design and many of the leading manufacturers of integrated circuits around the world. We intend to achieve these goals by pursuing the following key elements of our strategy described below.
Broaden relationships with integrated device manufacturers and application-specific integrated circuit manufacturers
Building upon our strong base of integrated circuit manufacturing customers, we intend to strengthen and expand our relationships with integrated device manufacturers and application specific integrated circuit manufacturers, which often produce integrated circuits in high volume. We intend to continue our sales effort to address the specific service and support requirements of integrated device manufacturers and application specific integrated circuit manufacturers. We also plan to play a key role in facilitating the emerging relationships between integrated device manufacturers, application specific integrated circuit manufacturers and foundries by providing integrated device manufacturers and application specific integrated circuit manufacturers with intellectual property components for use in external manufacturing processes.
Maintain technological leadership
Our experience in working with many leading integrated circuit manufacturing customers during the development of new manufacturing processes has enabled us to develop intellectual property components optimized for performance, density, power and yield for a given manufacturing process. As manufacturing process technology continues to evolve to ever smaller process geometries, we believe that an in depth understanding of manufacturing process technology is essential to the development of intellectual property components optimized for such manufacturing processes. We intend to maintain our technological leadership position by enhancing our existing digital, analog and mixed-signal products and continuing to develop, internally or through possible acquisitions, new generations of products. To further maintain our technological leadership, we plan to continue to develop our internal expertise in digital, analog and mixed-signal manufacturing process technology. Such expertise is particularly important for designing analog components. We also intend to continue to work with our integrated circuit manufacturing customers as early as possible in the development of new manufacturing process technologies.
Expand our intellectual property product offerings
We intend to develop and acquire additional intellectual property components that are complementary to our existing portfolio. By expanding our product portfolio, we expect to offer a more comprehensive solution to integrated circuit design teams and integrated circuit manufacturers and further our position as a leader in the integrated circuit intellectual property industry.
Continue to offer superior customer support
We intend to attract, train and retain qualified employees for customer support. In addition, we have recently implemented a customer relationship management system, or CRM System, and will continue to refine and enhance our CRM System. We plan to expand our operations geographically to maintain proximity to our expanding customer base and provide regional support to our customers. We have established an engineering service and support facility in Bangalore, India, and plan to increase our presence in China and Taiwan.
Further develop the Artisan user community
Our user community has grown as a result of the demand from design teams for our products. As our products have gained broad industry acceptance, licenses for our technology have helped manufacturers attract new integrated circuit design customers. We believe that the Artisan user community is a key asset of our business. We plan to work closely with this user community in order to gain insight into new process developments and leading-edge integrated circuit designs, improve our products and further expand the Artisan user community.
PRODUCTS
Our current family of intellectual property components includes embedded memory, standard cell, input/output components and analog and mixed-signal products. Together these components constitute a substantial majority of the silicon area on a typical system-on-a-chip integrated circuit and have a substantial impact on the overall performance of the integrated circuit. Our contracts with integrated circuit manufacturers generally require them to pay a license fee to us ranging from approximately $250,000 to $650,000 for each product delivered under a contract. Generally, our license contracts involve multiple products. Throughout the production cycle, integrated circuit manufacturers may request our support for derivative processes that result in additional license revenue.
Our intellectual property components are developed and delivered using a proprietary methodology called “Process-PerfectTM” that includes a set of commercial and proprietary electronic design automation tools and techniques. This methodology ensures that our intellectual property components are designed to achieve the best combination of performance, density, power and yield for a given manufacturing process. Our portfolio of products combined with the Process-Perfect methodology, allows us to satisfy our integrated circuit manufacturing customers’ timing and quality requirements in a cost effective manner. Our intellectual property components are easily integrated into a variety of customer design methodologies and support industry standard integrated circuit design tools, including those from electronic design automation tool vendors such as Cadence Design Systems, Inc., or Cadence, Mentor Graphics Corporation, or Mentor Graphics and Synopsys, Inc., or Synopsys, as well as customers’ proprietary integrated circuit design tools. To support these various integrated circuit design tool environments, each of our products includes a comprehensive set of verified tool models.
Memory products
Our embedded memory components include random access memories, read only memories and register files. Our high-speed, high-density and low-power components include single- and dual-port random access memories, read only memories, and single-, two- and three-port register files. Our embedded memory components are configurable and vary in size to meet the customer’s specification. For example, our memory components will support sizes from 2 to 128 bits wide and from 8 to 16,384 words. All of our memory
components include features such as a power down mode, low voltage data retention and fully static operation. In addition, our memory components may include built-in test interfaces that support popular test methodologies. We offer an additional feature for our memory components, known as Flex-Repair™ that includes redundant storage elements which may help increase the manufacturing yield of integrated circuit designs containing large memories.
• High-speed memory family. Our high-speed memory components are designed to achieve speeds in excess of 1 GHz for 90nm manufacturing processes. We achieve the high performance of our memory components through a combination of proprietary design innovations that include latch-based sense amplifiers, high-speed row select technology, precise core cell balancing and rapid recovery bitlines.
• High-density memory family. Our high-density memory components are designed for applications where achieving the lowest possible manufacturing cost is critical. These are typically consumer applications with high manufacturing volumes. To achieve the lowest possible manufacturing cost for these products, we utilize proprietary circuit and layout techniques to reduce the overall area of the memories. In addition, we use specific design and analysis techniques to enhance production yield.
• Low-power memory family. Our low-power memory components are designed to prolong battery life when used in battery-powered electronic systems. These intellectual property components achieve low power through a combination of proprietary design innovations that include latch-based sense amplifiers, a power efficient banked memory architecture, precise core cell balancing and unique address decoder and driver circuitry.
Standard cell products
Standard cells map the logic functions of a design to the physical functions of the design, an essential function for all integrated circuits. Our SAGE-X™ standard cell products include between 475-650 cells optimized for each customer’s preferred manufacturing process and integrated circuit design tool environment that result in greater density as compared to competitive standard cell components. We offer standard cell components that are optimized for high performance, high density or low power to meet the needs of different markets.
Input/output products
Our input/output components include over 600 standard input/output functions. We also offer a wide variety of specialized input/output components that are compatible with industry standard PCI, GTL, AGP, USB, SSTL2 and LVDS interfaces. In addition, we offer input/output components for many additional industry standard interfaces. Every input/output component utilizes each integrated circuit manufacturer’s proprietary manufacturing process rules, pad pitch and electrostatic discharge requirements, resulting in superior performance, reliability and manufacturability.
Analog products
Analog components are important elements in today’s system-on-a-chip designs because such designs often require, as part of their application, the ability to take real world inputs, such as sound and images, and process them in a digital format. Artisan offers a wide variety of analog components from analog timing functions to converter products. An example of our analog component offerings is our phase locked loops, which can be used in a variety of communications, consumer, computing and graphics applications.
Mixed-signal products
Mixed-signal products are used to process analog signals digitally. Our mixed-signal product offering includes our serializer/de-serializers, which are used for high-speed switching; our PCI-Express™ PHY, which is used for high-speed bus interfaces, and our DDRI/DDRII/GDDRIII Interface, which is used for high-speed memory interfacing.
PRODUCT DEVELOPMENT
We target the rapidly growing system-on-a-chip market. Our products include embedded memory, standard cell, input/output components and analog and mixed-signal products. Because of the complexity of these intellectual property components, our design and development process is a multidisciplinary effort requiring expertise in electronic circuit design, process technology, physical layout, design software, model generation, data analysis and processing and general integrated circuit design. These activities involve the development of more advanced versions of our intellectual property components and the continued development of new intellectual property components for current and anticipated manufacturing processes. We have engaged in and intend to continue to engage in research and development activities to automate our design processes.
Engineering costs are allocated between cost of revenue and product development. We track specific customer projects and product development efforts based on unique project codes that are assigned at the inception of each project. Individual engineers devoted to these projects record time to these project codes as actual hours are incurred. Engineering efforts devoted to specific customer projects are recognized as cost of revenue in the same period that revenues are recognized. Engineering efforts devoted to the general development of our technology are charged to product development. Engineering costs related to product development are expensed as incurred. Product development expenses were $18.4 million in fiscal 2003, $11.9 million in fiscal 2002 and $12.4 million in fiscal 2001. We expect that we will continue to invest substantial funds for product development.
SALES, MARKETING AND DISTRIBUTION
We license our intellectual property components on a nonexclusive, worldwide basis to major integrated circuit manufacturers. We have licensed and distributed our intellectual property components to over 15 companies involved in the manufacture of integrated circuits who have agreed to pay an upfront license fee and also agree to make royalty payments in the event that our intellectual property components are incorporated into designs ultimately manufactured. For most of our integrated circuit manufacturing customers, we distribute and license our intellectual property components to companies that design integrated circuits. While the basic elements of our memory, standard cell and input/output components are distributed to design companies at no charge, design companies pay us a direct license and support fee to receive analog, mixed-signal and other customized components and support from us. As part of the license agreement entered into by the design companies, the design companies agree to manufacture any integrated circuit design using any of our intellectual property components at the particular integrated circuit manufacturer for which we developed the intellectual property components. The integrated circuit manufacturer then generally pays us a royalty based on the selling prices of integrated circuits or wafers that contain our intellectual property components. We have licensed and distributed our intellectual property components at no charge to over a thousand companies involved in integrated circuit design, including companies involved in computing, communications, consumer products, graphics, networking and other applications. Over 100 of these design companies have paid us direct license or support fees in order to receive modified intellectual property components and/or support from us.
We have several industry partner programs whereby our partners provide a wide variety of intellectual property solutions, design services and tool support to streamline the design process for users of our intellectual property components. Through these programs, we provide intellectual property components and support to over 150 design support companies who use these intellectual property components in their work for our licensed users. Over 15 of these design support companies have paid us direct license or support fees in order to receive modified products and support from us.
As of September 30, 2003, our direct sales force consisted of 34 employees who are paid on commission in addition to their base salaries. In connection with our acquisition on February 19, 2003 of NurLogic Design, Inc., or NurLogic, we increased our direct sales force by 10 people. We believe that our sales, marketing and distribution approach enables us to leverage the integrated circuit manufacturers’ sales and marketing
organizations and limit the costs we would otherwise have associated with hiring, training and compensating the large sales force necessary to negotiate with each end-user customer. In addition, our web-based intellectual property design platform enables integrated circuit designers to access our intellectual property components 24 hours per day. The platform assists us in gathering data about designers using our intellectual property components and the potential integrated circuit manufacturers the designers may elect of have manufacture their integrated circuits. We have sales offices in Sunnyvale, California; San Diego, California; Boston, Massachusetts; Tokyo, Japan; Singapore and Paris, France.
CUSTOMERS
We license our intellectual property components on a nonexclusive, worldwide basis to major integrated circuit manufacturers. We charge manufacturers a license fee that gives them the right to manufacture integrated circuits containing intellectual property components we have developed for their manufacturing processes. Many of the world’s leading integrated circuit manufacturers are among our customers. Our top 20 customers in terms of total revenue for the three years ended September 30, 2003 were 1st Silicon (Malaysia) Sdn. Bhd., Chartered Semiconductor Manufacturing Ltd., or Chartered, Conexant Systems, Inc., Dongbu Electronics Co., Ltd., Hynix Semiconductor, Inc., International Business Machine Corporation, or IBM, Infineon Technologies AG, Jazz Semiconductor, Inc., National Semiconductor Corporation, NEC Corporation, NVIDIA Corporation, Sanyo Electric Co., Ltd., Sharp Electronics Corporation, Silterra Malaysia Sdn. Bhd., Semiconductor Manufacturing International Corporation, or SMIC, Sony Corporation, Semiconductor Technology Academic Research Center, or STARC, Tower Semiconductor Ltd., Taiwan Semiconductor Manufacturing Company, or TSMC, and United Microelectronics Corporation.
Historically, NurLogic licensed its products directly to end users who agreed to pay license fees directly to NurLogic. Our acquisition of NurLogic has led to an increase in our interaction with integrated circuit designers. To date, we have generally licensed our analog and mixed-signal components directly to integrated circuit designers. This relationship has provided us with a more in-depth understanding of end user’s business needs. Over the course of such relationships, we have had the opportunity to review end user design requirements earlier in the design cycle, which may help us deliver optimized intellectual property components to market sooner. We are in the process of marketing our analog and mixed-signal offerings to semiconductor manufacturers for purposes of distributing such products to designers who agree to manufacture their designs at the foundry for which such components were developed. We cannot be certain that semiconductor manufacturers will be willing to license and pay for analog and mixed-signal intellectual property components for the benefit of end users in the same way as such manufacturers have historically licensed digital intellectual property components from us. Such analog and mixed-signal intellectual property components tend to require a greater degree of customization for a particular use than do many of our other products.
We have been dependent on a relatively small number of integrated circuit manufacturing customers for a substantial portion of our annual revenue, although the integrated circuit manufacturers comprising this group have changed from time to time. In fiscal 2003, IBM accounted for 18% of our total revenue, TSMC accounted for 17% of our total revenue and Chartered accounted for 10% of our total revenue. In fiscal 2002, TSMC accounted for 39% of our total revenue. In fiscal 2001, TSMC accounted for 26% of our total revenue and Synopsys accounted for 12% of our total revenue. We anticipate that our revenue will continue to depend on a limited number of major integrated circuit manufacturing customers for the foreseeable future. However, the major integrated circuit manufacturing customers and the percentage of revenue they represent are likely to continue to vary from period to period depending on the addition of new contracts, the timing of work performed by us and the number of designs utilizing our intellectual property components.
COMPETITION
Our strategy of targeting integrated circuit manufacturers and integrated circuit designers that participate in, or may enter, the integrated circuit market requires us to compete in intensely competitive markets. We face
significant competition from third party intellectual property component providers, such as Barcelona Design, Inc. or Barcelona Design, DOLPHIN Integration SA, or DOLPHIN, Faraday Technology Corporation or Faraday Technology, Monolithic System Technology, Inc., or Monolithic System Technology, Neolinear, Inc., or Neolinear, Rambus Inc., or Rambus, TriCN, Inc., or TriCN, VeriSilicon Microelectronics (Shanghai) Co. Ltd., or VeriSilicon, Virage Logic Corporation, or Virage Logic and Virtual Silicon Technology, Inc., or Virtual Silicon and from the internal design groups of integrated circuit manufacturers such as TSMC and IBM. In addition, we face competition from small consulting firms and design companies that operate in the intellectual property component segment of the market and offer a limited selection of specialized intellectual property components.
We face significant competition from the internal design groups of integrated circuit manufacturers that have expanded their manufacturing capabilities and portfolio of intellectual property components to participate in the integrated circuit market. Integrated circuit manufacturers that license our intellectual property components have historically had their own internal intellectual property component design groups. These design groups continue to compete with us for access to the integrated circuit manufacturer’s intellectual property component requisitions and, in some cases, compete with us to supply intellectual property components to third parties on a merchant basis. Intellectual property components developed by internal design groups are designed to utilize the qualities of their own manufacturing process, and may therefore benefit from certain capacity, informational, cost and technical advantages. If internal design groups expand their product offerings to compete directly with our intellectual property components or actively seek to participate as vendors in the intellectual property component market, our revenue and operating results could be negatively affected.
TSMC, one of our largest integrated circuit manufacturing customers, has historically produced intellectual property components for use by third parties in designs to be manufactured at TSMC’s foundry. These components are designed to serve the same purpose as components produced by us. The intellectual property components developed by TSMC have competed and are expected to continue to compete with our products. We believe that TSMC is more aggressively developing and distributing these products to encourage its customers to use TSMC to manufacture their current and future designs. TSMC has substantially greater financial, manufacturing and other resources, name recognition and market presence than we do and the internal design group at TSMC has greater access to technical information about TSMC’s manufacturing processes. Distribution partners selected by TSMC include Cadence, Magma and Virage Logic. Some of TSMC’s distribution partners, such as Cadence, may have greater resources, name recognition and distribution networks than we do. If TSMC is successful in supplying its own intellectual property components to third parties either directly or through distribution arrangements with other companies, our revenue from TSMC, our revenue from other customers and our operating results could be negatively affected.
We believe that we have the following competitive advantages:
• Extensive product portfolio. We currently offer a wide range of analog, embedded memory, standard cell and input/output components that support the following process geometries: 0.25-micron, 0.18-micron, 0.15-micron, 0.13-micron and 90 nanometers. Within these process geometries, we also offer a range of product types, such as products that are optimized for speed, low power and area consumption.
• Access to large user community. We believe that our extensive user community allows us to offer manufacturers a valuable channel to potential design customers.
• Brand loyalty. We have a large number of end users who are comfortable and familiar with our products. We believe many of these users would prefer integrated circuit manufacturers with which they are working to make available our intellectual property components for their designs.
• Product distribution model. As a market leader in distributing our standard intellectual property components to design teams at no charge, we have gained valuable experience in making this model work while encouraging the use of our products.
• Technical experience. By developing and licensing intellectual property components to many of the world’s leading integrated circuit foundries, we have gained valuable experience in the customization of intellectual property components for use with different manufacturing processes. We have also invested significant resources in automating certain aspects of the product development and customization process that provides efficient and scalable delivery capability.
Despite these competitive advantages, we also faces numerous challenges associated with overcoming the following disadvantages:
• Size and resources. The internal design groups at foundries, application specific integrated circuit manufacturers and integrated device manufacturers may have access to substantially greater financial, engineering, manufacturing and other resources than we do, which may enable them to react more effectively to new market opportunities.
• Name recognition. Some of our competitors, such as TSMC, and distributors of competitive products, such as Cadence, have greater name recognition and market presence than we do, which may allow them to market themselves more effectively to new users.
• Access to technical information. The internal design groups at foundries, application specific integrated circuit manufacturers and integrated device manufacturers may have more current and complete access to technical information regarding their own manufacturing processes, which may enable them to develop intellectual property components that more fully utilize their manufacturing process.
• Limits of product offerings. Although we offer a broad range of commonly used intellectual property components, a customer may require an intellectual property component that we do not offer. As a result, our competitors may exploit the areas in which we currently do not have complete product offerings.
• Reliance on manufacturers. We have a greater reliance on integrated circuit manufacturers than do some of our competitors. A substantial majority of our revenue is derived from integrated circuit manufacturers as opposed to end users. We believe that overall this model, which allows us to distribute our standard intellectual property components to design teams at no charge, has given us an advantage in the marketplace. However, we may be adversely affected by consolidation of integrated circuit manufacturers. We rely on integrated circuit manufacturers for access to their manufacturing processes for testing purposes. It is through this understanding of and access to manufacturing processes that we are able to provide end users with silicon proven intellectual property components that have well defined attributes and more predictable silicon output. In the case of analog components, we require even greater access to a manufacturer’s production process for analysis and testing. We require access to specific process information that may only be available from the integrated circuit manufacturers process development engineers. If this access is restricted or denied, our products may become less competitive.
• Scalability of analog components. A significant challenge in designing our analog components is to increase our ability to reuse or scale our analog components across multiple customers. All intellectual property components must be customized to specific foundry requirements. The challenge for us is to develop analog components that require less customization for each foundry or end user customer.
PATENTS AND INTELLECTUAL PROPERTY PROTECTION
We rely primarily on a combination of nondisclosure agreements, contractual provisions, patent, trademark, trade secret, and copyright law to protect our proprietary rights. We have an active program to protect our proprietary technology through the filing of patents. As of September 30, 2003, we had 41 issued US patents, 23 patent applications pending before the US Patent and Trademark Office, five issued foreign patents and 12 patent applications pending in foreign countries. Generally our patents expire between 2017 and 2020.
ARTISAN, the ARTISAN COMPONENTS logo, and PROCESS-PERFECT are registered U.S. trademarks. Foreign trademark applications for these marks are pending.
We protect our trade secrets and other proprietary information through confidentiality agreements with our employees and customers. Despite these efforts, there can be no assurance that others will not gain access to our trade secrets, that our trade secrets will not be independently discovered by competitors or that we can meaningfully protect our intellectual property. Effective trade secret protection may be unavailable or limited in certain foreign jurisdictions, such as China, where we sell our intellectual property components. The risks associated with protection of our intellectual property rights in foreign countries are likely to increase as we expand our international operations. As a result, we may experience difficulty protecting our intellectual property from misuse or infringement by others.
Our typical license agreements contain indemnification provisions under which we may be required to defend or settle an infringement claim and pay settlement amounts or damages awarded with respect to such claims. Such indemnification obligations are subject to a number of exceptions and generally limited to specific jurisdictions. In addition, the total amount of liability is generally capped at a specific dollar amount approximating the consideration received by us under the contract in question; however, such limits on our liability are generally not included in contracts we assumed in connection with our acquisition of NurLogic. As part of our indemnification obligations, we may also be required to provide substantial technical assistance to our customers regarding allegedly infringing products. If a product is, or in our opinion is likely to become, the subject of a claim alleging infringement, our indemnification obligations generally grant us the option to choose to procure a license for our customer, replace or modify the allegedly infringing product, or terminate the license to the allegedly infringing product and refund a portion of the license fees, the amount of which varies inversely with the length of time elapsed since the product was delivered.
In any potential dispute involving our intellectual property, our customers and strategic partners could also become the target of litigation. This could trigger our technical support and indemnification obligations in our license agreements, which could result in substantial expense to us. In addition to the time and expense required for us to supply support or indemnification to our customers and strategic partners, any litigation could severely disrupt or shut down the business of our customers and strategic partners, which in turn would hurt our relations with them and harm our operating results.
From time to time, we may be subject to claims by customers of the companies we acquire that our intellectual property components or products of acquired companies that have been incorporated into end user products infringe the intellectual property rights of others.
We have been notified by one of NurLogic’s customers that it is requesting indemnification from NurLogic (now one of our wholly owned subsidiaries) because of two complaints filed against that customer alleging that some of that customer’s products infringe third party patents. We believe that one complaint is without merit with respect to technology licensed by NurLogic and we are in the process of evaluating another complaint for which we believe we have meritorious defenses with respect to the technology licensed by NurLogic. However, there can be no assurance that the courts would not find that the technology licensed by NurLogic infringes third party patents. Whether or not the asserted patents are valid and whether or not a court finds that the customer’s products infringe, the investigation and resolution of these indemnity claims and any related litigation could be expensive and could consume substantial amounts of management time and attention.
FOREIGN OPERATIONS
We offer various intellectual property components and services to our customers; however, we do not manage our operations by these intellectual property components and services. Instead, we view our company as one operating segment when making business decisions. We use one measurement of profitability for our business. We currently operate principally in the United States, Taiwan, Japan and other countries in Asia and Europe.
Historically, a substantial portion of our total revenue has been derived from customers outside the United States, primarily from Asia and Europe. International revenue as a percentage of our total revenue was approximately 69% in fiscal 2003, 75% in fiscal 2002 and 70% in fiscal 2001. We anticipate that international revenue will remain a substantial portion of our total revenue in the future. To date, all of the revenue from international customers has been denominated in U.S. dollars.
EMPLOYEES
As of September 30, 2003, we had 343 employees compared to 181 employees at September 30, 2002. Our success is highly dependent on our ability to attract, train and retain qualified employees. Competition for employees is intense in the software industry. To date, we believe we have been successful in our efforts to recruit qualified employees and train and retain them, but there is no assurance that we will continue to be as successful in the future. None of our employees are subject to collective bargaining agreements. We believe that our relationship with our employees is good.
EXECUTIVE OFFICERS
The following table lists our current executive officers as of the date of this filing and sets forth information as of October 1, 2003:
Name
Age
Position
Mark R. Templeton
President, Chief Executive Officer and Director
Joy E. Leo
Vice President, Finance and Administration, Chief Financial Officer and Secretary
Scott T. Becker
Chief Technical Officer and Director
Harry Dickinson
Chief Operating Officer
James H. Hogan
Senior Vice President, Business Development
Dhrumil Gandhi
Senior Vice President, Product Technology
Brent Dichter
Vice President, Engineering
Neal Carney
Vice President, Marketing
Edward Boule
Vice President, Asia and Japan Sales
J. Callan Carpenter
Vice President and General Manager, Analog/Mixed-Signal Business Unit
Mark R. Templeton has served as our president and chief executive officer since April 1991 when he co-founded our company. In addition, Mr. Templeton has served as a member of our board of directors since April 1991. From April 1990 to March 1991, Mr. Templeton was director of the Custom IC Design Group at Mentor Graphics Corporation, an electronic design automation company. From October 1984 to March 1990, he held various positions with Silicon Compilers Systems Corporation, an electronic design automation company, with the last position being director of the Custom IC Design Group.
Joy E. Leo has served as our vice president of finance and administration, chief financial officer and secretary since September 2000. From January 2000 to August 2000, she served as vice president of finance and administration and chief financial officer for IMP, Inc, an integrated circuit company. From August 1998 to January 2000, she was vice president of finance, operations and administration at Innomedia Incorporated, a telecommunications company. From June 1995 to January 1998, she was vice president and chief financial officer for Philips Components, a division of Royal Philips Electronics N.V.
Scott T. Becker has served as our chief technical officer since April 1991 when he co-founded Artisan Components. In addition, Mr. Becker has served as a member of our board of directors since April 1991. From
April 1990 to April 1991, he was manager of the library development group of the IC division of Mentor Graphics. From May 1985 to April 1990, he was responsible for library development at Silicon Compilers.
Harry Dickinson has served as our chief operating officer since June 2001. From January 2000 to June 2001, Mr. Dickinson took time off from his business activities to pursue personal interests. From December 1998 to January 2000, Mr. Dickinson was vice president of worldwide sales for Cygnus Solutions, now known as Red Hat, Inc., a computer software distribution company. From October 1997 to October 1998, he was president and chief executive officer of Entridia Corporation, subsequently acquired by Stratigos Networks, LLC, a network controller company, of which he was also a founder. From January 1992 to October 1997, he was senior vice president of sales for S3 Incorporated, now known as SONICblue Incorporated, a fabless integrated circuit company specializing in graphics chips.
James H. Hogan has served as our senior vice president of business development since October 2002. From August 2000 to September 2002, he was senior vice president of business development and chief technology officer of Cadence. From February 1997 to October 2000, Mr. Hogan held several positions at Cadence including president of Cadence Japan from December 1999 to October 2000, corporate vice president of marketing from December 1998 to December 1999, and corporate vice president for field operations from February 1997 to December 1998. From December 1996 to February 1997, he was chief operating officer of Smart Machines Inc., now a wholly-owned subsidiary of Brooks Automation, Inc., an integrated circuit equipment automation company.
Dhrumil Gandhi has served as our senior vice president of product technology since May 2001. From May 1993 to May 2001, Mr. Gandhi served as our vice president of engineering. From July 1983 to May 1993, he served as senior manager for advanced application specific integrated circuit design systems at Mentor Graphics.
Brent Dichter has served as our vice president of engineering since May 2001. Mr. Dichter served as our vice president of product/program management from March 2000 to May 2001 and as our director of engineering from November 1998 to March 2000. From January 1997 to November 1998, he served as vice president of silicon technology at Multi Dimensional Computing, a computer company specializing in graphics chip design. From July 1995 to January 1997, he was director of strategic marketing for Xilinx, Inc., a field programmable gate array company.
Neal Carney has served as our vice president of marketing since August 2001. From June 2000 to August 2001, he was vice president of marketing for Tripath Technology, Inc., a fabless integrated circuit company. From January 1998 to June 2000, he was business unit manager of imaging products for Agilent Technologies, Inc., a technology company focusing on communications, electronics and life sciences. From January 1994 to January 1998, Mr. Carney was marketing manager of the integrated circuit division at Hewlett-Packard Company. From November 1982 to January of 1994, Mr. Carney held various marketing management positions at Hewlett-Packard including a three year international assignment from May 1987 to May 1990 as the Japan marketing center manager for Hewlett-Packard’s integrated circuit products group.
Edward M. Boule has served as our vice president, Asia Pacific sales since January 2003. Mr. Boule served as our vice president, foundry partnerships from August 2001 to January 2003, and as our director of Japan operations from August 1999 to August 2001. From October 1995 to April 1999, Mr. Boule was director and vice president of sales for AKM Semiconductor Inc., a subsidiary of Asahi Kasei Microsystems specializing in semiconductor manufacturing.
J. Callan Carpenter has served as our vice president and general manager, analog/mixed-signal business unit since March 2003. From March 1998 to March 2003, Mr. Carpenter served as president, CEO and Director of Silicon Metrics Corporation, a company specializing in semiconductor design and verification software. From December 1997 to March 1998, Mr. Carpenter served as vice president of marketing for Ventix Systems, Inc., an enterprise automation software company. From May 1997 to December 1997, Mr. Carpenter provided
independent consulting services for several software companies. From January 1990 to April 1997, Mr. Carpenter held various marketing and managerial positions with Mentor Graphics Corporation, including the position of vice president of corporate marketing from January 1995 to April 1997.
ITEM 2.
ITEM 2. PROPERTIES
Our principal administrative and technical offices occupy 54,489 square feet in Sunnyvale, California pursuant to a lease that expires in August 2008. In addition, we lease administrative, technical and field support offices in seven cities throughout the world. The administrative, technical and field offices range from small executive offices to a 35,290 square foot facility. Lease terms range from month-to-month on certain executive offices to 3 years on certain direct leases. Our principal administrative, technical and field support facilities are in Sunnyvale, California; San Diego, California; Boston, Massachusetts; Bangalore, India; Tokyo, Japan; Paris, France and Singapore. We are continually evaluating the adequacy of existing facilities and additional facilities in new cities and we believe that suitable additional space will be available in the future on commercially reasonable terms as needed.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are not a party to any legal proceedings.
We have been notified by Broadcom Corporation that it is requesting indemnification from NurLogic (the successor entity of NurLogic is now one of our wholly owned subsidiaries) because a complaint was filed against Broadcom by STMicroelectronics, Inc. in November 2002 in the United States District Court for the Eastern District of Texas alleging that some of Broadcom’s products infringe several patents owned by STMicroelectronics. STMicroelectronics is seeking both an injunction against Broadcom and monetary damages. We have recently been further notified by Broadcom that it is requesting indemnification from NurLogic because a complaint was filed against Broadcom by Agere Systems Inc. in August 2003 in the United States District Court for the Eastern District of Pennsylvania, alleging that some of Broadcom’s products infringe several patents owned by Agere. We have received notice from Broadcom regarding one Agere patent that may relate to the technology licensed by NurLogic. Agere is seeking both an injunction against Broadcom and monetary damages.
We believe that the complaint brought by STMicroelectronics is without merit with respect to technology licensed by NurLogic to Broadcom. We are in the process of evaluating Agere’s claims and we believe that we have meritorious defenses with respect to the technology licensed by NurLogic to Broadcom. However, there can be no assurance that the courts will find that the patents asserted by STMicroelectronics and Agere are invalid or that the technology licensed by NurLogic does not infringe such patents.
Whether or not the asserted patents are valid and whether or not a court finds that Broadcom’s or NurLogic’s products infringe, the investigation and resolution of these indemnity claims and any related litigation could be expensive and could consume substantial amounts of management time and attention.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Price Range of Common Stock
Our Common Stock has been quoted on the NASDAQ National Market under the symbol “ARTI” since our initial public offering on February 3, 1998. Prior to such time, there was no public market for our Common Stock. The following table sets forth for the periods indicated the high and low sale prices per share of our Common Stock as reported on the NASDAQ National Market.
Dividend Policy
Since March 1996, when we converted to a C corporation from a subchapter S corporation, we have not declared or paid any cash dividends on our Common Stock or other securities. We presently intend to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying cash dividends in the foreseeable future.
Holders of Common Stock
As of October 31, 2003, there were approximately 92 stockholders of record of our Common Stock, not including those stockholders holding shares in street or nominee name.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and notes thereto included elsewhere in this Annual Report on Form 10-K. The consolidated balance sheet data as of September 30, 2003 and 2002 and the consolidated statement of operations data for the fiscal years ended September 30, 2003, 2002 and 2001 are derived from the financial statements that have been audited by PricewaterhouseCoopers LLP, independent accountants, and which are included elsewhere in this Annual Report on Form 10-K. The consolidated balance sheet data as of September 30, 2001, 2000 and 1999 and the consolidated statement of operations data for the fiscal years ended September 30, 2000 and 1999 are derived from the financial statements that have been audited by PricewaterhouseCoopers LLP, independent accountants, and which are not included in this Annual Report on Form 10-K. Historical results are not necessarily indicative of results to be expected in the future.
The acquisitions of NurLogic Design, Inc. in February 2003 and certain assets of Synopsys’ physical library business unit in January 2001 resulted in a significant increase in our costs and expenses primarily attributable to the increased headcount and amortization of goodwill and other intangibles associated with the acquisitions. The acquisitions have affected the comparability of the selected financial data set forth below.
(1) For an explanation of net income (loss) per share and shares used in per share calculations, see Note 13 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the Consolidated Financial Statements and notes thereto included elsewhere in this Annual Report on Form 10-K. Certain statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are forward-looking statements. The forward-looking statements contained herein are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those expressed in such forward-looking statements. Forward-looking statements can often be identified by the use of forward-looking words such as “may,” “will,” “could,” “should,” “expect,” “believe,” “anticipate,” “estimate,” “continue,” “plan,” “intend,” “project,” or other similar words. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those that expressed in any forward-looking statements. Readers are referred to risks and uncertainties identified below, and in the documents filed by us with the Securities and Exchange Commission, specifically the most recent reports on Form 10-K, 10-Q and 8-K, each as it may be amended from time to time. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.
Overview
We are a leading provider of physical intellectual property components for the design and manufacture of complex integrated circuits including those known as system-on-a-chip integrated circuits. Our products include embedded memory, standard cell, input/output components and analog and mixed-signal products, which are designed to achieve the best combination of performance, density, power and yield for a given manufacturing process. Our intellectual property components are pre-tested by producing them in silicon to ensure that they perform to specification. This enables designers to reduce the risk of design failure and gain valuable time to market. We license our products to customers for the design and manufacture of integrated circuits used in complex, high volume applications such as portable computing devices, communication systems, cellular phones, consumer multimedia products, automotive electronics, personal computers, workstations and other electronic applications.
We derive a substantial majority of our revenue from integrated circuit manufacturers who pay license fees and royalties to us to use our intellectual property components in the products they manufacture. These integrated circuit manufacturing customers work with integrated circuit designers who incorporate our intellectual property components in their designs. Our customers include the following: foundries, which are independent manufacturing facilities; integrated circuit companies that design and manufacture their own integrated circuit products; system manufacturers which are integrated circuit companies that design and manufacture integrated circuits for use in their electronic products; integrated circuit companies that manufacture products for their customers; and fabless integrated circuit companies, which do not have their own manufacturing facilities, but use our intellectual property components in their integrated circuit designs.
Integrated circuit designers use our intellectual property components to help ensure that integrated circuits will work to specification before they are manufactured. These integrated circuit designers are customers of our integrated circuit manufacturing customers. We serve as an interface layer between integrated circuit designers and manufacturers. This manufacturing process interface layer is important since every integrated circuit design must be mapped into a given manufacturing process to achieve specified performance and desired yield. The use of our intellectual property components by integrated circuit designers encourages integrated circuit manufacturers to license our intellectual property components. We believe that integrated circuit designers view intellectual property components as an important link between the design of an integrated circuit and the manufacturing process.
We have licensed our intellectual property components to over a thousand companies involved in integrated circuit design. We make the core set of our products available to licensed integrated circuit designers at no
charge. We also provide customized intellectual property components and services to our licensed customers on a separate fee basis.
We license our intellectual property components on a nonexclusive, worldwide basis to major integrated circuit manufacturers and generally grant these manufacturers the right to distribute our intellectual property components to their internal design teams and their integrated circuit customers. We charge manufacturers a license fee that gives them the right to manufacture integrated circuits containing intellectual property components we have developed for their manufacturing process. With limited exceptions, manufacturers also agree to pay us royalties based on the selling prices of integrated circuits or wafers that contain our intellectual property components. Generally, we credit a portion of the royalty payments to the manufacturer’s account to be applied against license fees for future orders placed with us, if any, payable by the manufacturer. The portion of the royalty payment that is credited to a manufacturer’s account to be applied against future license fees, if any, is based on negotiations at the time the license arrangement is signed.
SOURCES OF REVENUE
The license of our intellectual property components to an integrated circuit manufacturer typically involves a sales cycle of three to nine months and often coincides with an integrated circuit manufacturing customer’s migration to a new manufacturing process. Our contracts with integrated circuit manufacturers generally require them to pay a license fee for each product delivered under a contract. Generally, our license contracts involve multiple products. Throughout the production cycle, integrated circuit manufacturers often request additional products or modifications to existing products that result in additional license revenue. Our contracts generally require payment of a portion of the license fees upon signing of the contract with the final payment due within 30 to 90 days after delivery, which generally takes three to nine months from the contract signing date.
We have been dependent on a relatively small number of integrated circuit manufacturing customers for a substantial portion of our revenue, although the integrated circuit manufacturers comprising this group have changed from time to time. In fiscal 2003, IBM accounted for 18% of total revenue, TSMC accounted for 17% of total revenue and Chartered accounted for 10% of total revenue. In fiscal 2002, TSMC accounted for 39% of total revenue. In fiscal 2001, TSMC accounted for 26% of total revenue and Synopsys accounted for 12% of total revenue. We anticipate that our revenue will continue to depend on a limited number of major customers for the foreseeable future, although the companies considered to be major customers and the percentage of revenue represented by each major customer may vary from period to period depending on the customer’s contributing to the addition of new contracts, the timing of work performed by us and the number of designs utilizing our products.
The license of our intellectual property components typically involves a significant commitment of capital by the integrated circuit manufacturer and a purchase from us will often be timed to coincide with a manufacturer’s migration to a new manufacturing process geometry. Manufacturers migrating to a new process geometry often view our intellectual property components as a means of attracting integrated circuit designers that use our components. Within a given process geometry, manufacturers may also choose to license additional intellectual property components from us in response to their customer’s requirements. Once an order is received, we must commit significant time and resources to the customization of products for such manufacturer. Because we often recognize revenue from such orders on a percentage-of-completion basis, the customers representing a significant portion of our revenue in a given quarter will depend upon the timing of our receipt of new orders and our progress on the customization of projects actually performed by us during such quarter.
We derive a substantial majority of our total revenue from fees associated with the sale of licenses, including maintenance and support fees. Of these components, maintenance and support fees have historically represented less than 10% of license revenue. Together, these license, maintenance and support fees accounted for 85% of total revenue in fiscal year 2003, 74% of total revenue in fiscal 2002 and 82% of total revenue in fiscal 2001. We expect that license revenue will continue to account for a substantial portion of our total revenue for the foreseeable future.
We calculate royalty revenue based on the selling price of integrated circuits or wafers containing our intellectual property components. License arrangements call for royalty reporting by each integrated circuit manufacturing customer on either a per-integrated circuit or per-wafer basis. Given that we provide our intellectual property components early in the customer’s integrated circuit design process, there is a delay of approximately one to four years between the time we deliver an intellectual property component and the time we receive royalty revenue, if at all, when the integrated circuits incorporating our intellectual property components are manufactured and sold. In recent periods, we have established uniform royalty rates, calculated on the basis of the wafer selling prices, applicable to all new licensees. Prior to that, royalty rates varied among integrated circuit manufacturers. In addition, our agreements with TSMC provide that royalty and credit rates decrease in accordance with a fixed schedule over the life of a given process geometry. Our success will depend, in part, on our ability to generate royalty revenue from a large number of designs and on many of these designs achieving substantial manufacturing volumes.
To date, a substantial portion of our net royalty revenue has been derived from one integrated circuit manufacturer, TSMC. TSMC accounted for 75% of our net royalty revenue in fiscal 2003, 89% in fiscal 2002 and 88% in fiscal 2001. Net royalty revenue as a percentage of total revenue was 15% in fiscal 2003, 26% in 2002 and 18% in fiscal 2001.
Historically, a large portion of our total revenue has been generated from outside of the United States. International revenue as a percentage of our total revenue was approximately 69% in fiscal 2003, 75% in fiscal 2002 and 70% in fiscal 2001. We anticipate that international revenue will remain a substantial portion of our total revenue for the foreseeable future. As all of our sales are currently denominated in US dollars, a strengthening of the US dollar could make our intellectual property components less competitive in foreign markets. We do not use derivative financial instruments for speculative or trading purposes. We have not engaged in any foreign currency hedging transactions.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, assumptions and judgments including those related to revenue recognition, accounting for investments, allowance for doubtful accounts, goodwill impairments, contingencies, restructuring costs and other special charges and taxes. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results of these estimates form the basis for our judgments about the carrying values of assets and liabilities and our recognition of revenue that is not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Some of our most critical accounting policies are described in the following paragraphs:
REVENUE RECOGNITION
We follow specific and detailed guidelines in recognizing revenue in accordance with the provisions of AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-4 and Statement of Position 98-9, as well as Accounting Research Bulletin No. 45, “Long-Term Construction-Type Contracts,” and Statement of Position 81-1, “Accounting for Performance of Construction-Type and Certain Production Type Contracts.” However, our judgments may affect the application of our revenue recognition policy. Revenue in any given period is difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.
We recognize and report revenue in two separate categories: license revenue and net royalty revenue. License revenue is comprised of license, maintenance and support fees. License fees are derived from the purchase of a license for our products. Maintenance fees are derived from maintenance contracts with our integrated circuit manufacturing customers, which are generally purchased at the same time as a license for the product. Support fees are derived from arrangements with integrated circuit designers to support the use of our intellectual property components in their designs. Royalty revenue is derived from fees based on the selling prices of integrated circuits or wafers containing our intellectual property components.
License revenue. For all licenses, we use both a binding purchase order and a signed license agreement as evidence of an arrangement. We assess cash collectibility based on a number of factors, including past collection history with the customer and the credit worthiness of the customer. In cases where we believe a customer’s credit worthiness is uncertain, we require prepayment or a letter of credit as assurance of payment. If we determine that collection of a fee is not probable, we defer the revenue and recognize it at the time collection becomes probable.
For licensed products which do not require significant customization of intellectual property components, we generally recognize license revenue when a signed contract or other persuasive evidence of an arrangement exists, the software has been shipped or electronically delivered, the license fee is fixed or determinable and collection of the resulting receivable is probable.
For licensed products requiring significant customization of our intellectual property components, we generally recognize license revenue using the percentage-of-completion method of accounting over the period that services are performed. For all license and service agreements accounted for under the percentage-of-completion method, we determine progress to completion based on actual direct labor hours incurred to date as a percentage of the estimated total direct labor hours required to complete the project. We periodically evaluate the actual status of each project to ensure that the estimates to complete each contract remain accurate. A provision for estimated losses on contracts is made in the period in which the loss becomes probable and can be reasonably estimated. To date, these losses have not been significant. Costs incurred in advance of billings are recorded as costs in excess of related billings on uncompleted contracts. If the amount of revenue recognized exceeds the amounts billed to customers, the excess amount is recorded as unbilled accounts receivable. If the amount billed exceeds the amount of revenue recognized, the excess amount is recorded as deferred revenue. Revenue recognized in any period is dependent on our progress toward completion of projects in progress. Significant management judgment and discretion are used to estimate total direct labor hours. Any changes in or deviations from these estimates could have a material effect on the amount of revenue we recognize in any period.
For arrangements with multiple elements, such as product licenses and maintenance services, we allocate revenue to each element of a transaction based upon its fair value as determined in reliance on vendor specific objective evidence. Vendor specific objective evidence of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those licensed products and services when sold separately and for maintenance is additionally measured by the renewal rate. If we cannot objectively determine the fair value of any undelivered element included in license arrangements, we defer revenue until all elements are delivered, all services have been performed or fair value can objectively be determined. When the fair value of a license element has not been established, we use the residual method to record license revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the fee is allocated to the delivered elements and is recognized as revenue.
We derive maintenance fees from maintenance contracts, which are generally purchased by integrated circuit manufacturers at the same time as a license for our intellectual property components. Maintenance includes telephone and email support and the right to receive unspecified upgrades on a when-and-if-available basis. Maintenance may generally be renewed on an annual basis. We recognize revenue for maintenance, based on vendor specific objective evidence of fair value, ratably over the term of the maintenance period. We generally determine vendor specific objective evidence of maintenance based on the stated fees for maintenance renewal set forth in the original license and first maintenance agreement.
We derive support fees from arrangements with integrated circuit designers to support the use of our intellectual property components in their designs. Support includes telephone and email support and the right to receive unspecified upgrades on a when-and-if-available basis. We recognize support fees ratably over the support period. Support arrangements generally have a term of 12 months and may be renewed for additional 12 month periods.
Royalty revenue. We recognize royalty revenue based on royalty reports received from integrated circuit manufacturers, generally on a one-quarter lag basis. In accordance with contract terms, we generally credit a portion of each royalty payment back to the integrated circuit manufacturer’s account to be applied against future license fees, if any, payable by the manufacturer. We report the remaining portion of the royalty as net royalty revenue. The amount of credits that can be earned by an integrated circuit manufacturer is generally limited to the cumulative amount of orders placed by that integrated circuit manufacturer for a given process technology. An integrated circuit manufacturer has a limited time to use the credits before they expire, generally twelve to eighteen months from the time credits are earned. As a result, we defer revenue associated with our credit program until the integrated circuit manufacturer licenses additional products or the credit expires, whichever is earlier. If the integrated circuit manufacturer does not use the credits within the stated period, we record the amount of the expired credits as net royalty revenue as we no longer have an obligation to provide any future products for the expired credits. Historically, integrated circuit manufacturing customers have utilized substantially all credits to purchase additional licensed products prior to expiration of the credits. When the integrated circuit manufacturing customers use credits, we recognize the credits as license revenue when our revenue recognition criteria have been met.
ACCOUNTING FOR INVESTMENTS
We determine the appropriate classification of marketable securities at the time of purchase and evaluate such designation as of each balance sheet date. To date, all marketable securities have been classified as available-for-sale and are carried at fair value with unrealized gains and losses, if any, included as a component of accumulated other comprehensive income in stockholders’ equity. Marketable securities are presented as current or long-term assets based on their scheduled maturities. Realized gains and losses are recognized based on the specific identification method.
We review our investments on a regular basis to evaluate whether or not each security has experienced an other-than-temporary decline in fair value. If we believe that an other-than-temporary decline exists, we write down the investment to fair market value and record the related write-down as a loss on investments in our consolidated statements of operations.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of customers to make required payments. The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer accounts, the aging of the accounts receivable and our historical experience. If a major customer’s creditworthiness were to deteriorate, or actual defaults were higher than our historical experience, our allowance for doubtful accounts may be insufficient to cover the uncollectible receivables, which could have an adverse impact on our operating results in the period. The impact of any change in the allowance for doubtful accounts may be affected by our reliance on a relatively small number of integrated circuit manufacturers for a large portion of our total revenue.
IMPAIRMENT OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
We assess long-lived assets, goodwill and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable through the estimated undiscounted future cash flows resulting from the use of the assets. If we determine that the carrying value of
long-lived, goodwill and other intangible assets may not be recoverable, we measure impairment by using the projected discounted cash flow method.
In accordance with Statement of Financial Accounting Standards No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets,” goodwill and intangible assets deemed to have indefinite lives are no longer amortized, but instead are subject to impairment tests on at least an annual basis and between annual tests whenever events or circumstances may indicate an impairment has occurred. We adopted SFAS 142 during the first quarter of fiscal 2002. Our acquired workforce does not qualify as a separately identifiable intangible asset and on adoption of SFAS 142 was reclassified as goodwill. The adoption of SFAS 142 did not have a material impact on our financial position and results of operations, other than the cessation of amortization of goodwill.
CONTINGENCIES
We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. We accrue an estimated loss contingency when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether the accruals should be adjusted.
ACCOUNTING FOR INCOME TAXES
We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We consider historical taxable income, expectations and risks associated with our estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. As of September 30, 2003, we recorded a full valuation allowance against our deferred tax assets. Should we determine that it is more likely than not that we would be able to realize all or part of the deferred tax asset in the future, an adjustment to the net deferred tax asset would increase income in the period such determination is made.
ACQUISITIONS
In February 2003, we acquired NurLogic Design, Inc. (“NurLogic”) for consideration consisting of approximately $5.0 million in cash, 745,000 shares of common stock valued at approximately $12.9 million, and assumed options to acquire 819,000 shares of common stock with a weighted average exercise price per share of $11.89 and a fair value of approximately $11.3 million. We accounted for the acquisition under the purchase method of accounting. NurLogic’s technology adds complementary analog, mixed-signal and communication components to our product portfolio. Our acquisition of NurLogic has resulted in a significant increase in our costs and expenses relating primarily to the increased headcount and amortization of purchased intangible assets. This increase in our costs and expenses has affected and will continue to affect the comparability of our financial statements in future periods.
In January 2001, we acquired certain assets of the physical library business of Synopsys for approximately $27.4 million. We accounted for the acquisition under the purchase method of accounting. Upon consummation of our acquisition of certain assets of the Synopsys physical library business, we immediately charged to expense $2.4 million representing acquired in-process technology that had not yet reached technological feasibility and had no alternative future use. In fiscal 2001, our acquisition of such assets from Synopsys resulted in a significant increase in our costs and expenses relating primarily to the increased headcount and amortization of goodwill and other intangible assets associated with the acquisition.
In accordance with SFAS 142, we ceased amortizing goodwill in the first quarter of fiscal 2002.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, selected statements of operations data as a percentage of our total revenue:
Fiscal Years Ended September 30, 2003, 2002 and 2001
The increase in total revenue of $31.3 million in fiscal 2003 compared to fiscal 2002 was attributable to increased license revenue of $30.2 million and an increase in net royalty revenue of $1.0 million. Gross royalty payments are calculated based on per unit sales of integrated circuits or wafers containing our intellectual property components. Gross royalties were $14.2 million in fiscal 2003 and $13.3 million in fiscal 2002. From these amounts, $3.7 million was credited back to customer accounts in fiscal 2003 and $3.8 million was credited back to customer accounts in fiscal 2002, in each case, for use as payment of license fees for future orders to be placed with us, if any. The remaining portion of gross royalty revenue of $10.5 million in fiscal 2003 and $9.5 million in fiscal 2002 was reported as net royalty revenue.
The increase in total revenue of $11.5 million in fiscal 2002 compared to fiscal 2001 was attributable to increased license revenue of $6.6 million and an increase in net royalty revenue of $4.9 million. Gross royalties were $13.3 million in fiscal 2002 and $6.6 in fiscal 2001. From these amounts, $3.8 million was credited back to the customer accounts in fiscal 2002 and $ 2.0 million was credited back to customer accounts in fiscal 2001, in
each case, for use as payment of license fees for future orders to be placed with us. The remaining portion of gross royalty revenue of $9.5 million in fiscal 2002 and $4.6 million in fiscal 2001 was reported as net royalty revenue.
Engineering costs are allocated between cost of revenue and product development. We track specific customer projects and product development efforts based on unique project codes that are assigned at the inception of each project. Individual engineers devoted to these projects record time to these project codes as actual hours are incurred. Engineering efforts devoted to specific customer projects are recognized as cost of revenue in the same period that revenues are recognized. Engineering efforts devoted to the general development of our technology are charged to product development. Engineering costs related to product development are expensed as incurred.
The increase in cost of revenue of $8.9 million in fiscal 2003 compared to fiscal 2002 was primarily due to increased engineering hours allocated to revenue-generating projects of $8.7 million. We expect that cost of revenue will continue to increase in absolute dollars in future periods.
The increase in cost of revenue of $2.3 million in fiscal 2002 compared to fiscal 2001 was due to increased engineering hours allocated to revenue-generating projects of $1.8 million and increased use of outside services of $521,000.
The increase in product development expenses of $6.5 million in fiscal 2003 compared to fiscal 2002 was due to an increase in headcount and personnel related costs of $10.6 million, increased outside services costs of $1.9 million, increased depreciation and amortization costs of $1.9 million, increased facilities costs of $531,000 and increased supplies and materials costs of $216,000; partially offset by increased engineering hours allocated to revenue-generating projects of $8.7 million. We expect that product development expenses will continue to increase in absolute dollars in future periods.
The decrease in product development expenses of $569,000 in fiscal 2002 compared to fiscal 2001 was due to increased engineering hours allocated to revenue-generating projects of $1.8 million and decreased computer and networking equipment maintenance and depreciation costs of $622,000; partially offset by an increase in headcount and personnel related costs of $1.1 million, increased outside services of $254,000 and increased leasing costs associated with the relocation of our principal offices of $456,000.
Sales and marketing expenses include personnel related costs including salaries and commissions, travel expenses and costs associated with trade shows, advertising and other marketing efforts. The increase in sales and marketing expenses of $5.7 million in fiscal 2003 compared to fiscal 2002 was attributable to an increase in headcount and personnel related costs of $4.9 million, increased marketing and advertising program expenses of $317,000, increased depreciation and amortization costs of $380,000 and increased outside services costs of $111,000. We expect sales and marketing expenses will continue to increase in absolute dollars in future periods.
The increase in sales and marketing expenses of $2.3 million in fiscal 2002 compared to fiscal 2001 was attributable to an increase in personnel related costs of $2.4 million, increased outside services costs of $119,000 and increased facility costs of $252,000; partially offset by decreased marketing program expenses of $327,000 and decreased travel and miscellaneous expenses of $126,000.
The increase in general and administrative expenses of $2.9 million in fiscal 2003 compared to fiscal 2002 was due to increased personnel related costs of $1.9 million, increased outside services costs of $446,000, an increase in bad debt expense of $363,000, increased depreciation and amortization costs of $120,000 and increased facility and miscellaneous costs of $64,000. We expect general and administrative expenses will continue to increase in absolute dollars in future periods.
The increase in general and administrative expenses of $128,000 in fiscal 2002 compared to fiscal 2001 was due to increased personnel related costs of $289,000, increased insurance and legal expenses of $560,000 and increased facility and miscellaneous costs of $68,000; partially offset by the reduction in bad debt expense of $712,000 and decreased outside services costs of $77,000.
The decrease in the provision for unused facility lease in fiscal 2003 as compared to fiscal 2002 and 2001 is wholly attributable to the impairment of our unused leased facility for our former corporate office, which we vacated in fiscal 2001. As our original lease term expires in fiscal 2004, we made certain assumptions in determining the impairment, including our ability to sub-lease the facility for the remaining lease term in accordance with EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Due to the continued economic slowdown, we determined in fiscal 2002 that it was unlikely we would be able to sub-lease the facility and took an additional impairment charge for the full amount of the remaining lease liability.
In-process research and development expense of $520,000 in fiscal year 2003 reflected certain research projects (primarily next generation core technology) from the NurLogic acquisition that had not yet reached technological feasibility or had no alternative future use at the time of acquisition. In order to achieve technological feasibility, we estimated the cost required to complete the projects at approximately $300,000. We estimated the fair value assigned to in-process research and development using the income approach, which discounts to present value the cash flows attributable to the technology once it had reached technological feasibility using a discount rate of 40%.
In-process research and development expense of $2.4 million in fiscal year 2001 was related to our acquisition of certain assets of Synopsys’ physical library business in January 2001 and was expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed. The
fair value of the existing purchased technology and patents, as well as the technology under development, was determined using the income approach, which discounts expected future cash flows to present value. The 30% discount rate used in the present value calculations was derived from a weighted-average cost of capital analysis and venture capital surveys, adjusted upward to reflect additional risks inherent in the particular technologies and the development life cycle.
The increase in amortization of purchased intangible assets of $2.4 million in fiscal 2003 compared to fiscal 2002 was attributable to a $2.5 million increase related to the NurLogic acquisition; offset by a decrease of $140,000 in the amortization related to the Synopsys asset acquisition. The increase of $491,000 in the amortization of purchased intangible assets in fiscal 2002 compared to fiscal 2001 was attributable to the timing of the Synopsys asset acquisition in fiscal 2001.
The decrease in the amortization of goodwill and acquired workforce of $4.6 million in fiscal 2002 compared to fiscal 2001 was attributable to the adoption of SFAS 142 in the first quarter of fiscal 2002. As a result, we ceased amortizing goodwill and intangible assets with deemed indefinite lives on October 1, 2001.
The increase in interest and other income of $495,000 in fiscal 2003 compared to fiscal 2002 was primarily attributable to contract expirations related to one of our acquisitions of $444,000 and an increase in interest income of $82,000 due to higher cash, cash equivalent and marketable securities balances.
The decrease in interest and other income of $1.7 million in fiscal 2002 compared to fiscal 2001 reflected a lower rate of return on our investment portfolio in fiscal 2002.
The income tax provisions in fiscal 2003 and fiscal 2002 were results of the alternative minimum tax and foreign withholding tax. The tax provision in fiscal 2001 was a result of a full valuation allowance provided against the deferred tax assets that had been carried on our books. The valuation allowance was established due to uncertainty surrounding the realization of the benefit of such assets. The difference between the statutory and effective rates of income tax is due to the impact of state taxes and tax-free interest income and tax credits.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities in fiscal 2003 of $3.5 million was primarily attributable to the net income of $7.3 million, a decrease in prepaid and other currents assets of $324,000, a decrease in other assets of $1.2 million, an increase in accounts payable of $667,000 and non-cash related charges of $8.0 million; partially offset by an increase in contract receivables of $10.0 million, a decrease in accrued liabilities of $1.9 million and a decrease in other liabilities of $2.0 million. Net cash provided by operating activities in fiscal 2002 of $8.3 million was primarily attributable to the net income of $2.1 million, an increase in accounts payable of $689,000, an increase in deferred revenue of $2.9 million, an increase in other liabilities of $1.1 million and non-cash related charges of $4.6 million; partially offset by an increase in contract receivables of $1.5 million, an increase in prepaid and other currents assets of $800,000 and a decrease in accrued liabilities of $1.1 million. Net cash provided by operating activities in fiscal 2001 of $2.7 million was primarily attributable to a decrease in contract receivables of $1.1 million, an increase in deferred taxes of $4.1 million, an increase in accrued liabilities of $2.2 million, an increase in other liabilities of $398,000 and non-cash charges of $11.8 million; partially offset by the net loss of $14.0 million, a decrease in accounts payable of $601,000 and a decrease in deferred revenue of $2.2 million.
Net cash provided by investing activities in fiscal 2003 of $469,000 was attributable to a net decrease in purchases of marketable securities of $7.8 million; offset by an increase in purchases of property and equipment of $4.5 million and the acquisition of NurLogic of $2.8 million, net of cash acquired. Net cash used in investing activities in fiscal 2002 of $13.8 million was attributable to an increase in purchases of property and equipment of $1.5 million and a net increase in purchases of marketable securities of $12.3 million. Net cash used in investing activities in fiscal 2001 of $6.3 million was primarily attributable to an increase in purchases of property and equipment of $1.9 million and the acquisition of certain assets of the physical library business of Synopsys, net of cash acquired of $14.5 million; partially offset by the net decrease of marketable securities of $10.0 million.
Net cash provided by financing activities was $65.7 million in fiscal 2003, $3.1 million in fiscal 2002, and $2.0 million in fiscal 2001. Net cash provided by financing activities in fiscal 2003 was primarily attributable to the net proceeds of approximately $53.5 million from our May 2003 secondary public offering of 3.0 million shares of newly issued common stock, proceeds of $11.9 million from the issuance of common stock to employees upon the exercise of stock options and purchases under our employee stock purchase plan and proceeds of $240,000 from the repayment of a stockholder note. Net cash provided by financing activities in fiscal 2002 and 2001 consisted of proceeds from issuance of common stock to employees upon the exercise of stock options or our employee stock purchase plan.
We intend to continue to invest heavily in the development of new products and enhancements to our existing products. Our future liquidity and capital requirements will depend upon numerous factors, including the costs and timing of expansion of product development efforts and the success of these development efforts, the costs and timing of expansion of sales and marketing activities and our international operations, the extent to which our existing and new products gain market acceptance, the costs and timing of future acquisitions, if any, competing technological and market developments, the costs involved in maintaining and enforcing patent claims and other intellectual property rights, the level and timing of license and royalty revenue, available borrowings under line of credit arrangements, if any, and other factors. We believe that our current cash, cash equivalents and investment balances and any cash generated from operations will be sufficient to meet our operating and capital requirements for at least the next 12 months. However, from time to time, we may be required to raise additional funds through public or private financing, strategic relationships or other arrangements. There can be no assurance that such funding, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional debt or equity financing arrangements may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products. Our failure to raise capital when needed could have a material adverse effect on our business, operating results and financial condition.
We do not have any off-balance sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt, other than operating leases on our facilities. Additionally, we have not entered into any derivative contracts, nor do we have any synthetic leases. As of September 30, 2003, we had no foreign currency contracts outstanding.
The following table represents our future minimum annual lease payments as of September 30, 2003 (in thousands):
Our principal administrative and technical offices occupy 54,489 square feet in Sunnyvale, California. We hold this building pursuant to a lease that expires in 2008. In addition, we lease administrative, technical and field support offices in seven cities around the world. The administrative, technical and field offices range from small executive offices to a 35,290 square foot facility. Lease terms range from month-to-month on certain executive offices to 3 years on certain direct leases. Our principal administrative, technical and field support facilities are in Sunnyvale, California; San Diego, California; Boston, Massachusetts; Bangalore, India; Tokyo, Japan; Singapore and Paris, France. We are continually evaluating the adequacy of existing facilities and additional facilities in new cities and we believe that suitable additional space will be available in the future on commercially reasonable terms as needed.
In October 2002, we announced a stock buyback plan of up to $5 million of our common stock with a term of one year. As of September 30, 2003, no shares were repurchased by us under such plan and the plan terminated.
RECENT ACCOUNTING PRONOUNCEMENTS
In July 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This Statement requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on our financial position and results of operations.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material impact on our financial position and results of operations.
In November 2002, the Emerging Issues Task Force reached a consensus on Issue No. 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material impact on our financial position and results of operations.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation-Transition and Disclosure-an Amendment of SFAS 123.” SFAS 148 provides two additional transition methods for entities that adopt the preferable method of accounting for stock-based compensation. Further, the statement requires disclosure of comparable information for all companies regardless of whether, when, or how an entity adopts the preferable, fair value based method of accounting. These disclosures are now required for interim periods in addition to annual disclosure. We adopted the additional disclosure provisions of SFAS 148. The transition provisions of SFAS 148 are currently not applicable to us as we continue to account for options under APB 25.
In January 2003, the FASB issued FASB Interpretation FIN No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” In general, a variable interest entity (“VIE”) is a corporation, partnership, trust, or any other
legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss from the VIE’s activities or is entitled to receive a majority of the VIE’s residual returns or both. The consolidation requirements of FIN 46 are effective immediately for VIE’s created after January 31, 2003. The consolidation requirements for older VIE’s are effective for financial statements of interim or annual periods beginning after June 15, 2003. Certain of the disclosure requirements are effective for all financial statements issued after January 31, 2003, regardless of when the VIE was established. The adoption of FIN 46 did not have a material impact on our financial position or results of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity and further requires that an issuer classify as a liability (or an asset in some circumstances) financial instruments that fall within its scope because that financial instrument embodies an obligation of the issuer. Many of such instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic entities. SFAS 150 is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance date of SFAS 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The adoption of SFAS 150 did not have a material impact on our financial position or results of operations.
FACTORS AFFECTING FUTURE OPERATING RESULTS
The following lists some, but not all, of the risks and uncertainties which may have a material and adverse effect on our business, financial condition or results of operations. The risks and uncertainties set out below are not the only risks and uncertainties we face. If any of the material risks or uncertainties we face were to occur, the trading price of our securities could decline.
RISKS RELATED TO OUR BUSINESS
Our quarterly operating results may fluctuate, which could cause our stock price to decline.
Our operating results have fluctuated in the past, and may fluctuate in the future, as a result of a number of factors including:
• fluctuations in the demand for integrated circuits and end user products that incorporate integrated circuits;
• our ability to develop, introduce and market new intellectual property components before our competitors;
• the relatively large size and small number of orders we receive during a given period;
• the timing of orders, reflecting in part the capital budgeting and purchasing cycles of our customers;
• the length of our sales cycle;
• the gain or loss by us of a large integrated circuit manufacturing customer or the gain or loss by our customer of a major order of integrated circuits containing our intellectual property components;
• the size and timing of the manufacture and sale by our integrated circuit manufacturing customers of integrated circuits containing our intellectual property components;
• the timing and results of our audit of royalty reports submitted to us by our customers;
• the accuracy of our estimates for project completion costs, which require significant management judgment and discretion;
• our progress on contracts that are recognized as revenue on a percentage-of-completion basis, which represent a substantial majority of our contracts and generally have completion periods of six to nine months; and
• the timing and magnitude of costs incurred by us in developing and marketing new intellectual property components and market acceptance of such components.
Our future revenue may fluctuate from quarter to quarter and on an annual basis as a result of these and other factors. Our expense levels are based in part on our expectations regarding future revenue. If revenue is below our expectations in any quarter and we are not able to adjust spending in a timely manner, the negative effect of such shortfall may increase. We intend to continue our investment in product development as well as in product promotion, licensing and support programs in an effort to maximize the growth of future revenue and net income. Accordingly, it is likely that in some future quarters our expenses will represent a greater than expected percentage of our revenue, causing our operating results to fall below the expectations of public market analysts and investors, which could cause our stock price to decline, perhaps substantially.
Our sales cycle is unpredictable and may be more than 12 months, so we may fail to adjust our resources and expenses adequately to meet anticipated or actual demand.
The license of our intellectual property components typically involves a significant commitment of capital by the integrated circuit manufacturer and a purchase will often be timed to coincide with an integrated circuit manufacturer’s migration to a new manufacturing process or process variation. Potential customers generally commit significant resources to an evaluation of available intellectual property components and require that we expend substantial time, effort and resources to educate them about the value of our intellectual property components. Despite these efforts, potential customers may select an alternate product or delay or forego a license of our intellectual property components. As a result, the sales cycle for our intellectual property components is long, typically ranging from three to nine months, and may in some cases be more than 12 months. Our ability to forecast the timing and scope of specific sales is limited. If we were to experience a delay in our orders, it could harm our ability to meet our forecasts or investors’ expectations for a given quarter and ultimately result in a decrease in our stock price.
Once we receive and accept an order for a customized product from an integrated circuit manufacturer, we must commit significant resources to customizing our products for the integrated circuit manufacturer’s manufacturing process. We generate a substantial majority of our license revenue from customized products. This customization is complex and time consuming and is subject to a number of risks over which we have little or no control. These risks include the integrated circuit manufacturer’s alterations of its manufacturing process and the timing of its migration to a new process. Typically, this customization, once started, takes from six to nine months to complete and any delays may cause us to defer revenue recognition or potentially lose orders. If we fail to adequately adjust our resources and expenses to meet actual demand and actual revenue, our business may suffer. If anticipated orders fail to materialize, we may be unable to reduce our resources and expenses in time and our operating results could suffer. In addition, where integrated circuit manufacturer orders exceed our anticipated demand, we may be unable to deliver customized products in time to meet the integrated circuit manufacturer’s requirements. Any delays in product customization and delivery give rise to the risk of alteration or potential cancellation of orders or may harm our relationships with our customers.
Because we rely on a relatively small number of integrated circuit manufacturers for a large portion of our revenue, our revenue could decline if our integrated circuit manufacturing customers do not continue to purchase and use our intellectual property components.
We have been dependent on a relatively small number of integrated circuit manufacturing customers for a substantial portion of our revenue, although the integrated circuit manufacturers comprising this group have changed from time to time. In fiscal 2003, IBM accounted for 18% of total revenues, TSMC accounted for 17%
of total revenues and Chartered accounted for 10%. In fiscal 2002, TSMC accounted for 39% of total revenues. In fiscal 2001, TSMC accounted for 26% of total revenues and Synopsys accounted for 12% of total revenues. We anticipate that our revenue will continue to depend on a limited number of major customers for the foreseeable future, although the companies considered to be major customers and the percentage of revenue represented by each major customer may vary from period to period depending on the addition of new contracts, the timing of work performed by us and the number of designs utilizing our products.
Our business is subject to many risks beyond our control that influence the success of these and other customers, including competition faced by these manufacturers, market acceptance of their products, and the engineering, sales and marketing capabilities of such customers. In addition, we believe that the licensing of our intellectual property components by integrated circuit manufacturers is driven in part by a desire on the part of such manufacturers to attract integrated circuit designers to their foundries. In the event that such manufacturers begin to operate at or near their manufacturing capacities, they may elect to reduce their marketing activities, including their purchase of our products for use by integrated circuit design teams.
We have incurred operating losses in recent periods and may be unable to maintain profitability.
Although we were profitable in fiscal 2003 and fiscal 2002, we incurred net operating losses in the first six months of fiscal 2002, fiscal 2001 and fiscal 1999. If our revenue in future periods increases more slowly than we expect, or not at all, we may not maintain profitability. In addition, most of our operating expenses are fixed in the short term, so any shortfall in anticipated revenue in a given period could significantly reduce our operating results below expectations. We expect to continue to incur significant expenses in connection with product development, operational and administrative activities and expansion of our sales and marketing efforts. As a result, we will need to increase revenue relative to increases in costs to maintain profitability. We may be unable to sustain or increase profitability on a quarterly or annual basis. If we fail to maintain profitability, our business and financial condition would suffer, we could lose the benefit of tax credits and deferred tax assets and our stock price could decline.
TSMC, one of our largest customers, develops and distributes products that compete with ours.
TSMC, one of our largest integrated circuit manufacturing customers, has historically produced intellectual property components for use by third parties in designs to be manufactured at TSMC’s foundry. These components are designed to serve the same purpose as components produced by us. The intellectual property components developed by TSMC have competed and are expected to continue to compete with our products. We believe that TSMC is more aggressively developing and distributing these products to encourage its customers to use TSMC to manufacture their current and future designs. TSMC has substantially greater financial, manufacturing and other resources, name recognition and market presence than we do and the internal design group at TSMC has greater access to technical information about TSMC’s manufacturing processes. Distribution partners selected by TSMC include Cadence, Magma and Virage Logic. Some of TSMC’s distribution partners, such as Cadence, may have greater resources, name recognition and distribution networks than we do. If TSMC is successful in supplying its own intellectual property components to third parties either directly or through distribution arrangements with other companies, our revenue from TSMC, our revenue from other customers and our operating results could be negatively affected.
Our customers are not obligated to purchase additional products from us or manufacture integrated circuits with our products, which may cause our operating results to suffer.
None of our customers has a written agreement with us that obligates them to license future generations of intellectual property components or additional intellectual property components from us, and we cannot be certain that any customer will license intellectual property components from us in the future. Our revenue from these customers may be comprised of license fees and royalties. In addition, we cannot be certain that any of the integrated circuit manufacturers will produce products incorporating our intellectual property components or that,
if production occurs, they will generate significant royalty revenue for us. If one or more of our major integrated circuit manufacturing customers stops licensing our intellectual property components, reduces its orders, fails to pay license or royalty fees due or does not produce products containing our intellectual property components, our operating results could be materially and negatively affected.
We have relied and expect to continue to rely on royalties as a key component of our business model and if we fail to realize expected royalties our business will suffer.
Royalties are calculated based on the selling prices of integrated circuits or wafers containing our intellectual property components. We believe that our long-term success is substantially dependent on future royalties. We face risks inherent in a royalty-based business model, such as the rate of incorporation of our intellectual property components into integrated circuit designs, the rate of adoption of our intellectual property components by integrated circuit manufacturers and the demand for products incorporating these integrated circuits. Our royalty revenue is highly dependent upon the level of integrated circuit production and sales by our integrated circuit manufacturing customers. Fluctuations in orders placed with our integrated circuit manufacturing customers from their customers could significantly affect our royalty revenue and operating results. Additionally, our ability to forecast and realize royalty revenue is limited by factors that are beyond our control. These factors include the timing of the manufacture of royalty-bearing integrated circuits or wafers, the price charged by integrated circuit manufacturers to their customers for royalty-bearing integrated circuits or wafers, and the quantity of royalty-bearing integrated circuits or wafers ordered and actually manufactured. We believe that a significant portion of our royalty revenue in fiscal 2003 was derived from the manufacture and sale of integrated circuits for graphics applications. If the market for integrated circuits in graphics applications declines, our royalty revenue may be adversely affected. On a period-to-period basis, net royalty revenue may vary significantly. Net royalty revenue as a percentage of our total revenue was 16% in the fourth quarter of fiscal 2003, 18% in the third quarter, 14% in the second quarter and 14% in the first quarter.
There is significant delay and uncertainty between the delivery of our intellectual property components and the generation of royalty revenue. In addition to the factors described above, this delay and uncertainty is due to the delivery and application of our intellectual property components early in the integrated circuit design process and delays in the reporting of the production and sale of royalty bearing integrated circuits or wafers. The time between the delivery of our intellectual property components to a customer and the manufacture in volume of integrated circuits containing our intellectual property components may be three years or longer. Thus, we cannot anticipate the impact of royalty payments on our financial results when we negotiate royalty agreements. We recognize royalty revenue in the quarter in which we receive a royalty report from an integrated circuit manufacturer, provided that other conditions to revenue recognition have been satisfied. As a result, our recognition of royalty revenue typically lags behind the quarter in which the related integrated circuit is manufactured or sold by the integrated circuit manufacturing customer by at least one quarter. We cannot be certain that our business strategy will be successful in expanding the number of contracts with integrated circuit manufacturers, nor can we be certain that we will receive significant royalty revenue in the future.
TSMC accounted for 75% of our net royalty revenue in fiscal 2003, 89% in fiscal 2002 and 88% in fiscal 2001. Our agreements with TSMC provide that royalty rates decrease in accordance with a fixed schedule over the life of a given process. As a result, our net royalty revenue may decline if royalties from TSMC continue to represent a substantial portion of our net royalty revenue.
We also face risks relating to the accuracy and completeness of the royalty collection process. Our ability to generate royalty revenue depends, in part, on our ability to negotiate, structure, monitor and enforce agreements for the determination and payment of royalties. We have only limited experience and systems in place to conduct reviews of the accuracy of the royalty reports we receive from our licensees. We have the right to audit the records of integrated circuit manufacturers who license our intellectual property components to help ensure the integrity of their royalty reporting systems; however, these audits may only be conducted periodically and may be at our expense. We cannot be certain that the costs incurred by us in conducting these audits will not exceed
the royalties that result from these efforts. Furthermore, the timing and findings of such royalty audits have resulted in and are expected to continue to result in significant fluctuations in the level and timing of our royalty revenue.
We continue to experience intense competition from other intellectual property component providers, integrated circuit manufacturers and electronic design automation companies, and this competition could negatively affect our business and our revenue.
Our strategy of targeting integrated circuit manufacturers and integrated circuit designers that participate in, or may enter, the system-on-a-chip market requires us to compete in intensely competitive markets. We face significant competition from third party intellectual property component providers, such as Barcelona Design, DOLPHIN, Faraday Technology, Monolithic System Technology, Neolinear, Rambus, TriCN, VeriSilicon, Virage Logic and Virtual Silicon and from the internal design groups of integrated circuit manufacturers such as TSMC and IBM. In addition, we face competition from small consulting firms and design companies that operate in the intellectual property component segment of the market and offer a limited selection of specialized intellectual property components.
We face significant competition from the internal design groups of integrated circuit manufacturers that have expanded their manufacturing capabilities and portfolio of intellectual property components to participate in the system-on-a-chip market. Integrated circuit manufacturers that license our intellectual property components have historically had their own internal intellectual property component design groups. These design groups continue to compete with us for access to the integrated circuit manufacturer’s intellectual property component requisitions and, in some cases, compete with us to supply intellectual property components to third parties. Intellectual property components developed by internal design groups are designed to utilize the qualities of their own manufacturing process, and may therefore benefit from capacity, informational, cost and technical advantages. If internal design groups expand their intellectual property component offerings to compete directly with our intellectual property components or actively seek to participate as vendors in the intellectual property component market, our revenue and operating results could be negatively affected.
We expect competition to increase in the future from existing competitors and from new market entrants with intellectual property components that may be less expensive than ours or that may provide better performance or additional features not currently provided by our intellectual property components. Many of our current and potential competitors have substantially greater financial, technical, manufacturing, marketing, distribution and other resources, greater name recognition and market presence, longer operating histories, lower cost structures and larger customer bases than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. In addition, some of our principal competitors maintain their own electronic design automation tools and intellectual property component libraries which allow them to offer a single vendor solution.
Our ability to compete successfully in the market for intellectual property components will depend upon numerous factors, many of which are beyond our control including, but not limited to:
• continued market acceptance of products using integrated circuits and industry and general economic conditions;
• access to adequate electronic design automation tools, many of which are licensed from our current or potential competitors;
• access to adequate technical information from integrated circuit manufacturers, many of which are actual or potential competitors;
• our ability to implement new designs at smaller process geometries;
• our ability to expand and protect our intellectual property;
• our ability to manage our staffing levels to respond to increases in customer demand for specific products or services that may occur from time to time;
• the price, quality and timing of our new intellectual property components and those of our competitors;
• the emergence of new intellectual property component interchangeability standards;
• the widespread licensing of intellectual property components by integrated circuit manufacturers or their design groups to third party manufacturers;
• market acceptance of our intellectual property components; and
• success of competitive intellectual property components.
If we fail to enhance our intellectual property components and develop and introduce new intellectual property components on a timely basis, we may not be able to address the needs of our customers, our technology may become obsolete and our results of operations may be harmed.
Our customers compete in the integrated circuit industry, which is subject to rapid technological change, frequent introductions of new products, short product life cycles, changes in customer demands and requirements and evolving industry standards. The development of new manufacturing processes, the introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. Accordingly, our future success will depend on our ability to continue to enhance our existing intellectual property components and to develop and introduce new intellectual property components that satisfy increasingly sophisticated customer requirements and that keep pace with new product introductions, emerging manufacturing process technologies and other technological developments in the integrated circuit industry. We intend to continue to invest heavily in the development of new products and enhancements to our existing products. This investment of funds, time and other resources involves numerous risks, including risks of development obstacles and delays and risks of poor market reaction to such new products, which could cause our expenses to represent a greater than expected percentage of our revenue in any given quarter. If we fail to anticipate or adequately respond to changes in manufacturing processes or customer requirements, or if we experience significant delays in intellectual property component development, our business and operating results may be negatively affected. We cannot be certain that we will avoid difficulties that could delay or prevent the successful introduction, development and sale of new or enhanced intellectual property components or that the new or enhanced intellectual property components will achieve market acceptance. If we do not satisfy our delivery commitments, then we could also be exposed to litigation or claims from our customers. Any claim could have a material negative effect on our business, which could cause our stock price to decline.
From time to time, we have experienced delays in the progress of customization of new intellectual property components for a given customer, and we may continue to experience delays in the future. Any delay or failure to meet customers’ expectations could result in damage to customer relationships and our reputation, underutilization of engineering resources, delay in the market acceptance of our intellectual property components or a decline in revenue, any of which could negatively affect our business.
We face risks from sales to foreign customers and foreign operations, which could reduce our operating results and harm our financial condition.
Historically, a large portion of our total revenue has been derived from integrated circuit manufacturers located outside of the United States. International revenue as a percentage of our total revenue was approximately 69% in fiscal 2003, 75% in fiscal 2002 and 70% in fiscal 2001. Revenue derived from customers in Taiwan as a percentage of our total revenue was approximately 21% in fiscal 2003, 44% in fiscal 2002 and 34% in fiscal 2001. We anticipate that international revenue will remain a substantial portion of our total revenue in the future. To date, all of our revenue from international customers has been denominated in US dollars. If our competitors denominate their sales in a currency that becomes relatively inexpensive in comparison to the US dollar, then we may experience fewer orders from international customers whose business is based primarily on the less expensive currency. In addition, future dislocations in international financial markets may materially affect our business.
We intend to expand our sales, marketing and design activities in Asia and Europe. We have established an engineering services and support facility in Bangalore, India and intend to increase our presence in China and Taiwan. International expansion will result in increased costs and may not be successful, which could harm our business. Our expansion of international activity and dependence on customers outside the United States involves a number of risks including:
• the impact of possible recessions in economies outside the United States, which, given our reliance on foreign customers for a substantial portion of our revenue, could have a significant negative impact on our business and results of operations;
• political and economic instability, including instability relating to North Korea and tensions between Taiwan and China and India and Pakistan, which could have a significant impact on us due to the concentration of our manufacturing and design customers in Taiwan and our design center in India;
• the impact of a possible recurrence of Severe Acute Respiratory Syndrome (SARS) in China, Taiwan and other countries in which we do a significant amount of business;
• exchange rate fluctuations which, due to the denomination of our foreign sales in US dollars, could significantly increase the cost of our products to our foreign customers;
• the impact of export license requirements, such as those that may apply to our high-speed specialty input/output circuits, could necessitate changes to our existing open access web-based distribution platform and delay or prevent sales to customers in restricted countries;
• difficulties in enforcement of contractual and intellectual property rights, which difficulties could have a significant adverse effect on our business given our open access distribution model, and our reliance on contractual and intellectual property rights to limit the use of our products and generate royalties; and
• difficulties and costs of staffing and managing foreign operations, which, given our lack of experience with remote operations and our expansion into India, could have a significant negative impact on our business.
If we are unable to sustain or increase revenue derived from international customers or minimize the foregoing risks, our business may be materially and adversely affected, which could cause our stock price to decline.
International political instability may increase our cost of doing business and disrupt our business.
Increased international political instability, evidenced by the threat or occurrence of terrorist attacks, enhanced national security measures, continuing military action in Afghanistan and Iraq, strained international relations with North Korea, tensions between Taiwan and China, tensions between India and Pakistan and other conflicts in the Middle East and Asia, may halt or hinder our ability to do business, may increase our costs and may adversely affect our stock price. This increased instability may, for example, negatively impact the reliability and cost of transportation, negatively affect the desire of our employees and customers to travel, lead to stricter export controls, adversely affect our ability to obtain adequate insurance at reasonable rates or require us to take extra security precautions for our domestic and international operations. In addition, this international political instability has had and may continue to have negative effects on financial markets, including significant price and volume fluctuations in securities markets. If this international political instability continues or escalates, our business and results of operations could be harmed and the market price of our common stock could decline.
If we lose any of our key personnel or are unable to attract, train and retain qualified personnel, our ability to manage our business and continue our growth would be negatively impacted.
Our success depends in large part on the continued contributions of our key management, engineering, sales and marketing personnel, many of whom are highly skilled and would be difficult to replace. None of our senior
management, key technical personnel or key sales personnel is bound by a written employment contract to remain with us for a specified period. In addition, we do not currently maintain key man life insurance covering our key personnel. Our success also depends on our ability to attract, train and retain highly skilled managerial, engineering, sales, marketing and finance personnel and on the abilities of new personnel to function effectively, both individually and as a group. If we are unable to effectively integrate and utilize newly hired engineering, management or sales personnel, the execution of our business strategy and our ability to react to changing market conditions may be impeded and our business could suffer. Competition for personnel is intense, and we cannot be certain that we will be successful in attracting and retaining qualified personnel. If we lose the services of any key personnel, are unable to attract or retain qualified personnel in the future or experience delays in the integration of new personnel in the United States and abroad, our business and operations may suffer.
Our historical growth and acquisitions have placed and future acquisitions may place a significant strain on our management systems and resources and we may be unable to effectively control our costs and implement our business strategies as a result.
Our ability to license our intellectual property components and manage our business successfully in a rapidly evolving market requires an effective planning and management process. Our historical growth, international expansion, acquisitions, including our acquisition of NurLogic in February 2003, have placed, and are expected to continue to place, a significant strain on our managerial, operational and financial resources. We have established an engineering service and support facility in Bangalore, India and plan to increase our presence in China and Taiwan. The number of our employees or their full-time equivalents has increased to 343 on September 30, 2003 from 181 on September 30, 2002. Our international expansion has resulted and is expected to continue to result in increased costs.
Our customers rely heavily on our technological expertise in designing, testing and manufacturing products incorporating our intellectual property components. Relationships with new integrated circuit manufacturers generally require significant engineering support that may increase the strain on our personnel, particularly our engineers. We cannot be certain that our systems and resources will be adequate to support our operations or that our management will be able to achieve the rapid execution necessary to implement our business plan.
If we are not able to effectively integrate and develop the operations of NurLogic, our business may suffer.
We acquired NurLogic in February 2003. We have integrated the workforce and operations of NurLogic into our organizational structure and we are working towards the effective utilization of the additional workforce. We face various integration and operational risks as a result of this acquisition including, but not limited to:
• our ability to retain and motivate NurLogic’s employees;
• our ability to retain and develop NurLogic’s customers;
• our ability to use our traditional business model to market and sell NurLogic’s analog and mixed signal products and services to semiconductor manufacturers in exchange for license fees and royalties;
• the failure or a delay in integrating the technology, operations and workforce of NurLogic with our company;
• the failure to realize the potential financial or strategic benefits of the acquisition;
• the incurrence of substantial unanticipated integration costs;
• the diversion of significant management attention and financial resources in assimilating NurLogic’s business; and
• the disruption of our ongoing business.
We license our products on a nonexclusive, worldwide basis to major semiconductor manufacturers and grant these manufacturers the right to distribute our products to their internal design teams and to their application specific integrated circuit and fabless semiconductor customers. The basic elements of our product libraries are distributed to integrated circuit design companies or end users at no charge to them. Historically, NurLogic has licensed its products directly to end users who have agreed to pay license fees directly to NurLogic. We cannot be sure that semiconductor manufacturers will be willing to license and pay for analog and mixed signal intellectual property components for the benefit of end users in the same way as such manufactures have historically licensed digital intellectual property components from us. Such analog and mixed signal intellectual property components tend to require a greater degree of customization for a particular use than do many of our other products. To date, we have had only limited success in expanding the customer base for these products beyond NurLogic’s historical customer base, and if we are unable to expand the existing customer base for these products, our revenues from such products may not grow.
If we are not able to successfully integrate and develop NurLogic’s business, our business may be negatively affected in future periods, which may cause our stock price to decline. In addition, if the value of intangible assets acquired becomes impaired, we will be required to write down the value of the assets, which would negatively affect our financial results. We may incur liabilities from NurLogic including liabilities for intellectual property infringement or indemnification of NurLogic’s customers for similar claims, that could materially and adversely affect our business. If our efforts to integrate NurLogic’s business with our existing business are unsuccessful, our future revenue and operating results could be negatively affected, which could cause our stock price to decline.
Our acquisition of NurLogic will make planning and predicting our future growth rates and operating results more difficult.
Our acquisition of NurLogic may reduce our revenue growth rate and make prediction of our future revenue, costs and expenses and operating results more difficult. We have begun to offer NurLogic’s analog, mixed-signal and communications components to our existing customer base. However, we cannot predict the level of demand for NurLogic’s products from these customers. To date, we have had limited success in expanding the existing customer base for these products beyond NurLogic’s historical customer base, and if we are unable to expand the existing customer base for these products, revenues from these products may not grow. We may also incur additional costs in order to customize the existing NurLogic products to meet our customer requirements. We expect our results of operations in future periods will reflect an expanded workforce and product development effort and changed customer base. Due to the acquisition, we may not be able to accurately predict:
• how the combined business will evolve;
• the possible impairment of relationships with employees and customers as a result of the integration of the combined businesses; or
• the impairment of goodwill and other intangible assets resulting from the acquisition.
In addition, we have limited experience integrating remote operations into our organization structure. If we are unable to efficiently manage this integration, we may incur additional expenses and experience delays in our engineering and marketing efforts.
We may make future acquisitions that could cause our business to suffer.
We may continue to make investments in complementary companies, products or technologies. If we buy a company or a division of a company, we may experience difficulty integrating that company or division’s personnel and operations, which could negatively affect our operating results. In addition:
• the key personnel of the acquired company may decide not to work for us;
• we may experience additional financial and accounting challenges and complexities in areas such as tax planning, cash management and financial reporting;
• our ongoing business may be disrupted or receive insufficient management attention;
• we may not be able to recognize the cost savings or other financial benefits we anticipated; and
• our increasing international presence resulting from acquisitions may increase our exposure to foreign political, currency, and tax risks.
In connection with future acquisitions, we may be required to assume the liabilities of the companies we acquire. By assuming the liabilities, we may incur liabilities, including those related to intellectual property infringement or indemnification of customers of acquired businesses for similar claims that could materially and adversely affect our business. We may have to incur debt or issue equity securities to pay for any future acquisition, the issuance of which would involve restrictive covenants or be dilutive to our existing stockholders.
We are in the process of establishing our first remote engineering sites which, if not structured and managed effectively, could cause our business to suffer.
We are establishing an engineering service and support facility in Bangalore, India. In addition, due to our acquisition of NurLogic, we perform engineering services in San Diego, California. We have no prior experience in establishing or operating engineering centers outside of our headquarters in Sunnyvale, California. Our expansion of engineering operations to remotely situated offices presents a number of risks including increased difficulty in coordinating our engineering efforts, obtaining required equipment and tools and training new personnel, increased communications and travel costs and potential delays in our engineering efforts.
Our future capital needs may require that we seek debt financing or additional equity funding which, if not available, could cause our business to suffer.
We intend to continue to invest heavily in the development of new intellectual property components and enhancements to our existing intellectual property components. Our future liquidity and capital requirements will depend upon numerous factors, including:
• the costs and timing of expansion of product development efforts and the success of these development efforts;
• the costs and timing of expansion of sales and marketing activities;
• the costs and timing of expansion of our international operations;
• the extent to which our existing and new intellectual property components gain market acceptance;
• the cost and timing of future acquisitions, if any;
• competing technological and market developments;
• the cost involved in maintaining and enforcing our patent claims and other intellectual property rights and defending against any future claims of intellectual property infringement;
• the cost of any stock repurchases pursuant to our previously announced stock repurchase program; and
• the level and timing of license and royalty revenue.
We may raise additional funds through public or private financing, strategic relationships or other arrangements. We cannot be certain that the funding, if needed, will be available on attractive terms, or at all. Furthermore, any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products. If we fail to raise capital when needed, our business will be negatively affected, which could cause our stock price to decline.
RISKS RELATED TO OUR MARKET
Our business depends on continued demand for integrated circuits and the electronic equipment that incorporate them.
Our business is substantially dependent on the adoption of our technology by integrated circuit manufacturers and on an increasing demand for products requiring integrated circuits, such as portable computing devices, cellular phones, consumer multimedia products, automotive electronics, personal computers and workstations. Our business is subject to many risks beyond our control that influence the success of our customers including, among others, competition faced by each customer in its particular industry, market acceptance of the customer’s products that incorporate our technology, the engineering, sales and marketing capabilities of the customer and the financial and other resources of the customer. Demand for our intellectual property components may also be affected by consolidation in the integrated circuit and related industries, which may reduce the aggregate level of purchases of our intellectual property components and services by the combined companies.
The revenue we generate from licensing activities depends in large part on the rate at which integrated circuit manufacturers adopt new product generations, which, in turn, is affected by the level of demand for integrated circuits. With increasing complexity in each successive generation of integrated circuit products, we face the risk that the rate of adoption of smaller process geometries for integrated circuit manufacturing may slow. We also face the risk that our licensing revenue may suffer if our customers collaborate with each other regarding design standards for particular generations of integrated circuit products. Revenue generated from royalties depends on production and sale of integrated circuits or wafers that incorporate our technology. If the integrated circuit and electronics products industries experience a further downturn, our business could suffer.
The integrated circuit industry is cyclical in nature and a continued downturn may negatively affect the growth of our revenue.
The markets for integrated circuit products are cyclical. The integrated circuit industry suffered a sharp decline in orders and revenue in 2001 and 2002 and this weakness has continued in 2003. Many integrated circuit manufacturers and vendors of products incorporating integrated circuits have announced earnings shortfalls and employee layoffs. We believe these conditions may negatively affect our business in the future if they persist. The outlook for the electronics industry is uncertain and it is very difficult to predict future economic events.
The primary customers for our intellectual property components are integrated circuit design and manufacturing companies. Any significant downturn in our customers’ markets, or domestic and global conditions is likely to adversely affect our royalty revenue. Such a downturn may also result in a decline in demand for our intellectual property components and services and could harm our business. Continued weakness in the integrated circuit and related industries, a reduced number of design starts, shifts in the types of integrated circuits manufactured, such as a shift to field programmable gate arrays, tightening of customers’ operating budgets or consolidation among our customers could cause our business to suffer.
If the market for third party intellectual property components does not expand, our business may suffer.
Our ability to achieve sustained revenue growth and profitability in the future will depend on the continued development of the market for third party intellectual property components and, to a large extent, on the demand for system-on-a-chip integrated circuits. System-on-a-chip integrated circuits are characterized by rapid technological change and competition from an increasing number of alternate design strategies such as combining multiple integrated circuits to create a system-on-a-package and shifts to the use of field programmable gate arrays or FPGAs. We cannot be certain that the market for third party intellectual property components and system-on-a-chip integrated circuits will continue to develop or grow at a rate sufficient to support our business. If either of these markets fails to grow or develops slower than expected, our business may suffer. A significant number of our existing and potential customers currently rely on components developed internally and/or by other vendors. Our future growth, if any, is dependent on the adoption of, and increased reliance on, third party intellectual property components by both existing and potential customers.
Integrated circuit manufacturing facilities are subject to risk of natural disasters, which, if they were to occur, could harm our revenue and profitability.
Integrated circuit manufacturing facilities have in the past experienced major reductions in foundry capacity due to earthquakes in Taiwan, Japan and California. For example, Taiwan, where several of our largest customers are located, experienced several earthquakes in 1999 that impacted foundries through power outages, physical damage and employee dislocation. The license component of our revenue depends on manufacturers transitioning to new process geometries. The royalty component of our revenue is directly related to the manufacture and sale of integrated circuits containing our intellectual property components. As a result, our business could suffer if a major integrated circuit manufacturer’s transition to a new process geometry or manufacturing capacity was adversely affected by a natural disaster such as an earthquake, fire, tornado or flood.
RISKS RELATED TO OUR INTELLECTUAL PROPERTY RIGHTS
If we are not able to preserve and expand the value of the intellectual property included in our intellectual property components, our business will suffer.
We rely primarily on a combination of nondisclosure agreements and other contractual provisions and patent, trademark, trade secret and copyright law to protect our proprietary rights. If we fail to continue to expand our intellectual property and enforce and protect our patents, trademarks, copyrights and trade secrets, our business could suffer, which could cause our stock price to decline. We cannot be certain that our intellectual property rights can be successfully asserted in the future or will not be invalidated, circumvented or challenged.
In certain instances, we have elected to rely on trade secret law rather than patent law to protect our proprietary technology. However, trade secrets are difficult to protect. We protect our proprietary technology and processes, in part, through confidentiality agreements with our employees and customers. We cannot be certain that these contracts have not and will not be breached, that we will have adequate remedies for any breach or that our trade secrets will not otherwise become known or be independently discovered and possibly patented by competitors.
Effective intellectual property protection may be unavailable or limited in certain foreign jurisdictions, such as China, where we sell our intellectual property components. As a result, we may experience difficulty protecting our intellectual property from misuse or infringement by others in foreign countries. The risks associated with protection of our intellectual property rights in foreign countries are likely to increase as we expand our international operations.
An infringement claim or a significant damage award would adversely impact our operating results.
Substantial litigation and threats of litigation regarding intellectual property rights exist in our industry and the integrated circuit industry. From time to time, third parties, including our competitors, may assert patent, copyright and other intellectual property rights to technologies that are important to our business. We cannot be certain that we would ultimately prevail in any dispute or be able to license any valid and infringed patents from third parties on commercially reasonable terms. Any infringement claim brought against us, regardless of the duration, outcome or size of damage award, could:
• result in substantial cost to us;
• divert our management’s attention and resources;
• be time consuming to defend;
• result in substantial damage awards;
• cause product shipment delays; or
• require us to seek to enter into royalty or other licensing agreements.
Any infringement claim or other litigation against or by us could have a material negative affect on our business, which could cause our stock price to decline.
In any potential dispute involving our intellectual property, our customers and strategic partners could also become the target of litigation. This could trigger our technical support and indemnification obligations in our license agreements, which could result in substantial expense to us. In addition to the time and expense required for us to supply support or indemnification to our customers and strategic partners, any litigation could severely disrupt or shut down the business of our customers and strategic partners, which in turn would hurt our relations with them and harm our operating results.
From time to time, we may be subject to claims by our customers or customers of the companies we acquire that our intellectual property components or products of acquired companies that have been incorporated into electronic products infringe the intellectual property rights of others. Our future acquisitions, if any, may increase the risk that customers of these companies bring claims of intellectual property infringement or indemnification for intellectual property infringement against us.
We have been notified by one of NurLogic’s customers that it is requesting indemnification from NurLogic (now one of our wholly owned subsidiaries) because of two complaints filed against that customer alleging that some of that customer’s products infringed third party patents. While we believe that the complaints are without merit with respect to technology licensed by NurLogic, there can be no assurance that the courts would not find that the technology licensed by NurLogic does infringe third party patents. Whether or not the customer’s or NurLogic’s products infringe, the investigation and resolution of these indemnity claims and any related litigation can be expensive and can consume substantial amounts of management time and attention.
Defects in our proprietary technologies and intellectual property components could decrease our revenue and our competitive market share.
If the intellectual property components we provide to a customer contain defects that increase our customers’ cost of goods sold and time to market, the market acceptance of our intellectual property components would be harmed. Any actual or perceived defects in our intellectual property components may also hinder our ability to attract or retain industry partners or customers, leading to a decrease in our revenue. These defects are frequently found during the period following introduction of new proprietary technologies or enhancements to existing proprietary technologies. Our intellectual property components may contain errors or defects not discovered until after volume manufacture of integrated circuits containing our intellectual property components. If our intellectual property components contain errors or defects, we could be required to expend significant resources to alleviate these problems, which could result in the diversion of technical and other resources from our other development efforts. The defects or errors could also result in fewer wafers containing our intellectual property components reaching production, which would reduce our royalty revenue.
RISKS RELATED TO OUR STOCK
Our stock is subject to substantial price and volume fluctuations due to a number of factors, many of which are beyond our control, and those fluctuations may prevent our stockholders from reselling our common stock at a profit.
The trading price of our common stock has in the past been and could in the future be subject to significant fluctuations in response to:
• quarterly variations in our results of operations;
• international political instability, including instability associated with military action in Afghanistan and Iraq, strained relations with North Korea and other conflicts;
• fluctuations in national and international securities markets in response to changing economic or other conditions;
• announcements of technological innovations or new products by us, our customers or competitors;
• our failure to achieve the operating results anticipated by analysts or investors;
• sales or the perception in the market of possible sales of a large number of shares of our common stock by our directors, officers, employees or principal stockholders;
• releases or reports by or changes in security analysts’ recommendations; and
• developments or disputes concerning patents or proprietary rights or other events.
For example, from October 1, 2002 to September 30, 2003, the trading price of our common stock on the Nasdaq National Market has ranged from a high of $26.76 to a low of $7.65. If our revenue and results of operations are below the expectations of public market securities analysts or investors, significant fluctuations in the market price of our common stock could occur. In addition, the securities markets have, from time to time, experienced significant price and volume fluctuations, which have particularly affected the market prices for high technology companies and often are unrelated and disproportionate to the operating performance of particular companies. These broad market fluctuations, as well as general economic, political and market conditions, may negatively affect the market price of our common stock. In the past, following periods of volatility in the market price of a company’s stock, securities class action litigation has occurred against that company. The litigation could result in substantial costs and would at a minimum divert management’s attention and resources, which could have a material adverse effect on our business, which could further reduce our stock price. Any adverse decision in the litigation could also subject us to significant liabilities.
Our charter documents, Delaware law and our stockholder rights plan contain provisions that may inhibit potential acquisition bids, which may adversely affect the market price of our common stock, discourage merger offers or prevent changes in our management.
Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the rights, preferences, privileges and restrictions, including voting rights, of the shares without any further vote or action by our stockholders. If we issue any of these shares of preferred stock in the future, the rights of holders of our common stock may be negatively affected. If we issue preferred stock, a change of control of our company could be delayed, deferred or prevented. We have no current plans to issue shares of preferred stock.
Section 203 of the Delaware General Corporation Law restricts certain business combinations with any “interested stockholder” as defined by that statute. In addition, our certificate of incorporation and bylaws contain certain other provisions that may have the effect of delaying, deferring or preventing a change of control. These provisions include:
• cumulative voting for the election of directors;
• the elimination of actions by written consent of stockholders; and
• the establishment of an advance notice procedure for stockholder proposals and director nominations to be acted upon at annual meetings of the stockholders.
In December 2001, our board of directors adopted a stockholder rights plan. Under this plan, we issued a dividend of one right for each share of our common stock. Each right initially entitles stockholders to purchase a fractional share of our preferred stock for $115. However, the rights are not immediately exercisable. If a person or group acquires, or announces a tender or exchange offer that would result in the acquisition of, a certain percentage of our common stock, unless the rights are redeemed by us for $0.001 per right, the rights will become exercisable by all rights holders, except the acquiring person or group, for shares of our preferred stock or the stock of the third party acquirer having a value of twice the right’s then-current exercise price.
These provisions are designed to encourage potential acquirers to negotiate with our board of directors and give our board of directors an opportunity to consider various alternatives to increase stockholder value. These provisions are also intended to discourage certain tactics that may be used in proxy contests. However, the potential issuance of preferred stock, our charter and bylaw provisions, the restrictions in Section 203 of the Delaware General Corporation Law and our stockholder rights plan could discourage potential acquisition proposals and could delay or prevent a change in control, which may adversely affect the market price of our stock. These provisions and plans may also have the effect of preventing changes in our management.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
We are exposed to the impact of interest rate changes and changes in the market values of our marketable securities. We have not used derivative financial instruments in our investment portfolio. We invest our excess cash in debt instruments of high-quality corporate issuers and the U.S. Government or its agencies. Our investment policy limits the amount of credit exposure to any one issuer. We are averse to principal loss and seek to preserve our invested funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in high credit quality securities and by positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity.
Cash, cash equivalents and marketable securities in both fixed and floating rate interest-earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to rising interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future interest income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates.
The table below presents the carrying value and related weighted average interest rates for our cash, cash equivalents and marketable securities. The carrying values approximate fair values at September 30, 2003 and 2002. At September 30, 2003, marketable securities consisted of $9.9 million with a maturity date of less than one year and $5.4 million with a maturity date of greater than one year.
Currency Risk
Historically, a large portion of our total revenue has been generated from outside of the United States. International revenue as a percentage of our total revenue was approximately 69% for fiscal 2003, 75% for fiscal 2002 and 70% for fiscal 2001. We anticipate that international revenue will remain a substantial portion of our total revenue in the future. As all of our sales are currently denominated in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets. We do not use derivative financial instruments for speculative or trading purposes. We have not historically engaged in any foreign currency hedging transactions.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the Index to Consolidated Financial Statements that appears on page of this report. The Report of PricewaterhouseCoopers LLP, Independent Accountants, the Consolidated Financial Statements and the Notes to Consolidated Financial Statements listed in the Index to Consolidated Financial Statements, which appear beginning on page of this report, are incorporated by reference into this Item 8.
QUARTERLY RESULTS OF OPERATION
The following table presents certain unaudited consolidated statement of operations data for our eight most recent fiscal quarters. The information for each of these quarters is unaudited and has been prepared on the same basis as our audited Consolidated Financial Statements appearing elsewhere in this report on Form 10-K. In the opinion of our management, all necessary adjustments, consisting only of normal recurring adjustments, have been included to present fairly the unaudited quarterly results when read in conjunction with our Consolidated Financial Statements and related notes included elsewhere in this report on Form 10-K. We believe that results of operations for interim periods should not be relied upon as any indication of the results to be expected or achieved in any future period.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. DISCLOSURE CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of a date within 90 days prior to the filing of this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that 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”)) are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
Changes in internal control over financial reporting. There was no change in our internal controls over financial reporting that occurred during the period covered by this Annual Report on Form 10-K that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item concerning our directors is incorporated by reference to the sections captioned “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” contained in our definitive proxy statement relating to our 2004 Annual Meeting of Stockholders to be filed by us with the Securities and Exchange Commission within 120 days of the end of our fiscal year pursuant to General Instruction G(3) of Form 10-K. Certain information required by this item concerning executive officers is set forth in Part I of this Report under the caption “Business-Executive Officers” and certain other information required by this item is incorporated by reference to the section captioned “Section 16(a) Beneficial Ownership Reporting Compliance” contained in our definitive proxy statement for our 2004 Annual Meeting of Stockholders.
We have adopted a code of ethics that applies to our principal executive officer and all members of our finance department, including the principal financial officer and principal accounting officer. This code of ethics, which applies to employees generally, is posted on our Internet website. The Internet address for our website is http://www.artisan.com, and the code of ethics may be found as follows:
1. From our main Web page, first click on “About Artisan.”
2. Next, click on “Code of Business Conduct and Ethics.”
We intend to satisfy the disclosure requirement under Item 10 of Form 8-K regarding an amendment to, or waiver from, a provision of this code of ethics by posting such information on our website, at the address and location specified above.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference to the section captioned “Executive Compensation and Other Matters” contained in our definitive proxy statement for our 2004 Annual Meeting of Stockholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference to the sections captioned “Record Date and Principal Share Ownership” contained in our definitive proxy statement for our 2004 Annual Meeting of Stockholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference to the sections captioned “Compensation Committee Interlocks and Insider Participation” and “Certain Transactions” contained in our definitive proxy statement for our 2004 Annual Meeting of Stockholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is included under the captions “Ratification of Independent Auditors-Principal Accountant Fees and Services” and “-Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditors” in our proxy statement related to the 2004 Annual Meeting of Shareholders and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Form 10-K:
(1) Financial Statements
See the accompanying Index to Consolidated Financial Statements which appears on page of this report. The Report of Independent Accountants, the Consolidated Financial Statements and the Notes to the Consolidated Financial Statements listed in the Index to Consolidated Financial Statements, which appear beginning on page of this report are incorporated by reference in Item 8 of this report:
(2) Financial Statement Schedules
See the accompanying Index to Consolidated Financial Statements which appears on page of this report. Financial Statement Schedules not listed in the Index to Consolidated Financial Statements have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto.
(3) Exhibits
(1) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-1 (No. 333-41219) which was declared effective on February 2, 1998.
(2) Certain information in these exhibits has been omitted and filed separately with the Securities and Exchange Commission pursuant to a confidential treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83, 230.46 and 240.24b-2.
(3) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-1 (No. 333-50243) which was declared effective on April 29, 1998.
(4) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 10, 1999.
(5) Incorporated by reference to exhibits filed with the Registrant’s Current Report on Form 8-K (No. 000-23649) on January 19, 2001.
(6) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (No. 000-23649) on August 14, 2001.
(7) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 22, 2000.
(8) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 11, 2001.
(9) Incorporated by reference to the exhibit filed with the Registrant’s Registration Statement on Form 8-A (000-23649) on December 27, 2001.
(10) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (000-23649) on May 15, 2002.
(11) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-8 (333-101465) on November 26, 2002.
(12) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 27, 2002.
(13) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (000-23649) on February 14, 2003.
(14) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (000-23649) on August 14, 2003.
(15) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-3 (No. 333-103837) which was declared effective on May 6, 2003.
(16) Incorporated by reference to exhibits filed with the Registrant’s Current Report on Form 8-K (No. 000-23649) on February 26, 2003.
* Management contract or compensatory plan or arrangement covering executive officers or directors of the Registrant.
(b) Reports on Form 8-K
We filed a report on Form 8-K on July 17, 2003 in connection with our announcement of our earnings for the third quarter of fiscal 2003.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
ARTISAN COMPONENTS, INC.
By:
/s/ MARK R. TEMPLETON
Mark R. Templeton
President, Chief Executive Officer and Director
By:
/s/ JOY E. LEO
Joy E. Leo
Vice President, Finance and Administration,
Chief Financial Officer, and Secretary
Dated: December 18, 2003
POWER OF ATTORNEY
Know All Men By These Presents, that each person whose signature appears below constitutes and appoints Mark R. Templeton and Joy E. Leo, jointly and severally, his or her attorney-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Auditors
Consolidated Balance Sheets at September 30, 2003 and 2002
Consolidated Statements of Operations for the years ended September 30, 2003, 2002 and 2001
Consolidated Statements of Stockholders’ Equity for the years ended September 30, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the years ended September 30, 2003, 2002 and 2001
Notes to Consolidated Financial Statements
Schedule II-Valuation and Qualifying Accounts and Reserves
S-1
Report of Independent Auditors
To the Board of Directors and Stockholders of
Artisan Components, Inc.:
In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Artisan Components, Inc. and its subsidiaries at September 30, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2003 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Notes 2 and 3 to the consolidated financial statements, effective October 1, 2001, the Company changed its method of accounting for goodwill upon the adoption of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”
/s/ PRICEWATERHOUSECOOPERS LLP
San Jose, California
November 3, 2003
ARTISAN COMPONENTS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ARTISAN COMPONENTS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ARTISAN COMPONENTS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED SEPTEMBER 30, 2003, 2002 AND 2001
(In thousands)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ARTISAN COMPONENTS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
The accompanying notes are an integral part of these Consolidated Financial Statements.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. DESCRIPTION OF BUSINESS
Artisan Components, Inc. (“Artisan” or the “Company”) is a leading provider of physical intellectual property components for the design and manufacture of integrated circuits including those known as system-on-a-chip integrated circuits. The Company’s products include embedded memory, standard cell, communication, input/output components and analog and mixed-signal products which are designed to achieve the best combination of performance, density, power and yield for a given manufacturing process. The Company’s intellectual property components are pre-tested by producing them in silicon to ensure that they perform to specification. This enables designers to reduce the risk of design failure and gain valuable time to market. The Company licenses its products to customers for the design and manufacture of integrated circuits used in complex, high volume applications such as portable computing devices, communication systems, cellular phones, consumer multimedia products, automotive electronics, personal computers and workstations.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Significant Accounting Policies
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries after elimination of all significant inter-company balances and transactions. The Company’s fiscal year end is September 30.
Use of Estimates
The preparation of financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates including those related to revenue recognition, allowance for doubtful accounts, impairment of long-lived assets, goodwill and purchased intangible assets, contingencies, restructuring costs and other special charges and taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.
Reclassification
Certain reclassifications have been made to prior year balances in order to conform to the current year presentation.
Cash and Cash Equivalents
The Company considers all highly liquid investments with original maturities or remaining maturities at the date of acquisition of three months or less to be cash equivalents. Cash and cash equivalents are maintained with four major financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand.
Fair Value of Financial Instruments
The carrying amounts of certain of the Company’s financial instruments including cash and cash equivalents, contract receivables, accounts payable and accrued liabilities approximate fair value due to their short-term maturities.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Marketable Securities
The Company’s investments are primarily comprised of U.S. government notes and bonds; corporate notes and bonds; and commercial paper. Investments with original maturities of greater than three months and less than one year are considered to be short-term. Investments are custodied with major financial institutions. Realized gains and losses are recorded using the specific identification method. At September 30, 2003 and 2002, all of the Company’s investments were classified as available-for-sale and were recorded on the consolidated balance sheets at fair value. Unrealized gains and losses on these investments are recorded in comprehensive income. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity, both of which are included in interest income. The Company recognizes an impairment charge when the decline in fair value of its investments below the cost basis is judged to be other-than-temporary.
Software Development Costs
In accordance with Statement of Financial Accounting Standards No. 86, “Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. The Company believes its current process for developing software is essentially completed concurrently with the establishment of technological feasibility which is evidenced by a working model; accordingly, software costs incurred after the establishment of technological feasibility have not been significant and, therefore, no costs have been capitalized to date.
Costs related to software acquired, developed or modified solely to meet the Company’s internal requirements and for which there is no substantive plans to market the software are capitalized in accordance with the provisions of SOP 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Costs incurred after preliminary planning stage of the project and after management has authorized and committed funds to the project are capitalized. The Company had $194,000 and $0 of capitalized software costs included in property and equipment at September 30, 2003 and 2002, respectively.
Property and Equipment
Property and equipment are stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, generally three to five years. Depreciation and amortization of leasehold improvements are computed using the shorter of the estimated useful lives or the terms of their respective leases.
Goodwill and Other Intangible Assets
During the first quarter of fiscal 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations” and Statement of Financial Accounting Standards No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets.”
SFAS 142 requires goodwill to be tested on an annual basis and between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previous accounting standards required. Under this standard, goodwill is no longer amortized and, as such, the Company stopped amortizing its goodwill as of October 1, 2001. Furthermore, SFAS 142 requires purchased intangible assets other than goodwill to be amortized over their expected useful lives unless these lives are determined to be indefinite (See Note 3). Purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally six months to three years.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table presents the impact of SFAS 142 on net income (loss) and net income (loss) per share had the accounting standard been in effect for the periods presented below (in thousands, except per-share amounts):
The components of goodwill are as follows (in thousands):
Purchased intangible assets, except for goodwill and other intangible assets with useful lives deemed indefinite, are subject to amortization over their estimated useful lives. Amortization expense of purchased intangible assets was $4.4 million, $2.0 million and $1.5 million for fiscal years ended September 30, 2003, 2002 and 2001, respectively.
The components of purchased intangible assets are as follows (in thousands):
As of September 30, 2003, the Company believes there are no impairment losses on its goodwill and purchased intangible assets. However, no assurances can be given that future evaluations of goodwill and purchased intangible assets will not result in charges as a result of future impairment.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Expected future estimated annual amortization expense as of September 30, 2003 of intangible assets is as follows (in thousands):
Impairment of Long-Lived Assets
The Company evaluates the recoverability of long-lived assets with finite lives in accordance with Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for the Impairment of Long-Lived Assets.” Finite-lived intangible assets are amortized on a straight-line basis over their estimated useful lives, generally three to five years. SFAS 144 requires recognition of impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment charge is recognized in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets.
The Company evaluates goodwill and intangible assets deemed to have indefinite lives in accordance with SFAS 142. The Company assesses these assets for impairment on an annual basis. On adoption of SFAS 142, the Company determined its operations represent a single reporting unit. To assess goodwill for impairment, the Company performs the following procedures:
Step 1: The Company compares its fair value to the carrying value, including goodwill. In determining fair value, the Company considers two components 1) the Company’s market capitalization during the reporting period and 2) the expected present value of future cash flows and future operating trends. If the Company’s fair value exceeds the carrying value, no impairment charge is necessary. Where the carrying value, including goodwill, exceeds the unit’s fair value, the Company moves on to step two as described below.
Step 2: The Company performs an allocation of the fair value of its identifiable tangible and non-goodwill intangible assets and liabilities. From this allocation, the Company derives an implied fair value for its goodwill. The Company then compares the implied fair value of goodwill with the carrying amount of its goodwill. If the carrying amount of the goodwill is greater than the implied fair value of its goodwill, an impairment loss is recognized for the excess of such amount.
As required by the provisions of SFAS 142, the Company evaluates goodwill for impairment on an annual basis or more frequently whenever events or circumstances may indicate an impairment has occurred. A significant impairment could have a material adverse effect on the Company’s financial position and results of operations.
Comprehensive Income
Comprehensive income generally represents all changes in stockholders’ equity except those resulting from investments of contributions by stockholders. Total comprehensive income is presented in the accompanying Consolidated Statement of Stockholders’ Equity. Total accumulated other comprehensive income is displayed as a separate component of stockholder’s equity in the accompanying Consolidated Balance Sheets. The unrealized gains and losses on marketable securities and foreign currency translation adjustments are comprehensive income items applicable to the Company. The accumulated balances for comprehensive income for all periods presented consist of unrealized gain on investments.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Revenue Recognition
The Company recognizes and reports revenue in two separate categories: license revenue and net royalty revenue. License revenue is comprised of license, maintenance and support fees. License fees are derived from the purchase of a license for the Company’s products. Maintenance fees are derived from maintenance contracts with the Company’s integrated circuit manufacturing customers which are generally purchased at the same time as a license for the product. Support fees are derived from arrangements with integrated circuit designers to support the use of the Company’s intellectual property components in their designs. Royalty revenue is derived from fees based on the selling prices of integrated circuits or wafers containing the Company’s intellectual property components.
License revenue. For all licenses, the Company uses both a binding purchase order and a signed license agreement as evidence of an arrangement. The Company assesses cash collectibility based on a number of factors, including past collection history with the customer and the credit worthiness of the customer. In cases where the Company believes a customer’s credit worthiness is uncertain, the Company requires prepayment or a letter of credit as assurance of payment. If the Company determines that collection of a fee is not probable, the Company defers the revenue and recognize it at the time collection becomes probable.
For licensed products which do not require significant customization of intellectual property components, the Company generally recognizes license revenue when a signed contract or other persuasive evidence of an arrangement exists, the software has been shipped or electronically delivered, the license fee is fixed or determinable and collection of the resulting receivable is probable.
For licensed products requiring significant customization of the Company’s intellectual property components, the Company generally recognizes license revenue using the percentage-of-completion method of accounting over the period that services are performed. For all license and service agreements accounted for under the percentage-of-completion method, the Company determines progress to completion based on actual direct labor hours incurred to date as a percentage of the estimated total direct labor hours required to complete the project. The Company periodically evaluates the actual status of each project to ensure that the estimates to complete each contract remain accurate. A provision for estimated losses on contracts is made in the period in which the loss becomes probable and can be reasonably estimated. To date, these losses have not been significant. Costs incurred in advance of billings are recorded as costs in excess of related billings on uncompleted contracts. If the amount of revenue recognized exceeds the amounts received from customers, the excess amount is recorded as unbilled accounts receivable. If the amount billed exceeds the amount of revenue recognized, the excess amount is recorded as deferred revenue. Revenue recognized in any period is dependent on the Company’s progress toward completion of projects in progress. Significant management judgment and discretion are used to estimate total direct labor hours. Any changes in or deviation from these estimates could have a material effect on the amount of revenue the Company recognizes in any period.
For arrangements with multiple elements, such as product licenses and maintenance services, the Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on vendor specific objective evidence. Vendor specific objective evidence of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those licensed products and services when sold separately and for maintenance is additionally measured by the renewal rate. If the Company cannot objectively determine the fair value of any undelivered element included in license arrangements, the Company defers revenue until all elements are delivered, all services have been performed or fair value can objectively be determined. When the fair value of a license element has not been established, the Company uses the residual method to record license revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the fee is allocated to the delivered elements and is recognized as revenue.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company derives maintenance fees from maintenance contracts, which are generally purchased by integrated circuit manufacturers at the same time as a license for the Company’s intellectual property components. Maintenance includes telephone and email support and the right to receive unspecified upgrades on a when-and-if-available basis. Maintenance may generally be renewed on an annual basis. The Company recognizes revenue for maintenance, based on vendor specific objective evidence of fair value, ratably over the term of the maintenance period. The Company generally determines vendor specific objective evidence of maintenance based on the stated fees for maintenance renewal set forth in the original license and first maintenance agreement.
The Company derives support fees from arrangements with integrated circuit designers to support the use of the Company’s intellectual property components in their designs. Support includes telephone and email support and the right to receive unspecified upgrades on a when-and-if-available basis. The Company recognizes support fees ratably over the support period. Support arrangements generally have a term of 12 months and may be renewed for additional 12 month periods.
The Company recognizes royalty revenue based on royalty reports received from integrated circuit manufacturers, generally on a one-quarter lag basis. In accordance with contract terms, the Company generally credits a portion of each royalty payment back to the integrated circuit manufacturer’s account to be applied against future license fees, if any, payable by the manufacturer. The Company reports the remaining portion of the royalty as net royalty revenue. The amount of credits that can be earned by an integrated circuit manufacturer is generally limited to the cumulative amount of orders placed by that integrated circuit manufacturer for a given process technology. An integrated circuit manufacturer has a limited time to use the credits before they expire, generally 18 months from the time credits are earned. As a result, the Company defers revenue associated with the credit program until the integrated circuit manufacturer licenses additional products or the credit expires, whichever is earlier. If the integrated circuit manufacturer does not use the credits within the stated period, the Company records the amount of the expired credits as net royalty revenue as the Company no longer has an obligation to provide any future products for the expired credits. Historically, integrated circuit manufacturing customers have utilized substantially all credits to purchase additional licensed products prior to expiration of the credits. When the integrated circuit manufacturing customers use credits, the Company recognizes the credits as license revenue when the Company’s revenue recognition criteria have been met.
Product development
The Company expenses the cost of product development as incurred. Product development expenses principally consist of payroll and related costs and depreciation and amortization of equipment and software used in product development projects.
Advertising Costs
Expenses related to advertising and promotional activities are charged to sales and marketing expense as incurred. Advertising expense was $113,000 in fiscal 2003, $28,000 in fiscal 2002 and $177,000 in fiscal 2001.
Foreign Currency Translation
Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment are translated to U.S. dollars at exchange rates in effect at the balance sheet date with resulting translation adjustments directly recorded as a separate component of accumulated other comprehensive income (loss), if material. Income and expense accounts are translated at average exchange rates during the year. Where the U.S. dollar is the functional currency, translation adjustments are recorded in other income (loss). Translation adjustments have been immaterial.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Income Taxes
Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. A valuation allowance is established when necessary to reduce deferred tax assets to the amounts expected to be realized.
Stock-Based Compensation
The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation an interpretation of APB Opinion No. 25,” and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.” Under APB 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price of the option.
The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” The Company uses the Black-Scholes option pricing model to value options granted to non-employees.
In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for Stock-based Compensation Transition and Disclosure, an Amendment of FASB 123.” Had compensation expense for the Company’s stock option plans and stock purchase plan been determined based on the fair value at the grant dates for awards under such plans consistent with SFAS 123, the Company’s net income (loss) would have been affected as follows:
The SFAS 123 adjusted impact of options on the net loss for the years ended September 30, 2003, 2002 and 2001 is not representative of the effects on net income (loss) for future years.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Net Income (Loss) Per Share
Basic and diluted net income (loss) per share are computed in accordance with SFAS No. 128, “Earnings per share.” Basic net income (loss) per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted net income(loss) per share is computed using the treasury stock method giving effect to all potentially dilutive common shares that were outstanding during the period. Potentially dilutive common shares consist of the exercise of stock options for all periods. Such potentially dilutive common shares are not included during periods in which the Company experiences a net loss, as the impact would be anti-dilutive.
Recent Accounting Pronouncements
In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on the Company’s financial position and results of operations.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor s fiscal year end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material impact on the Company’s financial position and results of operations.
In November 2002, the Emerging Issues Task Force reached a consensus on Issue No. 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material impact on the Company’s financial position and results of operations.
In December 2002, the FASB issued SFAS 148 and provides two additional transition methods for entities that adopt the preferable method of accounting for stock-based compensation. Further, the statement requires disclosure of comparable information for all companies regardless of whether, when, or how an entity adopts the preferable, fair value based method of accounting. These disclosures are now required for interim periods in addition to annual disclosure. We adopted the additional disclosure provisions of SFAS 148. The transition provisions of SFAS 148 are currently not applicable to the Company as the Company continues to account for options under APB 25.
In January 2003, the FASB issued FASB Interpretation FIN No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” In general, a variable interest entity (“VIE”) is a corporation, partnership, trust, or any other
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss from the VIE’s activities or is entitled to receive a majority of the VIE’s residual returns or both. The consolidation requirements of FIN 46 are effective immediately for VIE’s created after January 31, 2003. The consolidation requirements for older VIE’s are effective for financial statements of interim or annual periods beginning after June 15, 2003. Certain of the disclosure requirements are effective for all financial statements issued after January 31, 2003, regardless of when the VIE was established. The adoption of FIN 46 did not have a material impact on the Company’s financial position or results of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity and further requires that an issuer classify as a liability (or an asset in some circumstances) financial instruments that fall within its scope because that financial instrument embodies an obligation of the issuer. Many of such instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic entities. SFAS 150 is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before the issuance date of SFAS 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The adoption of SFAS 150 did not have a material impact on the Company’s financial position or results of operations.
NOTE 3. ACQUISITIONS
NurLogic Design, Inc.
On February 19, 2003, the Company acquired NurLogic, a private provider of integrated circuit intellectual property, whose technology adds complementary analog, mixed-signal and communications components to the Company’s product portfolio. The Company acquired NurLogic for consideration consisting of approximately $5.0 million in cash, 745,000 shares of common stock, valued at approximately $12.9 million, and assumed options to acquire 819,000 shares of common stock with a weighted average exercise price per share of $11.89 and a fair value of approximately $11.3 million. The Company also incurred an estimated $1.5 million in transaction fees, including legal, valuation and accounting fees. The purchase price of approximately $30.8 million was allocated to the tangible and identifiable intangible assets acquired and liabilities assumed on the basis of their estimated fair values on the acquisition date.
The shares issued in the acquisition were valued in accordance with Emerging Issue Task Force Issue No. 99-12 (“EITF 99-12”), “Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination.” In accordance with EITF 99-12, the Company established the first date on which the number of the Company shares and the amount of other consideration became fixed as of February 19, 2003. Accordingly, the Company valued the transaction using the average closing price of the Company’s common stock two days before and after February 19, 2003, or $17.32 per share. The assumed options to acquire common stock were valued using the Black-Scholes valuation model with a volatility factor of 97%, an average risk free interest rate of 1.91%, and estimated lives of two to six years.
The NurLogic acquisition was accounted for under SFAS 141 and SFAS 142. The results of operations of NurLogic were included in the Company’s Consolidated Statement of Operations from February 20, 2003.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table summarizes the estimated fair values of the tangible assets acquired and the liabilities assumed at the date of acquisition (in thousands):
The intangible assets recognized, apart from goodwill, represented contractual or other legal rights of NurLogic and those intangible assets of NurLogic that could be clearly identified. These intangible assets were identified and valued through interviews and analysis of data provided by NurLogic concerning development projects, their stage of development, the time and resources needed to complete them and, if applicable, their expected income generating ability. There were no other contractual or other legal rights of NurLogic clearly identifiable by management, other than those identified below. The allocation of the purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed was as follows (in thousands):
Developed technology of approximately $9.2 million consisted of intellectual property components for use in system-on-a-chip integrated circuits and consisted of: intellectual property blocks of $5.3 million for analog and core products; existing technology of $3.5 million consisting of standard cells, standard input/output products and specialty input/output products; and core technology of $430,000 consisting of processes, patents, filed patent applications and trade secrets used in standard cell and input/output products that are the basis for existing, in-process and future technology.
At the date of acquisition, the developed technology was complete and had reached technological feasibility. Any costs to be incurred in the future will relate to the ongoing maintenance of the developed technology and
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
will be expensed as incurred. To estimate the fair value of the developed technology, an income approach was used with a discount rate of 18%, which included an analysis of future cash flows and the risks associated with achieving such cash flows. All developed technologies are being amortized over their estimated useful lives of two to four years.
The customer base of $910,000 and order backlog of $340,000 represented the fair value of the existing customer relationships and maintenance agreements. To estimate the fair value of the customer base and order backlog, a cost approach (replacement value) was used. The customer base and order backlog are being amortized over their estimated useful lives of two to three years for customer base and six months for order backlog.
Development projects that had reached technological feasibility were classified as developed technology and the value assigned to developed technology was capitalized. Expensed in-process research and development of approximately $520,000 reflected certain research projects (primarily next generation core technology) that had not yet reached technological feasibility or had no alternative future use at the time of the acquisition. In order to achieve technological feasibility, the Company estimated the hours required to complete the projects to cost approximately $300,000. The Company estimated the fair value assigned to in-process research and development using the income approach, which discounts to present value the cash flows attributable to the technology once it had reached technological feasibility using a discount rate of 40%.
The stages of completion were determined by estimating the costs and time incurred to date relative to the costs and time incurred to develop the in-process technology into a commercially viable technology or product, while considering the relative difficulty of completing the various tasks and overcoming the obstacles necessary to attain technological feasibility. The weighted average stage of completion for all projects, in the aggregate, was approximately 33% as of the acquisition date. Upon completion, cash flows from sales of products incorporating those technologies were estimated to commence in fiscal 2003.
Goodwill of approximately $22.3 million represented the excess of the purchase price over the fair value of the net tangible and intangible assets acquired. NurLogic’s technology added complementary analog, mixed-signal and communications components to the Company’s existing product portfolio and allowed the Company to provide more comprehensive products and pursue an expanded market opportunity. These opportunities, along with the ability to hire the NurLogic workforce, were significant contributing factors to the establishment of the purchase price, resulting in the recognition of a significant amount of goodwill. In accordance with SFAS 142, the Company is not amortizing goodwill relating to the NurLogic acquisition. The Company will carry the goodwill at cost and test it for impairment annually and whenever events indicate that an impairment may have occurred.
The results of operations of NurLogic are included in the Company’s Consolidated Statement of Operations from the date of the acquisition. If the Company had acquired NurLogic at the beginning of the periods presented, the Company’s unaudited pro forma revenue, net income (loss) and net income (loss) per share would have been as follows (in thousands, except per share data):
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Synopsys’ Physical Library Business
On January 4, 2001, the Company completed its acquisition of certain assets of Synopsys’ physical library business (“Physical Library Business”) for $27.4 million including $14.5 million in cash, 1.5 million shares of the Company’s common stock valued at $11.5 million and the assumption of $1.4 million of liabilities.
The acquisition was accounted for using the purchase method of accounting, and the results of the Physical Library Business have been included in the Company’s Consolidated Financial Statements since the date of acquisition. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on their estimated fair values on the date of the acquisition, based on management’s estimates and an independent valuation report. The excess of the purchase price over the amounts allocated to the assets acquired and liabilities assumed was recorded as goodwill.
Portions of the purchase price were allocated to certain intangible assets such as existing technology, acquired workforce and in-process research and development. The amount of the purchase price allocated to in-process research and development was determined by estimating the stage of completion of each in-process research project at the date of acquisition and the estimated net present value of cash flows based on incremental future cash flows from revenue expected to be generated by the technologies in the process of development, taking into account the characteristics and applications of the technologies, the size and growth rate of existing and future markets and an evaluation of past and anticipated technology and product life cycles. Estimated net future cash flows included allocations of operating expenses and income taxes, but excluded the expected completion costs of the in-process research projects. The discount rate applied to the net cash flows was 30%, which reflected the level of risk associated with the particular technologies and the current return on investment requirements of the market. At the date of acquisition, technological feasibility of these in-process research projects had not been reached and the technology had no alternative future uses without further development. Accordingly, the Company expensed the portion of the purchase price allocated to in-process research and development of $2.4 million at the date of acquisition.
The stages of completion were determined by estimating the costs and time incurred to date relative to the costs and time incurred to develop the in-process technology into a commercially viable technology or product, while considering the relative difficulty of completing the various tasks and overcoming the obstacles necessary to attain technological feasibility. The weighted average stage of completion for all projects, in the aggregate, was approximately 75% as of the acquisition date. Upon completion, cash flows from sales of products incorporating those technologies were estimated to commence in fiscal 2001.
The purchase price was allocated as follows (in thousands, except number of years):
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 4. BUSINESS RISKS AND CREDIT CONCENTRATION
The Company operates in an intensely competitive industry that has been characterized by rapid technological change, short product life cycles, cyclical market patterns and heightened foreign and domestic competition. Significant technological changes in the industry could affect operating results adversely.
The Company markets and sells its technology to a narrow base of customers and generally does not require collateral. At September 30, 2003, two customers accounted for 15% each of gross contract receivables. At September 30, 2002, three customers accounted for 27%, 26% and 14% of gross contract receivables. Gross contract receivables include unbilled receivables.
As of September 30, 2003, the Company’s cash and cash equivalents were deposited with four major financial institutions in the form of demand deposits, money market accounts, corporate and government bonds, certificates of deposit and commercial paper. Financial instruments that potentially subject the Company to concentrations of credit risk comprise principally cash and cash equivalents, marketable securities and contract receivables. The Company invests its excess cash primarily in high-quality government and corporate debt instruments that mature within two years.
NOTE 5. MARKETABLE SECURITIES
Marketable securities, classified as available-for-sale securities, included the following (in thousands):
All short-term investments have maturities of less than one year from the respective balance sheet dates.
NOTE 6. CONTRACT RECEIVABLES
Contract receivables were comprised of the following (in thousands):
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 7. PROPERTY AND EQUIPMENT
Property and equipment were comprised of the following (in thousands):
Depreciation and amortization expense was $2.3 million, $1.9 million and $2.5 million for fiscal years ended September 30, 2003, 2002 and 2001, respectively.
NOTE 8. ACCRUED LIABILITIES
Accrued liabilities were comprised of the following (in thousands):
NOTE 9. COMMITMENTS AND CONTINGENCIES
The following table represents the future minimum annual lease payments of the Company as of September 30, 2003 (in thousands):
The Company’s principal administrative and technical offices occupy 54,489 square feet in Sunnyvale, California. The Company holds this building pursuant to a lease that expires in 2008. In addition, the Company leases administrative, technical and field support offices in seven cities throughout the world. The administrative, technical and field offices range from small executive offices to a 35,290 square foot facility. Lease terms range
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
from month-to-month on certain executive offices to 3 years on certain direct leases. The Company’s principal administrative, technical and field support facilities are in Sunnyvale, California; San Diego, California; Boston, Massachusetts; Bangalore, India; Tokyo, Japan; Paris, France and Singapore. The Company continually evaluates the adequacy of existing facilities and additional facilities in new cities and the Company believes that suitable additional space will be available in the future on commercially reasonable terms as needed.
The Company recognizes rent expense on a straight-line basis over the lease period and has accrued for rent expense incurred but not paid. Net rent expense was $2.5 million in fiscal 2003, $2.2 million in fiscal 2002 and $783,000 in fiscal 2001.
NOTE 10. STOCKHOLDERS’ EQUITY
Authorized Preferred Stock
The Company is authorized to issue 5,000,000 shares of undesignated preferred stock, $0.001 par value per share, of which no shares were issued and outstanding as of September 30, 2003 and 2002. Preferred stock may be issued from time to time in one or more series. The Board of Directors is authorized to determine the rights, preferences, privileges and restrictions granted to and imposed upon any wholly unissued series of preferred stock and to fix the number of shares of any series of preferred stock and the designation of any such series without any vote or action by the Company’s stockholders.
Stock Option Plans
The Company adopted its 2003 Stock Plan (the “2003 Plan”) on March 6, 2003 and reserved 1,000,000 shares of its common stock for issuance thereunder. The 2003 Plan authorizes the Board of Directors to grant incentive and non-statutory stock options and stock purchase rights to eligible employees and directors of the Company. If an option granted under the 1993 Plan or the 2003 Plan expires or becomes unexercisable for any reason without having been exercised in full, or is surrendered pursuant to an option exchange program, the unissued shares subject to such option are again available for issuance under the 2003 Plan, and if shares sold under the 2003 Plan are forfeited to the Company or are repurchased by the Company at the issue price paid per share, the number of shares forfeited or repurchased are again available for issuance under the 2003 Plan. During fiscal 2003, the number of shares reserved for issuance under the 2003 plan increased by 462,000 shares to 1,462,000 shares resulting from shares returned to the 1993 Plan. Incentive stock options are granted under the 2003 Plan with exercise prices of no less than fair market value, and non-statutory stock options are granted with exercise prices of no less than 85% of the fair market value of the common stock on the grant date, as determined by the Board of Directors. Options granted under the 2003 Plan become exercisable as determined by the Board of Directors but generally at a rate of 25% after the first year and 6.25% each quarter thereafter. Options granted under the 2003 Plan expire as determined by the Board of Directors but not more than ten years after the date of grant. At September 30, 2003, options to purchase a total of 566,000 shares of Common Stock were outstanding under the 2003 Plan.
In February 2003, the Company assumed 819,000 options in connection with the acquisition of NurLogic. The assumed plans were terminated upon acquisition, and no further option grants or share issuances will be made under the assumed plans. The outstanding options under the assumed plans will continue to be governed by the terms and conditions of their respective plans and existing option agreements for those grants. At September 30, 2003, options to purchase a total of 646,000 shares of Common Stock were outstanding under assumed option plans.
In December 2000, the Company adopted the 2000 Supplemental Stock Option Plan (the “2000 Plan”) for issuance upon the exercise of non-statutory stock options to employees and consultants, other than officers of the
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Company and members of the Board of Directors of the Company. The 2000 Plan provides for granting of options of up to 1,000,000 shares of Common Stock of the Company. On October 1, 2002, the number of shares reserved for issuance under the 2000 Plan was increased by 208,000 to a total of 1,208,000. The 2000 Plan expires in 2010. The 2000 Plan does not provide for automatic increases in the shares reserved for issuance thereunder. At September 30, 2003, options to purchase a total of 981,000 shares of Common Stock were outstanding under the 2000 Plan.
In November 1997, the Company adopted the 1997 Director Option Plan (the “Director Plan”) and reserved 200,000 shares of its Common Stock for issuance thereunder. The Director Plan was amended to increase the shares reserved thereunder to a total of 350,000 shares on March 6, 2003. The option grants under the Director Plan are automatic and nondiscretionary, and the exercise price of the options is 100% of the fair market value of the Company’s Common Stock on the date of grant. The Director Plan provides for an initial grant of options to purchase 25,000 shares of Common Stock to each new non-employee director. In addition, each non-employee director will automatically be granted an option to purchase 15,000 shares of Common Stock annually. The Director Plan also provides for additional annual grants of 30,000 shares to the Chairman of the Board of Directors, 20,000 shares to the Chairman of the Audit Committee, 10,000 shares to the Chairman of the Compensation Committee and 10,000 shares to the Chairman of the Nominating and Governance Committee. Options granted under the Director Plan become exercisable over a four year period with the initial share grants vesting as to one-fourth of the shares on the first anniversary of the date of grant and then monthly thereafter and the subsequent annual share grants vesting monthly. At September 30, 2003, options to purchase a total of 271,000 shares of Common Stock were outstanding under the Director Plan. The Director Plan expires in February 2008.
The Company had previously reserved 7,393,000 shares of its Common Stock under its 1993 Stock Option Plan, as amended (the “1993 Plan”) for issuance upon the exercise of incentive and non-statutory stock options to employees, directors and consultants. On October 1, 2002, the number of shares reserved for issuance under the 1993 Plan was increased by 846,000 shares to a total of 7,394,000. On October 1, 2001, the number of shares reserved for issuance under the 1993 Plan was increased by 824,000 shares to a total of 6,548,000. On October 1, 2000, the number of shares reserved for issuance under the 1993 Plan was increased by 736,000 shares to a total of 5,723,000. The 1993 Plan was terminated on March 6, 2003, and no further option grants or share issuances will be made under the 1993 Plan. However, all outstanding options under the 1993 Plan will continue to be governed by the terms and conditions of the 1993 Plan and existing option agreements for those grants. Incentive stock options granted under the 1993 Plan were granted with exercise prices of no less than fair market value, and non-statutory stock options were granted with exercise prices of no less than 85% of the fair market value of the common stock on the grant date, as determined by the Board of Directors. Options became exercisable as determined by the Board of Directors but generally at a rate of 25% after the first year and 6.25% each quarter thereafter. Options granted under the 1993 Plan expire as determined by the Board of Directors but not more than ten years after the date of grant. At September 30, 2003, options to purchase a total of 3,574,000 shares of Common Stock were outstanding under the 1993 Plan.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Activity under the 2003 Plan, 2000 Plan, Director Plan and 1993 Plan was as follows (in thousands except per share data):
The options outstanding and currently exercisable by exercise price at September 30, 2003 are as follows (in thousand, except per share data):
At September 30, 2003, 2002 and 2001, options to purchase 2,510,000, 2,182,000 and 1,300,000 shares of Common Stock, respectively, were exercisable pursuant to the 1993 Plan, the Director Plan, the 2000 Plan and the 2003 Plan, respectively with a weighted average cost of $8.50, $8.37 and $7.84, respectively.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The fair value of option grants related to the above plans is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:
The weighted average fair value of options granted was $14.16 in fiscal 2003, $8.82 in fiscal 2002 and $7.33 in fiscal 2001.
In connection with the grant of options for the purchase of 96,000 shares of Common Stock to employees during the period from December 1996 through March 1997 and 15,000 shares of Common Stock to non-employees in January 1998, the Company recorded aggregate deferred compensation of approximately $281,000, representing the difference between the deemed fair value of the Common Stock and the option exercise price at the date of grant. Such deferred compensation is amortized over the vesting period relating to the options, of which approximately $8,000 were amortized in fiscal 2001.
Employee Stock Purchase Plan
In November 1997, the Company adopted the 1997 Employee Stock Purchase Plan (the “Purchase Plan”) and reserved 600,000 shares of common stock for issuance under the Purchase Plan. The Purchase Plan provides for an automatic annual increase in the number of shares reserved for issuance under the Purchase Plan. On each anniversary date of the adoption of the Purchase Plan an amount equal to the lesser of (i) 200,000 shares, (ii) 1% of the outstanding shares on such date or (iii) a lesser amount as determined by the Board of Directors will be added to the shares available under the Purchase Plan. In November 2003, 200,000 incremental shares were reserved for issuance under the Purchase Plan. In November 2002, 169,000 incremental shares were reserved for issuance under the Purchase Plan. In November 2001, 165,000 incremental shares were reserved for issuance under the Purchase Plan. In November 2000, 148,000 incremental shares were reserved for issuance under the Purchase Plan. The Purchase Plan authorizes the granting of stock purchase rights to eligible employees during two-year offering periods with exercise dates approximately every six months. Shares are purchased through employee payroll deductions at purchase prices equal to 85% of the lesser of the fair market value of the Company’s Common Stock at either the first day of each offering period or the date of purchase. As of September 30, 2003, 974,000 shares had been issued under the Purchase Plan at an average price of $6.60 per share.
The estimated fair value of purchase rights under the Company’s Purchase Plan is determined using the Black-Scholes pricing model with the following assumptions:
The weighted average per share fair value of purchase rights under the Purchase Plan was $4.97 during fiscal 2003, $4.39 during fiscal 2002 and $4.26 during fiscal 2001.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Treasury Stock
On January 11, 2003, two officers of the Company exercised stock options to purchase 150,000 shares of the Company’s common stock at an exercise price of $7.70 per share. As consideration for the exercise of the stock options and the related taxes, the officers transferred 77,000 shares of common stock of the Company to the Company at the then current market price of $18.28. The Company recorded $1.4 million as treasury stock related to this transaction.
NOTE 11. INTEREST AND OTHER INCOME (EXPENSE)
Interest and other income (expense) were comprised of the following (in thousands):
NOTE 12. INCOME TAXES
The provision for income taxes were comprised of the following (in thousands):
The Company’s effective tax rate on pretax income (loss) differed from the U.S. federal statutory regular tax rate as follows:
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Income (loss) before provision for income taxes consisted of the following (in thousands):
Temporary differences and carryforwards that gave rise to significant portions of deferred tax assets and liabilities were as follows (in thousands):
The Company established a full valuation allowance against its deferred tax assets due to the uncertainty surrounding the realization of the benefit of such assets. Management periodically evaluates the recoverability of the deferred tax assets and will recognize the tax benefit only as reassessment demonstrates they are realizable. At such time, if it is determined that it is more likely than not that the deferred tax assets are realizable, the valuation allowance will be reduced.
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
NOTE 13. NET INCOME (LOSS) PER SHARE
In accordance with the disclosure requirements of SFAS 128, a reconciliation of the numerator and denominator of basic and diluted net income (loss) per share is provided as follows (in thousands, except per share amounts).
Employee stock options to purchase approximately 182,000 shares in fiscal 2003, 820,000 shares in fiscal 2002 and 1,785,000 shares in fiscal 2001 were outstanding, but were not included in the computation of diluted earnings per share because the exercise price of the stock options was greater than the average share price of the common shares and, therefore, the effect would have been anti-dilutive.
NOTE 14. SEGMENT REPORTING
The Company has adopted SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information.” Although the Company offers various intellectual property components and services to its customers, the Company does not manage its operations by these intellectual property components and services, but instead views the Company as one operating segment when making business decisions. The Company does not manage its operations on a geographical basis. Revenue attributed to the United States and to all foreign countries is based on the geographical location of the customer. The Company uses one measurement of profitability for its business.
The distribution of revenue by geographic area are summarized as follows (in thousands):
ARTISAN COMPONENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The distribution of long-term assets by geographic region are summarized as follows (in thousands):
Revenue from individual customers equal to 10% or more of our total revenue was as follows:
NOTE 15. BENEFIT PLAN
The Company sponsors a 401(k) profit sharing plan (the “401(k) Plan”) for substantially all employees. The 401(k) Plan provides for profit sharing contributions to be made at the discretion of the Company’s Board of Directors. The Company did not elect to make a profit sharing contribution for fiscal 2003, 2002 or 2001.
The 401(k) Plan also provides for elective employee salary reduction contributions and Company matching of employees’ contributions. Employees may contribute up to 20% of elective compensation. The Company’s matching contribution is at the discretion of the Company’s Board of Directors. The Company’s matching contributions were $427,000 in fiscal 2003, $267,000 in fiscal 2002 and $169,000 in fiscal 2001.
NOTE 16. SUBSEQUENT EVENTS
On October 28, 2003, the Company was notified by Broadcom Corporation (“Broadcom”) that it is requesting indemnification from NurLogic Design, Inc. (“NurLogic”) (the successor entity of NurLogic is now one of our wholly owned subsidiaries) because a complaint was filed against Broadcom by Agere Systems, Inc. (“Agere”) in August 2003 in the United States District Court for the Eastern District of Pennsylvania alleging that some of Broadcom’s products infringe several patents owned by Agere. The Company has received notice from Broadcom of only one Agere patent that may relate to technology licensed by NurLogic. Agere is seeking both an injunction against Broadcom and monetary damages.
There can be no assurance that the courts will find that the patents asserted by STMicroelectronics and Agere are invalid or that the technology licensed by NurLogic does not infringe such patents. Whether or not the asserted patents are valid and whether or not a court finds that Broadcom’s or NurLogic’s products infringe, the investigation and resolution of these indemnity claims and any related litigation could be expensive and could consume substantial amounts of management time and attention.
ARTISAN COMPONENTS, INC.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
S-1
EXHIBIT INDEX
(1) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-1 (No. 333-41219) which was declared effective on February 2, 1998.
(2) Certain information in these exhibits has been omitted and filed separately with the Securities and Exchange Commission pursuant to a confidential treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83, 230.46 and 240.24b-2.
(3) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-1 (No. 333-50243) which was declared effective on April 29, 1998.
(4) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 10, 1999.
(5) Incorporated by reference to exhibits filed with the Registrant’s Current Report on Form 8-K (No. 000-23649) on January 19, 2001.
(6) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (No. 000-23649) on August 14, 2001.
(7) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 22, 2000.
(8) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 11, 2001.
(9) Incorporated by reference to the exhibit filed with the Registrant’s Registration Statement on Form 8-A (000-23649) on December 27, 2001.
(10) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (000-23649) on May 15, 2002.
(11) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-8 (333-101465) on November 26, 2002.
(12) Incorporated by reference to exhibits filed with the Registrant’s Annual Report on Form 10-K (No. 000-23649) on December 27, 2002.
(13) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (000-23649) on February 14, 2003.
(14) Incorporated by reference to exhibits filed with the Registrant’s Quarterly Report on Form 10-Q (000-23649) on August 14, 2003.
(15) Incorporated by reference to exhibits filed with the Registrant’s Registration Statement on Form S-3 (No. 333-103837) which was declared effective on May 6, 2003.
(16) Incorporated by reference to exhibits filed with the Registrant’s Current Report on Form 8-K (No. 000-23649) on February 26, 2003.
* Management contract or compensatory plan or arrangement covering executive officers or directors of the Registrant.