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MENT > SEC Filings for MENT > Form 10-Q on 4-Jun-2014All Recent SEC Filings

Show all filings for MENTOR GRAPHICS CORP

Form 10-Q for MENTOR GRAPHICS CORP


4-Jun-2014

Quarterly Report


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

Unless otherwise indicated, numerical references are in millions, except for percentages, per share data, and conversion rate data.

Overview

The following discussion should be read in conjunction with the condensed consolidated financial statements and notes included elsewhere in this Form 10-Q. Certain of the statements below contain forward-looking statements. These statements are predictions based upon our current expectations about future trends and events. Actual results could vary materially as a result of certain factors, including but not limited to, those expressed in these statements. In particular, we refer you to the risks discussed in Part II, Item 1A. "Risk Factors" and in our other Securities and Exchange Commission filings, which identify important risks and uncertainties that could cause our actual results to differ materially from those contained in the forward-looking statements.

We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Form 10-Q. All subsequent written or spoken forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements included in this Form 10-Q are made only as of the date of this Form 10-Q. We do not intend, and undertake no obligation, to update these forward-looking statements.

The Company

We are a supplier of electronic design automation (EDA) tools - advanced computer software and emulation hardware systems used to automate the design, analysis, and testing of complex electro-mechanical systems, electronic hardware, and embedded systems software in electronic systems and components. We market our products and services worldwide, primarily to large companies in the communications, computer, consumer electronics, semiconductor, networking, military/aerospace, multimedia, and transportation industries. Through the diversification of our customer base among these various customer markets, we attempt to reduce our exposure to fluctuations within each market. We sell and license our products through our direct sales force and a channel of distributors and sales representatives. In addition to our corporate offices in Wilsonville, Oregon, we have sales, support, software development, and professional service offices worldwide.

We focus on products and design platforms where we have or believe we can attain leading market share. Part of this approach includes developing new applications and exploring new markets where EDA companies have not generally participated. We believe this strategy leads to a more diversified product and customer mix and can help reduce the volatility of our business and our risk as a creditor, while increasing our potential for growth.

We derive system and software revenues primarily from the sale of term software license contracts, which are typically three to four years in length. We generally recognize revenue for these arrangements upon product delivery at the beginning of the license term. Larger enterprise-wide customer contracts, which are approximately 50% or more of our system and software revenue, drive the majority of our period-to-period revenue variances. We identify term licenses where collectibility is not probable and recognize revenue on those licenses when cash is received. Ratable license revenues primarily include short-term term licenses as well as other term licenses where we provide the customer with rights to unspecified or unreleased future products. For these reasons, the timing of large contract renewals, customer circumstances, and license terms are the primary drivers of revenue changes from period to period, with revenue changes also being driven by new contracts and increases in the capacity of existing contracts, to a lesser extent.

The EDA industry is competitive and is characterized by very strong leadership positions in specific segments of the EDA market. These strong leadership positions can be maintained for significant periods of time as the software can be difficult to master and customers are disinclined to make changes once their employees, as well as others in the industry, have developed familiarity with a particular software product. For these reasons, much of our profitability arises from areas in which we are the leader. We expect to continue our strategy of developing high quality tools with number one market share potential, rather than being a broad-line supplier with undifferentiated product offerings. This strategy allows us to focus investment in areas where customer needs are greatest and where we have the opportunity to build significant market share.

Our products and services are dependent to a large degree on new design projects initiated by customers in the integrated circuit (IC) and electronics system industries. These industries can be cyclical and are subject to constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles, and wide fluctuations in product supply and demand. Furthermore, extended economic downturns can result in reduced funding for development due to


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downsizing and other business restructurings. These pressures are offset by the need for the development and introduction of next generation products once an economic recovery occurs.

Known Trends and Uncertainties Impacting Future Results of Operations

Our revenue has historically fluctuated quarterly and has generally been the highest in the fourth quarter of our fiscal year due to our customers' corporate calendar year-end spending trends and the timing of contract renewals.

Ten accounts make up approximately 35% of our receivables, including both short and long-term balances. We have not experienced and do not presently expect to experience collection issues with these customers.

Net of reserves, we have no receivables greater than 90 days past due, and continue to experience no difficulty in factoring our high quality receivables.

Bad debt expense recorded for the first three months of fiscal 2015 was not material. However, we do have exposures within our receivables portfolio to customers with weak credit ratings. These receivable balances do not represent a material portion of our portfolio but could have a material adverse effect on earnings in any given quarter, should significant additional allowances for doubtful accounts be necessary.

Bookings during the first three months of fiscal 2015 decreased by approximately 50% compared to the first three months of fiscal 2014 primarily due to the timing of term license contract renewals. Bookings are the value of executed orders during a period for which revenue has been or will be recognized within six months for software products and within twelve months for emulation hardware systems, professional services, and training. Ten customers accounted for approximately 35% of total bookings for the first three months of fiscal 2015 compared to 65% for the first three months of fiscal 2014. The number of new customers during the first three months of fiscal 2015 increased approximately 15% from the levels experienced during the first three months of fiscal 2014.

Product Development

During the first three months of fiscal 2015, we continued to execute our strategy of focusing on technical challenges encountered by customers, as well as building upon our well-established product families. We believe that customers, faced with leading-edge design challenges in creating new products, generally choose the best EDA products in each category to build their design environment. Through both internal development and strategic acquisitions, we have focused on areas where we believe we can build a leading market position or extend an existing leading market position.

We believe that the development and commercialization of EDA software tools is generally a three to five year process with limited customer adoption and sales in the first years of tool availability. Once tools are adopted, however, their life spans tend to be long. During the first three months of fiscal 2015, we introduced new products and upgrades to existing products and did not have any significant products reaching the end of their useful economic life.

Critical Accounting Policies

We base our discussion and analysis of our financial condition and results of operations upon our condensed consolidated financial statements which have been prepared in accordance with United States (U.S.) generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, and contingencies as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We evaluate our estimates on an on-going basis. We base our estimates on historical experience, current facts, and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenue, costs, and expenses that are not readily apparent from other sources. As future events and their effects cannot be determined with precision, actual results could differ from those estimates.

We believe that the accounting for revenue recognition, valuation of trade accounts receivable, income taxes, business combinations, goodwill, intangible assets, long-lived assets, special charges, and stock-based compensation are the critical accounting estimates and judgments used in the preparation of our condensed consolidated financial statements. For further discussion of our critical accounting policies, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies" in Part II of our Annual Report on Form 10-K for the year ended January 31, 2014.


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RESULTS OF OPERATIONS

Revenues and Gross Profit

                                      Three months ended April 30,
                                      2014         Change       2013
System and software revenues     $     148.2         20 %     $ 123.3
System and software gross profit $     119.9          6 %     $ 113.2
Gross profit percent                      81 %                     92 %
Service and support revenues     $     103.9          1 %     $ 103.2
Service and support gross profit $      74.8          2 %     $  73.1
Gross profit percent                      72 %                     71 %
Total revenues                   $     252.1         11 %     $ 226.5
Total gross profit               $     194.7          5 %     $ 186.3
Gross profit percent                      77 %                     82 %



System and Software

                                           Three months ended April 30,
                                             2014             Change      2013
Upfront license revenues           $      124.8                 24 %    $ 100.3
Ratable license revenues                   23.4                  2 %       23.0
Total system and software revenues $      148.2                 20 %    $ 123.3

We derive system and software revenues from the sale of licenses of software products and emulation hardware systems, including finance fee revenues from our long-term installment receivables resulting from term product sales. Upfront license revenues consist of perpetual licenses and term licenses for which we recognize revenue upon product delivery at the start of a license term. We identify term licenses where collectibility is not probable and recognize revenue on those licenses when cash is received. Ratable license revenues primarily consist of short-term term licenses, term licenses where we provide the customer with rights to unspecified or unreleased future products, and finance fees from the accretion of the discount on long-term installment receivables.

Ten customers accounted for approximately 60% of system and software revenues for the three months ended April 30, 2014 compared to approximately 50% for the three months ended April 30, 2013.

System and software revenues increased for the three months ended April 30, 2014 compared to the three months ended April 30, 2013 primarily as a result of increased sales of emulation hardware systems.

For the three months ended April 30, 2014, one customer accounted for 14% of total revenues. For the three months ended April 30, 2013, no single customer accounted for 10% or more of total revenues.

System and software gross profit percent was lower for the three months ended April 30, 2014 compared to the three months ended April 30, 2013 primarily due to increased sales of lower-margin emulation hardware systems.

Service and Support

We derive service and support revenues from software and hardware post-contract maintenance or support services and professional services, which include consulting, training, and other services. Professional services are lower margin offerings which are staffed according to fluctuations in demand. Support services operate under a less variable cost structure.

The increase in service and support revenues for the three months ended April 30, 2014 compared to the three months ended April 30, 2013 was primarily due to increased support revenues resulting from an increase in our installed base.


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Geographic Revenues Information

Revenue by Geography

                      Three months ended April 30,
                       2014            Change      2013
North America  $     127.0               28  %   $  99.1
Europe                60.1               23  %      48.7
Japan                 21.3              (20 )%      26.7
Pacific Rim           43.7              (16 )%      52.0
Total revenues $     252.2               11  %   $ 226.5

The changes in revenues in North America and Europe for the three months ended April 30, 2014 compared to the three months ended April 30, 2013 were primarily due to increased sales of emulation hardware systems. The changes in revenues in Japan for the three months ended April 30, 2014 compared to the three months ended April 30, 2013 were primarily due to the timing of contract renewals.

We recognize additional revenues in periods when the U.S. dollar weakens in value against foreign currencies. Likewise, we recognize lower revenues in periods when the U.S. dollar strengthens in value against foreign currencies. For the three months ended April 30, 2014, approximately one-fourth of European and approximately 90% of Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies.

Foreign currency had an unfavorable impact of ($1.4) for the three months ended April 30, 2014 compared to the three months ended April 30, 2013 primarily as a result of the strengthening of the U.S. dollar against the Japanese yen.

For additional description of how changes in foreign exchange rates affect our condensed consolidated financial statements, see discussion in Part I, "Item 3. Quantitative and Qualitative Disclosures About Market Risk -Foreign Currency Risk."

Revenue by Category

We segregate revenues into five categories of similar products and services.
Each category includes both product and related support revenues. Revenues for
each category as a percent of total revenues are as follows (percentages rounded
to the nearest 5%):

                           Three months ended April 30,
                              2014                2013
Revenues:
IC Design to Silicon             25 %                 35 %
Scalable Verification            35 %                 20 %
Integrated System Design         25 %                 30 %
New & Emerging Products           5 %                  5 %
Services & Other                 10 %                 10 %
Total revenues                  100 %                100 %


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Operating Expenses

                                      Three months ended April 30,
                                      2014          Change      2013
Research and development          $     84.5           6 %    $  79.7
Marketing and selling                   84.6           7 %       79.1
General and administration              17.7           9 %       16.3
Equity in earnings of Frontline         (1.4 )       250 %       (0.4 )
Amortization of intangible assets        1.8           6 %        1.7
Special charges                          5.9          48 %        4.0
Total operating expenses          $    193.1           7 %    $ 180.4

Selected Operating Expenses as a Percentage of Total Revenues

                                    Three months ended April 30,
                                      2014               2013
Research and development                33 %               35 %
Marketing and selling                   34 %               35 %
General and administration               7 %                7 %
Total selected operating expenses       74 %               77 %

Research and Development

Research and development expenses increased by $4.7 for the three months ended
April 30, 2014 compared to the three months ended April 30, 2013. The components
of this increase are summarized as follows:

                                                                     Change for
                                                                    three months
                                                                   ended April 30,
Salaries, variable compensation, and benefits expenses            $           2.1
Expenses associated with acquired businesses                                  2.2
Other expenses                                                                0.4
Total change in research and development expenses                 $           4.7

Marketing and Selling

Marketing and selling expenses increased by $5.5 for the three months ended
April 30, 2014 compared to the three months ended April 30, 2013. The components
of this increase are summarized as follows:

                                                                            Change for
                                                                   three months ended April 30,
Salaries, variable compensation, and benefits expenses            $                    4.6
Expenses associated with acquired businesses                                           0.8
Bad debt expense                                                                      (1.2 )
Other expenses                                                                         1.3
Total change in marketing and selling expenses                    $                    5.5

General and Administration

There were no significant changes within general and administration expenses, which increased by $1.3 for the three months ended April 30, 2014 compared to the three months ended April 30, 2013.


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We incur a substantial portion of our operating expenses outside the U.S. in various foreign currencies. We recognize additional operating expense in periods when the U.S. dollar weakens in value against foreign currencies and lower operating expenses in periods when the U.S. dollar strengthens in value against foreign currencies. We experienced favorable currency movements in total operating expenses of approximately $0.5 for the three months ended April 30, 2014, compared to the three months ended April 30, 2013. The impact of these currency movements is reflected in the changes in operating expenses detailed above.

Equity in Earnings of Frontline

We have a 50% interest in a joint venture, Frontline P.C.B. Solutions Limited Partnership (Frontline). Frontline is owned equally by Orbotech, Ltd., an Israeli company, and us.

Frontline reports on a calendar year basis; therefore we record our interest in the earnings of Frontline on a one-month lag. The following presents the summarized financial information of our 50% interest in Frontline for the three months ended March 31, 2014 and 2013:

                                                              For the three months ended March 31,
                                                                   2014                    2013
Net income, as reported                                    $           1.5           $           1.1
Amortization of purchased technology and other identified
intangible assets                                                     (0.1 )                    (0.7 )
Equity in earnings of Frontline                            $           1.4           $           0.4



Special Charges

                                            Three months ended April 30,
                                              2014             Change     2013
Litigation costs                     $     4.0                  111 %    $ 1.9
Employee severance and related costs       1.1                  (48 )%     2.1
Other costs, net                           0.8                    - %        -
Total special charges                $     5.9                   48 %    $ 4.0

Special charges may include expenses incurred related to certain litigation costs, employee severance, acquisitions, excess facility costs, and asset related charges.

Litigation costs consist of professional service fees for services rendered, related to patent litigation involving us, Emulation and Verification Engineering S.A. and EVE-USA, Inc. (together EVE), and Synopsys regarding emulation technology.

Employee severance and related costs include severance benefits, notice pay, and outplacement services. These rebalance charges generally represent the aggregate of numerous unrelated rebalance plans which impact several employee groups, none of which is individually material to our financial position or results of operations. We determine termination benefit amounts based on employee status, years of service, and local statutory requirements. We communicate termination benefits to the affected employees prior to the end of the quarter in which we record the charge.

Provision for Income Taxes

                                  Three months ended April 30,
                                 2014            Change       2013
Income tax expense (benefit) $     (0.2 )        (133 )%     $ 0.6

Generally, the provision for income taxes is the result of the mix of profits and losses earned in various tax jurisdictions with a broad range of income tax rates, withholding taxes (primarily in certain foreign jurisdictions), changes in tax reserves, and the application of valuation allowances on deferred tax assets. The provision considers that a significant amount of our earnings are in certain foreign operations, including our Irish subsidiaries. Accounting guidance requires for interim reporting that we evaluate our provision for income tax expense (benefit) based on our projected results of operations for the full year, and record


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adjustments in each quarter. Such adjustments consider period specific items and a separate determination of tax expense for entities in our consolidated group that are projected to have losses for which no tax benefit will be recognized.

                                                     Three months ended April 30,
                                                      2014                 2013
Effective tax rate                                     5.4 %                     381 %
Net period specific items benefit                $       -           $           0.4
Effective tax rate without period specific items       5.7 %                     140 %

For the three months ended April 30, 2014, we have a 5.7% effective tax rate without period specific items. This current period effective tax rate differs from our effective tax rate for the three months ended April 30, 2013 due to the fact that our income before income tax for the three months ended April 30, 2013 was near break-even and to the application of the accounting guidance for interim periods with respect to jurisdictions with projected losses before tax for which no tax benefits will be recognized and the variability in the mix of profits and losses earned in various tax jurisdictions with a broad range of income tax rates.

For our full year forecast, we have projected an 11% effective tax rate. This rate is inclusive of period specific items recognized through April 30, 2014. Our projected rate differs from tax computed at the U.S. federal statutory rate of 35% primarily due to:
The benefit of lower tax rates on earnings of foreign subsidiaries; and

Forecasted utilization of net operating loss carryforwards and tax credit carryforwards for which no benefit was previously recognized.

These differences are partially offset by:
Repatriation of foreign subsidiary earnings to the U.S.;

Non-deductible equity compensation expense; and

Withholding taxes.

We have not provided for income taxes on the undistributed earnings of our foreign subsidiaries to the extent they are considered permanently reinvested outside of the U.S. Upon repatriation, some of these earnings may be sheltered by U.S. loss carryforwards, research and development credits and foreign tax credits, which may reduce the federal tax liability associated with any future foreign dividend. Where the earnings of our foreign subsidiaries are not treated as permanently reinvested, we have considered the impact in our provision.

We are subject to income taxes in the U.S. and in numerous foreign jurisdictions. In the ordinary course of business, there are many transactions and calculations where the ultimate tax determination is uncertain. The statute of limitations for adjustments to our historic tax obligations varies from jurisdiction to jurisdiction. In some cases it may be extended or be unlimited. Furthermore, net operating loss and tax credit carryforwards may be subject to adjustment after the expiration of the statute of limitations of the year such net operating losses and tax credits originated. Our larger jurisdictions generally provide for a statute of limitations from three to five years. For U.S. federal income tax purposes, the tax years which remain open for examination are fiscal years 2011 and forward, although net operating loss and tax credit carryforwards from all years are subject to examination and adjustment for three years following the year in which they were utilized. We are currently under examination in various jurisdictions. The examinations are in different stages and timing of their resolution is difficult to predict. The statute of limitations remains open for years on or after fiscal 2010 in Ireland.

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