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

The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes to unaudited condensed consolidated financial statements in Item 1 of this report. This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the Exchange Act). Our actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including the risk factors set forth in this discussion, especially under the caption “Factors that May Affect Future Results,” and elsewhere in this Form 10-Q. The words “may,” “will,” “could,” “would,” “anticipate,” “expect,” “intend,” “believe,” “continue,” or the negatives of such terms, or other comparable terminology and similar expressions identify these forward-looking statements. The information included herein is as of the filing date of this Form 10-Q with the Securities and Exchange Commission (SEC) and future events or circumstances could differ significantly from these forward-looking statements. Accordingly, we caution readers not to place undue reliance on such statements.

Overview

The following summary of our financial condition and results of operations is qualified in its entirety by the more complete discussion contained in this Item 2 and by the risk factors set forth below under the caption entitled “Factors That May Affect Future Results.”

Synopsys is the world leader in electronic design automation (EDA) software for semiconductor design. We deliver technology-leading semiconductor design and verification platforms and integrated circuit (IC) manufacturing software products to the global electronics market, enabling the development and production of complex systems-on-chips (SoCs). We also provide intellectual property (IP) and design services to simplify the design process, reduce design costs and accelerate time-to-market for our customers.

Business Environment

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

Beginning in late calendar 2000, the semiconductor industry entered its steepest and longest downturn of the past 20 years, with industry sales dropping approximately 46% from late 2000 to early 2002. As a result, over the past three years our customers have focused on controlling costs and reducing risk, including constraining R&D expenditures, reducing the number of design engineers they employ, cutting back on their design starts, purchasing from fewer suppliers, requiring more favorable pricing, payment and license terms from those suppliers, and pursuing consolidation within their own industry. Further, during this downturn, many start-up semiconductor design companies failed or were acquired and the pace of investment in new companies declined.

The semiconductor industry recovered modestly in 2003 and industry analysts have forecasted semiconductor industry revenue growth of over 20% and R&D spending growth in the range of 5% in 2004. Historically, growth in semiconductor revenue has typically led to growth in R&D spending, and thus EDA expenditures, by semiconductor companies as they expand their design activities, although usually with some lag between the increased growth in revenue and increasing spending on R&D. While we believe this pattern should be repeated if the current recovery continues as forecasted, we cannot predict the timing or magnitude of any such increase.

Product Developments for the Three Months Ended April 30, 2004.

Since the end of the first quarter of fiscal 2004, we announced or introduced a number of new products and enhancements to existing products, including:

•                 Announcement of Galaxy ä 2004, which incorporates major enhancements to our complete design platform delivering up to two times faster run time and improvements in capacity, quality of results, process technology support and turn-around time.

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•                 Enhancements to our Prime Time ^â timing analysis tool, including up to three times faster run time compared to the prior version and capacity to handle analysis of 100 million gate designs.

•                 Improvements to our Proteus ä optical proximity correction (OPC) tool that provides near linear scalability when using industry-leading processors.

•                 Validation of our Star-RCXT ä extraction product by two major IC foundries for their 90 nanometer manufacturing processes.

•                 Advancements in our DFT Compiler ä and Tetra MAX ^â ATPG design testing tools to help significantly reduce overall IC test development time.

•                 Release of Design Compiler ^â FPGA, a new FPGA synthesis product targeted at designers who prototype ASICs using high-end FPGAs.

Financial Performance for the Three Months Ended April 30, 2004

•                 Revenue was $294.6 million, up 1% over the three months ended April 30, 2003.

•                 Approximately 81% of our total revenue was from software sales, 15% was from maintenance, and 4% was from professional services.

•                 Our Galaxy Design and Discovery Verification Platforms (including allocated maintenance) accounted for 83% of total revenue, compared to 89% for the same period in fiscal 2003. Our Intellectual Property and Design for Manufacturing businesses (including allocated maintenance) accounted for 6% and 7% of total revenue, respectively, compared to  4% and 5%, respectively for the same period in fiscal 2003.

•                 We booked approximately 76% of our software orders as renewable licenses (either term licenses or Technology Subscription Licenses (TSLs)) and 24% as perpetual licenses, compared to 74% renewable licenses and 26% perpetual licenses for the same period during fiscal 2003. A total of 42% of our software orders were for upfront licenses (perpetual licenses and term licenses on which revenue was or will be recognized on shipment).

•                 Time-based and upfront licenses accounted for approximately 68% and 32% of our software revenue, respectively, compared to 64% and 36%, respectively, for the same period in fiscal 2003.

•                 Software maintenance revenue decreased approximately 21% from the same period in fiscal 2003, reflecting generally lower maintenance renewal rates through fiscal 2003 and the impact of including maintenance with our TSLs. However, maintenance bookings increased both from the three months ended January 31, 2004 and from the three months ended April 30, 2003, reflecting improved maintenance renewal rates.

•                 Professional service revenue, at $11.4 million, doubled from $5.7 million for the same period in fiscal 2003 as a result of customers’ greater use of outside consultants to make up for reduced internal staff and need for assistance in addressing the problems of designing ICs for manufacture using advanced processes. As a result, we believe that our consulting business has stabilized.

•                 Net income for the three months ended April 30, 2004 was $28.7 million compared to $22.3 million for the same period in fiscal 2003. The 29% increase was due to a 1% increase in revenue, a 5% decrease in operating expenses and a 41% decrease in our provision for income taxes, partially offset by a 9% increase in cost of revenue and an 88% decrease in other income (expenses), net.

•                 Cash provided by operations for the six months ended April 30, 2004 was $101.7 million compared to $148.1 million for the same period in fiscal 2003. This decrease largely resulted from disbursements for foreign income taxes, net of US income tax refunds received, disbursement of the $10.0 million MoSys termination fee and disbursements associated with maintenance contracts for our design and information systems electronic infrastructure, offset by a reduction in cash used to satisfy accounts payable.

•                 We repurchased approximately 2.2 million shares of our common stock at an average price of approximately $36 per share, for a total of approximately $77.4 million.

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•                 In April, we entered into a three-year, $250.0 million revolving credit facility.

Acquisitions for the Three Months Ended April 30, 2004

On February 20, 2004, we acquired Accelerant Networks Inc. (Accelerant), a provider of low-power, high-speed analog interface technology, enhancing our connectivity IP offerings.

On February 23, 2004, we acquired certain test-related assets of iRoC Technologies S.A. (iRoC), which will help expand our offerings of products used to test manufactured ICs.

Finally, on February 26, 2004, we acquired the technology assets of Analog Design Automation, Inc. (ADA), which provides us with automated circuit optimization solutions for analog, mixed-signal and custom integrated circuits.

The aggregate consideration for the Accelerant, iRoC and ADA transactions was approximately $42.3 million. These transactions were not material to Synopsys’ financial condition or results of operations for the quarter.

Critical Accounting Policies

We base the discussion and analysis of our financial condition and results of operations for the three and six months ended April 30, 2004 upon our unaudited condensed consolidated financial statements for such periods, which we prepare in accordance with accounting principles generally accepted in the United States of America. In preparing these financial statements, we must make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses and related disclosure of our contingent assets and liabilities. On an on-going basis, we evaluate our estimates based on historical experience and various other assumptions we believe are reasonable under the circumstances. Our actual results may differ from these estimates.

The accounting policies that most frequently require us to make estimates and judgments, and therefore are critical to understanding our results of operations, are:

•                 Revenue recognition;

•                 Valuation of intangible assets;

•                 Income taxes;

•                 Allowance for doubtful accounts; and

•                 Strategic investments.

Revenue Recognition. We have designed and implemented revenue recognition policies in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions , and SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2, Software Revenue Recognition.

With respect to software sales, Synopsys utilizes three license types:

•                 Technology Subscription Licenses (TSLs) are for a finite term, on average approximately three years, and generally provide the customer limited rights to receive, or to exchange certain quantities of licensed software for, unspecified future technology. Post-contract customer support (maintenance or PCS) is bundled for the term of the license and not purchased separately.

•                 Term Licenses are also for a finite term, usually three years, but do not provide the customer any rights to receive, or to exchange licensed software for, unspecified future technology. Customers purchase maintenance separately for the first year and may renew annually for the balance of the term. The annual maintenance fee is typically calculated as a percentage of the net license fee.

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•                 Perpetual Licenses , which continue as long as the customer renews maintenance, plus an additional 20 years. Perpetual licenses do not provide the customer any rights to receive, or to exchange licensed software for, unspecified future technology. Customers purchase maintenance separately for the first year and may renew annually. The annual maintenance fee for purchases under $2 million, sometimes referred to as variable maintenance perpetuals, is typically calculated as a percentage of the list price of the licensed software; for purchases over $2 million, the annual maintenance fee is typically calculated as a percentage of the net license fee.

We sometimes refer to TSLs and term licenses, either individually or collectively, as “renewable licenses” because the customer must purchase an extension or a new license in order to continue using the software after the specified term of the contract expires. We have very high renewal rates on our renewable licenses as our products are integral to the design process of our customers.  In most cases, renewable licenses are renewed in advance of their expiration date, and sometimes well in advance.  In some cases, a three-year agreement may be renewed with as many as two years remaining.  This practice helps customers secure their design flow on a rolling basis.  For us, the renewal discussion gives us an opportunity to expand our level of business with the customer by selling them incremental software and, if the customer licenses products under a TSL, helps us gain visibility into our future revenue.

Typical renewal transactions include an increment of the total amount of software remaining available to the customer, an extension of the term of the agreement and/or modifications of other terms of use in exchange for a fee. Depending upon the specific arrangements negotiated with the customer, we may either replace the pre-existing arrangement with an entirely new agreement or maintain two overlapping agreements. Where we replace the existing agreement, we supersede the original agreement and thereafter deliver software and recognize revenue based upon the type of license reflected in the new agreement. Where we maintain two agreements, revenue recognition on the new incremental agreement is based on the license type purchased, assuming all other revenue recognition criteria have been met. If the extension or new arrangement is a TSL, we recognize the license revenue from the new arrangement ratably in proportion to the incremental software delivered. If the extension or new arrangement is a term license, we recognize the license revenue upfront on the entire extension or new arrangement, using the residual method, assuming all other revenue recognition criteria have been met. If extended payment terms are granted (as discussed below), revenue will be recognized as payments become due and payable.

Customers occasionally convert their existing TSLs to perpetual licenses, paying an incremental fee to convert the TSL to a perpetual license, which we recognize upon contract signing in accordance with AICPA Technical Practice Aid (TPA) 5100.74, assuming all other revenue recognition criteria have been met. In some situations, the contract converting the TSL to a perpetual license is modified to such an extent that a new arrangement exists. The changes to the contract may include increases or decreases in the total technology under license, changes in payment terms, changes in license terms and other pertinent factors. In these situations, we account for all of the arrangement fees as a new sale and recognize revenue when all other revenue recognition criteria have been met. We have a policy that defines the specific circumstances under which we account for these transactions as a new perpetual license sale.

We report revenue in three categories: upfront license, time-based license and services.

Upfront license revenue includes:

•                 Perpetual licenses. We recognize the perpetual license fee in full if, upon shipment of the software, payment terms require the customer to pay at least 75% of the perpetual license fee within one year from shipment.

•                 Upfront term licenses. We recognize the term license fee in full if, upon shipment of the software, payment terms require the customer to pay at least 75% of the term license fee within one year from shipment.

Time-Based License (TBL) revenue includes:

•                 Technology Subscription Licenses. We typically recognize revenue from TSL license fees (which include bundled maintenance) ratably over the term of the license period. However, where extended payment terms are offered under the license arrangement, (i.e., where less than 75% of the TSL license fees are due within one year from shipment), we recognize revenue from TSL license fees in an amount that is the lesser of the ratable portion of the entire fee or customer installments as they become due and payable.

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•                 Term Licenses with Extended Payment Terms. For term licenses where less than 75% of the term license fee is due within one year from shipment, we recognize revenue as customer installments become due and payable.

Services revenue includes:

•                 Maintenance Fees Associated with Perpetual and Term Licenses. We generally recognize revenue from maintenance associated with perpetual and term licenses ratably over the maintenance term.

•                 Consulting and Training Fees. We generally recognize revenue from consulting and training services as services are performed.

We allocate revenue on software transactions (referred to as an “arrangement” in the accounting literature) involving multiple elements to each element based on the respective fair values of the elements. Our determination of fair value of each element in multiple element arrangements is based on vendor-specific objective evidence (VSOE). We limit our assessment of VSOE for each element to the price charged when the same element is sold separately.

We have analyzed all of the elements included in our multiple-element arrangements and determined that we have sufficient VSOE to allocate revenue to the maintenance components of our perpetual and term license products and to consulting. Accordingly, assuming all other revenue recognition criteria are met, we recognize revenue from perpetual and term licenses upon delivery using the residual method in accordance with SOP 98-9 and recognize revenue from maintenance ratably over the maintenance term.

We make significant judgments related to revenue recognition. Specifically, in connection with each transaction involving our products, we must evaluate whether (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) our fee is fixed or determinable, and (iv) collectibility is probable. We apply these criteria as discussed below.

•                 Persuasive Evidence of an Arrangement Exists . We require a written contract, signed by both the customer and us, or a purchase order from those customers that have previously negotiated a standard end-user license arrangement or volume purchase agreement with us prior to recognizing revenue on an arrangement.

•                 Delivery Has Occurred . We deliver software to our customers physically or electronically. For physical deliveries, our standard transfer terms are typically FOB shipping point. For electronic deliveries, delivery occurs when we provide the customer access codes or “keys” that allow the customer to take immediate possession of software.

•                 The Fee is Fixed or Determinable . Our determination that an arrangement fee is fixed or determinable depends principally on the arrangement’s payment terms. Our standard payment terms require 75% or more of the arrangement fee to be paid within one year. Where these terms apply, we regard the fee as fixed or determinable, and we recognize revenue upon delivery (assuming other revenue recognition criteria are met). If the payment terms do not meet this standard, which we refer to as “extended payment terms,” we do not consider the fee to be fixed or determinable and generally recognize revenue when customer installments are due and payable. In the case of a TSL, we recognize revenue ratably even if the fee is fixed or determinable, due to application of other revenue accounting guidelines relating to maintenance services and arrangements that include rights to unspecified future technology.

•                 Collectibility is Probable . To recognize revenue, we must judge collectibility of the arrangement fees, which we do on a customer-by-customer basis pursuant to our credit review policy. We typically sell to customers with whom we have a history of successful collection. For a new customer, we evaluate the customer’s financial position and ability to pay and typically assign a credit limit based on that review. We increase the credit limit only after we have established a successful collection history with the customer. If we determine at any time that collectibility is not probable based upon our credit review process or the customer’s payment history, we recognize revenue on a cash-collected basis.

Description of Other Critical Accounting Policies. Other than our revenue recognition policy, which is summarized above, our critical accounting policies reflecting these estimates and judgments are described in Part II, Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the fiscal

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year ended October 31, 2003, filed with the SEC on January 29, 2004. We have not changed those policies since such date. Investors should therefore read this Item 2 in conjunction with such description.

Results of Operations

Revenue Background. We primarily license our software through TSLs under which we generally recognize both product and service revenue ratably over the term of the license, or, under certain circumstances, as payments become due. As a result, a TSL order results in significantly lower current-period revenue than an equal-sized order for a perpetual or upfront term license. Conversely, a TSL order will result in higher revenue recognized in future periods than an equal-sized order for a perpetual or upfront term license. For example, on a $120,000 order for a perpetual or upfront term license, we recognize $120,000 of revenue in the quarter the product is shipped and no revenue in future quarters. On a $120,000 order for a three-year TSL shipped on the first day of the quarter, we recognize $10,000 of revenue in the quarter the product is shipped and in each of the eleven succeeding quarters.

Since adopting TSLs in the fourth quarter of fiscal 2000, our ratable revenue has grown as TSL orders we receive each quarter contribute revenue that is “layered” over the revenue recognized from TSL orders we received in prior quarters. Growth in ratable revenue in any quarter depends on revenue derived from new TSL orders received in the current and previous quarters, offset by the loss of revenue from TSLs that expire in such quarter, and therefore cease to contribute to revenue. Due to this “layering” effect, revenue may grow from quarter to quarter even if orders do not grow, or may not grow from one quarter to the next at the same rate that orders grow.

Our license revenue in any given quarter depends upon the volume of upfront licenses shipped during the quarter, the amount of TBL revenue recognized from TBLs booked in prior periods, and to a much smaller degree, the amount of revenue recognized on TBL orders booked during the quarter. We set our revenue targets based in large part on orders targets and our expected mix of upfront and time-based licenses for a given period. If we achieve the total orders target but not our target license mix, we may not reach our revenue targets (if upfront license orders are lower than we expect) or may exceed them (if upfront license orders are higher than we expect). If orders are below target in any quarter we may still meet our revenue targets, but only if the license mix includes a higher proportion of upfront licenses than our target license mix.

The precise mix of orders fluctuates from quarter to quarter. Our historical average license order mix since adopting TSLs in August 2000 through the second quarter of fiscal 2004 has been 74% time-based licenses and 26% upfront licenses, although the percentage of upfront license orders in any given quarter has varied between 14% and 57%. The license order mix for the three months ended April 30, 2004 was 58% time-based and 42% upfront.  For fiscal 2004 as a whole, our target license order mix range is 65% to 75% time-based license and 25% to 35% upfront license.

Below is a table showing the breakdown of orders by license type for the last five fiscal quarters.

The increase in total revenue for the three months and six months ended April 30, 2004 compared to the same periods in fiscal 2003 was primarily due to increased time-based license revenue, partially offset by a decline in service revenue and upfront license revenue compared to the same periods in fiscal 2003, as discussed below.

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The decrease in upfront license revenue for the three months and six months ended April 30, 2004 is due to a lower level of upfront license shipments during the quarter compared to the same quarter in fiscal 2003.

The increase in time-based license revenue for the three months and six months ended April 30, 2004 is primarily due to the additional year that we have been selling TSLs.

Service revenue is comprised of two main components: maintenance fees and professional services fees. The overall decrease in service revenue for the three months and six months ended April 30, 2004 is due mostly to the decline in maintenance fees, which declined due to (i) a lower renewal rate of maintenance on perpetual licenses, (ii) our adoption of variable maintenance perpetual arrangements in which the maintenance rate is lower than the maintenance rate on our standard perpetual licenses, and (iii) our adoption of TSLs, which bundle maintenance with the software and do not contribute any separately recognized maintenance fees, partially offset by an increase in professional services fees. However, we believe maintenance revenue is stabilizing based on increased maintenance bookings during the quarter compared to the three months ended April 30, 2003 and January 31, 2004.

Professional services fees declined in fiscal 2003 compared to fiscal 2002 due to ongoing adverse economic conditions which led our customers to reduce their costs by curtailing their use of outside consultants. However, professional services revenue increased substantially during the three and six months ended April 30, 2004 compared to the same periods in fiscal

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2003  as the semiconductor industry has continued to recover. In particularly, customers are using outside consultants to make up for reduced internal staff and to address the problems of designing ICs for manufacture using advanced processes.

Orders and Revenue Seasonality. Historically, our orders and revenue have been lowest in our first quarter and highest in our fourth quarter, with a material decline between the fourth quarter of one fiscal year and the first quarter of the next fiscal year. The difference is more pronounced in orders than in revenue because, under our license model, we typically derive between 70% and 80% of the revenue in any quarter from committed, non-cancelable backlog (i.e., from orders received in prior quarters), which means that quarter-to-quarter changes in orders do not result in equal changes in quarter-to-quarter revenue. Our book-to-bill ratio for the three months ended April 30, 2004 was between 1 and 1.1, as compared to 1.5 to 1.6 for the same period during fiscal 2003.

The first quarter of fiscal 2004 contributed a lower-than-typical proportion of orders, and we expect the fourth quarter of fiscal 2004 will contribute a higher-than-typical proportion of orders, based on our expectations regarding contract renewals we believe will be entered into later this fiscal year and continued recovery in the semiconductor industry. However, we can provide no assurances that these renewals or such continued recovery will in fact occur.

Revenue — Product Groups. For management reporting purposes, we organize our products and services into five distinct groups: Galaxy Design Platform, Discovery Verification Platform, Intellectual Property (IP), Design for Manufacturing and Professional Services & Other.

Galaxy Design Platform . Our Galaxy Design Platform includes our logic synthesis, physical synthesis, physical design, timing analysis, signal integrity analysis and physical verification products, as well as certain analog and mixed-signal tools. Our principal products in this category are Design Compiler ^® , Apollo ^™ , Astro ^™ , Physical Compiler ^® , Prime Time, Hercules ^™ , Star RXCT and DFT Compiler. We believe physical design and design analysis products will account for an increasing share of Galaxy Design Platform revenue relative to our logic synthesis products as customers recognize the importance of using physical level design and analysis tools to address challenges particular to small geometry designs.

Discovery Verification Platform . Our Discovery ^™ Verification Platform includes our verification and simulation products. Our principal products in this category are VCS ^® , HSPICE ^® , NanoSim ^® , Formality ^® , Vera ^® , System Studio, LEDA and Magellan ^™ , as well as Discovery AMS, a subset of our verification technologies tuned to perform verification on analog and mixed-signal designs.

Intellectual Property . Our IP solutions, branded as DesignWare ^® , includes a library of basic, low-level IC design components, a portfolio of standards-based cores, principally for connectivity (i.e. USB) and verification models.

Design for Manufacturing . Our Design for Manufacturing products and technologies address the design and production challenges of very small geometry ICs and include our CATS ^® and Proteus OPC products and our phase-shift masking technologies.

Professional Services & Other . Our Professional Services group provides consulting services, including design methodology assistance, specialized systems design services, turnkey design and training.

The following table summarizes the revenue attributable to these groups as a percentage of total revenue for the last eight quarters. We include revenue from companies or products we have acquired during the periods covered from the acquisition date through the end of the relevant periods. For presentation purposes, we allocate software maintenance revenue, which represented approximately 15% and 19% of our total revenue for the three months ended April 30, 2004 and 2003, respectively, to the products to which those support services related. Further, with the adoption of our platform strategy in fiscal 2003, we redefined our product groups and have reclassified prior period revenues in accordance with this grouping to provide a consistent presentation.