Management Discussion - SNPS

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

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 7 and by the risk factors set forth in Item 1A of this Form 10-K. Please also see the cautionary language at the beginning of Part I of this Form 10-K regarding forward-looking statements.

Business Summary

Synopsys, Inc. provides products and services used by designers across the entire silicon to software spectrum, from engineers creating advanced semiconductors to software developers seeking to ensure the security and quality of their code. We are a global leader in supplying the electronic design automation (EDA) software that engineers use to design and test integrated circuits (ICs), also known as chips. We also offer semiconductor intellectual property (IP) products, which are pre-designed circuits that engineers use as components of larger chip designs rather than designing those circuits themselves. We provide software and hardware used to validate the electronic systems that incorporate chips and the software that runs on them. To complement these offerings, we provide technical services and support to help our customers develop advanced chips and electronic systems. We

are also a leading provider of software tools and services that improve the security and quality of software code in a wide variety of industries, including electronics, financial services, media, automotive, medicine, energy and industrials.

Our EDA and IP customers are generally semiconductor and electronics systems companies. Our solutions help these companies overcome the challenges of developing increasingly advanced electronics products while also helping them reduce their design and manufacturing costs. While our products are an important part of our customers' development process, their research and development budget and spending decisions may be affected by their business outlook and willingness to invest in new and increasingly complex chip designs. In addition, a number of consolidations have taken place in the semiconductor industry over the past several years. While we do not believe customer consolidations have had a material impact on our results, the future impact of ongoing consolidation is uncertain. For a discussion of potential risks, please see the risk factor titled "Consolidation among our customers and within the industries in which we operate, as well as our dependence on a relatively small number of large customers, may negatively impact our operating results" in Part I, Item 1A. Risk Factors.

Despite global economic uncertainty, we have consistently grown our revenue since 2005. We achieved these results not only because of our solid execution, leading technologies and strong customer relationships, but also because of our time-based revenue business model. Under this model, a substantial majority of our customers pay over time and we typically recognize this revenue over the life of the contract, which averages approximately three years. Time-based revenue consists of time-based products, maintenance and service revenue. The revenue we recognize in a particular period generally results from selling efforts in prior periods rather than the current period. Due to our business model, decreases or increases in customer spending do not immediately affect our revenues in a significant way.

Our growth strategy is based on building on our leadership in our EDA products, expanding and proliferating our IP offerings, and driving growth in the software security and quality market. As we continue to expand our product portfolio and our total addressable market, for instance in the software security and quality space, and as hardware product sales grow, we expect to experience increased variability in our total revenue. In addition, due to our adoption of Topic 606 in fiscal 2019, as further described in Note 14 of Notes to Consolidated Financial Statements, the way in which we are required to account for certain types of arrangements will increase the variability in our total revenue from period to period. Nevertheless, this accounting impact will not affect our cash generation or change the way we operate our business. Based on our leading technologies, customer relationships, business model, diligent expense management, and acquisition strategy, we believe that we will continue to execute our strategies successfully.

Fiscal Year End

Our fiscal year ends on the Saturday nearest to October 31 and consists of 52 weeks, with the exception that approximately every five years, we have a 53-week year. Fiscal 2018 was a 53-week year and ended on November 3, 2018. Fiscal 2017 and 2016 were 52-week years ending on October 28, 2017 and October 29, 2016, respectively. Fiscal 2019 will be a 52-week year.

For presentation purposes, this Form 10-K refers to the closest calendar month end.

Fiscal 2018 Financial Performance Summary

In fiscal 2018, compared to fiscal 2017, our financial performance reflects the following:

•

Revenues were $3.1 billion, an increase of $396.2 million or 15%, primarily driven by the overall growth in our business mainly due to higher TSL revenue, acquisitions, and professional services revenue. The increase also included additional revenue of approximately $46.0 million due to the extra week in fiscal 2018;

•

Total cost of revenue and operating expenses were $2.8 billion, an increase of $383.5 million or 16%, primarily due to increases in headcount, including those from acquisitions. The increase also included one additional week of expenses of approximately $33.7 million;

•

Higher operating income of $360.2 million, an increase of $12.7 million or 4%; and

•

Benefit for income taxes of $69.0 million in fiscal 2018 compared to provision for income taxes of $246.5 million in fiscal 2017, primarily due to the expense recorded for repatriation in fiscal 2017,

compared to the benefit recorded for restructuring of foreign IP rights, and a decrease in the statutory federal corporate income tax rate in fiscal 2018.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial results under Results of Operations below are based on our audited results of operations, which we have prepared in accordance with U.S. GAAP. In preparing these financial statements, we make assumptions, judgments and estimates that can affect the reported amounts of assets, liabilities, revenues and expenses, and net income. On an ongoing 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. For further information on our significant accounting policies, see Note 2 of Notes to Consolidated Financial Statements.

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

•

Revenue recognition;

•

Valuation of business combinations; and

•

Income taxes.

Revenue Recognition

We generate our revenue from the sale of products that include software licenses and to a lesser extent, hardware products, maintenance and services. Time-based products revenue consists of fees associated with the licensing of our software. Maintenance and service revenue consists of maintenance fees associated with perpetual licenses and hardware products, and professional services fees. Upfront products revenue includes hardware revenue consisting of sales of Field Programmable Gate Array (FPGA)-based emulation and prototyping products and perpetual software licenses.

Most of our customer arrangements are complex, involving hundreds of products and various license rights, bundled with post-contract customer support and additional meaningful rights that provide a complete end-to-end solution to the customer. Throughout the contract, our customers are typically using a myriad of products to complete each phase of a chip design and are concurrently working on multiple chip designs, or projects, in different phases of the design. During this time, the customer looks to us to release state-of-the-art technology as we keep up with the pace of change, to address requested enhancements to our tools to meet customer specifications, to provide support at each stage of the customer's design, including the final manufacturing of the chip (the tape-out stage), and other important services.

With respect to software licenses, we primarily utilize two license types:

•

Technology Subscription Licenses (TSLs). TSLs are time-based licenses for a finite term, and generally provide the customer with limited rights to receive, or to exchange certain quantities of licensed software for, unspecified future technology. The majority of our arrangements are TSLs due to the nature of the business and customer requirements. In addition to the licenses, the arrangements also include: post-contract customer support, which includes providing frequent updates and upgrades to maintain the utility of the software due to rapid changes in technology; other intertwined services such as multiple copies of the tools; assistance to our customers in applying our technology in their development environment; and rights to remix licenses for other licenses.

•

Perpetual licenses. Perpetual licenses 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.

For the two software license types, we recognize revenue as follows:

•

TSLs. We typically recognize revenue from TSL fees ratably over the term of the license period, or as customer installments become due and payable, whichever is later. Revenue attributable to TSLs is reported as "time-based products revenue" in the consolidated statements of operations.

•

Perpetual licenses. We recognize revenue from perpetual licenses in full upon shipment of the software if payment terms require the customer to pay at least 75% of the license fee and 100% of

the maintenance fee within one year from shipment and all other revenue recognition criteria are met. Revenue attributable to these perpetual licenses is reported as "upfront products revenue" in the consolidated statements of operations. For perpetual licenses in which less than 75% of the license fee and 100% of the maintenance fee is payable within one year from shipment, we recognize revenue as customer installments become due and payable. Such revenue is reported as "time-based products revenue" in the consolidated statements of operations.

Our maintenance and service revenue consists of maintenance fees associated with perpetual licenses and hardware products, and professional services fees. We recognize revenue from maintenance arrangements ratably over the maintenance period to the extent cash has been received or fees become due and payable, and recognize revenue from professional services and training fees as such services are performed and accepted by the customers as needed. Revenue attributable to maintenance, professional services and training is reported as "maintenance and service revenue" in the consolidated statements of operations.

Hardware revenue consists of sales of FPGA-based emulation and prototyping products. We recognize revenue from sales of hardware products in full upon shipment if all other revenue recognition criteria are met. Revenue attributable to these sales is reported as "upfront products revenue" in the consolidated statements of operations.

We also enter into arrangements in which portions of revenue are contingent upon the occurrence of uncertain future events, such as royalty arrangements. We refer to this revenue as "contingent revenue." Contingent revenue is recognized if and when the event that removes the contingency occurs. Such revenue is reported as "time-based products revenue" in the consolidated statements of operations. These arrangements are not material to our total revenue.

We infrequently enter into multiple-element arrangements that contain both software and non-software deliverables such as hardware. We have determined that the software and non-software deliverables in our contracts are separate units of accounting. We recognize revenue for the separate units of accounting when all revenue recognition criteria are met. Revenue allocated to hardware units of accounting is recognized upon shipment when all other revenue recognition criteria are met. Revenue allocated to software units of accounting is recognized depending on the software license type (TSL or perpetual license). Such arrangements have not had a material effect on our consolidated financial statements and are not expected to have a material effect in future periods.

We also enter into arrangements to deliver software products, either alone or together with other products or services, that require significant modification or customization of the software. We account for such arrangements using the percentage of completion method as we have the ability to make reasonably dependable estimates that relate to the extent of progress toward completion, contract revenues and costs. We measure the progress towards completion using the labor hours incurred to complete the project. Revenue attributable to these arrangements is reported as "maintenance and service revenue" in the consolidated statements of operations.

We determine the fair value of each element in multiple element software arrangements that only contain software and software-related deliverables based on vendor-specific objective evidence (VSOE). We limit our assessment of VSOE of fair value for each element to the price charged when such element is sold separately. We have analyzed all of the elements included in our multiple-element software arrangements and have determined that we have sufficient VSOE to allocate revenue to the maintenance components of our perpetual license products and to professional services. Accordingly, assuming all other revenue recognition criteria are met, we recognize license revenue from perpetual licenses upon delivery using the residual method, recognize revenue from maintenance ratably over the maintenance term, and recognize revenue from professional services as services are performed and accepted by the customer. With respect to TSL arrangements, due to the complexity of the tools, the complexity of the arrangement terms and intertwined services, the license, maintenance and other services are not separable and are considered as a combined unit. Additionally, we do not have sufficient VSOE of fair value to allocate the fee between these services. Therefore, we recognize revenue from TSLs ratably over the term of the license, assuming all other revenue recognition criteria are met.

Revenue recognition involves certain judgments. Specifically, in connection with each transaction involving our products, we must evaluate whether: (1) persuasive evidence of an arrangement exists, (2) delivery of software or services has occurred, (3) the fee for such software or services is fixed or determinable, and (4) collectability of the full license or service fee is probable. All four of these criteria must be met in order for us to recognize revenue with respect to a particular arrangement. We apply these revenue recognition criteria as follows:

•

Persuasive Evidence of an Arrangement Exists. Prior to recognizing revenue on an arrangement, our customary policy is to have a written contract, signed by both the customer and by us, or a

purchase order from those customers that have previously negotiated a standard end-user license arrangement or purchase agreement.

•

Delivery Has Occurred. We deliver our products to our customers electronically or physically. For electronic deliveries, delivery occurs when we provide access to our customers to take immediate possession of the software through downloading it to the customer's hardware. For physical deliveries, the standard transfer terms are typically Freight on Board (FOB) shipping point. We generally ship our products or license keys promptly after acceptance of customer orders. However, a number of factors can affect the timing of product shipments and, as a result, timing of revenue recognition, including the delivery dates requested by customers and our operational capacity to fulfill product orders at the end of a fiscal quarter.

•

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 for perpetual licenses require 75% or more of the license fee and 100% of the maintenance fee to be paid within one year. If the arrangement includes these terms, we regard the fee as fixed or determinable, and recognize all license revenue under the arrangement in full upon delivery (assuming all other revenue recognition criteria are met). If the arrangement does not include these 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, because of the right to exchange products or receive unspecified future technology and because VSOE for maintenance services does not exist for a TSL, we recognize revenue ratably over the term of the license, but not in advance of when customers' installments become due and payable.

•

Collectability Is Probable. We judge collectability of the arrangement fees 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, or when an existing customer substantially expands its commitments, 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 collectability is not probable under a particular arrangement based upon our credit review process or the customer's payment history, we recognize revenue under that arrangement as customer payments are actually received.

Valuation of Business Combinations

We allocate the fair value of purchase consideration to tangible assets, liabilities including contingencies assumed, and intangible assets acquired in a business combination. Any excess fair value of purchase consideration over the estimated fair value of assets acquired and liabilities assumed is recorded as goodwill. The allocation of the purchase consideration requires management to make estimates and assumptions, based in part on our judgments, in determining the fair value of assets acquired and liabilities assumed, especially with respect to intangible assets. Our estimates and assumptions may include, but are not limited to, future cash flows of an acquired business, other assumptions and the appropriate discount rate. These estimates are inherently difficult, subjective and unpredictable, and if different estimates were used, the fair value allocation to the acquired intangible assets could be different. Therefore, our assessment of the estimated fair value of each of these assets can have a material effect on our consolidated financial statements.

Income Taxes

We recognize deferred tax assets and liabilities for the temporary differences between the book and tax bases of assets and liabilities using enacted tax rates in effect for the year in which we expect the differences to reverse, and for tax loss and credit carryovers. Determining whether a valuation allowance is necessary to reduce deferred tax assets require assumptions, judgments, and estimates. We record a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. In evaluating our ability to utilize our deferred tax assets, we consider all available positive and negative evidence, including our past operating results, our forecast of future taxable income on a jurisdiction by jurisdiction basis, as well as feasible and prudent tax planning strategies. In fiscal 2018, we also considered the impact of the Tax Cuts and Jobs Act. We believe that the net deferred tax assets of approximately $397.4 million, which are recorded on our balance sheet as of October 31, 2018, based on current tax law, will ultimately be realized. However, if we determine in the future that it is more likely than not that we will not be able to realize a portion or the full amount of deferred tax assets, we would record an adjustment to the deferred tax asset or a valuation allowance as a charge to earnings in the period that such determination is made.

Uncertain tax positions are recorded by applying a two-step approach. The first step is to evaluate the tax position for recognition by determining whether it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. An uncertain tax position is considered effectively settled on completion of an examination by a taxing authority if certain other conditions are satisfied.

Effect of New Accounting Pronouncements Not Yet Adopted

See Note 14 of Notes to Consolidated Financial Statements.

Results of Operations

Revenue Background

We generate our revenue from the sale of products that include software licenses, maintenance and services, and to a lesser extent, hardware products. Under current accounting rules and policies, we recognize revenue from orders we receive for software licenses, services and hardware products at varying times.

•

In most instances, we recognize revenue on a TSL software license order over the license term and on a perpetual software license order in the quarter in which the license is delivered. The weighted-average term of the TSLs is typically three years, but varies from quarter to quarter due to the nature and timing of the arrangements entered into during the quarter. The weighted-average term of the TSLs we entered into in fiscal 2018, 2017, and 2016 was 2.7 years, 2.7 years and 3.0 years, respectively.

•

Revenue on contracts requiring significant modification or development is accounted for using the percentage of completion method over the period of modification or development.

•

Revenue on hardware product orders is generally recognized in full at the time the product is shipped and when title is transferred.

•

Contingent revenue is recognized if and when the event that removes the contingency occurs.

•

Revenue on maintenance orders is recognized ratably over the maintenance period (normally one year).

•

Revenue on professional services orders is generally recognized as the services are performed.

•

Infrequently, we enter into certain license arrangements wherein licenses are provided for a finite term without any other services or rights, including rights to receive, or to exchange licensed software for, unspecified future technology. We recognize revenue from these term licenses in full upon shipment of the software and when all other revenue recognition criteria are met.

Our revenue in any period is equal to the sum of our time-based products, upfront products, and maintenance and services revenues for the period. We derive time-based products revenue largely from TSL orders received and delivered in prior quarters and to a smaller extent from contracts in which revenue is recognized as customer installments become due and payable and from contingent revenue arrangements. We derive upfront products revenue directly from perpetual license and hardware product orders mostly booked and shipped during the period. We derive maintenance revenue largely from maintenance orders received in prior periods since our maintenance orders generally yield revenue ratably over a term of one year. We also derive professional services revenue primarily from orders received in prior quarters, since we recognize revenue from professional services as those services are delivered and accepted or on percentage of completion for arrangements requiring significant modification of our software, and not when they are booked.

Our revenue is sensitive to the mix of TSLs and perpetual licenses delivered during a reporting period. A TSL order typically yields lower current quarter revenue but contributes to revenue in future periods. For example, a $120,000 order for a three-year TSL delivered on the last day of a quarter typically generates no revenue in that quarter, but $10,000 in each of the 12 succeeding quarters. Conversely, a $120,000 order for perpetual licenses with greater than 75% of the license fee due within one year from shipment typically generates $120,000 in revenue in the quarter the product is delivered, but no future revenue. Additionally, revenue in a particular quarter may also be impacted by perpetual licenses in which less than 75% of the license fees and 100% of the maintenance fees are payable within one year from shipment as the related revenue will be recognized as revenue in the period when customer payments become due and payable.

Most of our customer arrangements are complex, involving hundreds of products and various license rights, and our customers bargain with us over many aspects of these arrangements. For example, they often demand a broader portfolio of solutions, support and services and seek more favorable terms such as expanded license usage, future purchase rights and other unique rights at an overall lower total cost. No single factor typically drives our customers' buying decisions, and we compete on all fronts to serve customers in a highly competitive EDA market. Customers generally negotiate the total value of the arrangement rather than just unit pricing or volumes.

Total Revenue

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

3,121.1

2,724.9

2,422.5

396.2

302.4

The overall growth of our business, including contributions from acquisitions, has been the primary driver of the increase in our revenue. Our revenues are subject to fluctuations, primarily due to customer requirements, including payment terms and the timing and value of contract renewals. For example, we experience variability in our revenue due to factors such as the timing of IP consulting projects, royalties, and variability in hardware sales, and due to certain contracts where revenue is recognized when customer installment payments are due. As revenue from hardware sales is recognized upfront, customer demand and timing requirements for such hardware may result in increased variability of our total revenue.

The increase in total revenue for fiscal 2018 compared to fiscal 2017 was primarily attributable to the overall growth of our business, mainly due to higher TSL license revenue from arrangements booked in prior periods, an increase in professional services, additional revenue of approximately $46.0 million due to an extra week in the first quarter of fiscal 2018 compared to fiscal 2017, and contributions from acquired companies.

The increase in total revenue for fiscal 2017 compared to fiscal 2016 was primarily attributable to the overall growth of our business mainly due to higher TSL revenues, hardware sales, and IP consulting projects and, to a lesser extent, due to revenue from acquired companies.

For a discussion of revenue by geographic areas, see Note 13 of Notes to Consolidated Financial Statements.

Time-Based Products Revenue

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

2,303.3

2,021.8

1,910.9

281.5

110.9

Percentage of total revenue

The increase in time-based products revenue for fiscal 2018 compared to fiscal 2017 was primarily attributable to an increase in TSL license revenue due to arrangements booked in prior periods, including contributions from acquired companies, and additional revenue due to an extra week in fiscal 2018 compared to fiscal 2017.

The increase in time-based products revenue for fiscal 2017 compared to fiscal 2016 was primarily attributable to an increase in TSL license revenue due to arrangements booked in prior periods.

Upfront Products Revenue

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

357.7

338.2

248.1

19.5

90.1

Percentage of total revenue

Changes in upfront products revenue are generally attributable to normal fluctuations in customer requirements, which can drive the amount of upfront orders and revenue in any particular period.

The increase in upfront products revenue for fiscal 2018 compared to fiscal 2017 was primarily attributable to an increase in the sale of IP products driven by higher demand from customers.

The increase in upfront products revenue for fiscal 2017 compared to fiscal 2016 was primarily attributable to an increase in the sale of hardware products driven by timing of customer requirements.

Upfront products revenue as a percentage of total revenue will likely fluctuate modestly based on the timing of IP products and hardware sales. Such fluctuations will continue to be impacted by the timing of shipments due to customer requirements.

Maintenance and Service Revenue

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

Maintenance revenue

100.4

84.1

74.4

16.3

9.7

Professional service and other revenue

359.6

280.8

189.1

78.8

91.7

Total

460.0

364.9

263.5

95.1

101.4

Percentage of total revenue

The increase in maintenance revenue for fiscal 2018 compared to fiscal 2017, and for fiscal 2017 compared to fiscal 2016, was primarily due to an increase in the volume of arrangements that include maintenance.

The increase in professional services and other revenue for fiscal 2018 compared to fiscal 2017 was primarily due to an increase in consulting projects, including contributions from acquisitions, and to a lesser extent, the impact of the extra week in fiscal 2018.

The increase in professional services and other revenue for fiscal 2017 compared to fiscal 2016 was primarily due to an increase in, and the timing of, IP consulting projects that are accounted for using the percentage of completion method and contributions from acquisitions.

Cost of Revenue and Operating Expenses

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

Cost of revenue

735.9

654.2

543.0

81.7

111.2

Operating expenses

2,024.9

1,723.1

1,562.2

301.8

160.9

Total

2,760.8

2,377.3

2,105.2

383.5

272.1

Total expenses as a percentage of total revenue

Our expenses are generally impacted by changes in personnel-related costs including salaries, benefits, stock-based compensation and variable compensation; changes in amortization; and changes in selling and marketing expenses. The increase in our expenses compared to prior fiscal years was primarily due to an increase in personnel-related costs, driven by increased headcount from our overall growth, including those from acquisitions, and related fixed charges including facilities, as well as higher product costs due to increased hardware sales. We allocate certain human resource programs, information technology and facility expenses among our functional income statement categories based on headcount within each functional area. Annually, or upon a significant change in headcount (such as a workforce reduction, realignment or acquisition) or other factors, management reviews the allocation methodology and expenses included in the allocation pool.

Foreign currency fluctuations, net of hedging, did not have a significant impact on expenses during fiscal 2018 as compared to fiscal 2017, or fiscal 2017 as compared to fiscal 2016. See Note 5 of Notes to Consolidated Financial Statements for details on our foreign exchange hedging programs.

Cost of Revenue

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

Cost of products revenue

448.4

413.2

346.9

35.2

66.3

Cost of maintenance and service revenue

203.5

164.9

94.0

38.6

70.9

Amortization of intangible assets

84.0

76.1

102.1

7.9

(26.0

)

(25

Total

735.9

654.2

543.0

81.7

111.2

Percentage of total revenue

We divide cost of revenue into three categories: cost of products revenue, cost of maintenance and service revenue, and amortization of intangible assets. We segregate expenses directly associated with consulting and training services from cost of products revenue associated with internal functions providing license delivery and post-customer contract support services. We then allocate these group costs between cost of products revenue and cost of maintenance and service revenue based on products and maintenance and service revenue reported.

Cost of products revenue. Cost of products revenue includes costs related to products sold and software licensed, allocated operating costs related to product support and distribution costs, royalties paid to third-party vendors, and the amortization of capitalized research and development costs associated with software products that had reached technological feasibility.

Cost of maintenance and service revenue. Cost of maintenance and service revenue includes operating costs related to maintaining the infrastructure necessary to operate our services and costs to deliver our consulting services, such as hotline and on-site support, production services and documentation of maintenance updates. We expect our cost of maintenance and service revenue to increase in future periods because of recent acquisitions, but we do not expect the impact to be material to our total cost of revenue.

Amortization of intangible assets. Amortization of intangible assets, which is recorded to cost of revenue and operating expenses, includes the amortization of core/developed technology, trademarks, trade names, customer relationships, covenants not to compete related to acquisitions and certain contract rights related to acquisitions.

The increase in cost of revenue for fiscal 2018 compared to fiscal 2017 was primarily due to an increase of $47.7 million in personnel-related costs as a result of headcount increases, including those from acquisitions, an increase of $11.3 million in costs related to servicing IP consulting arrangements, and an increase of $7.9 million in amortization of intangible assets, as well as one additional week of expenses of approximately $4.5 million.

The increase in cost of revenue for fiscal 2017 compared to fiscal 2016 was primarily due to an increase of $62.4 million in personnel-related costs as a result of headcount increases, including those from acquisitions, an increase of $37.5 million in hardware product costs due to increases in, and timing of, shipments, an increase of $24.8 million in costs related to servicing IP consulting arrangements, and functionally allocated expenses that were higher by $8.6 million. The increases were partially offset by decreases of $26.0 million in amortization of intangible assets.

Changes in other cost of revenue categories for the above-mentioned periods were not individually material.

Operating Expenses

Research and Development

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

1,084.8

908.8

856.7

176.0

52.1

Percentage of total revenue

The increase in research and development expense in fiscal 2018 compared to fiscal 2017 was primarily due to an increase of $114.4 million in personnel-related costs as a result of headcount increases, including those from acquisitions, and one additional week of expenses of approximately $19.3 million.

The increase in research and development expense in fiscal 2017 compared to fiscal 2016 was primarily due to an increase of $47.4 million in personnel-related costs as a result of headcount increases, including those from acquisitions.

Changes in other research and development expense categories for the above-mentioned periods were not individually material.

Sales and Marketing

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

623.0

549.2

502.4

73.8

46.8

Percentage of total revenue

The increase in sales and marketing expense for fiscal 2018 compared to fiscal 2017 was primarily attributable to an increase of $51.0 million in personnel costs as a result of headcount increases, an increase of $7.5 million due to timing of marketing events, and one additional week of expenses of approximately $5.8 million.

The increase in sales and marketing expense for fiscal 2017 compared to fiscal 2016 was primarily attributable to an increase of $40.8 million in personnel costs as a result of higher headcount and higher variable compensation primarily based on timing of shipments.

Changes in other sales and marketing expense categories for the above-mentioned periods were not individually material.

General and Administrative

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

262.6

196.8

166.0

65.8

30.8

Percentage of total revenue

The increase in general and administrative expenses for fiscal 2018 compared with fiscal 2017 was primarily due to an increase of $21.5 million in personnel-related costs as a result of headcount increases, an increase of $22.1 million in professional service costs primarily due to additional legal, accounting, and tax services related to various projects, an increase of $18.2 million in net litigation settlement costs primarily due to a $26.0 million litigation settlement recorded in fiscal 2018 compared with $7.6 million net litigation charges recorded in fiscal 2017, an increase of $11.0 million in facilities expenses, and one additional week of expenses of approximately $4.1 million.

The increase in general and administrative expenses for fiscal 2017 compared with fiscal 2016 was primarily due to an increase of $38.0 million for accrued loss contingencies as a result of litigation, an increase of $18.8 million in personnel-related costs as a result of headcount increases, and an increase of $5.5 million in facilities expenses, partially offset by a $30.4 million gain as a result of a legal settlement.

Changes in other general and administrative expense categories for the above-mentioned periods were not individually material.

Change in Fair Value of Deferred Compensation

The income or loss arising from the change in fair value of our non-qualified deferred compensation plan obligation is recorded in cost of sales and each functional operating expense, with the offsetting change in the fair value of the related assets recorded in other income (expense), net. These assets are classified as trading securities. There is no overall impact to our net income from the income or loss of our deferred compensation plan obligation and asset.

Amortization of Intangible Assets

Amortization of intangible assets includes the amortization of contract rights and the amortization of core/developed technology, trademarks, trade names, customer relationships, and in-process research and development related to acquisitions completed in prior years. Amortization expense is included in the consolidated statements of operations as follows:

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

Included in cost of revenue

84.0

76.1

102.1

7.9

(26.0

)

(25

Included in operating expenses

41.6

31.6

27.5

10.0

4.1

Total

125.6

107.7

129.6

17.9

(21.9

)

(17

Percentage of total revenue

The increase in amortization of intangible assets for fiscal 2018 compared to fiscal 2017 was primarily due to the additions of acquired intangible assets, partially offset by certain intangible assets being fully amortized.

The decrease in amortization of intangible assets for fiscal 2017 compared to fiscal 2016 was primarily due to intangible assets that were fully amortized, partially offset by additions of acquired intangible assets.

Restructuring Charges

During fiscal 2018, we recorded $12.9 million of restructuring charges as part of a business realignment. The restructuring actions were undertaken to position us for future growth, reallocate resources to priority areas and, to a lesser extent, eliminate operational redundancy. These charges consisted primarily of severance and benefits. The remaining balance of $8.1 million is expected to be paid in fiscal 2019.

During fiscal 2017, we recorded $36.6 million of restructuring charges for severance and benefits due to involuntary and voluntary employee termination actions. The restructuring actions were undertaken to position us for future growth, reallocate resources to priority areas and, to a lesser extent, eliminate operational redundancy. These charges consisted primarily of severance and retirement benefits. As of the end of fiscal 2018, there were no unpaid balances remaining of the 2017 restructuring charges.

During fiscal 2016, we recorded $9.6 million of restructuring charges for severance and benefits due to involuntary employee terminations, which was fully paid in fiscal 2017.

The following is a summary of our restructuring activities:

Fiscal Year

Balance at Beginning of Period

Costs Incurred (Reduced)

Cash Payments

Others

Balance at End of Period

(in millions)

2018

17.5

12.9

(22.1

)

(0.2

)

8.1

2017

5.7

36.6

(24.8

)

17.5

2016

9.6

(3.9

)

5.7

See Note 2 of Notes to Consolidated Financial Statements.

Other Income (Expense), Net

Year Ended October 31,

$ Change

% Change

$ Change

% Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

Interest income

5.3

7.2

3.7

(1.9

)

(26

3.5

Interest expense

(15.6

)

(7.3

)

(3.8

)

(8.3

)

114

(3.5

)

Gain (loss) on assets related to executive deferred compensation plan

4.6

29.6

4.4

(25.0

)

(84

25.2

573

Foreign currency exchange gain (loss)

3.6

3.4

0.2

3.2

1,600

Other, net

5.4

2.6

7.7

2.8

108

(5.1

)

(66

Total

3.3

35.5

12.2

(32.2

)

(91

23.3

191

The net decrease in other income (expense) in fiscal 2018 as compared to fiscal 2017 was primarily due to lower gains in the market value of our executive deferred compensation plan assets and higher interest expense due to a higher debt balance.

The net increase in other income (expense) in fiscal 2017 as compared to fiscal 2016 was primarily due to higher gains in the market value of our executive deferred compensation plan assets.

Income Taxes

The Tax Cuts and Jobs Act (Tax Act), enacted on December 22, 2017, lowered the statutory federal corporate income tax rate from 35% to 21% effective on January 1, 2018. Because our fiscal 2018 commenced on November 1, 2017, the annual statutory federal corporate tax rate applicable to fiscal 2018 is a blended rate of 23.4%. Beginning in fiscal 2019, our annual statutory federal corporate tax rate will be 21%.

Our effective tax rate for fiscal 2018 was (19.0%), which included a tax benefit of $172.0 million relating to the restructuring of our foreign intellectual property rights, a U.S. federal research tax credit of $35.1 million, a settlement with the Internal Revenue Service (IRS) of $21.8 million tax benefit for fiscal 2017, and excess tax benefits from stock-based compensation of $31.0 million. These benefits were partially offset by tax expense of $63.1 million for a one-time transition tax on foreign earnings, $51.1 million due to re-measurement of U.S. deferred tax assets as a result of the Tax Act, and tax expense related to the integration of acquired technologies of $27.9 million.

Our effective tax rate for fiscal 2017 was 64.4%, which included income tax expense of $166.2 million relating to a repatriation of foreign earnings of $825 million, $30.5 million due to an increase in valuation allowance on state

deferred tax assets, a settlement with the Korean National Tax Service for the audit of fiscal years 2012 to 2016 of $7.9 million, and tax expense related to the integration of acquired technologies of $36.4 million. These expenses were partially offset by excess tax benefits from stock-based compensation of $38.1 million, a U.S. federal research tax credit of $25.5 million, and a settlement with the Taiwanese tax authorities for fiscal 2014 of $10.9 million.

Our effective tax rate for fiscal 2016 was 19.0%, which included tax benefits from a settlement with the IRS of $20.7 million for fiscal 2015 and the permanent reinstatement of the U.S. federal research tax credit of approximately $37.1 million, partially offset by tax expense from the integration of acquired technologies of $37.5 million, the impact of undistributed foreign earnings of $9.6 million, and an increase in the valuation allowance on deferred tax assets of $14.0 million as a result of changes in the expected utilization of state tax credits. The reinstatement of the research tax credit resulted in an additional tax credit for ten months of fiscal 2015 and the full year of fiscal 2016, which was recorded in fiscal 2016.

The integration of acquired technologies represents the income tax effect resulting from the transfer of certain intangible assets among company-controlled entities. The income tax effect is generally recognized over five years. These intangible assets generally result from the acquisition of technology by a company-controlled entity as part of a business or asset acquisition.

During the year, we made provisional estimates of the accounting impacts of certain provisions of the Tax Act. In the fourth quarter, as a result of further analyzes of certain aspects of the Tax Act, we have finalized the following provisional estimates.

As a result of the reduction in the federal corporate tax rate, we remeasured our deferred taxes, resulting in a first-quarter provisional tax expense of $45.6 million based on the tax rate that will apply when these deferred taxes are settled or realized in future periods. In the fourth quarter, we finalized our calculations resulting in a tax expense for fiscal 2018 of $51.1 million.

As part of the adoption of a new territorial tax system, the Tax Act required us to pay a one-time transition tax on previously untaxed earnings represented by foreign cash and certain other net current assets, and 8% on the remaining earnings. As of the third quarter of fiscal 2018, we had recorded a provisional transition tax expense of $73.4 million, as well as a provisional income tax payable of $17.9 million. In the fourth quarter, we finalized our calculations resulting in a tax expense of $63.1 million and income tax payable of $8.9 million. We intend to elect to pay the transition tax over a period of eight years as permitted by the Tax Act.

We continue to obtain, analyze and interpret additional guidance issued related to the Tax Act. The applicability and impact of the following new tax provisions, are dependent in part on forthcoming IRS guidance.

•

A tax on global intangible low-tax income (GILTI), which is determined annually based on our aggregate foreign subsidiaries' income in excess of certain qualified business asset investment return, will be effective for us in fiscal year 2019. We need additional information to complete our analysis on whether to adopt an accounting policy to account for the tax effects of GILTI in the period that we are subject to such tax, or to provide deferred taxes for book and tax basis differences that upon reversal, may be subject to such tax. Accordingly, we have not recorded any tax or deferred tax assets or liabilities with respect to GILTI in fiscal year 2018. We will make our accounting policy decision and complete the required accounting in the first quarter of fiscal 2019.

•

A base erosion and anti-abuse tax (BEAT), which functions as a minimum tax that partially disallows deductions for certain related party transactions, that is not effective for us until fiscal year 2019.

•

A special tax deduction for foreign-derived intangible income (FDII), which, in general, allows a deduction of certain intangible income earned in the U.S. and derived from foreign sources, that is not effective for us until fiscal year 2019.

As part of the adoption of a territorial tax system, the Tax Act also provides an exemption from federal income taxes for distributions from foreign subsidiaries made after December 31, 2017 that were not subject to the one-time transition tax. We have provided for foreign withholding taxes on undistributed earnings of certain of our foreign subsidiaries to the extent such earnings are no longer considered to be indefinitely reinvested in the operations of those subsidiaries.

In the fourth quarter of 2018, we made significant changes to our international tax structure by transferring intangible assets between certain foreign subsidiaries and changing the tax status of these subsidiaries for U.S. tax purposes. As a result, we recorded a deferred tax benefit of $172.0 million for the future U.S. tax deduction related

to these intangible assets. We paid foreign income tax of $67.7 million associated with the gain recognized on certain of these transactions. The tax liabilities associated with these transfers are treated as prepaid taxes. A portion of these foreign taxes may result in a U.S. foreign tax credit, but the amount expected to be realized cannot be determined at this time. The tax liabilities and benefits are subject to examination by U.S. and foreign tax authorities in future years.

In fiscal 2018, we reevaluated our strategy and subsequently withdrew our contest concerning the Hungary tax litigation related to one issue in the audit of fiscal years 2011 through 2013 and recorded a tax expense of $5.7 million.

For further discussion of the provision for income taxes, impacts related to the Tax Act, the restructuring of our foreign intellectual property rights and the Hungary audit, see Note 11 of Notes to Condensed Consolidated Financial Statement.

Liquidity and Capital Resources

Our sources of cash and cash equivalents are funds generated from our business operations and funds that may be drawn down under our revolving credit and term loan facilities.

As of October 31, 2018, we held an aggregate of $177.6 million in cash and cash equivalents in the United States and an aggregate of $545.5 million in our foreign subsidiaries. As a result of the Tax Act, we have recorded a tax liability for the transition tax on foreign earnings, payable over eight years, of $0.7 million and $8.2 million reflected as a short-term and long-term liability, respectively. If we decide to repatriate the undistributed earnings of our foreign subsidiaries for use in the U.S. in the future, the earnings that were subject to the transition tax would not be subject to further U.S. tax. In addition, we have provided foreign deferred taxes on our undistributed earnings sufficient to address the incremental tax that would be due on future foreign earnings. During the fourth quarter of fiscal 2018, we completed a restructuring of our foreign intellectual property rights, resulting in a one-time tax payment of $67.7 million, which is included in current prepaid taxes.

The following sections discuss changes in our consolidated balance sheets and statements of cash flow, and other commitments of our liquidity and capital resources during fiscal 2018.

Cash and Cash Equivalents

Year Ended October 31,

$ Change

% Change

2018

2017

(dollars in millions)

Cash and cash equivalents

723.1

1,048.4

(325.3

)

(31

Cash and cash equivalents decreased primarily due to cash used for business combinations and asset acquisitions, and stock repurchases under our accelerated stock repurchase agreements, partially offset by cash from our operations and net proceeds from our credit facilities.

Cash Flows

Year Ended October 31,

$ Change

2018

2017

2016

2017 to 2018

2016 to 2017

(dollars in millions)

Cash provided by operating activities

424.2

634.6

586.6

(210.4

)

48.0

Cash used in investing activities

(743.5

)

(189.3

)

(142.7

)

(554.2

)

(46.6

)

Cash provided by (used in) financing activities

5.1

(373.1

)

(306.9

)

378.2

(66.2

)

Cash Provided by Operating Activities

We expect cash from our operating activities to fluctuate as a result of a number of factors, including the timing of our billings and collections, our operating results, and the timing and amount of tax and other liability payments. Cash provided by our operations is dependent primarily upon the payment terms of our license agreements. We generally receive cash from upfront arrangements much sooner than from time-based products revenue, in which the license fee is typically paid either quarterly or annually over the term of the license.

Fiscal 2018 compared to fiscal 2017. The decrease in cash provided by operating activities was primarily driven by higher vendor disbursements, higher income taxes payment, higher accounts receivable due to timing of customer billings, and higher inventory. Disbursements in fiscal 2018 included certain one-time payments of $163.3 million for income taxes and $65.0 million for a litigation settlement.

Fiscal 2017 compared to fiscal 2016. The increase in cash provided by operating activities was primarily driven by higher cash collections, partially offset by higher disbursements for operations, including vendors.

Cash Used in Investing Activities

Fiscal 2018 compared to fiscal 2017. The increase in cash used in investing activities was primarily driven by higher cash paid for acquisitions of $393.4 million and lower proceeds from sales and maturities of short-term investments, net of purchases, of $128.1 million.

Fiscal 2017 compared to fiscal 2016. The increase in cash used in investing activities was primarily driven by higher cash paid for acquisitions and intangible assets of $199.1 million, partially offset by higher proceeds from the sales and maturities of short-term investments of $139.3 million.

Cash Provided by (Used in) Financing Activities

Fiscal 2018 compared to fiscal 2017. Cash provided by financing activity in fiscal 2018 was higher compared to fiscal 2017 primarily due to higher proceeds of $300.6 million from drawdowns of our credit facilities and lower debt repayment of $85.3 million.

Fiscal 2017 compared to fiscal 2016. The increase in cash used in financing activities was primarily due to higher debt repayments of $195.6 million, partially offset by higher proceeds from the drawdown of our senior unsecured revolving credit facility of $135.0 million.

Accounts Receivable, net

Year Ended October 31,

2018

2017

$ Change

% Change

(dollars in millions)

$554.2

$451.1

$103.1

23%

Changes in our accounts receivable balance are primarily driven by timing of customer billing, collection activities and to a lesser extent, customer receivables acquired through our acquisitions.

Working Capital

Working capital is comprised of current assets less current liabilities, as shown on our consolidated balance sheets:

Year Ended October 31,

2018

2017

$ Change

% Change

(dollars in millions)

Current assets

1,543.8

1,682.6

(138.8

)

Current liabilities

2,102.4

1,614.1

488.3

Working capital (deficit)

(558.6

)

68.5

(627.1

)

(915

Decreases in our working capital were primarily due to a decrease in cash and cash equivalents of $325.3 million, an increase in short term debt of $333.8 million, an increase in deferred revenue of $88.3 million, and an increase in accounts payable and accrued liabilities of $78.5 million, partially offset by an increase in accounts receivable of $103.1 million, an increase in inventory of $60.5 million, and an increase in income taxes receivable and prepaid taxes of $28.3 million.

Other

As of October 31, 2018, our cash equivalents consisted of taxable money market mutual funds. We follow an established investment policy and set of guidelines to monitor, manage and limit our exposure to interest rate and credit risk.

We proactively manage our cash equivalents balances and closely monitor our capital and stock repurchase expenditures to ensure ample liquidity. Additionally, we believe the overall credit quality of our portfolio is strong,

with our global excess cash, and our cash equivalents, invested in banks and securities with a weighted-average credit rating exceeding AA. The majority of our investments are classified as Level 1 or Level 2 investments, as measured under fair value guidance. See Notes 5 and 6 of Notes to Consolidated Financial Statements.

We believe that our current cash and cash equivalents, cash generated from operations, and available credit under our Revolver (defined below) will satisfy our routine business requirements for at least the next 12 months and the foreseeable future.

Other Commitments - Credit and Term Loan Facilities

In July 2018, we entered into a 220.0 million RMB (approximately $33.0 million) credit agreement with a lender in China to support our facilities expansion. Borrowings bear interest at a floating rate based on the Chinese Central Bank rate plus 10% of such rate. As of October 31, 2018, we had $5.5 million outstanding under the agreement.

On November 28, 2016, we entered into an amended and restated credit agreement with several lenders (the Credit Agreement) providing for (i) a $650.0 million senior unsecured revolving credit facility (the Revolver) and (ii) a $150.0 million senior unsecured term loan facility (the Term Loan). The Credit Agreement amended and restated our previous credit agreement dated May 19, 2015 (the 2015 Agreement), in order to increase the size of the revolving credit facility from $500.0 million to $650.0 million, provide a new $150.0 million senior unsecured term loan facility, and extend the termination date of the revolving credit facility from May 19, 2020 to November 28, 2021. Subject to obtaining additional commitments from lenders, the principal amount of the loans provided under the Credit Agreement may be increased by us by up to an additional $150.0 million. The Credit Agreement contains financial covenants requiring us to operate within a maximum leverage ratio and maintain a minimum interest coverage ratio, as well as other non-financial covenants. As of October 31, 2018, we were in compliance with all financial covenants.

As of October 31, 2018, we had $133.8 million outstanding balance, net of debt issuance costs, under the Term Loan, of which $120.0 million was classified as long-term liabilities. Outstanding principal payments under the Term Loan are due as follows:

Fiscal year

(in thousands)

2019

14,062

2020

17,813

2021

27,187

2022

75,000

Total

134,062

As of October 31, 2017, we had $144.0 million outstanding balance, net of debt issuance costs, under the Term loan, of which $134.1 million was classified as long-term liabilities, and no outstanding balance under the Revolver.

The total outstanding balance of the Revolver as of October 31, 2018 was $330.0 million, which was included in short-term liabilities. We expect the borrowings under the Revolver will fluctuate from quarter to quarter. Borrowings bear interest at a floating rate based on a margin over our choice of market observable base rates as defined in the Credit Agreement. As of October 31, 2018, borrowings under the Term Loan bore interest at LIBOR +1.125% and the applicable interest rate for the Revolver was LIBOR +1.000%. In addition, commitment fees are payable on the Revolver at rates between 0.125% and 0.200% per year based on our leverage ratio on the daily amount of the revolving commitment.

Subsequent to fiscal year 2018, we drew down $150.0 million under the Revolver. The total outstanding balance of the Revolver as of December 14, 2018 is $430.0 million, net of repayments.

Contractual Obligations

The following table summarizes our contractual obligations as of October 31, 2018:

Total

Fiscal 2019

Fiscal 2020/ Fiscal 2021

Fiscal 2022/ Fiscal 2023

Thereafter

Other

(in thousands)

Lease Obligations:

Operating Leases(1)

589,900

61,819

116,784

93,162

318,135

Purchase Obligations(2)

456,823

272,979

183,526

318

Revolver(3)

335,535

Term Loan(3)

134,062

14,062

45,000

75,000

Other Long-Term Obligations(4)

2,588

863

1,725

Long term accrued income taxes(5)

50,590

1,429

5,357

42,375

Total

1,569,498

685,258

348,464

169,909

323,492

42,375

(1)

See Note 7 of Notes to Consolidated Financial Statements.

(2)

Purchase obligations represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business for which we have not received the goods or services as of October 31, 2018. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule and adjust our requirements based on our business needs prior to the delivery of goods or performance of services.

(3)

These commitments relate to the principal of the Revolver, the Term Loan, and a credit facility as discussed in Other Commitments above.

(4)

These other obligations include fees associated with our Revolver.

(5)

Long-term accrued income taxes represent uncertain tax benefits and transition tax liability as of October 31, 2018. Currently, a reasonably reliable estimate of timing of payments related to uncertain tax benefits in individual years beyond fiscal 2018 cannot be made due to uncertainties in timing of the commencement and settlement of potential tax audits.

The expected timing of payments of the obligations discussed above is estimated based on current information. Timing of payment and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations.

Off-Balance Sheet Arrangements

As of October 31, 2018, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.