10-Q 1 f72560e10-q.txt FORM 10-Q 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------------------- FORM 10-Q (Mark One) [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarter ended March 31, 2001 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from __________ to __________ COMMISSION FILE NUMBER 0-18623 --------------------------------- IKOS SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0100318 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 79 GREAT OAKS BLVD., SAN JOSE, CA 95119 (Address of principal executive offices) (zip code) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 284-0400 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. COMMON STOCK $.01 PAR VALUE 8,985,000 --------------------------- (Outstanding as of (Title of Class) March 31, 2001) 2 IKOS SYSTEMS, INC. FORM 10-Q QUARTER ENDED MARCH 31, 2001 INDEX Part I: Financial Information Item 1:Financial Statements

3 PART 1 FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS IKOS SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except per-share amounts)

See notes to condensed consolidated financial statements 3 4 IKOS SYSTEMS INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share amounts)

See notes to condensed consolidated financial statements 4 5 IKOS SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Increase (decrease) in cash and cash equivalents (in thousands)

See notes to condensed consolidated financial statements. 5 6 IKOS SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements at March 31, 2001 and for the three and six months ended March 31, 2001 and April 1, 2000, have been prepared in conformity with generally accepted accounting principles, consistent with those applied in, and should be read in conjunction with, the audited consolidated financial statements for the year ended September 30, 2000 included in the Form 10-K as filed with the Securities and Exchange Commission on December 21, 2000. The unaudited interim financial information reflects all normal recurring adjustments, which are, in the opinion of management, necessary for a fair statement of results for the interim periods presented. The results for the three and six months ended March 31, 2001 are not necessarily indicative of results expected for the full year. 2. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out) or market and consisted of (in thousands):

3. NET INCOME PER SHARE The computation of basic net income per share for the periods presented is derived from the information on the face of the income statement, and there are no reconciling items in either the numerator or denominator. Additionally, there are no reconciling items in the numerator used to compute dilutive net income per share. The incremental common shares attributable to outstanding options for the three and six month periods ended March 31, 2001 and April 1, 2000 included in the total shares used in the denominator of the diluted net income per share calculation are as follows (in thousands):

6 7 IKOS SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 4. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) for the three and six months ending March 31, 2001 and April 1, 2000 are as follows (in thousands):

5. INCOME TAXES The Company's effective tax rate on the consolidated pretax income was approximately 25% for the three and six month periods ending March 31, 2001 and April 1, 2000. The Company's effective tax rate for both periods differs from the federal statutory rate primarily due to benefits associated with its net operating loss carryforward. 6. LITIGATION AND CONTINGENCIES On February 9, 2001, the Company filed a patent infringement complaint against Axis Systems, Inc. (Axis) in the United States District Court in the District of Delaware. The complaint alleges infringement by Axis of four patents involving the Company's Virtual Wires(TM) technology, which allows high resource utilization in FPGA-based emulators. The Company is seeking both injunctive relief and monetary damages. On March 22, 2001, Axis filed a patent infringement complaint against the Company in the United States District Court for the Northern District of California. The complaint alleges infringement by IKOS of Axis's patent for a "Simulation/Emulation System and Method," U.S. Patent No 6,009,256. Axis claims that this patent covers technology for a single system that provides simulation, acceleration, and emulation of complex electronic integrated circuit and system-on-chip designs. The compliant alleges that certain of the Company's emulation products infringe on the patent. Axis is seeking both injunctive relief and monetary damages. The Company believes the claim is without merit and intends to vigorously defend the action. 7 8 IKOS SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 7. RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial Statements". IKOS is required to implement SAB101 no later than the quarter ending September 29, 2001. The Company is currently evaluating the impact of SAB 101 and is uncertain as to what impact, if any, SAB 101 will have on its revenues and results of operations. The impact of SAB 101, if any, will be reported as a change in accounting principle in accordance with FASB Statement No. 3. This may result in a significant cumulative effect change in accounting adjustment that would be reflected in the Company's results of operations for the fiscal year ended September 29, 2001. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments and hedging activities. It requires the Company to recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. It further provides criteria for derivative instruments to be designated as fair value, cash flow, or foreign currency hedges, and establishes accounting standards for reporting changes in the fair value of the derivative instruments. Upon adoption, the Company was required to adjust hedging instruments to fair value in the balance sheet and recognize the offsetting gains or losses as adjustments to be reported in net income or other comprehensive income, as appropriate. The Company adopted SFAS No. 133 as of October 1, 2000. The adoption of SFAS No. 133 did not have a material effect on the Company's results of operations or financial position. 8 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENT The statements in the Management's Discussion and Analysis of Financial Condition and Results of Operations that are forward looking involve numerous risks and uncertainties and are based on current expectations. Actual results may differ materially from those projected. Such risks and uncertainties may be more fully described in other reports and information filed by the Company with the Securities and Exchange Commission. Certain of these risks and uncertainties are discussed under the caption "Factors That May Affect Future Results of Operations." NET REVENUES Net revenues for the three month and six month periods ending March 31, 2001 were $17,410,000 and $38,419,000, respectively, representing a 4% and 19% increase, respectively, over the same periods of the prior year. The increase for the current quarter when compared to the same prior year quarter was primarily related to an increase in maintenance revenues of approximately 28% offset by a decrease in product revenues of 5%. Maintenance increased primarily as a result of growth in emulation maintenance orders. Emulation maintenance revenue grew approximately 145%. The base of emulation users has increased resulting in the related maintenance revenue increase. This growth is partially offset by a decrease in simulation users reflecting a decrease in simulation maintenance of approximately 6%. Product revenues declined due to a slowing economy resulting in certain equipment purchases being delayed or cancelled by customers. The major portion of the decrease related to simulation sales, which declined 47% while emulation product sales actually increased 43%. The decline in simulation sales is expected as the Company has continually focused on the emulation market since the Company's introduction of an emulation product in fiscal 1997. Emulation revenues, although increasing when compared to the prior year quarter, were down 26% from the first quarter of fiscal 2001, which the Company believes is due to the effects of the slowing economy. For the six month period ending March 31, 2001, revenues have increased on the overall strength of emulation product revenues which are up over 63% when compared with the first six months of the prior year. Maintenance revenues also contribute to the overall increase for the six month period increasing 17% over this period. Simulation product revenues have decreased by approximately 26%, which is expected. The Company expects to continue is focus on the emulation market in an effort to continue to grow emulation revenues. In addition, the Company continues to expect a decline in the simulation revenues. International revenues for the three and six month periods ending March 31, 2001, totaled $5,795,000 and $11,758,000, respectively or approximately 33% and 31% of total revenues, respectively. International revenues for the three months ending March 31, 2001 increased 28% as a result of increased sales in Japan during the quarter. For the six month period ending March 31, 2001, international revenues decreased approximately 4% when compared to the first six months of the prior year. The decrease in revenues is due to lower than planned revenues in Japan for the six month period. The Company believes the shortfall is a result of the Company's increased emphasis on emulation and the difficulties involved in penetrating the Japan market with a new product. 9 10 GROSS PROFIT MARGINS Gross profit margins for the three and six month periods ended March 31, 2001 were 77% and 78%, respectively. Gross profit margins for the three and six month periods end April 1, 2000 were 78% and 77%, respectively. Despite the lower than expected revenues during the quarter margins were reasonably flat and comparable with the prior year. RESEARCH AND DEVELOPMENT EXPENSES Research and development expenses for the three and six month periods ending March 31, 2001 were approximately $4,552,000 and $9,060,000, respectively, representing 26% and 24% of revenues, respectively. Research and development expenses for the three and six month periods ending April 1, 2000 were approximately $3,953,000 and $7,207,000, respectively, representing 23% and 22% of revenues, respectively. The increase for both the three and six months ended March 31, 2001, as a percentage of sales, are due to the overall increase in expense against lower than expected revenues for the quarter and six month periods. The increases for the three and six month periods are primarily related to increased payroll and related costs due to increased headcount and increased consulting fees. As the Company continues to research verification tool methodologies and introduce new products, research and development costs are expected to increase in absolute dollars over the remainder of the year. SALES AND MARKETING EXPENSES Sales and marketing expenses for the three and six month periods ending March 31, 2001 were approximately $7,222,000 and $14,500,000, respectively, representing 41% and 38% of revenues, respectively. Sales and marketing expenses for the three and six month periods ending April 1, 2000 were approximately $5,760,000 and $11,681,000, respectively, representing 34% and 36% of revenues, respectively. The increase as a percentage of sales, for both the three and six months ended March 31, 2001, are due to the overall increase in expense against lower than expected revenues for the quarter and six month periods. The increase in absolute dollars over the prior year quarter and six months is primarily related to increased payroll and commissions, recruiting, travel and trade show expenses. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses for the three and six month periods ending March 31, 2001 were approximately $1,462,000 and $3,046,000, respectively, representing 8% of revenues for both periods. General and administrative expenses for the three and six month periods ending April 1, 2000 were approximately $1,288,000 and $2,341,000, respectively, representing 8% and 7% of revenues, respectively. The slight increase for both the three and six months ended March 31, 2001, as a percentage of sales, is due to the overall increase in expenses against lower than expected revenues for the three and six month periods. For the three and six month periods ending March 31, 2001, the general and administrative expenses were higher than the prior year periods in terms of absolute dollars as a result of increased salaries and related expenses. INCOME TAXES The Company's effective tax rate on the consolidated pretax income was approximately 25% for the three and six month periods ending March 31, 2001 and April 1, 2000. The Company's effective tax rate for both periods differs from the federal statutory rate primarily due to benefits associated with its net operating loss carryforward. 10 11 OTHER The Company has experienced minimal gains or losses on foreign currency translation. With the exception of the Company's Japan operations, substantially all of its international sales to date have been billed and collected in U.S. dollars. The Company pays the expenses of its international operations in local currencies and to date the Company has not engaged in hedging transactions with respect to such obligations. The Company's sales in Japan are billed and collected in the Japanese local currency. As such, the Company periodically enters into foreign exchange contracts to minimize foreign exchange risk relating to the Japanese subsidiary's sales that are denominated in yen. A forward exchange contract obligates the Company to exchange predetermined amounts of a specified foreign currency at a specified exchange rate on a specified date or to make an equivalent US dollar payment equal to the value of such exchange. Through March 31, 2001, the impact of such arrangements have been immaterial to the Company operations. FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS Potential Fluctuations in Quarterly Results. The Company's quarterly operating results have in the past and may in the future vary significantly depending on factors including the timing of customer development projects and purchase orders, new product announcements and releases by the Company and other companies, gain or loss of significant customers, price discounting of the Company's products, the timing of expenditures, customer product delivery requirements, availability and cost of components or labor and economic conditions generally and in the electronics industry specifically. Any unfavorable change in these or other factors could have a material adverse effect on the Company's operating results for a particular quarter. Many of the Company's customers order on an as-needed basis and often delay issuance of firm purchase orders until their project commencement dates are determined. Quarterly revenue and operating results will therefore depend on the volume and timing of orders received during the quarter, which are difficult to forecast accurately. Moreover, a significant portion of the Company's revenue may result from shipments during the last few weeks of the quarter from orders generally received in the last month of the quarter. Any concentration of sales at the end of the quarter may limit the Company's ability to plan or adjust operating expenses and production and inventory levels. Therefore, if anticipated shipments in any quarter do not occur or are delayed, expenditure levels could be disproportionately high as a percentage of revenue, and the Company's operating results for that quarter would be adversely affected. In addition, sales of individual systems with high average sales prices can constitute a significant percentage of the Company's quarterly revenue. Operating results in any period should not be considered indicative of the results to be expected for any future period, and there can be no assurance that the Company's net revenues will increase or that the Company will remain profitable in any future period. Sales Trends. Over the past several years the marketplace for the Company's products has evolved substantially. The Company has seen a significant reduction in sales of its simulation products as revenues have declined from approximately $37,044,000 in fiscal 1997 to approximately $21,719,000 in fiscal 2000. While the decrease is due in part to the evolution of the market, the primary cause of the decrease is the result of the Company's focus on its new emerging product line of emulation solutions. The Company has seen its revenues from its emulation products increase from approximately $6,000,000 in fiscal 1997 to over $32,933,000 in fiscal 2000. There can be no assurance that the Company will be able to maintain these past trends. These trends will be dependent upon the Company introducing new products and methodologies. Furthermore, increased overall sales will also depend on an increasing number of complex ICs designed for electronic systems, integration of the Company's products with other tools for IC design, the ability of the Company's products to shorten overall customer design cycles and increased industry acceptance of the Company verifications solutions. Because the 11 12 market for hardware-assisted verification products is evolving, it is difficult to predict with any assurance whether the markets for such solutions will continue to expand. There can be no assurances that such market will expand, or even if such market expands, that the Company's products will achieve and maintain the market acceptance required to maintain revenue growth and profitability in the future. New Product Development. To obtain the expected revenue growth, the Company needs to continue to invest in new product development. The Company has focused most of its development resources on its emulation products. The Company's initial emulation product was commercially released in the first quarter of fiscal 1997. The Company encountered several product design issues with its second-generation emulation product, and in addition, the EDA marketplace for emulation products continued to evolve, impacting the original design. During 1998, the Company addressed its product design issues by completely redesigning the emulation product. The Company released its third generation system in fiscal 1999 and its fourth generation system was released in March 2001, providing emulation users with up to 15 million gates of emulation capacity. While the Company has seen favorable results with its third generation release and interest in the fourth generation system, there can be no assurance that this fourth generation product will adequately meet the requirements of the marketplace. There continues to be further development of the emulation product as well as other verification products, and as the Company continues to develop such products which are based on the new technology, there can be no assurance that the enhanced products or other developed products resulting from this development will provide the necessary solutions to customer design verification needs, be of acceptable quality or achieve further market acceptance. The success of the Company in developing, introducing, selling and supporting verification products will depend on a variety of factors, including but not limited to, the timely and successful enhancement of current products, completion of product design and development of future products, the timely and efficient implementation of manufacturing processes, effective sales, marketing and customer service. Furthermore, the absence of performance problems or other difficulties that may require design modifications and related expenses will contribute to overall success otherwise such issues may hinder or damage market acceptance of the products. While the Company's verification systems are designed to provide cost and ease of use advantages intended to broaden the market for hardware-assisted verification, there can be no assurance that its products will be able to achieve such goals. Moreover, there can be no assurance that the market for such verification solutions will broaden beyond the current set of users. The Company currently maintains a research and development facility in India. Through this facility, the Company has developed certain technology, which has resulted in new products. The research and development facility has positively impacted the Company's ability to meet its product development deadlines. However, the Company has significant development risk with respect to the continued incorporation of the acquired technology into future products. Such effort will result in increased spending on research and development as the Company attempts to continue to meet its goals and deadlines. There can be no assurance that such goals or deadlines will be achieved in a timely manner. Furthermore, should such goals and deadlines for the introduction of new products be attained, there can be no assurance that the resulting new products will adequately meet the requirements of the marketplace. Competition. The EDA industry is highly competitive and rapidly changing. The Company's products are specifically targeted at the emerging portion of the industry relating to complex designs that the Company believes benefit from its verification products. The Company currently competes with traditional software verification methodologies, including product offerings sold by Cadence, Synopsys and Mentor Graphics. The Company's main competition for the sale of emulation systems is Quickturn/Cadence and Mentor Graphics. The Company expects competition in the market for verification tools to increase as other companies attempt to 12 13 introduce new products and product enhancements. Moreover, the Company competes, and expects that it will continue to compete, with established EDA companies. A number of these companies have longer operating histories, significantly greater financial, technical and marketing resources, greater name recognition and larger installed customer bases than the Company. In addition, many of these competitors and potential competitors have established relationships with current and potential customers of the Company and offer a broader and more comprehensive product line. Increased competition could result in price reductions, reduced margins and loss of market share, all of which could materially adversely affect the Company. In addition, current competitors or other entities may develop other products that have significant advantages over the Company's products. There can be no assurance that the Company will be able to compete successfully against current and future competitors or that competitive pressures faced by the Company will not materially adversely affect its operating results. New Products and Technological Change. The EDA industry is characterized by extremely rapid technological change in both hardware and software development, frequent new product introductions, evolving industry standards and changing customer requirements. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. The Company's future success will depend upon its ability to enhance its current series of simulation and emulation systems and to design, develop and support its future simulation and emulation products on a timely basis. These efforts require a high level of expenditures for research and development by the Company to address the increasingly sophisticated needs of the customers. There can be no assurance that the Company will be successful in developing and marketing product enhancements or new products that respond to technological change or evolving industry standards or changing customer requirements, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products, or that its new products and product enhancements will adequately meet the requirements of the marketplace, will be of acceptable quality or will achieve market acceptance. If the Company is unable, for technological or other reasons, to develop and introduce products in a timely manner in response to changing market conditions or customer requirements, the Company's business, operating results and financial condition will be materially and adversely affected. Moreover, from time to time, the Company may announce new products or technologies that have the potential to replace the Company's existing product offerings. There can be no assurance that the announcement of new product offerings will not cause customers to defer purchases of existing Company products, which could adversely affect the Company's results of operations for any particular quarter. Dependence on Electronics Industry. The Company is dependent upon the electronics industry and, in particular, new system and IC design projects. The electronics industry is characterized by rapid technological change, short product life cycles, fluctuations in manufacturing capacity and pricing and margin pressures, all of which cause it to be volatile. As a result, the electronics industry has historically experienced sudden and unexpected downturns, at which time the number of new system and IC design projects decrease. Because most of the Company's sales occur upon the commencement of new projects for system and IC products, the Company is dependent upon the rate of commencement of new system and IC design projects. Accordingly, negative factors affecting the electronics industry could have a material adverse effect on the Company's results of operations. Dependence Upon Certain Suppliers. Certain key components used in the Company's products are presently available from sole or limited sources. The inability to develop alternative sources for these sole or limited source components or to obtain sufficient quantities of these components could result in delays or reductions in product shipments, which could adversely affect the Company's operating results. The Company's systems use proprietary FPGAs that are currently manufactured solely by Xilinx, Inc. ("Xilinx"). 13 14 The Company generally purchases these components, including semiconductor memories used in the Company's verification hardware, pursuant to purchase orders placed from time to time in the ordinary course of business and has no supply arrangements with any of its source suppliers that require the suppliers to provide components in guaranteed quantities or at set prices. Moreover, the manufacture of these components can be extremely complex, and the Company's reliance on the suppliers of these components exposes the Company to production difficulties and quality variations that may be experienced by these suppliers. Therefore, the Company's reliance on its sole and limited source suppliers involves several risks, including a potential inability to obtain an adequate supply of required components, reduced control over pricing and timely delivery and quality of acceptable components. While the timeliness and quality of deliveries to date from such suppliers have been acceptable, there can be no assurance that problems will not occur in the future. Any prolonged inability to obtain components or subassemblies in sufficient quantities or quality or on favorable pricing or delivery terms, or any other circumstances that would require the Company to seek alternative sources of supply, could have a material adverse effect on the Company's operating results and could damage the Company's relationships with its customers. Customer Concentration. A relatively limited number of customers have historically accounted for a substantial portion of the Company's net revenues. During fiscal 2000, 1999 and 1998, sales to the Company's top ten customers accounted for approximately 66%, 60% and 45%, respectively, of the Company's net revenues. The Company expects that sales of its products to a limited number of customers will continue to account for a high percentage of net revenues for the foreseeable future. The loss of a major customer or any reduction in orders by such customers, including reductions due to market or competitive conditions in the electronics or EDA industries, would have an adverse effect on the Company's results of operations. Moreover, the Company's ability to increase its sales will depend in part upon its ability to obtain orders from new customers, as well as the financial condition and success of its existing customers and the general economy. There can be no assurance that such increases will occur. Proprietary Rights. The Company protects its proprietary product information through the use of employee nondisclosure agreements and by limiting access to confidential information. The Company presently has 13 United States patents, that cover various aspects and features of its products, including its overall system architecture and certain features in the systems hardware for both simulation and emulation products. These licenses expire between November 22, 2005 and August 15, 2017. The Company also has licensed rights under certain patent applications relating to VirtualWires from MIT. This license is through December 2004, and thereafter becomes nonexclusive. MIT may terminate this license if the Company fails to meet certain minimum net sales milestones or upon certain other material breaches of the license agreement that remain uncured after 90 days' notice of such breach. Although the Company may file additional patent applications in the future, it does not expect to rely extensively on patents to protect its products. The Company also relies on certain software which it licenses from third parties, including software which is integrated with internally developed software and used in the Company's systems. From time to time the Company has received, and may receive in the future, notice of claims of infringement of other parties' proprietary rights. Although the Company does not believe that its products infringe the proprietary rights of any third parties, there can be no assurance that infringement or invalidity claims (or claims for indemnification resulting from infringement claims) will not be asserted against the Company or that any such assertions will not materially adversely affect the Company's business, financial condition or results of operations. On February 9, 2001, the Company filed a patent infringement complaint against Axis Systems, Inc. (Axis) in the United States District Court in the District of Delaware that alleges infringement by Axis of four patents involving the Company's Virtual Wires technology. The Company is seeking both injunctive relief and monetary damages. On March 22, 2001, Axis filed a patent infringement complaint against the Company in the United States District Court for the Northern District of California alleging infringement by IKOS of Axis's patent for a "Simulation/Emulation System and Method," U.S. Patent No 6,009,256. Axis is seeking both injunctive relief and monetary damages. The Company believes the claim is without merit and intends to vigorously defend the action; however, here can be no assurance that the Company will prevail in any future litigation. Irrespective of the validity or the successful assertion of such claims against the Company, the Company could incur significant costs and diversion of management efforts with respect to the defense thereof which could have a material adverse effect on the Company' business, financial condition or results of operations. If any claims or actions are asserted against the Company, the Company may seek to obtain a license under a third party's intellectual property rights. There can be no assurance, however, that under such circumstances, a license would be available under reasonable terms or at all. Adverse determinations in litigation could result in the loss of the Company's proprietary rights, subject the Company to significant liabilities, require the Company to seek licenses from third parties or prevent the Company from licensing our technology, any of which could have a material adverse effect on the Company's business, financial condition and operating results. Euro Conversion. On January 1, 1999, certain member countries of the European Union established fixed conversion rates between their existing currencies and the Euro. The transition period for the introduction of the Euro ends June 30, 2002. Issues facing the Company as a result of the introduction of the Euro include converting information technology systems, reassessing currency risk, renegotiating vendor contracts, and processing tax and accounting records. We are addressing these issues and do not currently expect the Euro to have a material effect on our financial conditions or results of operations. California Energy Crisis. The Company relies on a continuous power supply to conduct operations, and California's current energy crisis could disrupt its business and/or increase its expenses. California is in the midst of an energy crisis that could disrupt the Company's operations and increase its expenses. In the event of an acute power shortage, that is, when power reserves for California fall below 1.5%, California has on some occasions implemented, and may in the future continue to implement, rolling blackouts throughout California. The majority of the Company's operations are located in California and the Company currently has only limited backup generators for emergency alternate sources of power in the event of a blackout. If blackouts interrupt the power supply, the Company would be temporarily unable to continue operations at its facilities. Any such interruption in its ability to continue operations at its facilities could delay shipments of products to customers, and could result in lost revenue, which could harm the Company's business and results of operations. Economic Downturn. The current economic downturn in the U.S. could cause a decline in demand for the Company's products. The recent announcements of economic slowdown by major companies of which some are customers of the Company or are major end customers to the 14 15 Company's current customer base could result in a slowdown in demand for some of the Company's products. If the Company's customers are not successful in maintaining high levels of demand for their products, their demand for the Company's products may decrease and adversely affect the Company's operating results. LIQUIDITY AND CAPITAL RESOURCES Since inception, the Company has financed its operations, including increases in accounts receivable, inventory and capital equipment acquisitions, primarily through private and public sales of equity securities and a loan secured by capital equipment. The Company's cash, cash equivalents and short-term investments were $21,773,000 at March 31, 2001 up from $19,803,000 at September 30, 2000. The increase was a result of $5,162,000 of cash provided by operating activities offset by $834,000 of cash used in investing activities (excluding short-term investment activities) and $623,000 of cash used in financing activities. Operating Activities - The Company's operating activities provided cash of $5,162,000 during the first six months of fiscal 2001. The cash provided by operations was primarily due to net income adjusted for depreciation, amortization and accrued rent and a decreases in accounts receivables, combined with an increases in accounts payables and deferred revenues. These increases in cash provided by operations were partially offset by increases in inventories, prepaid expenses and other assets combined with decreases in accrued payroll expenses, accrued commissions, income taxes payable and other accrued liabilities. Investing Activities - Net cash used in investing activities for the first six months of fiscal 2001 was $834,000. The use of cash was primarily related to the purchases of short-term investments of $8,922,000 and the acquisition of capital equipment of $2,569,000, partially offset by the maturities of short-term investment in the amount of $10,657,000. Financing Activities - Net cash used in financing activities for the six months of fiscal, 2001, was $623,000 and was primarily related to the repayment of the outstanding line of credit in the amount of $1,809,000 partially offset by the net sales of stock under stock option and purchase plans during the six months. The Company's primary unused sources of funds at March 31, 2000 consisted of $15,737,000 of cash and cash equivalents, in addition to $6,036,000 of short-term investments. The Company renegotiated its working capital line of credit and currently maintains a $5,000,000 working capital line. Of this total the Company has approximately $3,500,000 available under the Company's line as the remainder serves as collateral under two letter of credit arrangements the Company has outstanding relating to its facilities. The Company believes that its current cash, cash equivalents, short-term investments and its available credit facility, together with cash and cash equivalents generated from operations will be sufficient to finance its operations for at least the next twelve months. Should the Company require other financing arrangements, there can be no assurance that such financing will be available, if at all, on terms favorable or acceptable to the Company. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As of March 31, 2001, the Company's investment portfolio consists of money market funds, corporate-backed debt obligations and mortgaged-backed government obligations generally due within one year. The Company's primary objective with its investment portfolio is to invest available cash while preserving principal and meeting liquidity needs. In accordance with the Company's investment policy, the Company places investments with high credit quality issuers and limits the amount of credit exposure to any one issuer. These securities, which approximate 15 16 $14,765,000 and have an average interest rate of approximately 5.50%, are subject to interest rate risks. However, based on the investment portfolio contents and the ability of the Company to hold these investments until maturity, the Company believes that if a significant change in interest rates were to occur, it would not have a material effect on the Company's financial condition, although there can be no assurance of this. In addition to its cash equivalents and short-term investments, the Company enters into derivative financial instruments such as forward exchange contracts to hedge certain identifiable receivables denominated in Japanese yen. Any market risks associated with these contracts and related underlying transactions are deemed minimal. PART II OTHER INFORMATION ITEM 1 LEGAL PROCEEDINGS On February 9, 2001, the Company filed a patent infringement complaint against Axis Systems, Inc. (Axis) in the United States District Court in the District of Delaware. The complaint alleges infringement by Axis of four patents involving the Company's Virtual Wires(TM) technology, which allows high resource utilization in FPGA-based emulators. The Company is seeking both injunctive relief and monetary damages. On March 22, 2001, Axis filed a patent infringement complaint against the Company in the United States District Court for the Northern District of California. The complaint alleges infringement by IKOS of Axis's patent for a "Simulation/Emulation System and Method," U.S. Patent No 6,009,256. Axis claims that this patent covers technology for a single system that provides simulation, acceleration, and emulation of complex electronic integrated circuit and system-on-chip designs. The compliant alleges that certain of the Company's emulation products infringe on the patent. Axis is seeking both injunctive relief and monetary damages. The Company believes the claim is without merit and intends to vigorously defend the action. ITEMS 2 AND 3 Not applicable ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The annual meeting of stockholders was held on January 23, 2001. The stockholders approved a proposal to elect the Board of Directors of the Company to serve for the ensuing fiscal year. The proposal received the following votes:

The stockholders approved a proposal to amend the Company's 1996 Employee Stock Purchase Plan increasing by 400,000 the maximum number of shares of the Company's common stock that may be issued thereunder. The proposal received the following votes:

16 17 In addition, stockholders ratified the appointment of Ernst & Young LLP as independent public accountants of the Company for the fiscal year ending September 29, 2001. The proposal received the following votes:

ITEM 5 NOT APPLICABLE. ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K (a) INDEX TO EXHIBITS INDEX TO EXHIBITS

17 18

18 19

(b) REPORTS ON FORM 8-K NONE 19 20 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. IKOS SYSTEMS, INC. Registrant Date: May 11, 2001 /s/ Joseph W. Rockom ----------------------------------- (JOSEPH W. ROCKOM CFO) Principal Financial Officer, Duly Authorized Officer 20

IKOS SYSTEMS INC 10-Q