PDF SOLUTIONS INC - Quarter Report: 2007 September (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period ended September 30, 2007

o		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 000-31311

PDF SOLUTIONS, INC.

(Exact name of Registrant as Specified in its Charter)

Delaware		25-1701361
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)
333 West San Carlos Street, Suite 700
San Jose, California		95110
(Address of Principal Executive Offices)		(Zip Code)

(408) 280-7900
(Registrant’s Telephone Number, Including Area Code)

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 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 þ   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act (Check one):

Large accelerated filer o           Accelerated filer þ           Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No þ

The number of shares outstanding of the Registrant’s Common Stock as of November 2, 2007 was 28,038,157.

 

 

TABLE OF CONTENTS

		Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements			3
Condensed Consolidated Balance Sheets (Unaudited)			3
Condensed Consolidated Statements of Operations (Unaudited)			4
Condensed Consolidated Statements of Cash Flows (Unaudited)			5
Notes to Condensed Consolidated Financial Statements (Unaudited)			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			15
Item 3. Quantitative and Qualitative Disclosures About Market Risk			26
Item 4. Controls and Procedures			26
PART II OTHER INFORMATION			26
Item 1. Legal Proceedings			26
Item 1A. Risk Factors			26
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			34
Item 3. Defaults Upon Senior Securities			34
Item 4. Submission of Matters to a Vote of Security Holders			34
Item 5. Other Information			34
Item 6. Exhibits			35
SIGNATURES			36
INDEX TO EXHIBITS			37
EXHIBIT 31.01
EXHIBIT 31.02
EXHIBIT 32.01
EXHIBIT 32.02

Item 1. Financial Statements.

PDF SOLUTIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(In thousands, except par values)

		September 30,				December 31,
		2007				2006
ASSETS
Current assets:
Cash and cash equivalents		$	38,461			$	36,451
Short-term investments			11,500				16,402
Accounts receivable, net of allowance of $254 in 2007 and 2006			32,609				27,575
Prepaid expenses and other current assets			2,825				2,796
Deferred tax assets			2,644				2,581
Total current assets			88,039				85,805
Property and equipment, net			3,761				3,916
Goodwill			64,593				60,034
Intangible assets, net			13,855				13,605
Deferred tax assets			6,265				4,994
Other assets			472				503
Total assets		$	176,985			$	168,857
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt		$	403			$	302
Accounts payable			2,424				3,182
Accrued compensation and related benefits			5,430				3,325
Other accrued liabilities			2,541				3,843
Taxes payable			2,919				4,767
Deferred revenue			4,221				3,705
Billings in excess of recognized revenue			301				95
Total current liabilities			18,239				19,219
Long-term debt			946				1,198
Long-term taxes payable			5,355				—
Other liabilities			78				221
Total liabilities			24,618				20,638
Stockholders’ equity:
Preferred stock, $0.00015 par value, 5,000 shares authorized: no shares issued and outstanding			—				—
Common stock, $0.00015 par value, 70,000 shares authorized: shares issued and outstanding 28,022 in 2007 and 27,948 in 2006			4				4
Additional paid-in-capital			177,992				167,323
Treasury stock at cost, 988 shares in 2007 and 551 shares in 2006			(10,001	)			(5,549	)
Accumulated deficit			(18,423	)			(13,890	)
Accumulated other comprehensive income			2,795				331
Total stockholders’ equity			152,367				148,219
Total liabilities and stockholders’ equity		$	176,985			$	168,857

See notes to condensed consolidated financial statements.

PDF SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(In thousands, except per share amounts)

		Three Months Ended								Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2007				2006				2007				2006
Revenue:
Design-to-silicon- yield solutions:
Integrated solutions		$	16,294			$	11,153			$	46,090			$	33,859
Software licenses			967				3,811				6,228				8,217
Gain share			6,807				4,400				17,590				15,155
Total revenue			24,068				19,364				69,908				57,231
Cost of design-to-silicon yield solutions:
Direct costs of design-to-silicon-yield solutions:
Integrated solutions			8,052				6,734				22,842				19,808
Software licenses			48				58				134				98
Amortization of acquired technology			1,331				1,266				4,516				3,798
Total cost of design—to silicon-yield solutions			9,431				8,058				27,492				23,704
Gross margin			14,637				11,306				42,416				33,527
Operating expenses:
Research and development			9,008				6,416				26,175				19,543
Selling, general and administrative			5,789				5,028				18,278				14,850
Amortization of other acquired intangible assets			985				235				3,029				705
Total operating expenses			15,782				11,679				47,482				35,098
Loss from operations			(1,145	)			(373	)			(5,066	)			(1,571	)
Interest and other income, net			322				892				1,347				2,338
Income (loss) before taxes			(823	)			519				(3,719	)			767
Income tax provision (benefit)			116				(51	)			276				776
Net income (loss)		$	(939	)		$	570			$	(3,995	)		$	(9	)
Net income (loss) per share:
Basic		$	(0.03	)		$	0.02			$	(0.14	)		$	(0.00	)
Diluted		$	(0.03	)		$	0.02			$	(0.14	)		$	(0.00	)
Weighted average common shares:
Basic			28,223				26,860				28,127				26,694
Diluted			28,223				27,621				28,127				26,694

See notes to condensed consolidated financial statements.

PDF SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)

		Nine Months Ended
		September 30,
		2007				2006
Operating activities:
Net loss		$	(3,995	)		$	(9	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			1,513				1,532
Stock-based compensation expense			5,453				5,462
Amortization of acquired intangible assets			7,594				4,503
Tax benefit related to stock-based compensation expense			223				579
Excess tax benefit from stock-based compensation expense			(43	)			(286	)
Deferred taxes			(3,706	)			(1,020	)
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable, net of allowances			(5,034	)			(1,338	)
Prepaid expenses and other assets			11				(986	)
Accounts payable			(1,081	)			1,045
Accrued compensation and related benefits			662				(2,179	)
Other accrued liabilities			(489	)			290
Taxes payable			3,815				(89	)
Deferred revenue			516				421
Billings in excess of recognized revenue			206				(1,465	)
Net cash provided by operating activities			5,645				6,460
Investing activities:
Purchases of available-for-sale securities			(20,840	)			(42,198	)
Maturities and sales of available-for-sale securities			26,221				25,242
Purchases of property and equipment			(1,654	)			(1,915	)
Payments on businesses acquired, net of cash acquired			(4,584	)			—
Net cash used in investing activities			(857	)			(18,871	)
Financing activities:
Proceeds from exercise of stock options			1,337				3,425
Proceeds from employee stock purchase plan			782				978
Stock repurchases			(4,452	)			—
Principal payments on long-term obligations			(267	)			(36	)
Principal payments on notes to stockholders			(416	)			—
Excess tax benefit from stock-based compensation expense			43				286
Net cash provided by (used in) financing activities			(2,973	)			4,653
Effect of exchange rate changes on cash			195				33
Net increase (decrease) in cash and cash equivalents			2,010				(7,725	)
Cash and cash equivalents, beginning of period			36,451				60,506
Cash and cash equivalents, end of period		$	38,461			$	52,781
Non-cash investing and financing activities:
Purchase price adjustments		$	9			$	923
Reversal of deferred stock compensation		$	—			$	27
Purchase of property and equipment on account		$	133			$	28
Stock issued for business acquired		$	2,874			$	—
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Taxes		$	518			$	1,381
Interest		$	36			$	1

See notes to condensed consolidated financial statements

PDF SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. BASIS OF PRESENTATION

     The interim unaudited condensed consolidated financial statements included herein have been prepared by PDF Solutions, Inc. (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), including the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. The interim unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary, (consisting only of normal recurring adjustments) to present a fair statement of results for the interim periods presented. The operating results for any interim period are not necessarily indicative of the results that may be expected for other interim periods or the full fiscal year. The accompanying interim unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

     The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. A significant portion of the Company’s revenues require estimates with respect to total costs which may be incurred and revenues earned. Actual results could differ from these estimates.

     The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after the elimination of all significant intercompany balances and transactions.

Revenue Recognition

     The Company derives revenue from two sources: Design-to-Silicon-Yield solutions and gain share. The Company recognizes revenue in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position (“SOP”) No. 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts and SOP No. 97-2, Software Revenue Recognition, as amended.

     Design-to-Silicon-Yield Solutions — Design-to-Silicon-Yield solutions revenue is derived from integrated solutions and software licenses. Revenue recognition for each element of Design-to-Silicon-Yield solutions is summarized as follows:

     Integrated Solutions — The Company generates a significant portion of its revenue from fixed-price contracts delivered over a specific period of time. These contracts require the accurate estimation of the cost to perform obligations and the overall scope of each engagement. Revenue under contracts for solution implementation services is recognized as the services are performed using the cost-to-cost percentage of completion method of contract accounting. Losses on solution implementation contracts are recognized when determined. Revisions in profit estimates are reflected in the period in which the conditions that require the revisions become known and can be estimated.

     On occasion, the Company has licensed its software products as a component of its fixed price integrated solutions implementations. In such instances, the software products are licensed to the customer over the specified term of the agreement with support and maintenance to be provided over the license term. Under these arrangements, where vendor-specific objective evidence of fair value (“VSOE”) does not exist to allocate a portion of the total fee to the undelivered elements, revenue is recognized ratably over the term of the agreement. Costs incurred under these arrangements are deferred and recognized in proportion to revenue recognized under these arrangements.

     Revenue from support and maintenance services is recognized ratably over the term of the support and maintenance contract, generally one year, while revenue from consulting, installation and training services is recognized as the services are performed. When bundled with software licenses in multiple element arrangements, support and maintenance, consulting (other than for our fixed price solution implementations), installation, and training revenue is allocated to each element of a transaction based upon its fair value as determined by the Company’s VSOE. VSOE is generally established for support and maintenance based upon negotiated renewal rates while VSOE for consulting, installation, and training is established based upon the Company’s customary pricing for such services when sold separately. When VSOE does not exist to allocate a portion of the total fee to the undelivered elements, the entire revenue, including license revenue, is recognized ratably over the term of the underlying element for which VSOE does not exist.

     Software Licenses — The Company also licenses its software products separately from its integrated solution implementations. In such cases revenue is recognized under the residual method when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, (iv) collectibility is probable and the arrangement does not require services that are essential to the functionality of the software. When arrangements include multiple elements such as support and maintenance, consulting (other than for our fixed price solution implementations), installation, and training, revenue is allocated to each element of a transaction based upon its fair value as determined by the Company’s VSOE and such services are recorded as integrated solutions. VSOE is generally established for support and maintenance based upon negotiated renewal rates while VSOE for consulting, installation and training services is established based upon the Company’s customary pricing for such services when sold separately. In multiple element arrangements for which VSOE does not exist, the entire revenue is recognized ratably over the term of the underlying element for which VSOE does not exist, and is recorded as integrated solutions revenue.

     Gain Share — Gain share revenue represents profit sharing and performance incentives earned based upon the Company’s customer reaching certain defined operational levels. Upon achieving such operational levels, the Company receives either a fixed fee and/or variable fee based on the units manufactured by the customer. Due to the uncertainties surrounding attainment of such operational levels, the Company recognizes gain share revenue (to the extent of completion of the related solution implementation contract) upon receipt of performance reports or other related information from the customer supporting the determination of amounts and probability of collection.

Stock-Based Compensation

     The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004) (“SFAS No. 123R”), Share-Based Payment. Under the provisions of SFAS No. 123R, stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model and is recognized as expense ratably over the requisite service period. The BSM model requires various highly judgmental assumptions including volatility, and expected option life. If any of the assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

2. BUSINESS COMBINATIONS

     In May 2007, the Company completed the acquisition of Fabbrix, Inc., a development stage company and provider of silicon intellectual property designed to create highly manufacturable and area-efficient designs targeted for advanced technology nodes. With this acquisition, the Company has enhanced its strength in silicon characterization to enable a true co-optimization of the manufacturing fabric and the logic elements. Total cost for the acquisition was $6.2 million, which includes $2.7 million cash, 271,531 shares of the Company’s common stock valued at $2.9 million, and $668,000 in acquisition costs. In connection with the acquisition, approximately $405,000 in cash and 41,000 shares of common stock is held in escrow as security against certain financial contingencies. The cash and shares held in escrow, less amounts deducted to satisfy contingencies will be released no later than on the 18 month anniversary of the acquisition. The remaining amounts in cash and shares have been paid to the selling stockholders as of September 30, 2007. In connection with the acquisition, the Company recorded $2.2 million of goodwill and $7.8 million of identifiable intangible assets with a weighted average life of 5.4 years. The unaudited condensed consolidated financial statements for the third quarter and first nine months of fiscal 2007 include the results of Fabbrix, Inc. since the date of acquisition.

     In addition to the initial cash and stock consideration, up to $14.0 million in earnout consideration will be paid to the selling stockholders if qualifying orders, received during the first twelve months following the closing date, are recognized as revenue during the forty-eight months following the closing date. Earnout consideration will consist of a combination of fifty percent of such amount as a cash payment and fifty percent of such amount as shares of PDF Solutions common stock. As the contingent consideration is based on future earnings, and is not determinable nor estimable at the date of acquisition, the additional consideration would be recorded only when it becomes determinable. Since the acquisition, the estimable qualifying revenue has not met the $2.0 million threshold, no additional consideration has been recorded as of September 30, 2007.

     The preliminary allocation of the purchase price for this acquisition, as of the date of the acquisition, is summarized below (in thousands, except amortization period). The allocation was based on management’s estimates of fair value, which included a third-party appraisal. The allocation of the purchase price may be subject to change based on final estimates of fair value, primarily related to actual transaction costs. As of September 30, 2007, the Company booked an adjustment to increase goodwill of $62,000 related to transaction costs.

		Amortization
		Period
Preliminary Allocation of Purchase Price		(Years)				Amount
Fair value of tangible assets						$	406
Fair value of intangible assets:
Developed technology			5				6,430
Patent and applications			7				1,400
Goodwill			N/A				2,217
Total assets acquired							10,453
Deferred tax liability							(3,210	)
Notes to stockholders							(416	)
Accrued liabilities							(364	)
Accounts payable							(219	)
Total liabilities assumed							(4,209	)
Total consideration, net						$	6,244

     The Company has repaid the notes to stockholders as of September 30, 2007.

     The following unaudited pro forma consolidated financial data represents the combined results of operations as if Fabbrix had been combined with the Company at the beginning of the respective periods. This pro forma financial data includes the straight line amortization of intangibles over their respective estimated useful lives (in thousands, except per share data):

		Nine Months Ended September 30,
		2007				2006
Revenue		$	69,908			$	57,231
Net income (loss)		$	(5,145	)		$	(1,050	)
Pro forma net income (loss) per share — basic		$	(0.18	)		$	(0.04	)
Pro forma net income (loss) per share — diluted		$	(0.18	)		$	(0.04	)

     The results do not purport to be indicative of what would have occurred had the acquisition been made as of the beginning of the respective periods or the results of operations which may occur in future periods.

     For the nine months ended September 30, 2007, the Company made final net payments of $4.6 million that were previously accrued as part of the purchases of Si Automation S.A. and Fabbrix, Inc.

3. RECENT ACCOUNTING PRONOUNCEMENTS

     In September, 2006, the Financial Accounting Standard Board (“FASB”) issued SFAS No. 157 (“SFAS No. 157”), Fair Value Measurement that establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America (“GAAP”), and expands disclosures about fair value measurements. Additionally, the pronouncement provides guidance on the definition, measurement, methodology and use of assumptions and inputs in determining fair value. The pronouncement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the impact of the adoption of SFAS No. 157 on its financial statements.

     Effective January 1, 2007, the Company adopted the provisions of the FASB’s Emerging Issues Task Force (“EITF”) No. 06-2, Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43 (“EITF No. 06-2”). Prior to the issuance of EITF No. 06-2 the Company accounted for sabbatical expense under SFAS No. 43, by expensing the cost of compensated absences for sabbatical programs as incurred. EITF No. 06-2 requires companies to accrue the cost of such compensated absences over the requisite service period. The Task Force allows the use of one of two specified methodologies for adopting the change in accounting principle: i) a cumulative-effect adjustment to retained earnings at the beginning of the year of adoption; or ii) retrospective application to all prior periods. The Company elected to use the cumulative-effect adjustment to the beginning balance of retained earnings resulting in an additional liability of $1.4 million, an additional deferred tax asset of $587,000, and an increase in the accumulated deficit of $845,000. Under this transition method, prior periods were not restated and accrued expenses as of September 30, 2007 include accrued sabbatical expense for all employees who are eligible for sabbatical leave.

     In February 2007, the FASB issued SFAS No. 159 (“SFAS No. 159”), The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115. SFAS No. 159 permits companies to choose to measure at fair value many financial instruments and certain other items that are not currently required to be measured at fair value. Entities choosing the fair value option would be required to recognize subsequent changes in the fair value of those instruments and other items directly in earnings. This standard also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No.159 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact of the adoption of SFAS No. 159 on its financial statements.

4. INVESTMENTS

The following tables summarize the Company’s investments (in thousands):

						September 30, 2007
						Unrealized				Unrealized
		Amortized				Holding				Holding				Market
		Cost				Gains				Losses				Value
Commercial paper		$	14,013			$	1			$	—			$	14,014
Auction rate securities			4,650				—				—				4,650
Money market funds			1,068				—				—				1,068
		$	19,731			$	1			$	—			$	19,732
Included in cash and cash equivalents														$	8,232
Included in short-term investments															11,500
Total														$	19,732

     As of September 30, 2007 and December 31, 2006 all securities held by the Company had a maturity of one year or less. Commercial paper and money market funds with original maturities when acquired less than or equal to 90 days were included in cash and cash equivalents. Securities with original maturities when acquired over 90 days and all auction rate securities were included in short-term investments.

						December 31, 2006
						Unrealized				Unrealized
		Amortized				Holding				Holding				Market
		Cost				Gains				Losses				Value
Commercial paper		$	13,307			$	1			$	—			$	13,308
Auction rate securities			5,050				—				—				5,050
Corporate bonds and notes			1,984				—				(1	)			1,983
Money market funds			23,744				—				—				23,744
		$	44,085			$	1			$	(1	)		$	44,085
Included in cash and cash equivalents														$	27,683
Included in short-term investments															16,402
Total														$	44,085

5. ACCOUNTS RECEIVABLE

     Accounts receivable include amounts that are unbilled at the end of the period. Unbilled accounts receivable are determined on an individual contract basis and were approximately $12.1 million and $7.8 million as of September 30, 2007 and December 31, 2006, respectively.

6. NET INCOME (LOSS) PER SHARE

     Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average common shares outstanding for the period. Diluted net income (loss) per share reflects the weighted average common shares outstanding plus the potential effect of dilutive securities which are convertible into common shares (using the treasury stock method), except in cases where the effect would be anti-dilutive. The following is a reconciliation of the numerators and denominators used in computing basic and diluted net income (loss) per share (in thousands, except per share data):

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2007				2006				2007				2006
Net income (loss)		$	(939	)		$	570			$	(3,995	)		$	(9	)
Denominator:
Weighted average common shares outstanding			28,223				26,860				28,127				26,694
Dilutive items:
Weighted average stock options outstanding			—				761				—				—
Denominator for diluted computation			28,223				27,621				28,127				26,694
Net income (loss) per share — basic		$	(0.03	)		$	0.02			$	(0.14	)		$	(0.00	)
Net income (loss) per share — diluted		$	(0.03	)		$	0.02			$	(0.14	)		$	(0.00	)

     The following table sets forth potential shares of common stock that are not included in the diluted net loss per share calculation above because to do so would be anti-dilutive for the periods indicated (in thousands):

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2007				2006				2007				2006
Common stock options			6,757				2,883				6,735				5,501

7. COMPREHENSIVE INCOME (LOSS)

     The components of comprehensive income (loss) are as follows (in thousands):

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2007				2006				2007				2006
Net income (loss)		$	(939	)		$	570			$	(3,995	)		$	(9	)
Unrealized gain (loss) on short term investments			—				38				1				(3	)
Foreign currency translation adjustments			1,066				(16	)			2,463				33
Comprehensive income (loss)		$	127			$	592			$	(1,531	)		$	21

8. GOODWILL AND PURCHASED INTANGIBLE ASSETS

     SFAS No. 142, Goodwill and Other Intangible Assets, requires goodwill to be tested for impairment on an annual basis (or more frequently if indicators of impairment exist) and requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite. The Company last completed its annual impairment test on December 31, 2006 and concluded that goodwill was not impaired.

     The following table provides information relating to the intangible assets and goodwill as of September 30, 2007 and December 31, 2006 (in thousands):

						December 31,																				September 30,
		Amortization				2006								Purchase								Foreign				2007
		Period				Net Carrying								Price								Currency				Net Carrying
		(Years)				Amount				Acquisition				Adjustments				Amortization				Translation				Amount
Goodwill			N/A			$	60,034			$	2,155			$	21			$	—			$	2,383			$	64,593
Acquired identifiable intangibles:
Acquired technology			4 - 5			$	7,901			$	6,430			$	—			$	(4,516	)		$	—			$	9,815
Brand name			4				822				—				—				(429	)			—				393
Customer relationships and backlog			1 - 6				4,362				—				—				(2,238	)			—				2,124
Patent and applications			7								1,400				—				(67	)			—				1,333
Other acquired intangibles			4				520				—				—				(344	)			14				190
Total						$	13,605			$	7,830			$	—			$	(7,594	)		$	14			$	13,855

						December 31,																				December 31,
		Amortization				2005								Purchase								Foreign				2006
		Period				Net Carrying								Price								Currency				Net Carrying
		(Years)				Amount				Acquisitions				Adjustments				Amortization				Translation				Amount
Goodwill			N/A			$	39,886			$	21,071			$	(923	)		$	—			$	—			$	60,034
Acquired identifiable intangibles:
Acquired technology			4			$	8,221			$	4,950			$	—			$	(5,270	)		$	—			$	7,901
Brand name			4				833				510				—				(521	)			—				822
Customer relationships and backlog			1 - 6				—				4,860				—				(498	)			—				4,362
Other acquired intangibles			4				733				255				—				(477	)			9				520
Total						$	9,787			$	10,575			$	—			$	(6,766	)		$	9			$	13,605

     During the nine months ended September 30, 2007, the Company recorded adjustments to goodwill of $21,000 related to the assumption of certain liabilities in connection with the acquisition of Si Automation S.A. and transaction costs in connection with the acquisition of Fabbrix, Inc., and of $2.4 million related to the effect of changes in exchange rates associated with recorded goodwill.

     In 2006, the Company recorded a non-cash adjustment of $923,000 relating to the reduction of a valuation allowance established for deferred tax assets that were assumed in connection with the Company’s acquisition of IDS Software Inc. in 2003. Such adjustment resulted in a decrease in goodwill.

     The Company expects the annual amortization of acquired intangible assets to be as follows (in thousands):

Year Ending December 31,		Amount
2007 (three-month period)		$	1,041
2008			3,296
2009			3,296
2010			3,029
2011			1,861
2012 and thereafter			1,332
Total		$	13,855

9. INCOME TAXES

     Effective January 1, 2007, the Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 provides a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. Unrecognized tax benefits represent tax positions for which reserves have been established. As a result of the implementation of FIN 48, the Company recognized a $308,000 decrease in net liabilities for unrecognized tax benefits. This was accounted for as an adjustment to the beginning balance of the accumulated deficit on the balance sheet. As the Company does not anticipate recognizing these tax benefits over the next twelve months, it has reclassified these liabilities as long-term. Prior to the adoption of FIN 48, the Company recorded its tax exposure as short-term liabilities.

     As of the date of adoption and as of September 30, 2007, the Company’s unrecognized tax benefits totaled approximately $4.4 million and $5.4 million, respectively. The entire amount of unrecognized tax benefits, if recognized, would favorably affect the effective tax rate in any future period.

     The Company conducts business globally and, as a result, files numerous consolidated and separate income tax returns in the U.S. federal, various state and foreign jurisdictions. The Company is not currently under audit by any tax authority. Because the Company used some of the tax attributes carried forward from previous years to tax years that are still open, statutes of limitation remain open for all tax years to the extent of the attributes carried forward into tax year 2003 for federal tax purposes and tax year 2002 for California tax purposes. With few exceptions, the Company is no longer subject to income tax examinations in its major foreign subsidiaries’ jurisdictions for years before 2003.

     Interest and penalties related to unrecognized tax benefits are recognized in income tax expense in the consolidated statements of operations. At the date of adoption and as of September 30, 2007, $309,000 and $485,000, respectively, of accrued interest was included in long-term taxes payable on the consolidated balance sheet.

     As of September 30, 2007, the Company believes it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase over the next twelve months. However, at this time the Company is unable to estimate the range of such possible change in unrecognized tax benefits.

     As of May 1, 2007, the Company has decided to no longer reinvest indefinitely its undistributed earnings in its French subsidiary.

10. STOCKHOLDERS’ EQUITY

     Effective January 1, 2006, the Company adopted the provisions of SFAS No.123R. Stock-based compensation expenses before taxes related to the Company’s employee stock purchase plan and stock-option plans were allocated as follows (in thousands):

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2007				2006				2007				2006
Cost of design-to-silicon yield solutions		$	435			$	443			$	1,405			$	1,519
Research and development			553				443				1,731				1,629
Selling, general and administrative			682				621				2,317				2,314
Stock-based compensation before income taxes		$	1,670			$	1,507			$	5,453			$	5,462

     The Company estimated the fair value of share-based payments using the Black-Scholes-Merton option-pricing model with the following weighted average assumptions and weighted average fair values:

Stock Plans:

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2007				2006				2007				2006
Expected life (in years)			6.07				4.26				6.05				4.26
Volatility			59.4	%			56.9	%			59.9	%			58.1	%
Risk-free interest rate			4.88	%			4.97	%			4.92	%			4.82	%
Expected dividend			—				—				—				—
Weighted average fair value of options granted during the period		$	7.14			$	6.26			$	6.53			$	7.63

Employee Stock Purchase Plan:

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2007				2006				2007				2006
Expected life (in years)			0.25				0.25				0.76				0.97
Volatility			57.4	%			60.3	%			52.2	%			52.8	%
Risk-free interest rate			5.02	%			5.08	%			5.15	%			3.79	%
Expected dividend			—				—				—				—
Weighted average fair value of employee stock		$	3.14			$	3.45			$	4.00			$	4.14

     As of September 30, 2007, the Company has in effect the following stock-based compensation plans:

     Stock Plans — During 2001, the Company terminated the 1996 and 1997 Stock Plans as to future option grants, and adopted the 2001 Stock Plan. Under the 2001 Stock Plan, on January 1 of each year, starting with year 2002, the number of shares in the reserve will increase by the lesser of (i) 3,000,000 shares, (ii) 5% of the outstanding common stock on the last day of the immediately preceding year, or (iii) the number of shares determined by the board of directors. Under the 2001 Stock Plan, the Company may grant options to purchase shares of common stock to employees, directors and consultants at prices not less than the fair market value at the date of grant for incentive stock options and not less than 85% of fair market value for nonstatutory stock options. These options generally expire ten years from the date of grant and become vested and exercisable ratably over a four-year period. Certain option grants under the 1996 and 1997 Stock Plans provide for the immediate exercise by the optionee with the resulting shares issued subject to a right of repurchase by the Company which lapses based on the original vesting provisions.

     Stock option activity under the Company plans as of September 30, 2007 and changes during the nine months ended September 30, 2007 were as follows:

										Weighted Average
						Weighted Average				Remaining				Aggregate
		Number of				Exercise Price				Contractual				Intrinsic Value
		Options				per Share				Term (years)				(in 000’s)
Outstanding, January 1, 2007			6,664,094			$	12.11
Granted			595,103				10.81
Exercised			(161,836	)			8.26
Forfeited or expired			(340,690	)			13.87
Outstanding, September 30, 2007			6,756,671				12.00				7.10			$	3,619
Vested and expected to vest			6,385,309				11.93				6.99			$	3,615
Exercisable, September 30, 2007			3,769,689				10.94				5.77			$	3,544

     The aggregate intrinsic value in the table above represents the total pretax intrinsic value based on the Company’s closing stock price of $9.88 as of September 30, 2007, which would have been received by the option holders had all option holders exercised their options as of that date.

     The total intrinsic value of options exercised during the nine months ended September 30, 2007 was $604,000.

     As of September 30, 2007, there was $14.6 million of total unrecognized compensation cost related to nonvested stock options. That cost is expected to be recognized over a weighted average period of 2.73 years. The total fair value of shares vested during the nine months ended September 30, 2007 was $4.4 million.

     Nonvested shares (restricted stock units) as of September 30, 2007 and changes during the nine months ended September 30, 2007 were as follows:

						Weighted Average
						Measurement
		Shares				Date Fair Value
Nonvested, January 1, 2007			—			$	—
Granted			133,000				9.88
Vested			—				—
Forfeited			—				—
Nonvested, September 30, 2007			133,000			$	9.88

     As of September 30, 2007, there was $1.2 million of total unrecognized compensation cost related to restricted stock. That cost is expected to be recognized over a weighted average period of 6.7 years. The total compensation expense related to shares expected to vest during the nine months ended September 30, 2007 was $116,000.

     Employee Stock Purchase Plan — In July 2001, the Company adopted an Employee Stock Purchase Plan (“Purchase Plan”), under which eligible employees can contribute up to 10% of their compensation, as defined in the Purchase Plan, towards the purchase of shares of PDF common stock at a price of 85% of the lower of the fair market value at the beginning of the offering period or the end of each six-month offering period. For the nine months ended September 30, 2007, the purchase plan compensation expense was $483,000.

     Stock Repurchase Program — In February 2003, the Board of Directors approved a program to repurchase up to $10.0 million of the Company’s common stock in the open market. As of September 30, 2007, the Company has repurchased 987,808 shares at a weighted average price of $10.12 per share for a total cost of $10.0 million. Under this authorization, the Company may not make additional stock repurchases. On October 29, 2007, the Board of Directors approved a new program to repurchase up to an additional $10.0 million of the Company’s common stock on the open market. The right of repurchase stock under this program will expire on October 29, 2010.

     The stock repurchase activity under the stock repurchase program for the nine months ended September 30, 2007 is summarized as follows (in thousands, except number of shares and per share amounts):

						Weighted-Average
Nine Months Ended September 30, 2007		Shares Repurchased				Price per Share				Amount Repurchased
Cumulative balance, January 1, 2007			550,521			$	10.08			$	5,549
Repurchase of common stock			437,287			$	10.18				4,452
Cumulative balance, September 30, 2007			987,808			$	10.12			$	10,001

11. CUSTOMER AND GEOGRAPHIC INFORMATION

     SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or group, in deciding how to allocate resources and in assessing performance.

     The Company’s chief operating decision maker, the Chief Executive Officer, reviews discrete financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. Accordingly the Company considers itself to be in one operating segment, specifically the licensing and implementation of yield improvement solutions for integrated circuit manufacturers.

     The Company had revenues from individual customers in excess of 10% of total revenues as follows:

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
Customer		2007				2006				2007				2006
A			20	%			9	%			18	%			12	%
B			16	%			18	%			16	%			27	%
C			10	%			7	%			9	%			3	%
D			6	%			9	%			6	%			10	%
E			2	%			14	%			2	%			8	%

     The Company had gross accounts receivable from the following individual customers in excess of 10% of gross accounts receivable as follows:

Customer		September 30, 2007				December 31, 2006
A			21	%			12	%
B			17	%			18	%
C			11	%			10	%
F			11	%			12	%

     Revenues from customers by geographic area are as follows (in thousands):

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2007				2006				2007				2006
Asia		$	13,792			$	10,396			$	37,820			$	28,626
United States			6,668				7,096				22,377				23,585
Europe			3,608				1,872				9,711				5,020
Total		$	24,068			$	19,364			$	69,908			$	57,231

     As of September 30, 2007 and December 31, 2006 long-lived assets related to PDF SAS (formerly SIA), located in France, totaled $473,000 and $583,000, respectively. As of September 30, 2007 and December 31, 2006, long-lived assets related to PDF Solutions GmbH (formerly AISS), located in Germany, totaled $121,000 and $216,000, respectively. The majority of the Company’s remaining long-lived assets are in the United States.

12. RELATED PARTY TRANSACTIONS

     Immediately prior to the merger with Fabbrix, Inc. (the “Merger”), Mr. Lucio L. Lanza, a director and Chairman of the Board of the Company, served as President, Chief Executive Officer and Chairman of the Board of Fabbrix. Mr. Lanza also held shares of capital stock of Fabbrix, both individually and through his venture capital firm, Lanza techVentures. In connection with the Merger, Mr. Lanza received $353,000 in cash and 35,722 shares of the Company’s common stock in exchange for his Fabbrix shares, and will be eligible to receive up to an additional $2.1 million worth of earnout consideration. Lanza techVentures received $1.2 million in cash and 121,720 shares of the Company’s common stock at the closing of the Fabbrix acquisition (the “Closing”) in exchange for its Fabbrix shares, and will be eligible to receive up to an additional $5.4 million worth of earnout consideration. In addition, out of the merger consideration, Lanza techVentures received $519,000 in cash as repayment of certain bridge loans previously made to Fabbrix. To consider a transaction with Fabbrix, the Company’s Board established a special committee consisting exclusively of independent directors (the “Special Committee”). The Special Committee reviewed, evaluated and directed the negotiation of the transaction and the Merger Agreement and recommended to the Company’s Board that the Company enter into the Merger Agreement. Mr. Lanza did not participate on behalf of the Company in any actions with respect to the transaction and the Merger Agreement, and did not participate in any deliberations or other activities of the Special Committee.

     In view of the Nasdaq independent director rules and other applicable requirements, the Company’s Board has determined that Mr. Lanza is no longer independent under those rules and therefore, Mr. Lanza has resigned from the Audit, Compensation, and Nominating and Corporate Governance Committees of the Company’s Board effective at the Closing. Mr. Lanza continues to serve as Chairman of the Company’s Board. The Company has replaced Mr. Lanza with other independent Board Members to fill the vacancies on the Company’s Audit, Compensation, and Nominating and Corporate Governance. The Company’s Board has also appointed a Lead Independent Director.

     Andrzej Strojwas, the Company’s Chief Technologist was a stockholder of Fabbrix immediately prior to the Merger. In connection with the Merger, Mr. Strojwas received $53,000 in cash and 5,402 shares of the Company’s common stock, and will be eligible to receive up to an additional $311,000 worth of earnout consideration.

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

Forward-Looking Statements

     The following discussion of our financial condition and results of operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “potential” or “continue”, the negative effect of terms like these or other comparable terminology. These statements are only predictions. These statements involve known and unknown risks and uncertainties and other factors that may cause actual events or results to differ materially. All forward-looking statements included in this document are based on information available to us on the date of filing, and we assume no obligation to update any such forward-looking statements. In evaluating these statements, you should specifically consider various factors, including the risk factors set forth in Item 1A and set forth at the end of Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2006. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.

Overview

     Our technologies and services enable semiconductor companies to improve the yield and performance of integrated circuits, or ICs, by improving the manufacturability of a design, integrating the design and manufacturing processes and better controlling equipment during mass production. Our solutions are designed to improve a semiconductor company’s time-to-market and yield and, thus, product profitability. Our solutions combine proprietary manufacturing process simulation software, yield and performance modeling software, design-for-manufacturability IP and software, test chips, a proprietary electrical wafer test system, yield and performance enhancement methodologies, yield management systems, process control system software, and professional services. We analyze yield loss mechanisms to identify, quantify and correct the issues that cause yield loss, as an integral part of the IC design process. This drives IC design and manufacturing improvements that enable our customers to have higher initial yields and achieve and exceed targeted IC yield and performance throughout product life cycles. Our solution is designed to increase the initial yield when a design first enters a manufacturing line, to increase the rate at which that yield improves, and to allow subsequent product designs to be added to manufacturing lines more quickly and easily.

     The result of implementing our solutions is the creation of value that can be measured based on improvements to our customers’ actual yield. We align our financial interests with the yield and performance improvements realized by our customers, and receive revenue based on this value. To date, we have sold our technologies and services to semiconductor companies including leading integrated device manufacturers, fabless semiconductor companies and foundries.

     From our incorporation in 1992 through late 1995, we were primarily focused on research and development of our proprietary manufacturing process simulation and yield and performance modeling software. From late 1995 through late 1998, we continued to refine and sell our software, while expanding our offering to include yield and performance improvement consulting services. In late 1998, we began to sell our software and consulting services, together with our newly developed proprietary technologies, as Design-to-Silicon-Yield solutions, reflecting our current business model. In April 2000, we expanded our research and development team and gained additional technology by acquiring AISS, now operating as PDF Solutions, GmbH, which continues to develop software and

provide development services to the semiconductor industry. In July 2001, we completed the initial public offering of our common stock. In 2003, we enhanced our product and service offerings through the acquisitions of IDS Software Inc. and WaferYield. In 2006, we complemented our technology offering by acquiring Si Automation S.A. and adding its FDC software capabilities to our integrated solution offering. In 2007, we added intellectual property building blocks for logic design technology to our solution portfolio by acquiring Fabbrix, Inc.

Industry Trend

     Demand for consumer electronics and communications devices continues to drive technological innovation as the need for products which have greater performance, lower power consumption, reduced costs and smaller size continues to grow with each new product generation. To meet this demand, IC manufacturers and designers are constantly challenged to improve the overall performance of ICs by designing and manufacturing ICs with more embedded applications to create greater functionality. As a result, in 2004 and through 2007 more and more companies have expanded or advanced their design and manufacturing processes to develop and produce deep submicron ICs containing component sizes measured at 90 nanometers and below. As this trend continues, companies will continually be challenged to improve process capabilities to optimally produce ICs with minimal random and systematic and yield loss, which is driven by the lack of compatibility between the design and its respective manufacturing process. We believe as volume production of deep submicron ICs continues to grow, the difficulties of integrating IC designs with their respective processes will create a greater need for products and services that address the performance yield loss issues the semiconductor industry is facing today and will face in the future.

Financial Highlights

     Financial highlights for the three months ended September 30, 2007 were as follows:

	•		Total revenue for the three months ended September 30, 2007 was $24.1 million, an increase of 24% compared to the three months ended September 30, 2006. Revenue from Design-to-Silicon-Yield solutions for the three months ended September 30, 2007 increased to $17.3 million compared to $15.0 million for the three months ended September 30, 2006. The change was primarily a result of increases in revenue related to integrated solutions of $5.1 million and partially offset by a decrease in revenue related to software licenses of $2.8 million over the three months ended September 30, 2006. Gain share revenue for the three months ended September 30, 2007 increased to $6.8 million from $4.4 million for the three months ended September 30, 2006. Our gain share revenue may continue to fluctuate from quarter to quarter as a result of each customer’s contractual performance measures for achieving gain share as well as each customer’s production volumes in any given period.
	•		Net loss for the three months ended September 30, 2007 was $939,000, compared to net income of $570,000 for the three months ended September 30, 2006. The decrease in net income was primarily attributable to increases in operating expenses and amortization of acquired intangible assets, both as a result of the acquisitions of Si Automation S.A. in October 2006 and Fabbrix, Inc. in May 2007.
	•		Net loss per basic and diluted share was $0.03 for the three months ended September 30, 2007 compared to net income per basic and diluted share of $0.02 for the three months ended September 30, 2006.

     Financial highlights for the nine months ended September 30, 2007 were as follows:

	•		Total revenue for the nine months ended September 30, 2007 was $69.9 million, an increase of 22% compared to the nine months ended September 30, 2006. Revenue from Design-to-Silicon-Yield solutions for the nine months ended September 30, 2007 increased to $52.3 million compared to $42.1 million for the nine months ended September 30, 2006. The change was primarily a result of increase in revenues related to integrated solutions of $12.2 million and partially offset by decrease in revenue related to software licenses of $2.0 million over the nine months ended September 30, 2006. Gain share revenue was $17.6 million, an increase of 16% compared to the nine months ended September 30, 2006.
	•		Net loss for the nine months ended September 30, 2007 was $4.0 million, compared to net loss of $9,000 for the nine months ended September 30, 2006. The net loss was primarily attributable to increases in operating expenses and amortization of acquired intangible assets, both primarily the result of the acquisition of Si Automation S.A. in October 2006 and Fabbrix, Inc. in May 2007.

	•		Net loss per basic and diluted share was $0.14 for the nine months ended September 30, 2007 compared to net loss per basic and diluted share of $0.00 for the nine months ended September 30, 2006.
	•		Cash, cash equivalents and short-term investments decreased by $2.9 million from $52.9 million as of December 31, 2006 to $50.0 million as of September 30, 2007. Net cash provided by operating activities for the nine months ended September 30, 2007 totaled $5.6 million. Net cash used in investing activities for the nine months ended September 30, 2007 included $1.9 million as final payments for our acquisition of Si Automation S.A., $2.7 million payment for our acquisition of Fabbrix, Inc., and $1.7 million to purchase property and equipment. Net cash used in financing activities for the nine months ended September 30, 2007 totaled $3.0 million and was primarily related to $4.5 million in stock repurchases and $683,000 in debt payments, partially offset by the exercise of stock options and purchases under the employee stock purchase plan of $2.1 million. The fluctuations in foreign exchange rates favorably impacted our cash flow by $195,000.

Critical Accounting Policies

     Financial Reporting Release No. 60 requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. Note 1 to the condensed consolidated financial statements, accompanying this Quarterly Report on Form 10-Q, includes a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements. The following is a brief discussion of the more significant accounting policies and methods that we use. For a more detailed discussion of our accounting policies and methods, please refer to our Form 10-K for the year ended December 31, 2006.

General

     Our discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. Our preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The most significant estimates and assumptions relate to revenue recognition, software development costs, recoverability of goodwill and acquired intangible assets, estimated useful lives of acquired intangibles and the realization of deferred tax assets. Actual amounts may differ from such estimates under different assumptions or conditions.

Revenue Recognition

     We derive revenue from two sources: Design-to-Silicon-Yield solutions and gain share. We recognize revenue in accordance with the provisions of American Institute of Certified Public Accountants’ SOP No. 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts and SOP No. 97-2, Software Revenue Recognition, as amended.

     Design-to-Silicon-Yield Solutions — Design-to-Silicon-Yield solutions revenue is derived from integrated solutions and software licenses. Revenue recognition for each element of Design-to-Silicon-Yield solutions is as follows:

     Integrated Solutions — We generate a significant portion of our revenue from fixed-price contracts delivered over a specific period of time. These contracts require the accurate estimation of the cost to perform obligations and the overall scope of each engagement. Revenue under contracts for solution implementation services is recognized as the services are performed using the cost-to-cost percentage of completion method of contract accounting. Losses on solution implementation contracts are recognized when determined. Revisions in profit estimates are reflected in the period in which the conditions that require the revisions become known and can be estimated. If we do not accurately estimate the resources required or the scope of work to be performed, or do not manage the projects properly within the planned period of time or satisfy our obligations under contracts, resulting contract margins could be materially different than those anticipated when the contract was executed. Any such reductions in contract margin could have a material negative impact on our operating results.

     On occasion, we have licensed our software products as a component of our fixed price solution implementations. In such instances, the software products are licensed to the customer over the specified term of the agreement with support and maintenance to be provided over the license term. Under these arrangements, where vendor-specific objective evidence of fair value (“VSOE”) does not exist to allocate a portion of the total fee to the undelivered elements, revenue is recognized ratably over the term of the agreement. Costs incurred under these arrangements are deferred and recognized in proportion to revenue recognized under these arrangements.

     Revenue from support and maintenance services is recognized ratably over the term of the support and maintenance contract, generally one year, while revenue from consulting, installation and training services is recognized as the services are performed. When bundled with software licenses in multiple element arrangements, support and maintenance, consulting (other than for our fixed price solution implementations), installation, and training revenue is allocated to each element of a transaction based upon its fair value as determined by our VSOE. VSOE is generally established for support and maintenance based upon negotiated renewal rates while VSOE for consulting, installation, and training is established based upon our customary pricing for such services when sold separately. When VSOE does not exist to allocate a portion of the total fee to the undelivered elements, the entire revenue, including license revenue, is recognized ratably over the term of the underlying element for which VSOE does not exist.

     Software Licenses — We also license our software products separately from our integrated solution implementations. In such cases revenue is recognized under the residual method when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, (iv) collectibility is probable and the arrangement does not require services that are essential to the functionality of the software. When arrangements include multiple elements such as support and maintenance, consulting (other than for our fixed price solution implementations), installation, and training, revenue is allocated to each element of a transaction based upon its fair value as determined by our VSOE and such services are recorded as integrated solutions. VSOE is generally established for support and maintenance based upon negotiated renewal rates while VSOE for consulting, installation and training services is established based upon our customary pricing for such services when sold separately. In multiple element arrangements for which VSOE does not exist, the entire revenue is recognized ratably over the term of the underlying element for which VSOE does not exist, and is recorded as integrated solutions revenue.

     Gain Share — Gain share revenue represents profit sharing and performance incentives earned based upon our customers reaching certain defined operational levels. Upon achieving such operational levels, we receive either a fixed fee and/or variable fee based on the units manufactured by the customer. Due to the uncertainties surrounding attainment of such operational levels, we recognize gain share revenue (to the extent of completion of the related solution implementation contract) upon receipt of performance reports or other related information from our customers supporting the determination of amounts and probability of collection. Gain share revenue is dependent on many factors which are outside our control, including among others, continued production of the related ICs by our customers, sustained yield improvements by our customers and our ability to enter into new Design-to-Silicon-Yield solutions contracts containing gain share provisions.

     Software Development Costs

     Costs for the development of new software products and substantial enhancements to existing software products are expensed as incurred until technological feasibility has been established, at which time any additional costs would be capitalized in accordance with SFAS No. 86, Computer Software to be Sold, Leased or Otherwise Marketed. Because we believe our current process for developing software is essentially completed concurrently with the establishment of technological feasibility, no costs have been capitalized to date.

     Goodwill and Acquired Intangible Assets

     As of September 30, 2007, we had $64.6 million of goodwill and $13.9 million of intangible assets. In valuing our goodwill and intangible assets, we must make assumptions regarding estimated future cash flows to be derived from the acquired assets. If actual results are different from these estimates, we may be required to record impairment charges for these assets, which would have a material adverse effect on our operating results. We evaluate goodwill for impairment pursuant to the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. We have selected December 31 as the date upon which to perform our annual testing for impairment. As of December 31, 2006, we completed our last annual testing requirements and determined that the carrying value of goodwill had not been impaired.

     We are currently amortizing our acquired intangible assets over estimated useful lives of 1 to 7 years, which are based on the estimated period of benefit to be delivered from such assets. However, a decrease in the estimated useful lives of such assets would cause additional amortization expense or an impairment of such assets in future periods.

Realization of Deferred Tax Assets

     Realization of deferred tax assets is dependent on our ability to generate future taxable income and utilize tax planning strategies. We have recorded a deferred tax asset in the amount that is more likely than not to be realized based on current estimations and assumptions. We evaluate the need for a valuation allowance on a quarterly basis. Any resulting changes to the valuation allowance will result in an adjustment to income in the period the determination is made. As of September 30, 2007 and December 31, 2006, the Company had not recorded a valuation allowance against its deferred tax assets.

Stock-Based Compensation

     The Company accounts for stock-based compensation in accordance with SFAS No. 123R. Under the provisions of SFAS No. 123R, stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model and is recognized as expense ratably over the requisite service period. The BSM model requires various highly judgmental assumptions including volatility, and expected option life. If any of the assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

Results of Operations

     The following table sets forth, for periods indicated, the percentage of total revenue represented by the line items reflected in our condensed consolidated statements of operations:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
Revenue:
Design-to-silicon-yield solutions
Integrated solutions			68	%			57	%			66	%			59	%
Software licenses			4				20				9				14
Gain share			28				23				25				27
Total revenue			100				100				100				100
Cost of design-to-silicon-yield solutions:
Direct costs of design-to-silicon-yield solutions
Integrated solutions			33				35				33				35
Software licenses			—				—				—				—
Amortization of acquired technology			6				7				6				7
Total cost of design-to silicon-yield solutions			39				42				39				42
Gross margin			61				58				61				58
Operating expenses:
Research and development			38				33				38				34
Selling, general and administrative			24				26				26				26
Amortization of other acquired intangible assets			4				1				4				1
Total operating expenses			66				60				68				61
Loss from operations			(5	)			(2	)			(7	)			(3	)
Interest and other income, net			1				5				2				4
Income (loss) before taxes			(4	)			3				(5	)			1
Income tax provision (benefit)			—				(—	)			—				1
Net income (loss)			(4	)%			3	%			(5	)%			(—	)%

Comparison of the Three Months Ended September 30, 2007 and 2006

																		Three Months Ended September 30,
																		2007				2006
		Three Months Ended September 30,								$				%				% of				% of
Revenue		2007				2006				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Design-to-silicon-yield solutions
Integrated solutions		$	16,294			$	11,153			$	5,141				46	%			68	%			57	%
Software licenses			967				3,811				(2,844	)			(75	)%			4	%			20	%
Gain share			6,807				4,400				2,407				55	%			28	%			23	%
Total		$	24,068			$	19,364			$	4,704				24	%			100	%			100	%

     Design-to-Silicon-Yield Solutions. Design-to-Silicon-Yield solutions revenue is derived from integrated solutions (including solution implementations, software support and maintenance and training service) and software licenses provided during our customer yield improvement engagements and solution product sales.

     Integrated Solutions. The increase in integrated solutions revenue of $5.1 million for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was primarily attributable to increases in yield integration services, software integration services and maintenance revenues. Our integrated solutions revenue may fluctuate in the future and is dependent on a number of factors including our ability to obtain new customers at emerging technology nodes and our ability to estimate costs associated with such contracts, as well as our customers’ willingness to renew their software maintenance contracts.

     Software Licenses. The decrease in software licenses revenue of $2.8 million for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was due to slower adoption of our software applications by new and existing customers, partially offset by the addition of new software offerings as a result of the acquisition of Si Automation in October 2006. Software license revenue may fluctuate in the future and is dependent upon a number of factors including the semiconductor industry’s acceptance of our products, our ability to attract new customers and further penetration of our current customer base.

     Gain Share. Gain share revenue represents profit sharing and performance incentives earned based upon our customer reaching certain defined operational levels. Gain share revenue increased by $2.4 million for the three months ended September 30, 2007 compared to the three months ended September 30, 2006, primarily the result of higher wafer fees earned on gain share contracts and increases in customer wafer volumes. We expect our gain share revenue will fluctuate from period to period. Our continued receipt of gain share revenue is dependent on many factors that are outside of our control, including among others, continued production of ICs by our customers, sustained yield improvements by our customers and our ability to enter into new Design-to-Silicon-Yield solutions contracts containing gain share provisions.

																		Three Months Ended September 30,
																		2007				2006
		Three Months Ended September 30,								$				%				% of				% of
Cost of Design-to-Silicon Yield Solutions		2007				2006				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Direct costs of design-to-silicon- yield solutions:
Integrated solutions		$	8,052			$	6,734			$	1,318				20	%			33	%			35	%
Software licenses			48				58				(10	)			(17	)%			—				—
Amortization of acquired technology			1,331				1,266				65				5	%			6	%			7	%
Total		$	9,431			$	8,058			$	1,373				17	%			39	%			42	%

     Direct Costs of Design-to-Silicon-Yield Solutions. Direct costs of Design-to-Silicon-Yield solutions consists of costs incurred to provide and support our integrated solutions and costs recognized in connection with licensing our software.

     Integrated Solutions. Integrated solutions costs consist of material, labor, stock-based compensation, and overhead costs associated with solution implementations and software support. Costs include purchased materials, employee compensation and benefits, travel and facilities-related costs. The increase in direct cost of $1.3 million is primarily due to the acquisition of Si Automation S.A. in October 2006, an increase in distribution of our pdFastest products, increased travel expenses, and increased expenses associated with outside consultants. If we do not accurately estimate the resources required or the scope of work to be performed, or we do not manage the projects properly within the planned period of time or satisfy our obligations under contracts, resulting contract margins could be materially different from those anticipated when the contract was executed. Any such reductions in contract margin could have a material negative impact on our operating results.

     Software Licenses. Software license costs consist of costs associated with licensing third-party software sold in conjunction with our software products and expenses incurred to produce and distribute our product documentation. The direct costs of Design-to-Silicon-Yield solutions software licenses decreased slightly for the three months ended September 30, 2007 as compared to the three months ended September 30, 2006. We expect the cost of software licenses to fluctuate in the future as a result of royalties and license fees paid for third-party applications incorporated in our software products.

     Amortization of Acquired Technology. Amortization of acquired technology consists of the amortization of intangibles acquired as a result of certain business combinations. The amortization of acquired technology expense increased $65,000 for the three months ended September 30, 2007 compared to the three months ended September 30, 2006, as a result of the acquisition of Si Automation S.A. in October 2006 and Fabbrix, Inc. in May 2007, which was offset by certain intangible assets becoming fully amortized during the third quarter of fiscal year 2007. We anticipate amortization of acquired technology to be $631,000 for the remaining three months in 2007, $2.5 million in 2008, $2.5 million in 2009, $2.3 million in 2010, and $1.8 million thereafter.

																		Three Months Ended September 30,
																		2007				2006
		Three Months Ended September 30,								$				%				% of				% of
Research and Development		2007				2006				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Research and development		$	9,008			$	6,416			$	2,592				40	%			38	%			33	%