PDF SOLUTIONS INC - Quarter Report: 2008 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, 2008

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

For the transition period from                      to                     

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller reporting company 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 October 31, 2008 was 27,582,940.

 

 

TABLE OF CONTENTS

		Page
PART I FINANCIAL INFORMATION		3
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		16
Item 3. Quantitative and Qualitative Disclosures About Market Risk		27
Item 4. Controls and Procedures		27
PART II OTHER INFORMATION		28
Item 1. Legal Proceedings		28
Item 1A. Risk Factors		28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		36
Item 3. Defaults Upon Senior Securities		36
Item 4. Submission of Matters to a Vote of Security Holders		36
Item 5. Other Information		36
Item 6. Exhibits		37
SIGNATURES		38
INDEX TO EXHIBITS		39
EX-31.01
EX-31.02
EX-32.01
EX-32.02

Item 1. Financial Statements.

PDF SOLUTIONS, INC.

		September 30,				December 31,
		2008				2007
		(In thousands,
		except par values)
ASSETS
Current assets:
Cash and cash equivalents		$	27,026			$	35,315
Short-term investments			15,178				9,949
Accounts receivable, net of allowance of $254 in 2008 and 2007			33,355				38,526
Prepaid expenses and other current assets			5,543				5,030
Total current assets			81,102				88,820
Property and equipment, net			3,049				3,621
Non-current investments			841				—
Goodwill			64,103				65,170
Intangible assets, net			10,342				12,818
Deferred tax assets and other non-current assets			600				8,922
Total assets		$	160,037			$	179,351
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt		$	393			$	421
Accounts payable			1,810				3,469
Accrued compensation and related benefits			5,874				5,950
Other accrued liabilities			2,292				2,604
Taxes payable			31				208
Deferred revenue			2,966				3,159
Billings in excess of recognized revenue			115				553
Total current liabilities			13,481				16,364
Long-term debt			550				907
Long-term taxes payable			3,339				5,581
Other liabilities			1,295				29
Total liabilities			18,665				22,881
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 29,331 in 2008 and 29,122 in 2007; shares outstanding 27,580 in 2008 and 27,933 in 2007			4				4
Additional paid-in-capital			187,373				181,566
Treasury stock at cost, 1,751 shares in 2008 and 1,190 shares in 2007			(14,632	)			(11,524	)
Accumulated deficit			(33,569	)			(16,892	)
Accumulated other comprehensive income			2,196				3,316
Total stockholders’ equity			141,372				156,470
Total liabilities and stockholders’ equity		$	160,037			$	179,351

See notes to unaudited condensed consolidated financial statements

PDF SOLUTIONS, INC.

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
		(In thousands, except per share amounts)
Revenues:
Design-to-silicon-yield solutions		$	13,348			$	17,261			$	43,824			$	52,318
Gainshare performance incentives			5,417				6,807				16,402				17,590
Total revenues			18,765				24,068				60,226				69,908
Cost of design-to-silicon-yield solutions:
Direct costs of design-to-silicon-yield solutions			7,152				8,100				22,185				22,976
Amortization of acquired technology			631				1,331				1,893				4,516
Total cost of design-to silicon-yield solutions			7,783				9,431				24,078				27,492
Gross margin			10,982				14,637				36,148				42,416
Operating expenses:
Research and development			7,835				9,008				26,045				26,175
Selling, general and administrative			5,401				5,789				17,346				18,278
Amortization of other acquired intangible assets			194				985				583				3,029
Restructuring charges			—				—				1,471				—
Total operating expenses			13,430				15,782				45,445				47,482
Loss from operations			(2,448	)			(1,145	)			(9,297	)			(5,066	)
Interest and other income (loss), net			(343	)			322				397				1,347
Loss before taxes			(2,791	)			(823	)			(8,900	)			(3,719	)
Income tax provision			9,433				116				7,777				276
Net loss		$	(12,224	)		$	(939	)		$	(16,677	)		$	(3,995	)
Net loss per share — basic and diluted		$	(0.44	)		$	(0.03	)		$	(0.60	)		$	(0.14	)
Weighted average common shares — basic and diluted			27,540				28,223				27,663				28,127

See notes to unaudited condensed consolidated financial statements

PDF SOLUTIONS, INC.

		Nine Months Ended
		September 30,
		2008				2007
		(In thousands)
Operating activities:
Net loss		$	(16,677	)		$	(3,995	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			1,447				1,513
Stock-based compensation expense			5,450				5,453
Losses on sale of investment security and disposal of fixed assets			450				—
Amortization of acquired intangible assets			2,476				7,594
Tax benefit related to stock-based compensation expense			—				223
Excess tax benefit from stock-based compensation expense			—				(43	)
Deferred taxes			8,446				(3,706	)
Changes in operating assets and liabilities, net of effect of acquisition:
Accounts receivable			5,213				(5,034	)
Prepaid expenses and other assets			189				11
Accounts payable			(1,638	)			(1,081	)
Accrued compensation and related benefits			(28	)			662
Other accrued liabilities			983				(489	)
Taxes payable			(2,496	)			3,815
Deferred revenues			(232	)			516
Billings in excess of recognized revenue			(438	)			206
Net cash provided by operating activities			3,145				5,645
Investing activities:
Purchases of available-for-sale securities			(27,094	)			(20,840	)
Maturities and sales of available-for-sale securities			20,665				26,221
Purchases of property and equipment			(1,007	)			(1,654	)
Payments on business acquired, net of cash acquired			—				(4,584	)
Net cash used in investing activities			(7,436	)			(857	)
Financing activities:
Proceeds from exercise of stock options			63				1,337
Proceeds from employee stock purchase plan			590				782
Purchases of treasury stock			(3,108	)			(4,452	)
Principal payments on long-term obligations			(361	)			(267	)
Principal payments on notes to stockholders			—				(416	)
Excess tax benefit from stock-based compensation expense			—				43
Net cash used in financing activities			(2,816	)			(2,973	)
Effect of exchange rate changes on cash			(1,182	)			195
Net increase (decrease) in cash and cash equivalents			(8,289	)			2,010
Cash and cash equivalents, beginning of period			35,315				36,451
Cash and cash equivalents, end of period		$	27,026			$	38,461
Non-cash investing and financing activities:
Stock issued for business acquired		$	—			$	2,874
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Taxes		$	1,837			$	518
Interest		$	31			$	36

See notes to unaudited condensed consolidated financial statements

PDF SOLUTIONS, INC.

1. BASIS OF PRESENTATION

Basis of Presentation

     The interim unaudited condensed consolidated financial statements included herein have been prepared by PDF Solutions, Inc., or the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, or the 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, a fair statement of results for the interim periods presented taking into account all adjustments necessary (consisting only of normal recurring adjustments). 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, 2007.

     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.

     The Company has chosen to replace the term “Integrated Solutions” with “Services” and “Gain Share” with “Gainshare Performance Incentives” in its condensed consolidated statements of operations to better describe the arrangements provided to its customers. Furthermore, the Company opted to combine “Services” revenue and “Software Licenses” revenue into one line item “Design-to-Silicon-Yield Solutions” in its condensed consolidated statements of operations.

Revenue Recognition

     The Company derives revenue from two sources: Design-to-Silicon-Yield Solutions, which includes Services and Software Licenses, and Gainshare Performance Incentives. The Company recognizes revenue in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position, or 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 — Revenue that is derived from Design-to-Silicon-Yield solutions comes from services and software licenses. The Company recognizes revenue for each element of Design-to-Silicon-Yield solutions as follows:

     Services — The Company generates a significant portion of its Design-to-Silicon-Yield solutions revenue from fixed-price solution implementation service contracts delivered over a specific period of time. These contracts require accurate estimation of cost to perform obligations and overall scope of each engagement. Revenue under contracts for solution implementation services is recognized as 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 services contracts. In such instances, software products are licensed to customers over a 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, or VSOE, exists for the support and maintenance element, the support and maintenance revenue is recognized separately over the term of the supporting period. The remaining fee is recognized as services are performed using the cost-to-cost percentage of completion method of contract accounting. VSOE for maintenance, in these instances, is generally established based upon a negotiated renewal rate. Under arrangements where software products are licensed as a component of its fixed-price service contract and where VSOE does not exist to allocate a portion of the total fixed-price to the undelivered elements, revenue is recognized for the total fixed-price as the lesser of either the percentage of completion method of contract accounting or 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 related 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 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 are allocated to each element of a transaction based upon its fair value as determined by the Company’s VSOE. VSOE is generally established for 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, 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. For software license arrangements that do not require significant modification or customization of the underlying software, software license revenue is recognized under the residual method when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the fee is fixed or determinable, (4) collectibility is probable, and (5) 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 its 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 services. VSOE is generally established for 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. When 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 underlying element for which VSOE does not exist, and such revenue is recorded as services. No revenue has been recognized for software licenses with extended payment terms in excess of amounts due. For software license arrangements that require significant modification or customization of the underlying software, the software license revenue is recognized as services are performed using the cost-to-cost percentage of completion method of contract accounting, and such revenue is recorded as services.

     Gainshare Performance Incentives — When the Company enters into a contract to provide yield improvement services, the contract usually includes two components: (1) a fixed fee for performance by the Company of services delivered over a specific period of time, and (2) a gainshare performance incentives component where the customer may pay a variable fee, usually after the fixed fee period has ended. Revenue derived from gainshare performance incentives represents profit sharing and performance incentives earned based upon the Company’s customers reaching certain defined operational levels established in related solution implementation services contracts. Gainshare performance incentives periods are usually subsequent to the delivery of all contractual services and therefore have no cost to the Company. Due to the uncertainties surrounding attainment of such operational levels, the Company recognizes gainshare performance incentives revenue to the extent of completion of the related solution implementation contract and upon receipt of performance reports or other related information from the customer supporting the determination of amounts and probability of collection.

2. RECENT ACCOUNTING PRONOUNCEMENTS AND ACCOUNTING CHANGES

     In March 2008, the Financial Accounting Standard Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 161, Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133, or SFAS No. 161. SFAS No. 161 enhances the disclosure about the Company’s derivative and hedging activities. This Statement requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. SFAS No. 161 does not change the accounting treatment for derivative instruments. SFAS No. 161 is effective for the Company beginning in the first quarter of fiscal year 2009. The adoption of SFAS No. 161 is not expected to have a significant impact on the Company’s results of operations, cash flow or financial position.

     In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations, or SFAS No. 141R. SFAS No. 141R establishes principles and requirements for how an acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree, and the goodwill acquired. SFAS No. 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141R is effective as of the beginning of an entity’s fiscal year that begins after December 15, 2008, and will be adopted by the Company in the first quarter of fiscal 2009. The Company is currently evaluating the potential impact, if any, of the adoption of SFAS No. 141R on its financial statements.

     In December 2007, the SEC issued Staff Accounting Bulletin No. 110, or SAB 110, to amend the SEC’s views discussed in SAB 107 regarding the use of the simplified method in developing an estimate of expected life of share options in accordance with SFAS No. 123(R). SAB 110 is effective for the Company beginning in the first quarter of fiscal year 2008. Effective January 1, 2008, the Company adopted the provisions of SAB 110 and determined that it had enough historical data to determine the expected life of its share options, in lieu of using the simplified method.

     Effective January 1, 2008, the Company adopted the provisions of the FASB’s SFAS No. 157, Fair Value Measurement, or SFAS No. 157, for financial assets and liabilities. SFAS No. 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. Additionally, the statement provides guidance on definition, measurement, methodology and use of assumptions and inputs in determining fair value. The Company applied the provisions of SFAS No. 157 to its financial assets which included its investments accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. See Note 12 “Fair Value” below. In February 2008, the FASB issued FASB Staff Position, or FSP, 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, or FSP 157-1, and FSP 157-2, Effective Date of FASB Statement No. 157, or FSP 157-2. FSP 157-1 removes certain leasing transactions from the scope of SFAS No. 157. FSP 157-2 delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008. The Company is currently evaluating the potential impact, if any, of the adoption of SFAS No. 157 with respect to nonfinancial assets and liabilities on its financial statements. Nonfinancial assets and liabilities for which the Company has not applied the provisions of SFAS No. 157 include those measured at fair value in impairment testing and those initially measured at fair value in a business combination. In October 2008, the FASB issued FSP 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, or FSP 157-3. FSP 157-3 provides guidance for the valuation of financial assets in an inactive market, the use of internal assumptions when relevant observable data does not exist, the use of observable market information when the market is not active, and the use of market quotes when assessing the relevance of observable and unobservable data. FSP 157-3 is effective for all periods presented in accordance with SFAS No. 157. The adoption of FAS 157-3 did not have a material impact on the Company’s financial results and position.

     Effective January 1, 2008, the Company adopted the provisions of the FASB’s SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115, or SFAS No. 159. 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. The adoption of SFAS No. 159 did not have an effect on the Company’s financial statements as the Company did not elect this fair value option, nor is it expected to have a material impact on future periods as the election of this option for the Company’s financial instruments is expected to be limited.

3. INVESTMENTS

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

						September 30, 2008
						Unrealized				Unrealized
		Amortized				Holding				Holding				Market
		Cost				Gains				Losses				Value
Commercial paper		$	11,687			$	—			$	(10	)		$	11,677
Agency obligations			6,510				—				(8	)			6,502
Auction-rate securities			1,000				—				(159	)			841
Corporate securities			400				—				(2	)			398
		$	19,597			$	—			$	(179	)		$	19,418
Included in cash and cash equivalents														$	3,399
Included in short-term investments															15,178
Included in non-current investments															841
Total														$	19,418

						December 31, 2007
						Unrealized				Unrealized
		Amortized				Holding				Holding				Market
		Cost				Gains				Losses				Value
Commercial paper		$	12,500			$	3			$	—			$	12,503
Auction-rate securities			4,450				—				—				4,450
Agency discount notes			1,543				—				—				1,543
		$	18,493			$	3			$	—			$	18,496
Included in cash and cash equivalents														$	8,547
Included in short-term investments															9,949
Total														$	18,496

     As of September 30, 2008, all securities other than auction-rate securities held by the Company had a maturity of one year or less. As of December 31, 2007, all securities held by the Company had a maturity of one year or less. Please refer to Note 12 “Fair Value” below for further discussion of auction-rate securities.

4. 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 $13.0 million and $12.1 million as of September 30, 2008 and December 31, 2007, respectively.

5. NET LOSS PER SHARE

     Basic net loss per share is computed by dividing net loss by the weighted average common shares outstanding for the period (excluding outstanding stock options and shares subject to repurchase). Diluted net 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 loss per share (in thousands, except per share data):

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2008				2007				2008				2007
Net loss		$	(12,224	)		$	(939	)		$	(16,677	)		$	(3,995	)
Denominator for basic calculation:
Weighted average common shares outstanding			27,540				28,223				27,663				28,127
Dilutive items
Stock options outstanding			—				—				—				—
Denominator for diluted computation			27,540				28,223				27,663				28,127
Net loss per share — basic and diluted		$	(0.44	)		$	(0.03	)		$	(0.60	)		$	(0.14	)

6. COMPREHENSIVE INCOME (LOSS)

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

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2008				2007				2008				2007
Net loss		$	(12,224	)		$	(939	)		$	(16,677	)		$	(3,995	)
Unrealized gain (loss) on investments, net of income tax effects			(97	)			—				(182	)			1
Foreign currency translation adjustments, net of income tax effects			(3,002	)			1,066				(938	)			2,463
Comprehensive income (loss)		$	(15,323	)		$	127			$	(17,797	)		$	(1,531	)

7. GOODWILL AND ACQUIRED 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 completed its annual impairment test on December 31, 2007 and concluded that goodwill was not impaired.

     The following table provides information relating to the intangible assets and goodwill as of September 30, 2008 and December 31, 2007 (in thousands):

						December 31,																				September 30,
		Amortization				2007								Purchase								Foreign				2008
		Period				Net Carrying								Price								Currency				Net Carrying
		(Years)				Amount				Acquisition				Adjustments				Amortization				Translation				Amount
Goodwill			N/A			$	65,170			$	—			$	(215	)		$	—			$	(852	)		$	64,103
Acquired identifiable intangibles:
Acquired technology			4-5			$	9,184			$	—			$	—			$	(1,893	)		$	—			$	7,291
Brand name			4				361				—				—				(96	)			—				265
Customer relationships and backlog			6				1,812				—				—				(282	)			—				1,530
Patent and applications			7				1,283				—				—				(150	)			—				1,133
Other acquired intangibles			4				178				—				—				(55	)			—				122
Total						$	12,818			$	—			$	—			$	(2,476	)		$	—			$	10,342

						December 31,																				December 31,
		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			$	6			$	—			$	2,975			$	65,170
Acquired identifiable intangibles:
Acquired technology			4-5			$	7,901			$	6,430			$	—			$	(5,147	)		$	—			$	9,184
Brand name			4				822				—				—				(461	)			—				361
Customer relationships and backlog			1-6				4,362				—				—				(2,550	)			—				1,812
Patent and applications			7				—				1,400				—				(117	)			—				1,283
Other acquired intangibles			4				520				—				—				(362	)			20				178
Total						$	13,605			$	7,830			$	—			$	(8,637	)		$	20			$	12,818

     During the nine months ended September 30, 2008, the Company recorded adjustments to goodwill of $852,000 related to the effect of changes in exchange rates.

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

Year Ending December 31,		Amount
2008 (remaining three-month period)		$	825
2009			3,296
2010			3,029
2011			1,861
2012			1,048
2013 and thereafter			283
Total		$	10,342

8. INCOME TAXES

          The Company accounts for temporary differences between the book and tax entries by recording deferred tax assets and liabilities in accordance with SFAS No. 109, Accounting for Income Taxes, which established financial accounting and reporting standards for the effect of income taxes. The Company must assess the likelihood that its deferred tax assets will be recovered from future taxable income and, to the extent the Company believes that recovery is not likely, the Company must establish a valuation allowance. Changes in the Company’s net deferred tax assets, less offsetting valuation allowance, in a period are recorded through the income tax provision in the condensed consolidated statements of operations.

     Based on the available objective evidence, both positive and negative, including the recent history of losses, forecasted U.S. pre tax income (loss), and the net operating losses that can be carried back to prior taxable years, management concluded as of September 30, 2008, that it is more likely than not that the Company’s net deferred tax assets would not be fully realizable. Accordingly, the Company recorded a valuation allowance of $7.5 million to reduce its net deferred tax assets to the estimated recoverable amount. This change in the Company’s valuation allowance was recorded in the income tax provision in the condensed consolidated statements of operations.

     The Company’s gross unrecognized tax benefits as of September 30, 2008 were $2.8 million, which if recognized, would affect the Company’s effective tax rate. As of December 31, 2007, the Company’s gross unrecognized tax benefits were $7.9 million, of which $4.1 million, if recognized, would affect the Company’s effective tax rate. The change in the effective tax rate impact is related to the Company’s position that certain deferred tax assets are no longer more likely than not to be realized.

     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. 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 2001 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. During the second fiscal quarter of 2008, the Company received the final German tax authority audit report for the years 2002 through 2004. The Company reviewed the results of the audit, noting no material adjustments to the prior years’ tax returns, and as a result, the Company recorded a $205,000 tax benefit related to previously recorded uncertain tax positions and accrued interest.

9. STOCKHOLDERS’ EQUITY

     The Company accounts for stock-based compensation in accordance with SFAS No. 123 (revised 2004), Share-Based Payment. 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,
		2008				2007				2008				2007
Cost of design-to-silicon yield solutions		$	453			$	435			$	1,383			$	1,405
Research and development			537				553				1,843				1,731
Selling, general and administrative			723				682				2,224				2,317
Stock-based compensation expenses		$	1,713			$	1,670			$	5,450			$	5,453

     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 Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
Expected life (in years)			5.77				6.07				5.77				6.05
Volatility			58.6	%			59.4	%			58.6	%			59.9	%
Risk-free interest rate			3.48	%			4.88	%			3.27	%			4.92	%
Expected dividend			—				—				—				—
Weighted average fair value of options granted during the period		$	2.75			$	7.14			$	3.13			$	6.53

Employee Stock Purchase Plan:

		Three Months Ended September 30,								Nine Months Ended September 30,
		2008				2007				2008				2007
Expected life (in years)			1.26				0.25				1.31				0.76
Volatility			69.8	%			57.4	%			60.8	%			52.2	%
Risk-free interest rate			2.33	%			5.02	%			2.80	%			5.15	%
Expected dividend			—				—				—				—
Weighted average fair value of employee stock issued during the period		$	2.43			$	3.14			$	3.13			$	4.00

     On September 30, 2008, the Company has the following stock-based compensation plans:

     Stock Plans — In 2001, the Company terminated the 1996 and 1997 Stock Plans with respect 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 (1) 3,000,000 shares, (2) 5% of the outstanding common stock on the last day of the immediately preceding year, or (3) 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 non-statutory stock options. These options generally expire ten years from the date of grant and become vested and exercisable ratably over a four-year period.

     Stock option activity under the Company stock plans as of September 30, 2008 and changes during the nine months ended September 30, 2008 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 at January 1, 2008			8,014,920			$	11.42
Granted			659,500				5.60
Exercised			(12,115	)			5.21
Forfeited or expired			(4,250,993	)			13.04
Outstanding at September 30, 2008			4,411,312				9.02				7.38			$	297
Vested and expected to vest			4,095,845				9.09				7.24			$	278
Exercisable at September 30, 2008			2,019,430				9.26				5.46			$	199

     The aggregate intrinsic value in the table above represents the total intrinsic value based on the Company’s closing stock price of $5.20 as of September 30, 2008, 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, 2008 was $27,000.

     As of September 30, 2008, there was $8.4 million of total unrecognized compensation cost related to nonvested stock options. That cost is expected to be recognized over a weighted average period of 2.9 years.

     On September 10, 2008, the Company filed a tender offer on Form SC TO-I, or the Offer, with the SEC under which holders of options with exercise prices equal to or greater than $10.00 per share could tender their options in exchange for restricted stock rights granted under the 2001 Stock Plan based upon a 4.2 option shares to 1.0 restricted stock right exchange ratio. Restricted stock rights received in exchange for eligible options are subject to new vesting schedules, ranging from 15 months to 51 months, depending on when stock options exchanged were granted.

     The Company completed the Offer on August 18, 2008. As a result, the Company accepted for exchange options to purchase an aggregate of 3,331,557 shares of the Company’s common stock from 210 eligible participants, representing 73% of the shares subject to options that were eligible to be exchanged in the Offer as of August 18, 2008. Upon the terms and subject to the conditions set forth in the Offer, the Company issued restricted stock rights covering an aggregate of 793,480 shares of the Company’s common stock in exchange for the options surrendered pursuant to the Offer.

     The fair value of the restricted stock rights awarded was measured as the total of the unrecognized compensation cost of the original options tendered and the incremental compensation cost of the restricted stock rights awarded on August 18, 2008, the date of cancellation. The incremental compensation cost was measured as the excess of the fair value of the restricted stock rights awards over the fair value of the options immediately before cancellation based on the share price and other pertinent factors at that date. The incremental cost of the 793,480 restricted stock rights awards was $984,000. The unrecognized compensation costs of the tendered options cancelled were $5.9 million. The total fair value of the restricted stock right awarded on August 18, 2008 was $6.8 million and these costs will be amortized over the service period of the restricted stock rights.

     Nonvested shares (restricted stock rights) as of September 30, 2008 and changes during the nine months ended September 30, 2008 were as follows:

						Weighted-Average
						Grant-Date
		Shares				Fair Value
Nonvested at January 1, 2008			133,000			$	10.73
Granted			793,480				8.54
Vested			(44,330	)			10.73
Forfeited			—				—
Nonvested at September 30, 2008			882,150				8.76

     As of September 30, 2008, there was $5.6 million of total unrecognized compensation cost related to restricted stock. That cost is expected to be recognized over a weighted average period of 3.72 years. The total compensation expense related to shares vested during the nine months ended September 30, 2008 was $250,000. As of September 30, 2008, there were 120,000 unvested shares with a total of $625,000 unrecognized compensation cost for non-employees.

     Employee Stock Purchase Plan — In July 2001, the Company adopted an Employee Stock Purchase Plan, or the 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 the Company’s 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, 2008, the Purchase Plan compensation expense was $370,000.

     Stock Repurchase Program — On March 26, 2003, the Company’s Board of Directors approved a share repurchase program to purchase up to $10.0 million of its outstanding common stock. The program was completed in August 2007 with 988,000 shares repurchased at the average price of $10.12. 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. As of September 30, 2008, 763,000 shares have been repurchased at the average price of $6.07 under this program and $5.4 million remained available for repurchase.

     The stock repurchase activity for the nine months ended September 30, 2008 is summarized as follows (in thousands, except per share amounts):

						Weighted-Average
		Shares Repurchased				Price per Share				Amount Repurchased
Cumulative balance at January 1, 2008			201			$	7.57			$	1,523
Repurchase of common stock			562				5.53				3,108
Cumulative balance at September 30, 2008			763				6.07			$	4,631

10. RESTRUCTURING

     On April 29, 2008, the Company announced a restructuring plan in an effort to better allocate its resources to improve its operational results in light of the current market conditions. As a result of this plan, the Company recorded restructuring charges of

$1.5 million during the three months ended June 30, 2008, of which $1.4 million related to employee severance costs and $121,000 related to professional and other fees. The following table summarizes the activities of these restructuring liabilities (in thousands):

Restructuring		Severance				Professional and Others Fees
Balance at January 1, 2008		$	—			$	—
Restructuring charges			1,350				121
Payments			(1,263	)			(121	)
Balance at September 30, 2008		$	87			$	0

     The remaining accrual for severance is expected to be paid out in the fourth fiscal quarter of 2008. At September 30, 2008, $87,000 was included in other accrued liabilities.

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 sole chief operating decision maker or group of decision makers 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		2008				2007				2008				2007
A			21	%			20	%			19	%			18	%
B			19	%			16	%			16	%			16	%
C			4	%			10	%			5	%			9	%

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

Customer		September 30, 2008				December 31, 2007
A			29	%			27	%
B			16	%			15	%
C			7	%			11	%

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

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2008				2007				2008				2007
Asia		$	10,499			$	13,792			$	33,032			$	37,820
United States			5,307				6,668				16,072				22,377
Europe			2,959				3,608				11,122				9,711
Total		$	18,765			$	24,608			$	60,226			$	69,908

     As of September 30, 2008 and December 31, 2007, long-lived assets related to PDF Solutions S.A.S. (formerly Si Automation S.A.), located in France, totaled $409,000 and $446,000, respectively. The majority of the Company’s remaining long-lived assets are in the United States.

12. FAIR VALUE

     Effective January 1, 2008, the Company adopted SFAS No. 157 (as impacted by FSP 157-1 and FSP 157-2) with respect to fair value measurements of (1) nonfinancial assets and liabilities that are recognized or disclosed at fair value in the Company’s

consolidated financial statements on a recurring basis (at least annually) and (2) all financial assets and liabilities. The adoption was limited to financial assets, which primarily relate to cash, cash equivalent, and available-for-sale securities and did not have material impact on the Company’s financial condition, results of operations or cash flows.

     Under SFAS No. 157, fair value is defined as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. SFAS No. 157 refers to the multiple assumptions used to value financial instruments as inputs, and establishes hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a reporting entity’s pricing based upon its own market assumptions. These inputs are ranked according to a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels.

Level 1 -		Inputs are quoted prices in active markets for identical assets or liabilities.
Level 2 -		Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable and market-corroborated inputs which are derived principally from or corroborated by observable market data.
Level 3 -		Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable.

     The following table represents the Company’s assets measured at fair value on a recurring basis as of September 30, 2008 and the basis for that measurement (in thousands):

						Quoted Prices in
						Active Markets for				Significant Other				Significant
						Identical Assets				Observable Inputs				Unobservable Inputs
Assets		Total				(Level 1)				(Level 2)				(Level 3)
Money market mutual funds		$	2,025			$	2,025			$	—			$	—
Commercial paper			11,677				—				11,677				—
Agency obligations			6,502				—				6,502				—
Auction-rate securities			841				—				—				841
Corporate securities			398				—				398				—
Total		$	21,443			$	2,025			$	18,577			$	841

     The Company holds investments in auction-rate securities, or ARS, which are variable rate debt instruments whose interest rates are reset through a “dutch” auction process at regular intervals, typically every 28 days. All ARS are backed by pools of student loans guaranteed by governmental agencies and private entities, and were rated AAA/Aaa or A as of September 30, 2008. The liquidity and fair value of these securities has been reduced by the uncertainty in the credit markets and the exposure of these securities to the financial condition of bond insurance companies, as evidenced by the rating downgrade of MBIA (bond insurer on one of the Company’s ARS) from Aaa to A2, by Moody’s Investor Services on June 19, 2008. All ARS have failed to sell at auction since February 2008, and as a result, their interest rates were reset to the maximum LIBOR + 150 basis points. The only activity since February 2008 was the repurchase of $500,000 of ARS at par by issuers. As a result of these auction failures, there was limited active market with observable prices for these securities as of September 30, 2008, and therefore the Company computed the fair value of these securities based on a discounted cash flow model, using significant Level 3 inputs, to take into account the lack of liquidity. The Company does not believe that the student loans backing these securities, the principal of these assets, is at risk. Furthermore, the Company is able to hold these securities until the credit markets recover and these securities resume pricing at or near par, and as a result, the Company recorded a temporary impairment to other comprehensive income and classified these securities as non-current assets. The valuation may be revised in future periods as market conditions evolve.

     The following represents the reconciliation of the beginning and ending balance of assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2008 (in thousands):

		Available-For-Sale
		Securities
Beginning balance at January 1, 2008		$	—
Total gains and losses (realized / unrealized):
Included in earnings			—
Included in other comprehensive income			(159	)
Purchases, issuances, and settlements			(500	)
Transfers, in Level 3			1,500
Ending balance at September 30, 2008		$	841
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at September 30, 2008		$	—

13. SUBSEQUENT EVENTS

     On October 7, 2008, the Company completed a transaction with Triant Holdings Inc. (TSX: TNT), or Triant, a British Columbia corporation and a provider of Fault Detection and Classification technologies, pursuant to which the Company acquired substantially all of the assets, excluding certain receivables, but including certain customer contracts, of Triant’s Canadian operating subsidiary. With the purchase, the Company creates additional opportunities for its leading process control solutions within the installed customer base. The purchase price was $1.6 million in cash.

     On October 28, 2008, the Company announced a restructuring plan in an effort to better allocate its resources to improve its operational results in light of the current market conditions. As a result of this plan, the Company will incur restructuring charges of approximately $1.6 million primarily related to personnel costs and facility exit costs. The actual amount spent by the Company in connection with the restructuring could be materially different from the initial estimation.

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. In some cases, you can identify forward-looking statements by terminology such as “may,” “could,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative effect of terms like these or other similar expressions. Any statement concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, and possible actions taken by us or our subsidiaries, which may be provided by us are also forward-looking statements. These forward-looking statements are only predictions. Forward-looking statements are based on current expectations and projections about future events and are inherently subject to a variety of risks and uncertainties, many of which are beyond our control, which could cause actual results to differ materially from those anticipated or projected. All forward-looking statements included in this document are based on information available to us on the date of filing and we further caution investors that our business and financial performance are subject to substantial risks and uncertainties. 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 herein and set forth at the end of Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2007.

Overview

     Our technologies and services enable semiconductor companies to improve profitability across the entire “process lifecycle,” which is the term we have coined for the time from the design of an integrated circuit, or IC, and design of a manufacturing process for ICs, through that IC’s volume manufacturing. Our solutions improve profitability by improving a semiconductor company’s time-to-market, increasing yield and reducing total design and manufacturing costs. Our solutions combine proprietary software, physical intellectual property in the form of cell libraries for IC designs, test chips, an electrical wafer test system, proven methodologies, and professional services. We analyze yield loss mechanisms to identify, quantify, and correct the issues that cause yield loss. This drives IC design and manufacturing improvements that enable our customers to optimize the technology development process, increase the initial yield when an IC design first enters a manufacturing line, increase the rate at which yield improves, and minimize excursions and process variability that cause yield loss throughout mass production.

     The result of successfully implementing our solutions is the creation of value that can be measured based on improvements to our customers’ actual yield. Through our gainshare performance incentives component, we have aligned our financial interests with the yield and performance improvements realized by our customers, and we receive revenue based on this value. Our technologies and services have been sold to 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, under the term 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. AISS now operates as PDF Solutions GmbH, a German company, 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, including increased software applications, through the acquisitions of IDS and WaferYield. In 2006, we further complemented our technology offering by acquiring Si Automation S.A., or SiA, and adding its fault detection and classification software capabilities to our integrated solution. In 2007, we increased our intellectual property solutions portfolio, particularly in logic design technology, through the acquisition of Fabbrix, Inc., or Fabbrix.

Industry Trend

     Demand for consumer electronics and communications devices continues to drive technological innovation in the semiconductor industry as the need for products with greater performance, lower power consumption, reduced costs and smaller size continues to grow with each new product generation. In addition, advances in computing systems and mobile devices have fueled demand for higher capacity memory chips. To meet these demands, IC manufacturers and designers are constantly challenged to improve the overall performance of their ICs by designing and manufacturing ICs with more embedded applications to create greater functionality while lowering cost per transistor. As a result, both logic and memory manufacturers have migrated to more and more advanced manufacturing nodes, capable of integrating more devices with higher performance, higher density, and lower power. As this trend continues, companies will continually be challenged to improve process capabilities to optimally produce ICs with minimal random and systematic yield loss, which is driven by the lack of compatibility between the design and its respective manufacturing process. We believe that as volume production of nanometer scale ICs continues to grow, the difficulties of integrating IC designs with their respective processes and ramping new manufacturing processes will create a greater need for products and services that address the yield loss and escalating cost issues the semiconductor industry is facing today and will face in the future.

Financial Highlights

     Financial highlights for the three months ended September 30, 2008 were as follows:

	•		Total revenue for the three months ended September 30, 2008 was $18.8 million, a decrease of $5.3 million, or 22% compared to the three months ended September 30, 2007. Revenue from Design-to-Silicon-Yield solutions for the three months ended September 30, 2008 decreased $3.9 million to $13.3 million from the three months ended September 30, 2007. Revenue from gainshare performance incentives for the three months ended September 30, 2008 decreased $1.4 million to $5.4 million from the three months ended September 30, 2007. The decrease in Design-to-Silicon Yield solutions revenue was primarily the result of lower bookings, as customers have delayed purchases for capacity expansion and investment in leading-edge technology. The dramatic downturn in the semiconductor industry combined with weakness in worldwide economies has been the primary contributors to this shortfall. The decrease in revenue from gainshare performance incentives was primarily the result of reduced volumes in customer manufacturing facilities.
	•		Net loss for the three months ended September 30, 2008 was $12.2 million, an increase of $11.3 million compared to $939,000 for the three months ended September 30, 2007. The increase in net loss was primarily attributable to the establishment of a valuation allowance against deferred tax assets and decreases in revenue, partially offset by decreases in operating expenses, the result of cost control efforts.
	•		Net loss per basic and diluted share was $0.44 for the three months ended September 30, 2008 compared to $0.03 for the three months ended September 30, 2007, an increase in net loss of $0.41 per basic and diluted share.

     Financial highlights for the nine months ended September 30, 2008 were as follows:

	•		Total revenue for the nine months ended September 30, 2008 was $60.2 million, a decrease of $9.7 million, or 14% compared to the nine months ended September 30, 2007. Revenue from Design-to-Silicon-Yield solutions for the nine months ended September 30, 2008 decreased $8.5 million to $43.8 million from the nine months ended September 30, 2007. Revenue from gainshare performance incentives for the nine months ended September 30, 2008 decreased $1.2 million to $16.4 million from the nine months ended September 30, 2007. The decrease in revenue for the nine months ended September 30, 2008 was primarily due to the aforementioned circumstances impacting the most recent three months’ results.
	•		Net loss for the nine months ended September 30, 2008 was $16.7 million, increased $12.7 million compared to $4.0 million for the nine months ended September 30, 2007. The increase in net loss was primarily attributable to the establishment of a valuation allowance against deferred tax assets, decreases in revenue, and increased expenses associated with our restructuring plan, partially offset by decreases in operating expenses, the result of such restructuring.
	•		Net loss per basic and diluted share was $0.60 for the nine months ended September 30, 2008 compared to $0.14 for the nine months ended September 30, 2007, an increase in net loss of $0.46 per basic and diluted share.
	•		Cash, cash equivalents and investments decreased $2.2 million to $43.0 million during the nine months ended September 30, 2008, primarily due to the repurchase of $3.1 million of our common stock.

Critical Accounting Policies

     The SEC’s 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 condensed consolidated financial statements. The following is a brief discussion of significant accounting policies and methods that we use.

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 generally accepted accounting principles 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, which includes Services and Software Licenses, and Gainshare Performance Incentives. We recognize revenue in accordance with the provisions of American Institute of Certified Public Accountants’ Statement of Position, or 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 — Revenue that is derived from Design-to-Silicon-Yield solutions comes from services and software licenses. We recognize revenue for each element of Design-to-Silicon-Yield solutions as follows:

     Services — We generate a significant portion of our Design-to-Silicon-Yield solutions revenue from fixed-price solution implementation service contracts delivered over a specific period of time. These contracts require accurate estimation of cost to perform obligations and overall scope of each engagement. Revenue under contracts for solution implementation services is recognized as 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 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 services contracts. In such instances, software products are licensed to customers over a 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, or VSOE, exists for the support and maintenance element, the support and maintenance revenue is recognized separately over the term of the supporting period. The remaining fee is recognized as services are performed using the cost-to-cost percentage of completion method of contract accounting. VSOE for maintenance, in these instances, is generally established based upon a negotiated renewal rate. Under arrangements where software products are licensed as a component of its fixed-price service contract and where VSOE does not exist to allocate a portion of the total fixed-price to the undelivered elements, revenue is recognized for the total fixed-price as the lesser of either the percentage of completion method of contract accounting or 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 related 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 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 are allocated to each element of a transaction based upon its fair value as determined by our VSOE. VSOE is generally established for 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, 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. For software license arrangements that do not require significant modification or customization of the underlying software, software license revenue is recognized under the residual method when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the fee is fixed or determinable, (4) collectibility is probable, and (5) 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 services. VSOE is generally established for 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. When 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 underlying element for which VSOE does not exist. No revenue has been recognized for software licenses with extended payment terms in excess of amounts due. For software license arrangements that require significant modification or customization of the underlying software, the software license revenue is recognized as services are performed using the cost-to-cost percentage of completion method of contract accounting, and such revenue is recorded as services.

     Gainshare Performance Incentives — When we enter into a contract to provide yield improvement services, the contract usually includes two components: (1) a fixed fee for performance by us of services delivered over a specific period of time, and (2) a gainshare performance incentives component where the customer may pay a variable fee, usually after the fixed fee period has ended. Revenue derived from gainshare performance incentives represents profit sharing and performance incentives earned based upon our customers reaching certain defined operational levels established in related solution implementation service contracts. Gainshare performance incentives periods are usually subsequent to the delivery of all contractual services and therefore have no cost to us. Due to the uncertainties surrounding attainment of such operational levels, we recognize gainshare performance incentives 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. Gainshare performance incentives 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 provisions for gainshare performance incentives.

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 Statement of Financial Accounting Standards, or 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, 2008, we had $64.1 million of goodwill and $10.3 million of intangible assets. When valuing our goodwill and intangible assets, we make assumptions regarding estimated future cash flows to be derived from the acquired assets. If these estimates or their related assumptions change in the future, 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, 2007, we completed our annual testing requirements and determined that the carrying value of goodwill had not been impaired. During the nine months ended September 30, 2008, we had a significant decline in trading price of our common stock; should we continue to experience a decline in the price of our common stock, a further analysis may be required and impairment charges, if any, could be recorded.

     We are currently amortizing our acquired intangible assets over estimated useful lives of four to seven 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 asset in future periods.

Income Taxes

     Realization of deferred tax assets is dependent on our ability to generate future taxable income and utilize tax planning strategies. We have recorded deferred tax assets in an amount that is more likely than not to be realized based on current estimations and assumptions. We evaluate the 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.

Stock-Based Compensation

     We account for stock-based compensation in accordance with SFAS No. 123 (revised 2004), Share-Based Payment, or SFAS No. 123(R). Under the provisions of SFAS No. 123(R), stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes-Merton, or 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, forfeiture rates, 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.

Recent Accounting Pronouncements and Accounting Changes

     See Note 2 to the condensed consolidated financial statements accompanying this Quarterly Report on Form 10-Q for a description of recent accounting pronouncements and accounting changes, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements.

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,
		2008				2007				2008				2007
Revenues:
Design-to-silicon-yield solutions			71	%			72	%			73	%			75	%
Gainshare performance incentives			29				28				27				25
Total revenues			100				100				100				100
Cost of design-to-silicon-yield solutions:
Direct cost of design-to-silicon-yield solutions			38				33				37				33
Amortization of acquired technology			3				6				3				6
Total cost of design-to-silicon-yield solutions			41				39				40				39
Gross margin			59				61				60				61
Operating expenses:
Research and development			42				38				43				38
Selling, general and administrative			29				24				29				26
Amortization of other acquired intangible assets			1				4				1				4
Restructuring charges			—				—				2				—
Total operating expenses			72				66				75				68
Loss from operations			(13	)			(5	)			(15	)			(7	)
Interest and other income (loss), net			(2	)			1				—				2
Loss before taxes			(15	)			(4	)			(15	)			(5	)
Income tax provision			50				—				13				—
Net loss			(65	)%			(4	)%			(28	)%			(5	)%

Comparison of the Three Months Ended September 30, 2008 and 2007

																		Three Months Ended September 30,
																		2008				2007
		Three Months Ended September 30,								$				%				% of				% of
Revenue		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Design-to-silicon-yield solutions		$	13,348			$	17,261			$	(3,913	)			(23	)%			71	%			72	%
Gainshare performance incentives			5,417				6,807				(1,390	)			(20	)%			29	%			28	%
Total		$	18,765			$	24,068			$	(5,303	)			(22	)%			100	%			100	%

     Design-to-Silicon-Yield Solutions. Design-to-Silicon-Yield solutions revenue is derived from services (including solution implementations, software support and maintenance, consulting, and training) and software licenses, provided during our customer yield improvement engagements and solution product sales. Design-to-Silicon-Yield solutions revenue decreased $3.9 million for the three months ended September 30, 2008 compared to the three months ended September 30, 2007, primarily due to a decrease of $2.8 million in fixed fee integrated solutions and a decrease of $1.0 million in revenue from software related consulting services. The decreases were primarily the result of lower bookings, as customers have delayed purchases for capacity expansion and investment in leading edge technology. The dramatic downturn in the semiconductor industry combined with weakness in worldwide economies has been the primary contributors to this shortfall. Our Design-to-Silicon-Yield solutions revenue may fluctuate in the future and is dependent on a number of factors, including our ability to obtain new customers.

     Gainshare Performance Incentives. Gainshare performance incentives revenue represents profit sharing and performance incentives earned based upon our customer reaching certain defined operational levels. Revenue derived from gainshare performance incentives decreased $1.4 million for the three months ended September 30, 2008 compared to the three months ended September 30, 2007, primarily due to fluctuations in customer wafer volumes, relative to our performance targets at our customer sites. The revenues from gainshare performance incentives were generated from six customers and eight engagements for the three months ended September 30, 2008 and seven customers and ten engagements for the three months ended September 30, 2007. Our gainshare performance incentives revenue may continue to fluctuate from period to period. Gainshare performance incentives revenue is dependent on many factors that are outside 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 provisions for gainshare performance incentives.

																		Three Months Ended September 30,
																		2008				2007
		Three Months Ended September 30,								$				%				% of				% of
Cost of Design-to-Silicon-Yield Solutions		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Direct costs of design-to-silicon-yield solutions		$	7,152			$	8,100			$	(948	)			(12	)%			38	%			33	%
Amortization of acquired technology			631				1,331				(700	)			(53	)%			3	%			6	%
Total		$	7,783			$	9,431			$	(1,648	)			(17	)%			41	%			39	%

     Costs of Design-to-Silicon-Yield Solutions. Costs of Design-to-Silicon-Yield solutions consist of costs incurred to provide and support our services, costs recognized in connection with licensing our software, and amortization of acquired technology.

     Direct costs of Design-to-Silicon-Yield Solutions. Direct costs of Design-to-Silicon-Yield solutions consist of services costs and software licenses costs. Services costs consist of material, labor, overhead costs, and stock-based compensation charges associated with solution implementations. Costs include purchased materials, employee compensation and benefits, travel and facilities-related costs. 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 decreased $948,000 for the three months ended September 30, 2008 compared to the three months ended September 30, 2007. The decrease was primarily due to a decrease of $912,000 in deployment of our pdFasTest products and a decrease of $209,000 in travel expenses, the result of our cost control efforts, partially offset by an increase of $374,000 in the use of local 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 than those anticipated when the contract was executed. Any such reductions in contract margin could have a material negative impact on our operating results.

     Amortization of Acquired Technology. Amortization of acquired technology consists of amortization of intangibles acquired as a result of certain business combinations. Amortization of acquired technology expense decreased $700,000 for the three months ended September 30, 2008 compared to the three months ended September 30, 2007. The decrease in amortization of acquired technology was due to certain intangible assets becoming fully amortized. We anticipate amortization of acquired technology to be $631,000 for the remaining three months in 2008, $2.5 million in 2009, $2.3 million in 2010, $1.3 million in 2011, and $536,000 in 2012.

																		Three Months Ended September 30,
																		2008				2007
		Three Months Ended September 30,								$				%				% of				% of
Research and Development		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Research and development		$	7,835			$	9,008			$	(1,173	)			(13	)%			42	%			38	%

     Research and Development. Research and development expenses consist primarily of personnel-related costs to support product development activities, including compensation and benefits, outside development services, travel and facilities cost allocations, and stock-based compensation charges. Research and development expenses decreased $1.2 million for the three months ended September 30, 2008 compared to the three months ended September 30, 2007, primarily due to decreased personnel expenses as a result of our cost control efforts. We anticipate our expenses in research and development will fluctuate in absolute dollars from period to period as a result of cost control initiatives and the timing of when we hire personnel based on the size and timing of product development projects.

																		Three Months Ended September 30,
																		2008				2007
		Three Months Ended September 30,								$				%				% of				% of
Selling, General and Administrative		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Selling, general and administrative		$	5,401			$	5,789			$	(388	)			(7	)%			29	%			24	%

     Selling, General and Administrative. Selling, general and administrative expenses consist primarily of compensation and benefits for sales, marketing and general and administrative personnel in addition to outside sales commissions, legal and accounting services, marketing communications, travel and facilities cost allocations, and stock-based compensation charges. The selling, general and administrative expenses decreased $388,000 for the three months ended September 30, 2008 compared to the three months ended September 30, 2007, primarily due to decreased personnel expenses as a result of our cost control efforts. We anticipate our selling, general and administrative expenses will fluctuate in absolute dollars from period to period as a result of cost control initiatives and to support increased sales efforts in the future.

																		Three Months Ended September 30,
																		2008				2007
		Three Months Ended September 30,								$				%				% of				% of
Amortization of Other Acquired Intangible Assets		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Amortization of other acquired intangible assets		$	194			$	985			$	(791	)			(80	)%			1	%			4	%