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 June 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 August 1, 2008 was 27,647,369.

 

 

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			25
Item 4. Controls and Procedures			26
PART II OTHER INFORMATION			26
Item 1. Legal Proceedings			26
Item 1A. Risk Factors			27
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			34
Item 3. Defaults Upon Senior Securities			35
Item 4. Submission of Matters to a Vote of Security Holders			35
Item 5. Other Information			35
Item 6. Exhibits			36
SIGNATURES			37
INDEX TO EXHIBITS			38
EXHIBIT 10.03
EXHIBIT 31.01
EXHIBIT 31.02
EXHIBIT 32.01
EXHIBIT 32.02

Item 1. Financial Statements.

PDF SOLUTIONS, INC.

		June 30,				December 31,
		2008				2007
		(In thousands,
		except par values)
ASSETS
Current assets:
Cash and cash equivalents		$	30,487			$	35,315
Short-term investments			12,708				9,949
Accounts receivable, net of allowance of $254 in 2008 and 2007			35,506				38,526
Prepaid expenses and other current assets			3,771				3,354
Deferred tax assets			1,514				1,676
Total current assets			83,986				88,820
Property and equipment, net			3,344				3,621
Non-current investments			1,262				—
Goodwill			67,264				65,170
Intangible assets, net			11,184				12,818
Deferred tax assets and other assets			10,825				8,922
Total assets		$	177,865			$	179,351
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt		$	418			$	421
Accounts payable			2,378				3,469
Accrued compensation and related benefits			6,574				5,950
Other accrued liabilities			2,253				2,604
Taxes payable			75				208
Deferred revenue			3,600				3,159
Billings in excess of recognized revenue			110				553
Total current liabilities			15,408				16,364
Long-term debt			911				907
Long-term taxes payable			5,670				5,581
Other liabilities			724				29
Total liabilities			22,713				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 29,170 in 2008 and 29,122 in 2007; shares outstanding 27,501 in 2008 and 27,933 in 2007			4				4
Additional paid-in-capital			185,333				181,566
Treasury stock at cost, 1,670 shares in 2008 and 1,190 shares in 2007			(14,135	)			(11,524	)
Accumulated deficit			(21,345	)			(16,892	)
Accumulated other comprehensive income			5,295				3,316
Total stockholders’ equity			155,152				156,470
Total liabilities and stockholders’ equity		$	177,865			$	179,351

See notes to unaudited condensed consolidated financial statements

PDF SOLUTIONS, INC.

		Three Months Ended June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
		(In thousands, except per share amounts)
Revenues:
Design-to-silicon-yield solutions		$	15,452			$	17,808			$	30,476			$	35,057
Gainshare performance incentives			5,662				5,890				10,985				10,783
Total revenues			21,114				23,698				41,461				45,840
Cost of design-to-silicon-yield solutions:
Direct costs of design-to-silicon-yield solutions			7,267				7,109				15,033				14,876
Amortization of acquired technology			631				1,610				1,262				3,185
Total cost of design-to silicon-yield solutions			7,898				8,719				16,295				18,061
Gross margin			13,216				14,979				25,166				27,779
Operating expenses:
Research and development			9,134				8,797				18,210				17,167
Selling, general and administrative			5,646				6,645				11,945				12,489
Amortization of other acquired intangible assets			195				1,031				389				2,044
Restructuring charges			1,471				—				1,471				—
Total operating expenses			16,446				16,473				32,015				31,700
Loss from operations			(3,230	)			(1,494	)			(6,849	)			(3,921	)
Interest and other income, net			251				529				740				1,025
Loss before taxes			(2,979	)			(965	)			(6,109	)			(2,896	)
Income tax provision (benefit)			(1,039	)			(264	)			(1,656	)			160
Net loss		$	(1,940	)		$	(701	)		$	(4,453	)		$	(3,056	)
Net loss per share – basic and diluted		$	(0.07	)		$	(0.02	)		$	(0.16	)		$	(0.11	)
Weighted average common shares – basic and diluted			27,608				28,155				27,724				28,067

See notes to unaudited condensed consolidated financial statements

PDF SOLUTIONS, INC.

		Six Months Ended
		June 30,
		2008				2007
		(In thousands)
Operating activities:
Net loss		$	(4,453	)		$	(3,056	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			1,014				985
Stock-based compensation expense			3,737				3,783
Losses on disposal of property, plant and equipment			3				—
Amortization of acquired intangible assets			1,651				5,261
Tax benefit (shortfall) related to stock-based compensation expense			(33	)			76
Excess tax benefit from stock-based compensation expense			—				(26	)
Deferred taxes			(2,873	)			(2,183	)
Changes in operating assets and liabilities, net of effect of acquisition:
Accounts receivable, net of allowances			3,103				(4,748	)
Prepaid expenses and other assets			(360	)			(102	)
Accounts payable			(1,233	)			(987	)
Accrued compensation and related benefits			508				(63	)
Other accrued liabilities			351				(375	)
Taxes payable			(69	)			2,090
Deferred revenues			367				1,532
Billings in excess of recognized revenue			(443	)			272
Net cash provided by operating activities			1,270				2,459
Investing activities:
Purchases of available-for-sale securities			(16,805	)			(16,315	)
Maturities and sales of available-for-sale securities			12,810				14,771
Purchases of property and equipment			(604	)			(1,376	)
Payments on business acquired, net of cash acquired			—				(1,883	)
Net cash used in investing activities			(4,599	)			(4,803	)
Financing activities:
Proceeds from exercise of stock options			63				1,057
Proceeds from employee stock purchase plan			—				782
Purchases of treasury stock			(2,611	)			—
Principal payments on long-term obligations			(113	)			(129	)
Principal payments on notes to stockholders			—				(416	)
Excess tax benefit from stock-based compensation expense			—				26
Net cash provided by (used in) financing activities			(2,661	)			1,320
Effect of exchange rate changes on cash			1,162				225
Net decrease in cash and cash equivalents			(4,828	)			(799	)
Cash and cash equivalents, beginning of period			35,315				36,451
Cash and cash equivalents, end of period		$	30,487			$	35,652
Non-cash investing and financing activities:
Amount due to Fabbrix stockholders		$	—			$	2,701
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Taxes		$	1,334			$	228
Interest		$	21			$	24

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, 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, 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 as Design-to-Silicon-Yield Solutions,

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 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 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 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 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 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) 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. Statement of Financial Accounting Standards, or SFAS, No. 161 enhances the disclosure regarding 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 its expected life, 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 pronouncement 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 to “Notes to Condensed Consolidated Financial Statements (Unaudited).” 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.

     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):

						June 30, 2008
						Unrealized				Unrealized
		Amortized				Holding				Holding				Market
		Cost				Gains				Losses				Value
Commercial paper		$	16,207			$	1			$	(1	)		$	16,207
Agency obligations			2,460				2				(1	)			2,461
Auction-rate securities			1,400				—				(138	)			1,262
Corporate securities			400				—				—				400
		$	20,467			$	3			$	(140	)		$	20,330
Included in cash and cash equivalents														$	6,360
Included in short-term investments															12,708
Included in non-current investments															1,262
Total														$	20,330

						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 June 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 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 $10.9 million and $12.1 million as of June 30, 2008 and December 31, 2007, respectively.

5. 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 (excluding outstanding stock options and shares subject to repurchase). 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								Six Months
		Ended June 30,								Ended June 30,
		2008				2007				2008				2007
Net loss		$	(1,940	)		$	(701	)		$	(4,453	)		$	(3,056	)
Denominator for basic calculation:
Weighted average common shares outstanding			27,608				28,155				27,724				28,067
Dilutive items
Stock options outstanding			—				—				—				—
Denominator for diluted computation			27,608				28,155				27,724				28,067
Net loss per share — basic and diluted		$	(0.07	)		$	(0.02	)		$	(0.16	)		$	(0.11	)

     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								Six Months
		Ended June 30,								Ended June 30,
		2008				2007				2008				2007
Outstanding options			7,827				6,854				7,928				6,724

6. COMPREHENSIVE INCOME (LOSS)

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

		Three Months								Six Months
		Ended June 30,								Ended June 30,
		2008				2007				2008				2007
Net loss		$	(1,940	)		$	(701	)		$	(4,453	)		$	(3,056	)
Unrealized gain (loss) on investments, net of income tax effects			(43	)			(1	)			(85	)			1
Foreign currency translation adjustments, net of income tax effects			106				286				2,064				1,397
Comprehensive loss		$	(1,877	)		$	(416	)		$	(2,474	)		$	(1,658	)

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 June 30, 2008 and December 31, 2007 (in thousands):

						December 31,																				June 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			$	—			$	(23	)		$	—			$	2,117			$	67,264
Acquired identifiable intangibles:
Acquired technology			4-5			$	9,184			$	—			$	—			$	(1,262	)		$	—			$	7,922
Brand name			4				361				—				—				(64	)			—				297
Customer relationships and backlog			1-6				1,812				—				—				(187	)			—				1,625
Patent and applications			7				1,283				—				—				(100	)			—				1,183
Other acquired intangibles			4				178				—				—				(38	)			17				157
Total						$	12,818			$	—			$	—			$	(1,651	)		$	17			$	11,184

						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 six months ended June 30, 2008, the Company recorded $2.1 million 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 six-month period)		$	1,654
2009			3,305
2010			3,033
2011			1,861
2012			1,048
2013 and thereafter			283
Total		$	11,184

8. INCOME TAXES

     The Company includes interest and penalties related to unrecognized tax benefits within the Company’s income tax provision (benefit). As of June 30, 2008 and December 31, 2007, the Company had $460,000 and $566,000, respectively, accrued for payment of interest and penalties related to unrecognized tax benefits.

     The Company’s total amounts of unrecognized tax benefits as of June 30, 2008 was $7.8 million, of which $4.2 million, if recognized, would affect the Company’s effective tax rate. As of December 31, 2007, the Company’s total amount of unrecognized tax benefits was $7.9 million, of which $4.1 million, if recognized, would affect the Company’s effective tax rate. As of June 30, 2008, the Company has recognized a net amount of $5.7 million in long-term tax payable for unrecognized tax benefits in its consolidated balance sheets. The Company does not expect the change in unrecognized tax benefits over the next twelve months to materially impact its results of operations and financial position.

     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								Six Months
		Ended June 30,								Ended June 30,
		2008				2007				2008				2007
Cost of design-to-silicon yield solutions		$	400			$	478			$	930			$	970
Research and development			711				615				1,306				1,178
Selling, general and administrative			643				852				1,501				1,635
Stock-based compensation expenses before income taxes		$	1,754			$	1,945			$	3,737			$	3,783

     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 June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Expected life (in years)			5.77				6.05				5.77				6.05
Volatility			59.2	%			59.9	%			58.7	%			60.0	%
Risk-free interest rate			3.23	%			4.95	%			3.07	%			4.93	%
Expected dividend			—				—				—				—
Weighted average fair value of options granted during the period		$	3.07			$	6.33			$	3.45			$	6.41

Employee Stock Purchase Plan:

		Three Months Ended June 30,								Six Months Ended June 30,
		2008				2007				2008				2007
Expected life (in years)			1.33				0.98				1.33				0.98
Volatility			54.9	%			50.0	%			54.9	%			50.0	%
Risk-free interest rate			3.10	%			5.21	%			3.10	%			5.21	%
Expected dividend			—				—				—				—
Weighted average fair value of employee stock issued during the period		$	3.60			$	4.36			$	3.60			$	4.36

     On June 30, 2008, 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 (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 plans as of June 30, 2008 and changes during the six months ended June 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, January 1, 2008			8,014,920			$	11.42
Granted			359,500				6.20
Exercised			(12,115	)			5.21
Forfeited or expired			(535,537	)			11.81
Outstanding at June 30, 2008			7,826,768				11.17				7.00			$	491
Vested and expected to vest			7,391,147				11.23				6.88			$	465
Exercisable at June 30, 2008			4,567,597				11.46				5.71			$	357

     The aggregate intrinsic value in the table above represents the total intrinsic value based on the Company’s closing stock price of $5.95 as of June 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 six months ended June 30, 2008 was $27,000.

     As of June 30, 2008, there was $14.3 million of total unrecognized compensation cost related to nonvested stock options. That cost is expected to be recognized over a weighted average period of 2.7 years.

     On June 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 share right exchange ratio. Restricted stock rights received in exchange for eligible options will be subject to new vesting schedules. The length of the vesting schedule for each restricted stock right will depend on when stock options exchanged were granted. All restricted stock rights will be subject to the terms of the 2001 Stock Plan. The Offer will expire on August 18, 2008, the deadline to tender eligible options, and the Company could, at its sole discretion, extend, amend, and withdraw the Offer at anytime prior to the expiration date.

     Nonvested shares (restricted stock units) as of June 30, 2008 and changes during the six months ended June 30, 2008 were as follows:

						Weighted Average
						Measurement
		Shares				Date Fair Value
Nonvested, January 1, 2008			133,000			$	9.01
Granted			—				—
Vested			(36,020	)			5.28
Forfeited			—				—
Nonvested, June 30, 2008			96,980				5.95

     As of June 30, 2008, there was $577,000 of total unrecognized compensation cost related to restricted stock. That cost is expected to be recognized over a weighted average period of 4.9 years. The total compensation expense related to shares vested during the six months ended June 30, 2008 was $9,000. All restricted stock units were granted to a non-employee.

     Employee Stock Purchase Plan — In July 2001, the Company adopted an Employee Stock Purchase Plan, or 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 six months ended June 30, 2008, the Purchase Plan compensation expense was $257,000.

     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 June 30, 2008, 682,000 shares have been repurchased at the average price of $6.06 under this program and $5.9 million remained available for repurchase.

     The stock repurchase activity under the stock repurchase program approved in October 2007 for the six months ended June 30, 2008 is summarized as follows (in thousands, except per share amounts):

						Weighted-Average
Six Months Ended June 30, 2008		Shares Repurchased				Price per Share				Amount Repurchased
Cumulative balance, January 1, 2008			201			$	7.57			$	1,523
Repurchase of common stock			481				5.43				2,611
Cumulative balance, June 30, 2008			682				6.06			$	4,134

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 due to the termination of 25 employees and $121,000 related to professional and other fees. The following table summarizes the activities and changes of these restructuring liabilities (in thousands):

Restructuring		Severance				Professional and Others Fees
Balance at January 1, 2008		$	—			$	—
Restructuring charges			1,350				121
Payments			(1,018	)			(101	)
Balance at June 30, 2008		$	332			$	20

     The remaining accrual for severance and professional fees is expected to be paid out in the third fiscal quarter of 2008. At June 30, 2008, $352,000 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 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								Six Months
		Ended June 30,								Ended June 30,
Customer		2008				2007				2008				2007
A			17	%			19	%			17	%			17	%
B			14	%			15	%			15	%			16	%
C			11	%			—				6	%			—
D			2	%			11	%			2	%			9	%

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

Customer		June 30, 2008				December 31, 2007
A			29	%			27	%
B			14	%			15	%
E			10	%			11	%

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

		Three Months								Six Months
		Ended June 30,								Ended June 30,
		2008				2007				2008				2007
Asia		$	12,135			$	11,998			$	22,534			$	24,028
United States			5,156				8,234				10,764				15,709
Europe			3,823				3,466				8,163				6,103
Total		$	21,114			$	23,698			$	41,461			$	45,840

     As of June 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 $532,000 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 June 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		$	2,323			$	2,323			$	—			$	—
Commercial paper			16,207				—				16,207				—
Agency obligations			2,461				—				2,461				—
Auction-rate securities			1,262				—				—				1,262
Corporate securities			400				—				400				—
Total		$	22,653			$	2,323			$	19,068			$	1,262

     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 June 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 $100,000 in ARS at par by one issuer. As a result of these auction failures, there was no active market with observable prices for these securities as of June 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 principal of the assets (student loans) backing these securities 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 six months ended June 30, 2008 (in thousands):

		Available-For-Sale
		Securities
Beginning balance, January 1, 2008		$	—
Total gains and losses (realized / unrealized):
Included in earnings			—
Included in other comprehensive income, before income tax effects			(138	)
Purchases, issuances, and settlements			(100	)
Transfers, in and/or (out) of Level 3			1,500
Ending balance, June 30, 2008		$	1,262
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 June 30, 2008		$	—

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,” “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 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 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 June 30, 2008 were as follows:

	•		Total revenue for the three months ended June 30, 2008 was $21.1 million, a decrease of $2.6 million, or 11% compared to the three months ended June 30, 2007. Revenue from Design-to-Silicon-Yield solutions for the three months ended June 30, 2008 decreased $2.4 million to $15.5 million compared to $17.8 million for the three months ended June 30, 2007. Revenue from gainshare performance incentives for the three months ended June 30, 2008 decreased $228,000 to $5.7 million from the three months ended June 30, 2007.
	•		Net loss for the three months ended June 30, 2008 was $1.9 million, increased $1.2 million compared to $701,000 for the three months ended June 30, 2007. The increase in net loss was primarily attributable to the decrease in revenue and to the expense associated with the restructuring plan, partially offset by an increase in income tax benefit.
	•		Net loss per basic and diluted share was $0.07 for the three months ended June 30, 2008 compared to $0.02 for the three months ended June 30, 2007, an increase in net loss of $0.05 per basic and diluted share.

     Financial highlights for the six months ended June 30, 2008 were as follows:

	•		Total revenue for the six months ended June 30, 2008 was $41.5 million, a decrease of $4.4 million, or 10% compared to the six months ended June 30, 2007. Revenue from Design-to-Silicon-Yield solutions for the six months ended June 30, 2008 decreased $4.6 million to $30.5 million compared to $35.1 million for the six months ended June 30, 2007. Revenue from gainshare performance incentives for the six months ended June 30, 2008 increased $202,000 to $11.0 million from the six months ended June 30, 2007.
	•		Net loss for the six months ended June 30, 2008 was $4.5 million, increased $1.4 million compared to $3.1 million for the six months ended June 30, 2007. The increase in net loss was primarily attributable to the decrease in revenue and to the expense associated with the restructuring plan, partially offset by an increase in income tax benefit.
	•		Net loss per basic and diluted share was $0.16 for the six months ended June 30, 2008 compared to $0.11 for the six months ended June 30, 2007, an increase in net loss of $0.05 per basic and diluted share.

•

Cash, cash equivalents and investments decreased $807,000 to $44.5 million during the six months ended June 30, 2008, primarily due to the repurchase of $2.6 million of our common stock and payment for restructuring charges of $1.2 million.

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 condensed consolidated financial statements. The following is a brief discussion of the more 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 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 is 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 June 30, 2008, we had $67.3 million of goodwill and $11.2 million of intangible assets. When valuing our goodwill and intangible assets, we must 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 six months ended June 30, 2008, we had a significant decline in trading price of our common stock; should further decline in the price of our common stock occur, 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 three 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 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 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. 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, 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 of “Notes to Condensed Consolidated Financial Statements (Unaudited)” of this 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								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
Revenues:
Design-to-silicon-yield solutions			73	%			75	%			74	%			76	%
Gainshare performance incentives			27				25				26				24
Total revenues			100	%			100	%			100	%			100	%
Cost of design-to-silicon-yield solutions:
Direct cost of design-to-silicon-yield solutions			34				30				36				32
Amortization of acquired technology			3				7				3				7
Total cost of design-to-silicon-yield solutions			37				37				39				39
Gross margin			63				63				61				61
Operating expenses:
Research and development			43				37				44				38
Selling, general and administrative			27				28				29				28
Amortization of other acquired intangible assets			1				4				1				4
Restructuring charges			7				—				4				—
Total operating expenses			78				69				78				70
Loss from operations			(15	)			(6	)			(17	)			(9	)
Interest and other income, net			1				2				2				2
Loss before taxes			(14	)			(4	)			(15	)			(7	)
Income tax provision (benefit)			(5	)			(1	)			(4	)			—
Net loss			(9	)%			(3	)%			(11	)%			(7	)%

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

																		Three Months Ended June 30,
																		2008				2007
		Three Months Ended June 30,								$				%				% of				% of
Revenue		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Design-to-silicon-yield solutions		$	15,452			$	17,808			$	(2,356	)			(13	)%			73	%			75	%
Gainshare performance incentives			5,662				5,890				(228	)			(4	)%			27	%			25	%
Total		$	21,114			$	23,698			$	(2,584	)			(11	)%			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. The decrease in Design-to-Silicon-Yield solutions revenue of $2.4 million for the three months ended June 30, 2008 compared to the three months ended June 30, 2007 was primarily due to a decrease of $3.8 million in software licenses and associated consulting services revenue, partially offset by an increase of $958,000 in revenue related to fixed fee integrated solutions and an increase of $431,000 in revenues related to software support and maintenance. 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 $228,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007, primarily due to fluctuations in customers wafer volumes in relation to our performance targets at our customers’ sites. The revenues from gainshare performance incentives were generated from six customers and nine engagements for both the three months ended June 30, 2008 and 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 June 30,
																		2008				2007
		Three Months Ended June 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		$	7,267			$	7,109			$	158				2	%			34	%			30	%
Amortization of acquired technology			631				1,610				(979	)			(61	)%			3	%			7	%
Total		$	7,898			$	8,719			$	(821	)			(9	)%			37	%			37	%

     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 moderately increased $158,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007. 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 $979,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007. The decrease in amortization of acquired technology was primarily due to certain intangible assets becoming fully amortized, which resulted in a decrease of $1.2 million in related expense. This decrease was partially offset by an increase of $214,000 in amortization of technology acquired as a result of our acquisition of Fabbrix in May 2007. We anticipate amortization of acquired technology to be $1.3 million for the remaining six 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 June 30,
																		2008				2007
		Three Months Ended June 30,								$				%				% of				% of
Research and Development		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Research and development		$	9,134			$	8,797			$	337				4	%			43	%			37	%

     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 increased $337,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007. The increase in research and development expenses was primarily due to increased expenses of $266,000 associated with our China subsidiary as we continue to expand our resources in lower cost regions and increased personnel expenses of $169,000 as a result of a full quarter compared to a partial quarter of expenses from our Fabbrix acquisition in May 2007. The increase was partially offset by a decrease of $280,000 in third-party developer costs. 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 as a result of the size and the timing of product development projects.

																		Three Months Ended June 30,
																		2008				2007
		Three Months Ended June 30,								$				%				% of				% of
Selling, General and Administrative		2008				2007				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Selling, general and administrative		$	5,646			$	6,645			$	(999	)			(15	)%			27	%			28	%