Summary of PDF SOLUTIONS INC

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.

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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.

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• 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

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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.

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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 )%

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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
. . .