PDF Solutions, Inc.

Now, I'd like to introduce John Kibarian, PDF's President and Chief Executive Officer; and Greg Walker, PDF's Chief Financial Officer. Mr.

Kibarian, please go ahead.

Thank you, and welcome, everyone. In the third quarter of 2012, PDF Solutions achieved revenue of $22.6 million and a GAAP profit of $0.17 per share.

On a non-GAAP basis, we achieved profit of $0.21 per share.

During this call, we are going to review our business in the third quarter both in terms of booking and revenues, in particular, gainshare revenues. After we talk about this past quarter, we will discuss the implications for our Q4 ,as well as our first thoughts about 2013.

a 28-nanometer DFM engagement for a U.S. fabless company; a 28-nanometer DFM engagement for a Japanese IDM that is starting to use foundries; another 28-nanometer DFM engagement for a second Japanese IDM that is also starting to use foundries; and an extension to an existing 28-nanometer DFM engagement for a U.S.

fabless company.

As this past quarter demonstrates, fabless companies are increasingly seeing the value in PDF's electrical characterization solutions as they design chips, ramp manufacturing and control production. In the case of the 4 contracts closed this quarter, these customers have all completed designs.

They are using PDF Solutions to accelerate the yield ramp of those designs. The 3 new accounts are relying on our new CV test chips, which are enabled by our next-generation SaaS tester, the F series.

This tester provides 2x to 5x the performance of our previous generation, and also enables new measurements, which are critical for parametric yield characterization.

One of these customers is using one of our new products, what we call a direct probe characterization vehicle to directly probe transistors and their complex designs, isolating discrepancies between the design kits provided by the foundries and actual performance of transistors in their products across multiple foundry suppliers. These new contracts advance PDF's solutions business with fabless customers, more in one quarter than any of our previous quarters.

Our business with fabless companies is strategic for our foundry customers as well. PDF Solutions work to characterize all of the leading-edge foundries, as well as many of the high volume designs, means we can be a critical link that makes it possible for all of our customers to behave like virtual IDMs.

This is particularly important for those foundries and fablesses serving the mobile computing market as they are facing strong potential competition from a large IDM who have the benefit of customizing both process technology and their IC designs.

Looking at revenues for the quarter as compared to last quarter, we experienced a mix shift from gainshare to fixed fee revenues. Gainshare revenues, while up significantly over last year's level, were below the second quarter levels, reflecting a transition for some of our customers from older process nodes to newer process nodes at 32-nanometer and 28-nanometer.

As customers manage inventory through this transition, overall volumes were reduced. As an example of this transition, this was our first quarter to see gainshare revenues at the 28-nanometer node for 1 customer.

That particular customer's volume on the previous node came down, both in part to ramp the 28-nanometer volume, and also due to reduced demand from their end customer serving the computing segment. We anticipate that our large customers will be ramping 32-nanometer and 28-nanometer over the next couple of quarters.

As we have stated in the past, we believe that in a year-over-year basis, gainshare will tend to increase. However, in any given quarter we may experience volatility as our customers react to market conditions and technology transitions.

In summary, we were excited to see 28-nanometer gainshare revenues start to ramp up, and while our gainshare decreased due to end demand and product transitions, our overall revenue and profitability remain comparable to Q2 due to increased demand for our solutions.

Moving from revenues to how we spend money, the company has and will continue to look for ways to optimize our business and improve our productivity.

I would like to put some perspective on this. During the last downturn, we made significant number of the structural changes to our business and implemented many short-term cost savings programs.

Entering the downturn, our operating cost, including cost of sales, were about $22 million per quarter on a non-GAAP basis. At the bottom of the downturn, we reduced those total operating costs to around $30 million per quarter.

At that time, we stated that the vast majority of these spending reductions are above 80% of the $9 million delta, were the result of structural changes from the company. Today, we are spending approximately $15.9 million per quarter on a non-GAAP basis.

As a result of the restructuring efforts that we began in early October, we expect to save about $600,000 per quarter of operating cost. We are planning on implementing these changes over the next few quarters.

Our intent is to reinvest a portion of those savings in other areas of our business and to utilize the remaining amounts to improve our operating leverage. Our continuing goal is to have a cost structure that is very consistent with our spending at the bottom of the downturn.

The majority of our remaining difference between today's spending rates and the $13 million per quarter level are related to variable compensation and other short-term variable expenses.

This has 3 implications for our business. First, we believe that we continue to have a cost structure that is able to support revenues greater than our present level without adding significant additional fixed cost; second, by reviewing our operation with an eye to maximizing productivity and efficiency, we are able to invest in new areas and technologies critical to the long-term future of our business; and third, in the event there will be another downturn like 2008 and 2009, we could quickly return to those spending levels without having to do the kinds of major restructuring we did during that time period.

Overall, we are focused on improving our investments, flexibility and profitability. Now, so that we may address both the highs and lows of the industry cycles more effectively.

Finally, as we do not provide quantitative guidance, we will not talk spending about our projected results for the near future. However, we can provide our perspective on the overall industry for Q4 in 2013.

We do see the rapid adoption of leading-edge silicon by the fabless community continuing and the competition within the foundry market increasing. The driver of leading-edge silicon is a demand for mobile computing chips while product supporting personal computers and consumer products are languishing.

What this means for us in Q4 and our expectations for 2013 is increased demand for characterization solutions in the leading-edge. In 2013, that will increasingly mean customer supply in PDF's technology to STM sets, an area where our electrical characterization vehicle infrastructure is very critical.

Second, we believe fabless customers who want to take advantage of the benefits of advanced nodes like 28-nanometer, 20-nanometer and STM sets will need to act as virtual IDMs, requiring strong characterization to design, ramp and control advanced chips.

Finally, from a gainshare perspective. We expect the transition to 32-nanometer and 28-nanometer to proceed over the next couple of quarters.

This means while there can be wafer volume volatility in the short term, over the long-term we would expect increases in wafer volumes.

In summary, as electrical characterization becomes essential to ramping new products and processes, we continue to see strong interest from the fabs and logic designers for our characterization vehicle technology. This bodes well for PDF Solution's future.

However, we are mindful about the cyclical nature of the chip industry. So while we see continued opportunities to both grow our solutions and gainshare revenue, we will be cautious as we make investments to disproportionately grow earnings with the increased revenue.

Thank you for your time and attention. Now I will turn the call over to Greg who will discuss in detail our financial results for the third quarter.

Greg?

Thanks, John. As a reminder to everyone, in addition to using GAAP results when evaluating PDF's business, we believe it is also useful to consider our results using non-GAAP measures.

In this case, non-GAAP measures exclude stock-based compensation expenses, amortization of expenses related to acquired technology and other intangible assets, restructuring charges and their-related tax effects as applicable. You can access the earnings press release that contains a reconciliation of non-GAAP to GAAP results in the Investors section of our website located at pdf.com.

Now let's turn to a review of the financial results. First, let me cover some of the highlights of the quarter, many of which you heard from John.

Total revenues were $22.6 million with a GAAP net income of $5 million. This resulted in an EPS of $0.17 per share for both basic and fully diluted shares.

Net income on a non-GAAP basis totaled $6.3 million or $0.21 per diluted share. Cash increased by $756,000 during the quarter.

Cost to sales and operating expenses together were $17.2 million dollars on a GAAP basis and $15.9 million on a non-GAAP basis, an increase of $415,000 from the last quarter.

Overall, we are very pleased with the continuing strength in our revenues, earnings and cash generation for the quarter.

Moving on to revenues. Total revenues of $22.6 million for the third quarter were up slightly as compared to $22.5 million in the prior quarter.

Total revenues were comprised of design-to-silicon-yield solutions or solutions revenue of $15.3 million, and gainshare performance incentives or gainshare revenue were $7.3 million.

Solutions revenue for the quarter increased by $1.5 million or 11% sequentially, while gainshare revenue decreased by $1.5 million or 17% sequentially. Our gainshare revenue for the quarter as a percentage of total revenues decreased from 39% to 32% in this quarter.

As John has indicated, the reductions in gainshare revenue were related to product transitions to new 32-nanometer and 28-nanometer processes at some of our key customers.

The total number of customers contributing to gainshare revenue in the quarter was 8, the same number as in the previous quarter.

During the quarter, we added the 4 DFM engagements that John has discussed and 2 extensions to existing solutions contracts at existing customers.

In the quarter, 15 engagements with a total of 10 different customers each contributed at least $150,000 of our solutions revenue. Our top 10 customers on a consolidated basis represented 90% of the total revenues in the quarter.

3 of these customers contributed revenues greater than 10% each for a total of 71% of revenue the same percentage as in the prior quarter.

On a geographic basis, North America accounted for 48% of total revenues, Europe represented 29% and Asia accounted for the remaining 23% of total revenues.

Looking at expenses. Cost of sales was $9.5 million on a GAAP basis, an increase of $552,000 as compared to the prior quarter.

This increase was primarily related to the full quarter impact of new hires added in Q2, in combination with customer-related travel expenses and other miscellaneous personnel cost.

The third quarter GAAP gross margin decreased to approximately 58% compared to 60% last quarter. Non-GAAP gross margin was 60% for the quarter compared to 63% last quarter.

These quarter-to-quarter reductions in gross margin are principally driven by the mix shift in revenues during the quarter from gainshare to solutions revenue.

Our total GAAP operating expenses were $7.8 million for the quarter or approximately 34% of total revenues as compared to $8.2 million or 36% of total revenues in the prior quarter. R&D expenses totaled $33.2 million or 14% of revenues for the quarter as compared to $3.3 million in the prior quarter.

SG&A expenses totaled $4.6 million or 20% of total revenues compared to $4.8 million or 21% in the prior quarter.

Looking at total operating expenses and cost of sales together, non-GAAP spending for the quarter was $15.9 million versus $15.5 million in the prior quarter. This difference in spending primarily reflects the impact of one-time cost savings of $500,000 recognized in the prior quarter and discussed at last quarter's earnings call.

Due to the effect of unfavorable foreign currency fluctuations, partially offset by an unrealized gain on auction rate securities, other income and expense was an expense of $178,000 compared to $154,000 of income in the previous quarter. Our last remaining auction rate security was sold and the gain realized during the current month.

The income tax provision decreased quarter-to-quarter by approximately $637,000 to a total of $170,000, primarily due to a refund of previously withheld foreign taxes, approximately $500,000 worth. Total cash for the quarter was $50.9 million, an increase of $756,000 over the prior year quarter, primarily driven by employee stock option exercises, partially offset by investing and financing activities.

During the quarter, the company repurchased approximately 162,000 common shares for $1.9 million.

DSO for the quarter, including unbilled receivables, was 138 days compared to 109 days in the prior quarter. Of the total accounts receivable of $34.2 million, 21% was more than 30 days past due at the end of the quarter.

However, the majority of this past due amount has been collected as of today. Accounts receivable was 102 days as compared to 76 days in the prior quarter.

Headcount at the end of Q3 was 353 employees worldwide compared to 335 at the end of Q2. The majority of this growth in headquarter was in our China subsidiary.

In conclusion, the overall financial results for the quarter continued to be strong despite lower gainshare revenues. The company has continued to effectively manage its spending, while at the same time, maintaining revenues and strengthening the balance sheet.

As John stated earlier, we are continuing to make organizational changes within the company to improve ongoing productivity, efficiency and operating leverage. As stated on our last call, the financial performance of the company will continue to be impacted by the volatility in gainshare revenues on a short-term basis.

This concludes the review of our financial results for the quarter. Now I will turn the call over to the operator for Q&A.

John, I just -- I wonder if you can talk a little bit more about these DFM engagement with the fabless guys and specifically kind of over the medium-term, how those engagements will affect revenue and at what points they affect gainshare? Just any guidance you can kind give us about how to look at those would be helpful.

Sure, Steve, yes, so I think those -- the direct way they affect revenue, these contracts are all for dollar amounts. They generally have a fixed fee portion.

We started these with they were all just purely fixed fee and helping us characterize the foundries and drive volumes, particularly to the foundries that are important yield ramp customers of ours, primarily the ISDA ones, although we were running -- we have been running fabless engagements across all -- primarily all the foundries, major leading-edge foundries out there. More recently, as we've started to put our scribe line solutions for these fabless customers who really want to understand that bring up and we hope eventually to control the processes, we started to put in place a mechanism where they pay us on a per wafer basis.

Some of that is optional at their point, and we're starting to move that more and more towards what looks like a wafer fee. And we're early in that.

This is our first quarter where we started signing some contracts like that. We need to see how they play out.

Our primary goal is to help those customers in particular get to the factories that will drive our base gainshare anyway, and overall, help us get a better footprint in the entire foundries/fabless interface. But we have an eye towards and in fact that next-generation test, which is why I made a comment to it, and the next generation scribes and test vehicles were all geared towards how could we help fabless companies get better control over the parametric variability that's going on in these advanced nodes and the impact they have on their product, their power consumption et cetera.

Okay. That's helpful.

And then obviously, you guys don't want to give forward guidance, but you are willing to make some comments regarding the outlook. And John, one of the comments that you made about future gainshare, I just want to make sure that I heard correctly.

Did you say that you expect future gainshare to be up on a year-over-year basis?

As we said -- I think what we said is we expect volumes to be up year-over-year and that would be contributing to gainshare. We need to see what the revenues look like and how our royalty amounts work out but generally speaking, you can think of who our customers are and their leading-edge volumes are going to be going up.

So it's safe to say their volumes in terms of the wafers that we get paid wafer fees on will be going up, and we want to make sure the prices and the royalty amounts are strong for us.

Okay. And that's over in the indefinite future period, or are you specifically talking just about the next quarter?

We're looking at over the next year. So over the next -- as I said on our comments, over the next quarter, it's a little bit bumpy because you're getting that transition, 32s coming in, 28s coming in, companies, our customers managing their volume mixes et cetera, the revenue they generate per wafer and some of the leading edge sometimes is lower as they are on a good die price as they come up the yield curves.

So we're watching those transitions pretty closely. We expect that to happen over the next couple of quarters and then as you look kind of year-over-year basis, we should see volumes generally up.

Okay, that's helpful. Obviously, the growing gainshare on a revenue basis year-over-year in the fourth quarter is in a very tough bar, but it becomes obviously a more significant bar in the first quarter and the second quarter of 2013 so...

That's right.

John, you talk about the fabless and then the comments on the virtual IDMs. When you look out to 2013 based on the deals you signed this quarter and the way it seems to be moving into new products.

Is it your expectation that we should start to see wafer fees from certain fabless customers or historical IDMs acting as fabless?

It's our expectation that we'll start seeing some of that as we get into 2013. I mean, the dollar amounts we don't know that were going to be very big early on and we don't know the sustainability of that.

It's too early, but at least we have people signed up to contracts that pay on a per wafer basis, which is a step forward for us.

And secondly, just getting back to the impact of the transition in your existing gainshare base for 32 nanometers and 28 nanometers, can you disclose in the aggregate what that transition impact had from Q2 to Q3?

I think, overall, the gainshare was down $1.5 million quarter-over-quarter. The 28-nanometer gainshare that started contributing was a relatively small amount, under $1 million.

So there is basically a decrease in some of the more mature nodes and a smaller increase on the 28 node. We expect that one to continue growing, and we expect actually some sale and growth in -- substantial growth in the 32 node, as well as some recovery on some of the other nodes as we get out into next year.

So add to those volumes take up because -- we can think of a specific example, one of our largest customers servicing obviously a very large customer there that was ramping some new products on a new processor at a more advanced node, historically, when you look at it, if you sort of talked within a specific customer, as the customer transitions let's say from a 45-nanometer wafer to a 28-nanometer wafer, our understanding is with the pricing on the 28-nanometer wafer is it's substantially higher. And as a result, our gainshare typically sort of tracks that.

Can you quantify that again at sort of in the aggregate to what you're seeing?

Yes, so I think it kind of breaks into a couple of categories. If our customer is second sourcing apart, then generally speaking, if they're late, they're going to be selling a good die.

In other words, in respect to what their initial yields are, they're going to sell die at a price that's competitive with where that fabless company is getting it from alternatively. At that point that wafer revenue will be less than what we would expect.

As it matures, that revenue would go up. For customers that are primary sourcing wafers for their leading-edge customers, probably, a 28-nanometer wafer is at a 40% to 50% premium to a 45-nanometer wafer at this point.

I guess, first couple of question on the gainshare. You talked a bit about the transition, you're bringing down some of the mature, but are you also seeing just a little bit of seasonality in the mature business where just the overall macroenvironment's creating a little bit slower demand for the mature chips at this point?

We think some of that -- that was some of the factor.

And do you see that as being seasonal where through the fourth quarter it's slow and then picks up again in the new year typically?

Typically, when we built our kind of model for volume growth in 2013 on the wafers, we assumed it wasn't seasonal. So we kind of took a guess in that case as to why we did that analysis.

But historically, it has been that way, yes.

Okay. And then you just talked a bit about the 28-nanometer, those wafers starting in the 40% to 50% premium.

Because the 28-nanometer is going to be such a large wafer volume node, is your pricing going to be offset a bit by volume discounts as well though?

Not particularly. And by the way, as the volumes come up, right, some of those prices are going to come down.

We do believe as you get to the second half of 2013, the foundry market at 28-nanometer is going to be very competitive. Just so I lost direction but I can put a little target to what I said to Andrew there, right?

We think the community has underestimated some of the company's capability at the 32, 28 node, in particular one of the foundries that we worked with pretty closely, and we think they're coming up very strong. And as a result, we do believe pricing is going to be more competitive and people may think, especially as you get in the second half of 2013.

And when we looked at our model we put in some pressure there, but our price per wafer is pretty invariant to the number of units they ship.

Okay. Well, this looks like that volumes are coming up pretty strong and units are pretty strong that would lead at least you guys to a pretty nice ramp in gainshare at least in the first half of the year then, it sounds like.

We expect to see a decent ramp as we go through 2013, yes.

Okay. And then the 28-nanometer business you had to date, did you say that was PC-related as opposed to the more broad-based foundries?

No [indiscernible].

Okay, all right. Okay, and then on the DFM projects you're working on right now, is it a different set of data that you're going to essentially give the fabless guys versus what you already give the foundries?

Yes, that's a really good question, Tom. It is because we have a series of tools and systems that analyze their IP and their designs, and identify patterns that are unique, structures that are different.

And we have incredible efficiency in terms of the amount that we can fit in the area of a scribe or on our MPW wafer. So we can give them a substantial amount of data around the specific structures they try to -- their products are very sensitive to.

The direct probe CV does the same thing, but within the actual product chip. And so all these are around ways of them understanding how their designs and their IP behave in the foundries process technology.

Okay. All right so It sounds like you...

The foundries are generally bringing up the general core technology, right, applicable to everybody, but the reality is you use a specific transistor or you use a different device at a different price, it makes a difference, especially in these geometries.

Okay, so it sounds like you could get an additional royalty stream from the foundries you're already using, and then maybe even get a royalty stream from the customers that are using foundries that you're not working with then, sounds like.

That would be a goal of this activity, one of the goals of this activity. [indiscernible] and it takes a long time [indiscernible] But at PDF we've been around for a long time, it's not like it's an overnight thing, all right?

[indiscernible].

We're all looking forward to a big ramp of the 28-nanometer next year, so it's nice to have secure revenue streams to look forward to as well.

Exactly. [indiscernible] really about the core businesses, gainshare going up in the core business, primarily on the back of 32 and 28.

This stuff is all stuff that we're laying the groundwork for this year. We want to see it help and improve our business in the future years, but we've been at this game for a long time.

We know how long it takes to make a good business model work in this market. And we'll be patient like we always are.

Yes. All right, that sounds good.

And then on the model itself. Greg, when you look at the COGS versus operating expenses, is that essentially just many people moving back and forth between those 2 lines?

Actually, no. We have that fairly stable right now as we've gone through as part of our financial structuring, we have paid a lot of attention to making sure we have everybody in the lines in which they're doing the majority of their work.

So we don't see too much shift in that, but we do see some changes particularly in the cost of sales area as different projects ramp up or ramp down or the amount of analysis that is baked into any particular deal increases. So we've seen a lot of growth as we said in the China organization, which rolls into the cost of sales primarily, but as I've said a much lower price per head as you're aware.

So we gain a lot of leverage out of that business. So the headcount rate is increasing much more rapidly than the total cost.

Okay, all right. And then you mentioned that you're in a pretty good shape right now where you can keep the fixed cost relatively stable as revenues ramp up next year because of the gainshare, but what is the variable cost of both the kind of the gainshare, which I assume is very little, as well as the design-to-silicon side of your business?

So when you look at the gainshare, you're right. That starts to approach 100% gross margin.

There's some minor cost every now and then contract per contract, but in general, it's a very high gross margin. So as we ramp gainshare faster than the design-to-silicon solutions, you'll see an improvement in the overall margin and we got a lot of leverage on that.

So that doesn't require any tremendous amount of fixed cost adjusting. On the design-to-silicon solutions where those are fixed fee project, as we stated before, that growth had a much slower rate, something approximating the overall industry growth rates in general.

And what we see there is as new projects come on board for advanced technologies, we start to see roll-offs on the fixed fee portion of the old contracts as they move from fixed fee into gainshare state. So while we'll see some slow growth in that area, we'll see some slow growth in cost of sales as that happens, but it will not be the major driver of the margin leverage, it's really the gainshare that's [indiscernible].

Okay. All right, that sounds good.

And then just finally on the other interest. Did you say there was an FX impact there and you had the biggest?

Yes, we've got an intercompany payable denominated in euros that as the euro strengthened through the quarter compared to our prior valuation, we took a fairly substantial loss on that. We were able to offset some of that, however, with the gain on the auction rate security.

Okay. In general, do you think that line is just a slight positive going forward just based on your cash level?

Well, we model it at either a slight positive or a slight negative, and we're trying to take some steps to limit the exposure to that intercompany item between the U.S. and the euro.

But it's really hard to project. So, yes, as I said, we project it fairly close to 0 in any given quarter.

And then it just comes in where it comes in. We're fortunate this quarter that we had -- while we had the loss on the euro, we had the gain on the refund of some withholding taxes that flowed through the tax rate, so as a result net-net, it didn't have all that much of an impact on us.

But something that we watch, but there's not much we can do about it at this point in time.

Okay. Thanks, everyone.

We'll see you next quarter. Bye.