PDF Solutions (PDFS) 10-Q 2008 Q2 Quarterly report

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

or

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

For the transition period from                    to                    

Commission File Number 000-31311

PDF SOLUTIONS, INC.

(Exact name of Registrant as Specified in its Charter)

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

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

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ   Noo

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 filero Accelerated filerþ Non-accelerated filero
(Do not check if a smaller reporting company) Smaller reporting companyo

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

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

2

Item 1. Financial Statements.

PDF SOLUTIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

	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

3

PDF SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

	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

4

PDF SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

	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

5

PDF SOLUTIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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 Contractsand 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.

6

     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.

7

     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

8

     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.

9

     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

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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.

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     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.

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     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	%

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     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

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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.

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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 Contractsand 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
	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.

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										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	%

     Selling, General and Administrative. Selling, general and administrative expenses consist primarily of compensation and benefits for sales, marketing and general and administrative personnel in addition to outside sales commissions, legal and accounting services, marketing communications, travel and facilities cost allocations, and stock-based compensation charges. The selling, general and administrative expenses decreased $999,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007, primarily due to a decrease of $421,000 in outside commissions as a result of reduced reliance on third-party distributors, a decrease of $270,000 in travel expense as a result of our cost control initiatives, and a decrease of $210,000 in legal fees as a result of a reimbursement of $500,000 in legal expenses in settlement of an intellectual property case. We anticipate our selling, general and administrative expenses will fluctuate in absolute dollars from period to period as a result of cost control initiatives and to support increased selling efforts in the future.

											Three Months Ended June 30,
											2008			2007
	Three Months Ended June 30,				$			%			% of			% of
Amortization of Other Acquired Intangible Assets	2008		2007		Change			Change			Revenue			Revenue
(In thousands, except for %’s)
Amortization of other acquired intangible assets	$	195	$	1,031	$	(836	)		(81	)%		1	%		4	%

     Amortization of Other Acquired Intangible Assets. Amortization of other acquired intangible assets consists of amortization of intangibles acquired as a result of certain business combinations. Amortization of other acquired intangible assets for the three months ended June 30, 2008 decreased $836,000 compared to the three months ended June 30, 2007, primarily the result of certain intangible assets becoming fully amortized. We anticipate amortization of other acquired intangible assets to be $391,000 in the remaining six months in 2008, $782,000 in 2009, $716,000 in 2010, $575,000 in 2011, and $796,000 in 2012 and thereafter.

									Three Months Ended June 30,
									2008			2007
	Three Months Ended June 30,				$		%		% of			% of
Restructuring Charges	2008		2007		Change		Change		Revenue			Revenue
(In thousands, except for %’s)
Restructuring charges	$	1,471	$	—	$	1,471		N/A		7	%		—	%

     Restructuring Charges. Restructuring charges of $1.5 million during the three months ended June 30, 2008 were related to expenses incurred as the result of the restructuring plan we announced on April 29, 2008, and consisted of employee severance costs of $1.4 million and professional and other fees of $121,000.

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											Three Months Ended June 30,
											2008			2007
	Three Months Ended June 30,				$			%			% of			% of
Interest and Other Income, net	2008		2007		Change			Change			Revenue			Revenue
(In thousands, except for %’s)
Interest and other income, net	$	251	$	529	$	(278	)		(53	)%		1	%		2	%

     Interest and Other Income, net. The decrease in interest and other income, net of $278,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007 was primarily due to a decrease in interest income of $373,000 from lower average cash and cash equivalent and investments balances coupled with lower interest rates. We anticipate interest and other income will fluctuate in future periods as a result of our projected use of cash.

													Three Months Ended June 30,
													2008			2007
	Three Months Ended June 30,						$			%			% of			% of
Income Tax Benefit	2008			2007			Change			Change			Revenue			Revenue
(In thousands, except for %’s)
Income tax benefit	$	(1,039	)	$	(264	)	$	(775	)		294	%		(5	)%		(1	)%

     Income Tax Benefit.The income tax benefit increased $775,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007, primarily as a result of the increased loss before taxes, and the recording of a $205,000 tax benefit related to the reversal of a previously recorded tax reserve following the successful conclusion of a tax audit in Germany during the three months ended June 30, 2008.

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

											Six Months Ended June 30,
											2008			2007
	Six Months Ended June 30,				$			%			% of			% of
Revenue	2008		2007		Change			Change			Revenue			Revenue
(In thousands, except for %’s)
Design-to-silicon-yield solutions	$	30,476	$	35,057	$	(4,581	)		(13	)%		74	%		76	%
Gainshare performance incentives		10,985		10,783		202			2	%		26	%		24	%
Total	$	41,461	$	45,840	$	(4,379	)		(10	)%		100	%		100	%

     Design-to-Silicon-Yield Solutions. The decrease in Design-to-Silicon-Yield solutions revenue of $4.6 million for the six months ended June 30, 2008 compared to the six months ended June 30, 2007 was primarily due to decreases of $6.7 million in software licenses and associated consulting services revenue, partially offset by an increase of $967,000 in revenue related to fixed fee integrated solutions and an increase of $884,000 in revenue related to software support and maintenance.

     Gainshare Performance Incentives. Revenue derived from gainshare performance incentives increased $202,000 for the six months ended June 30, 2008 compared to the six months ended June 30, 2007, primarily due to fluctuations in customers wafer volumes in relation to our performance targets at our customers’ sites. Revenue derived from gainshare performance incentives was generated from seven customers and eleven engagements for the six months ended June 30, 2008, and seven customers and ten engagements for the six months ended June 30, 2007.

											Six Months Ended June 30,
											2008			2007
	Six 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	$	15,033	$	14,876	$	157			1	%		36	%		32	%
Amortization of acquired technology		1,262		3,185		(1,923	)		(60	)%		3	%		7	%
Total	$	16,295	$	18,061	$	(1,766	)		(10	)%		39	%		39	%

     Costs of Design-to-Silicon-Yield Solutions.

     Direct Costs of Design-to-Silicon-Yield Solutions.The direct costs of Design-to-Silicon-Yield solutions increased slightly by $157,000 for the six months ended June 30, 2008 compared to the six months ended June 30, 2007.

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     Amortization of Acquired Technology. Amortization of acquired technology expense decreased $1.9 million for the six months ended June 30, 2008 compared to the six 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 $2.5 million. This decrease was partially offset by an increase of $537,000 in amortization of technology acquired as a result of our acquisition of Fabbrix in May 2007.

										Six Months Ended June 30,
										2008			2007
	Six Months Ended June 30,				$		%			% of			% of
Research and Development	2008		2007		Change		Change			Revenue			Revenue
(In thousands, except for %’s)
Research and development	$	18,210	$	17,167	$	1,043		6	%		44	%		38	%

     Research and Development.Research and development expenses increased $1.0 million for the six months ended June 30, 2008 compared to the six months ended June 30, 2007. The increase in research and development expenses was primarily due to increased expenses of $465,000 in our China subsidiary as we continue to expand our resources in lower cost regions and increased personnel expenses of $338,000 as a result of our Fabbrix acquisition in May 2007.

											Six Months Ended June 30,
											2008			2007
	Six 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	$	11,945	$	12,489	$	(544	)		(4	)%		29	%		28	%

     Selling, General and Administrative. Selling, general and administrative expenses decreased $544,000 for the six months ended June 30, 2008 compared to the six months ended June 30, 2007. The decrease was primarily due to a decrease of $751,000 in outside commissions as a result of reduced reliance on third-party distributors and a decrease of $318,000 in travel expenses as a result of our cost control initiatives, partially offset by increased expenses of $501,000 in our France subsidiary due to increased operating costs as a result of unfavorable exchange rates fluctuations and an increase in headcount.

											Six Months Ended June 30,
											2008			2007
	Six Months Ended June 30,				$			%			% of			% of
Amortization of Other Acquired Intangible Assets	2008		2007		Change			Change			Revenue			Revenue
(In thousands, except for %’s)
Amortization of other acquired intangible assets	$	389	$	2,044	$	(1,655	)		(81	)%		1	%		4	%

     Amortization of Other Acquired Intangible Assets. Amortization of other acquired intangible assets for the six months ended June 30, 2008 decreased $1.7 million compared to the six months ended June 30, 2007, primarily the result of certain intangible assets becoming fully amortized.

									Six Months Ended June 30,
									2008			2007
	Six Months Ended June 30,				$		%		% of			% of
Restructuring Charges	2008		2007		Change		Change		Revenue			Revenue
(In thousands, except for %’s)
Restructuring charges	$	1,471	$	—	$	1,471		N/A		4	%		—	%

     Restructuring Charges. Restructuring charges of $1.5 million during the six months ended June 30, 2008 were related to expenses incurred as the result of the restructuring plan we announced on April 29, 2008, and consisted of employee severance costs of $1.4 million and professional and other fees of $121,000.

											Six Months Ended June 30,
											2008			2007
	Six Months Ended June 30,				$			%			% of			% of
Interest and Other Income, net	2008		2007		Change			Change			Revenue			Revenue
(In thousands, except for %’s)
Interest and other income, net	$	740	$	1,025	$	(285	)		(28	)%		2	%		2	%

     Interest and Other Income, net. The decrease in interest and other income, net of $285,000 for the six months ended June 30, 2008 compared to the six months ended June 30, 2007 was primarily due to a decrease in interest income of $641,000 from lower average cash and cash equivalent and investments balances coupled with lower interest rates, partially offset by an increase in foreign currency gains of $396,000.

23

												Six Months Ended June 30,
												2008			2007
	Six Months Ended June 30,					$			%			% of			% of
Income Tax Provision (Benefit)	2008			2007		Change			Change			Revenue			Revenue
(In thousands, except for %’s)
Income tax provision (benefit)	$	(1,656	)	$	160	$	(1,816	)		(1,135	)%		(4	)%		—	%

     Income Tax Provision (Benefit).The income tax benefit reflected a favorable increase of $1.8 million for the six months ended June 30, 2008 when compared to the income tax provision of $160,000 for the six months ended June 30, 2007, as a result of the increased loss before taxes, the recording of a $205,000 tax benefit related to previously recorded uncertain tax positions and accrued interest following the conclusion of a tax audit in Germany and a change in applicable effective tax rate.

Liquidity and Capital Resources

Operating Activities

     Cash flows from operating activities consist of net loss adjusted for certain non-cash items and changes in assets and liabilities. Net cash provided by operating activities was $1.3 million for the six months ended June 30, 2008 compared to $2.5 million for the six months ended June 30, 2007. The decrease in cash flows from operating activities of $1.2 million compared to the six months ended June 30, 2007 was primarily due to a greater net loss, decreased amortization of acquired intangible assets, decreased cash provided by changes in tax payable and deferred revenue, and partially offset by increased cash provided by change of accounts receivable. Amortization of acquired intangible assets decreased $3.6 million as a result of certain intangible assets becoming fully amortized.

     Taxes payable decreased slightly by $69,000 during the six months ended June 30, 2008 compared to an increase of $2.1 million during the six months ended June 30, 2007. The increase in taxes payable during the six months ended June 30, 2007 was due to the expected taxable income for that year and the increase in uncertain tax benefits related to tax credits earned during the period. Deferred revenue increased $367,000 during the six months ended June 30, 2008 compared to an increase of $1.5 million during the six months ended June 30, 2007. The increase in deferred revenue during the six months ended June 30, 2008 was primarily due to increased software support and maintenance contracts renewals. The increase in deferred revenue during the six months ended June 30, 2007 was primarily due to the billing of certain software contracts with undelivered obligations during the period, which were primarily recognized during the remainder of 2007, and increased billings of software support and maintenance contracts. Accounts receivable decreased $3.1 million during the six months ended June 30, 2008 and increased $4.7 million during the six months ended June 30, 2007. The changes in accounts receivable during the six months ended June 30, 2008 and 2007 were primarily due to the timing of billing milestones and payments received.

Investing Activities

     Cash flows from investing activities consist of proceeds from investment maturities and sales, offset by payments for investments acquired, payments for businesses acquired, and payments for capital expenditures. Net cash used in investing activities was $4.6 million for the six months ended June 30, 2008 compared to $4.8 million for the six months ended June 30, 2007. The decreased cash used in investing activities was primarily due to the payment of $1.9 million to the selling stockholders for the acquisition of Fabbrix made during the six months ended June 30, 2007 whereas there was no such payment during the six months ended June 30, 2008, lower capital expenditure of $772,000 during the six months ended June 30, 2008 compared to the six months ended June 30, 2007, and offset by a decrease of $2.0 million in cash provided by maturities and sales of investments during the six months ended June 30, 2008 compared to the six months ended June 30, 2007.

Financing Activities

     Cash flows from financing activities consist of proceeds from sales of shares through employee equity incentive plans, offset by payments for purchase of treasury stock, and principal payments on long-term obligations. Net cash used in financing activities was $2.7 million for six months ended June 30, 2008 compared to cash provided by financing activities of $1.3 million for the six months ended June 30, 2007. The increase in cash used in financial activities was primarily due to the repurchase of 481,000 shares of common stock for $2.6 million during the six months ended June 30, 2008 whereas we did not repurchase any common stock during

24

the six months ended June 30, 2007, and a decrease in proceeds from exercise of stock options and employee stock purchase plan of $1.8 million during the six months ended June 30, 2008 compared to the six months ended June 30, 2007. The decrease in proceeds from the employee stock purchase plan is due to the one month extension of the withholding period to July 31, 2008 whereas the prior year withholding period ended on June 30, 2007.

Liquidity

     As of June 30, 2008, our working capital was $68.6 million, compared with $72.5 million as of December 31, 2007. Cash and cash equivalents, and short-term investments were $43.2 million as of June 30, 2008 compared to $45.3 million as of December 31, 2007, a decrease of $2.1 million. The decrease in cash and short-term investments was primarily attributable to the reclassification of $1.3 million in auction-rate securities from short-term investments to non-current investments, the repurchase of $2.6 million of our common stock, and payment for restructuring charges of $1.2 million during the six months ended June 30, 2008. We anticipate that our overall expenses, as well as planned capital expenditures, may constitute a material use of our cash resources. In addition, we may use cash resources to repurchase common stock, fund potential investments in, or acquisitions of complementary products, technologies or businesses. We believe that our existing cash resources and anticipated funds from operations will satisfy our cash requirements to fund our operating activities, capital expenditures and other obligations for at least the next twelve months. However, in the event that during such period, or thereafter, we are not successful in generating sufficient cash flows from operations we may need to raise additional capital through private or public financings, strategic relationships or other arrangements, which may not be available to us on acceptable terms or at all.

     As of June 30, 2008, our investments included auction-rate securities with a par value of $1.4 million, which are variable rate debt instruments whose interest rates are reset through a “dutch” auction process at regular intervals, typically every 28 days. See Note 3 to “Notes to Condensed Consolidated Financial Statements (Unaudited)” and Item 3. “Quantitative and Qualitative Disclosures About Market Risk” in Part I in this Form 10-Q for further discussion.

     We do not have any off-balance sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt, other than operating leases on our facilities and foreign currency forward exchange contracts designed to reduce our exposure to currency fluctuations in the Euro.

     The following table summarizes our known contractual obligations (in thousands):

	Payments due by period
	2008
	(Six months
Contractual obligations	remaining)		2009-2010		2011-2012		Thereafter		Other		Total
Debt principal(1)	$	270	$	827	$	127	$	—	$	—	$	1,224
Debt interest		14		36		5		—		—		55
Capital lease obligations (including interest)		55		55		2		—		—		112
Operating lease obligations		1,213		5,661		4,854		1,681		—		13,409
Unrecognized tax benefits(2)		—		—		—		—		5,670		5,670
Total	$	1,552	$	6,579	$	4,988	$	1,681	$	5,670	$	20,470

(1)	Amount represents the repayment of an interest free loan of€550,000 and a€400,000 euros loan with a variable interest rate based on the EURIBOR plus 160 basis points.
(2)	Due to the inherent uncertainty of the tax positions, it is not practicable to assign this liability to any particular years in the table.

     Operating lease amounts include minimum rental payments under our operating leases for our office facilities, as well as computers, office equipment, and vehicles that we utilize under lease agreements. These agreements expire at various dates through 2013. Capital lease amounts include $7,000 of imputed interest. Capital leases were contracted to purchase computer, software, office equipment, and vehicles in our French subsidiary.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

     The following discusses our exposure to market risk related to changes in interest rates and foreign currency exchange rates. We do not currently own any equity investments, nor do we expect to own any in the foreseeable future. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors.

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     Interest Rate Risk. As of June 30, 2008, we had cash and cash equivalents and short term investments of $43.2 million. Cash and cash equivalents consisted of cash, highly liquid money market instruments and commercial paper with maturities of 90 days or less. Short-term investments consisted of debt securities with maturities of more than three months but less than twelve months. Because of the short maturities of those instruments, a sudden change in market interest rates would not have a material impact on the fair value of the portfolio. We would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest on our portfolio. A hypothetical increase in market interest rates of 100 basis points from the market rates in effect at June 30, 2008 would cause the fair value of these investments to decrease by an immaterial amount which would not have significantly impacted our financial position or results of operations. Declines in interest rates over time will result in lower interest income and increased interest expense.

     As of June 30, 2008, we held auction-rate securities with a par value of $1.4 million. Auction-rate securities are variable rate debt instruments whose interest rates are reset through a “dutch” auction process at regular intervals, typically every 28 days. A portion of these securities are insured by third party bond insurers and are collateralized by student loans guaranteed by governmental agencies and private entities. The liquidity of the securities has been negatively impacted by the uncertainty in the credit markets and the exposure of these securities to the financial condition of bond insurance companies. All auction-rate securities we hold have been failing to sell at auction since February 2008 due to an insufficient number of bidders. We reviewed the value of these securities for impairment as of June 30, 2008, and concluded that these securities were temporarily impaired, and recorded an unrealized loss of $138,000 before income tax effects of $55,000. In future periods, the estimated fair value of our auction-rate securities could decline further based on market conditions, which could result in additional impairment.

     Foreign Currency and Exchange Risk.Certain of our sales contracts are denominated in a currency other than the functional currency of the selling entity. Therefore, a portion of our revenue is subject to foreign currency risks. In June 2008, we began entering into foreign currency forward exchange contracts, or forward contracts, designed to reduce our exposure to changes in the Euro. The outstanding forward contracts generally have maturities of approximately one month from the date into which they were entered and are entered into at or near the end of the month. These contracts are re-measured monthly using spot rates, with any gain or loss from rate fluctuations recorded in the consolidated statement of operations. As of June 30, 2008, we held a forward contract to purchase 1.5 million Euros at the exchange rate of 1.5875 USD per Euro for a total value US$2.4 million. The change in the values of the forward contracts was not material for the quarter ended June 30, 2008.

Item 4. Controls and Procedures.

     Evaluation of Disclosure Controls and Procedures. Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q, have concluded that our disclosure controls and procedures are effective and designed to ensure that information required to be disclosed by us in the reports we file and submit under the Exchange Act is (1) recorded, processed, summarized and reported within the timeframes specified in the rules and forms of the Securities and Exchange Commission, and (2) is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

     Changes in Internal Controls Over Financial Reporting. There were no changes in the our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 under the Exchange Act that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings.

     From time to time, we are subject to various legal proceedings and claims that arise in the ordinary course of business. In accordance with SFAS No. 5,Accounting for Contingencies, the Company records a contingent liability when the probable outcome of a claim against the Company can be reasonably assessed. In management’s opinion, the probable outcome of any current claim against the Company cannot be reasonably estimated. Also, in management’s opinion, the ultimate resolution of these claims will not materially impact our financial statements.

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Item 1A.Risk Factors

If semiconductor designers and manufacturers do not continue to adopt our Design-to-Silicon-Yield solutions, we may be unable to increase or maintain our revenue.

     If semiconductor designers and manufacturers do not continue to adopt our Design-to-Silicon-Yield solutions, both as currently constituted and as we may offer them in the future, our revenue could decline. To be successful, we will need to continue to enter into agreements covering a larger number of IC products and processes with existing customers and new customers. We need to develop new customer relationships with companies that are integrated device manufacturers, fabless semiconductor companies, and foundries, as well as system manufacturers so that we can continue to implement our Design-to-Silicon-Yield solutions and experience greater market acceptance of our solutions. Factors that may limit adoption of our Design-to-Silicon-Yield solutions by semiconductor companies include:

• our customers’ failure to achieve satisfactory yield improvements using our Design-to-Silicon-Yield solutions;

• a decrease in demand for semiconductors generally or the slowing of demand for nanometer scale semiconductors;

• our inability to develop, market, or sell effective solutions that are outside of our traditional MPS logic focus;

• our existing and potential customers’ delay in their adoption of the next process technology;

• the development in the industry of alternative methods to enhance the integration between the semiconductor design and manufacturing processes due to a rapidly evolving market and the emergence of new technologies;

• our existing and potential customers’ reluctance to understand and accept our innovative gainshare performance incentives fee component; and

• our customers’ concern about our ability to keep highly competitive information confidential.

We generate a large percentage of our total revenue from a limited number of customers, so the loss of any one of these customers could significantly reduce our revenue and results of operations below expectations.

     Historically, we have had a small number of large customers for our core Design-to-Silicon-Yield solutions and we expect this to continue in the near term. In the six months ended June 30, 2008, two customers accounted for 32% of our total net revenue, with Toshiba Corporation representing 17% and International Business Machines Corporation representing 15%. In the six months ended June 30, 2007, two customers accounted for 33% of our total net revenue, with Toshiba Corporation representing 17% and International Business Machines Corporation representing 16%. We could lose a customer due to its decision not to engage us on future process nodes, its decision not to develop its own future process node, or as a result of industry consolidation. The loss of any of these customers or a decrease in the sales volumes of their products could significantly reduce our total revenue below expectations. In particular, such a loss could cause significant fluctuations in results of operations because our expenses are fixed in the short term and it takes us a long time to replace customers.

If integrated device manufacturers of logic integrated circuits reduce investment in new process technology as a result of a shift to a fabless manufacturing business model, the pool of potential logic customers for our yield ramp solutions will shrink and our results of operations may suffer.

     Historically, the majority of our revenue from integrated yield ramps has been derived from integrated device manufacturers, or IDMs, of logic ICs. If IDMs decide to discontinue or significantly cut back their investment in the development of new process technology as a result of a shift to a model of outsourcing a larger proportion, or all, of the mass production of their ICs, there may be fewer IDMs that are potential customers for our solutions that integrate product designs with in-house manufacturing processes. As a result, the revenue we are able to generate from integrated yield ramps for logic ICs could fall below levels that are currently expected. Also, because our expenses are fixed in the short term and it takes a long time for us to replace customers, such a reduction in revenue could cause significant fluctuations in results of operations.

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If we do not effectively manage and support our operations and integrate recent and planned growth, our business strategy may fail.

     We will need to continue to grow in all areas of operation and successfully integrate and support our existing and new employees into our operations, or we may be unable to implement our business strategy in the time frame we anticipate, if at all. We have in the past, and may in the future, experienced interruptions in our information systems on which our global operations depend. Further, physical damage to, failure of, or digital damage (such as significant viruses or worms) to, our information systems could disrupt and delay time-sensitive services or computing operations that we perform for our customers, which could negatively impact our business results and reputation. In addition, we must frequently expand our internal information system to meet increasing demand in storage, computing and communication. Our internal information system is expensive to expand and must be highly secure due to the sensitive nature of our customers’ information that we transmit. Building and managing the support necessary for our growth places significant demands on our management and resources. In addition, we may need to switch to a new accounting system in the near future, which could disrupt our business operations and distract management. These demands may divert these resources from the continued growth of our business and implementation of our business strategy. Further, we must adequately train our new personnel, especially our client service and technical support personnel, to effectively and accurately, respond to and support our customers. If we fail to do this, it could lead to dissatisfaction among our customers, which could slow our growth.

If we fail to protect our intellectual property rights, customers or potential competitors may be able to use our technologies to develop their own solutions which could weaken our competitive position, reduce our revenue, or increase our costs.

     Our success depends largely on the proprietary nature of our technologies. We currently rely primarily on contractual, patent, copyright, trademark, and trade secret protection. Our pending patent applications may not result in issued patents, and even if issued, they may not be sufficiently broad to protect our proprietary technologies. Also, patent protection in foreign countries may be limited or unavailable where we need such protection. Litigation may be necessary from time to time to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. As a result of any such litigation, we could lose our proprietary rights and incur substantial unexpected operating costs. Litigation could also divert our resources, including our managerial and engineering resources.

Competition in the market for yield improvement solutions and increased integration between IC design and manufacturing may intensify in the future, which could impede our ability to grow or execute our strategy.

     Competition in our market may intensify in the future, which could slow our ability to grow or execute our strategy and could lead to increased pricing pressure. Our current and potential customers may choose to develop their own solutions internally, particularly if we are slow in deploying our solutions. Many of these companies have the financial and technical capability to develop their own solutions. Also, competitors could establish non-domestic operations with a lower cost structure than our engineering organization, which, unless we also establish lower cost non-domestic operations, would give any such competitor’s products a competitive advantage over our solutions. There may be other providers of commercial solutions for systematic IC yield and performance enhancement of which we are not aware. We currently face indirect competition from the internal groups at IC companies and some direct competition from providers of yield management or prediction software such as KLA-Tencor, MKS Instruments, inc., or MKS (through its acquisition of Yield Dynamics, Inc.), Mentor Graphics (through its acquisition of Ponte Solutions), Syntricity Inc., TIBCO Software Inc. (through its acquisition of Spotfire Inc.), and Synopsys, Inc., and process control software, such as Applied Materials, Inc., Triant Holdings Inc., Straatum Processware Ltd., and MKS. Further, ARM Ltd. and Virage Logic Corporation provide standard cells in the physical IP space, which could compete with our pdBRIX solution. Some providers of yield management software or inspection equipment may seek to broaden their product offerings and compete with us. For example, KLA-Tencor has announced adding the use of test structures to one of their inspection product lines. In addition, we believe that the demand for solutions that address the need for better integration between the silicon design and manufacturing processes may encourage direct competitors to enter into our market. For example, large integrated organizations, such as IDMs, electronic design automation software providers, IC design service companies or semiconductor equipment vendors, may decide to spin-off a business unit that competes with us. Other potential competitors include fabrication facilities that may decide to offer solutions competitive with ours as part of their value proposition to their customers. In addition, Synopsys, Inc. now appears to offer directly competing Design-for-Manufacturability, or DFM, while other Electronic Design Automation suppliers provide alternative DFM solutions that may compete for the same budgetary funds. If these potential competitors change the pricing environment or are able to attract industry partners or customers faster than we can, we may not be able to grow and execute our strategy as quickly or at all. In addition, customer preferences may shift away from our solutions as a result of the increase in competition.

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We face operational and financial risks associated with international operations that could negatively impact our revenue.

     We derive a majority of our revenue from international sales, principally from customers based in Asia. Revenue generated from customers in Asia accounted for 54% of total revenue in the six months ended June 30, 2008 and 52% in the six months ended June 30, 2007. We expect that a significant portion of our total future revenue will continue to be derived from companies based in Asia. In addition, we have expanded our non-U.S. operations recently and plan to continue such expansion by establishing overseas subsidiaries, offices, or contractor relationships in locations, and when, deemed appropriate by our management. The success of our business is subject to risks inherent in doing business internationally. These risks include:

• some of our key engineers and other personnel are foreign nationals and they may have difficulty gaining access to the United States and other countries in which our customers or our offices may be located and it may be difficult for us to recruit and retain qualified technical and managerial employees in foreign offices;

• greater difficulty in collecting account receivables resulting in longer collection periods;

• language and other cultural differences may inhibit our sales and marketing efforts and create internal communication problems among our U.S. and foreign research and development teams, increasing the difficulty of managing multiple, remote locations performing various development, quality assurance, and yield ramp analysis projects;

• compliance with, inconsistencies among, and unexpected changes in, a wide variety of foreign laws and regulatory environments with which we are not familiar, including, among other issues, with respect to protection of our intellectual property, and a wide variety of operational regulations and trade and export controls under domestic, foreign, and international law;

• currency risk due to the fact that expenses for our international offices are denominated in the local currency, including the Euro, while virtually all of our revenue is denominated in U.S. dollars;

• quarantine, private travel limitation, or business disruption in regions affecting our operations, stemming from actual, imminent or perceived outbreak of human pandemic or contagious disease;

• in the event a larger portion of our revenue becomes denominated in foreign currencies, we would be subject to a potentially significant exchange rate risk; and

• economic or political instability, including but not limited to armed conflict, terrorism, interference with information or communication networks or systems, and the resulting disruption to economic activity and business operations.

     In Japan, in particular, we face the following additional risks:

• a downturn in Asian economies which could limit our ability to retain existing customers and attract new ones in Asia; and

• if the U.S. dollar increases in value relative to the Japanese Yen, the cost of our solutions will be more expensive to existing and potential Japanese customers and therefore less competitive.

     In the Middle East, we use a third-party service provider, whose operations are not located in a U.S. embargoed country, to provide certain software quality assurance and other services for certain of our software products. The political uncertainty surrounding the region could disrupt our third-party service provider’s operations and thus negatively affect the range of services we are able to provide.

Our earnings per share and other key operating results may be unusually high in a given quarter, thereby raising investors’ expectations, and then unusually low in the next quarter, thereby disappointing investors, which could cause our stock price to drop.

     Historically, our quarterly operating results have fluctuated. Our future quarterly operating results will likely fluctuate from time to time and may not meet the expectations of securities analysts and investors in some future period. The price of our common stock could decline due to such fluctuations. The following factors may cause significant fluctuations in our future quarterly operating results:

• the size and timing of sales volumes achieved by our customers’ products;

• the loss of any of our large customers or an adverse change in any of our large customers’ businesses;

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• the size of improvements in our customers’ yield and the timing of agreement as to those improvements;

• our long and variable sales cycle;

• changes in the mix of our revenue;

• changes in the level of our operating expenses needed to support our projected growth; and

• delays in completing solution implementations for our customers.

Revenue from our gainshare performance incentives is dependent on factors outside of our control, including the volume of integrated circuits that our customers are able to sell to their customers.

     Our gainshare performance incentives fee component ties the profits of our customers to our own. Through this component, revenue for a particular product is largely determined by the volume of that product that our customer is able to sell to its customers, which is outside of our control. We have limited ability to predict the success or failure of our customers’ IC products. Further, our customers may decide to implement changes to their manufacturing processes during the period that is covered by gainshare performance incentives component, which could negatively affect yield results; a decision which is beyond our control. In addition, we may commit a significant amount of time and resources to a customer who is ultimately unable to sell as many units as we had anticipated when contracting with them or who makes unplanned changes to their processes. Since we currently work on a small number of large projects, any product that does not achieve commercial viability or a significant increase in yield could significantly reduce our revenue and results of operations below expectations. In addition, if we work with two directly competitive products, volume in one may offset volume, and thus any of our related gainshare performance incentives, in the other product. Further, decreased demand for semiconductor products decreases the volume of products our customers are able to sell, which may adversely affect our gainshare performance incentives revenue.

Measurement of our gainshare performance incentives requires data collection and is subject to customer agreement, which can result in uncertainty and cause quarterly results to fluctuate.

     We can only recognize revenue based on gainshare performance incentives once we have reached agreement with our customers on their level of yield performance improvements. Because measuring the amount of yield improvement is inherently complicated and dependent on our customers’ internal information systems, there may be uncertainty as to some components of measurement. This could result in our recognition of less revenue than expected. In addition, any delay in measuring revenue attributable to our gainshare performance incentives could cause all of the associated revenue to be delayed until the next quarter. Since we currently have only a few large customers and we are relying on gainshare performance incentives as a significant component of our total revenue, any delay could significantly harm our quarterly results.

Changes in the structure of our customer contracts, including the mix between fixed and variable revenue and the mix of elements, can adversely affect the size and timing of our total revenue.

     Our long-term success is largely dependent upon our ability to structure our future customer contracts to include a larger gainshare performance incentives component relative to the fixed fee component. We typically recognize the fixed fee component earlier than the gainshare performance incentives component so if we are successful in increasing the gainshare performance incentives component of our customer contracts, we will experience an adverse impact on our operating results in the short term as we reduce the fixed fee component. Due to acquisitions and expanded business strategies, the mix of elements in some of our contracts has changed recently and the relative importance of the software component in some of our contracts has increased. We have experienced, and may in the future experience, delays in the expected recognition of revenue associated with generally accepted accounting principles regarding the timing of revenue recognition in multi-element software arrangements, including the effect of acceptance criteria as a result of the change in our contracts. If we fail to meet contractual acceptance criteria on time or at all, the total revenue we receive under a contract could be delayed or decline. In addition, by increasing the gainshare performance incentives or the software component, we may increase the variability or timing of recognition of our revenue, and therefore increase the risk that our total future revenue will be lower than expected and fluctuate significantly from period to period.

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It typically takes us a long time to sell our unique solutions to new customers, which can result in uncertainty and delays in generating additional revenue.

     Because our gainshare performance incentives business model is unique and our Design-to-Silicon-Yield solutions are unfamiliar to some new customers, our sales cycle is lengthy and requires a significant amount of our senior management’s time and effort. Furthermore, we need to target those individuals within a customer’s organization who have overall responsibility for the profitability of an IC. These individuals tend to be senior management or executive officers. We may face difficulty identifying and establishing contact with such individuals. Even after initial acceptance, due to the complexity of structuring the gainshare performance incentives component, the negotiation and documentation processes can be lengthy. It can take nine months or more to reach a signed contract with a customer. Unexpected delays in our sales cycle could cause our revenue to fall short of expectations.

We have a history of losses, we may incur losses in the future and we may be unable to maintain profitability.

     We have experienced losses in the six months ended June 30, 2008, the year ended December 31, 2007, and in the past. We may not achieve and thereafter maintain profitability if our revenue increases more slowly than we expect or not at all. In addition, virtually all of our operating expenses are fixed in the short term, so any shortfall in anticipated revenue in a given period could significantly reduce our operating results below expectations. Our accumulated deficit was $21.3 million as of June 30, 2008. We expect to continue to incur significant expenses in connection with:

• funding for research and development;

• expansion of our solution implementation teams;

• expansion of our sales and marketing efforts; and

• additional non-cash charges relating to amortization of intangibles and stock-based compensation.

     As a result, we will need to significantly increase revenue to maintain profitability on a quarterly or annual basis. Any of these factors could cause our stock price to decline.

We may experience significant fluctuations in our operating results due to the cyclical nature of the semiconductor industry.

     Our revenue is highly dependent upon the overall condition of the semiconductor industry, especially because of our gainshare performance incentives revenue component. The semiconductor industry is highly cyclical and subject to rapid technological change and has been subject to significant economic downturns at various times, characterized by diminished product demand, accelerated erosion of average selling prices, and production overcapacity. The semiconductor industry also periodically experiences increased demand and production capacity constraints. As a result, we may experience significant fluctuations in operating results due to general semiconductor industry conditions and overall economic conditions.

We must continually attract and retain highly talented executives, engineers, and research and development personnel or we will be unable to expand our business as planned.

     In order to stay competitive, we will need to continue to hire highly talented executives, engineers, and research and development personnel to support our planned growth. We have experienced, and we expect to continue to experience, delays and limitations in hiring and retaining highly skilled individuals with appropriate qualifications. We intend to continue to hire foreign nationals, particularly as we expand our operations internationally. We have had, and expect to continue to have, difficulty in obtaining visas permitting entry into the United States, and delays in obtaining visas permitting entry into other key countries, for several of our key personnel, which disrupts our ability to strategically locate our personnel. If we lose the services of any of our key executives or a significant number of our engineers, it could disrupt our ability to implement our business strategy. Competition for executives and qualified engineers can be intense, especially in Silicon Valley where we are principally based.

If our products, technologies, services, and integrated solutions fail to keep pace with the rapid technological changes in the semiconductor industry, we could lose customers and revenue.

     We must continually devote significant engineering resources to enable us to keep up with the rapidly evolving technologies and equipment used in the semiconductor design and manufacturing processes. These innovations are inherently complex and require long

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development cycles. Not only do we need the technical expertise to implement the changes necessary to keep our technologies current, we also rely heavily on the judgment of our advisors and management to anticipate future market trends. Our customers expect us to stay ahead of the technology curve and expect that our products, technologies, services, and integrated solutions will support any new design or manufacturing processes or materials as soon as they are deployed. If we are not able to timely predict industry changes, or if we are unable to modify our products, technologies, services, and integrated solutions on a timely basis, our existing solutions will be rendered obsolete and we may lose customers. If we do not keep pace with technology, our existing and potential customers may choose to develop their own solutions internally as an alternative to ours and we could lose market share, which could adversely affect our operating results.

We intend to pursue additional strategic relationships, which are necessary to maximize our growth, but could substantially divert management attention and resources.

     In order to establish and maintain strategic relationships with industry leaders at each stage of the IC design and manufacturing processes, we may need to expend significant resources and will need to commit a significant amount of management’s time and attention, with no guarantee of success. If we are unable to enter into strategic relationships with these companies, we will not be as effective at modeling existing technologies or at keeping ahead of the technology curve as new technologies are introduced. In the past, the absence of an established working relationship with key companies in the industry has meant that we have had to exclude the effect of their component parts from our modeling analysis, which reduces the overall effectiveness of our analysis and limits our ability to improve yield. We may be unable to establish key industry strategic relationships if any of the following occur:

• potential industry partners become concerned about our ability to protect their intellectual property;

• potential industry partners develop their own solutions to address the need for yield improvement;

• our potential competitors establish relationships with industry partners with which we seek to establish a relationship; or

• potential industry partners attempt to restrict our ability to enter into relationships with their competitors.

Our solution implementations may take longer than we anticipate, which could cause us to lose customers and may result in adjustments to our operating results.

     Our solution implementations require a team of engineers to collaborate with our customers to address complex yield loss issues by using our software and other technologies. We must estimate the amount of time needed to complete an existing solution implementation in order to estimate when the engineers will be able to commence a new solution implementation. In addition, our accounting for solution implementation contracts, which generate fixed fees, sometimes requires adjustments to profit and loss based on revised estimates during the performance of the contract. These adjustments may have a material effect on our results of operations in the period in which they are made. The estimates giving rise to these risks, which are inherent in fixed-price contracts, include the forecasting of costs and schedules, and contract revenues related to contract performance.

Key executive officers are critical to our business and we cannot guarantee that they will remain with us indefinitely.

     Our future success will depend to a significant extent on the continued services of our key executive officers. If we lose the services of any of our key executive officers, it could slow execution of our business plan, hinder our product development processes and impair our sales efforts. Searching for replacements could divert our senior management’s time and increase our operating expenses. In addition, our industry partners and customers could become concerned about our future operations, which could injure our reputation and cause our stock price to drop. We do not have long-term employment agreements with our executives and we do not maintain any key person life insurance policies on their lives.

Inadvertent disclosure of our customers’ confidential information could result in costly litigation and cause us to lose existing and potential customers.

     Our customers consider their product yield information and other confidential information, which we must gather in the course of our engagement with the customer, to be extremely competitively sensitive. If we inadvertently disclosed or were required to disclose this information, we would likely lose existing and potential customers and could be subject to costly litigation. In addition, to avoid potential disclosure of confidential information to competitors, some of our customers may, in the future, ask us not to work with key competitive products, which could limit our revenue opportunities.

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Our technologies could infringe the intellectual property rights of others causing costly litigation and the loss of significant rights.

     Significant litigation regarding intellectual property rights exists in the semiconductor industry. It is possible that a third party may claim that our technologies infringe their intellectual property rights or misappropriate their trade secrets. Any claim, even if without merit, could be time consuming to defend, result in costly litigation, or require us to enter into royalty or licensing agreements, which may not be available to us on acceptable terms, or at all. A successful claim of infringement against us in connection with the use of our technologies could adversely affect our business.

Defects in our proprietary technologies, hardware and software tools, and the cost of support to remedy any such defects could decrease our revenue and our competitive market share.

     If the software, hardware, or proprietary technologies we provide to a customer contain defects that increase our customer’s cost of goods sold and time-to-market or damage our customer’s property, these defects could significantly decrease the market acceptance of our solutions. Further, the cost of support resources required to remedy any defects in our technologies, hardware, or software tools could exceed our expectations. Any actual or perceived defects with our software, hardware, or proprietary technologies may also hinder our ability to attract or retain industry partners or customers, leading to a decrease in our revenue. These defects are frequently found during the period following introduction of new software, hardware, or proprietary technologies or enhancements to existing software, hardware, or proprietary technologies. Our software, hardware, and proprietary technologies may contain errors not discovered until after customer implementation of the silicon design and manufacturing process recommended by us. If our software, hardware, or proprietary technologies contain errors or defects, it could require us to expend significant resources to alleviate these problems, which could reduce margins and result in the diversion of technical and other resources from our other development efforts.

Failing to maintain the effectiveness of our internal control over financial reporting could cause the cost related to remediation to increase and could cause our stock price to decline.

     In the future, our management may identify deficiencies regarding the design and effectiveness of our system of internal control over financial reporting that we engage in pursuant to Section 404 of the Sarbanes-Oxley Act, or Section 404, as part of our Form 10-K. Such deficiencies could include those arising from turnover of qualified personnel or arising as a result of acquisitions, which we may not be able to remediate in time to meet the continuing reporting deadlines imposed by Section 404 and the costs of which may harm our results of operations. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that our management can conclude on an ongoing basis that we have effective internal controls. We also may not be able to retain our independent registered public accounting firm with sufficient resources to attest to and report on our internal controls in a timely manner. Moreover, our registered public accounting firm may not agree with our management’s future assessments and may deem our controls as ineffective if we are unable to remediate on a timely basis. If in the future we are unable to assert that we maintain effective internal controls, our investors could lose confidence in the accuracy and completeness of our financial reports that in turn could cause our stock price to decline.

We may not be able to expand our business and proprietary technologies if we do not consummate potential acquisitions or investments or successfully integrate them with our business.

     To expand our proprietary technologies, we may acquire or make investments in complementary businesses, technologies, or products if appropriate opportunities arise. We may be unable to identify suitable acquisition or investment candidates at reasonable prices or on reasonable terms, or consummate future acquisitions or investments, each of which could slow our growth strategy. We may have difficulty integrating the acquired products, personnel or technologies of any acquisitions we might make. These difficulties could disrupt our ongoing business, distract our management and employees and increase our expenses.

We may not be able to raise necessary funds to support our growth or execute our strategy.

     Unanticipated efforts to support more rapid expansion, develop or enhance our Design-to-Silicon-Yield solutions, respond to competitive pressures or acquire complementary businesses or technologies could impact our future capital requirements and the adequacy of our available funds. In such event, we may need to raise additional funds through public or private financings, strategic relationships or other arrangements. We may not be able to raise any necessary funds on terms favorable to us, or at all.

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Recent acquisitions may adversely affect our business by diverting management’s attention, increasing our expenses or by being more difficult to integrate than expected.

     Our success in realizing the strategic benefits, the timing of this realization, and growth opportunities to be gained from incorporating into PDF the operations of recently acquired businesses, including SiA, a French company, acquired in October 2006, and Fabbrix, acquired in May 2007, depend upon our ability to successfully integrate those businesses. The integration of acquired businesses is a complex, costly and time-consuming process. The difficulties of combining our existing operations associated with acquired businesses include:

• consolidating research and development operations;

• retaining key employees;

• incorporating acquired products and business technology into our existing product lines;

• coordinating effective sales and marketing functions;

• preserving research and development, marketing, customer and other important relationships; and

• minimizing the diversion of management’s attention from ongoing business concerns.

If we were required to write down all or part of our goodwill, our net earnings and net worth could be significantly, negatively affected.

     We had $67.3 million of goodwill recorded on our consolidated balance sheet as of June 30, 2008. Goodwill represents the excess of cost over the fair market value of net assets acquired in business combinations. If our market capitalization drops significantly below the amount of net equity recorded on our balance sheet, it would indicate a decline in the fair value of the Company and would require us to further evaluate whether our goodwill has been impaired. We also perform an annual review, at December 31, of our goodwill to determine if it has become impaired, in which case we would write down the impaired portion of our goodwill. If we were required to write down all or a significant part of our goodwill, our net earnings and net worth could be significantly, negatively affected.

Changes in effective tax rates could negatively affect our operating results.

     We conduct our business globally and, as a result, are subject to taxation in the United States and foreign countries. Our future tax rates could be affected by numerous factors, including changes in tax laws or the interpretation of such tax laws and changes in accounting policies. Our filings are subject to reviews or audit by the Internal Revenue Service and state, local and foreign taxing authorities. We cannot be sure that any final determination in an audit would not be materially different than the treatment reflected in our historical income tax provisions and accruals. If additional taxes are assessed as a result of an audit, there could be a significant negative effect on our income tax provision and net income in the period or periods for which that determination is made.

The uncertainty in the credit markets might impact the value of certain auction-rate securities we have and we might have to record impairment charges in the future.

     Credit concerns in the capital markets have significantly reduced our ability to liquidate auction-rate securities that we classify as available-for-sale securities on our balance sheet. The liquidity of the 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. All auction-rate securities we hold have been failing to sell at auction since February 2008 due to an insufficient number of bidders. We reviewed the value of these securities for impairment as of June 30, 2008, and concluded that these securities were temporarily impaired, and recorded an unrealized loss of $83,000 net of income tax effects. In future periods, the estimated fair value of our auction-rate securities could decline further based on market conditions, which could result in additional impairment.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

(b)Use of Proceeds. Our first registration statement, filed on Form S-1 (Registration No. 333-43192), related to our initial public offering and was declared effective by the SEC on July 26, 2001. There has been no change in our use of proceeds from the disclosure made in our report on Form 10-Q for the quarter ended September 30, 2005 with respect to the use of proceeds generated by our initial public offering.

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(c)Stock Repurchase. The table below sets forth the information with respect to purchases made by or on behalf of the Company or any “affiliated purchaser” (as the term is defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934) of our common stock during the three months ended June 30, 2008:

ISSUER PURCHASES OF EQUITY SECURITIES

					Total Number of		Maximum Number (or
	Total				Shares (or Units)		Approximate Dollar
	Number of		Average		Purchased as		Value) of Shares (or
	Shares (or		Price Paid		Part of Publicly		Units) that May Yet Be
	Units)		Per Share		Announced Plans		Purchased Under the
Period	Purchased		(or Unit)		or Programs (1)		Plans or Programs(1)
Month #1 (April 1, 2008 through April 30, 2008)		—		—		—	$	7,353,005
Month #2 (May 1, 2008 through May 31, 2008)		283,500	$	5.24		283,500	$	5,866,140
Month #3 (June 1, 2008 through June 30, 2008)		—		—		—	$	5,866,140
Total		283,500	$	5.24		283,500

(1) On March 26. 2003, our Board of Directors approved a share repurchase program to purchase up to $10.0 million of our 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 had been repurchased at the average price of $6.06 under this program and $5.9 million remained available for repurchase.

Item 3. Defaults Upon Senior Securities.

     Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders.

     During the quarter ended June 30, 2008, we submitted the following matters to our stockholders for approval at our Annual Meeting of Stockholders held on May 22, 2008 and the following proposals were adopted by our stockholders by the margins indicated:

Proposals:

1. To elect three (3) Class I nominees to the Board of Directors.

Election of Director	Votes For		Votes Withheld
Thomas Caulfield, Ph.D. — Class I Director		23,504,408		721,425
Albert Y.C. Yu, Ph.D. — Class I Director		23,306,758		919,075
R. Stephen Heinrichs — Class I Director		23,306,758		919,075

     As a result, Mr. Caulfield, Mr. Yu, and Mr. Heinrichs were re-elected as Class I directors of the Company for a three year term expiring upon the Annual Meeting next following the fiscal year ending December 31, 2009, or until their respective successors have been duly qualified.

2. To ratify the appointment by the Audit Committee of Deloitte & Touche LLP as the Independent Registered Public Accounting Firm of the Company for the fiscal year ending December 31, 2008.

Votes for	Votes Against	Votes Abstained	Broker Non-votes
24,176,560	49,090	183	0

     Item 5. Other Information.

     Not applicable.

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Item 6. Exhibits.

Exhibit
Number		Description
	3.01	Third Amended and Restated Certificate of Incorporation of PDF Solutions, Inc. dated July 31, 2000.(1)
	3.02	Amended and Restated Bylaws of PDF Solutions, Inc., effective as of August 1, 2005.(2)
	4.01	Specimen Stock Certificate.(3)
	4.02	Second Amended and Restated Rights Agreement dated July 6, 2001.(1)
	10.01	2001 Stock Plan and related agreements, effective as of July 31, 2001, as amended on October 31, 2006.(4)
	10.02	2001 Employee Stock Purchase Plan and related agreements, as adopted on June 12, 2001.(1)
	10.03	Offer letter to Joy E. Leo dated July 14, 2008(6)
	31.01	Certification of the President and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31.02	Certification of the Chief Financial Officer and Vice President of Finance pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32.01	Certification of the President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(5)
	32.02	Certification the Chief Financial Officer and Vice President of Finance pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(5)

(1)	Incorporated by reference to PDF’s Registration Statement on Form S-1, Amendment No. 7 filed July 9, 2001 (File No. 333-43192).
(2)	Incorporated by reference to PDF’s Report on Form 10-Q filed August 9, 2005 (File No. 000-31311).
(3)	Incorporated by reference to PDF’s Report on Form 10-Q filed September 6, 2001 (File No. 000-31311).
(4)	Incorporated by reference to PDF’s Report on Form 10-Q filed May 10, 2007 (File No. 000-31311).
(5)	As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Quarterly Report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission and are not incorporated by reference in any filing of PDF Solutions, Inc. under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.
(6)	Indicates management contract or compensatory plan or arrangement.

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

By:	/s/ JOHN K. KIBARIAN
	John K. Kibarian
	President and Chief Executive Officer
By:	/s/ KEITH A. JONES
	Keith A. Jones
	Chief Financial Officer and Vice President of Finance

Date: August 11, 2008

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INDEX TO EXHIBITS

Exhibit
Number		Description
	3.01	Third Amended and Restated Certificate of Incorporation of PDF Solutions, Inc. dated July 31, 2000.(1)
	3.02	Amended and Restated Bylaws of PDF Solutions, Inc., effective as of August 1, 2005.(2)
	4.01	Specimen Stock Certificate.(3)
	4.02	Second Amended and Restated Rights Agreement dated July 6, 2001.(1)
	10.01	2001 Stock Plan and related agreements, effective as of July 31, 2001, as amended on October 31, 2006.(4)
	10.02	2001 Employee Stock Purchase Plan and related agreements, as adopted on June 12, 2001.(1)
	10.03	Offer letter to Joy E. Leo dated July 14, 2008(6)
	31.01	Certification of the President and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31.02	Certification of the Chief Financial Officer and Vice President of Finance pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32.01	Certification of the President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(5)
	32.02	Certification the Chief Financial Officer and Vice President of Finance pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(5)

(1)	Incorporated by reference to PDF’s Registration Statement on Form S-1, Amendment No. 7 filed July 9, 2001 (File No. 333-43192).
(2)	Incorporated by reference to PDF’s Report on Form 10-Q filed August 9, 2005 (File No. 000-31311).
(3)	Incorporated by reference to PDF’s Report on Form 10-Q filed September 6, 2001 (File No. 000-31311).
(4)	Incorporated by reference to PDF’s Report on Form 10-Q filed May 10, 2007 (File No. 000-31311).
(5)	As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Quarterly Report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission and are not incorporated by reference in any filing of PDF Solutions, Inc. under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.
(6)	Indicates management contract or compensatory plan or arrangement.

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