PDF Solutions Inc (PDFS) 2003 Q3 法說會逐字稿

Good day ladies and gentlemen and welcome to the PDF Solutions Incorporated Conference Call to discuss its financial results for the third fiscal quarter ended September 30, 2003. At this time all participants are in listen-only mode. Later we will conduct a question-and-answer session for which instructions will be given at that time. If you need assistance during the conference, please press * then 0 on your touchtone telephone. As a reminder, this conference is being recorded.

If you have not yet received a copy of the corresponding press releases, they have been posted to PDF's website at www.pdf.com. Some of the statements that will be made in the course of this conference are forward-looking, including statements regarding PDF's future financial results and performance, growth rates, and demand for its solutions. PDF's actual results could differ materially. You should refer to the section entitled "Factors Which May Affect Future Results" on pages 21 through 29 of PDF's annual report on Form 10-K for the fiscal year ended December 31, 2002, and similar disclosures and subsequent SEC filings. The forward-looking statements and risks stated in this conference call are based on information available to PDF today. PDF assumes no obligation to update them.

Now, I would like to introduce John Kibarian, PDF's President and CEO; and Steve Melman, PDF's Vice President -- Finance and Administration and CFO. Mr. Kibarian, please go ahead.

Thank you and welcome everyone. For the third quarter of 2003, PDF is reporting total revenue of $11.3m and pro forma net income of 1 cent per share. Our third quarter results are at the top-end of the range, as we have previously provided. Steve will discuss in more detail in a few minutes, I am sorry, as Steve will discuss in detail in a few minutes. Pro forma results exclude stock-based compensation, acquired intangibles, and write-offs of in-process engineering resulting from our acquisition of IDS Software Systems which we completed in the quarter.

Before Steve provides more details on these financial results, I'd like to cover three points with you. One, PDF's perspective on the semiconductor market dynamics. Two, continued execution on our business plans, and three, our product development.

First, as I have noted before, PDF's unique position in the industry gives us a broad view of process technology adoption and manufacturing yield trends. We continue to see an increased transition to leading edge technologies. Many of our customers' 130 nm processes are now moving to production volumes. Based on recent experiences, we see initial 90 nm designs, including low-K, to be in manufacturing this year. In parallel, companies are beginning next-stepped efforts at the 65nm progress node. In all of these scenarios, semiconductor companies are recognizing that process design integration issues and their impact on yield are critical considerations.

Mechanisms must be put in place to address nanometer level process design integration issues and this must be done before ramping either the process or designs. As a result, PDF Solutions is building momentum across a broader segment of the industry. While traveling to client sites recently, I am seeing chip companies are still careful relative to capital expenditures to build more fab capacity; however, they are more optimistic in looking forward for ways to improve production efficiencies, including investing in development of next generation technologies and improving yields.

This leads to my second point, execution on our business plan. During the quarter, we won two new engagements. Earlier this year, we announced the initial approval (ph) project with our new U.S.-based customer. I am pleased to announce that during this past quarter, we have successfully expanded business with that customer. This is consistent with our long-term customer penetration strategy. The second new engagement in the quarter is a new customer to PDF and a very important worldwide top-10 IDM located in Japan. Like PDF's successful penetration of the U.S. accounts just discussed, this initial engagement represents an opportunity for follow-on in 2004 with continued penetration of this top semiconductor company. Bottom line, PDF delivers value, both through its R&D investment and service delivery model which helps ensure that the customers are successful. Large semiconductor companies with significant investments in leading edge technologies and designs recognize that early investment in PDF's technology and services is a proven way of accelerating their return on investment.

On the third topic, product development, I want to update you on our acquisition of IDS. As you are aware, the acquisition was completed on September 24th. Since then, I have had conversations with executives at existing dataPOWER accounts. I am continually impressed with the great relationship the dataPOWER group established with its customers and the confidence those customers have in the dataPOWER team’s continued commitment to deliver yield management software solutions to them. We have moved quickly to integrate dataPOWER people and products. Within a week of closing, the IDS team moved into PDF’s San Jose offices. Joint sales calls began immediately. The sales and marketing teams merged and engineering discussions resulted in a first-pass roadmap, based upon the dataPOWER product work completed. In this proposed roadmap, the WAMA (ph) technology we acquired from Wafer Yield in the prior quarter will be one of the first applications to be in hand.

Going forward, we plan to develop our products on a common yield management system -- dataPOWER -- which already has an install base of more then 1,000 seats and more than 30 semiconductors companies worldwide. Using a standard platform will allow PDF Solutions to deliver our customers faster and greater capabilities for improving product yield. Our dataPOWER yield management systems helps our customers address the back end of yield improvement. In other words, analyzing in-production product data to improve yield. The front-end of yield improvement is designed for manufacturability. In the design development arena, PDF now offers customers a Process-Aware DFM Environment.

On October 9th at the FSA Expo in San Jose, PDF unveiled its new pDfx Environment. PDF has created extensive yield simulation models proven over years of running PDF’s proprietary characterization vehicles at nanometer technology. The pDfx Environment delivers this deep knowledge of IC manufacturability directly to IC designers. At advance geometries, design teams will be required not only to deliver working prototypes, but also be instrumental in achieving product yield. With pDfx, they now have the means and information needed to efficiently and cost effectively make IC designs more manufacturable. Using pDfx, designers can optimize products for manufacturability before tape up. The result is product cost savings and faster ramps to production-level yield.

In parallel with the introduction of pDfx, three leading EDA vendors -- Cadence, Magma, and Synopsis announced interoperability support for the pDfx design environment. When we debuted pDfx at the recent FSA Expo, we also showcased our new dataPOWER and WAMA products. Attendees were very positive. We provide a breadth of products to help customers ramp their products faster with higher and more consistent yield. PDF will continue to invest in development of products that meet our customers' nanometer needs and provide them with a competitive advantage. Now I will turn the call over to Steve, who will discuss in detail our financial results for the third quarter and provide guidance going forward. Steve?

Thank you, John, and good afternoon to everyone. First, let me again state that this presentation and our press releases issued earlier today include reference to certain non-GAAP financial measures. The press releases contain a reconciliation of such measures to the most directly comparable GAAP measures and you may access the press releases and reconciliations in the investor section of our website located at www.pdf.com. Revenue for the third quarter ending September 30, 2003, totaled 11.3m, an increase of 2% compared to the third quarter last year and an increase of 12% sequentially from last quarter.

The increase from last year’s third quarter was due to the increase in Design-to-silicon yield solutions, more than offsetting a decrease in gain share. The increase from Q2 to Q3 of 2003 was the result of an increase in Design-to-silicon yield solutions and a modest increase in gain share. Design-to-silicon yield solutions revenue which includes all software licenses including those for WAMA and dataPOWER products totaled 9m for the third quarter, a 10% increase from the comparable period last year and an increase of 12% from last quarter. The increases from last year and last quarter were the result of greater demand for PDF Solutions' products and services, as the industry continues to be more optimistic about a recovery and begins to make investments in new process technology.

With 12 engagements, from nine customers, in five countries, each contributing over 200,000 in revenue during the quarter, it is clear that our customers are continuing to adopt our technology as an essential component of their process design integration infrastructures. While these statistics will move up and down from quarter-to-quarter in similar fashion to gain share for that matter, the longer-term trend which includes the period covering the worst downturn in semiconductor history is in fact up and to the right. Gain share revenue for the third quarter generated from the three customers and three engagements totaled 2.3m, a 20% decrease versus the comparable period last year but an increase of 10% from last quarter. While we may still see some variability in gain share revenues from quarter-to-quarter, wafer volumes under contract with PDF are once again beginning to grow.

Gross margin for the third quarter was 67% of total revenue, only a fractional decline from the third quarter of last year and an increase of 1.5% from the second quarter of 2003. Improved margins on Design-to-silicon yield solutions offset the impact of the drop in gain share from last year while contributing to the improved margins compared to the last quarter. In order to provide more transparency with regard to our operating performance, we have decided to present expenses associated with current period and past acquisitions on individual lines on our P&L. This presentation is consistent with how stock compensation has been presented in the past.

As a result, total operating expenses before amortization of stock based compensation and acquired intangible assets and the write-off of in-process research and development were 7.5m for the quarter, up approximately 908,000 or 14% from the third quarter of 2002, while increasing approximately 204,000 or 3% from last quarter. Research and Development expenses for the third quarter increased approximately 432,000 or 11% from 4m in the third quarter of 2002 primarily due to increases in personnel-related expenses and expansion of development activities in Europe.

Research and Development expenses increased sequentially from the second quarter of 2003 by approximately 51,000 or just 1%. Selling general and administrative expenses were 3.1m in the third quarter of 2003, up approximately 476,000 or 18% from the third quarter of 2002, while increasing approximately 153,000 or 5% sequentially from the second quarter. Increases in personnel costs, particularly in sales and marketing function and outside sales rep commissions contributed to the increases.

Pro forma net income for the quarter excluding amortization of stock-based compensation and acquired intangible assets and the write-off in-process R&D totaled approximately 332,000 or 1 cent per share. This compares with pro forma net income of 853,000 or 4 cents per share for the third quarter of 2002 and a pro forma net loss of approximately 265,000 or 1 cent per share in the second quarter. These third quarter results, as John mentioned earlier, were at the top of the range provided in July.

On a GAAP basis, including all acquisitions related expenses and amortization and deferred stock compensation, reported net loss for the quarter was 1.2m or 5 cents per share. Our balance sheet as of September 30, 2003 shows a significant number of changes from last quarter and last year-end, with a vast majority of variations coming as a result of booking the acquisition of IDS software systems. While we continue to maintain our strong overall financial position, our cash and current ratio have declined as a result of this strategic initiative.

Total cash declined 20.5m during the quarter, actually somewhat less than we expected considering the acquisition, capital expenses, and an increase in accounts receivables as all cash consideration from the IDS acquisition had not been distributed as of the close of the quarter. The impact of the delay in distributing this consideration is reflected in the increase in other acquisition obligations in the current liabilities section of the balance sheet. Accounts receivables increased 3.1m to 9.7m during the quarter, due in part to billings late in the quarter and our focus on closing the IDS transaction before the end of September. As of today, over 30% of outstanding accounts receivables at September 30th have already been collected.

Lastly, unbilled accounts receivables at quarter-end remained flat at $1.3m. Before I turn to guidance, I will state again that some of the statements made in the course of this conference call, including the ones we are about to make with respect to Q4 2003 and Q1 2004, are forward looking. These statements include expectations about our future financial results and performance, growth rates, the success of any business objectives, product and services features and introductions, client products, and demand for PDF design-to-silicon yield solutions. PDF's actual results could differ materially. You should refer to our current SEC filings and understand that the forward-looking statements and risks made during this conference call are based upon information available to PDF today. We assume no obligation to update them.

Now for the fourth quarter of 2004, we reiterate the guidance we've provided in our outlook press release earlier today. Guidance is for revenue in the range of 12 to 12.5m, the result of continuing traction with infrastructure implementations coupled with gain share performance approaching that of recent quarters. We are also providing guidance for pro forma EPS in the range from a loss of 2 cents to break even, primarily the result of higher expenses associated with the increase in headcount from acquired companies. In other words, and more bluntly, the impact of the IDS and WAMA acquisitions are, in the short-term, dilutive to our earnings per share.

Having said that, let me everyone of our long-term objectives. We did not embark on the acquisition trail in order buy a short-term positive in revenue. Our acquisition of WAMA Technology and IDS Software Systems was a about immediately enhancing our capabilities and our ability to add more value to our customers, by adding thickness to the layer of technology that we provide to the semiconductor industry. As John mentioned, we have rapidly merged our companies physically and have merged our product road maps and plans to make both WAMA and dataPOWER integral parts of the overall PDF Solution. The end game, significantly increased revenue opportunities, will not develop overnight. To the contrary, IDS has been somewhat depleted of deferred revenue and backlog as a result of two things; one, purchase accounting related to an acquisition of a software company, and two, a weaker sales pipeline due to primary focus in the last 18 months being placed on acquisitions and financing events.

We understand that, and we understood that, at the time we signed the definitive agreement, actually incorporating such knowledge into our purchase price proposal. As such, we expect it to be a couple of quarters before sales of dataPOWER build momentum. However, we are still confident that the acquisition will accretive for fiscal 2004. We are as optimistic as ever about our prospects for 2004 and beyond. Remember, our goal is to bridge the design-to-silicon-yield gap, -- an increasingly significant problem in the industry. We've made tremendous progress towards that goal this quarter with the completion of the IDS transaction, the introduction of pDfx, and the continued broadening of our customer base.

Broad adoption of PDF technology and penetration throughout major players in the semiconductor industry are key to turning this industry oil tanker, one that has been heading in the same direction for the better part of 35 years. Additionally, our visibility is getting better as confidence grows that we are actually in a recovery. For the past year, we've provided guidance one quarter at time. At this point, we are comfortable providing guidance two quarters ahead, thereby including an outlook for the first quarter of 2004.

This afternoon we reiterate the first quarter guidance we provided earlier in the day in our outlook press release for revenue in the range of 13.5 to 14.3m, which would be a quarterly record for PDF and pro forma EPS of 1 cent to 3 cents. While the pro forma earnings per share guidance is not quite where we might wish it to be, we believe that entering Q2 of 2004 we will have established a foundation for a prosperous overall fiscal year. With that, I would like to turn the call back over to the operator, to open the floor for questions.

Thank you, Mr. Melman. Ladies and gentlemen, if you have a question at this time, please press * 1 on your touchtone phone. If you are using a speaker phone, please lift the handset before asking a question. Please wait one moment for our first question. Our first question comes from Garo Toomajanian of RBC Capital Markets.

Hi, good afternoon. First question to you, Steve. Congratulations and thanks for providing Q1 guidance. Is it safe to assume that the IDS acquisition has made that Q1 guidance maybe diluted from what it might been otherwise?

Well, you know, the outlook includes impact of the IDS acquisition and also includes a transition of the WAMA products line, but most assuredly it has an impact on our ability to grow revenue in the first quarter.

Not sure if that means that the acquisitions are diluted still in Q1 or not?

I'm sorry. I was speaking to revenue. Well that certainly has had an impact on the bottom line as well.

Okay. So I guess what quarter do you think that we might start to see some accretion?

Well, I'm not going to get into the specifics of the quarter, Garo, but you know we feel comfortable saying that for the year. We will see the acquisition be accretive to our results.

Okay, fair enough. And is it safe to assume that there was really no meaningful revenue contribution from IDS in Q3 -- I mean, the acquisition closed pretty late in the quarter anyway?

Right, it would not be significant to the fact that we would be reporting it as such.

And, I know you probably won't want to get into details, but with respect to Q4 revenue guidance, would you say that IDS has a, you know, are you expecting a meaningful contribution there or really still building up the organizations?

Well I think I'll have to go back to the general comments that I made during -- you know -- the conference call so far. You know, we think it is going to be a couple of quarters before we could build up the pipeline and contribute meaningfully to the revenue of the Company.

Okay, I think I got it. A couple of -- I guess it was about a year ago now, or maybe a little more than that, the DBYI was introduced, I'm curious as to how that might be doing to get fabless customers and then, sort of related to that, and on pDfx, you know, I know that that’s just getting off the ground. But why don’t they get a sense of what exactly the relationship is with EDA vendors, are they going to be OEMing a product? Or is it a tool integration? And can you also tell us if any dollars have changed hands?

Okay and thanks. I guess I'll take that and this is John, I'm sorry, Garo. Yeah, about a year a half ago we realized DBYI product or service really. And the key element on DBYI was manipulation of layout, particularly as you got through the design flow. And what we found pretty consistently was customers that had very large volumes of products that they expected would have a significant production life to them -- things such as game systems, graphics engines etc, you can see demand for a service offering like that. But for a lot of customers, the big concern would be would be what with the impact on timing closure, performance, other mechanisms. And if you adjust the layout at the very end, just like a lot of the dummy sale in OPC and other insertion points, customers are always concerned about what did that do to performance and power and other elements.

So, we went back to the drawing board and said, gee, for broader adoption of the DFM, we’ve got to figure out a way to get inserted in the design flow much earlier on and really as much as possible with the SPNR (ph) systems. So, we worked on that for a while, we've baited that with the customers during this summer and into this fall and then in October, we announced it at FSA. Believing that in seeing -- with our traction with the customers that it is more - it fits better in with the typical fabless design flow which is obviously kind of top down ASIC flow using SPNR systems, such as the one from Synopsis, Cadence, and Magma.

At this point, we are directly delivering the software to the customers and working with them to integrate in their design flows. We are also looking at other ways of distributing our technology, making use of relationships with design automation vendors and have found some interest from them. But we have not done anything formal at this point. Also our experience has been when you are really evangelizing a new product –- a new offering, you’ve got to work directly with the customers to make sure the first few customers really get the leverage out of it. You are going to take time to look at what's the best overall distribution model for the product, you know, as we get more and more customer traction.

Great, that's sound good, John. Thanks a lot.

Sure.

Your next question comes from Bill Frerichs of D.A. Davidson.

Okay, John to follow-up on Garo's question, are you selling these tools, as software tools? Or is it some kind of (technical difficulty).

It's a good question, Bill. We are selling a software piece and we are using it as a way of supporting the gain share as well because one of the key things you need is really -- a big element of it is the characterization of the process. And we feel at this point, we have the most unique characterization vehicles out there, most proven of these technology nodes. And we want to use the PDfx to drive up the need to be on a PDF infrastructure. So that means there is a gain share payment, but sometimes that payment comes from -- is separated out from the software purchase. And there is also software component that's being sold on a software basis.

And since the time line is probably longer, the gain share payment comes later. Is that right?

Yeah from our experience with the DBYI and were we’ve sold the DBYI with customers, we’ve found -- I think much more like the IP model, the time lag is longer than you expect -- than we are used to in yield ramps and the yield ramps there are pretty close together in the production -- with the design-based stuff you -- the further up you have started the flow the longer lag you have before you see meaningful volumes.

It could be 6 to 9 months maybe?

You know, I think it's going to be early for us to speculate on timing on that.

Right. And finally, Steve, how much deferred revenue evaporated through purchase accounting?

I don't know that I want answer this specifically, Bill, and we'll be filing the Form 8-K that will have all the historical ideas, results in the there. But as you know from following EDA companies, you know, any deferred revenue for which the software was delivered earlier and there was extended payment terms or there was some kind of an acceptance or support criteria, you lose all that deferred revenue that might have been sitting on the balance sheet in purchase accounting. So it's a material number.

Okay, great. I'll look for those filings.

Your next question comes from Gus Richard of First Albany.

Yes, good afternoon just a couple of questions on the model, can you talk a little bit about the impact on the P&L of IDS allocation expenses across cost of goods, SG&A and R&D?

Yeah most of the expenses associated with the IDS business model will be in R&D, but the more and more we could meld -- you know -- dataPOWER software and wrap it into a bundle of integration services and software, the more we'll be allocating some of the cost the cost of goods sold you know to properly align integration costs with revenue, but historically, you know the large majority of the expenses have been to R&D.

When you reach steady stay with IDS, you know, P equals four quarters from now, do you see -- is it going to have a positive or a negative contribution to -- is it going to be above or below historic gross margina?

From a software component, it will be above historic gross margins, but as we integrate services with the software model, it will be more traditional PDF, where software is equivalent to gain share and our backend licensing and integration is equivalent to our design-silicon-yield solutions.

So as time goes on, there will no material impact to gross margins?

I don't believe so, but it will depend on the contribution of software versus services.

Got it, and then share count for the coming quarter?

I think I used -- it is in the press release, I think it was around 26m shares -- it's in the press release.

Okay got it, and then just on gain share. Some of your customers are ramping process in the fourth quarter, and can you give some -- can you give me some view to Q1 guidance? Can you talk a little about what gain share will do in Q1?

Yeah this is John. Yes as you alluded that we expect some of the customers volumes in Q4 affect our Q1 gain share. And so we expect Q1 number to see some contribution from those. And hence we expect it to be increasing relative to what we have seen in the past couple of quarters.

Can you just bigger than a bread box, smaller than an elephant, 10% type of sequential growth in that line?

Yeah, I think that would be reasonable.

Okay. And then can you just talk a little more about your sales pipeline and sort of how you see -- you know, the opportunities going through your funnel and sort your win rate, you know over the next quarter or so?

Yeah that's a good question Gus. What we're seeing, I think, is a few things. By and large the customers are more confident and they are seemingly understand that they need to get to some decent production volumes in a relatively short time. So, we are seeing a higher concentration of customers wanting to get a proposal in place, wanting to start discussing terms, and closing the business in a more reasonable time than I think what we saw in 2002 and the first part of 2003. So, we do see a fairly robust amount of interest. It's certainly feeling better when you talk to the customers and in general I think that the time horizons that they willing to discuss, about the size of the commitment they are making seem to be improving than what we saw over the past.

Okay got it. Thanks a lot.

Your next question from Dennis Wassung of Adams, Harness & Hill.

Thanks guys. A couple of quick questions here I guess first one for Steve on the model. Talking about most of the expenses from IDS hitting here in the R&D lines -– is this something, I mean how much of a sequential uptick will we see into Q4 on that line at this point, is it something that is going go to 5 million or -- any color on that?

It's going -- in the average, R&D will certainly head up in that direction. You know, IDS with the financial position that they were in -- albeit they didn't have any debt -- they never took any venture financing; they did cut some edges off of their expense levels because they had to. We've identified areas where they’ve under-spent; we have identified areas where they need additional resources, and while we are going to see some elimination of expenses, for example we didn't bring over much of their administrative personnel; we are going to backfill where they had cut corners. But the bottom line answer to your question is yes, it's going to head up into that neighborhood.

Okay, quick question on the pro forma number you guys reported, in your - I guess sort of your reconciliation in the press release, the amortization intangibles numbers was different there then in the GAAP results -- I was just curious how you reconciled that difference?

Yes. It was different than in the P&L?

Yes.

As you could see, it has amortization of acquired intangibles net, I made a mistake there -- I should have put net of taxes -- maybe that would have been a little bit clearer. That particular line item is the only one is that is net of taxes.

Okay, fair enough. And I guess another couple of questions here for John. When you look at the customer side here, you talked about the major US customer, -- a new engagement there any details you can give us in terms of, is this another -- is this a 90-nanometer process? Is this is a similar group, different groups within this customer, any details you have there?

Yes. I don't know that I can only say just yet -- I think it’s another nanometer technology, and it's expanding within that customer's design, development to production flow, but I don't -- I think we will be able to make a press announcement at sometime in 2004 about it, my guess like the usual case -- some number of quarters after that through an implementation.

So, we won't find out who that is until next year sometime.

No.

Okay and the new customer you signed in Japan; I guess same kind of thing there -- any details you can give us?

No, not at this time, although we may a shorter wick on that in that case.

Okay, and I guess one more on the customer side -- the TSMC deal, any update there and with the pDfx launch here, I know it's early, but, I guess, what is their response as you try to push this out to their fabless customers and, I guess, if you would talk a little bit more about that whole interaction, that would will be helpful.

Sure, well as you know, I think I mentioned it, and I am sure you also follow them pretty closely. In April at their customer forum, they talked about at 90 nanometers, yield being a designer's issue and DFM being a more important part of a designers flow, and certainly we are working with them in demonstrating what pDfx could do for them and their customers and certainly find interest level there. But at this point, it is probably a little early as we have -- you know, we only started talking to customers other than the beta about pDfx in the late summer as we got through the beta on that. And it's probably a little bit early to say what we can expect in the short-term from the TSMC customer base. Although when we talked to their customers we certainly hear a lot of interest in FSA, their customers were clearly very interested in understanding when they could get availability of pDfx for their technology nodes. And the more the customers are talking about it, I think, the sooner you’ll see impact.

Okay. As far as the TSMC, how many, I guess, engagements do you have going on there now?

I believe at this point, there is one engagement going on there right now, it's still ongoing and certainly we're talking with them about how to expand and create more opportunity for them.

Okay. And I am assuming they are not generating gain share at this point, is that fair?

That's fair.

Okay, pDfx, any revenue contribution in Q4 at this point or is it still too early?

Still too early.

Okay, and I guess the last question, looking into Q4 here, can you characterize the, I guess, how much dilution you're expecting here from IDS?

[inaudible] I would like not to throw out a number there.

Okay, thank you guys much.

Thanks.

Your next question comes from Erach Desai of American Technology Research.

Hi, Erach.

Hi, guys I have a couple of questions. One is -- and probably just going on in the same circles that the other guys are, let's see, you have inQ1 '02, about $3 million of gain share. And I am just trying to figure out if you see that on a quarterly level occurring in the first half of next year or the second half of next year?

It's a good question -- and as you know, we have been putting together our own plan for '04; we are giving guidance for the first quarter. As I said, I thought it would be up over the Q3 level in Q1, but as I answered for Gus, up on the order of 10%. And, you know, we haven't really modeled in detail the Q2 and Q3 and 4. As you know, Q1 gain share is going to depend on Q4 starts -- I am sorry Q4 outs. So right now we are seeing what Q1 starts -- Q4 starts are which would be Q1 outs generally. But with about a two-month cycle, we are a little bit ahead of when we would kind of get a good grip -- good grasp on what Q2 and Q3 are going to look like.

What we do know is that there is a backlog of gain share contracts, some of which have contributed dollars and some of which are still not contributing as much as we had expected. So we anticipate those are going to build through out '04, but we don't really know exactly when. The short answer is, it's not Q1 and we don't know when it is in the remaining quarters.But, we do expect it to go back up (technical difficulty), grows [well] as above that.

On a simplistic level, with the overall wafers worldwide going up, especially at advanced geometries -- to the extent that PDF plays an important role, that’s not a bad piece of math to do. Just to get to the exact number, I guess.

Yeah, we certainly do it at all the time, you also have be -- we always have to go back and look specific accounts and what we see going on in those and how they are building.

On the expense side, I guess, perhaps just to make this very simple from my standpoint is, can you tell us what the incremental headcount you've added is, relative to before the two acquisitions and after?

Well, we -- you know -- hired about 30 --37, 38 people.

You added on 37 to38 people. That's very useful

You know, actually that was just IDS. So it's probably close to the 40 -- 41 -- in that neighborhood.

And when you include the rate -- okay. And I don't know, John, if want to handle this, maybe we could talk about it offline too, but one of the major graphics guys who has had a lot of problems moving to .13 has been working with IBM Microelectronics and has suggested publicly that they are going to be looking at a unique approach to design and manufacturing for their next processor or the GPU next year and I'm just wondering -- is that you something that you guys are involved in or do you believe that something that is being done uniquely with IBM Micro?

Yes, as you know, we are usually allowed to make press announcements about customers when they allow us to and we do do that. I am not familiar with that particular public disclosure that a company may have made. So at this point, I would probably back off from answering it.

Thanks.

Your next question comes from Joan Tong of Sidoti & Company.

Hi, good afternoon, I just have a couple questions here. You mentioned about three engagements with contributing gain share this quarter, are they the same engagements that were contributing gain share in the June quarter, can you comment on that?

I’ve got to think back a second here -- one of them overlaps and, two of them do not.

I see, okay, and then how about the one that the large U.S. deal that you sighed in the first quarter, is that deal contributing gain share already or I can't remember whether it started contributing gain share maybe in the June quarter already?

No, it's not.

It's not? So there is no gain share elements from that one yet?

No, we'vefound out -- on that conference call about that engagement. That was a prove out engagement to demonstrate the value of the technology and we as we're announcing today, we're building the business with an expansion on that engagement.

Okay, I see. Another question is about the software component that you are going to sell for those new products from IDS, as well as the pDfx. Are those software licenses going to be more on the time-based models or on the perpetual model? I just wanted to see like how much visibility -- would that be a visibility gain going forward, when software is like contributing more revenue percentage going forward?

Joan, this is John. Historically, IDS Systems, when they sell dataPOWER yields to mix perpetual licenses as well as time-based licenses. And we are, as I think we said on the earlier conference call when we first discussed dataPOWER, you know, we have not been in that business before. So we don't purport to know everything. We are certainly evaluating the mix that they had in the past and what would be the appropriate mix going forward. Their maintenance was a little bit higher than a typical design automation company's maintenance, it was on the order of 20%, I believe. So the ratability of the revenue even on the perpetual is a little bit more radical than typical perpetual design automation guys model. We'll be evaluating that -- in fact, are evaluating that now.

Alright. Thank you.

Joan, I made a mistake with the information I gave you, two of the three overlapped on the gain share, not one of the three.

Okay, got it, thanks.

Once again, if you'd like to ask a question, please press * and the number 1 on your telephone keypad at this time. We will pause for just a moment to compile the Q&A roster. Your next question comes from James Appello of Current Capital.

Hi, guys.

Hi Jamie

I had a question regarding the competitive landscape, we've recently been reading about design for manufacturability being a big opportunity and Synopsis I learned has about 50m in revenue in this area already, although I'm not sure exactly what products they're offering. Could you help me, in terms of what Synopsis is doing and competing with your products and they're also partner on pDfx? And tell me what product you're partnered on the Synopsis side?

Sure. I think design for manufacture -- it's a really good question. Design for manufacturability is the catchall for make my costs effective. And of course a lot of what that's been included in it -- and to make my costs effective as well as deal with processing effects. So, I think that in the first place if you go back to the mid 90s, the first design for manufacturability products were probably related -- were related to OPC and printability. So I think revenues associated with CATH (ph) as well as OPC tools may be included in that number.

I don't know specifically how Synopsis breaks out what they include in design for manufacturability. But when I looked in general, the design automation industry, they typically include printability in dealing with other processing effects such as substrate coupling etc., sometimes get included in DFM or manufacturability. The product that we're partnering with them – our pDfx environment integrates with what would be called a physical compiler or PC. That product is typically not thought of as a DFM product. That product is typically thought of as a synthesis in place of router or part of the physical synthesis.

In fact, physical compliance is the name, environment, I think, what's unique or new , folks don’t really think of the synthesis aspect has really being an area where you can affect design for manufacturability. Typically, I think, that's something you do at the printability stage or late stages in addressing the final finishing touches on the design. So, those are really very two separate areas of Synopsis. We ourselves don't really have a big presence in the OPC space or actually any. We don't know sell an OPC tool. So there is not a lot of overlap there, I think, because DFM has become such a catchall it may look like there is more direct overlap than there actually is.

So could Synopsis try and sell their product as a substitute answer for what you guys are trying to?

Well, the printability really addresses making sure the lines, you know, the design through a line and they want it to look like that on silicon, and what our software and technology does is make sure that even if – if you drew that line, you address the yield on that line, that that line actually yields and connects to the other things like the vias (ph) and the contacts and a lot of the yield effects. They are really pretty much orthogonal. And, yield is , the product of many numbers. So if you screw up one of them, your yield is still low., And, of course, if you look at -- as I said most of the DFM tools around -- they are related around printability, have been around since the mid-90s, and I think people are pretty well aware that yields at 130 have been difficult to achieve.

So, that element of the DFM design flaw I think has been taken into account. What's new about pDfx is addressing the yields that are related to, you know, contacts not being made, the materials not filling correctly, not being electrically robust -- and that element has not been addressed in the past. And if that number -- that limited yield is low, then your yield is -- on the parts that’s still low -- even if you brought all of the tools and design automation guys and took into account as much of the printability as possible.

Okay, so who are you competing with most often these days?

It's a good question. Jamie, I think the -- if you look at our business with respect to -- the majority of our business is integration and ramp. And when the customers buys from PDF, they are buying a combination of test vehicles attached to our software. And into this day, what we see as the number one thing is, the question should they make their own types of vehicle and make their own systems -- is by far the biggest thing we bump up against. And the question it comes down to there is, what's the investment the customer has at risk? Is the investment -- the investment in our test vehicles and technology or is the investment in their fab and their process, which is obviously a much bigger number. So I'd still say the majority of -- 90% is probably related to –- internally, can we build on our own system.

Okay.

(multiple speakers) driver.

How about the -- versus Mentor?

So, Mentor offers DRC tools -- that's probably the closest thing there. I think as we look at the evolving DFM market, I think you are right, Jamie that it is a new market and it's going to be a growing market. We need to be more careful in understanding how the design automation people will either partner or compete with pDfx. But today in what would be an integration ramp, I don't think we see Mentor at all.

Okay. And finally, can you discuss the recent insider sales?

A question about insider sale?

Well yeah. I guess I could address that, you know, for example, you know, both Kim and Michael’s and Tom Koburn who are quite significant shareholders, have implemented a 10b5-1 plan, you know, to diversify some of their holdings. We also had -- from years ago -- going back to 1998, there were promissory notes issued, you know, to all the executive officers that are becoming due and are being repaid -- I can personally speak to that myself -- that I sold shares to pay back my note. And I think that's why insiders are selling, because -- A; they have to pay back their notes and B; in the case of Tom and Kim, you know they are extremely large shareholders and they wanted to put small plan in place, you know, to help them with diversification.

Okay and regarding the promissory notes, how much further is there to go across the executive team?

Well, on the balance sheet there is $3.7m. I think the gentleman sitting next to me has a pretty sizeable note and John Kibarian, one of our Directors has a pretty sizeable note. And most of the rest of the management team have significantly paid down the notes, but I believe there is a few hundreds thousand dollars left and I am kind of speaking off the top of my head. The expectation is by the middle of next year, those notes will need to be repaid, as they have been being repaid over the last year.

Okay. Thank you very much.

Your next question comes from Greg Weaver of Front Capital.

Hi, ganging up on you here. Could you remind us again John, what the typical production run length is for a gain share contract?

Sure. Good question, Greg. As I said production, so after the implementation, there is usually a criteria that establishes when they are in and volume and then that's usually some number of wafers minimum that's start and then that production period is typically anywhere from 8 to 12 quarters.

So, Steve, you're answering Joan’s question about churn on your gain share customers, was that a sequential number?

Not sure I understand the question, Greg.

I think she asked you how many of the gain share guys this quarter were the same as last quarter?

Right. And there was two of the three were sequentially from last quarter, yes.

Okay. And on the WAMA product, my sense what you guys were trying to, you know, do some joint selling and get that moving, since July -- are you kind of holding off on selling that now because you're trying to integrate with the IDS stuff?

No, we're not holding off on it. I think we've started a number of demonstrations with customers, I think -- actually a great number last time I reviewed with the sales team – what they were doing, and we're also integrating partly customer requests, I think one of the first place that we find interest was a significant dataPOWER customer as well who said -- hey, we really wanted it integrated with dataPOWER because it should be the right driver for it and so that activity was greatly started at their behalf., aAnd I would anticipate that will be one of the places we see traction with the WAMA product.

Okay and just to touch on the OpEx front here, if I look at your guidance, just for simplicity sake, you are up 1m in revenue sequentially, right, but you're showing about the same EPS, so that would infer, given your current margin structure that you are adding about $650,000 in additional operating expenses? That seems low. I mean, are you cutting back on PDF’s side, or it didn't sound like there was much trimming to do over at IDS?

No. I have to look exactly at the numbers, but you know, as we move forward and we increase revenues, the allocation of labor between operating expenses and cost of sales will change, you know, proportionately, you know, I think the numbers are in line.

And when is the 8-K due out?

It will be filed before November 10th.

Okay. And on the new business development opportunities, John you touched on couple of new areas for you – memory, cell phone, guys any update there?

Yeah, I think, as we have said, the cell phone guys are people that do, you know, do things in the cell phone areas, based on cell phone chips; also related to silicon-germanium on the base stand part. We are seeing and we do have contracts that are in this quarter that were associated with that, I think both in Q3 and Q4 in those areas. In the memory area, it's a little bit longer term and that is something that we are, as Steve mentioned, I think in the last conference call, we are exploring and working with some vendors on looking the applicability of our technology in those spaces.

Okay. Thanks.

Thank you.

Your next question is a follow up question from Dennis Wassung of Adams, Harkness & Hill

Hi just a quick follow up here on the gain share customers -- three of them in Q3, do you have an expectation for Q4 and Q1? Is that number going to stay pretty stable here, but we just see better volumes, or do we see more contracts falling into the mix?

Well we've -- we certainly have a backlog of gain share contracts -- some of which, you know, volumes haven’t materialized -- some of which haven't reached the gain share period. So over the longer term, yes, we will see the breadth of gain share growing amongst customers and engagements, as more of them come to fruition, both from a contractual standpoint as well as increasing volumes.

And in the short-term though, do you see a couple of more add into the mix here. And I guess also, are any of this three that you have in there now are those -- any of those getting to the mature point where they may start to fall out or decline?

Well it's a little bit more complicated an answer, Dennis, because not all of the gain shares contracts are the same milestone quarter-after-quarter. For example, if the gain share contract was a wafer-based fee, you could say, oh, they are going to produce wavers every quarter -- therefore we are going to have gain share. Other contracts are a percentage of other baseline and from quarter-to-quarter the baseline moves. And you know, other gain share are time-to-market incentives and in some quarters you make them and some quarters you don't. So, it's not a situation where you could say, you know, if everybody was on a wafer-based fee, you could simply look at production -- and as we move out going forward, we anticipate more and more contracts going to that structure. But historically, it's been a mix of configurations. So, you really can't point to one particular trend that's going to drive repeatability within a customer or amongst the certain engagement.

Okay. And did you say anything about the, I guess, the sort of short-term in terms of new ads?

Yes, I think -- this is John, we expect at least within a couple of the accounts the number of contracts that contribute gain share will go up. I think we are starting to decide I don't remember the specifics on Q4 and Q1 and what the estimates coming out of the folks that track that here. I think Steve's point is, you know, with some of them with the baseline, they sometime go in and out, you know, one quarter they are in, and one quarter they are out, and then back in again. So, it’s, you know, I think that's were -- we have stopping with because we don't remember the specific estimates for Q4 and Q1 about how many of the contracts, some of the accounts have multiple contracts that contribute gain share, and is it one or two or three that make up that number the next quarter, I don't remember.

Right. Okay fair enough and just a last clarification -- you had given a number that gain share revenue could be up 10%, and I didn't know if you said Q4 or Q1?

That was in Q1.

So from the Q3 level to Q1?

Yes.

Okay. Very good. Thank you.

Your final question is a follow-up question from Bill Frerichs of D.A. Davidson & Co.

John, going back to your description of how pDfx might work with EDA flow -- what you are saying is the tool will have the ability to flag illegal connections or placements in the physical synthesis tool?

It's a great question. Bill, as you know physical synthesis tools really affect the technology mapping when you going and deciding how to map logic down into theories of building blocks, and it's always been the case that you trade off in that cost function, timing closure and the area -- and you’ve never been able to trade off or have a metric for yield. Usually what people do -- in fact, I think one of things people think about DFM is, extra rules -- so rules for I minimum space active is this, but it's recommended that you use this active space, it's also recommended that you doublecontext. Well, as soon as you say those two things, you can't get both of those recommendations in.

So, you need to go from a bunch of recommendations to a quantified number. So, what pDfx does -- in setup, when they setup pDfx, you provide a .PDFM files which is a, you know, a yield -- basically data for a yield model for each of the design blocks that are being used, just like you have a .lib file for your timing information. Then on synthesis, the pDfx tool basically gives the physical synthesis tool the ability to trade off yield with of course area and timing and other design considerations. So because you quantified and given it a yield metric, each piece of IP a yield metric, you can now make a different set of trade offs. And that's basically what it does.

Okay. And its ability to judge these trade offs is based on your actual experience with actual processes.

So, it's based on a characterization of the IP and how it maps to that process, so it's pretty much the same thing like a spice model being used to generate, you know, timing data.

Okay great, I understand. Thanks very much.

Thank you.

At this time, there are no more questions. And I will now turn the call back over to Mr. Kibarian for closing remarks.

Thank you. In summary, in the third quarter, we experienced what appears to be an improving market. PDF continued to execute on our business plan, began integrating the people and products at IDS, and expanded our product line with the successful launch of pDfx. These accomplishments position PDF for long term growth by providing broader solutions to help the customers as they move towards nanometer processors and products. Thank you for joining our third quarter 2003 conference call. Good bye.

Ladies and gentlemen, this concludes the program. Thank you, you may disconnect at this time.