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 September 30, 2006

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

For the transition period from                      to

PDF SOLUTIONS, INC.

(Exact name of Registrant as Specified in its Charter)

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

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

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

Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act (Check one):

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The number of shares outstanding of the Registrant’s Common Stock as of November 3, 2006 was 27,482,620

 

 

TABLE OF CONTENTS

		Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements			2
Unaudited Consolidated Balance Sheets			2
Unaudited Consolidated Statements of Operations			3
Unaudited Consolidated Statements of Cash Flows			4
Notes to Unaudited Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			13
Item 3. Quantitative and Qualitative Disclosures About Market Risk			24
Item 4. Controls and Procedures			25
PART II OTHER INFORMATION
Item 1. Legal Proceedings			25
Item 1A. Risk Factors			25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			33
Item 3. Defaults Upon Senior Securities			33
Item 4. Submission of Matters to a Vote of Security Holders			33
Item 5. Other Information			33
Item 6. Exhibits			34
SIGNATURES			35
INDEX TO EXHIBITS
EXHIBIT 31.01
EXHIBIT 31.02
EXHIBIT 32.01
EXHIBIT 32.02

Item 1. Financial Statements.

PDF SOLUTIONS, INC.

		September 30,				December 31,
		2006				2005
ASSETS
Current assets:
Cash and cash equivalents		$	52,781			$	60,506
Short-term investments			17,137				—
Accounts receivable, net of allowance of $254 in 2006 and 2005			23,420				22,082
Prepaid expenses and other current assets			2,378				1,992
Deferred tax assets			768				908
Total current assets			96,484				85,488
Property and equipment, net			3,533				3,328
Goodwill			38,963				39,886
Intangible assets, net			5,284				9,787
Deferred tax assets			2,361				877
Other assets			1,126				526
Total assets		$	147,751			$	139,892
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	2,779			$	1,728
Accrued compensation and related benefits			2,743				4,922
Other accrued liabilities			1,729				1,469
Taxes payable			4,262				4,950
Deferred revenue			2,702				2,281
Billings in excess of recognized revenue			139				1,604
Total current liabilities			14,354				16,954
Long-term liabilities			252				257
Total liabilities			14,606				17,211
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 and outstanding 26,890 in 2006 and 26,433 in 2005			4				4
Additional paid-in-capital			152,136				141,720
Treasury stock at cost, 551 shares			(5,549	)			(5,549	)
Deferred stock-based compensation			—				(27	)
Accumulated deficit			(13,460	)			(13,451	)
Accumulated other comprehensive income (loss)			14				(16	)
Total stockholders’ equity			133,145				122,681
Total liabilities and stockholders’ equity		$	147,751			$	139,892

See notes to unaudited consolidated financial statements

PDF SOLUTIONS, INC.

		Three Months Ended								Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2006				2005				2006				2005
Revenue:
Design-to-silicon-yield solutions
Integrated solutions		$	11,153			$	13,834			$	33,859			$	38,658
Software licenses			3,811				1,533				8,217				8,179
Gain share			4,400				3,090				15,155				8,069
Total revenue			19,364				18,457				57,231				54,906
Cost and expenses:
Cost of design-to-silicon-yield solutions:
Direct costs of design-to-silicon-yield solutions
Integrated solutions			6,734	(1)			6,382				19,808	(1)			17,898
Software licenses			58				15				98				273
Amortization of acquired core technology			1,266				1,266				3,798				3,798
Research and development			6,416	(1)			5,485				19,543	(1)			16,550
Selling, general and administrative			5,028	(1)			3,979				14,850	(1)			12,182
Amortization of other acquired intangible assets			235				235				705				705
Total costs and expenses			19,737				17,362				58,802				51,406
Income (loss) from operations			(373	)			1,095				(1,571	)			3,500
Interest and other income, net			892				463				2,338				1,085
Income before taxes			519				1,558				767				4,585
Tax provision (benefit)			(51	)(2)			22				776	(2)			313
Net income (loss)		$	570			$	1,536			$	(9	)		$	4,272
Net income (loss) per share:
Basic		$	0.02			$	0.06			$	(0.00	)		$	0.17
Diluted		$	0.02			$	0.06			$	(0.00	)		$	0.16
Weighted average common shares:
Basic			26,860				26,101				26,694				25,887
Diluted			27,621				27,779				26,694				27,298

See notes to unaudited consolidated financial statements

PDF SOLUTIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)

		Nine Months Ended
		September 30,				September 30,
		2006				2005
Operating activities:
Net income (loss)		$	(9	)		$	4,272
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization			1,532				1,690
Stock-based compensation			5,462				93
Amortization of acquired intangible assets			4,503				4,503
Tax benefit related to stock-based compensation plans			579				—
Excess tax benefit from stock-based compensation			(286	)			—
Deferred taxes			(1,020	)			(1,533	)
Changes in operating assets and liabilities:
Accounts receivable			(1,338	)			(1,649	)
Prepaid expenses and other assets			(986	)			146
Accounts payable			1,045				310
Accrued compensation and related benefits			(2,179	)			1,087
Other accrued liabilities			290				(826	)
Taxes payable			(89	)			1,675
Deferred revenue			421				(527	)
Billings in excess of recognized revenue			(1,465	)			844
Net cash provided by operating activities			6,460				10,085
Investing activities:
Purchases of available-for-sale securities and other investments			(42,198	)			—
Maturities and sales of available-for-sale securities and other investments			25,242				—
Purchases of property and equipment			(1,915	)			(1,784	)
Net cash used in investing activities			(18,871	)			(1,784	)
Financing activities:
Proceeds from exercise of stock options			3,425				4,687
Proceeds from employee stock purchase plan			978				808
Principal payments on long-term obligations			(36	)			(40	)
Excess tax benefit from stock-based compensation			286				—
Net cash provided by financing activities			4,653				5,455
Effect of exchange rate changes on cash and cash equivalents			33				(75	)
Net increase (decrease) in cash and cash equivalents			(7,725	)			13,681
Cash and cash equivalents, beginning of period			60,506				45,660
Cash and cash equivalents, end of period		$	52,781			$	59,341
Non-cash investing and financing activities:
Purchase of property and equipment on account		$	28			$	210
Repurchase of common stock in exchange for shareholder note receivable		$	—			$	742
Deferred stock-based compensation		$	—			$	10
Reversal of deferred stock compensation		$	27			$	—
Purchase price adjustment		$	923			$	—
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Taxes		$	1,381			$	153
Interest		$	1			$	—

See notes to unaudited consolidated financial statements

PDF SOLUTIONS, INC.

1. BASIS OF PRESENTATION

Basis of Presentation

     The interim unaudited consolidated financial statements included herein have been prepared by PDF Solutions, Inc. (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“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 unaudited interim 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 unaudited 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, 2005.

     The preparation of the 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 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 stock-based compensation expense disclosed separately in 2005 has been reclassified to research and development and to selling, general and administrative expenses to conform to current-year presentation as a result of the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No.123(R)”).

Revenue Recognition

     The Company derives revenue from two sources: Design-to-Silicon-Yield solutions and gain share. The Company recognizes revenue in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position (“SOP”) No. 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts and SOP No. 97-2, Software Revenue Recognition, as amended.

     Design-to-Silicon-Yield Solutions — Design-to-silicon-yield solutions revenue is derived from integrated solutions and software licenses. Revenue recognition for each element of Design-to-Silicon-Yield solutions is summarized as follows:

     Integrated Solutions — The Company generates a significant portion of its revenue from fixed-price contracts delivered over a specific period of time. These contracts require the accurate estimation of the cost to perform obligations and the overall scope of each engagement. Revenue under contracts for solution implementation services is recognized as the 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 integrated solutions implementations. In such instances, the software products are licensed to the customer over the 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 (“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 agreement. Costs incurred under these arrangements are deferred and recognized in proportion to revenue recognized under these arrangements.

     Revenue from 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 the 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. In such cases revenue is recognized under the residual method when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, (iv) collectibility is probable and 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 integrated solutions. 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. No revenue has been recognized for software licenses with extended payment terms in excess of amounts due.

     Gain Share — Gain share revenue represents profit sharing and performance incentives earned based upon the Company’s customer reaching certain defined operational levels. Upon achieving such operational levels, the Company receives either a fixed fee and/or variable fee based on the units manufactured by the customer. Due to the uncertainties surrounding attainment of such operational levels, the Company recognizes gain share 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.

Stock-Based Compensation

     Effective January 1, 2006, the Company adopted the provisions of SFAS No.123(R). The statement eliminates the ability to account for share-based compensation transactions using Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements based on estimated fair values. SFAS No. 123(R) applies to all share-based payment transactions in which the Company acquires goods or services by issuing its shares, share options, or other equity instruments or by incurring liabilities based on the price of the Company’s shares or that require settlement by the issuance of equity instruments. The Company elected to use the modified prospective transition method upon adopting this statement and accordingly prior periods have not been restated to reflect the impact of SFAS No.123(R). Under this transition method, stock-based compensation expense for the first quarter of fiscal 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company recognizes the compensation costs of options granted after January 1, 2006 on a straight-line basis over the vesting periods of the applicable stock purchase rights and stock options, generally four years. Prior to adoption of SFAS No. 123(R), the Company presented all tax benefits resulting from stock options as operating cash flow in its statement of cash flows. In accordance with SFAS No. l23(R), the cash flows resulting from excess tax benefits are classified as financing cash flows.

     Prior to the adoption of SFAS No. 123(R), the Company accounted for stock-based compensation in accordance with APB No. 25, and complied with the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures”. Deferred compensation recognized under APB No. 25 was amortized to expense using the graded vesting method. In March 2005, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS No. 123(R) and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R). See Note 9 to the Unaudited Consolidated Financial Statements for a further discussion on stock-based compensation.

2. RECENT ACCOUNTING PRONOUNCEMENTS

     In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, Accounting for Income Taxes. This Interpretation prescribes a more-likely-than not recognition threshold that a tax position will be sustained upon examination and a measurement attribute for the financial statement recognition of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The cumulative effect of applying the provisions of this Interpretation shall be reported as an adjustment to the opening balance of retained earnings in 2007. The Company is currently evaluating the requirements of FIN 48 and has not yet determined the impact on the consolidated financial statements.

     In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”), Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements, which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 will be adopted in connection with the preparation of the annual financial statements for fiscal year 2006. The adoption of SAB 108 is not expected to materially impact the consolidated financial statements.

     In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. SFAS No. 157 will be effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of the provisions of SFAS No. 157 is not expected to materially impact the consolidated financial statements.

3. INVESTMENTS

     The following tables summarize the Company’s investments (in thousands):

						September 30, 2006
						Unrealized				Unrealized
		Amortized				Holding				Holding				Market
		Cost				Gains				Losses				Value
Commercial paper		$	10,117			$	3			$	—			$	10,120
Auction rate securities			5,550				—				—				5,550
Corporate bonds and notes			5,975				—				(6	)			5,969
Money market funds			44,488				—				—				44,488
		$	66,130			$	3			$	(6	)		$	66,127
Included in cash and cash equivalents														$	48,990
Included in short-term investments															17,137
Total available-for-sale securities														$	66,127

     As of September 30, 2006 all securities held by the Company had a maturity of one year or less.

						December 31, 2005
						Unrealized				Unrealized
		Amortized				Holding				Holding				Market
		Cost				Gains				Losses				Value
Money market funds		$	57,652			$	—			$	—			$	57,652
Included in cash and cash equivalents														$	57,652
Included in short-term investments															—
Total available-for-sale securities														$	57,652

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 $6.8 million and $1.8 million at September 30, 2006 and December 31, 2005, 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								Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Net income (loss)		$	570			$	1,536			$	(9	)		$	4,272
Denominator:
Weighted average common shares outstanding			26,860				26,101				26,694				25,891
Weighted average common shares outstanding subject to repurchase			—				—				—				(4	)
Denominator for basic calculation			26,860				26,101				26,694				25,887
Weighted average shares subject to repurchase			—				—				—				4
Stock options outstanding			761				1,678				—				1,407
Denominator for diluted computation			27,621				27,779				26,694				27,298
Net income (loss) per share — basic		$	0.02			$	0.06			$	(0.00	)		$	0.17
Net income (loss) per share — diluted		$	0.02			$	0.06			$	(0.00	)		$	0.16

     The following table sets forth potential shares of common stock that are not included in the diluted net income (loss) per share calculation above because to do so would be anti-dilutive for the periods indicated (in thousands):

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Common stock options			2,883				157				5,501				546

6. COMPREHENSIVE INCOME (LOSS)

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

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Net income (loss)		$	570			$	1,536			$	(9	)		$	4,272
Unrealized gain (loss) on short-term investments			38				—				(3	)			—
Foreign currency translation adjustments			(16	)			(6	)			33				(75	)
Comprehensive income		$	592			$	1,530			$	21			$	4,197

7. GOODWILL AND PURCHASED INTANGIBLE ASSETS

     SFAS No. 142, Goodwill and other Intangible Assets, requires goodwill to be tested for impairment under certain circumstances, written down when impaired, and requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite.

     The following table provides information relating to the intangible assets and goodwill contained within the Company’s consolidated balance sheets as of September 30, 2006 and December 31, 2005 (in thousands):

		December 31, 2005				Purchase Price								September 30, 2006
		Net Carrying Amount				Adjustments				Amortization				Net Carrying Amount
Goodwill		$	39,886			$	(923	)		$	—			$	38,963
Acquired identifiable intangibles:
Acquired core technology		$	8,221			$	—			$	(3,798	)		$	4,423
Brand name			833				—				(375	)			458
Other acquired intangibles			733				—				(330	)			403
Total		$	9,787			$	—			$	(4,503	)		$	5,284

		December 31, 2004				Purchase Price								December 31, 2005
		Net Carrying Amount				Adjustments				Amortization				Net Carrying Amount
Goodwill		$	39,886			$	—			$	—			$	39,886
Acquired identifiable intangibles:
Acquired core technology		$	13,285			$	—			$	(5,064	)		$	8,221
Brand name			1,333				—				(500	)			833
Other acquired intangibles			1,173				—				(440	)			733
Total		$	15,791			$	—			$	(6,004	)		$	9,787

     SFAS No. 142 requires that goodwill be tested for impairment on an annual basis and more frequently in certain circumstances. Accordingly, the Company has selected December 31, to perform the annual testing requirements. As of December 31, 2005, the Company completed its annual testing requirements and determined that the carrying value of goodwill had not been impaired.

     During the three months ended September 30, 2006, the Company recorded a non-cash adjustment of $923,000 relating to the reduction of a valuation allowance established for deferred tax assets that were assumed in connection with the Company’s acquisition of IDS Software Inc. in 2003. Such adjustment resulted in a decrease in goodwill.

     The Company expects the annual amortization of acquired intangible assets to be as follows (in thousands):

Year Ending December 31,		Amount
2006 (three-month period ending December 31, 2006)		$	1,501
2007			3,783
Total		$	5,284

8. 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								Nine Months
		Ended September 30,								Ended September 30,
Customer		2006				2005				2006				2005
A			9	%			11	%			12	%			11	%
G			1	%			12	%			5	%			12	%
J			1	%			9	%			1	%			13	%
M			10	%			4	%			5	%			11	%
O			9	%			4	%			10	%			4	%
P			18	%			20	%			27	%			11	%
R			14	%			—				8	%			—

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

Customer		September 30, 2006				December 31, 2005
A			14	%			5	%
J			—				18	%
P			19	%			25	%
R			14	%			1	%

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

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Asia		$	10,396			$	9,522			$	28,626			$	32,400
United States			7,096				6,729				23,585				16,804
Europe			1,872				2,206				5,020				5,702
Total		$	19,364			$	18,457			$	57,231			$	54,906

     As of September 30, 2006 and December 31, 2005, long-lived assets related to PDF Solutions GmbH (formerly AISS), located in Germany, totaled $834,000 and $880,000, respectively, of which $659,000 and $659,000, respectively, relates to acquired intangible assets and goodwill. The majority of the Company’s remaining long-lived assets are in the United States.

9. STOCKHOLDERS’ EQUITY

     Effective January 1, 2006 the Company adopted SFAS No. 123(R). As a result, the Company recorded total stock-based compensation and related income tax expense of $1.5 million and $8,000 respectively, for the three months ended September 30, 2006, and $5.5 million and $72,000 respectively, for the nine months ended September 30, 2006. The deferred compensation expense computed under APB No. 25 and unamortized as of January 1, 2006 was reversed to equity upon adopting SFAS No. 123(R). For the three and nine months ended September 30, 2006, the Company incurred additional stock-based compensation expense of $1.5 million and $5.4 million respectively, compared to the expense the Company would have incurred under APB No. 25.

     For the three and nine months ended September 30, 2006 and September 30, 2005, stock-based compensation expense related to the Company’s ESPP and stock-option plans was allocated as follows (in thousands):

		Three Months Ended				Nine Months Ended				Three Months Ended				Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2006 (1)				2006 (1)				2005 (2)				2005 (2)
Cost of design-to-silicon yield solutions		$	443			$	1,519			$	—			$	—
Research and development			443				1,629				11				85
Selling, general and administrative			621				2,314				8				8
Stock based compensation before income taxes			1,507				5,462				19				93
Income tax expense associated with stock options			8				72				—				—
Stock-based compensation, net of taxes		$	1,515			$	5,534			$	19			$	93
Effect on net income (loss) per share:
Basic		$	0.06			$	0.21			$	0.00			$	0.00
Diluted		$	0.05			$	0.21			$	0.00			$	0.00

     Prior to January 1, 2006, the Company accounted for stock-based compensation in accordance with the provisions of APB No. 25 and complied with the disclosure only provisions of SFAS No. 123 as amended by SFAS No. 148, and accordingly, no expense computed under SFAS No. 123 had been recognized for options granted to employees under the various stock plans. Deferred compensation recognized under APB No. 25 was amortized to expense over the vesting period, usually four years, using the graded vesting method. For SFAS No. 123 as amended by SFAS No. 148 disclosure purposes, the Company amortized deferred stock-based compensation on the graded vesting method over the vesting periods of the applicable stock purchase rights and stock options, generally four years. The graded vesting method provided for vesting of portions of the overall awards at interim dates and results

in greater vesting in earlier years than the straight-line method. Had compensation expense been determined for employee awards based on the fair value at the grant date for the awards, consistent with the provisions of SFAS No. 123, the Company’s pro forma net income and pro forma net income per share for the three months and nine months ended September 30, 2005 would have been as follows (in thousands, except per share data):

		Three Months				Nine Months
		Ended September 30,				Ended September 30,
		2005				2005
Net income as reported:		$	1,536			$	4,272
Add: stock-based employee compensation expense included in reported net loss under APB No. 25, net of related tax effects			19				93
Deduct: total employee stock-based compensation determined under fair value based method for all awards, net of related tax effects			(1,636	)			(4,396	)
Pro forma net income (loss)		$	(81	)		$	(31	)
Basic net income (loss) per share:
As reported		$	0.06			$	0.17
Pro forma		$	(0.00	)		$	(0.00	)
Diluted net income per share:
As reported		$	0.06			$	0.16
Pro forma		$	(0.00	)		$	(0.00	)

     Upon its adoption of the fair value recognition provisions of SFAS No.123(R), the Company elected to use the modified prospective transition method, and accordingly prior periods have not been restated to reflect the impact of SFAS No. 123(R). Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Under the modified prospective transition method, stock-based compensation expense recognized in the Company’s unaudited consolidated statement of income for the three months and the nine months ended September 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123, and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). In conjunction with the adoption of SFAS No. 123(R), the Company changed its method of attributing the value of stock-based compensation to expense from the graded vesting method to the straight-line method. Compensation expense for all share-based payment awards granted on or prior to December 31, 2005 will continue to be recognized using the graded vesting method while compensation expense for all share-based payment awards granted subsequent to December 31, 2005 is recognized using the straight-line method. As stock-based compensation expense recognized in the unaudited consolidated statement of income for the three months and nine months ended September 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required under SFAS No. 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred. The Company estimated the forfeiture rate based on its employee turnover history over the last two fiscal years.

     The Company has elected to use the Black-Scholes-Merton option-pricing model, which incorporates various assumptions including volatility, expected life, and interest rates. The expected volatility is based on the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options. The expected life of an award is based on historical experience and on the terms and conditions of the stock awards granted to employees. The interest rate assumption is based upon observed Treasury yield curve rates appropriate for the expected life of the Company’s stock options.

     The assumptions used for the three months and nine months ended September 30, 2006 and the resulting estimates of weighted average fair value of options granted and for stock purchases during the period are as follows:

						Employee								Employee
						Stock Purchase								Stock Purchase
		Stock Plans				Plan				Stock Plans				Plan
		Three Months				Three Months				Nine Months				Nine Months
		Ended				Ended				Ended				Ended
		September 30, 2006				September 30, 2006				September 30, 2006				September 30, 2006
Expected life (in years)			4.26				0.25				4.26				0.97
Volatility			56.9	%			60.3	%			58.1	%			52.8	%
Risk-free interest rate			4.97	%			5.08	%			4.82	%			3.79	%
Expected dividend			—				—				—				—
Weighted average fair value of options granted during the period		$	6.26				n/a			$	7.63				n/a
Weighted average fair value of employee stock			n/a			$	3.45				n/a			$	4.14

     Stock option activity under the Company plans as of September 30, 2006 and changes during the nine months ended September 30, 2006 were as follows:

						Weighted				Weighted
						Average				Average
						Exercise				Remaining				Aggregate
		Number of				Price				Contractual				Intrinsic Value
		Options				per Share				Term (years)				(in 000’s)
Outstanding, January 1, 2006			5,674,045			$	11.13
Granted			376,500				15.18
Exercised			(353,057	)			9.70
Forfeited or expired			(196,204	)			13.16
Outstanding at September 30, 2006			5,501,284				11.43				7.20			$	6,714
Exercisable at September 30, 2006			3,278,020			$	10.22				6.24			$	5,632

     The aggregate intrinsic value in the table above represents the total pretax intrinsic value based on the Company’s closing stock price of $10.96 as of September 30, 2006, 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 nine months ended September 30, 2006 was $2.2 million.

     Nonvested options as of September 30, 2006 and changes during the nine months ended September 30, 2006 were as follows:

						Weighted
		Number of				Average
		Options				Grant Date Fair Value
Nonvested, January 1, 2006			2,796,371			$	6.94
Granted			376,500				7.63
Vested			(768,217	)			6.27
Forfeited			(181,390	)			7.26
Nonvested at September 30, 2006			2,223,264				6.86

     As of September 30, 2006, there was $7.2 million of total unrecognized compensation cost related to nonvested stock options. That cost is expected to be recognized over a weighted average period of 2.88 years. The total fair value of shares vested during the nine months ended September 30, 2006 was $4.8 million.

     On September 30, 2006, 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 (i) 3,000,000 shares, (ii) 5% of the outstanding common stock on the last day of the immediately preceding year, or (iii) 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 nonstatutory stock options. These options generally expire ten years from the date of grant and become vested and exercisable ratably over a four-year period. Certain option grants under the 1996 and 1997 Stock Plans provide for the immediate exercise by the optionee with the resulting shares issued subject to a right of repurchase by the Company which lapses based on the original vesting provisions.

     Employee Stock Purchase Plan — In July 2001, the Company adopted an Employee Stock Purchase Plan, (“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 three months ended September 30, 2006, the purchase plan compensation expense was $153,000.

     Stock repurchase program — In February 2003, the Board of Directors approved a program to repurchase up to $10.0 million of the Company’s common stock in the open market. As of September 30, 2006, the Company has repurchased 550,521 shares at a weighted average price of $10.08 per share for a total cost of $5.5 million. Under this authorization, the Company may continue to make additional stock repurchases from time to time, depending on market conditions, stock price and other factors. At September 30, 2006, $4.5 million remained available under the program to repurchase additional shares.

10. SUBSEQUENT EVENTS

     On October 31, 2006, PDF Solutions acquired Si Automation S.A. (SIA), a privately held Fault Detection and Classification software and services provider, based in Montpellier, France. Under terms of the agreement, PDF Solutions acquired SIA for approximately $26.6 million in cash and approximately 700,000 shares of PDF Solutions common stock, resulting in aggregate consideration of approximately $35.6 million, based upon the closing price of PDF Solutions common stock on the Nasdaq National Market of $14.15 per share on October 31, 2006, or approximately $30.6 million, net of expected net cash-on-hand at SIA, as of the close date of this transaction.

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. These statements relate to future events or our future financial performance. 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 comparable terminology. These statements are only predictions. These statements involve known and unknown risks and uncertainties and other factors that may cause actual events or results to differ materially. All forward-looking statements included in this document are based on information available to us on the date of filing, and 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 and set forth at the end of Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2005. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.

Overview

     Our technologies and services enable semiconductor companies to improve the yield and performance of integrated circuits, or ICs, by integrating the design and manufacturing processes. We believe that our solutions improve a semiconductor company’s time-to-market, yield and ultimately product profitability. Our solutions combine proprietary manufacturing process simulation software, yield and performance modeling software, design-for-manufacturability software, test chips, a proprietary electrical wafer test system, yield and performance enhancement methodologies, yield management systems, and professional services. We analyze yield loss mechanisms to identify, quantify and correct the issues that cause yield loss, as an integral part of the IC design process. This drives IC design and manufacturing improvements that enable our customers to have higher initial yields and achieve and exceed targeted IC yield and performance throughout product life cycles. Our solution is designed to increase the initial yield when a design first enters a manufacturing line, to increase the rate at which that yield improves, and to allow subsequent product designs to be added to manufacturing lines more quickly and easily.

     The result of implementing our solutions is the creation of value that can be measured based on improvements to our customers’ actual yield. We align our financial interests with the yield and performance improvements realized

by our customers, and receive revenue based on this value. To date, we have sold our technologies and services to semiconductor companies including leading integrated device manufacturers, fabless semiconductor companies and foundries.

     From our incorporation in 1992 through late 1995, we were primarily focused on research and development of our proprietary manufacturing process simulation and yield and performance modeling software. From late 1995 through late 1998, we continued to refine and sell our software, while expanding our offering to include yield and performance improvement consulting services. In late 1998, we began to sell our software and consulting services, together with our newly developed proprietary technologies, as 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, now operating as PDF Solutions, GmbH, 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 through the acquisitions of IDS and WaferYield. In 2006, we further complimented our technology offering through the acquisition of Si Automation S.A.

Industry Trend

     Demand for consumer electronics continues to drive technological innovation as the need for products which have greater performance, lower power consumption, reduced costs and smaller size continues to grow with each new product generation. To meet this demand, IC manufacturers and designers are constantly challenged to improve the overall performance of ICs by designing and manufacturing ICs with more embedded applications to create greater functionality. As a result, throughout 2004, 2005, and into the first nine months of 2006 more and more companies have expanded or advanced their design and manufacturing processes to develop and produce deep submicron ICs containing component sizes measured at 130 nanometers and below. As this trend continues, companies will continually be challenged to improve process capabilities to optimally produce ICs with minimal systematic and yield loss, which is driven by the lack of compatibility between the design and its respective manufacturing process. We believe as volume production of deep submicron ICs continues to grow, the difficulties of integrating IC designs with their respective processes will create a greater need for products and services that address the performance yield loss issues the semiconductor industry is facing today and will face in the future.

Financial Highlights

     Financial highlights for the three months ended September 30, 2006 were as follows:

     Total revenue for the three months ended September 30, 2006, was $19.4 million, an increase of 5% compared to the three months ended September 30, 2005. Revenue from Design-to-Silicon-Yield integrated solutions for the three months ended September 30, 2006 decreased 19% to $11.2 million compared to $13.8 million for the three months ended September 30, 2005. This decrease was the result of a slower booking rate for new integrated solution engagements in late 2005 and in the first half of 2006 which would have contributed to revenue in 2006 and, due to the timing of new contracts signed in the current quarter, was partially offset by an increase in software maintenance revenue. Revenue from Design-to-Silicon-Yield software licenses for the three months ended September 30, 2006 increased to $3.8 million compared to $1.5 million for the three months ended September 30, 2005 as a result of greater adoption of our software applications by new and existing customers. Gain share revenue for the three months ended September 30, 2006 increased to $4.4 million compared to $3.1 million for the three months ended September 30, 2005 as a result of increased wafer starts at our customers and a greater number of contracts reaching gain share thresholds. Our gain share revenue may continue to fluctuate from quarter to quarter as a result of each customer’s contractual performance measures for achieving gain share as well as each customer’s production volumes in any given period. We reported a net income of $570,000 for the three months ended September 30, 2006, compared to a net income of $1.5 million for the three months ended September 30, 2005. The decrease in net income was primarily attributable to an overall $1.5 million increase in stock-based compensation expense recognized and allocated to all functional expense categories as a result of our adoption of SFAS No. 123(R) and increased operating expenses, partially offset by increased other income. Direct cost of Design-to-Silicon-Yield solutions increased 6% to $6.8 million in the three months ended September 30, 2006 from $6.4 million in the comparable period in 2005, primarily the result of the increase in stock-based compensation expense under SFAS No. 123(R), and greater material costs associated with our expanded pdFasTest products. Research and development expenses increased 17% to $6.4 million for the three months ended September 30, 2006, from $5.5 million for the three months ended September 30, 2005, as a result of the increase in stock-based compensation expense under SFAS No. 123(R), increased use of outside resources on strategic product initiatives, an increase in personnel related costs and the opening of a new office in Shanghai, China. Selling, general and administrative

expenses increased to $5.0 million from $4.0 million as a result of the increase in stock-based compensation expense under SFAS No. 123(R) and higher legal and accounting fees. We will continue to monitor and control costs, relative to our revenue growth.

     Financial highlights for the nine months ended September 30, 2006 were as follows:

     Total revenue for the nine months ended September 30, 2006, was $57.2 million, an increase of 4% compared to the nine months ended September 30, 2005. Revenue from Design-to-Silicon-Yield integrated solutions for the nine months ended September 30, 2006 decreased 12% to $33.9 million compared to $38.7 million for the nine months ended September 30, 2005. This decrease was the result of a slower booking rate for new integrated solution engagements in late 2005 which would have contributed to revenue in 2006 and delays in signing certain new engagements until the second half of in the current year, partially offset by an increase in software maintenance revenue. Revenue from Design-to-Silicon-Yield software licenses for the nine months ended September 30, 2006 was consistent at $8.2 million for the nine months ended September 30, 2005. Gain share revenue for the nine months ended September 30, 2006 increased to $15.2 million compared to $8.1 million for the nine months ended September 30, 2005. We reported a net loss of $9,000 for the nine months ended September 30, 2006, compared to a net income of $4.3 million for the nine months ended September 30, 2005. The decrease in net income was primarily attributable to an overall $5.4 million increase in stock-based compensation expense recognized and allocated to all functional expense categories as a result of our adoption of SFAS No. 123(R), an increase in research and development expenses, and a higher effective tax rate. Direct cost of Design-to-Silicon-Yield solutions increased 10% to $19.9 million in the nine months ended September 30, 2006 from $18.2 million in the comparable period in 2005, primarily as the result of the increase in stock-based compensation expense under SFAS No. 123(R), and greater material costs associated with our expanded pdFasTest products. Research and development expenses increased 18% to $19.5 million for the nine months ended September 30, 2006, from $16.6 million for the nine months ended September 30, 2005, as a result of the increase in stock-based compensation expense under SFAS No. 123(R) and increased personnel-related and third party developer expenses. Selling, general and administrative expenses increased to $14.9 million from $12.2 million as a result of the increase in stock-based compensation expense under SFAS No. 123(R), increased personnel-related expenses, and increased legal expenses, partially offset by lower outside sales commissions.

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. The notes to the unaudited consolidated financial statements include a summary of the significant accounting policies and methods used in the preparation of our 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 consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. Our preparation of these 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 base 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 and gain share. We recognize revenue in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position (“SOP”) No. 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts and SOP No. 97-2, Software Revenue Recognition, as amended.

     Design-to-Silicon-Yield Solutions — Design-to-Silicon-Yield solutions revenue is derived from integrated solutions and software licenses. Revenue recognition for each element of Design-to-Silicon-Yield solutions is as follows:

     Integrated Solutions — We generate a significant portion our revenue from fixed-price contracts delivered over a specific period of time. These contracts require the accurate estimation of the cost to perform obligations and the overall scope of each engagement. Revenue under contracts for solution implementation services is recognized as the 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 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.

     On occasion, we have licensed our software products as a component of our fixed price solutions implementations. In such instances, the software products are licensed to the customer over the 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 (“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 agreement. Costs incurred under these arrangements are deferred and recognized in proportion to revenue recognized under these arrangements.

     Revenue from 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 the services are performed. When bundled with software licenses in multiple element arrangements, support and maintenance, consulting (other than for our fixed price solution implementations), installation, and training revenue is allocated to each element of a transaction based upon its fair value as determined by our VSOE. VSOE is generally established for maintenance based upon negotiated renewal rates while VSOE for consulting, installation, and training is established based upon our customary pricing for such services when sold separately. When VSOE does not exist to allocate a portion of the total fee to the undelivered elements, revenue is recognized ratably over the term of the underlying element for which VSOE does not exist.

     Software Licenses — We also license our software products separate from our integrated solutions. In such cases revenue is recognized under the residual method when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, (iv) collectibility is probable and 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 integrated solutions. 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. No revenue has been recognized for software licenses with extended payment terms in excess of amounts due.

     Gain Share — Gain share revenue represents profit sharing and performance incentives earned based upon our customers reaching certain defined operational levels. Upon achieving such operational levels, we receive either a fixed fee and/or variable fee based on the units sold by the customer. Due to the uncertainties surrounding attainment of such operational levels, we recognize gain share 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. Our continued receipt of gain share 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 gain share provisions.

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 (“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 September 30, 2006, we had $44.2 million of goodwill and intangible assets. In assessing the recoverability of our goodwill and intangible assets, we must make assumptions regarding estimated future cash flows and other factors. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets. We evaluate goodwill for impairment pursuant to the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. As of December 31, 2005, we completed our annual testing requirements and determined that the carrying value of goodwill had not been impaired.

     We are currently amortizing our acquired intangible assets over estimated useful lives of 4 years, which is 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.

Realization of Deferred Tax Assets

     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 need for a 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

     Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No.123(R)”). The statement eliminates the ability to account for share-based compensation transactions using Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) and requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements based on estimated fair values. SFAS No. 123(R) applies to all share-based payment transactions in which we acquire goods or services by issuing our shares, share options, or other equity instruments or by incurring liabilities based on the price of our shares or that require settlement by the issuance of equity instruments. We elected to use the modified prospective transition method upon adopting this statement and accordingly prior periods have not been restated to reflect the impact of SFAS No.123(R). Under this transition method, stock-based compensation expense for the first quarter of fiscal 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). We recognize the compensation costs of options granted after January 1, 2006 on a straight-line basis over the vesting periods of the applicable stock purchase rights and stock options, generally four years. Prior to adoption of SFAS No. 123(R), we presented all tax benefits resulting from stock options as operating cash flow in our statement of cash flows. In accordance with SFAS No. l23(R), the cash flows resulting from excess tax benefits are classified as financing cash flows.

     Prior to the adoption of SFAS No. 123(R), we accounted for stock-based compensation in accordance with APB No. 25, and complied with the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures”. Deferred compensation recognized under APB No. 25 was amortized to expense using the graded vesting method. In March 2005, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS No. 123(R) and the valuation of share-based payments for public companies. We have applied the provisions of SAB 107 in its adoption of SFAS No. 123(R). See Note 9 to the Unaudited Consolidated Financial Statements for a further discussion on stock-based compensation.

Results of Operations

     The following table sets forth, for years indicated, the percentage of total revenue represented by the line items reflected in our consolidated statements of operations:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Revenue:
Design-to-silicon-yield solutions
Integrated solutions			57	%			75	%			59	%			70	%
Software licenses			20				8				14				15
Gain share			23				17				27				15
Total revenue			100				100				100				100
Cost and expenses:
Cost of design-to-silicon-yield solutions:
Direct costs of design-to-silicon-yield solutions
Integrated solutions			35				35				35				33
Software licenses			—				—				—				—
Amortization of acquired core technology			7				7				7				7
Research and development			33				30				34				30
Selling, general and administrative			26				22				26				22
Amortization of other acquired intangible assets			1				1				1				1
Total costs and expenses			102				95				103				93
Income (loss) from operations			(2	)			5				(3	)			7
Interest and other income, net			5				3				4				2
Income before taxes			3				8				1				9
Tax provision (benefit)			(—	)			—				1				1
Net income (loss)			3	%			8	%			—				8	%

Comparison of the Three Months Ended September 30, 2006 and 2005

																		Three Months Ended September 30,
																		2006				2005
		Three Months Ended September 30,								$				%				% of				% of
Revenue		2006				2005				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Design-to-silicon-yield solutions
Integrated solutions		$	11,153			$	13,834			$	(2,681	)			(19	)%			57	%			75	%
Software licenses			3,811				1,533				2,278				149	%			20	%			8	%
Gain share			4,400				3,090				1,310				42	%			23	%			17	%
Total		$	19,364			$	18,457			$	907				5	%			100	%			100	%

     Design-to-Silicon-Yield Solutions. Design-to-Silicon-Yield solutions revenue is derived from integrated solutions (including solution implementations, software support and maintenance and training service) and software licenses provided during our customer yield improvement engagements and solution product sales.

     Integrated solutions. The decrease in integrated solutions revenue of $2.7 million for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was primarily attributable to a slower booking rate for new integrated solution engagements in late 2005 and in the first half of 2006 which would have contributed to revenue in 2006 and, due to the timing of new contracts signed in the current quarter, was partially offset by an increase in software maintenance revenue. Our integrated solutions revenue may fluctuate in the future and is dependent on a number of factors including our ability to obtain new customers at emerging technology nodes and our ability to estimate costs associated with such contracts.

     Software licenses. The increase in software licenses revenue of $2.3 million for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was due to an increase in the number of license seats sold to new and current customers who continue to adopt our yield management solutions offerings versus the comparable period in 2005. Software license revenue may fluctuate in the future and is dependent upon a number of factors including the semiconductor industry’s acceptance of our products, our ability to attract new customers and further penetration of our current customer base.

     Gain Share. Gain share revenue represents profit sharing and performance incentives earned based upon our customer reaching certain defined operational levels. Gain share revenue increased approximately $1.3 million for the three months ended September 30, 2006 compared to the three months ended September 30, 2005, a representation of the value our technology continues to deliver to our customers, for the most part, after our solution

implementations are complete. The increase in gain share revenue was primarily due to a greater number of engagements contributing to gain share at newer technology nodes, as well as a greater number of wafer starts at our customers’ sites. Our gain share revenue may continue to fluctuate from period to period. Our continued receipt of gain share revenue is dependent on many factors that are outside of 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 gain share provisions.

																		Three Months Ended September 30,
																		2006				2005
Cost of Design-to-Silicon Yield		Three Months Ended September 30,								$				%				% of				% of
Solutions		2006				2005				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Direct costs of design-to-silicon- yield solutions Integrated solutions		$	6,734			$	6,382			$	352				6	%			35	%			35	%
Software licenses			58				15				43				287	%			—				—
Amortization of acquired core technology			1,266				1,266				—				—				7	%			7	%
Total		$	8,058			$	7,663			$	395				5	%			42	%			42	%

     Direct Costs of Design-to-Silicon-Yield Solutions. Direct costs of Design-to-Silicon-Yield solutions consists of costs incurred to provide and support our integrated solutions and costs recognized in connection with licensing our software.

     Integrated solutions. Integrated solutions costs consist of material, labor and overhead costs associated with solution implementations. Costs include purchased materials, employee compensation and benefits, travel and facilities-related costs. The increase in direct costs of Design-to-Silicon-Yield integrated solutions of $352,000 for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was primarily attributable to the increase of $443,000 in stock-based compensation expense under SFAS No. 123(R), and the distribution of expanded pdFasTest products. 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.

     Software Licenses. 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 increase in direct costs of Design-to-Silicon-Yield solutions software licenses of $43,000 for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was attributable to a increase in third party software license fees and royalties resulting from increased license seat sales. We expect the cost of software licenses to fluctuate in the future as a result of royalties and license fees paid for third party applications incorporated in our software products.

     Amortization of Acquired Core Technology. Amortization of acquired core technology consists of the amortization of intangibles acquired as a result of certain business combinations. The amortization of acquired core technology expense remained unchanged at $1.3 million for both the three months ended September 30, 2006 and the three months ended September 30, 2005. We anticipate amortization of acquired core technology to increase in future periods as a result of our acquisition of Si Automation, S.A.

																		Three Months Ended September 30,
																		2006				2005
		Three Months Ended September 30,								$				%				% of				% of
Research and Development		2006				2005				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Research and development		$	6,416			$	5,485			$	931				17	%			33	%			30	%

     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. The increase in research and development expenses of $931,000 for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was primarily due to the increase of $432,000 in stock-based compensation expense under SFAS No. 123(R), increased use of outside resources on strategic product initiatives, and the additional operating costs associated with the opening of a new office in Shanghai, China. We anticipate that we will continue to commit considerable resources to research and development in the future and that these expenses may increase in absolute dollars.

																		Three Months Ended September 30,
																		2006				2005
Selling, General and		Three Months Ended September 30,								$				%				% of				% of
Administrative		2006				2005				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Selling, general and administrative		$	5,028			$	3,979			$	1,049				26	%			26	%			22	%

     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. The increase in selling, general and administrative expenses of $1.0 million for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was primarily due to the increase of $613,000 in stock-based compensation expense under SFAS No. 123(R), higher legal and accounting fees, and increased commissions resulting from higher bookings. We expect that selling, general and administrative expenses will increase in absolute dollars to support increased selling and administrative efforts in the future.

																		Three Months Ended September 30,
																		2006				2005
Amortization of Other		Three Months Ended September 30,								$				%				% of				% of
Acquired Intangible Assets		2006				2005				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Amortization of Other Acquired Intangible Assets		$	235			$	235				—				—				1	%			1	%

     Amortization of Other Acquired Intangible Assets. Amortization of other acquired intangible assets consists of the amortization of intangibles acquired as a result of certain business combinations. Amortization of other acquired intangible assets remained unchanged at $235,000 for the three months ended September 30, 2006 and the three months ended September 30, 2005. We anticipate amortization of these other acquired intangible assets to continue to increase in future periods as a result of the acquisition of Si Automation S.A.

																		Three Months Ended September 30,
																		2006				2005
Interest and Other		Three Months Ended September 30,								$				%				% of				% of
Income, net		2006				2005				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Interest and Other Income, net		$	892			$	463			$	429				93	%			5	%			3	%

     Interest and Other Income, Net. The increase in interest and other income, net of $429,000 for the three months ended September 30, 2006 compared to the three months ended September 30, 2005 was primarily due to increased interest earned on higher average cash and cash equivalent balances and short term investments during the period coupled with higher interest rates earned during the period.

																		Three Months Ended September 30,
																		2006				2005
Provision/(Benefit) for Income		Three Months Ended September 30,								$				%				% of				% of
Taxes		2006				2005				Change				Change				Revenue				Revenue
(In thousands, except for %’s)
Provision (Benefit) for Income Tax		$	(51	)		$	22			$	(73	)			(332	)%			—				—