PDF Solutions, Inc. (PDFS) Q2 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the PDF Solutions Inc. conference call to discuss its financial results for the second fiscal quarter ended Sunday, June 30, 2013. [Operator Instructions] As a reminder, this conference is being recorded. If you have not yet received a copy of the corresponding press release, it has 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 solution. PDF's actual results could differ materially. Should -- you should refer to the section entitled, Risk Factors, on Pages 10 through 16 of PDF's annual report on Form 10-K for the fiscal year ended December 31, 2012, 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'd like to introduce John Kibarian, PDF's President and Chief Executive Officer; and Greg Walker, PDF's Chief Financial Officer. Mr. Kibarian, please go ahead.

Thank you, and welcome, everyone. The second quarter of 2013 was another strong quarter for PDF Solutions. During this period, we continued to see growing adoption of our yield management solutions across both the fabless and foundry markets. For our key customers, their 28-nanometer processes continue to move into volume production and consequently PDF received material gain share revenues at this node from multiple customers. Also, the level of intensity around the development and introduction of more advanced nodes, for example, the 20-, 16-, 14- and 10-nanometer nodes is increasing rapidly. PDF continues to play a key role in the characterization of these new technologies across the major foundries. From a financial perspective, in the second quarter, we achieved revenue of $24.8 million, non-GAAP profit of $0.25 per share and generated $13.8 million of cash from operations. These results reflected the growing importance of PDF Solutions at the fabless foundry boundary. In a moment, Greg will go into more details of our second quarter financial results. On the new business side, we have the following engagements to report, all with existing clients. An expansion of the enterprise agreement that extends the usage of PDF technology at advanced nodes, a DFM engagement with an existing fabless client, an extension to YieldAware-FDC pilot engagement. These engagements reflect the growing trend our customers to leverage our characterization vehicle technology and services across the IP process life cycle to improve the yields and manufacturability of their designs and processes. Additionally, we are seeing growing interest by customers in the use of our YieldAware-FDC solution for ongoing process control in the foundries. The expansion of the enterprise agreement is particularly interesting. In that, a foundry customer is exploring how best to use our characterization-vehicle infrastructure for the purpose of end customer acquisition. By tailoring our solution to specific designs of potential high volume, fabless end customers, our foundry customer is able to present an accelerated path to high-yield production for any given fabless end customer. This competitive advantage may facilitate end customer wins by this foundry and will provide expanded fixed fees and gainshare opportunities for PDF. The DFM engagement and the extension to the YieldAware-FDC engagement demonstrate that the new solutions we are providing to customers for product debug and design optimization, as well as for factory control, are becoming increasingly accepted in the marketplace. Gainshare results in Q2 continued to show strength. During the quarter, we saw increased 28-nanometer volumes, which were partially offset by some reductions in 32-nanometer volumes. Overall, we continue to expect gainshare to grow year-over-year, as leading edge volumes increase. Of course, there is always the possibility of variability quarter-to-quarter, as foundries ramp up volumes and improve yields, while all the process nodes' volumes drop off. Although there are a variety of opinions about the strength of the semiconductor industry for the remainder of 2013, our belief is that PDF will continue to outperform the industry for the year. As electrical characterization becomes essential to ramping new products and processes, we continue to see strong interest from the fab and logic designers for our technology and solutions. However, we are mindful of the cyclical nature of the chip industry, so while we see opportunities to continue to grow both our solutions and gainshare revenue, we will be cautious as we make investments and continue to seek to disproportionally grow earnings with increased revenue. Thank you for your time and attention. Now, I'll turn the call over to Greg. He will discuss in detail our financial results for the second quarter. Greg?

Thanks, John. As a reminder, in addition to using GAAP results when evaluating PDF's business, we believe it is also useful to consider our results using other non-GAAP measures. For internal purposes, the company focuses on non-GAAP net income and EBITDAR. Non-GAAP net income excludes stock-based compensation expenses, amortization of expenses related to acquired technology and other intangible assets, restructuring charges and their related tax effects as applicable. Additionally, the income tax provision has been adjusted in our non-GAAP net income to reflect cash tax expenses only. EBITDAR is equal to earnings before income tax, adjusted to exclude depreciation, amortization, restructuring and stock-based compensation. You can access the earnings press release that contains a reconciliation of EBITDAR and non-GAAP net income to GAAP results in the Investor Section of our website located at pdf.com. Now, let's turn to review the financial results. Total revenues for the quarter were $24.8 million with a GAAP net income of $4.6 million. This resulted in GAAP EPS of $0.15 per fully diluted share. Net income on a non-GAAP basis totaled $7.7 million or $0.25 per fully diluted share. Cash increased by $13.6 million during the quarter. Cost of sales and operating expenses were $17.4 million on a GAAP basis and $15.6 million on a non-GAAP basis, which is a decrease in non-GAAP spending of approximately $900,000 from Q1. Overall, we are very pleased with the continued strength in revenues, earnings and cash for the quarter. Moving on to the revenue details. As we said, total revenues of $24.8 million for the second quarter was up approximately $700,000, as compared to the prior quarter. Total revenues were compromised -- comprised of design-to-silicon-yield solution or solutions revenue of $15 million and gainshare performance incentive or gainshare revenue of $9.8 million. Our top 10 customers represented 91% of total revenues in the current quarter, the same as in Q1. 3 of these customers contributed revenues greater than 10% each, for a total of 73%, as compared to 74% in the prior quarter. On a geographic basis, North America accounted for 44% of total revenues, which is up 3% from the prior quarter; Europe represented 25%, up 2% from the prior quarter; and Asia accounted for the remaining 31% of total revenues, down 5% from the prior quarter. Looking at solutions revenue in more detail, 9 engagements with a total of 8 different customers contributed at least $150,000 of solution revenue each. Overall, solutions revenue at $15 million was up from $14.8 million in Q1. Gainshare at $9.8 million, as stated earlier, represented an increase of about $600,000 over Q1. Gainshare revenues was primarily driven by expanding volumes in our 28-nanometer engagements, partially offset by reductions in 32-nanometer volumes. The total number of customers contributing to gainshare revenue in the quarter was 10, the same as in the previous quarter. Moving to expenses, cost of sales for the quarter was $9.7 million on a GAAP basis, which is slightly higher than the prior quarter. GAAP gross margin was 61%, compared to 60% in the prior quarter. Other total GAAP operating expenses, $7.6 million or approximately 31% of revenues, compared to $8.1 million or 34% of revenues in prior quarter. R&D expenses totaled $32 -- $3.2 million or 13% of total revenues, compared to $3.4 million or 14% of total revenues in the prior quarter. The decrease in R&D expenses is primarily due to reduced subcontractor cost and a few other miscellaneous expenses when compared to Q1. SG&A expenses totaled $4.4 million or 18% of total revenues for the quarter, compared to $4.8 million or 20% of total revenues in the prior quarter. This decrease was primarily related to one-time cost and audit fee expenses recognized in Q1 that were not as significant in Q2. On a non-GAAP basis, looking at operating expenses and cost of sales together, total spending was $15.6 million in the quarter versus $16.5 million in the prior quarter. Non-GAAP operating expenses were lower compared to Q1, as stated earlier, due to lower subcontractor expenses and lower audit and tax-related service fees. Other income and expense was an expense of $76,000, compared to an income of $250,000 in the previous quarter, as a result of euro-based foreign exchange losses. EBITDAR, which was defined earlier, was $9.4 million, compared to $8.1 million in the prior quarter. EBITDAR per fully diluted share was $0.30 per share, compared to $0.26 per share in the prior quarter. The GAAP income tax provision for the quarter was $2.8 million, which reflects an estimated tax provision rate of 38% in the quarter and that is our estimate for the full year. Of this $2.8 million, $1.4 million represented cash tax liabilities in the quarter. This represents an effective cash tax rate for the quarter when compared to GAAP net -- pre-tax net income of 18.7%. Our cash tax liability increased from the prior quarter by approximately $300,000, primarily related to increased gainshare revenue from Asia, which increased our foreign tax withholding liability. For the remainder of the year, we expect our cash tax rate to be in the range of 18% to 20% on a pre-tax net income basis in any given quarter. Quarterly GAAP net income of $4.6 million resulted in EPS of $0.15 per fully diluted share, which is equivalent to the prior quarter. On a non-GAAP basis, EPS was $0.25 per fully diluted share, which represents an increase of $0.03 per share over the prior quarter. Total cash at the end of the quarter was $76.8 million, an increase of $13.6 million when compared to March 31. This increase was driven by strong accounts receivable collections and proceeds from stock option exercises, partially offset by purchases of fixed assets primarily related to our proprietary testers. Cash from operations was $13.8 million, an increase of approximately $13.4 million over Q1 and the highest level achieved by the company in its history. DSO for the quarter, including unbilled receivables, was reduced to 98 days outstanding, compared to 122 days in the prior quarter. Of the total accounts receivable of $26.9 million at the end of the quarter, only $1.2 million, or 4%, was more than 30 days past due. The trade accounts receivable DSO was 77 days, a marked improvement, as compared to 99 days in the previous quarter. These improvements in DSO were facilitated by the timing of in-quarter billings, which allowed for the collections to be completed within the quarter. This type of timing for billing and collections does not reflect our normal AR activity. Headcount at the end of Q1 was 357 worldwide, compared to 342 at the end of Q1. This growth was primarily related to cost of sales organizations in our Asian subsidiaries. As with last quarter and last year, the overall financial results for the quarter reflect continued strength in our core business and our ongoing attention to spending levels. The company continues to effectively manage its spending while growing revenues, providing increased income leverage and a stronger balance sheet position. This concludes the review of the financial results for the quarter. Now, I will turn the call over to the operator for questions and answers. Operator?

[Operator Instructions] Our first question comes from Tom Diffely with D. A. Davidson. Thomas Diffely - D.A. Davidson & Co., Research Division: First question, when you look at the 28-nanometer business as starting to ramp here, is it -- I guess, last couple of quarters it was just at a very, very small level. Is it becoming a meaningful part of the overall royalty stream at this point?

Yes, it's becoming a more meaningful part of our royalty stream at this point and we expect that to continue through the year. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay. So when you look at that, you said this quarter was offset somewhat by some of the conversions and the slowdown of 32-nanometer going into that. Are those -- the conversion periods, are those almost past us at this point? Or do you still expect some drop-off in 32 as we continue to ramp 28?

Yes, some of the conversions were 32. We do expect some more of that -- some of them were 40, 45 that were converted to 28. We are -- it's hard for us to know, which product mix for each of the customers is selling. In general we expect in the mobile computing, the 28 to increase over the 32. In some of the more traditional computing areas, we think the 32 will remain pretty strong. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay, and ultimately it sounds like 28-nanometer is going to be one of the bigger nodes that you've seen?

We expect that. 32 has been a very good node too, but, yes, we do expect 28 to be a very good node. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay. And then, John, you also talked about how you now engage with the 20 and the 16 and the 14 and the 10-nanometer nodes. You all -- in addition to 20 and above. Does that -- is it a higher level of -- number of nodes you're engaged with at one time versus normal trends? And does that kind of lead to a ramp in Solutions business over the next few quarters or years?

Yes, it's a great question, Tom. We -- we're getting engaged in the nodes earlier and earlier and earlier but the factories, the processes, developers are having to ask bigger and bigger questions than they did in the past, right? So they need a longer period. That does mean our Solutions business will be stronger as more nodes will overlap each other. How much stronger and how it all works out, I don't know that we really know. We haven't really modeled it ourselves to go and sit down and think. Well, Q3 is really a starting of our strategic planning quarter. We'll probably take a sit back and see what that really means. We like the fact that we're being engaged really early. I was in a review on first silicon out for a customer in 10-nanometer and on some 14-nanometer stuff and man it's so complicated just how complex the data is and the models are needed that I felt very good about that. I was like, "Oh good this is good." This is very sophisticated stuff that we're generating for our comps. I think it's very super valuable for them. Hopefully that's going to result in better business for us. But as of this point, we haven't forecasted that, we just think intuitively it should, over some time. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay. And then because of the complexity, is there a chance of you expanding your customer base among the foundries and at the -- some of these lower nodes?

There's always a chance. Very likely -- we've talked about this before, Tom, and we talk with, generally, with the shareholders. We always base our business assuming we can win back our existing customers. We never forecast that we're going to gain new customers and build that into our plan because we don't know what it's going to take. It's more about what's going on in their operations and as they see the complexity scale up, recognition that systems like ours can really help them drive more efficiencies and more effectiveness. We don't know when that will be or how that will materialize. We, of course, have discussions with a variety of folks on an ongoing basis. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay, It seemed like in the past year, we talked about something along the lines of 1- to 2-year kind of solutions. And then, ending in the 4- to 6-year of royalty stream or gainshare. It sounds like that milestone's changed a little bit, where that the initial -- the upfront part is going to be longer now?

Yes, it is. And of course, that's part of the reason why we push longer -- for longer and longer wafer fee periods, because we've got to make a larger investment on the fixed fee portion. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay. And is there a cost to that, you having to ramp-up more people from the [indiscernible] business?

We have ramped up our folks a little bit. If you look, this quarter, we ended at 357 I think it was. No, we have not -- I don't think -- and that's been somewhat of a shift places in Europe where we had higher headcount to places in Asia where the net head count is higher, but the dollars or the headcount as you can see by our non-GAAP spending isn't up that much. So we're pretty mindful about how we increase that and a lot of it is on the automation side of our systems, particularly the software for cranking through all the test vehicle data. I think one of the project managers on 40-nanometer said just for Back-End-Of-Line short-flow wafers, it's gigabytes of data and even the PowerPoints, it's something like 20 megabytes that the software generates. I mean -- so it's heavily automated to try to keep that as efficient as possible. It's part of the value proposition we provide the accounts. So we don't expect to be, all of a sudden, to see this big ramp. But in general, as you know, fixed fee business comes at a lower gross margin than gainshare business. Thomas Diffely - D.A. Davidson & Co., Research Division: Yes, okay. And then, Greg, on the finance side, you said there's a little bit of euro exposure that cost you in the quarter. What is your exposure to the euro at this point?

Our euro exposure is related to the expenses that we have on the ground in Europe, primarily if you look at Dresden, and we also have locations in France and in Italy. So as the euro strengthens, that can have a negative impact on the relative cost of those organizations. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay. Is there any rule of thumb, as far as every $0.10 movement in the euro impacts you by certain percent or certain dollar amount?

Actually, there probably is, but i haven't modeled that because we haven't seen a lot of significance in the variance. But yes, I would imagine if I went back and modeled that, I could figure that out pretty quickly. But we've seen the euro moving up and down over the last 24 months. But even then, it doesn't have a dramatic impact on us, because quite frankly, those expenses are not that big a portion of our total expense. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay, and do you have a similar exposure to the yen?

Yes, but on a smaller basis because the expenses are not as high. Thomas Diffely - D.A. Davidson & Co., Research Division: Okay, and then finally, on the tax side. The cash tax rate of 18% to 20%, is that a good fairly long-term multiple year type number?

No, I think that's good for this year by -- yes, as we move out, we expect that rate -- if there are no actions taken on tax planning, we would expect that rate to increase as we drain off our deferred tax assets. Thomas Diffely - D.A. Davidson & Co., Research Division: And to migrate up towards the full tax rate at some point?

That's correct.

Our next question comes from the line of Adam Fisher with Samjo Capital.

A couple of questions. I wanted to discuss the process control opportunity. I think last quarter you talked about a couple of beta customers that started paying us. Can you just kind of give us an update as to where we are there and kind of the outlook over the next -- for the rest of the year and maybe beyond that?

Sure. So as you know, the -- the PDFS [ph] control solution is taking our CV data as a target or a response. And then we have a relatively substantial software system that collects what's -- the data that comes off the processing equipment, equipment might be acturals [ph] , the CMP tools, photolithography tools, builds models in terms of what on the processing tools affect yields of test structures. And then allows those models to be put online to better control the factory. A lot of times, once the engineer sees those models, they are able to go back and make changes to the process, understand how to better design the process so that variability -- so the -- for that same amount of equipment variability, you see less yield variability. We've started building systems like that in 2006. We release our latest version of that. The major upgrades in the beginning of 2012, we achieved beta sign-off on that and we've had smaller upgrades since then. We started doing pilots this year with our logic and foundry -- similar logic and foundry customers. Those transitioned into paid pilots and those transitioned into demonstrating yield benefits. And now, we are in the process of working with those customers on building out, deploying -- full-time, full-blown deployment we would hope that over the next few quarters, we would see some of these convert to full-blown deployments. That would mean taking the software and installing it on their premises. Today, it's been primarily data transfer back to our servers. The business model is very much like our normal business model, a fixed fee followed by a wafer fee tied to improvements and the benefits they see -- benefits being yield variation and overall factory efficiency.

And how do you think about kind of the market opportunity for this product line or all over the rest of the business?

Yes, we believe it's a very substantial market opportunity if we're able to consistently demonstrate the benefits. And it probably has applicability outside of the foundry fabrics market in memory and other adjacent markets. We started seeing some interest from some of the adjacent markets as well. We did have, from the beginning, some success in the image sensor market and continue to have success in the image sensor market. We think there's some -- generally processing in similar semiconductor-like processing are markets where there is a potential of opportunity. So overall, the opportunity could be quite large. We -- we're not very good at figuring out what -- what are the candidates for something like this just like we've never been that great at figuring out the TAM for our base business. But we believe it's on par with, if not more substantial than our base business.

And you mentioned memory and there's been a lot of discussion recently about the kind of transition in the memory market -- the 3D structures, the 3D architecture. I think the company, PDF, used to have a reasonable memory business kind of in the mid-2000. Is that an emerging opportunity for us?

Whenever there's a technology transition in a chip business and they need to be able to characterize that, it gives the chance for a new approach to spring up and control in DFM to come to the front. And we believe that there is some transitions going on like the 3D memory that you discussed and some material transitions and others that would make an opportunity for PDF. It seems like some -- we've been having discussions with customers about the viability of our solution for their problems. At the technical level, we see some good synergies there. But I think, Adam, as you know, it's a long time from, gee technically there's a glimmer in your eye and oh gee that's resulting in true gainshare for us. Even when you win the account as a business, doesn't mean you're going to make great gainshare. So we're not out there forecasting that all of a sudden this is going to change our business. These are the kind of investments that we have to make over multiple years. But we do see things moving more in our favor, than let's say, they were 5 years ago when we thought the DRAM business was going to be a very bad place for PDF to be. And you're correct, we stopped investing in the DRAM business at that time.

Our next question comes from the line of Steve Bohman [ph] with Divesor Capital [ph].

John, I just -- I wondered if you could talk a little bit more about the enterprise agreement that you talked about in your script with the foundry customer using your guys as solution to go prospect for their own customers. I wonder if you can walk through a little bit more about the potential timing of that for additional revenue to you guys. And then what support obligations or responsibilities you have to help that customer go find new customers?

Okay, yes, so we don't have much obligation to help them find new customers, Steve. But it's a great question. So as you know, I think many of our investors know, more and more fabless customers are designing -- using PDF CDs for DFM on their, what they call their multi-project wafers when they design, let's say, a new graphics core or arm core. They will use our CV test structures to characterize the interaction between their physical IP and the process technology they're targeting. In the -- a lot of times when it's their new -- their new investment in the new node with their initial foundry, the fabless company pays for that because it's time to market for them and they're trying to understand how to optimize their IP. And we've talked about those engagements frequently on the call. As our base yield ramp engagement has helped a number of new entrants into the foundry market develop credible technologies in step with the leader in terms of timing. Fabless companies are starting to get interested in evaluating and understanding that technology and capability. One of our customers thought that it would be good if they could offer that DFM capability as a part of their way of showing those customers that they've got a really good process design manufacturing interface and that they're operating in a more open and transparent way with the fabless. As you know, a number of the fabless often complain about the availability of really good insights from their foundry partners about the silicon characterization. So this foundry wanted to show that they were going to be really strong at that. And our test vehicles and capability probably have as good an acceptance as anybody's in the marketplace as being a very strong characterization of process design interactions. So they wanted to be able to offer that. Of course, that creates for us a channel for us, which is very useful. It creates fixed fees for us. We expect fixed fees to materialize from that activity this year. And, as you know, we've already established a wafer fee in a node from the existing ramp we do will be measured on the initial products. So the benefit to us is an increased adder wafer fees for those products -- for those product lines or customers that are brought in through this channel. So it enhances our dollar per wafer. And of course, the real benefit would be that, that foundry be successful with that customer and it also enhances the total number of wafers. Because as you know, I always joke that every royalty business is an N times P, where P is the price per unit and N is the number of units. And I've been at this business for a long time and we've been in general, and generally speaking, when we've had our failure periods it's not because it's P, but generally because it's N. And I think that's very typical of the royalty business and the chip industry. The key -- you have to always focus on growing N. That being said, this does enhance P for those products quite nicely actually.

John, that's helpful. I think another aspect of this that you discussed in the past is the potential to change the way that foundries interact with their customer and you mentioned that your foundry customers wants to be transparent with their customers. Is there a possibility or -- that this initiative will kind of force a change in industry behavior that could be beneficial to you guys as well?

Steve, force is such a strong word.

Encourage.

We'd like to -- we believe -- and I think the industry has understood this, technically -- and when I was going over the discussion about 10- and 14-nanometer and how all of the interactions between the multiple patterning and resistances you see in the layers and the changes in capacitance is and all the subtlety and the logical characteristics, more and more transparency is going to be required in order to get -- for everyone's economics to work in this industry because the foundries have to make multi-billion-dollar bets that the fabless companies have to design assuming they're going to hit a certain performance advantage over the previous node. And so this transparency, I believe, is going to be more required. We -- I think, of course, folks that are not the leader in the market are probably more open to changing the way you work to start driving that behavior in the marketplace. We hope that would spread to others. Certainly that would be good. We are -- even with today's number, we're a 24 point, whatever, million dollar a quarter company, I don't think we forced anything on anybody. It's got to make sense for people, otherwise we'll never get anywhere.

At this time, there are no more questions. Ladies and gentlemen, this concludes the program. Thank you.