Tom Diffely – DA Davidson & Co. [Gary Shiloh – River Park Funds] [Unidentified Analyst] [Brian Friedman – LF Capital]

Welcome to the PDF Solutions, Inc. conference call to discuss its financial results for the first fiscal quarter ended Sunday, March 31, 2014. At this time all participants are in a listen only mode. Later, we will conduct a question and answer session for which instructions will be given at that time. (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 during the course of this conference are forward-looking including statements regarding PDF’s future financial results and performance, growth base, and demand for its solutions. PDF’s actual results could differ materially. You should refer to the section entitled risk factors on pages 11 through 17 of PDF’s annual report on Form 10-K for the fiscal year ended December 31, 2013 and its similar disclosures in subsequent SEC filings. These forward-looking statements and [inaudible] stated in this conference call are based on information available to PDF today. PDF fulfills 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, you may begin sir.

The first quarter of 2014 was another successful quarter for PDF Solutions fueled by strong gain share revenues. If you recall the discussion on our yearend conference call in February, we were cautious about gain share revenues in the first half of 2014. This caution was based on public statements from key logic producers regarding their projected production volumes. Based on our Q1 2014 gain share revenues however, actual production levels turned out to be strong. We always remind you that we are likely to experience quarter-to-quarter volatility in gain share revenues. In this case Q1 results were better than anticipated. However, given the likely quarterly volatility, we haven’t changed our expectations for the full year. Looking at the logic business environment, industry leaders are continuing to invest in 28 and 20 nanometer process nodes as they ramp up manufacturing volumes. Concurrently there are enormous development efforts ongoing at the 16, 14, and 10 nanometer thin set nodes. Fabless and [inaudible] are taping out initial designs at 16 and 14 nanometer this year and fabless test [inaudible] are underway for 10 nanometer as well. PDF is aggressively working with our major customers on all of these of advance nodes. With the adoption of these nodes comes a variety of very difficult technical and economic challenges for both foundries and their customers. We view these challenges are creating great new opportunities for us to expand and strengthen the information bridge we provide for the fabless and the foundry gap. These new opportunities will drive our key R&D investments over the next few years both in our core business and in new technology markets. Q1 was a strong quarter for new engagements as both fabless and foundry customers continued to successfully implement our technologies to accelerate their positive yield ramps and product…

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 affects 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 www.PDF.com. Now, let’s turn to a review of the financial results. Total revenues for the quarter were $27.1 million with a GAAP net income of $6.3 million. This resulted in GAAP EPS of $0.20 per fully diluted share. Net income on a non-GAAP basis totaled $9.5 million or $0.30 per fully diluted share. Total cash increased by $11.6 million during the quarter. Cost of sales and operating expenses taken together were $17.7 million on a GAAP basis and $16 million on a non-GAAP basis which is an increase in non-GAAP spending of approximately $772,000 from Q4. Overall, we’re very pleased with the continued strength in our total revenues, earnings, and cash for the quarter. Now, let’s look at revenue in more detail. Total revenues of $27.1 million for the first quarter were the same as in the prior quarter. Total revenues were comprised of design to silicon yield solutions or solutions revenue of $14.9 million and gain share performance incentives or gain share revenue of $12.2 million.…

(Operator Instructions) Your first question comes from Tom Diffely – DA Davidson & Co. Tom Diffely – DA Davidson & Co.: First, another question I guess on the partnerships you talked about previously. When a couple of your large customers partner do you think it actually decreases the potential unit production that they would otherwise do as two independent companies or do you think it has any impact on the combined volume of the two companies?

Generally speaking we expect that to increase the combined volume of the two companies. In this industry one of the big concerns the large consumers of silicon expressed is they want risk mitigation on their volumes. They want to have multiple sources of production and they don’t want the cost of having to design really multiple designs to support that. Multiple producers producing the same technology in different geographic locations is a big desire to the industry. It’s always been very hard to achieve for a variety of reasons. I think you’ve seen announcements in the past couple of weeks where I think people are under pressure from their customers and desire from their customers. They’re seeing they’re tying up. That means, in all likelihood, first design designed specifically for that technology rather than second source production. Generally, first source production means better pricing better volumes and a healthier foundry customer for us and when our customers are healthy that’s always good for us. Tom Diffely – DA Davidson & Co.: You think that partnership actually speeds up the yield ramp or does it create an issue where you have a couple more cooks in the kitchen?

Speeds it up slows it down, that really depends on how the teams come together. PDF has a lot of experience in terms of running multiple engagements using the electrical characterization to help the factories make very in detailed comparisons by a layer-by-layer basis because invariably each factory is doing something better than the other factory. When you really share that detailed characterization data at a layer-by-layer basis you can greatly accelerate the learning it costs the two factories. You are right, if everybody thinks they’re better than the other guy, you can really go in the wrong direction too. It is a huge opportunity to get right and it is something that we a lot of experience running programs all the way back to when we first got into IBM in 2004 or ’05 when we were running the engagement between IBM and Charter that helped bring up the initial Qualcomm products in that time period. Tom Diffely – DA Davidson & Co.: I guess speaking of IBM, they are your third largest customer. A lot of talk about them selling their fab. I’m not sure if you have or can talk about your view on what that potential impact might be on you if they do go ahead and sell the fab?

We really can’t speak to specifics about any customer in that regard but suffice it to say that we’ve had engagements going on in fabs in the past, the ownership changes many times and the production continues and the customers continue. If you remember, Charter was at one time one of our top customers and they got sold to Global Foundries and at that time there was a lot of concerns about what that meant for PDF. It turned out to be an extremely good thing for PDF because Charter went from being an underfunded underinvested fab seven to a fully invested part of a larger entity and you can see it in our numbers today. Tom Diffely – DA Davidson & Co.: It was nice to see the strength in the gain share in the quarter. You did mention that an older customer kind of dropped off as a fab, no longer became active. I’m curious is there some way you can discuss your gain, your royalty run rate right now and maybe talk about it on node basis, are there more nodes or factories that could be falling off any time soon?

The one that dropped off was actually an old customer at an old node that was hanging in there and it finally got to a level below our cutoff for including it in gain share. That does not mean that we are not working on potential new engagements at new nodes with that customer it just hasn’t reached any gain share levels yet. When you look at what we kind of call the older nodes which is basically anything above 40 nanometer, some of those are a little long in the tooth and particularly for not the front running fab. Tom Diffely – DA Davidson & Co.: Is your exposure there just a couple million?

I wouldn’t even estimate it to be that much. Tom Diffely – DA Davidson & Co.: Then I guess finally, when you look on the partnership basis, when a couple of big guys come together, how long does it take to go through the whole development through to volume production where you might start getting a royalty stream? Are we looking at a year plus or can these things be fast tracked?

I think in general when these announcements get made there’s been a lot of activity that has gone on prior to that and we may have been part of a lot of that activity before the announcement comes out and activity is going on at least at one or both those facilities for multiple years leading up to it. In general, these things are done to bring up the volume at the announcement date of the node larger. They want to be able to bring up simultaneously multiple facilities and multiple locations in the world and so it doesn’t really change the schedule that much. I think we’d still anticipate the 20 nanometer schedule volumes ramping the latter half of this year, 14 16 nanometer by in large for the industry ramping in 2015, but it probably does increase the total number of facilities ramping at that same time.

Your next question comes from [Gary Shiloh – River Park Funds]. [Gary Shiloh – River Park Funds]: You touched on this with Tom’s question and in your intro but, can you elaborate on how the foundry partnership helps and maybe doesn’t help each of the foundries with their issues? I assume if one foundry is weaker in anything the partnership automatically makes them better from working together or are there certain things that it wouldn’t help with?

In general over a long enough time period as two teams share information especially, if you can kind of share it in the way that we enable at the electrical level on a per layer basis, on a per structure basis, you can understand exactly what it is about each implementation of that recipe makes it stronger or weaker, there is a great way to share and learn and get better. The reality is these are not like you open up the Julia Childs’ Cookbook and say, “Okay, let me see how I make a soufflé,” and you go of and implement a soufflé and you can get pretty close to Julia Childs’. These things are pretty difficult, they’re subtle recipes, they’re very subtle and there’s a lot of hidden parts to the recipe that are not well documented that are about how the fab operations work. Your schedule on PMs are slightly different, or preventative maintenance schedules. Slightly different behavior on filters. Even just you have to use different supplies for consumables because they’re in different parts of the world and who has got available sourcing in the location you’re in. All those subtle things make a big difference in this business and so while there is tremendous opportunity to get it right together, there’s a lot of risk in all the subtle choices and differences between the facilities that usually kind of have to harmonize. I think long ago Intel did the copy exact methodology and that methodology you build the facilities the same way, you use the same version of the equipment in those days when you read about that stuff. Even if the equipment vendor had a new etcher available you actually took the old etcher anyway so you had no differences because a software upgrade can make a difference in the way the tool behaves. So in the end with really great electrical data on the layer-by-layer basis you can close all those gaps but those gaps almost always exist. [Gary Shiloh – River Park Funds]: I think I get it and so at a risk of a huge over simplification to your cookbook analogy, if it were just a cookbook this partnership seemingly would be fantastic for you and for the foundries. But, because of the individual subtleties you’re saying that’s what would restrain it from being [inaudible].

It really does come down to the enlightenment of the way the parties come together because inevitably one party paid another party money, one party has an expectation about volumes, did the volumes materialize when they expected, did they get what they thought they got, it’s amazing how these things – they’re very complicated to manage and maintain. Our role ends up being usually pretty important in this whole thing. [Gary Shiloh – River Park Funds]: Presumably since they are partnered they would be sharing more and trying harder to reach that common goal than any time they have been in the past?

Yes, and it definitely can make things better so they can do better. [Gary Shiloh – River Park Funds]: The question is how good this can be for you. Is there any way it’s a negative for you?

No. In other words, you’re just back to independent entities. The reason why I’m being cautious, I think if you look in the past, the collaboration that went on between let’s say 2004 and 2011 or ’12 in the IBM Alliance had a lot of successes and its way of sinking the fabs and providing a single tape out or source for multiple factories there was a lot of skepticism about how all that really worked and so it didn’t live up to its full potential. If I were to go and say, “This is going to live up to the full potential,” the [inaudible] community out there would say, “The past history says it doesn’t work that well.” I think it has an opportunity to work incredibly well. Worst case you’re back to where you were with independent entities. But, there is an opportunity to get it really much more right and I think it has a good chance this time. [Gary Shiloh – River Park Funds]: If it is successful you should see that next year in your gain share?

They’ve made timing announcements about when they expect volumes to hit and I think it’s around that time period. [Gary Shiloh – River Park Funds]: Just on your solutions revenue, I think if we look at the last four or five quarters except for maybe a blip and I think it was the third quarter for maybe some additional software or something sales, that revenue line has been pretty flat. I get that engagements drop off but you’ve been also signing new engagements and I would think that the new engagements would be at higher prices so I’m surprised that line is at least not going up a little bit. Why is that?

I think number one, assuming the new engagements are at higher prices, you have to be careful with it. It’s possible the new engagement might have more dollars over time in it and it may extend for a longer period but the revenue recognition of that will also be spread out over a longer period. Fundamentally, very rarely do customers really allow you to dramatically increase margins on these types of projects so the kind of price per unit time is not going to change all that much, it may creep up a little bit. But as the difficulty and the length of the projects extend yes, you could see more money. But, it is a fairly slow growth line and that’s how we’ve always guided it, that it’s probably in the low single digits growth level. Part of that is there is just some natural limits to how many nodes you’re going to work on. Now, that’s barring an event where you pick up another major customer. But give the market that we’re playing in today, as you know, we don’t bake in these onetime events into our assumptions. That’s probably a low growth thing. [Gary Shiloh – River Park Funds]: When you say low growth, third quarter last year was a little bit of an outlier on the solutions revenue I think. So when you say low growth, excluding that outlier or including that?

Remember we say there’s quarter-to-quarter variability all of the time.

It’s an average on a rolling four quarter basis. We can sit down sometime and plan out the math. There’s always fun ways to go back and look at it to smooth out events. [Gary Shiloh – River Park Funds]: It’s not the most important thing to worry about.

As you know, it’s very hard to forecast on a quarter-by-quarter basis our business so we’re very careful about the way we spend. You were right, we are actually building a backlog of good solutions revenue. We don’t see the need to staff up and build a large organization there, it only leaves you exposed in bad times so there’s not a lot of desire on our part to grow that part of our revenue relative to the gain share part of the revenue. [Gary Shiloh – River Park Funds]: I just wanted to make sure that it was continuing to grow a little bit which was unclear because of the third quarter spike last year because otherwise it looked pretty flat. Over the last five quarters the revenue has been flat except for the third quarter.

That will happen for two reasons. One is, a lot of times there are these catch up transactions that will have deferred costs and deferred revenues associated with them and then once you actually get the deal completely inked you have a catch up. There was a little bit of an impact of that in Q3 and then also there is a component of our solutions revenue that is software related. It’s not a major component but there are a couple of large customers there that when they actually sign up for a new time based license there could be some spikes there or some catch up maintenance and things like that. So, quarter-to-quarter you just can’t pay much attention to it. It will go up, it will go down but overall what we’re looking for is an average growth rate annually in the low single digits.

Your next question comes from [Unidentified Analyst]. [Unidentified Analyst]: I won’t ask any more questions about the foundry tie ups because I understand you guys are kind of limited in what you can exactly say about that and obviously we’re all curious. But I wonder if you can talk a little bit more about the breakdown of gain share. If I understood you correctly, is most of gain share at sub 40 nanometers now?

Yes. [Unidentified Analyst]: Presumably that means 28 nanometers is a majority or will soon be a majority?

28 nanometer is the largest node now. [Unidentified Analyst]: Is there any 20 nanometer gain share revenue yet? That’s too soon for that correct?

Too soon for that. [Unidentified Analyst]: The last question for me since most of mine have been asked already, John I think TSM last week when they reported kind of took up their expectations for the growth of logics for the year. I just wondered if you agreed with that kind of improved tone for logic given your comments around slightly better production levels in the first half of the year and if you still thought you could outgrow the logic industry.

We did notice that. They and a lot of our customer all said they thought it was a very back end loaded year early on then Q1 turned out to be reasonably good. It made us question the visibility that the industry itself had. We still believe we will outgrow the overall logic industry. As I said on the call, our expectation of the year remains consistent with what we said in February. We know that they are more bullish than they were let’s say in January when they made their call. It’s a transition year, you start up a new node, you ship that node by 60 or 90 days and you have a tremendously different view on the amount of growth on that node. Our expectation and my experience in this business has always been, nodes don’t start up as fast as people say they are and they never die as soon as they say they are going to die either. If I were to pick the over under on that I tend to pick the under and that’s what’s baked into those assumptions.

Your next question comes from Tom Diffely – DA Davidson & Co. Tom Diffely – DA Davidson & Co.:

I don’t know how to answer that question effectively. We notice across the customer basis, they’re always getting new tape outs from multiple new customers and some tape outs are tapering off in volume and some are building up even within a node, let’s say 40 nanometer, 65, 28. It really comes down to the quality of their sales and marketing, their funnel for new customers more than it comes up to a limitation in the facilities. The facilities can usually turn over from one product to the next relatively quickly particularly if they’re not on IBMs. If they’re a foundry they’re very well set up to do this. The challenge is just how deep is their pipeline, how many customers have they been working with leading up to that transition, etc., and that is very hard for us to tell. Tom Diffely – DA Davidson & Co.: Is that something you worry about or is that just part of the dynamic of the industry that ebbs and flows over time?

The industry always has ebbs and flows and part of the reason why we’ve always set ourselves out to be very cautious with how we spend is the gain share is in effect a reflection of our customers’ success in the marketplace and it’s difficult to always assess how well or poorly they are doing. What we do know is they have very good understanding about when customers will be tapering off volume in their facilities. Usually, because the customer starts design activities when you make a transition on a node, a couple of years ahead of time. So there’s a lot of visibility that they have and they do a lot to figure out. They have got a big big asset they’ve got to figure out how to keep full. Generally speaking, if you go back and look at the 2008/2009 downturn, the first thing that came back in our business was gain share at that time. It doubled between one quarter to the next because the customer are greatly incented to figure out how to fill their facilities. Generally, there’s a reason why they run those big companies and we run a small company. They kind of have an idea of what they have to do to keep that going. We don’t overly worry about it, it’s kind of out of our control. We run our business in a way that we can do well in a number of different circumstances. Tom Diffely – DA Davidson & Co.: But you would think that the most advanced fabs are the biggest assets that they have and the ones they want to keep the fullest?

They have so much more incentive than you about figuring out how to fill that fab.

Your next question comes from [Brian Friedman – LF Capital]. [Brian Friedman – LF Capital]: I just wanted to talk about kind of some commentary with a little more emphasis on 20 nanometer. Obviously you guys have said on the call that you thought 20 nanometer nodes would start ramping in 2014. You’ve also said both on this call and in your 10K that you expected 2014 for you guys to grow faster in the logic industry and you touched on the [TSMC] increasing their estimates. I think there may be a slight concern in regards to where you guys are in 20 and a lot of positive things about 14. Could you potentially sort of touch on where you guys see yourself at 20 nanometer and your visibility there and then potentially kind of touch on the fact there was a new hire that you guys did and how potentially that new hire and your visibility within 20 nanometer all play together?

When we spoke on our confidence at the beginning of the year as well as this year’s, and by the way if you go back and look at [TSMC] and other foundries’ reports there’s growth happening this year in 28 nanometer. It is by far a huge node and a huge node for growth this year for us as well as the industry overall. We do believe that 20 nanometer is ramping this year, we said that in this call. Our expectation is I kind of alluded to with Steve’s question is when we put together our estimates of the [inaudible] gain share we put that together assuming that node basically happens later than when folks say because that has been our experience. Not speaking to the customers aren’t repping with us but for our own customers, we tend to be a little bit carefully about forecasting a big spike up over the years. I have enough scars on me from thinking it was going to be the next quarter and then it’s not the next quarter and then disappointing investors. We tend to be rather cautious about the ramp ups. We do believe that volume ramp ups for 20 nanometer are primarily a 2015 story at the end of the day. There’s a lot of discussion in the industry about given how quickly on the heels of 20 nanometer 16 and 14 are going to come, what is the life of that node, how does that node look, etc. We believe, and by the way if you go back and look at the transcripts for the other foundries and the like, that actually 20 nanometer and the 16, 14 thinset nodes are really one node. Much like if you look at 28 nanometer there was a polysilicon version that…

We have no further questions.

Thank you everyone, we look forward to speaking to you again after the second quarter. Have a good evening.

Ladies and gentlemen this concludes today’s program. Thank you.