John Kibarian - President, Chief Executive Officer, Director Greg Walker - Chief Financial Officer, Vice President of Finance.

Jon Tanwanteng - CJS Securities Tom Diffely - D.A. Davidson Christian Schwab - Craig-Hallum Capital Group.

Good day ladies and gentlemen and welcome to the PDF Solutions Inc. conference call to discuss its financial results for the second quarter ending Friday, June 30, 2017. 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 received a copy of the corresponding press release, it has been posted to the PDF's website at www.pdf.com.

Some of the statements that will be made in the course of this conference are forward-looking, including statements regarding PDF's future financial results and performance, growth rates and demand for its solutions. PDF's actual results could differ materialistically.

You should refer to the section entitled Risk Factors on Pages 10 through 17 of PDF's Annual Report on Form 10-K for the fiscal year ending December 31, 2016 and similar disclosures in subsequent SEC filings. The forward-looking statements and risks stated in this conference call are based on information available to PDF today.

PDF assumes no obligation to update them. Now I would like to introduce John Kibarian, PDF's President and Chief Executive Officer and Greg Walker, PDF's Chief Financial Officer. Mr. Kibarian, please go ahead..

Thank you and welcome everyone. If you have not already seen our earnings press release and financial results presentation for the quarter, please go to the investors section of our website where they are posted. My discussion today they will start with a summary of the business in the quarter, followed by an overview of the general environment.

We will then summarize some developments on our Exensio big data analysis platform and progress we are making with Design-for-Inspection for the quarter. I will then summarize my remarks and turn the call over to Greg. Revenue in Q2 was flat compared with Q1. Solutions revenue was down quarter-over-quarter due to delays in expected contract closures.

We believe this delay was a result in part of the recent softness at some of our foundry customers that we discussed in the Q1 call. To be conservative, we anticipate most of these contracts closing over the next two quarters. Gainshare however recovered in Q2.

Although existing 28-nanometer older nodes Gainshare remains soft, initial contributions of 28-nanometer Gainshare from China and strong 14 nanometer volumes as well as our achieving R&D milestones resulted in significantly higher Gainshare quarter-over-quarter. In Q2, we closed the following significant contracts.

An integrated yield ramp contract for a new 3D NAND customer in Asia, an Exensio renewal for an existing foundry customer in Asia and an Exensio renewal for an existing analog components customer. The contract we signed the 3D memory was the result of a successful pilot that was completed in Q1.

This contract includes CV's and Exensio for use in development of 3D NAND product and process. Like our foundry contracts, it is Gainshare based on achieving technical milestones.

We are very excited to begin deploying integrated yield ramps for 3D memories as we see both standalone NAND and embedded nonvolatile memories as good applications for PDF's technology. For these technologies, non-logical characterization may be more important than it has been for conventional planar technologies. Turning to the general environment.

In our core market, logic foundries, we saw a mix of customer confidence with some relatively bullish on their business and some less confident. 28-nanometer capacity at nonleading foundries continued to be weak. We saw some leadership changes at some of those foundries in the last quarter.

Overall, we continue to believe that our business with our customers should strengthen. We have seen significant presales activity in integrated yield ramps for logic and non-logic applications, Exensio pilots for fabless and fabs as well as DFI deployment. Now moving to Exensio, our big data analytics platform for manufacturing.

We had two significant events in July after Q2 close. First, we had an Exensio users conference with participation from 34 companies including foundries, fables, system companies and OSATs. At the conference, customers presented their applications of Exensio spanning factory control, yield improvement, product test and product quality.

The conference reinforced our belief in the accelerating need an opportunity for analytics leveraging integrated data from the fab through final package test data and that PDF's uniquely positioned to meet this need. The second recent event was the acquisition of the significant assets of KINESYS Software.

We acquired KINESYS due to their leading ability to track a individual die from wafer through final package. This capability greatly enhances the analytics resulting from integrating fabs through final test data. KINESYS has a strong position in assembly fabs with its software deployed to thousands of assembly tools around the world.

Combined with Exensio's connection to over 20,000 tools in wafer factories and thousands of connections in test floor, we believe Exensio is the only commercial system of full integration of front-end assembly and test equipment. While KINESYS was generating revenue, it was small relative to our Exensio revenue.

We believe the acquisition enables PDF to develop high-value solutions addressing chip quality and reliability. These applications are dependent on and require data from all aspects of chip manufacturing and vital to growing markets such as automotive. As we have done every quarter, we are providing an update about Design-for-Inspection or DFI.

As you know DFI is our innovation for wafer inspection metrology. By placing small on-chip instruments on the wafer in empty space and typically 5% to 10% of chip area is empty, we can provide a proprietary inspection tool that can read those instruments.

Coupled with our Exensio analytics platform, we have been able to demonstrate that customers can see electrical defects that are typically not possible to see with in-line inspection.

As more integrated circuits employ 3D structures and logical failures become more critical than geometric failures, DFI has the potential to be a new source of process control for fabs, a greatly expanded available market for PDF Solutions. In the second quarter, an eProbe 150 was placed in 24 hour production mode at a customer's factory.

This demonstrates the capability and stability of the system. Moreover, the DFI program at one customer has extend from 10-nanometer to seven, which provides further validity of the capability. In the first five months of this addition to the contract, we are taping out many know DFI on-chip instruments.

These are being included on test chips as well as product chips. Overall, the tapeout velocity of DFI has increased across all the customers in the last quarter and we are seeing that continuing this quarter as well.

In Q2, we shipped our fourth system as part of an overall 40-nanometer contract that was signed in the prior quarter and are bringing it up this quarter, We also released new eProbe 150 capability providing higher throughput and sensitivity as well as demonstrating the ability to catch partial opens and shorts.

This ability to identify and continuously provide new capability is a result of the business model of partnering with our clients and selling unique data versus selling conventional CapEx business model. Our customers tell us that identifying partial opens and shorts defects are particularly hard to find with conventional systems.

Since soft failures can result in quality and reliability issues, fabs and fabless see them as critical to inspect during production. For example, at our Exensio users conference, John Chen, VP of Technology at NVIDIA gave the keynote speech talking about the importance of seeing those invisible defects.

His focus of the talk was for chips in automotive, high-performance computing and AI. These soft failures are a key to success. This challenge to the industry for a number of years has been to detect the undetectable. DFI is demonstrating that capability. The eProbe 250 development plan remains consistent with our comments from last quarter.

The first system is built and we anticipate wafer testing in our lab this quarter. Depending on customer demand, beta shipment to customer can be as early as the end of the year. These achievements in Q2 mean that our DFI program is on target to have more impact on our business this year with significant impact next year.

In summary, while Gainshare recovered in Q2, the first half of the year was a difficult period from a revenue standpoint. However, we are pleased with the progress we have made with DFI and the success we have had with Exensio.

Initial 28-nanometer Gainshare from China and our first significant contract in 3D NAND were important milestones for the company this quarter. We have confidence that in Q3 and Q4, we will return to quarterly growth and set up a strong future. I will now turn the call over to Greg..

Thank you John. As you may have seen in our earnings release we have posted in the investor relations section of our website, a management report with detailed comments regarding the financial results of PDF for the quarter.

Given that, I am going to focus my verbal comments for the quarter on our few key highlights and issues reflected in those results. Turning to revenue, as John stated, total revenues of $24.3 million for the quarter were flat as compared to Q1 2017.

Gainshare revenues at $7.8 million increased by $3.2 million over Q1 while solutions revenue decreased by $3.2 million.

To reiterate some of John's comments, Gainshare volumes and revenues recovered during the quarter primarily driven by a 14-nanometer ramp at one of our major customers, the achievement of R&D milestones at another major customer and a new 28-nanometer node ramp at a foundry customer in China.

During the quarter, solutions revenue was negatively impacted by a slower than expected close rate on integrated yield ramp or IYR contracts in Asia. GAAP net income for the quarter was approximately $200,000, lower than Q1 by $300,000. Non-GAAP net income for the quarter was $2.7 million, up slightly from Q1. Looking at expenses.

On a GAAP and non-GAAP basis, total expenses for the quarter were approximately $200,000 higher than the previous quarter. This increase in expense was primarily due to merit based salary increases, which were effective at the beginning of this quarter.

On a GAAP and non-GAAP basis also, cost of sales and R&D expenses were approximately flat compared to the previous quarter. Sales and marketing expense increased by approximately $100,000 on both GAAP and non-GAAP basis.

GAAP G&A expense increased during the quarter by approximately $100,000 and was flat on a non-GAAP basis as compared to the prior quarter. Looking at the balance sheet. Total cash at $109 million declined by $5.9 million during the quarter.

This reduction was primarily the result of stock repurchases totaling $4.8 million, plant property and equipment purchases of $2.7 million, most of which was related to development of our DFI solution and let's see, that's it, the total of which was partially offset by cash generated from operations of $1.4 million.

Accounts receivable, including long-term unbilled, increased by approximately $1.8 million during the quarter. The total unbilled AR balance of $30.7 million decreased during the quarter by $3.8 million. Of the $30.7 million in unbilled AR balance, we expect to bill $21 million over the next 12 months of which more than 45% will be billed during Q3.

Since the end of the quarter, we have collected approximately $6.5 million of the $33 million of trade accounts receivable outstanding at the end of the quarter. Looking at taxes. Our GAAP tax benefit for the quarter was $800,000, driven by our Q2 pretax GAAP loss. Cash taxes incurred for the quarter were $200,000.

For the remainder of the year, we expect our GAAP tax provision rate to be in the range of 37% to 39% of pretax GAAP income. However, changes in tax regulations as we implement them may result in large variances in our actual rates. Cash taxes incurred for the remainder of the year are expected to be in the range of 27% to 30% of pretax GAAP income.

In summary, while total solutions revenue was below our expectations for the quarter, our big data Exensio solution and our new DFI solution met expectations for the quarter. However, as I mentioned earlier, delays in the contract closures primarily drove the quarter-over-quarter reduction in our IYR revenues.

Driven by recovery in Gainshare revenues and continued strength in our Exensio and DFI businesses, we expect total revenues to be stronger in the second half of the year when compared to the first half and approximately flat compared to the second half of 2016. With that, I will turn the call over to the operator for Q&A..

Thank you Mr. Walker. [Operator Instructions]. Our first question comes from Jon Tanwanteng..

Hi guys. Thank you for taking my questions.

Can you hear me?.

Yes..

Okay.

Should we view the delay in the engagements in the solutions business as pushing any business out of this year into 2018?.

I think from a booking standpoint, as we said in my prepared remarks, we are expecting to close this quarter and next. From a revenue recognition standpoint, because its 100%, they will all slide as a result..

Okay. Got it. And then Gainshare was obviously up nicely.

Was there any catch-up payments here? Or was this all organic strength in the quarter?.

Primarily all organic strength in the quarter..

Okay. Got it.

And how should we think of the prospects for the older 28-nanometer nodes and their contribution to Gainshare this year? Do you see a recovery there at all? Or is it going to be growth from new foundries?.

We anticipate some new contracts starting Gainshare up in the second half of this year. It's why when we had such a soft Q1 on Gainshare, we commented that we felt we are going to recover 28-nanometer and we got a lot of questions around that.

Part of that was because we know contracts were starting to contribute so that it drives some upside, even though we expect, by and large, for a lot of these foundries, they are going to be soft on demand.

If you look at some of the prepared remarks from the foundries in Asia that came out last night, they expect to ramp up demand for the second part of the year. So we are a little bit inflated from not because of the new contracts starting. And that's how we reported it..

Got you. And then just switching over to the topic of DFI.

Do you have a backlog or order book for DFI? How do you gauge the demand from your end?.

Jon, we are still figuring that out. Demand, the way that we model it is basically on tapeouts we know. Tapeouts in all situations drive demand for measurement, particularly as those tapeouts are in part combinations of fabless content and fabless involvement in the foundries themselves.

And we are seeing more and more that across all the customers where fabless are partnering with foundries to put on the content they want to monitor things that they feel drive performance and yield and reliability for their parts. So we usually look at that as early indicators and where we are going to then get customers signed up.

As I said, the velocity has been quite good this year with tapeouts and not just on the places where we have machine today, but in a number of places where we don't have machines installed yet. And that's kind of how we have been monitoring it. But we don't really know. We don't have a good model beyond that at this point..

Okay. Fair enough.

Is there any way that you can say, the first Gen-2 machine is spoken for at this point? Or the first one or two beyond that? How do you think about that kind of demand?.

Yes. For the Gen 1 one machine, we expect to demonstrate capability to customers in this quarter and next. We do not know where that first machine will go as of yet. We are still figuring that out..

Got it. And then just a question on the business that you acquired, KINESYS.

What were the trailing revenues for that? And then what are the expectations for it going forward?.

Yes. It was pretty small. And a lot of it is going to change with the way that we bring it forward. As I said in my prepared remarks, we didn't really buy it for revenue, though it did have some revenue associated with it.

We look at it, in fact how we, I don't know, say stumbled on this or recognized this, as we had customers that were deploying our yield and test solution that were using KINESYS to keep track of MEMS elements as they were included in the package with other silicon elements to build system-in-a-package capability.

And the end customer for that, the consumer product that these things went in, was demanding traceability of all elements.

So if a system came back that failed, they wanted to know exactly where the MEMS element came from and exactly where the SoC came from, so you could understand how many other parts they should be looking to call back, right, if this was on a certain, assembled with a certain machine and that means that all on that day, maybe other ones are at risk, et cetera.

And it was really that work that we did together with them over the last year that got us to recognizes that this with a general need for a lot of these applications like automotive. Even things like microphones and cell phones, we have systems-in-packages these days.

So we are really bringing out a series of new solutions based on their data collection and our analytics and we will price those separately than the way that KINESYS sold its products in the past..

Okay. Thanks. That was helpful. And finally just first congratulations on breaking to the 3D NAND business.

Is there any way you can size that market opportunity for us and what you bring to the table there?.

Yes. Thank you Jon. We are very excited about that. As I said, it is a Gainshare contract. So it has solutions revenue as well as Gainshare tied to basically pay per wafer. And so it has the potential to be substantial because as you know a lot of the volume or capacity build out right now has been in 3D NAND.

I think it's premature for us to say how large that market opportunity is for us, because we need to demonstrate what we are able to achieve, how much yield we are able to attain, what the volume profile looks like for these programs once you hit volume. So today, I wouldn't be able to put a number to that yet..

Okay. Great. Thank you very much..

Your next question comes from the line of Tom Diffely with D.A. Davidson..

Yes. Good afternoon.

I guess just following up on that last question, is the new 3D NAND customer a new customer or a new player in the space then? Someone who hasn't been in 3D NAND in the past?.

It is a new customer for us. I believe they have been in the market before, but this maybe a new entry for them..

Okay. Great.

And then when you look at the DFI, has the success of the 250 yield being built on schedule with all plans still on schedule, has that changed your customers' view of what the demand for additional 150s going forward?.

Not really. The 150, as we said in our prepared remarks, it's been qualified for mass production. It's running in mass production. And as we said in my prepared remarks, we continue to bring out new capability on it with firmware upgrades, such is new structures and new analytics.

So we are able to demonstrate that we can see things on the 150 that we couldn't see, let's say, a quarter ago. And so right now, the customers are quite pleased with that capability. As the 250 demonstrates its performance, we know that within chip, when you are looking for DFI structures inside a chip, it will be substantially faster than 150.

In the scribe line application where a lot of our customers are using the 150 today and in R&D, it will be also substantially faster but there will be a cost-benefit analysis there that we are going to run for the customers. The 150 is quite productive for the customer at the cost that we are able to charge..

So that being said, would you expect to get more 150 business before the 250 is ready to go out the door?.

Yes. We have built a number of 150s or in the process of building a number of 150s for where we expect to see business from customers over the remainder of this year and into next year. And we anticipate shipping those as we kind of went into this year thinking that that was going to happen.

Originally as I think, if you look it up, go back and look at our prepared remarks in 2016, we thought we would build one or two 150s and then move on to the 250s but what surprised us was when, for example, the customer that we talked about put the 150 online for manufacturing and ran it 24 hours a day.

And when inspecting scribe line on product wafers, we didn't anticipate that given the amount of area 150 can test, most of our customers will allow us to inspect a wafer for under two hours when they are in high volume manufacturing and then the wafer needs to move on.

And typically, e-beam tools with two hours of inspection time, once you get to good yields, you can't see anything. So we had thought, we would get to a point where with two hour budget, you wouldn't be able to see anything.

However, we are still able to correlate what we see on the 150 with customers' product yields even as they get to manufacturing defect densities, so competitive defect densities.

So at this point, as we said last, I think it was Q4 of last year, we started seeing that there was a manufacturing application for the 150 and we scrambled in the first half of this year to make that possible and Q2 was when we demonstrated. I mean the customers tested literally hundreds of wafers with this thing now.

And so now we believe there is an ongoing application in the scribe line for the 150..

Okay.

So when you talked about a significant, potentially significant impact to the model next year, is that more 150 driven or is that 250 ramping up?.

We built the model assuming it would be on the 150 itself and it would be significant. We believe there is even more we could do with the 250. But we have got to demonstrate to customers. One of the customers said, if you can hit those performance specs, I will be blown away, right. So you know we need to show them that that's actually achievable.

We work with manufacturers, right, not designers. They like to see how stuff actually really works, right. So people have asked us to send us wafers this quarter and we will do that..

Okay.

Now moving over to the model, when you talked about ramping business in the third and fourth quarter, was that just the royalty stream increase or the Gainshare? Or did you expect actually an increase in the Design-to-Silicon-Yield?.

Yes. We expected increase in both. That will bring us back to level similar to the second half of last year..

Okay. And so I know for a couple the contracts, you said that you probably are going to sign them this year and then revenue really hits next year.

What is the typical rollout of revenues for a standard contract for you?.

Yes. These particular contract, the reason they had an impact on revenue this quarter by not signing is that these are contracts where we have been working with the customer already. In fact, in some of the cases we have done quite a bit of extensive work with them.

So that when in fact they do sign which we are fairly confident they will, it's just a matter of timing, we will have catch-up revenue in whatever quarter that happens. And then they will go forward from there..

Okay.

And then finally, when you look at the ramp of the 250 as it matures over the next few quarters, what is going to be the impact you think to the CapEx and the OpEx?.

Yes. That's a good question. We are actually going through our modeling as we come out of this quarter into next quarter right now. But the major thing is that the 250, like the 150, will be sold on a usage model with fairly ratable revenues over extended period of time. The cash to do the actual bomb is incurred upfront.

So we will have some impact on cash flows as you initially buildup to the ramp. But once you get past a certain number of machines, the cash being generated by the existing machine base overwhelms the cash you have to spend to build additional machines. So we have a lot of variance on that model right now..

Okay.

What about on the OpEx side?.

On the OpEx side, basically what we said and it's our website, we expect R&D expense to basically flat net the levels it's at now.

And then as we get into 2018, we expect to see R&D come down related to these programs as we go into production on the 250 and you will see start to see the cost of sales line pickup which will be in depreciation expense..

Great. Okay. Thanks for your time today..

Thanks Tom..

Your next question comes from the line of Christian Schwab with Craig-Hallum Capital Group..

Hi guys.

On the Design-to-Silicon-Yield solutions, when did you know this was a problem?.

I think pretty close to the end of the quarter. So as Greg said, a lot of these were extensions of pilots we had done or actually early R&D engagements that converted over or anticipated to convert over.

As I said in my prepared remarks, we had some customers where those changes in leadership in the quarter and as we got to the end of the quarter, we found the sign passes was a little bit different than we had anticipated..

Okay.

In the guidance that you gave for total revenue in the second half of 2017 to be in aggregate similar dollar amount to the second half of 2016, does that include an assumption of a significant catch-up in that? Or are you assuming that if all these contracts do get signed, then that would be on top of that?.

I would say it's a partial catch-up..

It's a partial catch-up..

Yes..

I had to jump on the call late.

Did you quantify exactly the exact dollar amounts that these contract not signed cost you in the June quarter?.

No, we did not, but it was material to the results of the quarter, let's put it that way..

Right.

Is it safe to assume it was probably roughly $4 million?.

I would not say that, but it's in the millions..

Okay.

And then following up on an earlier question, would you anticipate that Gainshare revenue continues to improve sequentially from June to September and then potentially September to December depending on your largest customer's 14-nanometer volume?.

Yes. I would hate to try to predict the individual quarter to say, are they going to be in a nice linear ramp. But we are fairly confident that the second half in aggregate will be significantly higher than the first half..

Okay. I am struggling to remember a company and I have been doing this a long time who constantly cannot predict their business with a degree of accuracy.

Are putting in checks and balances? What are we doing? Or is it just as big as a black box for you as it is for us?.

So we understand your disappointment, Christian. Certainly, we were to about the lack of predictability. I think we have actually been pretty good over the previous few years. This first half of the year has been a surprise to us. I think there have been a number of factors.

There has been an awful lot of startup of new business activity with our customers in Asia. They have had some leadership changes to that certainly cost some timing issues on the signings. With respect to the volumes, they have also I think struggled a little bit with their volumes over there that have been more substantial than we anticipated.

We will, if you look at, I would say go back about 2014, 2015 and 2016, as we had times where we understood the customers pretty well, we will get a pretty good model on what's going on with the customer business and customer behavior..

Okay. That's fair. All right. Thanks guys..

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

Thank you..