John Kibarian - Co-Founder, CEO, President & Director Gregory Walker - CFO & VP, Finance.

Jonathan Tanwanteng - CJS Securities Thomas Diffely - D.A. Davidson & Co. Tyler Burmeister - Craig-Hallum Capital Group Auguste Richard - Northland Capital Markets.

Good day, ladies and gentlemen, and welcome to the PDF Solutions, Inc. conference call to discuss its financial results for the second quarter ended Saturday, June 30, 2018. [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 its solution.

PDF's actual results could differ materially. You should refer to the section entitled Risk Factors on Pages 13 through 19 of PDF's annual report on Form 10-K for the fiscal year ended December 31, 2017, and similar disclosure 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 obligations 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. If you have not already seen our earnings press release or written management report, please go to the Investors section of our website where both are posted. Today, we will discuss our business progress during the second quarter of 2018 as well as our view of the general semiconductor environment.

I will also describe the business environment we anticipate for the remainder of the year and our plans to address it. Selling activity in the second quarter was consistent with our view of the general business environment, evidenced by the significant contracts closed in the second quarter.

These include a 7-nanometer DFM contract with a large system company, a contract with an Asian foundry to use Exensio-Control and our CV infrastructure for 28-nanometer production control; a services contract for custom Exensio modules for an enterprise customer; a multiyear contract for Exensio-Test and Exensio-Yield for an RF fabless semiconductor company; and multiple other contracts on the Exensio platform in various modules, including Exensio-Test and related services.

The logic semiconductor industry is going through a very big transition. The driver for this industry has been transitions to leading-edge processes.

It was evident years ago that the transition to new nodes was slowing and investments were shifting to derivative nodes where electric scaling dominates over geometric scaling, NAND advances and multichip packaging.

In the past, majority of our revenue came from Integrated Yield Ramps or IYR solutions delivered to second-tier foundries investing in leading-edge processes. Our anticipation was that our business for bringing up new nodes would slow, while our business in controlling product manufacturing across the manufacturing supply chain would grow.

A number of years ago, we invested to move PDF's business from a dependency on the introduction of new process nodes to value across the manufacturing lifetime. Moreover, we invested in technologies internally and through acquisition that made our solution more valuable to fabless and system companies.

These investments include Exensio and related software acquisitions, DFI and our next-generation test platform. This past quarter demonstrates that if anything, the transition is happening faster than expected. We saw a continued decline in our yield ramp business with second-tier foundries.

We also saw increased business with system companies and fabless companies as well as deployment of our vehicles, software and systems to control existing manufacturing lines rather than bringing up new technologies. Turning to gainshare. As we saw in Q1 of this year, 14-nanometer revenue in Q2 was more than 70% of the total gainshare revenue.

We expect this trend to continue through the remainder of the year.

Despite this decline in IYR activity and soft gainshare, the new investments we've been talking to you about for a few - the last few years, including new applications of our CV infrastructure targeted at More-than-Moore technologies, our Exensio big data platform and our Design for Inspection or DFI solution, are beginning to reap benefits.

These products and services receive a strong level of interest in the marketplace, and business activity related to them is good. Exensio demand, while strong overall, is focused on applications that leverage our customers' ability to manage quality and yield from design and manufacture through multichip assembly and packaging.

Total revenue in the quarter from these newer products and services contributed more than 50% of our design-to-silicon solutions revenue. Turning to DFI.

While the listed contracts posted in Q2 mentioned previously did not include the - an extension or new contract with the lead customer, discussions continue, and we remain optimistic that one will close in the near future.

In addition, we have a number of ongoing demonstrations, including our newest eProbe 250 system that is testing customers' product wafers in our Milpitas facility. In the second quarter, the system identified leakage defects in product chips. These were verified by customers.

This is an important customer - this is important for customers building chips for AI and high-performance computing applications. For these customers, with their stringent requirements, the eProbe 250's ability to find leakage paths in line is particularly valuable.

This demo activity, along with expansion in the number of products and test chip designs that include DFI, will drive demand for future DFI system sales. For the remainder of the year, we believe the majority of our business activity will continue to be focused on our solution for fabless system companies and More-than-Moore fabs.

We anticipate the spending in logic foundries, particularly the second-tier foundries, to remain soft, which means a key part of our overall revenue will be - continue to be impacted. As a result, we expect 2018 to continue to be a challenging year from a revenue perspective.

As we look to the third quarter, we have a number of new customer selling activities ongoing, but the timing of closing these activities is not yet clear. Further, revenue from DFI, Exensio and contracts covering CV infrastructure plus Exensio for legacy fabs are primarily recognized on a ratable basis.

This means these new contracts, when signed, will not significantly impact revenue in the quarter. Hence, at this point, as you'll see in our outlook in the management report, we are cautious in our expectations for Q3 revenue.

As a result of a volatile market environment that we are experiencing and the slower revenue recognition related to usage-based models, we began taking some actions in Q1 to reduce our spending. These actions were primarily focused on our yield ramp business in the U.S. and Europe.

As we move through the remainder of this year, we will continue to look for opportunities to further reduce spending associated with our yield ramp business. While experiencing some savings due to the completion of the eProbe 250 hardware development, the savings will be offset by further investments in Exensio and field applications for DFI.

However, we expect our overall spending rates to continue to decline. In summary, we continue to transition PDF's business from dependency on the introduction of new processes to value across the manufacturing lifetime.

Moreover, we are adapting our technology, which was primarily used in leading-edge fabs, to increase relevance to fabless and system companies. These changes are aimed at diversifying our revenue sources, returning the company to growth and providing a more predictability to our financial performance. With this, I'll 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'm going to focus my verbal comments for the quarter on a few key highlights reflected in those results.

Turning to revenue. Total revenues at $21.1 million for the quarter were down by $3.6 million as compared to Q1 2018. Solutions revenues at $15.3 million decreased by $2.9 million when compared to Q1, while gainshare revenues at $5.9 million decreased by $700,000.

The Q2-over-Q1 decrease in solutions revenue was primarily the result of lower percentage of completion revenues across several IYR projects and the completion within the quarter of a specific IYR project. The decrease in gainshare revenue was primarily due to a onetime minimum gainshare billing that occurred in Q1, which was not repeated in Q2.

The revenue related to our Exensio and DFI solutions, as John said, represented over 50% of total solutions in the quarter. Turning to expenses. On a GAAP basis, total expenses for the quarter were $24 million, approximately $1.2 million lower than the previous quarter.

This decrease in expense was primarily due to lower audit and legal fees, lower cost of sales related to hardware sold to a customer as part of a Q1 sale, lower stock compensation expenses and severance payments that occurred during Q1 that did not reoccur in Q2.

Additionally, third-party development costs related to our DFI solution were lower in Q2 than in Q1 since development of the eProbe 250 hardware platform completed in Q1, which we previously discussed in the April call. On a non-GAAP basis, total expenses for the quarter were $21.1 million, approximately $700,000 lower than the previous quarter.

This decrease was primarily due to the items previously mentioned regarding the decrease in GAAP spending, except for the impact of severance payments and lower stock compensation expenses, which have been excluded from non-GAAP expenses. The breakout of total spending on a both GAAP and a non-GAAP basis is provided in our management report.

Other income and expense for the quarter was approximately $700,000 higher than Q1, primarily due to unrealized foreign currency exchange gains in the quarter. Net loss for the quarter was driven by lower revenues, and the GAAP net loss for the quarter was approximately $2.1 million, an additional loss of $1.7 million over Q1.

Non-GAAP net income for the quarter was $760,000, down approximately $1.5 million from Q1. Now looking at the balance sheet. Total cash at $101 million increased by $2.4 million during the quarter.

This increase was primarily the result of $6.5 million of cash generated from operations and the proceeds from employee stock option exercises of approximately $400,000.

This was partially offset by PP&E purchases of $2.4 million, most of which was related to development of our DFI solution; stock repurchases totaling $1.1 million and the purchase of company-related stock to the settlement - related to the settlement of employee tax obligations on RSU grants of approximately $800,000; and finally, the effective exchange rates of about - approximately $200,000.

Accounts receivable at approximately $61.2 million at the end of the quarter consisted of $30.7 million of trade AR and $30.5 million of unbilled AR. The combined AR was approximately $5 million lower than in the previous quarter, the result of strong collections in Q2.

DSO for combined accounts receivable, including contract assets recorded in other assets under ASC 606, increased from 257 days in Q1 to 277 in Q2, primarily as a result of lower revenues in Q2.

Of the $30.5 million of unbilled accounts receivable, we expect to bill $23.2 million over the next 12 months, of which $13.2 million will be billed during Q3. During Q2, we collected $27.5 million, which was up from $25.6 million in Q1.

Since the end of Q2, we have collected another $5.9 million of the $30.7 million trade accounts receivables, which would have reduced our quarter end DSO by approximately 25 days. Looking at taxes. Our GAAP tax benefit for the quarter was $439,000.

This benefit consisted of gross GAAP tax rate of approximately 20.1% plus adjustments for discrete items of $117,000. We expect our full year net GAAP and non-GAAP tax provision rate, after discrete items, to be approximately 25%. Looking at the remainder of the year, we now expect 2018 revenue to be down 5% to 10% when compared to 2017.

We expect Q3 revenues to remain approximately the same levels as in Q2 as we continue to work through declining contract revenues from our yield ramp business with second-tier foundries. This headwind will be offset by growth from our newer solutions, such as More-than-Moore and DFI solutions that John described.

As John also mentioned, for the majority of these new solutions, revenue will be recognized on a ratable basis.

Our cost reductions mentioned last quarter, when combined with ongoing COGS streamlining activities, will allow the company to make some strategic investments while still reducing total non-GAAP spending by approximately 5% or more year-over-year.

While we are disappointed that the yield ramp business is declining at a rate faster than we anticipated, we expect to transition our main business to our newer markets, products and services and to fund the development of our DFI solution without significantly impacting our cash position. With that, I will turn the call over to the operator for Q&A.

Operator?.

[Operator Instructions]. Your first question comes from the line of Jon Tanwanteng from CJS Securities..

Would you mind just telling us what the outlook is for your customers' volumes in the traditional gainshare business? When will or when can that recover? And what are the drivers to getting there?.

This is John. We do expect over time the second-tier foundries that we are collecting 28-nanometer gainshare to see an improvement in their gainshare. That would be probably the biggest driver. And then as our lead customers bring up new nodes, 14-nanometer and beyond, like 7-nanometer, will also be the second driver to gainshare growth..

And do you expect any fallout from the trade war that's going on between the U.S.

and China right now to impact the prospects for these customers?.

It's probably above my pay grade. I don't know. I mean, we definitely know that our customers in China are very concerned about what's going on in the trade war as some of our U.S. customers are. But to this point, I don't think it's anything more than just hearsay back and forth..

Okay.

And just moving on to DFI, is that still the opportunity that you think it is? And kind of what's going to take to get the contract over the line that you're going to sign with a customer in Asia?.

Yes. Still very much very positive. In the comments in my prepared remarks, I talked about what we're seeing with the 250 on the demos, and this is exactly what we originally set out to do, which [indiscernible], in die, in line, leakages and opens that drive product quality, product performance.

Biggest supporters of DFI from the - on the fabless side have been the companies that are doing the large [indiscernible] leading-edge technologies. At our users conference two years ago, NVIDIA was very vocal about why they thought technology with DFI was so important.

And they are really - those companies have been the driver that we have with our lead foundry customer as well.

And so we see that combination of where we'll see technically what the fabless customers want to be able to see in control and line and the technical support we've been getting from the lead customer to point to why we're very confident about the capability and the business opportunity that DFI represents..

Okay, great.

And what does the contract cover specifically? Is it going to be a number of machines on license? Or is it just the development and ramp of these products? How can we kind of model this when you actually have that?.

Yes. It's going to be - again, it'll be capacity of - usage of a machine over a time period with also some electrical test as well in all likelihood and the vehicles that support that usage. And then there's a - then a scale-up if they want to increase capacity on additional machines on how that would work out economically..

Okay, great. And then just on the Exensio business, I noted that there was a lot of contracts you signed. Obviously, DFI and Exensio combined for over 50% of the revenue in the solutions business.

What - where do you see Exensio itself on the big data and the control software in the next 2 to 3 years?.

Yes. We continue to see - and I've had a lot of discussions with many of our lead - our top customers on Exensio. Particularly for our customers in the RF, analog, mixed-signal business, they really want to have full control of their supply chain, sometimes being driven by their largest customers. We obviously see what's in the automotive market.

Overall, we think that means that the business for Exensio, which has been growing at a relatively substantial rate, will continue to grow at the rate we've experienced in the past. And there may be ways we could accelerate that, and we keep looking for ways that we can drive better growth on Exensio..

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

So looking at the gainshare part of the business or the yield ramp part of the business, I know at one point, we talked a lot about how kind of the new ramping customers in China, the 28-nanometer node would be a good potential business for you, albeit delayed a year or two because they were behind schedule or behind the rest of the world.

Is that still an opportunity going forward that's just been slower than you thought? Or is it actually the opportunity you see is smaller than you once perceived?.

Yes. Tom, that's a great question. And it's definitely been slower than we thought, that's for sure true. If you - and we had added - in this past year, in this past quarter, we added Gerald Yin on our board. I believe [indiscernible]. And Gerald, as you know, runs - maybe he runs the largest capital equipment company in China, AMEC.

And when he and I were discussing it in December, when we've looked at companies inside the country, headquartered inside China, their rate of expansion and their rate of bring-up has been slower than they certainly had expected. I - he is always to tell me, it's going to happen, it will happen.

But it certainly seems to be slower than we had expected. And we will keep monitoring exactly how that changes..

Okay. And then on the DFI part of the business, over the last years, you've been primarily focused on one large customer to prove out the 250.

At this point, have you started to reengage with some of the other customers?.

Yes, it's a great question. We actually - as we got through the first demos and the first example for the customers in this past quarter, we made a decision to start opening up the opportunity with who we've gone off and started to work with.

So over, let's say, the last - just a couple of months' time, we started to improve - increase the number of folks that we're talking with about DFI. And we generally find very good resonance for the solution..

And I know - and you're still going - you had one of the first-generation tools being put into production.

Is that tool still in production? Or was it just a onetime thing to get the ramp-up going?.

That tool is still running product wafers today, and we are still working with that customer. So yes, it's still being used as a production monitoring tool. The node that it's being used on has moved on from what it was doing originally, but it is more - to a more advanced node, but it's still being used..

Okay, good.

And Greg, when you look at the model and the revenue mix shifts a bit more towards Exensio and away from the gainshare IYR model, what does that do to the margin structure?.

Yes. And as we've said in the past, our goals for both DFI and Exensio are to get them looking very much like a technology software company that's on primarily a SaaS or a TBL model, very similar to the EDA companies. And we're making progress towards those numbers.

And as we continue to do that and we grow the percentage of that business, you should see our gross margins improve over time. How quickly that takes place is really depending on mix inside a specific quarter, but the trend line will be up..

[Operator Instructions]. Your next question comes from the line of Christian Schwab from Craig-Hallum..

This is Tyler on for Christian. They're mostly covered, but as you move from being less dependent on new nodes to try and add value over the lifetime of devices, I was just - a couple of questions on longer term, how the business might look.

So first, on gainshare, with your yield ramp business declining maybe faster than you guys thought, should we think about gainshare over the long term as kind of stable to the client business? Or is there a reason to think that we can see a return to growth from that?.

Yes. I think it's both possible and likely that as China progresses, particularly with 28-nanometer node, as John was talking about, and then later on some of the more advanced nodes, it's very possible we will see some growth returning into gainshare.

Will it get back up to the levels that we were experiencing in, say, 2013, 2014? That's highly dependent on what goes on in China..

All right.

And then on the [indiscernible] solutions business, with your yield ramp business declining but over 50% of your revenue in the segment you said coming from the newer businesses, would it be logical to think that, that growth would outpace the client in yield ramp?.

Yes, that's basically what we think, that we're going through that decline right now. At some point in time, whether that be a quarter out or two quarters out, our growth in our new businesses will outpace that decline, and you would see the company at some point in time in the near future returning to a growth curve..

Your next question comes from the line of Gus Richard from Northland..

John, in the past, you've given out metrics for how many tape-outs for DFI and how many customers you're engaged with.

Do you have any of those metrics handy?.

I don't have them handy. It's a little over 100 tape-outs now. It goes at quite a good clip. The - part of the problem has been now for our lead customer, one of the two lead customers, it is included in every 14-nanometer tape-out. So we don't get quite the visibility we used to when they were on the test chip side.

But the number's at a quite - well over 100 vehicles at this point. I can go back and look at that number and try to give you in the next call..

And then do you have a sense of like how many fabless companies or system companies are now in - have them in their designs [indiscernible]?.

Yes. I think there's two that are actually putting them in chips that are product ready and a number of - probably on the order of six or so that are in, two plus another four that are in R&D vehicles. And I think we're starting to see some traction from some of those to start looking at it on products.

And until we had the 250, there wasn't much we could do with product vehicles. Now that we have a 250, we can go back and start talking to customers about why you'd want to put this in product, not just in test vehicles..

Got it. And then a while back, you guys were working with a flash company.

And I was wondering how that effort was going, if that's proceeding as planned or are you going to pivot away from that?.

We continue to work with that company. We do see continued opportunity there that's contributing to revenue in the first half of this year and on the second half of the year.

We also are working with - because of the capability of the fifth-generation tester, working with folks that are doing embedded nonvolatile memories as well, some not based on flash technology but other technologies, so-called cross-point technologies.

And the testing capability that we're developing, we think, has - and releasing this quarter, adds value to both the flash as well as the nonconventional and nonvolatile memory technologies. We see opportunities in both those places..

Okay.

And then the nonvolatile other alternative memories phase change, is it ReRAM or MRAM?.

Yes. If you - from our standpoint, it doesn't really matter very much. We design the machines [indiscernible] pulses that works with those technologies. And from a vehicle standpoint, at the simplest level, they don't look very different. They have [indiscernible]. They have [indiscernible] changes. It's a lot of characteristics, and there's some physics.

And then you're able to program when you write them. And the purpose of the tester is to set it up for [indiscernible], in effect, do the periphery, and you can [indiscernible]. But the periphery testers [indiscernible] and you can get a lot of statistics [indiscernible] a very small number of math.

And we have been getting some customers - I'd look at 2 or 3 [indiscernible] systems. And again, hard for us to handicap which one of them has the winning physics, but they all have some either a phase-change MRAM or related technology..

And then last, just a housekeeping question. I missed the - I think you announced a couple of DFI contracts right at the beginning of the conference call.

Could you just repeat those for me?.

No, we did not announce the DFI contract.

We announced the 7-nanometer contract, DFM contract with a large system company; a contract with an Asian foundry for Exensio-Control and CV infrastructure for 28-nanometer; a services contract for custom Exensio modules for an enterprise customer; and a multiyear contract for Exensio-Test and Exensio-Yield for an RF fabless semiconductor company..

[Operator Instructions].

Okay.

Yes?.

Yes..

Thank you very much. Look forward to talking to you again soon..

Thank you..

All right. Ladies and gentlemen, this concludes the program. Thank you all for joining us today. You may now disconnect..