**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

** **

**FORM 10-Q**

 

| **(MARK ONE)**                                                                                      |
|-----------------------------------------------------------------------------------------------------|
|                                                                                                |
| x                                                                                                   |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                |
| **For the quarterly  period ended December 31, 2002**                                               |
|                                                                                                |   |   |
| **OR**                                                                                              |
|                                                                                                |
| o                                                                                                   |   | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                |   |   |
| **FOR THE TRANSITION  PERIOD FROM       TO     ** |
|                                                                                                     |  |  |  |  |

** **

**Commission filenumber 000-32967**

** **

**HPL TECHNOLOGIES, INC.**

(Exact Name of Registrant as Specified in itsCharter)

 

| **Delaware**                                                    |   | **77-0550714**                          |
|-----------------------------------------------------------------|--------|-----------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |   | (I.R.S. Employer Identification Number) |
|                                                            |   |                                    |
| **2033 Gateway Place,  Suite 400  San Jose, California 95110**  |
| (Address of Principal Executive Offices)                        |
|                                                            |   |                                    |
| **(408) 437-1466**                                              |
| (Registrant's Telephone Number, Including  Area Code)           |

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days YES o  NO x.

 

As of January 31, 2003, there were 31,084,167shares of Common Stock outstanding.

 

 

 

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**HPL Technologies,Inc.Table of Contents**

 
| **PART I. FINANCIAL INFORMATION** |
|-----------------------------------|
|                              |
| Item 1.                           | Condensed Consolidated Financial Statements  (unaudited): |
|                              |   |
|                              | Condensed Consolidated Statements of  Operations for the three and nine months ended December 31, 2002 and December  31, 2001 (as restated) |
|                              |   |
|                              | Condensed Consolidated Balance Sheets as of  December 31, 2002 and March 31, 2002 |
|                              |   |
|                              | Condensed Consolidated Statements of Cash  Flows for the nine months ended December 31, 2002 and December 31, 2001 (as  restated) |
|                              |   |
|                              | Notes to Condensed Consolidated Financial  Statements |
|                              |   |
| Item 2.                           | Management's Discussion and Analysis of  Financial Condition and Results of Operations |
|                              |   |
| Item 3.                           | Quantitative and Qualitative Disclosures  About Market Risk |
|                              |   |
| Item 4.                           | Controls and Procedures |
|                              |   |
| **PART  II. OTHER INFORMATION**   |
|                              |
| Item  1.                          | Legal  Proceedings |
|                              |   |
| Item 2.                           | Changes in Securities and Use of Proceeds |
|                              |   |
| Item 6.                           | Exhibits and Reports on Form 8-K |
|                              |   |
| Signatures                        |
|                                   |  |  |

 

----

 

**PART I — FINANCIAL INFORMATION**

 

**Item 1. *Condensed Consolidated Financial Statements***

 

**HPL Technologies,Inc.**

**CondensedConsolidated Statements of Operations**

*(In thousands,except per share amounts)*

*(unaudited)*

 
|                                                       |   | **Three Months Ended  December 31,** |   | **Nine Months Ended  December 31,** |       |
|------------------------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|------------|
|                                                       |   | **2002**                             |   | **2001**                            |       | **2002** |   | **2001** |   |
|                                                       |   |                                 |   | **(As restated)**                   | ** ** |   | ** ** | **(As restated)** |   |
| Revenues:                                                  |   |                                 |   |                                |       |   |   |   |   |
| Software licenses                                          |   | $                                    | 2,839  |                                | $          | 2,123 |   | $ | 4,841 |   | $ | 1,543 |   |
| Consulting services, maintenance and other                 |   | 2,409                                |   | 411                                 |       | 7,169 |   | 864 |   |
| Total revenues                                             |   | 5,248                                |   | 2,534                               |       | 12,010 |   | 2,407 |   |
|                                                       |   |                                 |   |                                |       |   |   |   |   |
| Cost of revenues:                                          |   |                                 |   |                                |       |   |   |   |   |
| Software licenses                                          |   | 559                                  |   | 147                                 |       | 656 |   | 437 |   |
| Consulting services, maintenance and other  (1)            |   | 883                                  |   | 28                                  |       | 2,244 |   | 111 |   |
| Total cost of revenues                                     |   | 1,442                                |   | 175                                 |       | 2,900 |   | 548 |   |
| Gross profit                                               |   | 3,806                                |   | 2,359                               |       | 9,110 |   | 1,859 |   |
|                                                       |   |                                 |   |                                |       |   |   |   |   |
| Operating expenses:                                        |   |                                 |   |                                |       |   |   |   |   |
| Research and development (1)                               |   | 1,938                                |   | 1,403                               |       | 8,764 |   | 3,992 |   |
| Selling, general and administrative (1)                    |   | 4,052                                |   | 2,629                               |       | 16,105 |   | 6,319 |   |
| Stock-based compensation                                   |   | 332                                  |   | 828                                 |       | 793 |   | 2,651 |   |
| Amortization of intangible assets                          |   | 332                                  |   | 48                                  |       | 1,162 |   | 62 |   |
| Total operating expenses                                   |   | 6,654                                |   | 4,908                               |       | 26,824 |   | 13,024 |   |
|                                                       |   |                                 |   |                                |       |   |   |   |   |
| Loss from operations                                       |   | (2,848                               | )      | (2,549                              | )          | (17,714 | ) | (11,165 | ) |
| Interest income (expense) and other income,  net           |   | 92                                   |   | 383                                 |       | 422 |   | 649 |   |
| Net loss                                                   |   | $                                    | (2,756 | )                                   | $          | (2,166 | ) | $ | (17,292 | ) | $ | (10,516 | ) |
|                                                       |   |                                 |   |                                |       |   |   |   |   |
| Net loss per share - basic and diluted                     |   | $                                    | (0.09  | )                                   | $          | (0.08 | ) | $ | (0.56 | ) | $ | (0.47 | ) |
|                                                       |   |                                 |   |                                |       |   |   |   |   |
| Shares used in per share calculations -  basic and diluted |   | 30,784                               |   | 27,015                              |       | 30,619 |   | 22,563 |   |

----

| (1) Excludes the following stock-based compensation  charges: |   |   |   |   |   |   |   |   |   |
|---------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Cost of revenues                                              |   | $      | 1      |   | $      | 9      |   | $      | 18     |   | $ | 32 |   |
| Research and development                                      |   | 166    |   | 131    |   | 283    |   | 552    |   |
| Selling, general and administrative                           |   | 165    |   | 688    |   | 492    |   | 2,067  |   |
|                                                          |   | $      | 332    |   | $      | 828    |   | $      | 793    |   | $ | 2,651 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

2

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**HPL Technologies,Inc.**

**CondensedConsolidated Balance Sheets**

*(In thousands,except per share data)*

*(unaudited)*

 
|                                                                                                                                                           |   | **December  31, 2002** |   | **March  31, 2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|--------|---------------------|--------|
| **ASSETS**                                                                                                                                                     |   |                   |   |                |   |
| ***Current assets:***                                                                                                                                          |   |                   |   |                |   |
| Cash and cash equivalents                                                                                                                                      |   | $                      | 17,839 |                | $      | 32,798 |   |
| Short-term investments                                                                                                                                         |   | 5,333                  |   | 14,311              |   |
| Accounts receivable, net                                                                                                                                       |   | 2,644                  |   | 1,212               |   |
| Unbilled accounts receivable                                                                                                                                   |   | 627                    |   | 783                 |   |
| Prepaid expenses and other current assets                                                                                                                      |   | 4,762                  |   | 3,870               |   |
| Total current assets                                                                                                                                           |   | 31,205                 |   | 52,974              |   |
| Property and equipment, net                                                                                                                                    |   | 2,674                  |   | 3,147               |   |
| Goodwill                                                                                                                                                       |   | 58,452                 |   | 42,040              |   |
| Other intangible assets, net                                                                                                                                   |   | 2,839                  |   | 2,701               |   |
| Other assets                                                                                                                                                   |   | 779                    |   | 446                 |   |
| **Total assets**                                                                                                                                               |   | $                      | 95,949 |                | $      | 101,308 |   |
|                                                                                                                                                           |   |                   |   |                |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                  |   |                   |   |                |   |
| ***Current  liabilities:***                                                                                                                                    |   |                   |   |                |   |
| Accounts payable                                                                                                                                               |   | $                      | 1,276  |                | $      | 2,570 |   |
| Accrued liabilities                                                                                                                                            |   | 7,061                  |   | 5,755               |   |
| Deferred revenue                                                                                                                                               |   | 4,435                  |   | 7,893               |   |
| Capital lease obligations—current portion                                                                                                                 |   | 411                    |   | 194                 |   |
| Convertible debenture                                                                                                                                          |   | 1,500                  |   | 1,500               |   |
| Total current liabilities                                                                                                                                      |   | 14,683                 |   | 17,912              |   |
| Capital lease obligations—net of current  portion                                                                                                         |   | 190                    |   | 280                 |   |
| Deferred revenue                                                                                                                                               |   | 178                    |   | —              |   |
| Other liabilities                                                                                                                                              |   | 584                    |   | 800                 |   |
| Total liabilities                                                                                                                                              |   | 15,635                 |   | 18,992              |   |
|                                                                                                                                                           |   |                   |   |                |   |
| Contingencies and Commitments (Note 3)                                                                                                                         |   |                   |   |                |   |
| ***Stockholders’  equity:***                                                                                                                              |   |                   |   |                |   |
| Preferred stock, $0.001 par value, 10,000  shares authorized, no  shares issued and outstanding at December 31, 2002 and  March 31, 2002                  |   | —                 |   | —              |   |
| Common stock, $0.001 par value; 75,000  shares authorized; 31,084  and 29,400 shares issued and outstanding at December 31, 2002  and March 31, 2002 |   | 31                     |   | 29                  |   |
| Additional paid-in capital                                                                                                                                     |   | 124,604                |   | 112,369             |   |
| Deferred stock-based compensation                                                                                                                              |   | (1,157                 | )      | (4,017              | )      |
| Accumulated other comprehensive income  (loss)                                                                                                                 |   | 14                     |   | (179                | )      |
| Accumulated deficit                                                                                                                                            |   | (43,178                | )      | (25,886             | )      |
| Total stockholders’ equity                                                                                                                                |   | 80,314                 |   | 82,316              |   |
| **Total liabilities and stockholders’ equity**                                                                                                            |   | $                      | 95,949 |                | $      | 101,308 |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

3

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**HPL Technologies,Inc.**

**CondensedConsolidated Statements of Cash Flows**

*(In thousands)*

*(unaudited)*

 
|                                                                         |   | **Nine months ended December 31,** |    |
|------------------------------------------------------------------------------|--------|-----------------------------------------|---------|
|                                                                         |   | **2002**                                |    | **2001** |   |
|                                                                         |   |                                    |    | **(As restated)** |   |
| ***Cash flows from  operating activities:***                                 |   |                                    |    |   |   |
| Net loss                                                                     |   | $                                       | (17,292 | ) | $ | (10,516 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |   |                                    |    |   |   |
| Depreciation and amortization                                                |   | 2,546                                   |    | 290 |   |
| Stock-based compensation                                                     |   | 793                                     |    | 2,651 |   |
| Loss on disposal of property and equipment                                   |   | —                                  |    | 172 |   |
| Changes in assets and liabilities, net of  effects from acquisitions:        |   |                                    |    |   |   |
| Accounts receivable                                                          |   | (1,194                                  | )       | 1,794 |   |
| Unbilled account receivable                                                  |   | 156                                     |    | — |   |
| Prepaid expenses and other current assets                                    |   | (869                                    | )       | (1,904 | ) |
| Other assets                                                                 |   | 117                                     |    | — |   |
| Accounts payable                                                             |   | (1,464                                  | )       | 504 |   |
| Accrued liabilities                                                          |   | (876                                    | )       | 2,478 |   |
| Other liabilities                                                            |   | (155                                    | )       | — |   |
| Deferred revenue                                                             |   | (4,216                                  | )       | (1,340 | ) |
| Net cash used in operating activities                                        |   | (22,454                                 | )       | (5,871 | ) |
|                                                                         |   |                                    |    |   |   |
| ***Cash flows from  investing activities:***                                 |   |                                    |    |   |   |
| Acquisition of property and equipment                                        |   | (414                                    | )       | (606 | ) |
| Issuance of notes receivable                                                 |   | (450                                    | )       | (2,745 | ) |
| Acquisitions, net of cash acquired                                           |   | (2,012                                  | )       | (498 | ) |
| Sale of short-term investments, net                                          |   | 9,016                                   |    | — |   |
| Net cash provided by (used in) investing  activities                         |   | 6,140                                   |    | (3,849 | ) |
|                                                                         |   |                                    |    |   |   |
| ***Cash flows from  financing activities:***                                 |   |                                    |    |   |   |
| Proceeds from issuance of notes payable and  line of credit                  |   | —                                  |    | 84 |   |
| Repayment of notes payable and  line of credit                          |   | —                                  |    | (284 | ) |
| Issuance of common stock                                                     |   | 164                                     |    | 68,797 |   |
| Principal payments on capital lease  obligations                             |   | (264                                    | )       | (95 | ) |
| Amounts received from HPL’s former Chief  Executive Officer             |   | 1,300                                   |    | — |   |
| Net cash provided by financing activities                                    |   | 1,200                                   |    | 68,502 |   |
| Effect of exchange rate changes on cash and  cash equivalents                |   | 155                                     |    | (208 | ) |
|                                                                         |   |                                    |    |   |   |
| Net increase (decrease) in cash and cash  equivalents                        |   | (14,959                                 | )       | 58,574 |   |
| Cash and cash equivalents at beginning of  period                            |   | 32,798                                  |    | 989 |   |
| Cash and cash equivalents at end of period                                   |   | $                                       | 17,839  |   | $ | 59,563 |   |
|                                                                         |   |                                    |    |   |   |
| **Supplemental disclosures of cash flow  information:**                      |   |                                    |    |   |   |
| Acquisition of property and equipment under  capital lease obligations       |   | $                                       | 391     |   | $ | 113 |   |
| Issuance of common stock and options  assumed in connection with acquisition |   | $                                       | 14,178  |   | $ | 8,255 |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

4

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**HPL Technologies,Inc.**

**Notes to theunaudited Condensed Consolidated Financial Statements**

 

**NOTE 1. GENERAL**

 

The unaudited condensed consolidated financial statements have beenprepared by HPL Technologies, Inc., a Delaware corporation (the “Company”),pursuant to the rules and regulations of the Securities and Exchange Commission(“SEC”). Certain information and footnote disclosures normally included inconsolidated financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America have beencondensed or omitted pursuant to such rules and regulations. These unauditedcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and the notes thereto for theyear ended March 31, 2002 included in the Company’s Annual Report on Form 10–K/Afiled with the SEC. In the opinion of management, all adjustments (consistingonly of normal recurring adjustments) necessary to present a fair statement offinancial position as of December 31, 2002 and 2001, and results of operationsfor the three months and nine months ended December 31, 2002 and 2001, and cashflows for the nine months ended December 31, 2002 and 2001, have been made. Theresults of operations for the three and nine months ended December 31, 2002 arenot necessarily indicative of the operating results for the full fiscal year orany future periods. Certain amounts for prior periods have been restated andreclassified to conform to the current period presentation. See Note 2.

 

The preparation of condensed consolidated financial statements inconformity with generally accepted accounting principles in the United StatedStates of America requires management to make estimates and assumptions thataffect the amounts reported in the financial statements. These estimates mayaffect the amounts of assets and liabilities reported in the balance sheet, thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expense during the periodspresented. Actual results may differ from those estimates.

 

The Company has funded its losses from operations principally throughits July 2001 initial public offering and debt financing. Management believesthe Company has sufficient cash, cash equivalents and short–terminvestments to fund its operations through at least March 31, 2003. Futurecapital requirements will be affected by slow or diminished revenue growth,additional research and development and sales and marketing costs, and highergeneral and administrative costs, including costs related to the litigationmatters described in Note 3. In the event the Company needs to raise capital,there is no assurance that funds would be available to the Company or, ifavailable, under terms that would be acceptable to the Company. The Company doesnot believe it will be able to raise additional capital until the litigationand other uncertainties described in Note 3 are resolved.

 

**NOTE 2. RESTATEMENT**

 

On July 19, 2002, the Company announced that the Audit Committee hadinitiated an investigation into a number of accounting irregularities involvingrevenue reported during prior periods. The purpose of this investigation was todetermine the scope and magnitude of these accounting irregularities andidentify any necessary corrections to be made to the Company’s previouslyissued consolidated financial statements. The Company also announced a numberof changes to its executive management team. As a result of the internalaccounting investigation, the Company’s consolidated balance sheets as of March31, 2002 and 2001 and consolidated statements of operations, cash flows andstockholders’ equity (deficit) for the years ended March 31, 2002 and 2001 werepresented on a restated basis in the Company’s Annual Report on Form 10–K/Afiled on November 8, 2002 with the restatement for the quarterly period endedDecember 31, 2001 contained herein.

 

The Audit Committee’s investigation into financial and accountingirregularities involving revenue reported identified a number of fictitioustransactions for which the Company previously recorded revenue in the yearsended March 31, 2002 and 2001. In addition, the investigation uncovered thatdocuments initially considered by the Company in determining the appropriateaccounting for transactions were altered from their original form to excludecertain terms and conditions. These terms and conditions provided customerswith rights of return and commitments with respect to integration andinstallation of the Company’s products and the delivery of futurefunctionality. The Company has reviewed these transactions in light of theseadditional terms and conditions and the Company’s revenue recognition policy,and either revised the periods for which revenue was recognized in thesefinancial statements or deferred the recognition of revenue to future periods.

 

As a result of the items noted above, the Company had identified thatthe previously reported revenues for the three and nine months ended December31, 2001 were overstated by approximately $7.2 million and $18.2 million relatedto fictitious transactions, and $1.2 million and $2.8 million related toimproper revenue recognition due to altered supporting documents used tosupport the previous timing of revenue recognition, respectively. As a resultof the adjustments necessary to correct the above irregularities, the Companyhas also deferred previously expensed costs of goods sold directly related torevenue deferred. The Company also revised the provisions for  bad debts and income taxes that werepreviously recorded in the consolidated financial statements. These adjustmentsaffected various asset and liability accounts.

 

5

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During the three months ended September 30, 2001, the Company sold $3.2million of software to its Japanese distributor and then immediatelyrepurchased the software through its Japanese subsidiary for $3.2 million. Inaddition, the Company entered into an agreement to pay its Japanese distributor$950,000 related to this transaction which was paid in December 2001. Therestated financial statements reflect the reversal of the software sale and afurther reduction to revenue of $950,000 related to this payment.

 

The Company’s investigation identified approximately $4.1 million,purported to represent proceeds from the collection of accounts receivablerelated to fictitious sales transactions, recorded as cash through December 31,2001.  These amounts were determined tobe fictitious and therefore eliminated from cash in the December 31, 2001balance sheet.

 

During the three months ended June 30, 2002, the  investigation revealed that the former ChiefExecutive Officer of the Company deposited approximately $1.3 million into theCompany’s bank accounts which was purported to have represented proceeds forthe payment of accounts receivable related to a fictitious sales transactionwhich occurred in the year ended March 31, 2002. The revenue on thistransaction has been eliminated in the appropriate periods and the amountreceived has been reflected in accrued liabilities.

 

During the year ended March 31, 2001, the Company sold certain softwareand maintenance to a related party for approximately $300,000 and recognizedthe revenue on this transaction.  On orabout the same time as agreeing to sell software to this company, HPL agreed tobuy software from that company.  DuringSeptember 2001, the Company purchased $500,000 of software from this samecompany and capitalized the cost of this software.  The Company believes the sale of software to the company, and thepurchase of software in September 2001 from the company were negotiated atapproximately the same time.   As such,the financial statements reflect no revenue on this transaction in the yearended March 31, 2001.  The restatedfinancial statements for the nine months ended December 31, 2001 reflect a netexpense in selling, general and administrative expense of $200,000 for thesoftware purchase.

 

During the three months ended September 30, 2001, the Company entered atransaction with Selastar Corporation (“Selastar”), a Japanese company owned byformer employees of the Company’s Japanese subsidiary and a former member ofthe Company’s board of directors.  TheCompany paid Selastar approximately $600,000 of which $545,000 was paid back tothe Company and recorded as payment on a fictious sale transaction and thepayment of $600,000 was recorded as sales and marketing expense.  The restated financial statements reflectthe reversal of this revenue and this expense in the nine months ended December31, 2001.

 

The following are the reconciliation of the Company’s results ofoperations, financial position and cash flows from financial statementspreviously filed to these restated and reclassified financial statements:

 

6

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**HPL Technologies,Inc.**

**CondensedConsolidated Statement of Operations**

**(in thousands, exceptper share data)**

 

**Three Months Ended December 31, 2001**

** **
|                                                          |   | **As Previously  Reported** |   | **Adjustments** |   | **As Restated** |   |
|---------------------------------------------------------------|--------|-----------------------------|--------|-----------------|--------|-----------------|--------|
| Revenues:                                                     |   |                        |   |            |   |            |   |
| Software licenses                                             |   | $                           | 8,713  |            | $      | (6,590          | )      | $ | 2,123 |   |
| Consulting services, maintenance and other                    |   | 2,190                       |   | (1,779          | )      | 411             |   |
| Total revenues                                                |   | 10,903                      |   | (8,369          | )      | 2,534           |   |
|                                                          |   |                        |   |            |   |            |   |
| Cost of revenues:                                             |   |                        |   |            |   |            |   |
| Software licenses                                             |   | 260                         |   | (113            | )      | 147             |   |
| Consulting services, maintenance and other  (1)               |   | 824                         |   | (796            | )      | 28              |   |
| Total cost of revenues                                        |   | 1,084                       |   | (909            | )      | 175             |   |
| Gross profit                                                  |   | 9,819                       |   | (7,460          | )      | 2,359           |   |
|                                                          |   |                        |   |            |   |            |   |
| Operating expenses:                                           |   |                        |   |            |   |            |   |
| Research and development (1)                                  |   | 1,431                       |   | (28             | )      | 1,403           |   |
| Selling, general and administrative (1)                       |   | 2,798                       |   | (169            | )      | 2,629           |   |
| Stock-based compensation                                      |   | 828                         |   | —          |   | 828             |   |
| Amortization of intangible assets                             |   | 48                          |   | —          |   | 48              |   |
| Total operating expenses                                      |   | 5,105                       |   | (197            | )      | 4,908           |   |
|                                                          |   |                        |   |            |   |            |   |
| Income (loss) from operations                                 |   | 4,714                       |   | (7,263          | )      | (2,549          | )      |
| Interest income (expense) and other income,  net              |   | 383                         |   | —          |   | 383             |   |
|                                                          |   |                        |   |            |   |            |   |
| Income (loss) before income taxes                             |   | 5,097                       |   | (7,263          | )      | (2,166          | )      |
| Provision for income taxes                                    |   | 2,753                       |   | (2,753          | )      | —          |   |
| Net income (loss)                                             |   | $                           | 2,344  |            | $      | (4,510          | )      | $ | (2,166 | ) |
|                                                          |   |                        |   |            |   |            |   |
| Net income (loss) per share:                                  |   |                        |   |            |   |            |   |
| Basic                                                         |   | $                           | 0.09   |            |   |            | $      | (0.08 | ) |
| Diluted                                                       |   | $                           | 0.07   |            |   |            | $      | (0.08 | ) |
|                                                          |   |                        |   |            |   |            |   |
| Shares used in computing per share amounts:                   |   |                        |   |            |   |            |   |
| Basic                                                         |   | 27,015                      |   |            |   | 27,015          |   |
| Diluted                                                       |   | 35,073                      |   |            |   | 27,015          |   |
|                                                               |   |                        |   |            |   |            |   |
| (1) Excludes the following stock-based  compensation charges: |   |                        |   |            |   |            |   |
| Cost of revenues                                              |   | $                           | 9      |            |   |            | $      | 9 |   |
| Research and development                                      |   | 131                         |   |            |   | 131             |   |
| Selling, general and administrative                           |   | 688                         |   |            |   | 688             |   |
|                                                          |   | $                           | 828    |            |   |            | $      | 828 |   |

 

7

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**HPL Technologies,Inc.**

**Condensed ConsolidatedStatement of Operations**

**(in thousands, exceptper share data)**

 

**Nine Months Ended December 31, 2001**

** **
|                                                          |   | **As Previously  Reported** |   | **Adjustments** |   | **As Restated** |   |
|---------------------------------------------------------------|--------|-----------------------------|--------|-----------------|--------|-----------------|--------|
| Revenues:                                                     |   |                        |   |            |   |            |   |   |   |   |
| Software licenses                                             |   | $                           | 19,786 |            | $      | (18,243         | )      | $ | 1,543 |   |
| Consulting services, maintenance and other                    |   | 3,656                       |   | (2,792          | )      | 864             |   |
| Total revenues                                                |   | 23,442                      |   | (21,035         | )      | 2,407           |   |
|                                                          |   |                        |   |            |   |            |   |
| Cost of revenues:                                             |   |                        |   |            |   |            |   |
| Software licenses                                             |   | 652                         |   | (215            | )      | 437             |   |
| Consulting services, maintenance and other  (1)               |   | 1,293                       |   | (1,182          | )      | 111             |   |
| Total cost of revenues                                        |   | 1,945                       |   | (1,397          | )      | 548             |   |
| Gross profit                                                  |   | 21,497                      |   | (19,638         | )      | 1,859           |   |
|                                                          |   |                        |   |            |   |            |   |
| Operating expenses:                                           |   |                        |   |            |   |            |   |
| Research and development (1)                                  |   | 4,043                       |   | (51             | )      | 3,992           |   |
| Selling, general and administrative (1)                       |   | 6,929                       |   | (610            | )      | 6,319           |   |
| Stock-based compensation                                      |   | 2,651                       |   | —          |   | 2,651           |   |
| Amortization of intangible assets                             |   | 62                          |   | —          |   | 62              |   |
| Total operating expenses                                      |   | 13,685                      |   | (661            | )      | 13,024          |   |
|                                                          |   |                        |   |            |   |            |   |
| Income (loss) from operations                                 |   | 7,812                       |   | (18,977         | )      | (11,165         | )      |
| Interest income (expense) and other income,  net              |   | 649                         |   | —          |   | 649             |   |
|                                                          |   |                        |   |            |   |            |   |
| Income (loss) before income taxes                             |   | 8,461                       |   | (18,977         | )      | (10,516         | )      |
| Provision for income taxes                                    |   | 4,570                       |   | (4,570          | )      | —          |   |
| Net income (loss)                                             |   | $                           | 3,891  |            | $      | (14,407         | )      | $ | (10,516 | ) |
|                                                          |   |                        |   |            |   |            |   |
| Net income (loss) per share:                                  |   |                        |   |            |   |            |   |
| Basic                                                         |   | $                           | 0.17   |            |   |            | $      | (0.47 | ) |
| Diluted                                                       |   | $                           | 0.12   |            |   |            | $      | (0.47 | ) |
|                                                          |   |                        |   |            |   |            |   |
| Shares used in computing per share amounts:                   |   |                        |   |            |   |            |   |
| Basic                                                         |   | 22,563                      |   |            |   | 22,563          |   |
| Diluted                                                       |   | 31,323                      |   |            |   | 22,563          |   |
|                                                               |   |                        |   |            |   |            |   |
| (1) Excludes the following stock-based  compensation charges: |   |                        |   |            |   |            |   |
| Cost of revenues                                              |   | $                           | 32     |            |   |            | $      | 32 |   |
| Research and development                                      |   | 552                         |   |            |   | 552             |   |
| Selling, general and administrative                           |   | 2,067                       |   |            |   | 2,067           |   |
|                                                          |   | $                           | 2,651  |            |   |            | $      | 2,651 |   |
|                                                               |        |                             |        |                 |        |                 |        |  |  |  |  |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

8

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**HPL Technologies,Inc.**

**Condensed Consolidated Balance Sheet**

**(in thousands, exceptper share data)**

 

**December 31, 2001**

 
|                                                                                            |   | **As  Previously  Reported** |   | **Adjustments** |   | **As  Restated** |    |
|-------------------------------------------------------------------------------------------------|--------|------------------------------|--------|-----------------|--------|------------------|---------|
| **ASSETS**                                                                                      |   |                         |   |            |   |             |    |
| ***Current assets:***                                                                           |   |                         |   |            |   |             |    |
| Cash and cash equivalents                                                                       |   | $                            | 63,621 |            | $      | (4,058           | )       | $ | 59,563 |   |
| Accounts receivable, net                                                                        |   | 15,565                       |   | (14,472         | )      | 1,093            |    |
| Prepaid expenses and other current assets                                                       |   | 1,220                        |   | 1,347           |   | 2,567            |    |
| Total current assets                                                                            |   | 80,406                       |   | (17,183         | )      | 63,223           |    |
|                                                                                            |   |                         |   |            |   |             |    |
| Property and equipment, net                                                                     |   | 1,510                        |   | (589            | )      | 921              |    |
| Goodwill and intangible assets, net                                                             |   | 11,707                       |   | (639            | )      | 11,068           |    |
| Other assets                                                                                    |   | 4,220                        |   | (1,036          | )      | 3,184            |    |
| **Total assets**                                                                                |   | $                            | 97,843 |            | $      | (19,447          | )       | $ | 78,396 |   |
|                                                                                            |   |                         |   |            |   |             |    |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                   |   |                         |   |            |   |             |    |
| ***Current  liabilities:***                                                                     |   |                         |   |            |   |             |    |
| Accounts payable                                                                                |   | $                            | 1,682  |            | $      | (39              | )  | $ | 1,643 |   |
| Accrued liabilities                                                                             |   | 5,220                        |   | 653             |   | 5,873            |    |
| Deferred revenue                                                                                |   | 2,061                        |   | 5,098           |   | 7,159            |    |
| Convertible debenture                                                                           |   | 1,500                        |   | —          |   | 1,500            |    |
| Total current liabilities                                                                       |   | 10,463                       |   | 5,712           |   | 16,175           |    |
| Capital lease obligations—net of current  portion                                          |   | 96                           |   | —          |   | 96               |    |
| Total liabilities                                                                               |   | 10,559                       |   | 5,712           |   | 16,271           |    |
|                                                                                            |   |                         |   |            |   |             |    |
| ***Stockholders’  equity:***                                                               |   |                         |   |            |   |             |    |
| Preferred stock, $0.001 par value, 10,000  shares authorized, no shares issued and outstanding  |   | —                       |   | —          |   | —           |    |
| Common stock, $0.001 par value; 75,000  shares authorized; 27,520 shares issued and outstanding |   | 27                           |   | —          |   | 27               |    |
| Additional paid-in capital                                                                      |   | 90,883                       |   | (4,070          | )      | 86,813           |    |
| Deferred stock-based compensation                                                               |   | (3,007                       | )      | —          |   | (3,007           | )       |
| Accumulated other comprehensive loss                                                            |   | (517                         | )      | 294             |   | (223             | )       |
| Accumulated deficit                                                                             |   | (102                         | )      | (21,383         | )      | (21,485          | )       |
| Total stockholders’ equity                                                                 |   | 87,284                       |   | (25,159         | )      | 62,125           |    |
| **Total liabilities and stockholders’ equity**                                             |   | $                            | 97,843 |            | $      | (19,447          | )       | $ | 78,396 |   |

 

9

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**HPL Technologies,Inc.**

**CondensedConsolidated Statement of Cash flows**

**(in thousands)**

** **

**Nine Months Ended December 31, 2001**

 
|                                                                                   |   | **As  Previously  Reported** |   | **Adjustments** |    | **As  Restated** |   |
|----------------------------------------------------------------------------------------|--------|------------------------------|--------|-----------------|---------|------------------|--------|
| ***Cash flows from  operating activities:***                                           |   |                         |   |            |    |             |   |
| Net income (loss)                                                                      |   | $                            | 3,891  |            | $       | (14,407          | )      | $ | (10,516 | ) |
| Adjustments to reconcile net income (loss)  to net cash used in  operating activities: |   |                         |   |            |    |             |   |
| Depreciation and amortization                                                          |   | 373                          |   | (83             | )       | 290              |   |
| Tax benefit from stock options                                                         |   | 4,085                        |   | (4,085          | )       | —           |   |
| Stock-based compensation                                                               |   | 2,651                        |   | —          |    | 2,651            |   |
| Loss on disposal of property and equipment                                             |   | —                       |   | 172             |    | 172              |   |
| Changes in assets and liabilities, net of  effects from acquisition:                   |   |                         |   |            |    |             |   |
| Accounts receivable                                                                    |   | (10,393                      | )      | 12,187          |    | 1,794            |   |
| Prepaid expenses and other current assets                                              |   | (910                         | )      | (994            | )       | (1,904           | )      |
| Accounts payable                                                                       |   | 543                          |   | (39             | )  | 504              |   |
| Accrued liabilities                                                                    |   | 678                          |   | 1,800           |    | 2,478            |   |
| Deferred revenue                                                                       |   | (1,922                       | )      | 582             |    | (1,340           | )      |
| Net cash used in operating activities                                                  |   | (1,004                       | )      | (4,867          | )       | (5,871           | )      |
|                                                                                   |   |                         |   |            |    |             |   |
| ***Cash flows from  investing activities:***                                           |   |                         |   |            |    |             |   |
| Acquisition of property and equipment                                                  |   | (1,106                       | )      | 500             |    | (606             | )      |
| Issuance of note receivable                                                            |   | (2,745                       | )      | —          |    | (2,745           | )      |
| Acquisitions, net of cash acquired                                                     |   | (498                         | )      | —          |    | (498             | )      |
| Net cash used in investing activities                                                  |   | (4,349                       | )      | 500             |    | (3,849           | )      |
|                                                                                   |   |                         |   |            |    |             |   |
| ***Cash flows from  financing activities:***                                           |   |                         |   |            |    |             |   |
| Proceeds from issuance of notes payable and  line of credit                            |   | 84                           |   | —          |    | 84               |   |
| Repayment of notes payable and line of  credit                                         |   | (284                         | )      | —          |    | (284             | )      |
| Issuance of common stock                                                               |   | 68,797                       |   | —          |    | 68,797           |   |
| Principal payments on capital lease  obligations                                       |   | (95                          | )      | —          |    | (95              | )      |
| Net cash provided by financing activities                                              |   | 68,502                       |   | —          |    | 68,502           |   |
| Effect of exchange rate changes on cash and  cash equivalents                          |   | (517                         | )      | 309             |    | (208             | )      |
|                                                                                   |   |                         |   |            |    |             |   |
| Net increase in cash and cash equivalents                                              |   | 62,632                       |   | (4,058          | )       | 58,574           |   |
| Cash and cash equivalents at beginning of  period                                      |   | 989                          |   | —          |    | 989              |   |
| Cash and cash equivalents at end of period                                             |   | $                            | 63,621 |            | $       | (4,058           | )      | $ | 59,563 |   |
|                                                                                   |   |                         |   |            |    |             |   |
| **Supplemental disclosures of cash flow  information:**                                |   |                         |   |            |    |             |   |
| Acquisition of property and equipment under  capital lease obligations                 |   | $                            | 113    |            |    |             | $      | 113 |   |
| Issuance of common stock and options  assumed in connection with acquisition           |   | $                            | 8,255  |            |    |             | $      | 8,255 |   |

 

10

----

 

**NOTE3. LEGAL PROCEEDINGS**

 

Between July 31, 2002 and November 15, 2002, fourteen class–actionlawsuits have been filed and are pending against the Company and certaincurrent and former officers and/or directors (collectively, the “Defendants”)in the United States District Court for the Northern District of California.The lawsuits allege that the Defendants violated Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934, and rule 10b–5 promulgatedthereunder by the SEC, by making a series of material misrepresentations as tothe financial condition of the Company during the class period of July 31, 2001to July 19, 2002. Several of the lawsuits further allege violations of Sections11, 12(a)(2) and 15 of the Securities Act of 1933. The plaintiffs are generallyseeking to recover compensatory damages, costs and expenses incurred, interestand such other relief as the court may deem appropriate. The Company expectsthat these lawsuits will be consolidated into a single action in the UnitedStates District Court for the Northern District of California. Because theselawsuits are still in their early stages, the Company is still evaluating themerits of these claims and formulating a defense to these actions.

 

The Company is also a nominal defendant in five stockholder derivativelawsuits pending in Superior Court in the County of Santa Clara, California.These lawsuits, which were filed between July 31, 2002 and September 30, 2002,assert derivative claims on behalf of the Company against current and/or formerofficers and directors of the Company and others. The claims asserted in theselawsuits include insider trading, breach of fiduciary duties, aiding andabetting breaches of fiduciary duties, negligence and professional malpractice,negligent misrepresentation and omission, contribution and indemnification,abuse of control, gross mismanagement, unjust enrichment and breach ofcontract. These lawsuits seek damages suffered by the Company, treble damagesfor the sale of shares, costs and expenses of these actions and such otherrelief as the court may deem appropriate. Because these lawsuits are still intheir early stages, the Company is still evaluating the merits of these claimsand its responsibilities with respect to the lawsuits.

 

The Company has been informed that five stockholders of the Companyhave sued the Company’s independent auditors, and the managing underwriter inthe Company’s initial public offering, in Texas in connection with claimsrelating to the merger of Covalar Technologies Group, Inc. with the Company onFebruary 15, 2002. Those Defendants have filed a motion to join the Company,but as of the date of this filing, the Company has not yet been joined althougha motion has been filed in Texas on this matter. Pursuant to an underwritingagreement, the Company has agreed under a reservation of rights to indemnifythe underwriter in this action. Accordingly, there is no assurance that theCompany will not sustain any liability as a result of this lawsuit.

 

The aforementioned litigation matters are in the early stages. TheCompany believes, based in part on advice of legal counsel and otherconsiderations, that no amount should be accrued for these matters underStatement of Financial Accounting Standard No. 5, “Accounting forContingencies,” as the Company is unable to provide an evaluation of thelikelihood of an unfavorable outcome or an estimate of the amount or range ofpotential loss, if any.

 

Any resolution of the aforementioned litigation could have a materialeffect on the Company’s financial position, results of operations or cashflows. The Company is investigating informal or formal restructuringalternatives which potentially may dilute stockholders equity but couldmitigate any material adverse affect on our financial position or results ofoperations which might otherwise result from an unfavorable resolution of theselawsuits.

 

**NOTE 4. ACQUISITION**

 

On April 10, 2002, the Company acquired 100% of the outstanding commonand preferred shares of Defect & Yield Management, Inc. (“DYM”), a defectanalysis and yield optimization software company offering software solutions tosemiconductor companies. The results of DYM have been included in theconsolidated financial statements from April 10, 2002, the acquisition date. Inconnection with the acquisition, the Company issued 967,260 shares of itscommon stock, paid $2.0 million in cash and assumed options to purchase up to82,740 shares of the Company’s common stock. The Company may also be requiredto issue up to $5.0 million of common stock to the former DYM shareholders if acertain number of customer maintenance contracts with the current DYM installedbase of customers are achieved in the one–year period ending April 9,2003. As of December 31, 2002, three qualifying maintenance contracts wouldhave provided the DYM stockholders with the right to $30,000 of the Company’scommon stock which will be valued at the end of earn-out period. This issuance,when made, may result in substantial dilution to the Company’s stockholders.The transaction has been accounted for using the purchase method of accounting.The acquisition of DYM provides the Company access to an installed customerbase in over 70 facilities worldwide.

 

The aggregate purchase price was approximately $17.1 million, issummarized as follows (in thousands):

 
| Cash                                  |   | $      | 2,000  |   |
|---------------------------------------|--------|--------|--------|--------|
| Fair market value of common  stock    |   | 13,474 |   |
| Fair market value of options  assumed |   | 704    |   |
| Estimated acquisition related  costs  |   | 943    |   |
|                                  |   |   |   |
| Total                                 |   | $      | 17,121 |   |

 

11

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Thepreliminary allocation of the purchase price to assets acquired and liabilitiesassumed is as follows (in thousands):

 
| Tangible assets acquired   |   | $      | 665    |   |
|----------------------------|--------|--------|--------|--------|
| Intangible assets acquired |   | 1,300  |   |
| Deferred compensation      |   | 38     |   |
| Goodwill                   |   | 16,545 |   |
| Liabilities assumed        |   | (1,427 | )      |
|                       |   |   |   |
| Total                      |   | $      | 17,121 |   |

 

Deferred compensation recorded in connection with the acquisition willbe amortized over the remaining term of the options assumed, which is generallyless than five years. Acquired intangible assets will be amortized over theirestimated useful life of three years. Amounts allocated to goodwill will not beamortized and will be subject to periodic impairment tests.

 

The following unaudited pro forma revenues, net loss and net loss pershare data for the three and nine months ended December 31, 2002 and 2001 arebased on the respective historical financial statements of the Company, Tyecin–InnotechCorporation (“Tyecin”), FabCentric, Inc. (“FabCentric”), Covalar TechnologiesGroup, Inc. (“Covalar”) and DYM. The pro forma data reflects the consolidatedresults of operations as if the acquisitions of Tyecin, FabCentric, Covalar andDYM occurred at the beginning of each of the periods indicated and includes theamortization of intangible assets and deferred compensation. The pro formafinancial data presented are not necessarily indicative of the Company’sresults of operations that might have occurred had the transactions beencompleted at the beginning of the periods specified, and do not purport torepresent what the Company’s consolidated results of operations might be forany future period.

 

**(Unaudited Pro Forma)**

**(in thousands, exceptfor per share data)**

 
|                                                               |   | **Three months ended  December 31,** |   |
|--------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                               |   | **2002**                             |   | **2001** | ** ** |
|                                                               |   |                                 |   |   |   |
| Revenues                                                           |   | $                                    | 5,248  |   | $ | 5,253 |   |
| Net loss                                                           |   | (2,756                               | )      | (4,725 | ) |
| Net loss per share-basic and  diluted                              |   | $                                    | (0.09  | ) | $ | (0.16 | ) |
| Shares used in computing per  share amounts—basic and diluted |   | 30,784                               |   | 29,968 |   |

 
|                                                               |   | **Nine months ended  December 31,** |   |
|--------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                               |   | **2002**                            |   | **2001** | ** ** |
|                                                               |   |                                |   |   |   |
| Revenues                                                           |   | $                                   | 12,129 |   | $ | 11,356 |   |
| Net loss                                                           |   | (17,298                             | )      | (19,176 | ) |
| Net loss per share—basic and  diluted                         |   | $                                   | (0.56  | ) | $ | (0.75 | ) |
| Shares used in computing per  share amounts—basic and diluted |   | 30,654                              |   | 25,649 |   |

 

On September 30, 2002, the Company entered into a mutual settlementagreement with IDS Software Systems, Inc. (“IDS”) related to the termination ofthe acquisition of IDS by the Company. Pursuant to the IDS settlementagreement, the Company paid IDS $350,000 related to the reimbursement ofexpenses it had incurred in connection with the proposed acquisition.

 

**NOTE 5. LOSS PER SHARE**

 

Basic and diluted net loss per share is computed by dividing the netloss for the period by the weighted average number of shares of common stockoutstanding during the period, less shares outstanding that are subject torepurchase. The calculation of diluted net loss per share excludes shares ofpotential common stock if their effect is anti–dilutive. Potential commonstock consists of shares of common 

 

12

----

 

stock thatare incremental common shares issuable upon the exercise of stock options andwarrants, computed using the treasury stock method, and shares issuable uponconversion of the convertible debenture, computed using the if–convertedmethod.

 

The totalnumber of shares excluded from the calculation of diluted net loss per shareare detailed in the table below (in thousands):

 
|                                                       |   | **Three months ended  December 31,** |   |
|------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                       |   | **2002**                             |   | **2001** |   |
|                                                       |   |                                 |   |   |   |
| Outstanding stock options                                  |   | 1,884                                |   | 8,303 |   |
| Convertible debenture                                      |   | 1,032                                |   | 1,032 |   |
| Shares issuable under warrants                             |   | 55                                   |   | 138 |   |
| Contingent shares issuable to  former Covalar shareholders |   | 600                                  |   | — |   |
| Total                                                      |   | 3,571                                |   | 9,473 |   |

 

**NOTE 6. CONCENTRATION OF CREDIT RISK**

 

Financial instruments that potentially subject the Company tosignificant concentrations of credit risk consist principally of cash, cashequivalents, short–term investments, unbilled receivables, accountsreceivable and a note receivable. Cash and cash equivalents are deposited withfinancial institutions that management believes are credit worthy. The Companyperforms ongoing credit evaluations of its customers’ financial condition andgenerally requires no collateral from its customers. At December 31, 2002,three customers accounted for 31%, 15% and 12% of the Company’s accountsreceivable and unbilled receivables combined. At December 31, 2001, asrestated, two customers accounted for 37% and 34% of the Company’s accountsreceivable.

 

For the three and nine months ended December 31, 2002, the Companyderived 71%**,** and 52% of itsrevenue from two and three end–user customers, respectively.

 

Revenue for the three months ended December 31, 2001 was $2.5 million.Excluding the revenue reduction of $950,000 (see Note 2 as restated).

 

Revenue during the nine months ended December 31, 2001 was $3.4million.

 

For the threemonths ended December 31, 2001, as restated, the Company derived 86% of itsrevenues from three end–user customers that individually represented 38%,31% and 17% of the Company’s total revenues, respectively.

 

For the ninemonths ended December 31, 2001, as restated, the Company derived 71% of itsrevenues from three end–user customers that individually represented 29%,24% and 18% of the Company’s total revenues, respectively.

 

On September 4, 2002, the Company’s Japanese distributor, Canon SalesCo., Inc. (“Canon”) notified the Company that they intend to terminate itsdistribution agreement on March 31, 2003, the end of the initial term of thedistribution agreement. Canon accounted for 3% and 18% of total revenues in thethree and nine months ended December 31, 2002, respectively.  Excluding the revenue reduction of $950,000,Canon accounted for 36% and 28% of total revenues in the three and nine monthsended December 31, 2001, respectively.

 

**NOTE 7. COMPREHENSIVE LOSS**

 

Comprehensive loss consists of gains and losses that are not recordedin the statements of operations but instead are recorded directly tostockholders’ equity. For the three and nine months ended December 31, 2002,comprehensive loss was $2.8 million and $17.1 million, respectively. Thedifference between net loss and comprehensive loss for the three and ninemonths ended December 31, 2002, is the result of foreign currency translationgains and losses and the net unrealized gains and losses on available for salesecurities in the aggregate amount of loss of $4,000 and gain of $193,000,respectively. For the three and nine months ended December 31, 2001, theCompany had no components of comprehensive loss other than net loss.

 

13

----

 

**NOTE 8. ACCRUED LIABILITIES**

 

Accrued liabilities consist of the following (in thousands):

 
|                                                                           |   | **December 31, 2002** |   | **March 31, 2002** |   |
|--------------------------------------------------------------------------------|--------|----------------------------|--------|-------------------------|--------|
|                                                                           |   |                       |   |                    |   |
| Payroll and related expenses                                                   |   | $                          | 918    |                    | $      | 588 |   |
| Severance accrual (see Note  10)                                               |   | 130                        |   | —                  |   |
| Professional fees                                                              |   | 594                        |   | 638                     |   |
| Other accrued expenses                                                         |   | 1,084                      |   | 1,494                   |   |
| Amounts received from HPL’s  former Chief Executive Officer (see Note 13) |   | 4,335                      |   | 3,035                   |   |
|                                                                           |   | $                          | 7,061  |                    | $      | 5,755 |   |

 

**NOTE 9. CONVERTIBLE DEBENTURE**

 

In February 2000, the Company issued a $1.5 million convertibledebenture against which all of the assets of Heuristic Physics Laboratories,Inc., a wholly owned subsidiary of the Company, have been pledged as security.The debenture bears interest at the rate of 8% per annum. This debenture may beconverted at any time at the option of the holder to common stock of theCompany, at a conversion price of $1.45 per share. The debenture, if notconverted, is due on February 15, 2005. The note provides that following the completionof the Company’s initial public offering, the holder has the right to demandrepayment. As of December 31, 2002, the holder has not demanded repayment.

 

At December 31, 2002, the Company was not in compliance with certainnon–financial covenants of the debenture. As a result, the debentureholder may declare all outstanding obligations under the debenture immediatelydue and payable. If the Company repays the debenture, the debenture holder willforfeit its right to convert the debenture into 1,032,388 shares of commonstock of the Company at $1.45 per share.

 

**NOTE 10. REDUCTION IN WORKFORCE**

 

On September27, 2002, the Company implemented a reduction in workforce plan, reducing itsheadcount by 89 people worldwide. These reductions were primarily in the UnitedStates. For the nine months ended December 31, 2002, the severance benefitsassociated with this reduction of approximately $807,000 is included inselling, general and administrative expense. Most of these severance benefitswere paid during the three months ended December 31, 2002.  The remaining accrual at December 31, 2002totaled $130,000 and will be paid through September 30, 2003.

 

This reduction in workforce has resulted in previously expensed stock–basedcompensation charges totaling $907,000 being reversed in the nine months endedDecember 31, 2002. Additionally, $2.1 million of associated deferred stockbased compensation and additional paid–in capital related to theseterminated employees was also eliminated.

 

**NOTE 11. INTANGIBLE ASSETS**

 

Intangible assets consist of the following (in thousands):

 
|                |   |                     |   | **December 31, 2002** |   |
|---------------------|--------|--------------------------|--------|----------------------------|--------|
|                |   | **Amortization  Period** |   | **Gross  Amount**          |   | **Accumulated  Amortization** |   | **Net Carrying  Amount** |   |
|                |   |                     |   |                       |   |   |   |   |   |
| Existing technology |   | 3 years                  |   | $                          | 2,760  |   | $ | (785 | ) | $ | 1,975 |   |
| Modular library     |   | 3 years                  |   | 1,220                      |   | (356 | ) | 864 |   |
|                |   |                     |   | $                          | 3,980  |   | $ | (1,141 | ) | $ | 2,839 |   |

 

14

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|                |   |                     |   | **March 31, 2002** |   |
|---------------------|--------|--------------------------|--------|-------------------------|--------|
|                |   | **Amortization  Period** |   | **Gross  Amount**       |   | **Accumulated  Amortization** |   | **Net Carrying  Amount** |   |
|                |   |                     |   |                    |   |   |   |   |   |
| Existing technology |   | 3 years                  |   | $                       | 1,460  |   | $ | (94 | ) | $ | 1,366 |   |
| Modular library     |   | 3 years                  |   | 1,220                   |   | (51 | ) | 1,169 |   |
| Order backlog       |   | 6 months                 |   | 310                     |   | (144 | ) | 166 |   |
|                |   |                     |   | $                       | 2,990  |   | $ | (289 | ) | $ | 2,701 |   |

 

The amortization of intangible assets for the three and nine months endedDecember 31, 2002 was $332,000 and $1.2 million, respectively. The amortizationof intangible assets for the three and nine months ended December 31, 2001 was$48,000 and $62,000, respectively.

 

The estimated future amortization of intangible assets for the fiscalyears ending March 31 are as follows (in thousands):

 
| 2003  (fourth quarter) |   | $     | 331    |   |
|------------------------|--------|-------|--------|--------|
| 2004                   |   | 1,327 |   |
| 2005                   |   | 1,181 |   |
|                   |   | $     | 2,839  |   |

 

**NOTE 12. SEGMENT AND GEOGRAPHIC INFORMATION**

 

The Company has determined that it has one reportable business segment:the sale of yield optimization software and services used in the design,fabrication and testing of semiconductors and flat panel displays.

 

For the three months ended December 31, 2002, sales to end–usercustomers located in the United States, Japan, and the rest of the world accounted for 85%, 4% and 11% of the Company’stotal revenues, respectively. For the three months ended December 31, 2001,sales to end–user customers located in the United States, Japan, and therest of the world accounted for 39%, 44% and 17% of the Company’s totalrevenues, respectively.

 

For the nine months ended December 31, 2002, sales to end–usercustomers located in the United States, Japan and the rest of the worldaccounted for 65%, 20% and 15% of the Company’s total revenues, respectively.For the nine months ended December 31, 2001, excluding the revenue reduction of$950,000 (Note 2), sales to end–user customers located in the UnitedStates, Japan, and the rest of the world accounted for 48%, 34% and 18% of theCompany’s total revenues, respectively.

 

**NOTE 13. RELATED PARTY TRANSACTIONS**

 

In June 2002, the former Chief Executive Officer of the Company, Y.David Lepejian, deposited approximately $1.3 million into the Company’s bankaccounts, which amounts were purported to have represented proceeds from thepayment of accounts receivable related to the fictitious sales transactionsdescribed in Note 2. As of  December 31,2002, including amounts previously deposited, there was $4.3 million includedin accrued liabilities representing amounts received from the Company’s formerChief Executive Officer. The Company does not expect it will be required torepay this sum because the Company believes it has offsetting claims againstits former Chief Executive Officer.

 

See Note 2 for other related party transactions.

 

**NOTE 14. RECENT ACCOUNTING PRONOUNCEMENTS**

 

Effective April 1, 2002, the Company adopted all of the provisions ofStatement of Financial Accounting Standards No. 142

 

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(“SFAS142”), “Goodwill and Other Intangible Assets.” SFAS 142 requires, among otherthings, the discontinuance of amortization related to goodwill and indefinitelived intangible assets. These assets will then be subject to an impairmenttest at least annually.

 

The Company performed an impairment review in accordance with SFAS 142at April 1, 2002, and determined that there was no impairment in goodwill atApril 1, 2002. Additionally, the Company performed interim impairment reviewsat June 30, 2002, September 30, 2002 and December 31, 2002 and determined therewas no impairment in goodwill at those dates.

 

Effective April 1, 2002, the Company adopted Statement of FinancialAccounting Standards No. 144 (“SFAS 144”), “Accounting for the Impairment orDisposal of Long–Lived Assets.” This statement addresses financialaccounting and reporting for the impairment of long–lived assets. Theadoption of this statement did not have a significant impact on the Company’sresults of operations or financial position.

 

In July 2002, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 146, “Accounting for Costs Associatedwith Exit or Disposal Activities” (“SFAS 146”). SFAS 146 requires that aliability for costs associated with an exit or disposal activity be recognizedand measured initially at fair value only when the liability is incurred. SFAS146 is effective for exit or disposal activities that are initiated afterDecember 31, 2002. The Company does not expect the adoption of SFAS 146 to havea material impact on its operating results or financial position.

 

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**Item 2.*****Management’s Discussion and Analysis of Financial Condition and Resultsof Operations***

 

*Certain parts of thisQuarterly Report on Form 10-Q, including the “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and “LegalProceedings,” may contain forward–looking statements that involve risksand uncertainties. Statements that are not historical fact are forward–lookingstatements within the meaning of the Federal securities laws. These statementsare based on current expectations, estimates and projections about theindustries in which we operate and management’s beliefs, and assumptions.Specifically, the amount and timing of future sales, research and developmentexpenses and results, industry demand, and competitive pressures could varygreatly and affect the results of operations. Readers should refer to theinformation under the caption “Risk Factors” in this Quarterly Reportconcerning certain factors that could cause our actual results to differmaterially from the results anticipated in such forward–lookingstatements.*

 

**Overview**

 

We provide comprehensive yield–optimization solutions to thesemiconductor industry and flat–panel display manufacturers. We licenseour software products and sell related services through our direct sales force,our Japanese distributor, Canon, and semiconductor equipment manufacturers(“OEMs”) that bundle our software with their hardware. As described below,Canon has notified us that they intend to terminate our distributor agreementon March 31, 2003.

 

Our sales cycle for the license of our software products hashistorically been very long. Our products are relatively new and our customersspend a significant amount of time evaluating our products. Customer purchaseorders typically include integration and installation services, rights ofreturn and acceptance criteria. As such, we defer a significant amount of ourlicense revenue until integration and installation services are complete,rights of return lapse and final acceptance occurs. The amount of our licenserevenue is currently at levels that have resulted in no meaningful trends fromperiod to period. Our ability to sell our products in the future may also beaffected by the current decline in capital spending by potential customers inthe semiconductor industry.

 

In July 2001, we sold 6,900,000 shares of our common stock in ourinitial public offering, raising aggregate gross offering proceeds of$75.9 million. In connection with this offering, we incurred totalexpenses of approximately $7.2 million, consisting of $5.3 millionfor underwriting discounts and commissions and approximately $1.9 millionin other expenses. A portion of the net proceeds have been used to expand ouroperations, including payments related to the following acquisitions:

 

On October 4, 2001, we acquired Tyecin–Innotech Corporation(“Tyecin”), a corporation organized under the laws of Japan, for approximately$789,000 in cash. The transaction was accounted for using the purchase methodof accounting. Tyecin provides software support and services to manufacturingcompanies. The acquisition provides us with an experienced workforce in Japanand will help support existing and future customers in Japan.

 

On December 5, 2001, we acquired FabCentric, Inc. (“FabCentric”),for an estimated purchase price of approximately $8.5 million. Inconnection with the acquisition, we issued 703,355 shares of common stock andassumed options to purchase 23,231 shares of common stock. The transaction wasaccounted for using the purchase method of accounting. FabCentric is engaged inthe business of software development and sales to semiconductor companies. Theacquisition gives us access to FabCentric’s customer base, complementarytechnology and a highly skilled workforce.

 

On February 15, 2002, we acquired Covalar Technologies Group, Inc.(“Covalar”), a design yield optimization and productivity improvement softwarecompany that offers solutions to semiconductor companies that include testing,analysis and advanced circuit design. In connection with the acquisition, weissued 1,481,566 shares of common stock, paid $10.0 million in cash and assumedoptions to purchase 418,434 shares of common stock. We have also reserved anadditional 600,000 shares of common stock to be issued to the former Covalarshareholders if certain revenue targets are achieved in the twelve monthsfollowing the closing of the acquisition on February 15, 2002. Theaggregate purchase price was approximately $36.0 million. The transactionwas accounted for using the purchase method of accounting. The acquisition ofCovalar will allow us to offer our customers a complete end–to–endsoftware and related services solution from design through manufacturing, gaina broader customer base and relationships, and provide us with a highly skilledworkforce.

 

On April 10, 2002, we acquired Defect & Yield Management, Inc.(“DYM”), a company engaged in the sales and support of fab floor defect datamanagement software. In connection with the acquisition, we paid theshareholders $2.0 million in cash, issued 967,260 shares of common stockand agreed to assume options to purchase up to 82,740 shares of common stock.The total value of the transaction, including estimated transaction costs of$900,000 was $17.1 million. We may issue additional shares of common stockwith a value of up to $5.0 million, depending on the number of qualifyingsoftware maintenance contracts, as defined, entered into by DYM in the firstyear following the effective date of the acquisition. The acquisition providedthe Company access to an installed customer base in over 70 facilitiesworldwide.

 

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Our standard payment terms for our customers provide for payment in30 days. It is frequently the case that our receivables are outstandingfor more than 30 days. Our accounts receivable from internationalcustomers have been outstanding longer than our domestic receivables and weexpect this to continue to be the case.

 

In the three and nine months ended December 31, 2002 and 2001, arelatively small number of customers have accounted for a large portion of ourrevenues, and the composition of our major customers has changed from period toperiod. This is because we currently have a limited sales force, our productshave a lengthy sales cycle and we recognize relatively large license revenuesupon entering into perpetual licensing agreements. We had two and three endcustomers that individually accounted for at least 10% of our revenues in thethree months ended December 31, 2002 and 2001, respectively. In the aggregate,these end customers accounted for 71% and 86% of our revenues in the threemonths ended December 31, 2002 and 2001, respectively. Excluding the revenuereduction of $950,000 during the nine months ended December 31, 2001, we hadthree and three end customers that individually accounted for at least 10% of ourrevenues, in the nine months ended December 31, 2002 and 2001, respectively. Inthe aggregate, these end customers accounted for 52% and 71% of our revenues inthe nine months ended December 31, 2002 and 2001, respectively.

 

**RecentEvents**

 

On August 12, 2002, Y. David Lepejian, the former Presidentand CEO of the Company, notified us of the exercise of his option to purchase2,670,000 shares of our common stock. Based on the actions theretofore taken bythe Board of Directors of the Company and the terms of the Company’s 2001Equity Incentive Plan, we refused to permit the exercise of Mr. Lepejian’soption. We have been notified by Mr. Lepejian that he disagrees with theactions of the Company and intends to contest them.

 

On September 4, 2002, our Japanese distributor, Canon Sales Co.,Inc. (“Canon”) notified us that they intend to terminate our distributionagreement on March 31, 2003, the end of the initial term of thedistribution agreement. Excluding the revenue reduction of $950,000, Canonaccounted for 3%, 18%, 36% and 28% of our revenues in the three and nine monthsended December 31, 2002 and 2001, respectively.  The loss of Canon as our distributor in Japan is not expected tomaterially affect our sales efforts in Japan.

 

As a result ofthe special investigation undertaken by our Audit Committee in the secondquarter of this year, the restatement of our financial statements for fiscal2001 and 2002, the ensuing class-action and derivative litigation and resultingimpact on the Company’s sales, we reduced our headcount worldwide by89 people in September 2002. These reductions were primarily in the UnitedStates. As of October 4, 2002, we had 276 employees worldwide with100 in the United States, 142 in Armenia and 34 people in five otherlocations around the world. We recorded severance benefits associated with thisreduction totaling approximately $807,000.

 

On September 30, 2002, we entered into a mutual settlementagreement with IDS Software Systems, Inc. (“IDS”) related to the termination ofthe acquisition of IDS by the Company. Pursuant to the IDS settlementagreement, the Company paid IDS $350,000 related to the reimbursement ofexpenses it had incurred in connection with the proposed acquisition.

 

**CRITICAL ACCOUNTING POLICIES**

 

The discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States. The preparation of these financial statements requires us tomake estimates and judgments that affect our reported assets, liabilities,revenues and expenses, and our related disclosure of contingent assets andliabilities. On an on-going basis, we evaluate our estimates, including thoserelated to revenue recognition, goodwill and identifiable, separately recordedintangible assets, litigation, contingent liabilities and income taxes. We baseour estimates on historical experience and on various other assumptions thatare believed to be reasonable under the circumstances. Our estimates then formthe basis of judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. Actual results may differ fromthese estimates under different assumptions or conditions.

 

We believe the following critical accounting policies and the relatedjudgments and estimates significantly affect the preparation of ourconsolidated financial statements:

 

**Revenue Recognition**

 

Revenue recognition rules are very complex, and certain judgmentsaffect the application of our revenue policy. The amount and timing of ourrevenue is difficult to predict, and any shortfall in revenue or delay inrecognizing revenue could cause our operating results to vary significantlyfrom quarter to quarter. In addition to determining our results of operationsfor a given period, our revenue recognition determines the timing of certainexpenses, such as commissions, royalties and other variable expenses.

 

We derive revenues principally from the sale of software licenses,software maintenance contracts and consulting services. We offer two types oflicenses: perpetual and time-based. Perpetual licenses have no expiration date,while time-based licenses require

 

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renewal.Our software product licenses provide a narrowly defined subset of features fora given customer. The customer may acquire additional licenses to extend thefunctionality of our products as its technologies and facilities change or ifit wishes to use additional features of our software for its productionprocess. Our licenses usually limit the number of people who can use thesoftware at a given time.

 

Revenues from software licenses are generally recognized upon theexecution of a binding agreement and delivery of the software, provided that:the fee is fixed or determinable; vendor–specific objective evidenceexists to allocate a portion of the total license fee to any undeliveredelements of the arrangement; collection is reasonably assured; and theagreement does not contain customer acceptance clauses. If customer acceptanceclauses exist, revenues are recognized upon customer acceptance and all otherrevenue recognition criteria are met.

 

If the consulting or other services sold in connection with thesoftware license are essential to the functionality of the software or involvesignificant production, customization or modification of software, we recognizerevenue on either a percentage–of–completion or completed contract basis.For the percentage–of–completion method, we recognize revenuesusing labor hours incurred as the measure of progress against the total laborhours estimated for completion of the project. We consider a project completedafter all contractual obligations are met. At times, an unbilled accountsreceivable balance can exist which comprises revenue recognized in advance ofcontractual billings. We make provisions for estimated contract losses in theperiod in which the loss becomes probable and can be reasonably estimated.Estimates of total labor hours or expected losses on contracts are subject tojudgment and actual amounts may differ significantly from those estimates.

 

For contracts with multiple obligations (e.g., deliverable andundeliverable products, post–contract support and other services), weallocate revenues to the undelivered element of the contract based on objectiveevidence of its fair value. This objective evidence is the sales price of theelement when sold separately or the renewal rate specified in the agreement forlicensing arrangements with terms of one year or greater that include post–contractcustomer support and software updates. We recognize revenues allocated toundelivered products when the criteria for software license revenues set forthabove are met. Revenues from time–based software licenses are generallyrecognized ratably over the period of the licenses. Determining whetherobjective evidence of fair value exists is subject to judgment and resultingfair values used in determining the value of the undelivered elements is alsosubject to judgment and estimates.

 

Software maintenance revenues are recognized ratably over the term ofthe maintenance period, which is generally one year. Our software maintenanceincludes product maintenance updates, Internet–based technical supportand telephone support. Revenues derived from our consulting services arerecognized as the services are performed.

 

We also derive revenues from the sale of software licenses, maintenanceand post–contract support services through our distributors. Revenuesfrom sales made through our distributors for which the distributors have returnrights are recognized when the distributors have sold the software licenses orservice to their customers and the criteria for revenue recognition underSOP 97-2, as amended, are met. Revenues from maintenance and post–contractsupport services sold through our distributors are recognized ratably over thecontract period.

 

Amounts invoiced to our customers in excess of recognized revenues arerecorded as deferred revenues. The timing and amounts invoiced to customers canvary significantly depending on specific contract terms and can therefore havea significant impact on deferred revenues in any given period.

 

**Goodwill and Intangible Assets**

 

Consideration paid in connection with acquisitions is required to beallocated to the acquired assets, including certain identifiable intangibleassets, goodwill, and liabilities acquired. Acquired assets and liabilities arerecorded based on our estimate of fair value, which requires significantjudgments, including those with respect to future estimated cash flows anddiscount rates. For identifiable intangible assets that we separately record,we are required to estimate the useful life of the assets and recognize theircost as an expense over the useful lives. We use the straight–line methodto expense long-lived assets, except goodwill, which results in an equal amountof expense in each period. We regularly evaluate acquired businesses forpotential indicators of impairment of allocated goodwill and identifiableintangible assets. Our judgments regarding the existence of impairmentindicators are based on market conditions, operational performance of ouracquired businesses and identification of reporting units. Future events couldcause us to conclude that impairment indicators exist and that goodwill andother identifiable intangible assets associated with our acquired businessesare impaired. This fiscal year, the methodology for assessing potentialimpairments of intangibles is based on new accounting rules issued by theFinancial Accounting Standards Board (see recent accounting pronouncements) andit did not have a material effect on our financial position or results of  operations. Any resulting impairment loss inthe future based on this policy could have a material adverse impact on ourfinancial condition and results of operations.

 

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**Litigation**

 

Management’s estimated range of liability related to some of thepending litigation is based on claims for which our management can estimate theamount and range of loss. Because of the uncertainties related to our insurancecoverage and indemnification obligations extended to current and formerofficers and directors who are defendants and the amount and range of loss, ifany, related to litigation, management is unable to make a reasonable estimateof the liability that could result from an unfavorable outcome. As additionalinformation becomes available, we will assess the potential liability relatedto our pending litigation and revise our estimates. Such revisions in estimatesof the potential liability could materially impact our results of operation andfinancial position. Any resolution of the litigation could materially affectour financial resources and liquidity.

 

**Income Taxes**

 

We are required to estimate our income taxes in each of thejurisdictions in which we operate as part of the process of preparing ourconsolidated financial statements. This process involves estimating our actualcurrent tax exposure together with assessing temporary differences resultingfrom differing treatment of items, such as deferred revenue, for tax andaccounting purposes. These differences result in deferred tax assets andliabilities. We then assess the likelihood that our net deferred tax assetswill be recovered from future taxable income and, to the extent we believe thatrecovery is not likely, we must establish a valuation allowance. We currentlyhave a full valuation allowance on our gross deferred tax assets. In the eventour future taxable income is expected to be sufficient to utilize our deferredtax assets, an adjustment to the valuation allowance will be made, increasingincome in the period in which such determination is made.

 

**RECENT ACCOUNTING PRONOUNCEMENTS**

 

Effective April 1, 2002, we adopted all of the provisions ofStatement of Financial Accounting Standards No. 142 (“SFAS 142”),“Goodwill and Other Intangible Assets.” SFAS 142 requires, among other things,the discontinuance of amortization related to goodwill and indefinite livedintangible assets. These assets will then be subject to an impairment test atleast annually.

 

We performed an impairment review in accordance with SFAS 142 atApril 1, 2002 and determined that there was no impairment in goodwill atApril 1, 2002. Additionally, we performed interim impairment reviews atJune 30, 2002, September 30, 2002 and December 31, 2002 anddetermined there was no impairment in goodwill at those dates.

 

Effective April 1, 2002, we adopted Statement of FinancialAccounting Standards No. 144 (“SFAS 144”), “Accounting for theImpairment or Disposal of Long-Lived Assets.” This statement addressesfinancial accounting and reporting for the impairment of long–livedassets. The adoption of this statement did not have a significant impact on theCompany’s results of operations or financial position.

 

In July 2002, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146requires that a liability for costs associated with an exit or disposalactivity be recognized and measured initially at fair value only when theliability is incurred. SFAS 146 is effective for exit or disposalactivities that are initiated after December 31, 2002. We do not expectthe adoption of SFAS 146 to have a material impact on our operatingresults or financial position.

 

**Results of Operations**

 

**Comparison of the three months and ninemonths ended December 31, 2002 and December 31, 2001, as restated**

 

*Revenues.*  Totalrevenues increased to $5.2 million in the three months ended December 31,2002 from $2.5 million in the three months ended December 31, 2001. Totalrevenues increased to $12.0 million in the nine months ended December 31, 2002from $2.4 million in the nine months ended December 31, 2001. These increaseswere primarily related to increases in consulting services related to our acquisitionof Covalar. Our sales cycle for the license of our software products hashistorically been very long. Our products are new and our customers spend asignificant amount of time evaluating our products. Customer purchase orderstypically include integration and installation services, rights of return andacceptance criteria. As such, we defer a significant amount of our licenserevenue until integration and installation services are complete, rights ofreturn lapse and final acceptance occurs.

 

Revenues were highly concentrated, with 71% and 52% of total revenuesin the three and nine months ended December 31, 2002 coming from two and threeend customers respectively, and 86% and 71% of total revenues in the three andnine months ended December 31, 2001, excluding the revenue reduction of$950,000, coming from three and three end customers, respectively.

 

Software license revenue increased to $2.8 million in the three monthsended December 31, 2002, from $2.1 million in the three months ended December31, 2001. Software license revenue increased to $4.8 million in the nine

 

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months ended December 31, 2002, from $1.5 million in the nine monthsended December 31, 2001.  Softwarelicense revenue in the three months ended December 31, 2002 relates primarilyto previously deferred revenue for which the revenue was recognized in thecurrent period.  Our ability to sell ourproducts in the future may also be affected by the current decline in capitalspending by potential customers in the semiconductor industry.

 

Consulting services, maintenance and otherrevenues increased to $2.4 million in the three months ended December 31, 2002,from $411,000 in the three months ended December 31, 2001. Consulting services,maintenance and other revenues increased to $7.2 million in the nine monthsended December 31, 2002, from $864,000 in the nine months ended December 31,2001. These increases were due to an increase in consulting services related toour acquisition of Covalar and an increase in maintenance fees from a greaternumber of customers, both existing customers and those from our acquisitions.

 

*Gross profit.*  As apercentage of revenues, gross profit was 73% and 76% for the three and ninemonths ended December 31, 2002, respectively**.**As a percentage of revenues, gross profit was 93% and 77% for thethree and nine months ended December 31, 2001, respectively**.** Gross profit has been and will continueto be affected by a variety of factors, the most important of which is therelative mix of revenues among software licenses, maintenance fees andconsulting services. The quarter–to–quarter decrease in grossprofit as a percentage of revenue was the result of a revenue mix from licensesversus consulting services in the three months ended December 31, 2002.

 

*Research anddevelopment.*  Research and development expenses increasedto $1.9 million in the three months ended December 31, 2002, compared to$1.4 million in the three months ended December 31, 2001. Research and developmentexpenses increased to $8.8 million in the nine months ended December 31,2002, compared to $4.0 million in the nine months ended December 31, 2001.These increases are primarily attributable to the hiring of additional softwareengineers and technical staff and increases of headcount related toacquisitions completed after December 31, 2001. Salaries and relatedbenefits of research and development engineers represent the single largestcomponent of our research and development expenses.

 

 *Sales, general and administrative.*  Sales, general and administrative expensesfor the three months ended December 31, 2002 were $4.1 million compared to$2.6 million in the three months ended December 31, 2001. Sales, generaland administrative expenses for the nine months ended December 31, 2002 were$16.1 million compared to $6.3 million in the nine months endedDecember 31, 2001. Included in the costs for the nine months endedDecember 31, 2002 is $2.1 million in professional fees related to thespecial investigation conducted by our Audit Committee and the resultantrestatement of our financial statements and $807,000 in severance relatedbenefits. The balance of the increase in costs was primarily due to increasesin headcount, and increases related to acquisitions we completed after December31, 2001.

 

*Stock–basedcompensation.*  Stock–based compensation expense forthe three and nine months ended December 31, 2002 was an expense of $332,000and $793,000, respectively, compared with expenses of $828,000 and $2.6 millionfor the three and nine months ended December 31, 2001, respectively. Stock–basedcompensation expense in the three and nine months ended December 31, 2002decreased as a result of our reduction in workforce on September 30, 2002and the resulting reversal of previously expensed stock–basedcompensation which was not earned by the terminated employees. Additionally, asa result of our acquisitions where we have recorded deferred compensationrelated to stock options assumed, we expect stock–based compensationexpense to decrease in the future.

 

*Amortization ofintangible assets.*  Amortization of intangible assets was$332,000 and $1.2 million in the three and nine months ended December 31, 2002,respectively,  compared to $48,000 and$62,000 in the three and nine months ended December 31, 2001, respectively.This increase in amortization resulted from the acquisitions of FabCentric,Covalar and DYM post September 30, 2001.

 

*Interest income(expense) and other, net.*  Interest income, net ofinterest and other expenses for the three and nine months ended December 31,2002 was $92,000 and $422,000, respectively, compared with $383,000 and$649,000, for the three and nine months ended December 31, 2001, respectively.The change is a direct result of the proceeds received on our initial publicoffering on July 30, 2001 and the subsequent decrease in cash balances ascash was used for acquisitions and to fund operations, further reduced as aresult of falling interest rates.

 

*Provision for incometaxes.*  In the three and nine months ended December31, 2002 and 2001, we incurred operating losses for which we have recordedvaluation allowances for the full amount of our net deferred tax assets,because the future realization of the deferred tax assets was not likely as ofDecember 31, 2002 and 2001.

 

**LIQUIDITY AND CAPITAL RESOURCES, AS RESTATED**

** **

At December 31, 2002, we had approximately$23.2 million in cash and cash equivalents and short–term investments.

 

Net cash used in operating activities for thenine months ended December 31, 2002 was approximately $22.5 million compared to$5.9 million used in operating activities for the nine months ended December31, 2001. Our cash used in operations for the nine months December 31, 2002 wasprimarily due to our net loss, adjusted for certain non–cash itemsincluding depreciation and amortization,

 

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stock-based compensation, and deferred revenue. Our cash used inoperations for the nine months ended December 31, 2001 was primarily attributedto our net loss, adjusted for certain non-cash items including the depreciationand amortization, stock-based compensation, deferred revenue, collection ofaccounts receivables and increases in accounts payable and accrued liabilities.

 

Net cash provided by investing activities was$6.1 million for the nine months ended December 31, 2002 compared to net cashused in investing activities of $3.8 million for the nine months endedDecember 31, 2001. Our investing activities for the nine months ended December31, 2002 consisted primarily of the acquisition of DYM and equipment purchases,offset by the maturity of short-term investments. The investing activities forthe nine months ended December 31, 2001 consisted of the issuance of a notereceivable and the purchase of equipment.

 

Net cash provided by financing activities was$1.2 million for the nine months ended December 31, 2002, primarily fromamounts received from our former Chief Executive Officer, Y. David Lepejian,and proceeds from exercise of stock options, partially offset by the repaymentof capital lease obligations. Net cash provided by financing activities was$68.5 million for the nine months ended December 31, 2001, primarily fromthe issuance of common stock in connection with our initial public offering inJuly 2001, offset by repayment of notes payable and payments on capital leaseobligations.

 

We are currently not in compliance withcertain non–financial covenants of the $1.5 million securedconvertible debenture issued by our subsidiary Heuristic Physics Laboratories,Inc. to Applied Materials, and as a result Applied Materials may declare alloutstanding obligations under the debenture immediately due and payable. Todate, the holder of the debenture has not demanded repayment of the debenture.If the Company repays the debenture, the debenture holder will forfeit itsright to convert the debenture into shares of common stock.

 

In connection with the acquisition ofCovalar, we have reserved an additional 600,000 shares of common stock to beissued to Covalar shareholders if certain revenue targets are achieved in thetwelve months following the closing of the acquisition on February 15,2002.

 

In connection with the acquisition of DYM, wemay issue additional shares of common stock with a value of up to$5.0 million, depending on the number of qualifying software maintenancecontracts entered by DYM in the first year following the closing of theacquisition. This could cause substantial dilution depending on the number ofqualifying contracts and our stock price on the one–year anniversary ofthe closing.  As of December 31, 2002,DYM had entered into three qualifying software maintenance contracts that wouldhave entitled the former DYM stockholders to $30,000 of the Company’s commonstock which will be valued at the end of the earn-out period.

 

We believe our current cash and cashequivalents, our short–term investments, and our cash flows fromoperations will be sufficient to meet our capital requirements for at least thenext twelve months. Our future capital requirements will be adversely affectedby slow or diminished revenue growth, committed research and developmentexpenses, additional sales and marketing costs and higher general andadministrative expenses, such as attorneys' fees and litigation costs. Webelieve that our restatement and pending securities litigation will make itdifficult, if not impossible to raise additional capital until the litigationdescribed below and other uncertainties are resolved.

 

See Note 9 to our March 31, 2002Consolidated Financial Statements filed on Form 10-K/A for informationregarding our operating leases. As of March 31, 2002, our aggregate futureminimum lease commitments through the year ending 2007 totaled$4.8 million. Subsequent to March 31, 2002, in connection with theacquisition of DYM, we have additional operating lease commitments totaling$438,000 through the year ending October 31, 2005.

 

As described below, we are a party tonumerous lawsuits. The effect of these lawsuits on our liquidity and capitalresources cannot be estimated at this time as these actions are in their earlystages.

 

Between July 31, 2002 and November 15,2002, fourteen class-action lawsuits have been filed and are pending against usand certain current and former officers and/or directors (collectively, the"Defendants") in the United States District Court for the NorthernDistrict of California. The lawsuits allege that the Defendants violatedSections 10(b) and 20(a) of the Securities Exchange Act of 1934, andrule 10b-5 promulgated thereunder by the SEC, by making a series ofmaterial misrepresentations as to our financial condition during the classperiod of July 31, 2001 to July 19, 2002. Several of the lawsuitsfurther allege violations of Sections 11, 12(a)(2) and 15 of theSecurities Act of 1933. The plaintiffs are generally seeking to recovercompensatory damages, costs and expenses incurred, interest and such otherrelief as the court may deem appropriate. We expect that these lawsuits will beconsolidated into a single action in the United States District Court for theNorthern District of California. Because these lawsuits are still in theirearly stages, we are still evaluating the merits of these claims andformulating a defense to these actions.

 

We are also a nominal defendant in fivestockholder derivative lawsuits pending in Superior Court in the County ofSanta Clara,

 

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California. These lawsuits, which were filed between July 31, 2002and September 30, 2002, assert derivative claims on behalf of us againstour current and/or former officers and directors and others. The claimsasserted in these lawsuits include insider trading, breach of fiduciary duties,aiding and abetting breaches of fiduciary duties, negligence and professionalmalpractice, negligent misrepresentation and omission, contribution andindemnification, abuse of control, gross mismanagement, unjust enrichment andbreach of contract. These lawsuits seek damages suffered by us, treble damagesfor the sale of shares, costs and expenses of these actions and such otherrelief as the court may deem appropriate. Because these lawsuits are still intheir early stages, we are still evaluating the merits of these claims and ourresponsibilities with respect to the lawsuits.

 

We have been informed that five of ourshareholders have sued our independent auditors and the managing underwriter inour initial public offering, in connection with claims relating to theacquisition of Covalar Technologies Group, Inc. Those Defendants have filed amotion to join the Company, but as of the date of filing, the Company has notyet been joined in this matter. Pursuant to an underwriting agreement, we haveagreed under a reservation of rights to indemnify the underwriter in thisaction. Accordingly, there is no assurance that we will not sustain anyliability as a result of this lawsuit.

 

The Company is investigating informal orformal restructuring alternatives which potentially may dilute shareholderequity but could mitigate any material adverse affect on our financial positionor results of operations which might otherwise result from an unfavorableresolution of these lawsuits.

 

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**RISK FACTORS**

** **

**RISKS ASSOCIATED WITHOUR BUSINESS**

 

**An investment in oursecurities is highly speculative.**

** **

We have sustained a substantial decline inthe value of our securities since announcing the accounting and financialinaccuracies in our previously filed financial statements and our securitieshave been delisted from the NASDAQ National Market System.  We have also been named in a number ofsecurities class–action and derivative lawsuits and been the subject ofan SEC investigation.  The ultimate costand effect of these matters on the financial condition, results of operations,customer relations and management of the Company is unknown at this time.  In addition, the Company is investigatinginformal and formal restructuring alternatives which potentially may diluteshareholder equity. Accordingly, an investment in our securities is highlyspeculative and should not be made unless you are prepared to lose your entireinvestment.

 

**We face risks relatedto securities litigation and an SEC investigation into our recent restatementof our financial statements.**

** **

Since announcing the accounting and financialinaccuracies in our previously filed financial statements, we have been namedas a defendant in fourteen securities class–action lawsuits and as anominal defendant in five derivative lawsuits. The Securities and ExchangeCommission is currently investigating our financial and accountingirregularities. Defending the Company in these actions may result in asignificant diversion of management's attention and resources. If the Companyis unsuccessful in defending itself in these actions, we may face significantsanctions and civil damage awards which could materially impair our liquidityand results of operations.

 

**The restatement ofour financial statements and pending securities litigation may raise concernsamong our customers regarding our long-term stability. These concerns mayadversely affect future sales.**

** **

Customers who purchase our software productsmake a significant long–term investment in our technology. Our productsoften become an integral part of each installed fabrication facility and ourcustomers look to us to provide continuing support, enhancements and newversions of our products. Because of the long–term nature of aninvestment in yield–optimization software, customers are often concernedabout the stability of their suppliers. Our restatement and the pendingsecurities litigation may cause current and potential customers concern overour stability and these concerns may cause us to lose sales. Any loss in salescould adversely affect our results of operations, further deepening concernamong current and potential customers.

 

**Our restatement andpending securities litigation will make it difficult, if not impossible, toraise additional capital.**

** **

Our pending securities litigation raisessubstantial uncertainty regarding the financial condition and long termviability of the Company. Until this litigation is resolved, it is unlikelythat the Company will be able to raise additional capital.

 

**Although we have anobligation to indemnify our officers and directors and underwriters, we may nothave insurance coverage available for this purpose and may be forced to paythese indemnification costs directly.**

** **

Our charter and bylaws require that we indemnifyour directors and officers to the fullest extent provided by applicable law. Inaddition, the Underwriting Agreement with our underwriters for our

 

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initial public offering requires us to indemnify the underwriters incertain instances. Although we have purchased directors and officers liabilityinsurance to fund such obligations, we have been notified by our insurancecarriers that coverage may not be available. If our insurance carriers are ableto deny coverage, we would be forced to bear these indemnification costsdirectly, which could be substantial and may have an adverse effect on ourresults of operations and liquidity.

 

**Our stock has beendelisted from the Nasdaq National Market and a subsequent public market for ourstock may never develop.**

** **

In July 2002, we received a StaffDetermination Notice from the Nasdaq National Market informing us that ourstock may be delisted due to a failure to comply with Nasdaq continued listingstandards. We appealed the Nasdaq staff determination in August 2002 and weresubsequently notified by Nasdaq that on September 30, 2002, our stock would nolonger be listed on the Nasdaq National Market. Our stock is currently tradedin the over–the–counter market or "pink sheets." Stockstrading in this market typically suffer significantly lower volume (liquidity)and lower share prices.

 

**We currently haveonly three directors and believe we will have difficulty attracting qualifiedcandidates to serve on our board. Our failure to add additional directors couldadversely impact the management of our company, our compliance with securitieslaws and our future Nasdaq listing eligibility.**

** **

Two of our directors recently resigned fromthe board of directors of the Company, leaving only three directors. We havebegun searching for candidates to fill these vacancies. However, in light ofthe restatement of our financial statements and the pending securitieslitigation, we believe we will have difficulty attracting qualified individualsto serve on our board. Our inability to attract and retain qualifiedindependent directors may adversely affect the quality of our management andmay make it more difficult for us to comply with corporate governancerequirements of Nasdaq and those imposed by the Securities and ExchangeCommission pursuant to the Sarbanes-Oxley Act of 2002.

 

**There are significantbarriers to widespread adoption of our yield–optimization products by thesemiconductor industry.**

** **

In order for our business to grow, we mustovercome certain barriers to the adoption of our yield–optimizationproducts by the semiconductor industry. Many semiconductor designers andmanufacturers have in–house yield–management systems and may bereluctant to implement our software because they may believe that third-partytools will not incorporate their existing know-how and methodology. Ifparticipants in this industry reject using third–party software tooptimize their yield, our growth would be impaired, which would negativelyaffect our results of operations and cause our business to fail. In addition,because our yield–optimization solutions are relatively new to thesemiconductor industry and can be difficult to explain, intensive marketing andsales efforts will be necessary to educate prospective industry partners andcustomers regarding the uses and benefits of our technologies and softwareproducts. Accordingly, we cannot assure you that our software products willgain acceptance at the level or in the time frame we anticipate. Such a failureto gain acceptance would have a material adverse effect on our business.

 

**The semiconductorindustry is currently experiencing a downturn and has experienced downturns inthe past and any future downturns or prolonged current downturn could adverselyaffect our revenues and operating results.**

** **

Our business depends in part on the economichealth of our customers: IDMs, or integrated device manufacturers, fablesssemiconductor companies, and semiconductor equipment OEMs, or originalequipment manufacturers. The semiconductor industry is prone to periods ofoversupply resulting in significantly reduced capital expenditures, and it iscurrently experiencing such a downturn. When the industry last experienced aslowdown in 2002, some semiconductor manufacturers postponed or canceledcapital expenditures for previously planned expansions or new fabricationfacility construction projects, resulting in a substantial decline in worldwidesemiconductor capital expenditures.

 

Current conditions and future downturns couldlead to another slowdown in growth that would have a similar effect on thewillingness of semiconductor companies to purchase our yield-optimizationproducts and services or to purchase equipment from semiconductor equipmentOEMs that have embedded our software in their products. Significant downturnscould materially and adversely affect our business and operating results. Inaddition, we expect to continue increasing our investment in engineering,research and development, and marketing, which limits our ability to reduceexpenses during such downturns.

 

**In any particularperiod, we derive a substantial portion of our revenues from a small number ofcustomers, and our revenues may decline significantly if any major customercancels or delays a purchase of our products.**

** **

In each of the years ended March 31,2002, 2001, and 2000, customers that individually accounted for at least 10% ofour revenues together represented 66% (of which 24% was sold through Canon),61% (of which 18% was sold through Canon) and 44% of our revenues,respectively, and in each of these years, there was substantial change amongthe companies that represented our largest customers. In the year ended March31, 2002, sales to four customers accounted for 24%, 18%, 14% and 10%, respectively,of our 

 

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revenues. The large percentage of revenues derived from a small groupof customers has resulted from the relatively large license revenues werecognize upon entering into perpetual licensing agreements, from our currentlimited sales force, and from the lengthy sales cycle for our products. Becausewe derive most of our revenues from sales of perpetual licenses and because ourexisting customers' needs for additional products are based on intermittentevents, such as the introduction of new technologies or processes, building ofnew facilities or the need to increase capacity of existing facilities, ourlargest customers change substantially from period to period. Delays or failuresin selling new licenses to existing or new customers would cause significantperiod–to–period changes in our operating results, which may resultin our failure to meet market expectations. We may also incur significantexpense and devote management attention to the pursuit of potentiallysignificant license revenues, but ultimately fail to secure these revenues.

 

**We have a long andvariable sales cycle, which can result in uncertainty and delays in generatingadditional revenues.**

** **

Because our yield–optimization softwareand services are often unfamiliar to our prospective customers, it can take asignificant amount of time and effort to explain the benefits of our products.For example, it generally takes at least six months after our first contactwith a prospective customer before we start licensing our products to thatcustomer. In addition, due to the nature of fabrication facility deployment andthe extended time required to bring a fabrication facility to full capacity,capital expenditures vary greatly during this time. Accordingly, we may beunable to predict accurately the timing of any significant future sales ofsoftware licenses. We may also spend substantial time and management attentionon potential licenses that are not consummated, thereby foregoing otheropportunities.

 

**We must continuallyreplace the revenues generated from the sale of perpetual licenses and one–timeorders to maintain and grow our business.**

** **

Over the past year, we have generated thebulk of our revenues from the sale of perpetual licenses and one–timecustomer orders. These licenses and orders produce large amounts of revenues inthe periods in which the license fees are recognized and are not necessarilyindicative of a commensurate level of revenues from the same customers infuture periods. Achieving period–to–period growth will dependsignificantly on our ability to expand the number of users of our productswithin our customers' organizations, license additional software to ourcustomers and attract new customers. We may not be successful in these salesefforts and, consequently, revenues in any future period may not match that ofprior periods.

 

**Our operating resultsmay fluctuate significantly and any failure to meet financial expectations maydisappoint investors and could cause our stock price to decline.**

** **

Historically, our quarterly operating resultshave fluctuated and we expect them to continue to fluctuate in the future dueto a variety of factors, many of which are outside of our control. Because ofour current limited sales force, the lengthy sales cycle of our products andthe intermittent needs of customers, we derive our revenues primarily from arelatively small number of large transactions in any given operating period.Accordingly, the timing of large orders has significantly affected, and willcontinue to significantly affect, quarterly operating results. In addition tothe previously discussed risk resulting from our restatement of previouslyissued financial statements, factors that could cause our revenues andoperating results to vary from period to period include:

 

•                  large sales unevenly spaced over time;

 

•                  timing of new products and product enhancements byus and our competitors;

 

•                  the cyclical nature of the semiconductor industry;

 

•                  changes in our customers' development schedules,expenditure levels and product support requirements; and

 

•                  incurrence of sales and marketing and research anddevelopment expenses that may not generate revenues until subsequent quarters.

 

As a result, we believe that period–to–periodcomparisons of our results of operations are not necessarily meaningful and maynot be accurate indicators of future performance. These factors may cause ouroperating results to be below market expectations in some future quarters,which could cause the market price of our stock to decline.

 

**We may not succeed indeveloping new products and our operating results may decline as a result.**

** **

Our customers and competitors operate inrapidly evolving markets that are characterized by introduction of newtechnologies and more complex designs, shorter product life cycles anddisaggregation of the industry into new subsectors. For example, ever–smallergeometries are being used in semiconductors and new materials are beingemployed to enhance performance. We must continually create new software andadd features and functionality to our existing software products to keep pacewith these changes in the semiconductor

 

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industry. Specifically, we need to focus our research and developmentto:

 

•                  interface with new semiconductor–producinghardware and systems that others develop;

 

•                  remain competitive with companies marketing third–partyyield–management software and consulting services;

 

•                  continue developing new software modules that areattractive to existing customers, many of which have purchased perpetuallicenses and are under no ongoing obligation to make future purchases from us;and

 

•                  attract new customers to our software.

 

Maintaining and capitalizing on our currentcompetitive strengths will require us to invest heavily in research anddevelopment, marketing, and customer service and support. Although we intend todevote substantial expenditures to product development, we may not be able tocreate new products in

 

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a timely manner that adequately meet the needs of our existing andpotential customers. A failure to do so would adversely affect our competitiveposition and would result in lower sales and a decline in our profitability.

 

**We may not be able toeffectively compete against other companies, which could impair our growth andprofitability.**

** **

We target IDMs, fabless semiconductorcompanies, foundries and semiconductor equipment OEMS. The tools and systemsagainst which our products and services most commonly compete are those thatsemiconductor companies have created in–house. In order to grow ourbusiness, we must convince these producers of the benefit of an outsidesolution. The third–party providers against whom we compete are,generally, divisions of larger semiconductor equipment OEMs, such asKLA-Tencor. These companies can compete on the basis of their greaterfinancial, engineering and manufacturing resources, and their long-standing relationshipswith the same companies we are targeting. If we cannot compete successfullyagainst these forms of competition, the growth of our business will beimpaired.

 

In addition, a key part of our strategy is togain competitive advantage by establishing YIELDirector, our proprietary systemplatform and integrated yield–optimization software, as the standard inthe semiconductor industry. If we do not rapidly establish ourselves as theleading yield–optimization solution provider, we may not be able to growfast enough to compete effectively with existing and future competitors.

 

Errors in our products or the failure of ourproducts to conform to specifications could hurt our reputation and result inour customers demanding refunds or asserting claims against us for damages.

 

Because our software products are complex,they could contain errors or "bugs" that can be detected at any pointin a product's lifecycle. We have a team dedicated to detecting errors in ourproducts prior to their release in order to enable our software developers toremedy any such errors. In the past we have discovered errors in some of ourproducts and have experienced delays in the delivery of our products because ofthese errors. In addition, we have software engineers and developers whoparticipate in the maintenance and support of our products and assist indetecting and remedying errors after our products are sold. On some occasionsin the past, we have had to replace defective products that were alreadydelivered. These delays and replacements have principally related to newproduct releases. Detection of any significant errors may result in:

 

•                  the loss of, or delay in, market acceptance andsales of our products;

 

•                  the delay or loss of revenues;

 

•                  diversion of development resources;

 

•                  injury to our reputation; or

 

•                  increased maintenance and warranty costs.

 

Any of these problems could harm our businessand operating results. If our products fail to conform to specifications,customers could demand a refund for the purchase price or assert claims fordamages. Liability claims could require us to spend significant time and moneyin litigation or to pay significant damages. Any such claims, whether or notsuccessful, could seriously damage our reputation and our business.

 

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**We may continue to experience losses in thefuture.**

** **

We will need to continue to generate newsales while controlling our costs and we may not be able to successfullygenerate enough revenues to cover our expenses. We anticipate that our expensesmay increase in the next twelve months as we:

 

•                  increase our direct sales and marketing personneland activities;

 

•                  develop our technology, expand our existingproduct lines and create additional software modules for our products;

 

•                  develop additional strategic alliances with third–partyproviders of semiconductor design, fabrication and test solutions;

 

•                  implement additional internal systems, developadditional infrastructure and hire additional management; and

 

•                  pay professional fees and other costs related tolitigation matters.

 

Any failure to increase our revenues andcontrol costs as we implement our product and distribution strategies wouldharm our profitability and would likely negatively affect the market price ofour common stock.

 

**Our limited operatinghistory selling our software products makes our business difficult to evaluate.**

** **

Because we are in the early stages of ourdevelopment as a provider of yield–optimizing software, it may bedifficult to evaluate our business operations and prospects. Past revenues andsales figures may be a poor indicator of future performance. In addition, wehave only sold our current product line for approximately three years. Thismakes it more difficult for us to plan for the further development of ourbusiness than if we had a more mature business line.

 

**We may incur non–cashcharges resulting from acquisitions and equity issuances, which could harm ouroperating results.**

** **

We will continue to incur charges to reflectamortization and any impairment of identified intangible assets acquired inconnection with our acquisitions of FabCentric, Covalar and DYM, and we maymake other acquisitions or issue additional stock or other securities in thefuture that could result in further accounting charges. In addition, a newstandard for accounting for goodwill acquired in a business combination hasrecently been adopted. This new standard requires recognition of goodwill as anasset but does not permit amortization of goodwill. Instead goodwill must beseparately tested for impairment. As a result, our goodwill amortizationcharges ceased for acquisitions subsequent to July 1, 2001. However, inthe future, we may incur less frequent, but potentially larger, impairment chargesrelated to the goodwill already recorded, as well as goodwill arising out ofany future acquisitions. Current and future accounting charges like these couldresult in significant losses and delay our achievement of net income.

 

**Our cost reductioninitiatives may adversely affect the morale and performance of our personneland our ability to hire new personnel.**

** **

In connection with our effort to streamlineoperations, reduce costs and bring our staffing and structure in line withindustry standards, we restructured our organization on September 27,2002, with substantial reductions in our workforce. There have been and maycontinue to be substantial costs associated with the workforce reductions,including severance and other employee–related costs, and our restructuringplan may yield unanticipated consequences, such as attrition beyond our plannedreduction in workforce. As a result of these reductions, our ability to respondto unexpected challenges may be impaired and we may be unable to take advantageof new opportunities.

 

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In addition, many of the employees who wereterminated possessed specific knowledge or expertise that may prove to havebeen important to our operations. In that case, their absence may createsignificant difficulties. This personnel reduction may also subject us to therisk of litigation, which may adversely impact our ability to conduct ouroperations and may cause us to incur significant expense.

 

**RISKS RELATED TO OURINTERNATIONAL OPERATIONS**

 

**Our business could beharmed by political or economic instability in the Republic of Armenia.**

** **

Our software products are largely developed,produced, delivered and supported from our facilities in the Republic ofArmenia. Armenian employees participate in our direct sales and marketingefforts. Changes in the political or economic conditions in Armenia and thesurrounding region, such as fluctuations in exchange rates, the imposition ofcurrency transfer restrictions or limitations, or the adoption of burdensometrade or tax policies, procedures, rules, regulations or tariffs, couldadversely affect our ability to develop new products and take advantage ofArmenia's low labor and production costs, and to otherwise conduct businesseffectively in Armenia.

 

Armenia voted for independence in 1991 andadopted its current constitution in 1995. Laws protecting property (includingintellectual property) are not well established and may be difficult toenforce. In recent years, Armenia has suffered significant political andeconomic instability. Any future political and economic instability couldinterfere with our ability to retain or recruit employees, significantlyincrease the cost of our operations, or result in regulatory restrictions onour business, making it difficult for us to maintain our business in Armenia ordisrupting our Armenian operations. Any significant increase in the costs ofour Armenian operations (whether due to inflation, imposition of additionaltaxes or other causes) would diminish, and could eliminate their currentcost-advantages. Furthermore, we cannot assure you that restrictive foreign–relationslaws or policies on the part of Armenia or the United States will not constrainour ability to operate effectively in both countries. If we lose or choose toterminate any part of our Armenian operation, replacements could be costly andwe could experience delays in our product development, thereby harming ourcompetitive position and adversely affecting our results of operations.

 

**Our expansion intointernational markets may result in higher costs and could reduce our operatingmargins due to the higher costs of international sales.**

** **

Our current strategy for growth includesfurther expansion in Asia, Europe, and other international markets. Toeffectively further this strategy, we must find additional partners to sell ourproducts in international markets and expand our direct international salespresence. We would likely incur higher sales costs by expanding our directsales staff abroad, but we might not realize corresponding increases inrevenues or profitability. Furthermore, we may be forced to share salesrevenues with distributors or other sales partners abroad in order tosuccessfully penetrate foreign markets. Even if we successfully expand ourdirect and indirect international sales efforts, we cannot be certain that wewill be able to create or increase international market penetration or demandfor our products.

 

**Problems withinternational business operations could adversely affect our sales.**

** **

Sales to customers located outside the UnitedStates accounted for approximately 30%, 31% and 13% of our revenues in theyears ended March 31, 2002, 2001 and 2000, respectively. We anticipate thatsales to customers located outside the United States will represent asignificant portion of our total revenues in future periods. In addition, manyof our customers rely on third–party foundries operating outside of theUnited States. Accordingly, our operations and revenues are subject to a numberof risks associated with foreign commerce, including the following:

 

•      managingforeign distributors;

 

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•     staffing and managing foreign branch offices;

 

•     political and economic instability abroad;

 

•      foreigncurrency exchange fluctuations;

 

•      changesin tax laws and tariffs;

 

•      timingand availability of export licenses;

 

•      inadequateprotection of intellectual property rights in some countries; and

 

•      obtaininggovernmental approvals for certain technologies.

 

Any of these factors could result indecreased sales to international customers and domestic customers that useforeign fabrication facilities.

 

Our accounts receivable from internationalcustomers are generally outstanding longer than our domestic receivables and,as a result, we may need a proportionately greater amount of working capital tosupport our international sales.

 

**INTELLECTUAL PROPERTY–RELATEDRISKS**

 

 

**Our success dependsin part on our ability to protect our intellectual property, and any inabilityto do so could cause our business material harm.**

** **

Our success depends in significant part onour intellectual property. While we have attempted to protect our intellectualproperty through patents, copyrights, or the maintenance of trade secrets,there can be no assurance that these measures will successfully protect ourtechnology or that competitors will not be able to develop similar technologyindependently. It is possible, for example, that the claims we are allowed onany of our patents will not be sufficiently broad to protect our technology. Inaddition, patents issued to us could be challenged, invalidated or circumventedand the rights granted under those patents might not provide us with anysignificant competitive advantage. We have not attempted to secure patentprotection in foreign countries, and the laws of some foreign countries do notprotect our intellectual property as effectively as the laws of the UnitedStates. Also, our source code developed in Armenia may not receive the samecopyright protection that it would receive if it was developed in the UnitedStates. As we increase our international presence, we expect that it willbecome more difficult to monitor the development of competing products that mayinfringe on our rights as well as unauthorized use of our products.

 

**Our operating resultswould suffer if we were subject to a protracted intellectual propertyinfringement claim or one with a significant damages award.**

** **

Litigation regarding intellectual propertyrights frequently occurs in the software industry. We expect we will be subjectto infringement claims as the number of competitors in our industry segmentgrows. While we are unaware of any claims that our products infringe on theintellectual property rights of others, such claims may arise in the future.Regardless whether these claims have merit, they could:

 

•                  be costly to defend;

 

•                  divert senior management's time, attention andresources;

 

•                  cause product shipment delays; and

 

•                  require us to enter into costly licensing orroyalty arrangements.

 

Any of these potential results ofintellectual property infringement claims could limit our ability to maintainour business and negatively affect our operating results.

 

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**Item 3**. ***Quantitative and Qualitative Disclosures About Market Risk***

*** ***

In the normal course of business, ourfinancial position is subject to a variety of risks, including market riskassociated with interest rate and foreign currency exchange movements. Weregularly assess these risks and have established policies and businesspractices to protect against these and other exposures. As a result, we do notanticipate material potential losses in these areas.

 

**Interest Rate Risk**

 

We are exposed to interest rate risk on our$1.5 million convertible debenture and our investment portfolio which isprimarily in fixed rate securities at December 31, 2002. We invest excess cashin debt instruments of the US Government and its agencies, and in high qualitycorporate issuers and, limit the amount of credit exposure to any one issuer.Changes in the fixed rate interest market would change the estimated value ofour debenture. Our investments in fixed rate securities may have their fairmarket value adversely impacted due to a rise in interest rates. We believethat a change in long–term interest rates would not have a materialeffect on our business, financial condition results of operations or cash flow.Our cash and cash equivalents consist of cash and highly liquid money marketinstruments with original or remaining maturities of 90 days or less.Because of the short maturities of these instruments, a sudden change in marketinterest rates would not have a material impact on the fair value of theportfolio, but it may cause the amount of income we derive to varysignificantly from period to period. A hypothetical 10% increase in interestrates would result in approximately $7,000 decrease in the fair value ofour available–for–sale securities as of December 31, 2002.

 

**Foreign Exchange Risk**

** **

Our sales are primarily denominated inUS dollars and, as a result, we have relatively little exposure to foreigncurrency exchange risk with respect to revenues. Our sales through our Japanesesubsidiaries, which represented approximately 1%****of total revenues for the three months ended December 31,2002, are denominated in yen. A 10% adverse change in yen exchange rates wouldnot have had material impact on revenues for the three months ended December31, 2002. Additionally, our exposure to foreign exchange rate fluctuationsarises in part from inter–company accounts which can be denominated inthe functional currency of the foreign subsidiary. As exchange rates vary whenthe accounts are translated, results may vary from expectations and adverselyimpact earnings. The effect of foreign exchange rate fluctuations for the ninemonths ended December 31, 2002 was not material.

*** ***

While our sales are generally denominated inUS dollars, our international subsidiaries' books and records are maintainedin the local currency. As a result, our financial statements are remeasured inUS dollars using a combination of current and historical exchange rates.The functional currencies of our foreign subsidiaries are their localcurrencies. We translate certain assets and liabilities to US dollars atthe current exchange rate as of the applicable balance sheet date. Revenues andexpenses are translated at the average exchange rates prevailing during theperiod. Adjustments resulting from the translation of the foreign subsidiaries'financial statements are recorded in accumulated other comprehensive income(loss) in stockholders' equity.

 

**Item 4**. ***Controls and Procedures***

 

Evaluation of Controls and Procedures

 

We maintain disclosure controls and procedures,which we have designed to ensure that material information related to theCompany and its subsidiaries, is made known to our management and auditcommittee on a regular basis. In response to recent legislation and proposedregulations, we reviewed our internal control structure and our disclosurecontrols and procedures. As disclosed in our Form 10-K/A filed onNovember 8, 2002, the restatement of our March 31, 2002 and 2001financial

 

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statements occurred as a result of material weaknesses in our system ofinternal controls and its operation. Starting in July 2002, we took measures tostrengthen and ensure compliance with our internal controls to help preventsimilar events from occurring again. These weaknesses have been discussed withour audit committee. The internal controls specifically addressed by us involveour sales order fulfillment and revenue recognition procedures, cash receiptsand disbursements procedures and our segregation of duties. In addition, wehave reviewed the qualifications and training of our management and employeesand determined that they are sufficient to allow them to fulfill their assignedroles. We believe that our disclosure controls and procedures as of the date ofthis filing are adequate to enable us to comply with our disclosureobligations.

 

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**PART II****Item 1.**

 

***LegalProceedings***

*** ***

The information set forth in Note 3 to theCondensed Consolidated Financial Statements appearing in this report isincorporated herein by reference.

 

***Item2. Changes in Securities and Use of Proceeds***

*** ***

**USE OF PROCEEDS FROMREGISTERED SECURITIES.**

** **

The Company'sRegistration Statement on Form S–1 (Commission File No. 333–61810)for its initial public offering of common stock was declared effective on July30, 2001. The Company sold a total of 6,900,000 shares of common stock to anunderwriting syndicate for aggregate gross offering proceeds of $75.9 million.In connection with this offering, the Company incurred total expenses ofapproximately $7.2 million, consisting of $5.3 million for underwritingdiscounts and commissions, and approximately $1.9 million of other expenses.None of these expenses were paid directly or indirectly to any of the Company'sdirectors, officers, or their associates, persons owning 10% or more of anyclass of the our securities, or affiliates of the corporation. Offeringproceeds, net of expenses were approximately $68.7 million. The Company hasapplied the proceeds to temporary investments in a commercial money marketinvestment account and has spent a portion of the proceeds on the acquisitionof Tyecin, FabCentric, Covalar, and DYM, and to fund operating losses.

 

**Item 6. *Exhibits and Reports on Forms 8-K***

*** ***

***(a)***

*** ***
| **Exhibit** |   | **Description**                                                                      |
|-------------|--------|--------------------------------------------------------------------------------------|
|        |   |                                                                                 |
| 99.1        |   | Certification filed pursuant to Section 906  of the Sarbanes–Oxley Act of 2002. |

 

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**SIGNATURES**

** **

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
| February 14, 2003 |                                     |
|-------------------|------------------------------------------|
|              | HPL Technologies, Inc.                   |
|              | By:                                      | /S/ THOMAS A. TOMASETTI |
|              |                                     |
|              | Thomas A.Tomasetti                       |
|              | *President and  Chief Executive Officer* |

 

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**CERTIFICATIONS**

 

I, Michael P. Scarpelli, certify that:

 

1.                                       I have reviewed this quarterly report on Form 10-Qof HPL Technologies, Inc.;

 

2.                                       Based on my knowledge, this quarterly report doesnot contain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this report;

 

3.                                       Based on my knowledge, the financial statements,and other financial information included in this quarterly report, fairlypresent in all material respects the financial condition, results of operationsand cash flows of the registrant as of, and for, the periods presented in thisquarterly report;

 

4.                                       The registrant's other certifying officer and Iare responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and we have:

 

a)                                      designed such disclosure controls and proceduresto ensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this quarterly report is beingprepared;

 

b)                                     evaluated the effectiveness of the registrant'sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report (the "Evaluation Date"); and

 

c)                                      presented in this quarterly report our conclusionsabout the effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.                                       The registrant's other certifying officer and Ihave disclosed, based on our most recent evaluation, to the registrant'sauditors and the audit committee of the registrant's board of directors (orpersons performing the equivalent functions):

 

a)                                      all significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant'sability to record, process, summarize, and report financial data and haveidentified for the registrant's auditors any material weaknesses in internalcontrols; and

 

b)                                     any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant'sinternal controls; and

 

6.                                       The registrant's other certifying officer and Ihave indicated in this quarterly report whether or not there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
|                         |                     |
|------------------------------|--------------------------|
| Date: February 14, 2003 |                     |
|                         | /s/ MICHAEL P. SCARPELLI |   |
|                         |                     |
|                         | Michael P. Scarpelli     |
|                         | Chief Financial Officer  |

 

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I, Thomas A. Tomasetti, certify that:

 

1.                                       I have reviewed this quarterly report on Form 10-Qof HPL Technologies, Inc.;

 

2.                                       Based on my knowledge, this quarterly report doesnot contain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this report;

 

3.                                       Based on my knowledge, the financial statements,and other financial information included in this quarterly report, fairlypresent in all material respects the financial condition, results of operationsand cash flows of the registrant as of, and for, the periods presented in thisquarterly report;

 

4.                                       The registrant's other certifying officer and Iare responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and we have:

 

a)                                      designed such disclosure controls and proceduresto ensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this quarterly report is beingprepared;

 

b)                                     evaluated the effectiveness of the registrant'sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report (the "Evaluation Date"); and

 

c)                                      presented in this quarterly report our conclusionsabout the effectiveness of the disclosure controls and procedures based on ourevaluation as of the Evaluation Date;

 

5.                                       The registrant's other certifying officer and Ihave disclosed, based on our most recent evaluation, to the registrant'sauditors and the audit committee of the registrant's board of directors (orpersons performing the equivalent functions):

 

a)                                      all significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant'sability to record, process, summarize, and report financial data and haveidentified for the registrant's auditors any material weaknesses in internalcontrols; and

 

b)                                     any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant'sinternal controls; and

 

6.                                       The registrant's other certifying officer and Ihave indicated in this quarterly report whether or not there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
|                         |                                   |
|------------------------------|----------------------------------------|
| Date: February 14, 2003 |                                   |
|                         | /s/ THOMAS A. TOMASETTI                |   |
|                         |                                   |   |
|                         | Thomas Tomasetti                       |
|                         | President and Chief Executive  Officer |

 

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** **

**EXHIBIT INDEX**

 
| **Exhibit** |   | **Description**                                                                      |
|-------------|--------|--------------------------------------------------------------------------------------|
|        |   |                                                                                 |
| 99.1        |   | Certification filed pursuant to Section 906  of the Sarbanes–Oxley Act of 2002. |

 

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