10-Q 1 hpl10q_123104.txt ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------ FORM 10-Q |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 2004 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to _____ Commission file number: 000-32967 ----------------------------- HPL TECHNOLOGIES, INC. (Exact Name of Registrant as Specified in Its Charter) Delaware 77-0550714 (State of Incorporation) (I.R.S. Employer Identification No.) 2033 Gateway Place, Suite 400 San Jose, California 95110 (408) 437-1466 (Address of Principal Executive Offices) (Registrant's telephone number, including area code) Securities registered under Section 12(b) of the Act: None Securities registered under Section 12(g)of the Act: Common Stock, $0.001 Par Value ---------------------------- Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 under the Securities Exchange Act of 1934) Yes |_| No |X| As of January 31, 2005, the registrant had outstanding 31,423,766 shares of common stock. ================================================================================ TABLE OF CONTENTS PART I - FINANCIAL INFORMATION

2 PART I - FINANCIAL INFORMATION ITEM 1 - CONDENSED CONSOLIDATED FINANCIAL STATEMENTS HPL Technologies, Inc. Consolidated Statements of Operations (In thousands, except per share amounts) (Unaudited)

3 HPL Technologies, Inc. Consolidated Balance Sheets (In thousands, except per share data)

4 HPL Technologies, Inc. Consolidated Statements of Cash Flows (In thousands) (Unaudited)

5 HPL Technologies, Inc. Notes to unaudited Condensed Consolidated Financial Statements NOTE 1. GENERAL The interim unaudited condensed consolidated financial statements included herein have been prepared by HPL Technologies, Inc. ("HPL" or "Company"), pursuant to the rules and regulations of the United States Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, pursuant to these rules and regulations. However, management believes that the disclosures are adequate to ensure that the information presented is not misleading. The interim unaudited condensed consolidated financial statements reflect, in the opinion of management, all adjustments necessary (consisting only of normal recurring adjustments) to present a fair statement of results for the interim periods presented. The operating results for any interim period are not necessarily indicative of the results that may be expected for the entire fiscal year ending March 31, 2005. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company's Form 10-K for the year ended March 31, 2004, as filed with the SEC on July 14, 2004. The accompanying unaudited condensed consolidated balance sheet at March 31, 2004 is derived from audited consolidated financial statements at that date. Preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business; and, accordingly, the financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company has experienced net losses and negative cash flows since going public in July 2001 and, as of December 31, 2004, had an accumulated deficit of $105.8 million. The Company expects to have a net operating loss in the year ending March 31, 2005. For the nine months ended December 31, 2004, cash used in operations and to fund capital expenditures was $5.3 million. Management's plans for the Company to continue as a going concern include increases in revenues or raising additional capital. At December 31, 2004, the Company had approximately $5.1 million in cash and cash equivalents and short-term investments. The Company's current operating plan for the year ending March 31, 2005 projects that cash available from planned revenue combined with the $5.1 million on hand at December 31, 2004 will be adequate to fund operations through March 31, 2005. There can be no assurances that the current cash on hand combined with the projected revenues will be adequate to sustain operations beyond March 31, 2005. Future capital requirements will be affected by slow or diminished revenue growth, additional research and development and sales and marketing costs, and higher general and administrative costs, including costs related to the litigation matters described in Note 2. There is no assurance that additional capital will be available to the Company or, if available, under terms that would be acceptable to the Company. Furthermore, management is not certain that it will be able to raise additional capital until the litigation and other uncertainties described in Note 2 are resolved. NOTE 2. LEGAL PROCEEDINGS Between July 31, 2002 and November 15, 2002, several class-action lawsuits were filed against the Company, certain current and former officers and directors of the Company, and the Company's independent auditors in the United States District Court for the Northern District of California. The lawsuits were consolidated into a single action (the "Securities Class Action"), which alleges that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, Rule 10b-5 promulgated thereunder, and Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 by making a series of material misrepresentations as to the financial condition of the Company during the class period of July 31, 2001 to July 19, 2002. The plaintiffs are generally seeking to recover compensatory damages, costs and expenses incurred, interest and such other relief as the court may deem appropriate. The Company has entered into a Stipulation of Settlement with the lead plaintiffs that resolves the Securities Class Action. Under the Stipulation, the Company would issue shares of common stock to the class. Final settlement is contingent on several conditions, including court approval. The motion for preliminary approval of the settlement was heard on November 4, 2004, and granted in an order issued on November 5, 2004. The court will consider the final approval of the settlement at a hearing on February 24, 2005. 6 Former shareholders of Covalar Technologies Group, Inc., which was acquired by the Company in February 2002, brought suit in the District Court of Dallas County, Texas, against the Company's independent auditors and the managing underwriter in the Company's initial public offering, in connection with claims relating to the acquisition (the "Covalar Action"). On April 26, 2004, the Company and the Company's former President and Chief Executive Officer were named as defendants in this action. Subject to a reservation of rights, the Company has accepted the underwriter's request to indemnify the underwriter in connection with the Company's initial public offering and to advance expenses in this matter. On July 13, 2004 the Company signed a settlement and release agreement with the plaintiffs in the Covalar Action pursuant to which the Company has issued the plaintiffs additional shares of common stock, which have been placed in escrow pending the final approval of the settlement in the Securities Class Action. On December 20, 2004 the court issued an order dismissing the Company without prejudice from the Covalar Action, pursuant to the Company's settlement agreement with the plaintiffs. Based on the terms of the above settlements, the Company determined that a liability related to the Securities Class Action and the Covalar Action was probable and that the value was reasonably estimable. Accordingly, the Company recorded a non-cash long term liability of approximately $7.9 million in its consolidated financial statements as of March 31, 2004, representing management's estimate of the value of the 7 million new shares of common stock that the Company has agreed to issue under the Securities Class Action and Covalar Action settlements. This liability was calculated by utilizing a valuation based on both the income and market approaches as of March 31, 2004, consistent with the Company's assessment of goodwill impairment. This liability will be revalued quarterly until the actual effective date of the settlements. There was no change in the revalued amount from March 31, 2004. On May 22, 2003, five former shareholders of FabCentric, Inc., which was acquired by the Company in December 2001, sued the Company, the Company's former President and Chief Executive Officer and former Chief Financial Officer, and the Company's independent auditors in a lawsuit pending in Superior Court in the County of Santa Clara, California (the "FabCentric Action"). This lawsuit alleges claims for fraud, negligent misrepresentation, breach of warranties and covenants, breach of contract, and negligence, and seeks rescission or, alternatively, damages, costs and expenses. On October 31, 2003, the plaintiffs filed an amended complaint adding the managing underwriter in the Company's initial public offering and the Company's current Chief Financial Officer as defendants. On October 12, 2004, the Court heard the demurrers of the Company, the underwriters, the auditors, the Company's former CEO and the Company's former CFO. The Court sustained in part with leave to amend and overruled in part the Company's demurrer, overruled the auditors' demurrer, and sustained the other defendants' demurrers with leave to amend. Plaintiffs filed a second amended complaint on November 1, 2004, which added claims for violations of the California Corporations Code and for attorneys' fees under the "tort of another" doctrine. The Company and the other defendants filed demurrers, which were heard on January 25, 2005. The Court sustained the Company's demurrer to the breach of contract and "tort of another" claims and the underwriters' demurrer with leave to amend and overruled the demurrers of the auditors and the Company's former CFO. A further case management conference has been scheduled for April 5, 2005. The Company is also a nominal defendant in consolidated stockholder derivative lawsuits pending in Superior Court in the County of Santa Clara, California. These lawsuits, which were filed between July 31, 2002 and December 31, 2002, assert derivative claims on behalf of the Company against certain current and former officers and directors of the Company and the Company's independent auditors. The consolidated complaint asserts claims for insider trading, breach of fiduciary duties, breach of contract, professional negligence and unjust enrichment, and seek damages suffered by the Company, treble damages for the sale of shares, costs and expenses of these actions and such other relief as the court may deem appropriate. The parties have reached an agreement in principle to settle these derivative actions and are preparing a stipulation of settlement. The Company estimates that its exposure in this matter will be fully covered by directors and officers liability insurance ("D&O") proceeds received from its third and fourth layer excess D&O carriers as discussed below which have been deposited in escrow with the Company's attorneys. The parties have stipulated to extend the time to respond to the consolidated derivative action until March 29, 2005. A case management conference has been scheduled for April 26, 2005. Additionally, Twin City Fire Insurance Company (the Company's first-layer excess "D&O" insurance carrier) filed a declaratory relief action on October 6, 2003, in Superior Court in the County of Santa Clara, California, against the Company, its former President and Chief Executive Officer, its former Chief Financial Officer, and other former and current officers and directors of the Company seeking a determination that no coverage is afforded the defendants under Twin City's policy, which follows form to the Company's primary D&O policy issued by Executive Risk Indemnity Inc. Executive Risk has already agreed to pay its policy limits for the Securities Class Action, exhausting the limits of the Company's primary D&O policy. The Company filed a Second Amended Cross-Complaint on September 29, 2004, seeking a declaration that Twin City and the Company's other excess D&O insurance carriers, National Union and St. Paul, are obligated to indemnify the Company for losses in connection with the Securities Class Actions and related litigation and that Twin City has breached its insurance contract by not paying the defendants' defense expenses on a current basis. 7 On December 21, 2004, National Union, the Company's third-layer excess D&O carrier, paid $1,000,000 into escrow in exchange for a full policy release. The Company has dismissed National Union from its coverage action. St. Paul, the Company's fourth-layer excess D&O carrier has similarly paid $125,000 subsequent to December 31, 2004 into escrow in exchange for a full policy release and the Company has dismissed St. Paul from its coverage action. The proceeds will be used to settle the consolidated derivative action and for legal defense costs. On January 11, 2005, the Company and Twin City argued cross-motions for summary adjudication. The parties sought a declaration regarding whether exclusionary language in the Company's D&O liability insurance application excluded coverage for insureds that did not have knowledge of Y. David Lepejian's unlawful conduct. The Superior Court, in a ruling issued on January 12, 2005, held that this exclusionary language did not preclude coverage for insureds that did not have knowledge of the unlawful conduct, including the Company. Twin City has filed a motion to reconsider the Superior Court's January 12, 2005 ruling, which the Company has opposed. This motion will be heard on February 22, 2005. The Company intends to continue to oppose the remaining claims made in the Third Amended Complaint and to seek coverage under Twin City's policy. As of December 31, 2004, the company has accrued $9.1 million for the above matters. Except as noted above, these matters are in the early stages of litigation and accordingly they may ultimately be resolved on a basis different than currently estimated. Because many factors that enter into the ultimate resolution of these matters are not within the Company's control, the Company is not able to estimate the maximum potential financial exposure related to these matters. Any adverse resolution of the aforementioned litigation could have a material effect on the Company's financial condition, results of operations or cash flows. NOTE 3. LOSS PER SHARE Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of shares of common stock outstanding during the period, less shares outstanding that are subject to repurchase. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of shares and potential shares of common stock outstanding during the period. The calculation of diluted net loss per share excludes shares of potential common stock if their effect is anti-dilutive. Potential common stock consists of shares of common stock that are incremental common shares issuable upon the exercise of stock options and warrants, computed using the treasury stock method. The total number of shares excluded from the calculation of diluted net loss per share is detailed in the table below (in thousands):

NOTE 4. CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, cash equivalents, short-term investments, unbilled receivables, accounts receivable and a note receivable. Cash and cash equivalents are deposited with financial institutions that management believes are credit worthy. The Company performs ongoing credit evaluations of its customers' financial condition and generally requires no collateral from its customers. At December 31, 2004, two customers accounted for 30% and 17 % of the Company's accounts receivable and unbilled receivables combined. At December 31, 2003, three customers accounted for 23%, 14%, 10% of the Company's accounts receivable and unbilled receivables combined. 8 NOTE 5. COMPREHENSIVE LOSS Other comprehensive loss consists of gains and losses that are not recorded in the statements of operations but instead are recorded directly to stockholders' equity. For the three and nine months ended December 31, 2004, comprehensive loss was $1.8 million and $7.7 million, respectively. The difference between net loss and comprehensive loss for the three and nine months ended December 31, 2004, is the result of foreign currency translation gains and losses and the net unrealized gains and losses on available for sale securities in the aggregate amount of net gain of $254,000 and net gain of $226,000, respectively. For the three months and nine months ended December 31, 2003, comprehensive loss was $2.2 million and $11.0 million, respectively. The difference between net loss and comprehensive loss for the three months and six months ended December 31, 2003, is the result of foreign currency translation gains and losses and the net unrealized gains and losses on available for sale securities in the aggregate amount of net loss of $13,000 and $32,000, respectively. NOTE 6. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands):

The derivative action settlement and defense costs relates to funds received from the Company's third-layer excess carrier which have been placed in escrow as described in Note 2 above for the purpose of settling the derivative action and funding certain defense costs. There is a corresponding balance in other current assets representing the cash balance in the escrow account at December 31, 2004. As funds are disbursed out of the escrow account, the other current asset account will be reduced with a corresponding reduction in accrued liabilities. Although the amounts received from HPL's former Chief Executive Officer are included in accrued liabilities, the Company does not expect it will be required to repay this sum. As part of the former Chief Executive Officer's settlement in the derivative action, he has agreed to forgo any claim he may have against the Company related to the $4,335,000. On final resolution of the derivative action, this amount will become part of additional paid-in capital. 9 NOTE 7. INTANGIBLE ASSETS Intangible assets consist of the following (in thousands):

NOTE 8. STOCK-BASED COMPENSATION The Company accounts for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25 ("APB No. 25"), Accounting for Stock Issued to Employees, and complies with the disclosure provisions of SFAS No. 123 as amended by SFAS No.148, Accounting for Stock-Based Compensation - Transition and Disclosures. Deferred compensation recognized under APB No. 25 is amortized to expense using the graded vesting method. The Company accounts for stock options and warrants issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force No. 96-18 under the fair value based method. The Company adopted the disclosure-only provisions of SFAS No. 123, and accordingly, no expense has been recognized for options granted to employees under the Company's various stock plans. The Company amortizes deferred stock-based compensation on the graded vesting method over the vesting periods of the applicable stock purchase rights and stock options, generally four years. The graded vesting method provides for vesting of portions of the overall awards at interim dates and results in greater vesting in earlier years than the straight-line method. Had compensation expense been determined based on the fair value at the grant date for the award, consistent with the provisions of SFAS No. 123, the Company's pro forma net loss and net loss per share for the following periods would be (in thousands, except per share data):

10 NOTE 9. 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. The following is a geographic breakdown of the Company's revenues by destination for the following periods (in thousands):

For the three months ended December 31, 2004, the Company derived revenue from three customers which comprised 25%, 18% and 14% of the Company's total revenues, respectively. For the nine months ended December 31, 2004, the Company derived revenue from three customers which comprised 17%, 16% and 11% of the Company's total revenues, respectively. For the three months ended December 31, 2003, the Company derived revenue from two customers which comprised 16% and 12% of the Company's total revenues, respectively. For the nine months ended December 31, 2003, the Company derived revenue from two customers which comprised 17% and 17% of the Company's total revenues, respectively. NOTE 10. GUARANTEES AND INDEMNIFICATIONS Indemnification Obligations The Company's Amended and Restated Certificate of Incorporation (the "Certificate") provides that, except to the extent prohibited by the Delaware General Corporation Law (the "DGCL"), the Company's directors and officers shall not be personally liable to the Company or its stockholders for monetary damages for any breach of fiduciary duty as a director or officer. The Certificate eliminates the personal liability of directors and officers to the fullest extent permitted by the DGCL and, together with the Company's Bylaws (the "Bylaws"), provides that the Company shall fully indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding (whether civil, criminal, administrative or investigative) by reason of the fact that such person is or was a director or officer of the Company, or is or was serving at the request of the Company as a director or officer of another corporation, partnership, joint venture, trust, employee benefit plan or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with such action, suit or proceeding ("Expenses"). Additionally, the Company has entered into indemnification agreements with its directors and officers pursuant to which the Company is required to indemnify its officers and directors and advance any and all Expenses. These agreements have no term and the maximum potential amount of future payments HPL could be required to make under these indemnification agreements is unlimited. Except as noted below, no claims for indemnification have been made against the Company. To limit the Company's exposure to indemnification claims by directors and officers, the Company obtained in July 2001 four directors and officers liability insurance policies with aggregate limits of $20 million. The validity of these policies is being contested with respect to coverage for the Company, Mr. Lepejian, the Company's former President and Chief Executive Officer, and other of the Company's current and former directors and officers. In February 2003, the Company obtained two new directors and officers' liability insurance policies with aggregate policy limits of $10 million which were renewed in February 2004. These two new policies exclude claims relating to prior acts, including the acts giving rise to the previous restatement of the Company's financial statements. 11 Certain of the Company's current and former directors and officers have been named as defendants in the litigation described in Note 2. Except for our former Chief Financial Officer, who has requested advancement of expenses in connection with her deposition before the SEC, no other directors or former officers have requested indemnification from the Company. However, if the Company is unable to settle its litigation, it expects all of the defendant directors and officers will demand indemnification and advancement of expenses under their respective indemnification agreements. Because management is not currently able to evaluate the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss, management cannot determine the estimated fair value of these obligations and, accordingly, the Company has recorded no liability for these obligations as of December 31, 2004. The Company is also obligated to provide indemnification to the underwriters in its initial public offering pursuant to an Underwriting Agreement, dated July 30, 2001, by and among the Company, UBS Warburg LLC, Dain Rauscher Wessels, Wit SoundView Corporation and Adams Harkness & Hill, Inc., as representatives of the several underwriters (the "Underwriting Agreement"). In October 2002, UBS Warburg was named as a defendant in a lawsuit relating to the Company's issuance of stock in the acquisition of Covalar Technologies Group, Inc. Pursuant to the Underwriting Agreement, UBS Warburg demanded that the Company indemnify it in connection with this matter and advance its litigation expenses. While the Company had obtained insurance to cover its obligation to indemnify and advance UBS Warburg's expenses, its insurers have raised certain defenses to coverage. Furthermore, even if coverage is afforded, coverage for these indemnification obligations is subject to a sub-limit of $1,000,000. Because management is not currently able to evaluate the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss, management cannot determine the estimated fair value of these obligations and, accordingly, the Company has recorded no liability for these obligations as of December 31, 2004. The Company includes standard intellectual property indemnification clauses in its software license agreements. Pursuant to these provisions, HPL agrees to hold harmless and defend the indemnified party, generally HPL's business partners and customers, in connection with certain patent, copyright or trade secret infringement claims by third parties with respect to HPL's products. The term of the indemnification provisions is generally for the term of the license agreement and the applicable statute of limitations. The Company believes the estimated fair value of these obligations is minimal. HPL has recorded no liabilities for these obligations as of December 31, 2004 and has never had to make a payment under such indemnification provisions. Warranties The Company offers its customers a warranty that its products will conform to the documentation provided with the products. To date, there have been no payments or material costs incurred related to fulfilling these warranty obligations. Accordingly, the Company has no liabilities recorded for these warranties as of December 31, 2004. The Company assesses the need for a warranty accrual on a quarterly basis, and there can be no guarantee that a warranty accrual will not become necessary in the future. 12 NOTE 11. RECENT ACCOUNTING PRONOUNCEMENTS In September 2004, the EITF delayed the effective date for the recognition and measurement guidance previously discussed under EITF Issue No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-01") as included in paragraphs 10-20 of the proposed statement. The proposed statement will clarify the meaning of other-than-temporary impairment and its application to investments in debt and equity securities, in particular investments within the scope of FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and investments accounted for under the cost method. The Company is currently evaluating the effect of this proposed statement on its financial position and results of operations. In December 2004, the FASB issued SFAS No. 123 (revised 2004),"Share-Based Payment." This Statement is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes APB Opinion No.25, "Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123(R) requires that compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. This statement is effective beginning with the Company's second quarter ending September 30, 2005. The Company is currently evaluating the requirements of SFAS No. 123(R) and although the Company believes the impact to its financial statements will be in a similar range as the amounts presented in its pro forma financial results required to be disclosed under the current SFAS No. 123, the Company has not yet fully determined its impact on its consolidated financial statements. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 20, Accounting for Non-monetary Transactions." The amendments made by this Statement are based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. This Statement also eliminates the exception for non-monetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of non-monetary assets that do not have commercial substance. The Company is required to adopt the provisions of this Statement beginning April 1, 2006 for all non-monetary asset exchanges and will apply its provisions prospectively upon adoption. The Company does not believe this will have a material impact on its consolidated financial statements. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain parts of this Quarterly Report on Form 10-Q, including the "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Legal Proceedings," may contain forward-looking statements that involve risks and uncertainties. Statements that are not historical fact are forward-looking statements within the meaning of the Federal securities laws. These statements are based on current expectations, estimates and projections about the industries in which we operate and management's beliefs, and assumptions. Specifically, any resolution of pending litigation matters, the amount and timing of future sales, research and development expenses and results, industry demand, and competitive pressures could vary greatly and affect the results of operations. Readers should refer to the information under the caption "Risk Factors" in this Quarterly Report concerning certain factors that could cause our actual results to differ materially from the results anticipated in such forward-looking statements and in our most recent Annual Report on Form 10-K filed with the Securities and Exchange Commission. OVERVIEW We provide comprehensive yield-optimization solutions to the semiconductor industry and flat-panel display manufacturers. We license our software products and sell related services through our direct sales force, distributors and sales agents. Since July 2002, we experienced a significant period of transition as a result of our investigation into financial and accounting irregularities which ultimately led to a restatement of our financial statements for the years ended March 31, 2001 and 2002, and the litigation discussed above in Note 2 to the Condensed Consolidated Financial Statements. In our year ended March 31, 2003, senior management was focused on determining the impact of the financial restatement on our business going forward, integrating previously acquired businesses and cutting costs to reflect the level of sales activities we were experiencing. In our year ended March 31, 2004, we began to hire a new management team, filling senior positions with the hiring of a new Chief Executive Officer, Vice President of Software Development, Vice President of Marketing and Vice President of Business Development. With the new management team in place, we have shifted our focus and resources to better integrate our yield analysis software capabilities with our TestChip solutions to more effectively compete in the DFM market segment. This has resulted in a decrease in our revenue in the year ended March 31, 2004 from the year ended March 31, 2003. 13 Since going public in 2001, we have not achieved profitability on a quarterly or annual basis. At December 31, 2004, we had $5.1 million in cash, cash equivalents and short term investments and an accumulated deficit of $105.8 million. As we continue to strive to build our customer base and further develop new products, we expect to continue to incur net operating losses at least through our year ending March 31, 2005. We will need to generate significantly higher revenues in order to support research and development, sales and marketing and general and administrative expenses, and to achieve and maintain profitability. Our ability to generate higher revenues may continue to be impacted by our litigation, the capital spending trends of our potential and current customers in the semiconductor industry, the lead time to get our new products to market and our ability to compete in our market segment. See "Liquidity and Capital Resources" below. In the three and nine months ended December 31, 2004 and 2003, a relatively small number of customers accounted for a large portion of our revenue, and the composition of these customers' changes from period to period. This is because our products have a lengthy sales cycle and are characterized by large license fees or engagement contracts. During the three months ended December 31, 2004 and December 31, 2003, three customers and two customers, accounted for 57% and 28% of our revenues, respectively. During the nine months ended December 31, 2004 and December 31, 2003, three customers and two customers, accounted for 44% and 34% of our revenues, respectively. CRITICAL ACCOUNTING POLICIES The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, goodwill and identifiable, separately recorded intangible assets, litigation, contingent liabilities and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Our estimates then form the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe there have been no significant changes in our critical accounting estimates during the nine months ended December 31, 2004 as compared to what was previously disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended March 31, 2004. RECENT ACCOUNTING PRONOUNCEMENTS In September 2004, the EITF delayed the effective date for the recognition and measurement guidance previously discussed under EITF Issue No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-01") as included in paragraphs 10-20 of the proposed statement. The proposed statement will clarify the meaning of other-than-temporary impairment and its application to investments in debt and equity securities, in particular investments within the scope of FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and investments accounted for under the cost method. We are currently evaluating the effect of this proposed statement on our financial position and results of operations. In December 2004, the FASB issued SFAS No. 123(R) (revised 2004),"Share-Based Payment." This Statement is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes APB Opinion No.25, "Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123(R) requires that compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. This statement is effective beginning with our quarter ending September 30, 2005. We are currently evaluating the requirements of SFAS No. 123(R) and although we believe the impact to our financial statements will be in a similar range as the amounts presented in our pro forma financial results required to be disclosed under the current SFAS No. 123, we have not yet fully determined its impact on our consolidated financial statements. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 20, Accounting for Non-monetary Transactions." The amendments made by this Statement are based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. This Statement also eliminates the exception for non-monetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of non-monetary assets that do not have commercial substance. We are required to adopt the provisions of this Statement beginning April 1, 2006 for all non-monetary asset exchanges and we will apply its provisions prospectively upon adoption. We do not believe this will have a material impact on our consolidated financial statements. 14 RESULTS OF OPERATIONS Comparison of the three and nine months ended December 31, 2004 and 2003 Revenues. Total revenues decreased to $2.9 million in the three months ended December 31, 2004 from $3.5 million in the three months ended December 31, 2003, or a decrease of 17%. Total revenues decreased to $7.8 million in the nine months ended December 31, 2004 from $8.9 million in the nine months ended December 31, 2003, or a decrease of 12%. Our sales cycle for the license of our software products has historically been very long as our customers spend a significant amount of time evaluating our products. The decrease in revenue is primarily due to a decline in customer orders during the three months ended December 31, 2004 compared to the corresponding three months ended December 31, 2003. Customer purchase orders typically include integration and installation services and acceptance criteria. As such, we defer a significant amount of our license revenue until integration and installation services are complete, rights of return lapse and final acceptance occurs. The amount of our license revenue is currently at levels that have resulted in no meaningful trend from period to period, and our ability to sell our products in the future may be adversely affected by our pending lawsuits. Our revenues were highly concentrated. During the three months ended December 31, 2004 and December 31, 2003, three customers and two customers, accounted for 57% and 28% of our revenues, respectively. During the nine months ended December 31, 2004 and December 31, 2003, three customers and two customers, accounted for 44% and 34% of our revenues, respectively. Software license revenue decreased to $1.1 million in the three months ended December 31, 2004 from $1.7 million in the three months ended December 31, 2003. Software license revenue decreased to $2.8 million in the nine months ended December 31, 2004 from $3.7 million in the nine months ended December 31, 2003. The decrease in our license revenue during the three and nine months ended December 31, 2004 is primarily due to a decline in new licenses during the three and nine months ended December 31, 2004 compared with the three and nine months ended December 31, 2003. Consulting services, maintenance and other revenues decreased slightly to $1.7 million in the three months ended December 31, 2004, from $1.8 million in the three months ended December 31, 2003. Consulting services, maintenance and other revenues decreased slightly to $5.0 million in the nine months ended December 31, 2004, from $5.2 million in the nine months ended December 31, 2003. Gross profit. As a percentage of revenues, gross profit decreased to 69% for the three months ended December 31, 2004 from 82%, for the three months ended December 31, 2003. As a percentage of revenues, gross profit decreased to 69% for the nine months ended December 31, 2004 from 73%, for the nine months ended December 31, 2003. Gross profit has been and will continue to be affected by a variety of factors, the most important of which is the relative mix of revenues in the period among software licenses, maintenance fees and consulting services. Research and development. Research and development expenses represented 54% of revenues in the three months ended December 31, 2004, compared to 42% of revenues in the three months ended December 31, 2003. Research and development expenses represented 62% of revenues in the nine months ended December 31, 2004, compared to 55% of revenues in the nine months ended December 31, 2003. Actual costs remained flat at $1.5 million for the three months ended December 31, 2004, and 2003. Actual costs remained flat at $4.9 million for the nine months ended December 31, 2004 and 2003. Salaries and related benefits of research and development engineers represent the single largest component of our research and development expenses. We expect our research and development expenses to remain relatively stable for the foreseeable future. Sales, general and administrative. Sales, general and administrative expenses for the three months ended December 31, 2004 were $1.9 million, or 68% of revenues, compared to $3.2 million, or 92% of revenues in the three months ended December 31, 2003. The decrease in costs was primarily due to decreases in staff in the amount of approximately $600,000 and lower professional fees associated with our pending litigation in the amount of approximately $700,000. Sales, general and administrative expenses for the nine months ended December 31, 2004 were $6.3 million, or 80% of revenues, compared to $11.5 million, or 130% of revenues in the nine months ended December 31, 2003. The decrease in costs was primarily due to decreases in staff in the amount of approximately $1.2 million and lower professional fees associated with our pending litigation in the amount of approximately $2.4 million. 15 Stock-based compensation. Stock-based compensation expense for the three months ended December 31, 2004 decreased to $12,000, compared with $117,000 for the three months ended December 31, 2003. Stock-based compensation expense for the nine months ended December 31, 2004 decreased to $36,000, compared with $245,000 for the nine months ended December 31, 2003. The decrease was primary a result of reversing previously expensed stock-based compensation that was being amortized on an accelerated basis that was not earned by certain terminated employees during the three and nine months ended December 31, 2004. Amortization of intangible assets. Amortization of intangible assets was $332,000 in the three months ended December 31, 2004 and December 31, 2003. Amortization of intangible assets was $995,000 in the nine months ended December 31, 2004 and the nine months ended December 31, 2003. The estimated quarterly amortization of intangible assets will be $186,000 in the quarter ending March 31, 2005. Interest income (expense) and other, net. Interest income, net of interest and other expenses for the three months ended December 31, 2004, was $25,000, compared to $39,000 for the three months ended December 31, 2003. Interest income, net of interest and other expenses for the nine months ended December 31, 2004, was $117,000 compared to $135,000 for the nine months ended December 31, 2003. The decrease was due to lower interest income from lower average balances of cash, cash equivalents and short-term investments during the three months ended December 31, 2004. Provision for income taxes. In the three and nine months ended December 31, 2004 and 2003, we incurred operating losses for which we have recorded valuation allowances for the full amount of our net deferred tax assets, because the future realization of the deferred tax assets was not likely as of December 31, 2004 and 2003. Our income tax provision of $9,000 in the three months ended December 31, 2004 was primarily from the Company's international subsidiaries payable to the local jurisdictions. Our income tax benefit of $135,000 in the nine months ended December 31, 2004 was primarily due to a tax refund resulting from filing an amended income tax return for the prior year which was never recorded as a receivable in prior period financial statements. LIQUIDITY AND CAPITAL RESOURCES Our financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Accordingly, the financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary if we are unable to continue as a going concern. We have experienced net losses and negative cash flows since going public in July 2001 and as of December 31, 2004 we had an accumulated deficit of $105.8 million. We expect to have a net operating loss in our year ending March 31, 2005. For the nine months ended December 31, 2004 cash used in operations and to fund capital expenditures was $5.1 million. Our continuing losses raise doubt about our ability to continue as a going concern unless we increase our revenues or raise additional capital. At December 31, 2004, we had approximately $5.1 million in cash and cash equivalents and short-term investments. Our current operating plan for the year ending March 31, 2005 projects that cash available from planned revenue combined with the $5.1 million in cash and cash equivalents and short-term investments on hand at December 31, 2004 will be adequate to fund operations through March 31, 2005; however, there can be no assurance that the current cash and short-term investments on hand combined with the projected revenues will be adequate to sustain operations beyond March 31, 2005. Our future cash position will be adversely affected by slow or diminished revenue growth, research and development expenses, additional sales and marketing costs and higher general and administrative expenses, such as professional fees associated with the litigation. Although we intend to seek additional funds to support our future operations, there is no assurance that we will be able to raise such funds on terms acceptable to us, or at all, until all of our pending litigation discussed in Note 2 to our Condensed Consolidated Financial Statements is resolved. If we are unable to raise adequate capital to fund our future operations, we may need to curtail our operations and seek other strategic alternatives. Net cash used in operating activities was $4.9 million for the nine months ended December 31, 2004, compared to $9.0 million used in operating activities for the nine months ended December 31, 2003, mainly due to a lower operating loss and higher accounts receivable collection during the nine months ended December 31, 2004. Net cash provided by investing activities was $1.4 million for the nine months ended December 31, 2004, compared to $4.5 million used in operating activities for the nine months ended December 31, 2003. The cash provided by investing activities for the nine months ended December 31, 2003 consisted primarily of the sale of marketable securities in the amount of $1.8 million. Net cash used in financing activities was $68,000 for the nine months ended December 31, 2004. Net cash used in financing activities was $1.8 million for the nine months ended December 31, 2003, mainly due to the repayment of our $1.5 million convertible debenture and $281,000 in payments of capital lease obligations. 16 We have commitments that will expire at various times through 2010. We lease offices and certain property and equipment under non-cancelable operating leases that will expire in 2010 with certain renewal options. Otherwise, we have no other significant contractual obligations or commitments that were not recorded in our financial statements. At December 31, 2004, a summary of our contractual commitments is as follows:

Overall, we used $2.0 million of cash, cash equivalents, and short-term investments during the three months ended December 31, 2004. We estimate that we will continue to use cash through our year ending March 31, 2005 to fund operating losses. RISK FACTORS RISKS ASSOCIATED WITH OUR BUSINESS We need to increase revenues, reduce costs or raise additional capital to fund our operating activities. We currently are able to pay our debts and meet our obligations as they become due, and we believe that our existing capital resources will be sufficient to satisfy our current and projected funding requirements through March 31, 2005. Although these estimates reflect our current expectations, it is possible that our actual expenditures could exceed these estimates, or that our revenues could fall short of expectations, which, in either case, would shorten the time during which we could fund our operations. We intend to seek additional funding to support our future operations through public or private sales of our equity or debt securities. However, our pending securities litigation raises uncertainty regarding the financial condition and long term viability of the Company. Until these matters are resolved, it may be difficult for the Company to raise additional capital on terms acceptable to the Company, or at all. If we are unable to obtain additional funds to support our operations, we may need to reduce or curtail our operations, and you may lose your investment in our company. We expect to issue shares of common stock in settlement of our pending litigation matters and any such issuances could be highly dilutive to our existing investors. We are currently attempting to settle our pending litigation matters and, in an effort to preserve operating capital, we expect to issue shares of common stock to the plaintiffs in these actions. We recently entered into settlements in the Securities Class Action and the Covalar Action whereby we have agreed to issue approximately 7 million new shares of common stock to the plaintiffs. The settlement of our other pending litigation matters will likely result in additional stock issuances, which could be dilutive to our existing stockholders and could depress our stock price. An investment in our securities is highly speculative. We have sustained a substantial decline in the value of our securities since announcing the accounting and financial inaccuracies in our previously filed financial statements for the years ended March 31, 2001 and 2002 and our securities have been delisted from the Nasdaq National Market System. We have also been named in a number of lawsuits. The ultimate cost and effect of these matters on the financial condition, results of operations, customer relations and management of the Company is unknown at this time. If the Company is unsuccessful in defending itself in these actions, we may face significant damage awards that could materially impair our liquidity and results of operations Accordingly, an investment in our securities is highly speculative and should not be made unless you are prepared to lose your entire investment. The restatement of our financial statements and pending securities litigation may raise concerns among our customers regarding our long-term stability. These concerns may adversely affect future sales. Customers who purchase our software products make a significant long-term investment in our technology. Our products often become an integral part of each installed fabrication facility and our customers look to us to provide continuing support, enhancements and new versions of our products. 17 Because of the long-term nature of an investment in yield optimization software, customers are often concerned about the stability of their suppliers. Our restatement, the pending securities litigation and our limited cash reserves may cause current and potential customers concern over our stability and these concerns may cause us to lose sales. Any loss in sales could adversely affect our results of operations, further deepening concern among current and potential customers. Although we have an obligation to indemnify our officers and directors and underwriters, we may not have insurance coverage available for this purpose and may be forced to pay these indemnification costs directly. Our charter and bylaws require that we indemnify our directors and officers to the fullest extent provided by applicable law. In addition, the Underwriting Agreement with our underwriters for our initial public offering requires us to indemnify the underwriters in certain instances. Although we have purchased directors and officers liability insurance to fund such obligations, our insurance carriers have notified us that coverage may not be available. If our insurance carriers are able to deny coverage, we would be forced to bear these indemnification costs directly, which could be substantial and may have an adverse effect on our results of operations and liquidity. Our stock is currently only traded in the over the counter market. Our stock is currently traded in the over the counter market or "pink sheets." Stocks trading in this market typically suffer significantly lower volume (liquidity) and lower share prices. As a result, you may have difficulty selling shares of our stock and larger sales affected over the pink sheets could significantly depress our stock price. We currently have only three directors and believe we will have difficulty attracting qualified candidates to serve on our board. Our failure to add additional directors could adversely impact the management of our company, our compliance with securities laws and our future exchange listing eligibility. Since July 2002, two of our directors resigned from the board of directors of the Company, leaving only three directors. We have begun searching for candidates to fill these vacancies. However, in light of the restatement of our financial statements and the pending securities litigation, we believe we will have difficulty attracting qualified individuals to serve on our board. Our inability to attract and retain qualified independent directors may adversely affect the quality of our management and may make it more difficult for us to comply with corporate governance requirements of the securities exchanges, such as NASDAQ and those imposed by the Securities and Exchange Commission pursuant to the Sarbanes-Oxley Act of 2002. The semiconductor industry has experienced downturns in the past and any future downturns could adversely affect our revenues and operating results. Our business depends in part on the economic health of our customers: IDMs, or integrated device manufacturers, fabless semiconductor companies, and semiconductor equipment OEMs, or original equipment manufacturers. The semiconductor industry is prone to periods of oversupply resulting in significantly reduced capital expenditures. As a result of slowdowns, some semiconductor manufacturers have postponed or canceled capital expenditures for previously planned expansions or new fabrication facility construction projects, resulting in a substantial decline in worldwide semiconductor capital expenditures. Current conditions and future downturns could affect the willingness of semiconductor companies to purchase our yield-optimization products and services. Significant downturns could materially and adversely affect our business and operating results. In addition, we expect to continue increasing our investment in engineering, research and development, and marketing, which limits our ability to reduce expenses during such downturns. In any particular period, we derive a substantial portion of our revenues from a small number of customers, and our revenues may decline significantly if any major customer cancels or delays a purchase of our products. In each of the years ended March 31, 2004, 2003, and 2002, customers that individually accounted for at least 10% of our revenues together represented 42%, 61% and 66% of our revenues, respectively, and in each of these years, there was substantial change among the companies that represented our largest customers. In the nine months ended December 31, 2004, sales to three customers accounted for 17%, 16% and 11%, respectively, of our revenues. Because we derive most of our revenues from a few customers and because our existing customers' needs for additional products are based on intermittent events, such as the introduction of new technologies or processes, building of new facilities or the need to increase capacity of existing facilities, our largest customers change from period to period. Delays or failures in selling new licenses to existing or new customers would cause significant period-to-period changes in our operating results, which may result in our failure to meet market expectations. We may also incur significant expense and devote management attention to the pursuit of potentially significant license revenues, but ultimately fail to secure these revenues. 18 We must continually replace the revenues generated from the sale of licenses and one-time orders to maintain and grow our business. Over the past year, we have generated the bulk of our revenues from sales of one-time customer orders. These licenses and orders produce large amounts of revenues in the periods in which the license fees are recognized and are not necessarily indicative of a commensurate level of revenues from the same customers in future periods. Achieving period-to-period growth will depend significantly on our ability to expand the number of users of our products within our customers' organizations, license additional software to our customers and attract new customers. We may not be successful in these sales efforts and, consequently, revenues in any future period may not match that of prior periods. We have a long and variable sales cycle, which can result in uncertainty and delays in generating additional revenues and results in potentially significant fluctuations in revenues from period to period. Because our yield optimization software and services are often unfamiliar to our prospective customers, it can take a significant amount of time and effort to explain the benefits of our products. This means that we may spend substantial time and management attention on potential licenses that are not consummated, thereby foregoing other opportunities. In addition, due to the nature of fabrication facility deployment and the extended time required to bring a fabrication facility to full capacity, capital expenditures vary greatly during this time. Accordingly, we may be unable to predict accurately the timing of any significant future sales of software licenses, which has significantly affected, and will continue to significantly affect quarterly operating results. Additional factors that could cause our revenues and operating results to vary from period to period include: o large sales unevenly spaced over time; o timing of new products and product enhancements by us and our competitors; o the cyclical nature of the semiconductor industry; o changes in our customers' development schedules, expenditure levels and product support requirements; and o incurrence of sales and marketing and research and development expenses that may not generate revenues until subsequent quarters. As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and may not be accurate indicators of future performance. These factors may cause our operating 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 in developing new products and our operating results may decline as a result. Our customers and competitors operate in rapidly evolving markets that are characterized by introduction of new technologies and more complex designs, shorter product life cycles and disaggregation of the industry into new subsectors. For example, ever smaller geometries are being used in semiconductors and new materials are being employed to enhance performance. We must continually create new software and add features and functionality to our existing software products to keep pace with these changes in the semiconductor industry. Specifically, we need to focus our research and development to: o interface with new semiconductor producing hardware and systems that others develop; o remain competitive with companies marketing third party yield management software and consulting services; o continue developing new software modules that are attractive to existing customers, many of which have purchased perpetual licenses and are under no ongoing obligation to make future purchases from us; and o attract new customers to our software. Maintaining and capitalizing on our current competitive strengths will require us to invest heavily in research and development, marketing, and customer service and support. Although we intend to devote substantial expenditures to product development, we may not be able to create new products in a timely manner that adequately meet the needs of our existing and potential customers. A failure to do so would adversely affect our competitive position and would result in lower sales and a decline in our profitability. Our competitors generally have greater resources and our failure to effectively compete against other companies could impair our growth and profitability. 19 We target IDMs, fabless semiconductor companies, foundries and flat panel display manufacturers. The tools and systems against which our products and services most commonly compete are those that semiconductor companies have created in house. In order to grow our business, we must convince these producers of the benefit of an outside solution. The third party providers against whom we compete are, generally, divisions of larger semiconductor equipment OEMs, such as KLA-Tencor. These companies can compete on the basis of their greater financial, engineering and manufacturing resources, and their long-standing relationships with the same companies we are targeting. If we cannot compete successfully against these forms of competition, the growth of our business will be impaired. Errors in our products or the failure of our products to conform to specifications could hurt our reputation and result in our 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 point in a product's lifecycle. We have a team dedicated to detecting errors in our products prior to their release in order to enable our software developers to remedy any such errors. In the past we have discovered errors in some of our products and have experienced delays in the delivery of our products because of these errors. In addition, we have software engineers and developers who participate in the maintenance and support of our products and assist in detecting and remedying errors after our products are sold. These delays and replacements have principally related to new product releases. Detection of any significant errors may result in: o the loss of, or delay in, market acceptance and sales of our products; o the delay or loss of revenues; o diversion of development resources; o injury to our reputation; or o increased maintenance and warranty costs. Any of these problems could harm our business and operating results. If our products fail to conform to specifications, customers could demand a refund for the purchase price or assert claims for damages. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. Any such claims, whether or not successful, could seriously damage our reputation and our business. We may incur non-cash charges resulting from acquisitions and equity issuances, which could harm our operating results. We incurred $9.1 million in charges related to our estimated cost of settling our litigation described in Note 2 to the condensed consolidated financial statements based on the estimated value of the new shares of our stock we have agreed to issue and expect to issue. We may incur additional charges related to settling these matters as we revalue the accrual for issuances quarterly until the shares are actually issued. We incurred a $30.6 million goodwill impairment charge in the fourth quarter of our year ended March 31, 2003. We will continue to incur charges to reflect amortization and any future impairment of identified intangible assets acquired in connection with our acquisitions of FabCentric, Covalar and DYM, and we may make other acquisitions or issue additional stock or other securities in the future that could result in further accounting charges. In the future, we may incur additional impairment charges related to the goodwill already recorded, as well as goodwill arising out of any future acquisitions. Current and future accounting charges like these could result in significant losses and delay our achievement of net income. Terrorist activities and resulting military and other actions could adversely affect our business. Terrorist attacks in New York, Pennsylvania and Washington, D.C. in September 2001 disrupted commerce throughout the United States and other parts of the world. The continued threat of terrorism within the United States and abroad, and the potential for military action and heightened security measures in response to such threats, may cause significant disruption to commerce throughout the world. To the extent that such disruptions result in delays or cancellations of customer orders, a general decrease in corporate spending, or our inability to effectively market, sell or operate our services and software, our business and results of operations could be materially and adversely affected. We rely on our employees for their scientific, technical and management experience in connection with our business operations. Our employees are vital to our success, and our key management, engineering and other employees are difficult to replace. We generally do not have employment contracts with our key employees. Further, we do not maintain key person life insurance on any of our employees. The expansion of high technology companies worldwide has increased the demand and competition for qualified personnel. If we are unable to retain key personnel, or if we are not able to attract, assimilate or retain additional highly qualified employees to meet our needs in the future, our business and operations could be harmed. These factors could seriously harm our business. 20 RISKS RELATED TO OUR INTERNATIONAL OPERATIONS Our business could be harmed by political or economic instability in the Republic of Armenia. Some of our software products are largely developed, produced, delivered and supported from our facilities in the Republic of Armenia. Changes in the political or economic conditions in Armenia and the surrounding region, such as fluctuations in exchange rates, the imposition of currency transfer restrictions or limitations, or the adoption of burdensome trade or tax policies, procedures, rules, regulations or tariffs, could adversely affect our ability to develop new products and take advantage of Armenia's low labor and production costs, and to otherwise conduct business effectively in Armenia. Armenia voted for independence in 1991 and adopted its current constitution in 1995. Laws protecting property (including intellectual property) are not well established and may be difficult to enforce. In recent years, Armenia has suffered significant political and economic instability. Any future political and economic instability could interfere with our ability to retain or recruit employees, significantly increase the cost of our operations, or result in regulatory restrictions on our business, making it difficult for us to maintain our business in Armenia or disrupting our Armenian operations. Any significant increase in the costs of our Armenian operations (whether due to inflation, imposition of additional taxes or other causes) would diminish, and could eliminate their current cost-advantages. Furthermore, we cannot assure you that restrictive foreign relations laws or policies on the part of Armenia or the United States will not constrain our ability to operate effectively in both countries. If we lose or choose to terminate any part of our Armenian operation, replacements could be costly and we could experience delays in our product development, thereby harming our competitive position and adversely affecting our results of operations. Our expansion into international markets may result in higher costs and could reduce our operating margins due to the higher costs of international sales. Our current strategy for growth includes further expansion in Asia, Europe, and other international markets. To effectively further this strategy, we must find additional partners to sell our products in international markets and expand our direct international sales presence. We would likely incur higher sales costs by expanding our direct sales staff abroad, but we might not realize corresponding increases in revenues or profitability. Furthermore, we may be forced to share sales revenues with distributors or other sales partners abroad in order to successfully penetrate foreign markets. Even if we successfully expand our direct and indirect international sales efforts, we cannot be certain that we will be able to create or increase international market penetration or demand for our products. Problems with international business operations could adversely affect our sales. Sales to customers located outside the United States accounted for approximately 53%, 36% and 30% of our revenues in the years ended March 31, 2004, 2003 and 2002, respectively. We anticipate that sales to customers located outside the United States will represent a significant portion of our total revenues in future periods. In addition, many of our customers rely on third party foundries operating outside of the United States. Accordingly, our operations and revenues are subject to a number of risks associated with foreign commerce, including the following: o managing foreign distributors; o maintaining relationships with foreign distributors; o staffing and managing foreign branch offices; o political and economic instability abroad; o foreign currency exchange fluctuations; o changes in tax laws and tariffs; o timing and availability of export licenses; o inadequate protection of intellectual property rights in some countries; and o obtaining governmental approvals for certain technologies. Any of these factors could result in decreased sales to international customers and domestic customers that use foreign fabrication facilities. Our accounts receivable from international customers are generally outstanding longer than our domestic receivables and, as a result, we may need a proportionately greater amount of working capital to support our international sales. 21 INTELLECTUAL PROPERTY RELATED RISKS Our success depends in part on our ability to protect our intellectual property, and any inability to do so could cause our business material harm. Our success depends in significant part on our intellectual property. While we have attempted to protect our intellectual property through patents, copyrights, or the maintenance of trade secrets, there can be no assurance that these measures will successfully protect our technology or that competitors will not be able to develop similar technology independently. It is possible, for example, that the claims we are allowed on any of our patents will not be sufficiently broad to protect our technology. In addition, patents issued to us could be challenged, invalidated or circumvented and the rights granted under those patents might not provide us with any significant competitive advantage. The laws of some foreign countries do not protect our intellectual property as effectively as the laws of the United States. Also, our source code developed in Armenia may not receive the same copyright protection that it would receive if it was developed in the United States. As we increase our international presence, we expect that it will become more difficult to monitor the development of competing products that may infringe on our rights as well as unauthorized use of our products. Our operating results would suffer if we were subject to a protracted intellectual property infringement claim or one with a significant damages award. Litigation regarding intellectual property rights frequently occurs in the software industry. We may be subject to infringement claims as the number of competitors in our industry segment grows. While we are unaware of any claims that our products infringe on the intellectual property rights of others, such claims may arise in the future. Regardless whether these claims have merit, they could: o be costly to defend; o divert senior management's time, attention and resources; o cause product shipment delays; and o require us to enter into costly licensing or royalty arrangements. Any of these potential results of intellectual property infringement claims could limit our ability to maintain our business and negatively affect our operating results. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK In the normal course of business, our financial position is subject to a variety of risks, including market risk associated with interest rate and foreign currency exchange movements. We regularly assess these risks and have established policies and business practices to protect against these and other exposures. As a result, we do not anticipate material potential losses in these areas. Interest Rate Risk We invest excess cash in debt instruments of the U.S. Government and its agencies, and in high quality corporate issuers and, limit the amount of credit exposure to any one issuer. Our investments in fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates. We believe that a change in long-term interest rates would not have a material effect on our business, financial condition results of operations or cash flow. Our cash and cash equivalents consist of cash and highly liquid money market instruments with original or remaining maturities of 90 days or less. Because of the short maturities of these instruments, a sudden change in market interest rates would not have a material impact on the fair value of the portfolio, but it may cause the amount of income we derive to vary significantly from period to period. A hypothetical 10% increase in interest rates would result in an approximate $4,000 decrease in the fair value of our available-for-sale securities as of December 31, 2004. Foreign Exchange Risk Our foreign sales are primarily denominated in U.S. dollars and, as a result, we have relatively little exposure to foreign currency exchange risk with respect to revenues. Our sales through our Japanese subsidiary, which represented approximately 16% and 9% of total revenues for the three months and nine months ended December 31, 2004, are denominated in Yen. A 10% adverse change in Yen exchange rates would not have had a material impact on revenues for the three months ended December 31, 2004. 22 While our foreign sales are generally denominated in U.S. dollars, our international subsidiaries' books and records are maintained in the local currency. As a result, our financial statements are remeasured in U.S. dollars using a combination of current and historical exchange rates. The functional currencies of our foreign subsidiaries are their local currencies. We translate certain assets and liabilities to U.S. dollars at the current exchange rate as of the applicable balance sheet date. Revenues and expenses are translated at the average exchange rates prevailing during the period. Adjustments resulting from the translation of the foreign subsidiaries' financial statements are recorded in accumulated other comprehensive income (loss) in stockholders' equity. 23 ITEM 4. CONTROLS AND PROCEDURES CEO and CFO Certifications Attached as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q are certifications of our Chief Executive Officer and Chief Financial Officer. The certifications are required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. This section of the Quarterly Report on Form 10-Q contains the information concerning the disclosure controls and procedures evaluation referred to in the Section 302 certifications and this information should be read in conjunction with the Section 302 certifications for a more complete understanding of the topics presented. Disclosure Controls and Internal Controls Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, or the Exchange Act, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure. Internal controls are procedures which are designed with the objective of providing reasonable assurance that our transactions are properly authorized, our assets are safeguarded against unauthorized or improper use and our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with generally accepted accounting principles. Limitations on the Effectiveness of Controls Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls or our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within HPL have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Scope of the Controls Evaluation At the end of the period covered by this report (the "Evaluation Date"), the Company's Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the Company's disclosure controls and procedures. The evaluation of our disclosure controls included a review of disclosure controls implemented by HPL and the effect of the controls on the information generated for use in this Quarterly Report on Form 10-Q. In the course of the controls evaluation, we sought to identify data errors, weaknesses in the control system or acts of fraud and to confirm that appropriate corrective action, including process improvements, if any, were being undertaken. This type of evaluation will be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our quarterly reports on Form 10-Q and our Annual Report on Form 10-K. The overall goals of these various evaluation activities are to monitor our disclosure controls and to make modifications as necessary; our intent in this regard is that the disclosure controls will be maintained as dynamic systems that change (with improvements and corrections) as conditions warrant. Among other matters, we sought in our evaluation to determine whether there were any significant deficiencies or material weaknesses in our disclosure controls, or whether we had identified any acts of fraud involving personnel who have a significant role in our disclosure controls. This information was important both for the controls evaluation generally and because the Section 302 certifications of the Chief Executive Officer and the Chief Financial Officer require that the Chief Executive Officer and the Chief Financial Officer disclose that information to our board's audit committee and to our independent auditors and to report on related matters in this section of the Quarterly Report on Form 10-Q. We also sought to deal with other controls matters in the controls evaluation and, in each case if a problem was identified, we considered what revision, improvement, and/or correction to make in accordance with our ongoing procedures. In accordance with SEC requirements, the Chief Executive 24 Officer and the Chief Financial Officer note that, since the date of the controls evaluation to the date of this Quarterly Report on Form 10-Q, there have been no significant changes in disclosure controls or in other factors that could significantly affect our disclosure controls, including any corrective actions with regard to significant deficiencies and material weaknesses. Conclusions Based upon the disclosure controls evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that, subject to the limitations noted above, our disclosure controls are effective to ensure that material information relating to HPL is made known to management, including our Chief Executive Officer and Chief Financial Officer, particularly during the period when our periodic reports are being prepared, and that our disclosure controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with generally accepted accounting principles. There were no significant changes in the Company's disclosure controls, or to the Company's knowledge, in other factors that could significantly affect the Company's disclosure controls and procedures subsequent to the Evaluation Date. 25 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The information set forth in Note 2 to the Condensed Consolidated Financial Statements appearing in this report is incorporated herein by reference. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None ITEM 6. EXHIBITS Exhibit Number Description ------- ----------------------------------------------------------------------- 31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 26 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HPL Technologies, Inc. Date: February 14, 2005 By: /s/ CARY D. VANDENBERG ------------------------------------------- Cary D. Vandenberg President and Chief Executive Officer 27 EXHIBIT INDEX Exhibit Number Description ------- ----------------------------------------------------------------------- 31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 28 Exhibit 31.1 CERTIFICATION I, Cary D. Vandenberg, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of HPL Technologies, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 14, 2005 /s/ Cary D. Vandenberg --------------------------------- Cary D. Vandenberg President and Chief Executive Officer 29 Exhibit 31.2 CERTIFICATION I, Michael P. Scarpelli, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of HPL Technologies, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 14, 2005 /s/ Michael P. Scarpelli ---------------------------------- Michael P. Scarpelli Chief Financial Officer 30 Exhibit 32.1 CERTIFICATION PURSUANT TO SECTIONS 906 OF THE SARBANES-OXLEY ACT OF 2002 The undersigned hereby certifies that, in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, in his capacity as an officer of HPL Technologies, Inc. that this quarterly report on Form 10-Q (the "Report") fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, and that the information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of HPL Technologies, Inc. Date: February 14, 2005 /s/ CARY D. VANDENBERG ------------------------------------- Cary D. Vandenberg President and Chief Executive Officer The foregoing certification (the "Certification") is being furnished solely pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code). A signed original of the Certification has been provided to the Company and will be retained by the Company in accordance with Rule 12b-11(d) of the Act and furnished to the Securities and Exchange Commission or its staff upon request. 31 Exhibit 32.2 CERTIFICATION PURSUANT TO SECTIONS 906 OF THE SARBANES-OXLEY ACT OF 2002 The undersigned hereby certifies that, in accordance with 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, in his capacity as an officer of HPL Technologies, Inc. that this quarterly report on Form 10-Q (the "Report") fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, and that the information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of HPL Technologies, Inc. Date: February 14, 2005 /s/ Michael P. Scarpelli ------------------------------------- Michael P. Scarpelli Chief Financial Officer The foregoing certification (the "Certification") is being furnished solely pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code). A signed original of the Certification has been provided to the Company and will be retained by the Company in accordance with Rule 12b-11(d) of the Act and furnished to the Securities and Exchange Commission or its staff upon request. 32

HPL TECHNOLOGIES INC 10-Q