HPL TECHNOLOGIES INC - 10-Q Quarterly Report

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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 June 30, 2003

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 July 31, 2003, the registrant had outstanding 31,206,622 shares
of common stock.

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PART I - FINANCIAL INFORMATION

ITEM 1 - CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

HPL Technologies, Inc.
Notes to unaudited Condensed Consolidated Financial Statements
NOTE 1. GENERAL

The unaudited condensed consolidated financial statements have been
prepared by HPL Technologies, Inc., a Delaware corporation (the "Company"),
pursuant to the rules and regulations of the Securities and Exchange Commission
("SEC"). Certain information and footnote disclosures normally included in
consolidated financial statements prepared in accordance with accounting
principles generally accepted in the United States have been condensed or
omitted pursuant to such rules and regulations. These unaudited condensed
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements and the notes thereto for the year ended March
31, 2003 included in the Company's Annual Report on Form 10-K filed with the
SEC. In the opinion of management, all adjustments (consisting only of normal
recurring adjustments) necessary to present a fair statement of financial
position as of June 30, 2003 and 2002, and results of operations and cash flows
for the three months ended June 30, 2003 and 2002, have been made. The results
of operations for the three months ended June 30, 2003 are not necessarily
indicative of the operating results for the full fiscal year or any future
periods.

The preparation of condensed consolidated financial statements in
conformity with generally accepted accounting principles in the United States of
America requires management to make estimates and assumptions that
affect the amounts reported in the financial statements. These estimates may
affect the amounts of assets and liabilities reported in the balance sheet, the
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expense during the periods
presented. Actual results may differ from those estimates.

The Company has funded its losses from operations principally through
its July 2001 initial public offering and debt financing. Management believes
the Company has sufficient cash, cash equivalents and short-term investments to
fund its operations through at least March 31, 2004. Future cash 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. In
the event the Company needs to raise capital, there is no assurance that funds
would be available to the Company or, if available, under terms that would be
acceptable to the Company. The Company does not believe 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, fourteen class-action
lawsuits were filed and are pending against the Company, certain current and
former officers and/or directors of the Company, and the Company's independent
auditors (collectively, the "Defendants") in the United States District Court
for the Northern District of California. The lawsuits allege that the Defendants
violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and
Rule 10b-5 promulgated thereunder by the SEC, 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. Several of the lawsuits further allege
violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933. 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 expects that these lawsuits will be consolidated into a
single action in the United States District Court for the Northern District of
California. Motions for appointment of a lead plaintiff are pending before the
Court.

The Company is also a nominal defendant in five stockholder derivative
lawsuits pending in Superior Court in the County of Santa Clara, California.
These lawsuits, which were filed between July 31, 2002 and September 30, 2002,
assert derivative claims on behalf of the Company against current and/or former
officers and directors of the Company and the Company's independent auditors.
The claims asserted in these lawsuits include insider trading, breach of
fiduciary duties, aiding and abetting breaches of fiduciary duties, negligence
and professional malpractice, negligent misrepresentation and omission,
contribution and indemnification, abuse of control, gross mismanagement, unjust
enrichment and breach of contract. These lawsuits 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. In an order
dated December 3, 2002, the Court consolidated these actions and appointed lead
plaintiff's counsel. The date for filing a consolidated complaint has been
continued to August 29, 2003.

Five shareholders of the Company have sued in state court of the
District Court of Dallas County, Texas, the Company's independent auditors and
the managing underwriter in the Company's initial public offering, in connection
with claims relating to the Company's acquisition of Covalar Technologies Group,
Inc. in February 2002. The Company has been named as a responsible third party
in this action for purposes of apportioning fault in jury findings; to date, no
claims have been brought against the Company. 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. While the Company had obtained insurance to
cover its obligation to indemnify and advance expenses to the underwriter, the
insurer has stated that it intends to rescind coverage to HPL for this claim,
but also stated that it might revisit this issue after reviewing certain
requested information. That information has been provided, but the insurer has
not yet informed the Company as to whether it will modify its position. If it
does not contest coverage, however, coverage for these indemnification
obligations is subject to a sub-limit of $1,000,000. Discovery is ongoing in the
lawsuit, and the Company's potential liability cannot be determined at this
time.

Five former shareholders of FabCentric, Inc., which was acquired by the
Company in December 2001, have sued the Company, the Company's former President
and CEO and former CFO, and the Company's independent auditors in a lawsuit
pending in Superior Court in the County of Santa Clara, California. This lawsuit
was filed on or about May 22, 2003. 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. No defendants have responded to the complaint yet. Because this
lawsuit was only recently filed, the Company has not evaluated the merits of
these allegations.

Additionally, in April 2003, UBS PaineWebber, Inc. filed suit against
the Company in the Supreme Court of the State of New York, County of New York
(the "New York Action") alleging tortius interference of contract and a
violation of the Uniform Commercial Code. This action relates to the transfer of
shares of HPL common stock putatively pledged to UBS PaineWebber, Inc. by Y.
David Lepejian, our former President and CEO, and his spouse and seeks, among
other things, mandatory injunctive relief requiring HPL to effect the transfer
of the subject stock. In May 2003, the Company filed an interpleader action in
United States District Court for the Northern District of California relating to
the New York Action. Mr. Lepejian and UBS PaineWebber are currently engaged in
an NASD arbitration proceeding regarding the pledge of the shares.

All of the aforementioned litigation matters are in the early stages.
As a result, the Company believes that no amount should be accrued for these
matters under SFAS No. 5, "Accounting for Contingencies," because we are
currently unable to evaluate the likelihood of an unfavorable outcome or an
estimate of the amount or range of potential loss, if any.

Any adverse resolution of the aforementioned litigation could have a
material effect on the Company's financial position, results of operations or
cash flows. The Company is investigating a number of alternatives, including
informal and formal restructuring, which potentially may dilute shareholder
equity but could mitigate any material adverse affect on our financial position
or results of operations which might otherwise result from an unfavorable
resolution of these lawsuits.

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, and shares issuable upon conversion of the
convertible debenture, computed using the if-converted method.

The total number of shares excluded from the calculation of diluted net loss per
share are 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 June 30, 2003, three customers
accounted for 31%, 19% and 14% of the Company's accounts receivable and unbilled
receivables combined. At June 30, 2002, three customers accounted for 38%, 17%
and 11% of the Company's accounts receivable and unbilled receivables combined.

For the three months ended June 30, 2003, the Company derived 52% of
its revenue from two end-user customers that individually represented 34% and
18% of the company's total.

For the three months ended June 30, 2002, the Company derived 55% of
its revenues from one end-user.

NOTE 5. COMPREHENSIVE LOSS

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 months ended June 30, 2003 and 2002,
comprehensive loss was $5.3 million and $7.5 million, respectively. The
difference between net loss and comprehensive loss for the three months ended
June 30, 2003, is the result of foreign currency transaction gains and losses
and the net unrealized gains and losses on available for sale securities in the
aggregate amount of loss of $8,000 and loss of $15,000, respectively. The
difference between net gain and comprehensive gain for the three months ended
June 30, 2002, is the result of foreign currency transaction gains and the net
unrealized gains on available for sale securities in the aggregate amount of
$112,000 and $83,000, respectively.

NOTE 6. ACCRUED LIABILITIES

NOTE 7. CONVERTIBLE DEBENTURE

In February 2000, the Company issued a $1.5 million convertible
debenture against which all of our principal operating subsidiary's assets were
pledged as security. The debenture bore interest at the rate of 8% per annum.
This debenture was convertible at any time at the option of the holder to common
stock of the Company, at a conversion price of $1.45 per share. The debenture,
if not converted, was due on February 15, 2005.

The debenture was repaid in full on May 13, 2003, along with accrued
interest of $164,000.

NOTE 8. INTANGIBLE ASSETS

Intangible assets consist of the following (in thousands):

The amortization of intangible assets for the three months ended June
30, 2003 and 2002 was $332,000 and $463,000 respectively.

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

2004 (second, third and fourth quarters).......................... $ 995
2005.............................................................. 1,181
---------
$ 2,176
---------

NOTE 9. 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 Statement of Financial Accounting Standards No. 123
("SFAS No. 123") as amended by SFAS 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 123, and
accordingly, no expense has been recognized for options granted to employees
under the 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 award, consistent with the provisions of SFAS 123,
the Company's pro forma net loss and net loss per share would be as follows (in
thousands, except per share data):

Three months ended June 30,
--------------------------------------------
2003 2002
---------------------- --------------------
Net loss as reported: $ (5,366) $ (7,650)
Add: stock-based employee compensation expense included in reported net
loss under APB 25 106 706
Deduct: total employee stock-based compensation determined under fair (121) (1,952)
value based method for all awards, net of tax effects ---------------------- --------------------
Pro forma net loss $ (5,381) $ (8,896)
Basic and diluted net loss per share:
As reported $ (0.17) $ (0.25)
Pro forma $ (0.17) $ (0.29)

NOTE 10. 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 three-month periods ended (in thousands):

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For the three months ended June 30, 2003, the Company derived revenue
from two customers which comprised 34% and 18% of the Company's total revenues,
respectively.

For the three months ended June 30, 2002, the Company derived revenue
from one customer which comprised 55% of the Company's total revenues.

NOTE 11. RELATED PARTY TRANSACTIONS

During the year ended March 31, 2002, the former Chief Executive
Officer of the Company had deposited approximately $3,035,000 into the Company's
bank accounts which were purported to have represented proceeds from the payment
of accounts receivable related to fictitious sales transactions. An additional
$1,300,000 was deposited by this individual for this purpose in the three months
ended June 30, 2002. Although these amounts are included in accrued liabilities,
the Company does not expect it will be required to repay this sum because the
Company believes it has offsetting claims against its former Chief Executive
Officer.

NOTE 12. RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, the Financial Accounting Standards Board ("FASB")
issued FIN 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45
requires a guarantor to recognize a liability for obligations it has undertaken
in relation to the issuance of a guarantee. It requires that the liability be
recorded at fair value on the date that the guarantee is issued. It also
requires a guarantor to provide additional disclosures regarding guarantees,
including the nature of the guarantee, the maximum potential amount of future
payments under the guarantee, the carrying amount of the liability, if any, for
the guarantor's obligations under the guarantee, and the nature and extent of
any recourse provisions or available collateral that would enable the guarantor
to recover the amounts paid under the guarantee. The disclosure requirements
under FIN 45 are effective for the interim and annual periods ending after
December 15, 2002. The recognition and measurement provisions under FIN 45 are
effective for guarantees issued or modified after December 31, 2002. In June
2003, the FASB issued a FASB Staff Position which indicated that indemnification
clauses in software agreements related to intellectual property infringement are
subject to the disclosure requirements of FIN 45, but not the initial
recognition or measurement provisions. The adoption of FIN 45 did not have a
material impact upon the Company's financial position, cash flows or results of
operations.

In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51"("FIN 46"). FIN 46 requires
certain variable interest entities to be consolidated by the primary beneficiary
of the entity if the equity investors in the entity do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. FIN 46 is effective
immediately for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. The Company does not believe
that the adoption of this standard will have a material effect on its financial
position or results of operations.

In April 2003, the FASB issued SFAS 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities," which amends SFAS 133 for
certain decisions made by the FASB Derivatives Implementation Group. In
particular, SFAS 149 (1) clarifies under what circumstances a contract with an
initial net investment meets the characteristic of a derivative, (2) clarifies
when a derivative contains a financing component, (3) amends the definition of
an underlying to conform it to language used in FIN 45, and (4) amends certain
other existing pronouncements. This Statement is effective for contracts entered
into or modified after June 30, 2003, and for hedging relationships designated
after June 30, 2003. In addition, most provisions of SFAS 149 are to be applied
prospectively. The Company does not expect the adoption of SFAS 149 to have a
material impact upon its financial position, cash flows or results of
operations.

In May 2003, the FASB issued SFAS 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." SFAS
150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). SFAS 150 is effective for
financial instruments entered into or modified after May 31, 2003, and otherwise
is effective at the beginning of the first interim period beginning after June
15, 2003. It is to be implemented by reporting the cumulative effect of a change
in an accounting principle for financial instruments created before the issuance
date of the Statement and still existing at the beginning of the interim period
of adoption. Restatement is not permitted. The Company does not expect the
adoption of SFAS 150 to have a material impact upon its financial position, cash
flows or results of operations.

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, 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.

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, sales agents and semiconductor equipment manufacturers ("OEMs")
that bundle our software with their hardware.

Our sales cycle for the license of our software products has
historically been very long. Our products are new and our customers spend a
significant amount of time evaluating our products. Customer purchase orders
typically include integration and installation services, rights of return 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. Our ability to sell our products in the future may also be affected by
the current decline in capital spending by potential customers in the
semiconductor industry.

Our standard payment terms for our customers provide for payment in 30
days. It is frequently the case that our receivables are outstanding for more
than 30 days. Our accounts receivable from international customers have been
outstanding longer than our domestic receivables and we expect this to continue.

In the three months ended June 30, 2003 and 2002, a relatively small
number of customers have accounted for a large portion of our revenues, and the
composition of our major customers has changed from period to period. This is
because we currently have a limited sales force and our products have a lengthy
sales cycle. We had two and one end customers that individually accounted for at
least 10% of our revenues in the three months ended June 30, 2003 and 2002,
respectively. In the aggregate, these end customers accounted for 52% and 55% of
our revenues in the three months ended June 30, 2003 and 2002, respectively.

CRITICAL ACCOUNTING POLICIES

The discussion and analysis of our financial condition and results of
operations are based upon our 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 the following critical accounting policies and the related
judgments and estimates significantly affect the preparation of our consolidated
financial statements:

Revenue Recognition

Revenue recognition rules are very complex, and certain judgments
affect the application of our revenue policy. The amount and timing of our
revenue is difficult to predict, and any shortfall in revenue or delay in
recognizing revenue could cause our operating results to vary significantly from
quarter to quarter. In addition to determining our results of operations for a
given period, our revenue recognition determines the timing of certain expenses,
such as commissions, royalties and other variable expenses.

We derive revenues principally from the sale of software licenses,
software maintenance contracts and consulting services. We offer two types of
licenses: perpetual and time-based. Perpetual licenses have no expiration date,
while time-based licenses require renewal. Our software product licenses provide
a narrowly defined subset of features for a given customer. The customer may
acquire additional licenses to extend the functionality of our products as its
technologies and facilities change or if it wishes to use additional features of
our software for its production process. Our licenses usually limit the number
of people who can use the software at a given time.

Revenues from software licenses are generally recognized upon the
execution of a binding agreement and delivery of the software, provided that:
the fee is fixed or determinable; vendor-specific objective evidence exists to
allocate a portion of the total license fee to any undelivered elements of the
arrangement; collection is reasonably assured; and the agreement does not
contain customer acceptance clauses. If customer acceptance clauses exist,
revenues are recognized upon customer acceptance provided that all other revenue
recognition criteria are met.

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

For contracts with multiple obligations (e.g., deliverable and
undeliverable products, post-contract support and other services), we allocate
revenues to the undelivered element of the contract based on objective evidence
of its fair value. This objective evidence is the sales price of the element
when sold separately or the renewal rate specified in the agreement for
licensing arrangements with terms of one year or greater that include
post-contract customer support and software updates. We recognize revenues
allocated to undelivered products when the criteria for software license
revenues set forth above are met. Revenues from time-based software licenses are
generally recognized ratably over the period of the licenses. Determining
whether objective evidence of fair value exists is subject to judgment and
resulting fair values used in determining the value of the undelivered elements
is also subject to judgment and estimates.

Software maintenance revenues are recognized ratably over the term of
the maintenance period, which is generally one year. Our software maintenance
includes product maintenance updates, Internet-based technical support and
telephone support. Revenues derived from our consulting services are recognized
as the services are performed. Revenues derived from software development
projects are recognized on a completed contract basis.

We also derive revenues from the sale of software licenses, maintenance
and post-contract support services through our distributors. Revenues from sales
made through our distributors for which the distributors have return rights are
recognized when the distributors have sold the software licenses or service to
their customers and the criteria for revenue recognition under SOP 97-2, as
amended, are met. Revenues from maintenance and post-contract support services
sold through our distributors are recognized ratably over the contract period.

Amounts invoiced to our customers in excess of recognized revenues are
recorded as deferred revenues. The timing and amounts invoiced to customers can
vary significantly depending on specific contract terms and can therefore have a
significant impact on deferred revenues in any given period.

Goodwill and Intangible Assets

Consideration paid in connection with acquisitions is required to be
allocated to the acquired assets, including certain identifiable intangible
assets, goodwill, and liabilities acquired. Acquired assets and liabilities are
recorded based on our estimate of fair value, which requires significant
judgments, including those with respect to future estimated cash flows and
discount rates. For identifiable intangible assets that we separately record, we
are required to estimate the useful life of the assets and recognize their cost
as an expense over the useful lives. We use the straight-line method to amortize
long-lived assets, except goodwill, which results in an equal amount of expense
in each period.

We assess the impairment of identifiable intangibles and long-lived
assets whenever events or changes in circumstances indicate that the carrying
value may not be recoverable. Furthermore, we assess the impairment of goodwill
at least annually. Factors we consider important which could trigger an
impairment review include the following:

o significant underperformance relative to expected historical or projected
future operating results;
o significant changes in the manner of our use of
the acquired assets or the strategy for our overall business;
o significant negative industry or economic trends;
o significant decline in our stock price for a sustained period;
o market capitalization relative to net book value; and
o a current expectation that, more likely than not, a long-lived
asset will be sold or otherwise disposed of significantly
before the end of its previously estimated useful life.

When one or more of the above indicators of impairment occurs we estimate
the value of long-lived assets and intangible assets to determine whether there
is an impairment. We measure any impairment based on the projected discounted
cash flow method, which requires us to make several estimates including the
estimated cash flows associated with the asset, the period over which these cash
flows will be generated and a discount rate commensurate with the risk inherent
in our current business model. These estimates are subjective and if we made
different estimates, it could materially impact the estimated fair value of
these assets and the conclusions we reached regarding an impairment.

The first and second steps of the two-step process are as follows:

Step 1 - We compare the fair value of our reporting units to the carrying value,
including goodwill. For each reporting unit where the carrying value, including
goodwill, exceeds the unit's fair value, we proceed on to Step 2. If a unit's
fair value exceeds the carrying value, no further analysis is performed and no
impairment charge is necessary.

Step 2 - We perform an allocation of the fair value of the reporting unit to our
identifiable tangible and non-goodwill intangible assets and liabilities. This
derives an implied fair value for the reporting unit's goodwill. We then compare
the implied fair value of the reporting unit's goodwill with the carrying amount
of the reporting unit's goodwill. If the carrying amount of the reporting unit's
goodwill is greater than the implied fair value of its goodwill, an impairment
charge would be recognized for the excess.

We determined that we have one reporting unit. We performed Step 1 of
the goodwill impairment analysis required by SFAS 142 as of April 1, 2002, June
30, 2002, September 30, 2002 and December 31, 2002 and concluded that goodwill
was not impaired. Accordingly, Step 2 was not performed. We performed Step 1 as
of March 31, 2003 and determined that goodwill was impaired. We then performed
Step 2 and determined that a $30.6 million impairment charge was required in the
three months ended March 31, 2003. We will continue to test for impairment on an
annual basis and on an interim basis if an event occurs or circumstances change
that would potentially reduce the fair value of our reporting units below their
carrying amount.

Litigation

Management's estimated range of liability related to some of the
pending litigation is based on claims for which our management can estimate the
amount and range of loss. Because of the uncertainties related to our insurance
coverage and indemnification obligations we have provided to various parties who
are defendants and the amount and range of potential losses, if any, related to
litigation, management is currently unable to make a reasonable estimate of the
liability that could result from an unfavorable outcome. As additional
information becomes available, we will assess the potential liability related to
our pending litigation and create and/or revise our estimates. Such revisions in
estimates of the potential liability could materially impact our results of
operation and financial position. Any resolution of the litigation could
materially affect our financial resources and liquidity.

Income Taxes

We are required to estimate our income taxes in each of the
jurisdictions in which we operate as part of the process of preparing our
consolidated financial statements. This process involves estimating our actual
current tax exposure, together with assessing temporary differences resulting
from differing treatment of items, such as deferred revenue, for tax and
accounting purposes. These differences result in deferred tax assets and
liabilities. We then assess the likelihood that our net deferred tax assets will
be recovered from future taxable income and, to the extent we believe that
recovery is not likely, we must establish a valuation allowance. We currently
have a full valuation allowance on our gross deferred tax assets. In the event
our future taxable income is expected to be sufficient to utilize our deferred
tax assets, an adjustment to the valuation allowance will be made, increasing
income in the period in which such determination is made.

Stock-based compensation

We account for our employee stock option plans using the intrinsic
value method described in Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees" and related interpretations. Under
APB Opinion No. 25, deferred stock compensation is recorded for the difference,
if any, between an option's exercise price and the fair value of the underlying
common stock on the grant date of the option. As permitted by SFAS No. 123,
"Accounting for Stock-Based Compensation," we adopted the "disclosure only"
alternative described in SFAS No. 123 for its employee stock plans.

We account for stock issued to non-employees in accordance with the
provisions of SFAS No. 123 and Emerging Issues Task Force Consensus ("EITF") No.
96-18 "Accounting for Equity Instruments that Are Issued to Other than Employees
For Acquiring, or in Conjunction with Selling, Goods or Services." Under SFAS
No. 123 and EITF No. 96-18, stock options and warrants issued to non-employees
are accounted for at their fair value calculated using the Black-Scholes option
pricing model.

Compensation expense resulting from employee and non-employee stock
options are amortized to expense using an accelerated approach over the term of
the options in accordance with Financial Accounting Standards Board
Interpretation ("FIN") No. 28, "Accounting for Stock Appreciation Rights and
Other Variable Stock Option or Award Plans."

RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, the Financial Accounting Standards Board ("FASB")
issued FIN 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45
requires a guarantor to recognize a liability for obligations it has undertaken
in relation to the issuance of a guarantee. It requires that the liability be
recorded at fair value on the date that the guarantee is issued. It also
requires a guarantor to provide additional disclosures regarding guarantees,
including the nature of the guarantee, the maximum potential amount of future
payments under the guarantee, the carrying amount of the liability, if any, for
the guarantor's obligations under the guarantee, and the nature and extent of
any recourse provisions or available collateral that would enable the guarantor
to recover the amounts paid under the guarantee. The disclosure requirements
under FIN 45 are effective for the interim and annual periods ending after
December 15, 2002. In June 2003, the FASB issued a FASB Staff Position which
indicated that indemnification clauses in software agreements related to
intellectual property infringement are subject to the disclosure requirements of
FIN 45, but not the initial recognition or measurement provisions. The
recognition and measurement provisions under FIN 45 are effective for guarantees
issued or modified after December 31, 2002. The adoption of FIN 45 did not have
a material impact upon our financial position, cash flows or results of
operations.

In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51"("FIN 46"). FIN 46 requires
certain variable interest entities to be consolidated by the primary beneficiary
of the entity if the equity investors in the entity do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. FIN 46 is effective
immediately for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. We do not believe that the
adoption of this standard will have a material effect on our financial position
or results of operations.

In April 2003, the FASB issued SFAS 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities," which amends SFAS 133 for
certain decisions made by the FASB Derivatives Implementation Group. In
particular, SFAS 149 (1) clarifies under what circumstances a contract with an
initial net investment meets the characteristic of a derivative, (2) clarifies
when a derivative contains a financing component, (3) amends the definition of
an underlying to conform it to language used in FIN 45, and (4) amends certain
other existing pronouncements. This Statement is effective for contracts entered
into or modified after June 30, 2003, and for hedging relationships designated
after June 30, 2003. In addition, most provisions of SFAS 149 are to be applied
prospectively. We do not expect the adoption of SFAS 149 to have a material
impact upon our financial position, cash flows or results of operations.

In May 2003, the FASB issued SFAS 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." SFAS
150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). SFAS 150 is effective for
financial instruments entered into or modified after May 31, 2003, and otherwise
is effective at the beginning of the first interim period beginning after June
15, 2003. It is to be implemented by reporting the cumulative effect of a change
in an accounting principle for financial instruments created before the issuance
date of the Statement and still existing at the beginning of the interim period
of adoption. Restatement is not permitted. We do not expect the adoption of SFAS
150 to have a material impact upon our financial position, cash flows or results
of operations.

RESULTS OF OPERATIONS

Comparison of the three months ended June 30, 2003 and 2002

Revenues. Total revenues decreased to $2.1 million in the three months
ended June 30, 2003 from $2.3 million in the three months ended June 30, 2002,
or a decrease of 9%. 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. Customer purchase orders typically include
integration and installation services, rights of return 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. Our ability to sell
our products in the future may also be affected by the current decline in
capital spending by potential customers in the semiconductor industry and our
pending lawsuits.

Revenues were highly concentrated, with 52% of total revenues in the
three months ended June 30, 2003 coming from two customers and 55% of total
revenues in the three months ended June 30, 2002 coming from one customer.

Software license revenue increased to $141,000 in the three months
ended June 30, 2003, from $57,000 in the three months ended June 30, 2002, or an
increase of 147%.

Consulting services, maintenance and other revenues decreased to $1.9
million in the three months ended June 30, 2003, down from $2.2 million in the
three months ended June 30, 2002, or a decrease of 13%. The decrease was due to
customer delays in providing layout design specifications for custom services
work.

Gross profit. As a percentage of revenues, gross profit decreased from
73% for the three months ended June 30, 2002 to 60% for the three months ended
June 30, 2003. The decrease in gross profit percentage is a result of providing
lower margin services work in the three months ended June 30, 2003 versus the
three months ended June 30, 2002. 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 among software licenses, maintenance fees and consulting
services.

Research and development. Research and development expenses represented
89% of revenues in the three months ended June 30, 2003 compared to 159% of
revenues in the three months ended June 30, 2002. Actual costs decreased to $1.8
million for the three months ended June 30, 2003, down from $3.6 million for the
three months ended June 30, 2002. This decrease is primarily attributable to the
cost cutting measures we put in place in September 2002. Salaries and related
benefits of research and development engineers represent the single largest
component of our research and development expenses.

Sales, general and administrative. Sales, general and administrative
expenses for the three months ended June 30, 2003 were $4.4 million, or 212% of
revenues, compared to $4.7 million, or 207% of revenues in the three months
ended June 30, 2002. The decrease in costs was primarily due to decreases in
staff as a result of our cost cutting measures in September 2002, offset by
legal fees associated with litigation.

Stock-based compensation. Stock-based compensation expense for the
three months ended June 30, 2003 decreased to $106,000, compared with $706,000
for the three months ended June 30, 2002. Stock-based compensation expense in
the three months ended June 30, 2003 decreased from the previous three months
primarily as a result of our reduction in workforce on September 30, 2002 and
due to stock-based compensation being amortized on an accelerated basis.

Amortization of intangible assets. Amortization of intangible assets
was $332,000 in the three months ended June 30, 2003, compared to $463,000 in
the three months ended June 30, 2002. This decrease in amortization is due to
certain intangible assets being fully amortized prior to the three months ended
June 30, 2003.

Interest income (expense) and other, net. Interest income, net of
interest and other expenses for the three months ended June 30, 2003, was
$49,000, compared to $195,000, for the three months ended June 30, 2002. This
decrease was due to less interest income from lower average balances of cash,
cash equivalents and short-term investments and low interest rates on cash
balances during the three months ended June 30, 2003.

Provision for income taxes. In the three months ended June 30, 2003 and
2002, 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 June 30, 2003
and 2002. Our tax provision of $7,000 in the three months ended June 30, 2003
relates to international withholding taxes.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2003, we had approximately $16.5 million in cash and cash
equivalents and short-term investments.

Net cash used in operating activities for the three months ended June
30, 2003 was approximately $3.4 million, compared to $8.6 million used in
operating activities for the three months ended June 30, 2002. Our cash used in
operations for the three months ended June 30, 2003 and 2002 was primarily due
to our net loss, adjusted for certain non-cash items including depreciation and
amortization, goodwill impairment, stock-based compensation and deferred revenue
and the timing of the payment of accounts payable and accrued liabilities.

Net cash used in investing activities was $7.3 million for the three
months ended June 30, 2003 compared to $8.0 million used in investing activities
for the three months ended June 30, 2002. The cash used in investing activities
for the three months ended June 30, 2003 consisted primarily of the purchase of
marketable securities. Our investing activities for the three months ended June
30, 2002 consisted primarily of the acquisition of DYM, purchases of marketable
securities, issuance of a note receivable and equipment purchases.

Net cash used in financing activities was $1.6 million for the three
months ended June 30, 2003, mainly due to the repayment of our $1.5 million
convertible debenture and $121,000 in payments of capital lease obligations. Net
cash provided by financing activities was $1.4 million for the three months
ended June 30, 2002, primarily from amounts received from our former Chief
Executive Officer and proceeds from exercise of stock options, partially offset
by the repayment of capital lease obligations.

We believe our current cash and cash equivalents, our short-term
investments, and our cash flows from operations will be sufficient to meet our
cash requirements through at least March 31, 2004. 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. The Company does not believe that it will be able to raise
additional capital until the litigation described below is resolved.

See Note 8 to our March 31, 2003 Consolidated Financial Statements
filed on Form 10-K for information regarding our operating leases. As of March
31, 2003, our aggregate future minimum lease commitments through the year ending
2007 totaled $3.6 million.

Between July 31, 2002 and November 15, 2002, fourteen class-action
lawsuits were filed and are pending against the Company, certain current and
former officers and/or directors of the Company, and the Company's independent
auditors (collectively, the "Defendants") in the United States District Court
for the Northern District of California. The lawsuits allege that the Defendants
violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and
Rule 10b-5 promulgated thereunder by the SEC, 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. Several of the lawsuits further allege
violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933. The
plaintiffs are generally seeking to recover compensatory damages, costs and
expenses incurred, interest and such other relief as the court may deem
appropriate. We expect that these lawsuits will be consolidated into a single
action in the United States District Court for the Northern District of
California. Motions for appointment of a lead plaintiff are pending before the
Court.

We are also a nominal defendant in five stockholder derivative lawsuits
pending in Superior Court in the County of Santa Clara, California. These
lawsuits, which were filed between July 31, 2002 and September 30, 2002, assert
derivative claims on behalf of the Company against current and/or former
officers and directors of the Company and the Company's independent auditors.
The claims asserted in these lawsuits include insider trading, breach of
fiduciary duties, aiding and abetting breaches of fiduciary duties, negligence
and professional malpractice, negligent misrepresentation and omission,
contribution and indemnification, abuse of control, gross mismanagement, unjust
enrichment and breach of contract. These lawsuits 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. In an order
dated December 3, 2002, the Court consolidated these actions and appointed lead
plaintiff's counsel. The date for filing a consolidated complaint has been
continued to August 29, 2003.

Five shareholders of the Company have sued in the state court of the
District Court of Dallas County, Texas, the Company's independent auditors and
the managing underwriter in the Company's initial public offering, in connection
with claims relating to the Company's acquisition of Covalar Technologies Group,
Inc. in February 2002. The Company has been named as a responsible third party
in this action for purposes of apportioning fault in jury findings; to date, no
claims have been brought against the Company. Subject to a reservation of
rights, we have accepted the underwriter's request to indemnify the underwriter
in connection with the initial public offering and to advance expenses in
this matter. While we have obtained insurance to cover our obligation to
indemnify and advance expenses to the underwriter, the carrier stated that it
intends to rescind coverage to HPL for this claim, but also stated that it might
revisit this issue after reviewing certain requested information. That
information has been provided, but the insurer has not yet informed the Company
as to whether it will modify its position. If it does not contest coverage,
however, coverage for these indemnification obligations is subject to a
sub-limit of $1,000,000. Discovery is ongoing in the lawsuit, and the Company's
potential liability cannot be determined at this time.

Five former shareholders of FabCentric, Inc., which was acquired by the
Company in December 2001, have sued the Company, the Company's former President
and CEO and former CFO, and the Company's independent auditors in a lawsuit
pending in Superior Court in the County of Santa Clara, California. This lawsuit
was filed on or about May 22, 2003. 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. No defendants have responded to the complaint yet. Because this
lawsuit was only recently filed, we have not evaluated the merits of these
allegations.

Additionally, in April 2003, UBS PaineWebber, Inc. filed suit against
the Company in the Supreme Court of the State of New York, County of New York
(the "New York Action") alleging tortius interference of contract and a
violation of the Uniform Commercial Code. The action relates to the transfer of
shares of HPL common stock putatively pledged to UBS PaineWebber, Inc. by Y.
David Lepejian, our former President and CEO, and his spouse and seeks, among
other things, mandatory injunctive relief requiring HPL to effect the transfer
of subject stock. In May 2003, we filed an interpleader action in United States
District Court for the Northern District of California relating to the New York
Action. Mr. Lepejian and UBS PaineWebber are currently engaged in an NASD
arbitration proceeding regarding the pledge of the shares.

All of the aforementioned litigation matters are in the early stages.
As a result, we believe that no amount should be accrued for these matters under
SFAS No. 5, "Accounting for Contingencies," because we are currently unable to
evaluate the likelihood of an unfavorable outcome or an estimate of the amount
or range of potential loss, if any.

Any adverse resolution of the aforementioned litigation could have a
material effect on our financial position, results of operations or cash flows.
We are investigating informal or formal restructuring alternatives which
potentially may dilute shareholder equity but could mitigate any material
adverse affect on our financial position or results of operations which might
otherwise result from an unfavorable resolution of these lawsuits. Any such
dilution could be significant and could greatly affect the value of our common
stock. See, Risk Factors

RISK FACTORS

RISKS ASSOCIATED WITH OUR BUSINESS

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 and our securities have been delisted from the Nasdaq
National Market System. We have also been named in a number of lawsuits and been
the subject of an SEC investigation. 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. In addition, the Company is investigating informal and formal
restructuring alternatives which potentially may dilute shareholder equity.
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.
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 and the pending securities litigation 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.

Our restatement and pending securities litigation will make it difficult, if not
impossible, to raise additional capital.

Our pending securities litigation raises uncertainty regarding the
financial condition and long term viability of the Company. Until this
litigation is resolved, it is unlikely that the Company will be able to raise
additional capital.

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 has been delisted from the Nasdaq National Market and a subsequent
public market for our stock may never develop.

In July 2002, we received a Staff Determination Notice from the Nasdaq
National Market informing us that our stock may be delisted due to a failure to
comply with Nasdaq's continued listing standards. We appealed the Nasdaq staff
determination in August 2002 and were subsequently notified by Nasdaq that on
September 30, 2002, our stock would no longer be listed on the Nasdaq National
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.

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 2003, 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.

There are significant barriers to widespread adoption of our yield optimization
products by the semiconductor industry.

In order for our business to grow, we must overcome certain barriers to
the adoption of our yield optimization products by the semiconductor industry.
Many semiconductor designers and manufacturers have in-house yield management
systems and may be reluctant to implement our software because they may believe
that third party tools will not incorporate their existing know-how and
methodology. If participants in this industry reject using third party software
to optimize their yield, our growth would be impaired, which would negatively
affect our results of operations and cause our business to fail. In addition,
because our yield optimization solutions are relatively new to the semiconductor
industry and can be difficult to explain, intensive marketing and sales efforts
will be necessary to educate prospective industry partners and customers
regarding the uses and benefits of our technologies and software products.
Accordingly, we cannot assure you that our software products will gain
acceptance at the level or in the time frame we anticipate. Such a failure to
gain acceptance would have a material adverse effect on our business.

The semiconductor industry is currently experiencing a downturn and has
experienced downturns in the past and any future downturns or prolonged current
downturn 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, and it is currently experiencing
such a downturn. As a result of the slowdown, 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
or to purchase equipment from semiconductor equipment OEMs that have embedded
our software in their products. Significant downturns could materially and
adversely affect our business and operating results.

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 three months ended June 30, 2003 and 2002, customers
that individually accounted for at least 10% of our revenues together
represented 52% and 55% of our revenues, respectively, and in each of these
three months, there was substantial change among the companies that represented
our largest customers. In the three months ended June 30, 2003, sales to two
customers accounted for 34% and 18%, 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.

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 three months, 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.

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. For example, it
generally takes at least six months after our first contact with a prospective
customer before we start licensing our products to that customer. 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. We
may also spend substantial time and management attention on potential licenses
that are not consummated, thereby foregoing other opportunities.

Our operating results may fluctuate significantly and any failure to
meet financial expectations may disappoint investors and could cause our stock
price to decline.

Historically, our quarterly operating results have fluctuated and we
expect them to continue to fluctuate in the future due to a variety of factors,
many of which are outside of our control. Because of our current limited sales
force, the lengthy sales cycle of our products and the intermittent needs of
customers, we derive our revenues primarily from a relatively small number of
large transactions in any given operating period. Accordingly, the timing of
large orders has significantly affected, and will continue to significantly
affect, quarterly operating results. In addition to the previously discussed
risk resulting from our restatement of previously issued financial statements,
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.

We may not be able to effectively compete against other companies, which
could impair our growth and profitability.

We target IDMs, fabless semiconductor companies, foundries and
semiconductor equipment OEMS. 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. On some occasions in the past, we have had to replace defective
products that were already delivered. 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 continue to experience losses in the future.

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

o increase our direct sales and marketing personnel and activities;
o develop our technology, expand our existing product lines and create
additional software modules for our products;
o develop additional strategic alliances with third party providers of
semiconductor design, fabrication and test solutions;
o implement additional internal systems, develop additional infrastructure and
hire additional management; and
o pay professional fees and other costs related to litigation matters.

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

We may incur non cash charges resulting from acquisitions and equity
issuances, which could harm our operating results.

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.

Our cost reduction initiatives may adversely affect the morale and
performance of our personnel and our ability to hire new personnel.

In connection with our effort to streamline operations, reduce costs and
bring our staffing and structure in line with industry standards, we
restructured our organization on September 27, 2002, with substantial reductions
in our workforce. There have been and may continue to be substantial costs
associated with the workforce reductions, including severance and other employee
related costs, and our restructuring plan may yield unanticipated consequences,
such as attrition beyond our planned reduction in workforce. As a result of
these reductions, our ability to respond to unexpected challenges may be
impaired and we may be unable to take advantage of new opportunities.

In addition, many of the employees who were terminated possessed
specific knowledge or expertise that may prove to have been important to our
operations. In that case, their absence may create significant difficulties.
This personnel reduction may also subject us to the risk of litigation, which
may adversely impact our ability to conduct our operations and may cause us to
incur significant expense.

Key employees

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.

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.

RISKS RELATED TO OUR INTERNATIONAL OPERATIONS

Our business could be harmed by political or economic instability in the
Republic of Armenia.

Our software products are largely developed, produced, delivered and
supported from our facilities in the Republic of Armenia. Armenian employees
participate in our direct sales and marketing efforts. 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 44% and 25% of our revenues in the three months ended June 30,
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.

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 expect we will 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 $1,000 decrease in the fair value of our available-for-sale
securities as of June 30, 2003.

Foreign Exchange Risk

Our 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 6.1% of total revenues for the three months ended June
30, 2003, 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 June
30, 2003. Additionally, our exposure to foreign exchange rate fluctuations
arises in part from inter-company accounts which can be denominated in the
functional currency of the foreign subsidiary. As exchange rates vary when the
accounts are translated, results may vary from expectations and adversely impact
earnings. The effect of foreign exchange rate fluctuations for the three months
ended June 30, 2003 was not material.

While our 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.

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 the chief executive officer and the 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 syste