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 September 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.

Delaware 77-0550714
2033 Gateway Place, Suite 400
San Jose, California 95110 (408) 437-1466

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 October 31, 2003, the registrant had outstanding 31,273,472
shares of common stock.

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TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

PART II - OTHER INFORMATION

PART I - FINANCIAL INFORMATION

ITEM 1 - CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

HPL Technologies, Inc.
Consolidated Statements of Operations
(In thousands, except per share amounts)
(Unaudited)

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

HPL Technologies, Inc.
Consolidated Balance Sheets
(In thousand, except per share date)
(Unaudited)

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

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

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 September 30, 2003 and 2002, results of operations for the three
months and six months ended September 30, 2003 and 2002, and cash flows for the
six-month periods ended September 30, 2003 and 2002, have been made. The results
of operations for the three and six months ended September 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
amount 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. 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 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. On September 29, 2003, the United States District Court for the
Northern District of California issued an order consolidating all of these
lawsuits into a single action. The order also named a lead plaintiff and a lead
plaintiff's counsel. A status conference is scheduled for November 12, 2003.
Lead plaintiff's counsel has until December 1, 2003 to file a consolidated
complaint.

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 certain current and
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 December 15, 2003.

Five shareholders of the Company have brought suit in state court of
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 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. On October 6, 2003 plaintiffs filed a second amended
complaint.

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. On September 15, 2003, the Company filed a motion to stay this
action. On or about October 31, 2003, Plaintiffs filed a First Amended Complaint
adding the managing underwriter in the Company's initial public offering and the
Company's current CFO as defendants.

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, the Company's 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. The interpleader action and the action in New York were dismissed and on
October 1, 2003, UBS Paine Webber filed suit in Delaware state court which
essentially re-stated the claims originally asserted in the New York action. The
Company is evaluating these allegations.

Additionally, Twin City Fire Insurance Company (one of the Company's
excess insurance carriers) 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 CEO, its former CFO, and other former and current
officers and directors of the Company. On October 23, 2003, Twin City filed an
amended complaint adding additional defendants. On October 30, 2003, Twin City
filed a second amended complaint adding certain exhibits. Twin City is seeking a
determination that no coverage is afforded defendants because of
misrepresentations in the insurance application. We are evaluating these
allegations.

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 Statement of Financial Accounting Standard ("SFAS") No. 5,
"Accounting for Contingencies," because we are currently unable to evaluate the
likelihood of an unfavorable outcome or estimate 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 is detailed in the table below (in thousands):

Three months ended Six months ended
September 30, September 30,
-------------------- ----------------------
2003 2002 2003 2002
-------- --------- ---------- -----------
Outstanding stock options 7,876 4,413 7,876 4,413
Convertible debenture - 1,032 - 1,032
Shares issuable under warrants 138 138 138 138
Contingent shares issuable
to former Covalar shareholders - 600 - 600
-------------------- ---------- -----------
Total 8,014 6,183 8,014 6,183
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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 September 30, 2003, four customers
accounted for 17%, 13%, 11% and 10% of the Company's accounts receivable and
unbilled receivables combined. At September 30, 2002, three customers accounted
for 26%, 18% and 10% of the Company's accounts receivable and unbilled
receivables combined.

For the three months ended September 30, 2003, the Company derived 45%
of its revenue from its Japanese distributor. For the six months ended September
30, 2003, the Company derived 28% and 17% of its revenue from two customers.

For the three and six months ended September 30, 2002, the Company
derived 57% and 49% of its revenues, respectively, from two end-user customers.

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 and six months ended September 30,
2003, comprehensive loss was $3.5 million and $8.8 million, respectively. The
difference between net loss and comprehensive loss for the three months and six
months ended September 30, 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 $22,000 and $45,000,
respectively. For the three and six months ended September 30, 2002,
comprehensive loss was $6.9 million and $14.3 million respectively. The
difference between net loss and comprehensive loss for the three months and six
months ended September 30, 2002, is the result of the foreign currency
translation gains and the net unrealized gains and losses on available for sale
securities in the aggregate amount of $2,000 and $197,000, respectively.

NOTE 6. ACCRUED LIABILITIES

Accrued liabilities consist of the following (in thousands):

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 three
months and six months ended September 30, 2003, and 2002, respectively, would be
as follows (in thousands, except per share data):

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):

Three months ended Six months ended
September 30, September 30,
------------------------- -------------------------
2003 2002 2003 2002
------------ ----------- ------------ ------------

United States $ 683 $ 1,484 $ 1,838 $ 3,316
Japan 1,963 1,824 2,247 2,179
Rest of Asia 304 688 897 743
Rest of the world 334 487 374 524
------------ ----------- ------------ ------------
Total $ 3,284 $ 4,483 $ 5,356 $ 6,762
============ =========== ============ ============

NOTE 10. RELATED PARTY TRANSACTIONS

During the year ended March 31, 2002, the Company's former CEO 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 the same 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 CEO.

NOTE 11. GUARANTEES AND INDEMNIFICATIONS

In November 2002, the Financial Accounting Standards Board ("FASB")
issued Interpretation No. 45 ("FIN 45"), "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others." FIN 45 requires that a guarantor recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee or indemnification. FIN 45 also requires additional
disclosure by a guarantor in its interim and annual financial statements about
its obligations under certain guarantees and indemnifications. The initial
recognition and measurement provisions of FIN 45 are applicable for guarantees
issued or modified after December 31, 2002. The disclosure requirements of FIN
45 are effective for financial statements of interim or annual periods ending
after December 15, 2002. The Company adopted the recognition and measurement
provisions of FIN 45 prospectively to guarantees issued or modified after
December 31, 2002, and the adoption did not have a material impact on its
financial position or results of operations. The following is a summary of the
agreements that the Company has determined are within the scope of FIN 45:

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
and Mr. Lepejian, the Company's former President and Chief Executive Officer. In
February 2003, the Company obtained two new directors and officers' liability
insurance policies with aggregate policy limits of $10 million. 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.

The Company's directors and officers have been named as defendants in
the class action and derivative litigation described in Note 2. Furthermore, one
or more of the Company's former officers have given testimony in connection with
investigations conducted by the SEC and the Department of Justice. 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, once a lead
plaintiffs' lawyer is designated in the class action litigation and a
consolidated amended complaint is filed, we expect all of our directors,
officers and former officers will demand indemnification and advancement of
expenses under their respective indemnification agreements. Because we are not
currently able to evaluate the likelihood of an unfavorable outcome or an
estimate of the amount or range of potential loss, we cannot determine the
estimated fair value of these obligations and, accordingly, the Company has
recorded no liability for these obligations at September 30, 2003.

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, the insurer has not yet taken a
position as to whether such obligations are covered under the policy. If it does
not contest coverage, however, coverage for these indemnification obligations is
subject to a sub-limit of $1,000,000. Because we are not currently able to
evaluate the likelihood of an unfavorable outcome or an estimate of the amount
or range of potential loss, we cannot determine the estimated fair value of
these obligations and, accordingly, the Company has recorded no liability for
these obligations at September 30, 2003.

The Company includes standard intellectual property indemnification
clauses in its software license agreements. Pursuant to these provisions, HPL
holds harmless and agrees to 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 September 30, 2003.

The Company generally warrants that its software products will perform
in all material respects in accordance with its standard published
specifications in effect at the time of delivery of the licensed products to the
customer for a period of ninety days following delivery. If necessary, HPL would
provide for the estimated cost of product warranties based on specific warranty
claims and claim history. The Company has incurred no significant expense under
its product warranties to date and, as a result, the Company believes the
estimated fair value of these warranties is minimal. The Company has recorded no
liabilities for these warranties as of September 30, 2003.

NOTE 12. RECENT ACCOUNTING PRONOUNCEMENTS

In January 2003, the FASB issued FIN 46, "Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51". 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. In October 2003,
the FASB issued FASB Staff Position ("FSP") 46-e, effective date of
Interpretation 46, which deferred the latest date by which all public entities
must apply FIN 46, to the first reporting period ending after December 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 No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," which amends SFAS No. 133
for certain decisions made by the FASB Derivatives Implementation Group. In
particular, SFAS No. 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 No. 149 are to be applied prospectively. The Company does not expect the
adoption of SFAS No. 149 to have a material impact upon its financial position,
cash flows or results of operations.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." SFAS
No.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 No. 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, with the exception of the provisions of paragraphs 9 and 10
of SFAS No. 150 related to mandatorily redeemable non-controlling interests,
which have been deferred. 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 No. 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, and our ability to sell our products in the future may 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 September 30, 2003 and 2002, a relatively
small number of customers accounted for a large portion of our revenues, and the
composition of our major customers has changed from period to period. This is
because our products have a lengthy sales cycle. We had one and two customers
that individually accounted for at least 10% of our revenues in the three months
ended September 30, 2003 and 2002, respectively. In the aggregate, these
customers accounted for 45% and 57% of our revenues in the three months ended
September 30, 2003 and 2002, respectively. In the six months ended September 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. We had two customers that individually accounted for at
least 10% of our revenues in each of the six-month periods ended September 30,
2003 and 2002. In the aggregate, these customers accounted for 45% and 49% of
our revenues in the six months ended September 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 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 we can estimate the amount and
range of loss. Because of the uncertainties related to our insurance coverage
and the indemnification 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 adverse resolution of the pending 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 APB 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 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 FIN No. 28, "Accounting for Stock Appreciation
Rights and Other Variable Stock Option or Award Plans."

RECENT ACCOUNTING PRONOUNCEMENTS

In January 2003, the FASB issued FIN 46, "Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51". 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. In October 2003,
the FASB issued FASB Staff Position ("FSP") 46-e, effective date of
Interpretation 46, which deferred the latest date by which all public entities
must apply FIN 46, to the first reporting period ending after December 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 No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," which amends SFAS No. 133
for certain decisions made by the FASB Derivatives Implementation Group. In
particular, SFAS No. 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 No. 149 are to be applied prospectively. We do not expect the adoption of
SFAS No. 149 to have a material impact upon our financial position, cash flows
or results of operations.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." SFAS
No. 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 No. 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, with the exception of the provisions of paragraphs 9 and 10
of SFAS No. 150 related to mandatorily redeemable non-controlling interests,
which have been deferred. 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 No.150 to have a material impact upon our financial
position, cash flows or results of operations.

RESULTS OF OPERATIONS

Comparison of the three and six months ended September 30, 2003 and 2002

Revenues. Total revenues decreased to $3.3 million in the three months
ended September 30, 2003 from $4.5 million in the three months ended September
30, 2002, or a decrease of 27%. Total revenues decreased to $5.4 million in the
six months ended September 30, 2003 from $6.8 million in the six months ended
September 30, 2002, or a decrease of 21%. 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, and our ability to sell our products in the future may be affected by
the current decline in capital spending by potential customers in the
semiconductor industry and our pending lawsuits. Our revenues in all periods
were highly concentrated, with 45% of total revenues in the three months ended
September 30, 2003 coming from one customer, 57% of total revenues in the three
months ended September 30, 2002 coming from two customers, 45% of total revenues
in the six months ended September 30, 2003 coming from two customers and 49% of
total revenues in the six months ended September 30, 2002 coming from two
customers.

Software license revenue remained flat at $1.9 million in the three
months ended September 30, 2003 and the three months ended September 30, 2002.
Software license revenue remained constant at $2.0 million in the six months
ended September 30, 2003 and in the six months ended September 30, 2002.

Consulting services, maintenance and other revenues decreased to $1.4
million in the three months ended September 30, 2003, down from $2.5 million in
the three months ended September 30, 2002, or a decrease of 45%. The decrease
was due to customer delays in providing layout design specifications for custom
services work and verifying silicon testing result, as well as a reduction in
the size of new services contracts. Consulting services, maintenance and other
revenues decreased to $3.3 million in the six months ended September 30, 2003,
down from $4.8 million in the six months ended September 30, 2002, or a decrease
of 30%. The decrease was due to customer delays in providing layout design
specifications for custom services work and verifying silicon testing result, as
well as a reduction in the size of new services contracts.

Gross profit. As a percentage of revenues, gross profit decreased from
81% for the three months ended September 30, 2002 to 71% for the three months
ended September 30, 2003. As a percentage of revenues, gross profit decreased
from 78% for the six months ended September 30, 2002 to 67% for the six months
ended September 30, 2003. The decrease in gross profit percentage is a result of
providing lower margin services work in the three and six months ended September
30, 2003 versus the three and six months ended September 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
47% of revenues in the three months ended September 30, 2003 compared to 72% of
revenues in the three months ended September 30, 2002. Research and development
expenses represented 63% of revenues in the six months ended September 30, 2003
compared to 101% of revenues in the six months ended September 30, 2002. Actual
costs decreased to $1.5 million for the three months ended September 30, 2003,
down from $3.2 million for the three months ended September 30, 2002. Actual
costs decreased to $3.4 million for the six months ended September 30, 2003,
down from $6.8 million for the six months ended September 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 September 30, 2003 were $3.9 million, or
119% of revenues, compared to $7.3 million, or 163% of revenues in the three
months ended September 30, 2002. Sales, general and administrative expenses for
the six months ended September 30, 2003 were $8.3 million, or 155% of revenues,
compared to $12.1 million, or 178% of revenues in the three months ended
September 30, 2002. The decrease in costs was primarily due to decreases in
staff as a result of our cost cutting measures in September 2002 and
professional fees related to the special investigation and resultant restatement
of our financial statement during the three months ended September 30, 2002,
offset by legal fees associated with our pending litigation.

Stock-based compensation. Stock-based compensation expense for the
three months ended September 30, 2003 increased to $22,000, compared with a
recovery of $245,000 for the three months ended September 30, 2002. Stock-based
compensation expense for the six months ended September 30, 2003 decreased to
$128,000, compared with $461,000 for the six months ended September 30, 2002.
The recovery of stock-based compensation expense in the three months ended
September 30, 2003 and 2002 was primarily as a result of reversing previously
expensed stock-based compensation being amortized on an accelerated basis which
was not earned by certain terminated employees.

Amortization of intangible assets. Amortization of intangible assets
was $332,000 in the three months ended September 30, 2003, compared to $367,000
in the three months ended September 30, 2002. Amortization of intangible assets
was $664,000 in the six months ended September 30, 2003, compared to $830,000 in
the six months ended September 30, 2002. This decrease in amortization is due to
certain intangible assets being fully amortized prior to the three months ended
September 30, 2003.

Interest income (expense) and other, net. Interest income, net of
interest and other expenses for the three months ended September 30, 2003, was
$47,000, compared to $135,000, for the three months ended September 30, 2002.
Interest income, net of interest and other expenses for the six months ended
September 30, 2003, was $96,000, compared to $330,000, for the six months ended
September 30, 2002. This decrease was due to less interest income from lower
average balances of cash, cash equivalents and short-term investments and
further reduced as a result of lower interest rates during the three months
ended September 30, 2003, compared to September 2002.

Provision for income taxes. In the three months ended September 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 $5,000 in the three months ended September 30,
2003, and $12,000 in the six months ended September 30, 2003, relates to
international withholding taxes.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2003, we had approximately $12.7 million in cash and
cash equivalents and short-term investments. Net cash used in operating
activities for the six months ended September 30, 2003 was approximately $7.0
million, compared to $16.9 million used in operating activities for the six
months ended September 30, 2002. Our cash used in operations for the six months
ended September 30, 2003 and 2002 was primarily due to our net loss, adjusted
for certain non-cash items including depreciation and amortization and
stock-based compensation, and the timing of the collection of accounts
receivable, the timing of the payment of accounts payable and accrued
liabilities, and a decrease in the deferred revenue balances.

Net cash used in investing activities was $5.2 million for the six
months ended September 30, 2003, compared to $481,000 used in investing
activities for the six months ended September 30, 2002. The cash used in
investing activities for the six months ended September 30, 2003 consisted
primarily of the purchase of marketable securities. Our investing activities for
the six months ended September 30, 2002 consisted primarily of the acquisition
of DYM, issuance of a note receivable and equipment purchases, offset by sales
of marketable securities.

Net cash used in financing activities was $1.7 million for the six
months ended September 30, 2003, mainly due to the repayment of our $1.5 million
convertible debenture and $221,000 in payments of capital lease obligations. Net
cash provided by financing activities was $1.4 million for the six months ended
September 30, 2002, primarily from amounts received from our former CEO and
proceeds from the 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 our
pending 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 operating 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 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. On September 29, 2003, the United States District Court for the
Northern District of California issued an order consolidating all of these
lawsuits into a single action. The order also named a lead plaintiff and a lead
plaintiff's counsel. A status conference is scheduled for November 12, 2003.
Lead plaintiff's counsel has until December 1, 2003 to file a consolidated
complaint.

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 certain current and 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 December 15, 2003.

Five shareholders of the Company have brought suit in the state court
of 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 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. On October
6, 2003, plaintiffs filed a second amended complaint.

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. On September 15, 2003, we filed a motion to stay this action. On
or about October 31, 2003, Plaintiffs filed a First Amended Complaint adding the
managing underwriter in the Company's initial public offering and the Company's
current CFO as defendants.

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, the Company's 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. The
interpleader action and the action in New York were dismissed and on October 1,
2003, UBS Paine Webber filed suit in Delaware state court which essentially
re-stated the claims originally asserted in the New York action. We are
evaluating these allegations.

Additionally, Twin City Fire Insurance Company (one of the Company's
excess insurance carriers) 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 CEO, its former CFO, and other former and current
officers and directors of the Company. On October 23, 2003, Twin City filed an
amended complaint adding additional defendants. On October 30, 2003, Twin City
filed a second amended complaint adding certain exhibits. Twin City is seeking a
determination that no coverage is afforded defendants because of
misrepresentations in the insurance application. We are evaluating these
allegations.

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
Statement of Financial Accounting Standard ("SFAS No. 5"), "Accounting for
Contingencies," because we are currently unable to evaluate the likelihood of an
unfavorable outcome or estimate 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 as a defendant 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, and
customer relations 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.

As of September 30, 2002, our stock was delisted from Nasdaq due to
failure to comply with continued listing standards. 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 may not be able to list our securities on Nasdaq or another national
market and a liquid market for our securities may never develop.

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.

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 and six months ended September 30, 2003,
customers that individually accounted for at least 10% of our revenues together
represented 45% of our revenues and in each of the three months and six months
ended September 30, 2002, customers that individually accounted for at least 10%
of our revenues together represented 57% and 49% of our revenues, respectively.
In each of these three and six months, there was substantial change among the
companies that represented our largest customers. In the three months ended
September 30, 2003, sales to one customer accounted for 45% of our revenues. In
the six months ended September 30, 2003, sales to two customers accounted for
28% and 17%, 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 six 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 meets 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 and it will adversely affect
our future cash position.

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 and develop additional
infrastructure; 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, adversely
affect our cash position, and would likely negatively affect the market price of
our common stock. We also do not believe that we will be able to raise
additional capital until the litigation, described in Note 2 to the Unaudited
Condensed Consolidated Financial Statements, is resolved.

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. Further, we do not
maintain key person life insurance on any of our employees. 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. 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 the 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 79% and 67% of our revenues in the three months ended September
30, 2003 and 2002, respectively, and 66% and 51% for the six months ended
September 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
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.