**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**(Mark One)**

| **ý**                                                                                                                                                                                                                                                                | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                      |       |                                                                                          |   |
| **For the quarterly period ended  September 30, 2004**                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                      |       |                                                                                          |   |
| **OR**                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                      |       |                                                                                          |   |
| **o**                                                                                                                                                                                                                                                                     | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                                                | ** ** | ** **                                                                                    |
| **For the transition period  from                   to                   ** |
|                                                                                                                                                                                                                                                                           |            |                                                                                               |  |  |  |  |

 

**CommissionFile Number 000-30637**

 

 

**AUGUSTTECHNOLOGY CORPORATION**

(Exact name of Registrant as specified in its charter)

 

| **Minnesota**                                              | ** ** | **41-1729485**                            |
|------------------------------------------------------------|------------|-------------------------------------------|
| (State of  incorporation)                                  |       | (I.R.S. Employer Identification No.) |
|                                                       |       |                                      |
| **4900  West 78th Street  Bloomington, MN**                | ** ** | **55435**                                 |
| (Address of  principal executive offices)                  |       | (Zip Code)                                |
|                                                       |       |                                      |
| **(952)  820-0080**                                        |
| (Registrant’s  telephone number, including area code) |

 

**N/A**

(Former name,former address, and former fiscal year, if changed since last report.)

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.    Yes  ý  No  o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined by Exchange Act Rule12b-2).  Yes  ý  No  o

 

As of October 29, 2004,there were 17,810,778 shares of common stock outstanding.

 

 

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**AUGUST TECHNOLOGY CORPORATION**

**TABLE OF CONTENTS**

 
|          |   | **Description**                                                                                                     |   |   |
|---------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|
|          |   |                                                                                                                |   |   |
| PART  I       |   | FINANCIAL  INFORMATION                                                                                              |   |   |
|          |   |                                                                                                                |   |   |
| Item 1.       |   | Financial Statements                                                                                                |   |   |
|          |   |                                                                                                                |   |   |
|          |   | Consolidated Balance Sheets  as of September 30, 2004 and December 31, 2003 (unaudited)                             |   |   |
|          |   |                                                                                                                |   |   |
|          |   | Consolidated  Statements of Operations for the three and nine months ended September 30,  2004 and 2003 (unaudited) |   |   |
|          |   |                                                                                                                |   |   |
|          |   | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2004 and  2003 (unaudited)           |   |   |
|          |   |                                                                                                                |   |   |
|          |   | Notes to  Consolidated Financial Statements (unaudited)                                                             |   |   |
|          |   |                                                                                                                |   |   |
| Item  2.      |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |   |
|          |   |                                                                                                                |   |   |
|          |   |                                                                                                                |   |   |
| Item  3.      |   | Quantitative  and Qualitative Disclosures about Market Risk                                                         |   |   |
|          |   |                                                                                                                |   |   |
| Item  4.      |   | Controls  and Procedures                                                                                            |   |   |
|          |   |                                                                                                                |   |   |
| PART II       |   | OTHER  INFORMATION                                                                                                  |   |   |
|          |   |                                                                                                                |   |   |
| Item 6.       |   | Exhibits                                                                                                            |   |   |
|          |   |                                                                                                                |   |   |
| SIGNATURES    |   |                                                                                                                |
|          |   |                                                                                                                |   |   |
| EXHIBIT INDEX |   |                                                                                                                |

 

2

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**PART I FINANCIAL INFORMATION**

 

**Item1.  FinancialStatements**

 

**AUGUSTTECHNOLOGY CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands, except share amounts)**

**(Unaudited)**

 
| ** **                                                                                                                        | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                        |       |                    |       |                   |       |
|                                                                                                                              |       |                    |       |                   |       |
| Current assets:                                                                                                                   |       |                    |       |                   |       |
| Cash and cash  equivalents                                                                                                        |       | $                       | 3,432      |                   | $          | 10,027 |   |
| Short-term  marketable debt securities                                                                                            |       | 42,060                  |       | 43,528                 |       |
| Accounts  receivable, net                                                                                                         |       | 11,315                  |       | 4,094                  |       |
| Inventories                                                                                                                       |       | 20,135                  |       | 11,651                 |       |
| Inventories at  customers under purchase orders                                                                                   |       | 4,741                   |       | 2,293                  |       |
| Prepaid expenses  and other current assets                                                                                        |       | 2,011                   |       | 1,631                  |       |
| Total current  assets                                                                                                             |       | 83,694                  |       | 73,224                 |       |
|                                                                                                                              |       |                    |       |                   |       |
| Property and  equipment, net                                                                                                      |       | 6,449                   |       | 3,141                  |       |
| Long-term  marketable debt securities                                                                                             |       | 5,362                   |       | 10,295                 |       |
| Purchased  technology, net                                                                                                        |       | 3,314                   |       | 1,179                  |       |
| Goodwill                                                                                                                          |       | 498                     |       | 498                    |       |
| Other assets                                                                                                                      |       | 515                     |       | 610                    |       |
| Total assets                                                                                                                      |       | $                       | 99,832     |                   | $          | 88,947 |   |
|                                                                                                                              |       |                    |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                     |       |                    |       |                   |       |
|                                                                                                                              |       |                    |       |                   |       |
| Current  liabilities:                                                                                                             |       |                    |       |                   |       |
| Accounts payable                                                                                                                  |       | $                       | 6,461      |                   | $          | 5,409 |   |
| Accrued  compensation                                                                                                             |       | 2,431                   |       | 1,146                  |       |
| Accrued  liabilities                                                                                                              |       | 1,778                   |       | 1,414                  |       |
| Customer  deposits and deferred revenue                                                                                           |       | 7,489                   |       | 2,436                  |       |
| Total current  liabilities                                                                                                        |       | 18,159                  |       | 10,405                 |       |
|                                                                                                                              |       |                    |       |                   |       |
| Other  non-current liabilities                                                                                                    |       | 82                      |       | 65                     |       |
| Total  liabilities                                                                                                                |       | 18,241                  |       | 10,470                 |       |
|                                                                                                                              |       |                    |       |                   |       |
| Commitments and  contingencies                                                                                                    |       | —                  |       | —                 |       |
|                                                                                                                              |       |                    |       |                   |       |
| Shareholders’  equity:                                                                                                       |       |                    |       |                   |       |
| Common stock, no  par value, 42,000,000 shares authorized, 17,804,696 and 17,382,538 shares  issued and outstanding, respectively |       | 90,090                  |       | 88,086                 |       |
| Undesignated  capital stock, no par value, 3,000,000 shares authorized, no shares issued or  outstanding                          |       | —                  |       | —                 |       |
| Deferred  compensation related to stock options                                                                                   |       | (12                     | )          | (49                    | )          |
| Accumulated  deficit                                                                                                              |       | (8,404                  | )          | (9,578                 | )          |
| Accumulated  other comprehensive income (loss)                                                                                    |       | (83                     | )          | 18                     |       |
| Total  shareholders’ equity                                                                                                  |       | 81,591                  |       | 78,477                 |       |
| Total  liabilities and shareholders’ equity                                                                                  |       | $                       | 99,832     |                   | $          | 88,947 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

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**AUGUSTTECHNOLOGY CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Inthousands, except per share amounts)**

**(Unaudited)**

 
| ** **                                       | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                             |       |                                 |       |                                |       |   |   |   |   |
| Net revenues                                     |       | $                                    | 15,516     |                                | $          | 11,685 |   | $ | 51,771 |   | $ | 26,005 |   |
| Cost of revenues                                 |       | 8,187                                |       | 5,100                               |       | 24,304 |   | 11,603 |   |
| Gross profit                                     |       | 7,329                                |       | 6,585                               |       | 27,467 |   | 14,402 |   |
|                                             |       |                                 |       |                                |       |   |   |   |   |
| Selling, general  and administrative expenses    |       | 6,202                                |       | 3,808                               |       | 16,781 |   | 10,228 |   |
| Research and  development expenses               |       | 3,822                                |       | 2,595                               |       | 10,052 |   | 7,797 |   |
| Operating income  (loss)                         |       | (2,695                               | )          | 182                                 |       | 634 |   | (3,623 | ) |
|                                             |       |                                 |       |                                |       |   |   |   |   |
| Interest income                                  |       | 204                                  |       | 71                                  |       | 594 |   | 247 |   |
| Other income                                     |       | 46                                   |       | —                              |       | 46 |   | — |   |
|                                             |       |                                 |       |                                |       |   |   |   |   |
| Income (loss)  before provision for income taxes |       | (2,445                               | )          | 253                                 |       | 1,274 |   | (3,376 | ) |
| Provision for  income taxes                      |       | —                               |       | —                              |       | 100 |   | — |   |
| Net income  (loss)                               |       | $                                    | (2,445     | )                                   | $          | 253 |   | $ | 1,174 |   | $ | (3,376 | ) |
|                                             |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss) per share:                    |       |                                 |       |                                |       |   |   |   |   |
| Basic                                            |       | $                                    | (0.14      | )                                   | $          | 0.02 |   | $ | 0.07 |   | $ | (0.25 | ) |
| Diluted                                          |       | $                                    | (0.14      | )                                   | $          | 0.02 |   | $ | 0.06 |   | $ | (0.25 | ) |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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**AUGUSTTECHNOLOGY CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                           | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Cash flows from operating  activities:                                                               |       |                                |       |   |   |
| Net income  (loss)                                                                                   |       | $                                   | 1,174      |   | $ | (3,376 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                |       |   |   |
| Depreciation and  amortization                                                                       |       | 1,890                               |       | 1,368 |   |
| Provision for  doubtful accounts                                                                     |       | 115                                 |       | 134 |   |
| Amortization of  deferred compensation related to stock options                                      |       | 40                                  |       | 45 |   |
| Changes in  operating assets and liabilities, net of affects of acquisitions:                        |       |                                |       |   |   |
| Accounts  receivable                                                                                 |       | (7,213                              | )          | 1,829 |   |
| Inventories                                                                                          |       | (8,484                              | )          | (967 | ) |
| Inventories at  customers under purchase orders                                                      |       | (2,448                              | )          | (746 | ) |
| Prepaid expenses  and other current assets                                                           |       | (397                                | )          | (141 | ) |
| Accounts payable                                                                                     |       | 1,052                               |       | 1,696 |   |
| Accrued  compensation                                                                                |       | 1,285                               |       | 745 |   |
| Accrued  liabilities                                                                                 |       | 304                                 |       | 572 |   |
| Customer  deposits and deferred revenue                                                              |       | 4,804                               |       | 919 |   |
| Net cash  provided by (used in) operating activities                                                 |       | (7,878                              | )          | 2,078 |   |
|                                                                                                 |       |                                |       |   |   |
| Cash flows from  investing activities:                                                               |       |                                |       |   |   |
| Purchases of  marketable securities                                                                  |       | (166,391                            | )          | (62,539 | ) |
| Maturities of  marketable securities                                                                 |       | 172,710                             |       | 29,161 |   |
| Purchases of  property and equipment                                                                 |       | (4,703                              | )          | (739 | ) |
| Cash paid for  acquisitions                                                                          |       | (2,300                              | )          | (1,485 | ) |
| Investments in  other assets                                                                         |       | (14                                 | )          | — |   |
| Net cash used in  investing activities                                                               |       | (698                                | )          | (35,602 | ) |
|                                                                                                 |       |                                |       |   |   |
| Cash flows from  financing activities:                                                               |       |                                |       |   |   |
| Net proceeds  from follow on common stock offering                                                   |       | —                              |       | 36,122 |   |
| Net proceeds  from issuances of common stock to employees                                            |       | 2,001                               |       | 604 |   |
| Net cash  provided by financing activities                                                           |       | 2,001                               |       | 36,726 |   |
|                                                                                                 |       |                                |       |   |   |
| Effect of  exchange rates on cash and cash equivalents                                               |       | (20                                 | )          | — |   |
|                                                                                                 |       |                                |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                                |       | (6,595                              | )          | 3,202 |   |
| Cash and cash  equivalents at beginning of period                                                    |       | 10,027                              |       | 1,895 |   |
| Cash and cash  equivalents at end of period                                                          |       | $                                   | 3,432      |   | $ | 5,097 |   |
|                                                                                                 |       |                                |       |   |   |
| Supplemental cash  flow information:                                                                 |       |                                |       |   |   |
| Cash refunds  (payments) of income taxes, net                                                        |       | $                                   | (83        | ) | $ | 227 |   |
| Common stock  issued for acquisitions                                                                |       | $                                   | —     |   | $ | 2,160 |   |

 

See accompanying notes toconsolidated financial statements.

 

5

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**AUGUST TECHNOLOGY CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30, 2004**

**(In thousands, except per share amounts)**

**(Unaudited)**

 

**Note****1 –****Basisof Presentation**

 

The accompanying unaudited consolidated financialstatements have been prepared pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnote disclosures, normally included inconsolidated financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America, have beencondensed or omitted pursuant to such rules and regulations.  In the opinion of the management of AugustTechnology Corporation (collectively with its subsidiaries, the “Company”), alladjustments (consisting of normal recurring adjustments) considered necessaryfor a fair presentation have been included in the consolidated balance sheet atSeptember 30, 2004, the consolidated results of operations for the three andnine months ended September 30, 2004 and 2003, and the consolidated statementsof cash flows for the nine months ended September 30, 2004 and 2003.  The results of operations of the interimperiods are not necessarily indicative of the results of operations that may beexpected for any other period or for the year as a whole.  These consolidated financial statements andnotes hereto should be read in conjunction with the audited consolidatedfinancial statements and notes thereto included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2003, filed with the Securitiesand Exchange Commission on March 1, 2004.

 

The accompanying consolidated financial statementsinclude the accounts of August Technology Corporation and its wholly ownedsubsidiaries.  All significantintercompany balances and transactions are eliminated in consolidation.

 

**Note 2****–****Business Combination**

 

OnJuly 27, 2004, the Company purchased certain assets relating to the DMSVisionsoftware division (“DMS”) of Inspex, Inc. The purchase was made pursuant to an Asset Purchase Agreement betweenthe Company and Inspex, Inc. dated June 23, 2004.  DMS develops and markets product characterization softwaresolutions that allow customers to collect and analyze process information froma broad range of applications.  The totalconsideration paid for DMS, including direct acquisition costs, was$2,288.  In addition, the Company may oweadditional future consideration based on new orders for DMS software licensesreceived in the twelve months after the purchase (See note 9).

 

The allocation of thepurchase price to the net assets acquired and liabilities assumed based upontheir estimated fair market values was as follows:

 

6

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| Accounts  receivable  |   | $     | 123    |   |
|-----------------------|--------|-------|--------|--------|
| Purchased  technology |   | 2,435 |   |
| Accrued  liabilities  |   | (21   | )      |
| Deferred revenue      |   | (249  | )      |
|                  |   | $     | 2,288  |   |

 

The following unaudited pro forma consolidatedfinancial information presents the combined results of operations of theCompany and DMS as if the acquisition occurred at the beginning of the periodspresented, after giving effect to certain adjustments, including amortizationexpense.  The unaudited pro forma consolidated financial information doesnot necessarily reflect the results of operations that would have occurred hadthe acquisition been completed as of the dates indicated or the results thatmay be obtained in the future.

 
| ** **                    | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                    | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net Revenues                  |       | $                                    | 15,590     |                                | $          | 12,095 |   | $ | 52,289 |   | $ | 27,387 |   |
| Net income  (loss)            |       | (2,587                               | )          | (99                                 | )          | 179 |   | (4,280 | ) |
|                          |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss) per share: |       |                                 |       |                                |       |   |   |   |   |
| Basic                         |       | $                                    | (0.15      | )                                   | $          | (0.01 | ) | $ | 0.01 |   | $ | (0.32 | ) |
| Diluted                       |       | (0.15                                | )          | (0.01                               | )          | 0.01 |   | (0.32 | ) |

 

**Note 3– Marketable Securities**

 

The amortized cost and estimated fair value ofavailable-for-sale marketable debt securities were as follows:

 
| ** **      | ** ** | **September 30, 2004** | ** ** |
|-----------------|------------|------------------------|------------|
| ** **      | ** ** | **Amortized  Cost**    | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Corporate bonds |       | $                      | 13,196     |   | $ | 1 |   | $ | (31 | ) | $ | 13,166 |   |
| Municipal bonds |       | 34,270                 |       | 1 |   | (15 | ) | 34,256 |   |
|            |       | $                      | 47,466     |   | $ | 2 |   | $ | (46 | ) | $ | 47,422 |   |

 
| ** **      | ** ** | **December 31, 2003** | ** ** |
|-----------------|------------|-----------------------|------------|
| ** **      | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Corporate bonds |       | $                     | 12,484     |   | $ | 35 |   | $ | (2 | ) | $ | 12,517 |   |
| Municipal bonds |       | 41,301                |       | 7 |   | (2 | ) | 41,306 |   |
|            |       | $                     | 53,785     |   | $ | 42 |   | $ | (4 | ) | $ | 53,823 |   |

 

The maturities of available-for-sale marketable debtsecurities were as follows:

 

7

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| ** **                              | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **Amortized  Cost**    | ** ** | **Fair  Value**       | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Due within one  year                    |       | $                      | 42,092     |                  | $          | 42,060 |   | $ | 43,524 |   | $ | 43,528 |   |
| Due after one  year through three years |       | 5,374                  |       | 5,362                 |       | 10,261 |   | 10,295 |   |
|                                    |       | $                      | 47,466     |                  | $          | 47,422 |   | $ | 53,785 |   | $ | 53,823 |   |

 

Net realized gains and losses were not material forthe nine months ended September 30, 2004 and the year ended December 31, 2003.

 

**Note 4 – Accounts Receivable**

 

Accounts receivable consisted of the following:

 
| ** **                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------|------------|-------------------------|------------|------------------------|------------|
|                             |       |                    |       |                   |       |
| Billed  receivables              |       | $                       | 10,246     |                   | $          | 3,837 |   |
| Unbilled revenue                 |       | 1,739                   |       | 812                    |       |
|                             |       | 11,985                  |       | 4,649                  |       |
| Allowance for  doubtful accounts |       | (670                    | )          | (555                   | )          |
| Accounts  receivable, net        |       | $                       | 11,315     |                   | $          | 4,094 |   |

 

**Note 5 – Inventories**

 

Inventories consisted of the following:

 
| ** **               | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------|------------|-------------------------|------------|------------------------|------------|
|                     |       |                    |       |                   |       |
| Raw materials            |       | $                       | 6,859      |                   | $          | 4,645 |   |
| Work in process          |       | 4,640                   |       | 2,305                  |       |
| Demonstration  equipment |       | 4,554                   |       | 1,603                  |       |
| Finished goods           |       | 4,082                   |       | 3,098                  |       |
| Inventories              |       | $                       | 20,135     |                   | $          | 11,651 |   |

 

**Note 6 – Purchased Technology**

 

As of September 30, 2004, purchased technology was $3,865 and related accumulatedamortization of $551.  Purchased technology is amortized on astraight-line basis over an estimated useful life of four years.  Amortization expense for the three months ended September 30, 2004 and 2003 was$187 and $84, respectively.  Amortization expense for the nine months ended September 30, 2004 and 2003 was$361 and $103, respectively.  Assuming no change in the grosscarrying value of purchased technology, the estimated amortization expense forthe twelve months ending December 31, 2004 is $648 and for each of the nextfour years is $953, $953, $761 and $304.

 

8

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**Note 7 – Accumulated Other Comprehensive Income(Loss)**

 

The accumulated balances foreach classification of accumulated other comprehensive income (loss) are asfollows:

 
| ** **                                           | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | ** **              | ** ** | ** **             | ** ** |
| Currency  translation adjustments                    |       | $                       | (39        | )                      | $          | (20 | ) |
| Net unrealized  gain (loss) on marketable securities |       | (44                     | )          | 38                     |       |
| Accumulated  other comprehensive income (loss)       |       | $                       | (83        | )                      | $          | 18 |   |

 

**Note 8 – Shareholders’ Equity**

 

Changes in shareholders’ equity during the nine monthsended September 30, 2004 were as follows:

 
| Shareholders’  equity balance at December 31, 2003         |   | $      | 78,477 |   |
|-----------------------------------------------------------------|--------|--------|--------|--------|
| Net income                                                      |   | 1,174  |   |
| Accumulated  other comprehensive loss:                          |   |   |   |
| Foreign currency  translation adjustment                        |   | (19    | )      |
| Net unrealized  loss on marketable debt securities              |   | (82    | )      |
| Comprehensive  income                                           |   | 1,073  |   |
| Issuances of  common stock in conjunction with:                 |   |   |   |
| Exercises of  employee stock options and warrants               |   | 1,864  |   |
| Employee stock  purchase plan                                   |   | 137    |   |
| Amortization of  deferred compensation related to stock options |   | 40     |   |
| Shareholders’  equity balance at September 30, 2004        |   | $      | 81,591 |   |

 

On September 23, 2003, theCompany sold 3,000 shares of its Common Stock at a price of $13.00 per share ina follow-on public offering (the “Offering”). In conjunction with the Offering, on October 21, 2003, the underwritersexercised their over-allotment option to acquire an additional 490 shares ofCommon Stock at the same price to the public and with the same underwritingdiscount as the Offering.  The netproceeds from the Offering, including the exercise of the underwritersover-allotment, after deducting the underwriting discount and offeringexpenses, was $42,049.

 

***Net Income (Loss) Per Share***

 

The components of basic and diluted net income (loss)per share were as follows:

 

9

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| ** **                                     | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                     | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                           |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss)                             |       | $                                    | (2,445     | )                                   | $          | 253 |   | $ | 1,174 |   | $ | (3,376 | ) |
|                                           |       |                                 |       |                                |       |   |   |   |   |
| Weighted average  common shares:               |       |                                 |       |                                |       |   |   |   |   |
| Basic                                          |       | 17,803                               |       | 13,844                              |       | 17,735 |   | 13,451 |   |
| Effect of  dilutive stock options and warrants |       | —                               |       | 734                                 |       | 610 |   | — |   |
| Diluted                                        |       | 17,803                               |       | 14,578                              |       | 18,345 |   | 13,451 |   |
|                                           |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss) per share:                  |       |                                 |       |                                |       |   |   |   |   |
| Basic                                          |       | $                                    | (0.14      | )                                   | $          | 0.02 |   | $ | 0.07 |   | $ | (0.25 | ) |
| Diluted                                        |       | $                                    | (0.14      | )                                   | $          | 0.02 |   | $ | 0.06 |   | $ | (0.25 | ) |

 

The total weighted average number of stock options andwarrants excluded from the calculation of potentially dilutive securitieseither due to the exercise price exceeding the average market price or theinclusion of such securities in a calculation of net income (loss) per sharewould have been anti-dilutive for the three months ended September 30, 2004 and2003 were 1,710 and 517, respectively, and for the nine months ended September30, 2004 and 2003 were 296and 1,887, respectively.

 

***Stock-based Compensation***

 

TheCompany applies Accounting Principles Board Opinion (“APB”) No. 25, *“Accounting for Stock Issued to Employees,”* and relatedinterpretations in accounting for stock-based compensation.  The exercise price of the Company’s stockoptions equals the market price of the underlying stock on the date of grantfor all options granted, and thus, under APB 25, no compensation expense isrecognized in the consolidated statements of operations.

 

Theestimated per share weighted average fair value of all stock options grantedduring the three months ended September 30, 2004 and 2003 was $6.01 and $6.11, respectively, and for the nine monthsended September 30, 2004 and 2003 was $8.10 and$3.82, respectively. The fair value of each option grant was estimated usingthe Black-Scholes option pricing model with the following weighted averageassumptions:

 
| ** **               | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **               | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                     |       |                                 |       |                                |       |   |   |   |   |
| Expected life            |       | 4.7 years                            |       | 5.9 years                           |       | 4.5 years |   | 5.6 years |   |
| Risk free  interest rate |       | 3.0                                  | %          | 3.2                                 | %          | 2.9 | % | 3.0 | % |
| Volatility               |       | 73.8                                 | %          | 75.1                                | %          | 74.0 | % | 75.1 | % |
| Dividend yield           |       | —                               |       | —                              |       | — |   | — |   |

 

Hadthe Company recorded compensation cost based on the estimated fair value on thedate of grant, as defined by SFAS 123, the Company’s pro forma net income(loss) would have been as follows:

 

10

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| ** **                                                                                          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                          | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss), as reported                                                                     |       | $                                    | (2,445     | )                                   | $          | 253 |   | $ | 1,174 |   | $ | (3,376 | ) |
| Stock-based  employee compensation expense determined under fair value based method for  all awards |       | (629                                 | )          | (377                                | )          | (2,303 | ) | (1,053 | ) |
| Net income  (loss), pro forma                                                                       |       | $                                    | (3,074     | )                                   | $          | (124 | ) | $ | (1,129 | ) | $ | (4,429 | ) |
|                                                                                                |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss) per share:                                                                       |       |                                 |       |                                |       |   |   |   |   |
| As reported:                                                                                        |       |                                 |       |                                |       |   |   |   |   |
| Basic                                                                                               |       | $                                    | (0.14      | )                                   | $          | 0.02 |   | $ | 0.07 |   | $ | (0.25 | ) |
| Diluted                                                                                             |       | $                                    | (0.14      | )                                   | $          | 0.02 |   | $ | 0.06 |   | $ | (0.25 | ) |
|                                                                                                |       |                                 |       |                                |       |   |   |   |   |
| Pro forma:                                                                                          |       |                                 |       |                                |       |   |   |   |   |
| Basic                                                                                               |       | $                                    | (0.17      | )                                   | $          | (0.01 | ) | $ | (0.06 | ) | $ | (0.33 | ) |
| Diluted                                                                                             |       | $                                    | (0.17      | )                                   | $          | (0.01 | ) | $ | (0.06 | ) | $ | (0.33 | ) |

 

11

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**Note 9 – Commitments andContingencies**

 

***Warranties***

 

The Company provideswarranty coverage for its systems for a period of one year, including parts andlabor necessary to repair the systems during the warranty period.  The estimated warranty cost is based on ourhistorical experience rate of incurred expenses to corresponding systemrevenues.

 

The following tablesummarizes the activity related to the warranty liability during the nine months ended September 30, 2004 and2003:

 
| ** **                    | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------|------------|-------------------------------------|------------|
| ** **                    | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                          |       |                                |       |   |   |
| Accrual at  beginning of year |       | $                                   | 239        |   | $ | 111 |   |
| Warranties  issued            |       | 955                                 |       | 267 |   |
| Costs incurred                |       | (553                                | )          | (148 | ) |
| Accrual at end of  period     |       | $                                   | 641        |   | $ | 230 |   |

 

***Contingent Consideration***

 

In connection with theacquisition of DMS, the Company is subject to certain contingent considerationarrangements at September 30, 2004.  Thisarrangement is based upon new orders for DMS software licenses received in thetwelve months after the purchase.  Thepayment of the contingency will result in an increase in the allocation ofpurchase price to purchased technology. As a result, amortization expense related to this asset willincrease.  Amounts paid under thisarrangement are not expected to have a material effect on the Company’sfinancial condition or results of operations. The Company currently estimates the total contingent consideration to bepaid will be between $250 and $750.

 

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**Note 10 – Geographic, Product Lineand Significant Customer Information**

 

Allof the Company’s tangible long-lived assets are located in the United States,except for a small amount of property and equipment in Taiwan.  The Company derives revenues from shipmentsto customers outside of the United States. The percentage of net revenues by geographical region was as follows:

 
| ** **    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **    | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenues: |       |                                 |       |                                |       |   |   |   |   |
| United States |       | 21                                   | %          | 17                                  | %          | 27 | % | 25 | % |
| Asia          |       | 68                                   | %          | 72                                  | %          | 69 | % | 64 | % |
| Europe        |       | 11                                   | %          | 11                                  | %          | 4 | % | 11 | % |
|          |       | 100                                  | %          | 100                                 | %          | 100 | % | 100 | % |

 

Thepercentage of net revenues by major product line was as follows:

 
| ** **           | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenues:        |       |                                 |       |                                |       |   |   |   |   |
| NSX Series           |       | 39                                   | %          | 36                                  | %          | 50 | % | 53 | % |
| All Surface  Modules |       | 40                                   | %          | 14                                  | %          | 25 | % | 6 | % |
| 3Di Series           |       | 4                                    | %          | 25                                  | %          | 7 | % | 16 | % |
| Other                |       | 17                                   | %          | 25                                  | %          | 18 | % | 25 | % |
|                 |       | 100                                  | %          | 100                                 | %          | 100 | % | 100 | % |

 

Thepercentage of net revenues derived from major customers, which includedistributors, were as follows:

 
| ** **    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **    | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net revenues: |       |                                 |       |                                |       |   |   |   |   |
| Customer A    |       | 29                                   | %          | 15                                  | %          | 19 | % | 7 | % |
| Customer B    |       | 11                                   | %          | 4                                   | %          | 10 | % | 2 | % |
| Customer C    |       | 10                                   | %          | 1                                   | %          | 9 | % | 5 | % |
| Customer D    |       | 1                                    | %          | 20                                  | %          | 5 | % | 12 | % |
| Customer E    |       | 4                                    | %          | 18                                  | %          | 5 | % | 16 | % |
| Customer F    |       | —                               |       | 8                                   | %          | 2 | % | 16 | % |
|          |       | 55                                   | %          | 66                                  | %          | 50 | % | 58 | % |

 

**Note 13 – Recently Issued AccountingPronouncements**

 

In December 2003, the Financial Accounting Standards Board (“FASB”)issued FASB Interpretation (“FIN”) No. 46R, “*Consolidationof Variable Interest Entities,”* which addresses how a businessenterprise should evaluate whether it has a controlling financial interest inan entity through means other than voting rights and accordingly shouldconsolidate the entity.  FIN 46R replacesFASB Interpretation No. 46, “*Consolidationof Variable Interest Entities,”* which was issued in January 2003.The Company is required to apply FIN 46R to variable interests in variable

 

13

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interestentities (“VIE”) created after December 31, 2003. For variable interests inVIEs created before January 1, 2004, the Interpretation will be appliedbeginning on January 1, 2005. For any VIEs that must be consolidated under FIN46R that were created before January 1, 2004, the assets, liabilities andnoncontrolling interests of the VIE initially would be measured at theircarrying amounts with any difference between the net amount added to thebalance sheet and any previously recognized interest being recognized as thecumulative effect of an accounting change. If determining the carrying amountsis not practicable, fair value at the date FIN 46R first applies may be used tomeasure the assets, liabilities and noncontrolling interest of the VIE. TheCompany believes it has no variable interest entities and, therefore, FIN 46Rdid not have an impact on the Company’s consolidated financial statements.

 

In May 2003, the FASB issued SFAS No. 150, “*Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity.”* The Statement establishes standards for theclassification and measurement of certain financial instruments withcharacteristics of both liabilities and equity. The Statement also includes required disclosures for financialinstruments within its scope.  For theCompany, the Statement was effective for instruments entered into or modifiedafter May 31, 2003, and otherwise will be effective as of January 1, 2004,except for mandatorily redeemable financial instruments.  For certain mandatorily redeemable financialinstruments, the Statement will be effective for the Company on January 1,2005.  The effective date has beendeferred indefinitely for certain other types of mandatorily redeemablefinancial instruments.  The Companycurrently does not have any financial instruments that are within the scope ofthe Statement.

 

**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**Cautionary Factors That May Affect Future Results**

 

Certain statements made in this Quarterly Report onForm 10-Q, as well as oral statements made by us from time to time, which areprefaced with words such as “expects,” “anticipates,” “believes,” “projects,”“intends,” “plans” and similar words and other statements of similar sense, areforward-looking statements.  Ourforward-looking statements generally relate to our growth strategies, financialresults, future financial projections, product development activities and salesefforts.  Our actual results could differ materially from those projectedin the forward-looking statements as a result of a number of factors, includingbut not limited to market acceptance of our products, our ability tosuccessfully develop new products, our ability to protect our intellectualproperty, our dependence upon international customers and suppliers, ourdependence on a small number of customers that account for a significantportion of revenues, availability of products from our suppliers, cyclicalityin the microelectronic manufacturing equipment and other industries, managementof growth, integration of acquired businesses, and the other risk factorsdetailed below and in our Annual Report on Form 10-K for the year endedDecember 31, 2003, as filed with the SEC on March 1, 2004.  We disclaim any obligation to reviseforward-looking statements, or to update the reasons actual results coulddiffer materially from those anticipated, to reflect events or circumstancesafter the date of such statements or to reflect the occurrence of anticipatedor unanticipated events. Because many factors are unforeseeable, the foregoingshould not be considered an exhaustive list.

 

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**Introduction**

 

Thefollowing discussion of our results of operations and financial conditionshould be read together with the other financial information and consolidatedfinancial statements and related notes included in this Form 10-Q. Thisdiscussion contains forward-looking statements that involve risks anduncertainties. Our actual results could differ materially from thoseanticipated in the forward-looking statements as a result of a variety offactors.

 

**Critical Accounting Policies**

 

Thepreparation of our consolidated financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities.  We based these estimates andassumptions on historical experience and evaluate them on an on-going basis tohelp ensure they remain reasonable under current conditions.  Actualresults could differ from those estimates. We discuss the development andselection of the critical accounting estimates with the audit committee of ourboard of directors on a quarterly basis, and the audit committee has reviewedthe Company’s critical accounting policies as described in Item 7,“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in our Annual Report on Form 10-K for the year ended December 31,2003.  For the nine months ended September 30, 2004, there were nochanges to these critical accounting policies.

 

**Overview**

 

We are a world-class provider of automated defect detection and productcharacterization systems for microelectronic device manufacturers. Our systemsprovide manufacturers with information that enables process-enhancingdecisions, ultimately lowering manufacturing costs and decreasingtime-to-market. We sell our systems to many of the leading microelectronicdevice manufacturers throughout the world for inspecting semiconductors,advanced packaging applications, optoelectronics devices, MEMS, data storagedevices and micro displays.  We havetraditionally provided systems to address the automated inspection needs of theearly stages of the final manufacturing or back-end of the microelectronicdevice manufacturing process. These needs were met primarily with our NSXSeries and 3Di Series of products.  Werecently introduced the AXi Series, E20 and B20 inspection options for advancedmacro detection in the front-end of the wafer manufacturing process. When usedin conjunction with one another these systems allow a manufacturer to inspectthe top, edge and back of a wafer’s surface. We believe we are the first to offer all surface wafer inspection.  We complement this broad inspectioncapability with an expanding suite of software tools designed to enhance thespeed and effectiveness of the process by which device manufacturers analyzedefects, and make decisions regarding their manufacturing process to reduce oreliminate such defects.  We refer to thisprocess as the “detection-to-decision” process.

 

In addition to internaldevelopment, we look to expand through strategic acquisitions of complementaryproducts and technologies. In April 2003 we completed the acquisition ofSemiconductor Technologies & Instruments, Inc. (“STI”), enhancing our probemark inspection and metrology capabilities. In July 2003 we acquired theassets of Counterpoint Solutions, Inc. (“CSI”), including the design for theVersaScope a defect review system for advanced microscope-based

 

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imaging and analysis.  The VersaScope provides us the ability toserve our customers earlier in their device development process and to morequickly analyze defects and understand their manufacturing process once theyinitiate high volume production.  In July2004 we acquired certain assets of the DMSVision software division of Inspex,Inc.  We plan to use the DMSVisionsoftware to further expand and enhance our current defect analysis softwareofferings.

 

Our business is subject to the highly cyclical natureof the microelectronic device manufacturing markets we serve. These cycles arecaused by significant, and often rapid, fluctuations in the supply and demandof microelectronic devices driven by such factors as changes in technology andglobal economic conditions. As a result of these fluctuations, our quarterlyorders and revenues have fluctuated dramatically.  After a three year industry downturn we began to experience signs of an industryrecovery during the second half of 2003 and continued through the first half of2004.  This resulted in a significantincrease in the level of orders and revenues during this period, and a recordlevel of backlog at June 30, 2004.  Inresponse to the increased activity level we added additional staff in allfunctional areas and increased our manufacturing levels.  Near the end of the third quarter of 2004, asa result of a slowdown in the microelectronic device manufacturing market, weencountered a slowdown in the rate of orders being received, and a delay inshipments of certain systems under previously received orders.  This resulted in a sequential decrease inquarterly revenues and a lower level of orders in backlog, as compared to the endof the second quarter.  Although wecurrently believe this slowdown may only be temporary in nature.  We have implemented cost cutting initiativesduring the fourth quarter of 2004.  These initiatives include staffingreductions, a freeze on new hires, reductions in management compensation, cutsin discretionary spending and mandatory time-off for employees (the “CostCutting Initiatives”).

 

Management focuses onseveral key financial metrics in evaluating our financial condition andoperating performance. Although we do not believe backlog is always ameaningful or accurate indication of future revenues and performance, sinceonly a portion of our revenues for any quarter include systems that were inbacklog as of the beginning of that quarter, we do closely monitor the level oforders both geographically and by product line and in relation to the level ofrevenues, referred to as the book-to-bill ratio.  During the third quarter of 2004 ourbook-to-bill ratio was below parity for the first time in nine consecutivequarters.  A book-to-bill ratio greaterthan parity indicates a growing level of backlog.  In addition to monitoring our level oforders and backlog, we focus on revenues by product family compared toprior-period and current-year plans, year-over-year revenue growth compared tothe overall semiconductor equipment industry, operating profit or lossperformance compared with prior-period and current-year plans and the level ofoperating cash flow.

 

Future quarterly andannual results will continue to be impacted by fluctuations in supply anddemand of microelectronic devices, the timing of new product announcements andreleases by us or our competitors, market acceptance of new or enhancedversions of our products, changes in the pricing of our products and the timingand level of our research and development expenditures.  We cannot predict the sustainability or depth of these fluctuations andtheir impact on our business, and/or the overall industry’s rate of growth. Ifwe are unable to effectively manage our resources and production capacityduring an industry cycle, there could be a material adverse effect on ourbusiness, financial condition and results of operations.

 

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**Results of Operations**

 
| ** **                                           | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                           | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                 |       |                                 |       |                                |       |   |   |   |   |
| Net revenues                                         |       | 100.0                                | %          | 100.0                               | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                                     |       | 52.8                                 |       | 43.6                                |       | 46.9 |   | 44.6 |   |
| Gross profit                                         |       | 47.2                                 |       | 56.4                                |       | 53.1 |   | 55.4 |   |
|                                                 |       |                                 |       |                                |       |   |   |   |   |
| Selling, general  and administrative expenses        |       | 40.0                                 |       | 32.6                                |       | 32.4 |   | 39.4 |   |
| Research and  development expenses                   |       | 24.6                                 |       | 22.2                                |       | 19.4 |   | 30.0 |   |
| Operating income  (loss)                             |       | (17.4                                | )          | 1.6                                 |       | 1.3 |   | (14.0 | ) |
|                                                 |       |                                 |       |                                |       |   |   |   |   |
| Interest income                                      |       | 1.3                                  |       | 0.6                                 |       | 1.1 |   | 1.0 |   |
| Other income                                         |       | 0.3                                  |       | —                              |       | 0.1 |   | — |   |
|                                                 |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss) before provision for income taxes |       | (15.8                                | )          | 2.2                                 |       | 2.5 |   | (13.0 | ) |
| Provision for  income taxes                          |       | —                               |       | —                              |       | 0.2 |   | — |   |
| Net income  (loss)                                   |       | (15.8                                | )%         | 2.2                                 | %          | 2.3 | % | (13.0 | )% |

 

*Three and nine months endedSeptember 30, 2004 compared to the three and nine months ended September 30,2003*

 

*NetRevenues.*  Net revenues increased $3.8 million, or32.8%, to $15.5 million for the three months ended September 30, 2004, from$11.7 million for the same period in 2003. Net revenues increased $25.8 million, or 99.1%, to $51.8 million for thenine months ended September 30, 2004, from $26.0 million for the same period in2003.  The increase in net revenues wasprimarily due to increased sales of higher throughput NSX Series systemsinstalled in a broader array of wafer and device fabrication processes andsales related to the AXi Series, for which we began to recognize revenue duringthe third quarter of 2003.  Revenues fromthese product lines increased primarily as a result of higher sales of systemsinto the front end of the wafer fabrication process and an overall increase indemand due to the industry recovery that began in the second half of 2003 andcontinued through the first half of 2004. Revenues are expected to be relatively flat, as compared to thirdquarter, due to the industry slowdown described above.

 

Netrevenues from international sales represented 79% and 83% of total net revenuesfor the three months ended September 30, 2004 and 2003.  International revenues during these periodswere primarily the result of sales to Asia, which comprised 68% and 72% oftotal net revenues, respectively.  Netrevenues from international sales represented 73% and 75% of net revenues forthe nine months ended September 30, 2004 and 2003, and were primarily theresult of sales to Asia, which comprised 69% and 64% of total net revenues.

 

*GrossMargin.*  Gross margin decreased to 47.2% for the threemonths ended September 30, 2004, from 56.4% for the same period in 2003.  Gross margin decreased to 53.1% for the nine months ended September 30,2004, from 55.4% for the same period in 2003. Gross margins decreasedprimarily as a result of the write-off of inventory related to the WAV Seriesproduct line, as the WAV’s functionality is being integrated into the NSXSeries product line.  This write-offcaused margins to decrease by 5.6 and 1.6 percentage points, during the threeand nine months ended September 30, 2004, respectively.  Gross margins in the third quarter of 2004were also negatively impacted by 1.7 percentage points due to under-absorptionof fixed overhead costs due to a decrease in the number of systemsmanufactured.  The remaining decrease isdue to lower gross margins onsales of our AXi Series and NSX Series product lines due to an increase in thenumber of systems sold that included higher cost automated material handlingsubsystem options.  In addition, we haveexperienced pricing pressure primarily related to our inspection systems soldinto final manufacturing applications as competitors have continued to enterthis market.  These decreases

 

17

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were offset by increased revenue from ourYield*Pilot* product line.  We expect future gross margins to be between53% and 56%.

 

*Selling, General andAdministrative Expenses.* Selling, general and administrative expenses consist primarily ofemployee salaries and related benefits, travel expenses and occupancy relatedcosts.  Selling, general and administrativeexpenses were $6.2 million and $16.8 million for the three and nine monthsended September 30, 2004, compared to $3.8 million and $10.2 million for thesame periods in 2003.  Selling, generaland administrative expenses as a percentage of net revenues were 40.0% and32.4% for the three and nine months ended September 30, 2004, compared to 32.6%and 39.4% of net revenues for the sameperiods in 2003.  The increase in expensedollars was primarily the result of costs associated with both new hires andcontractors in our field service and sales groups to support increased revenuesand our direct sales and service office in South Korea, which opened inFebruary 2004, and expenses associated with the ongoing operations of threeacquisitions completed subsequent to the first quarter of 2003.  The quarterly selling, general andadministrative expense dollars, and as a percentage of revenues, are expectedto decrease in the fourth quarter of 2004, as compared to the third quarter of2004, primarily as a result of the Cost Cutting Initiatives.

 

*Researchand Development Expenses.*  Research and development expensesconsist primarily of employee salaries and related benefits and consulting feesfor individuals engaged in the research, design and development of newproducts.  Research and developmentexpenses were $3.8 million and $10.1 million for the three and nine monthsended September 30, 2004, compared to $2.6 million and $7.8 million for thesame periods in 2003.  Research anddevelopment expenses as a percentage of net revenues were 24.6% and 19.4% for the three and nine monthsended September 30, 2004, compared to 22.2% and 30.0% for the same periods in2003.  The increase in expense dollarswas primarily due to employeecompensation and related benefits associated with the hiring ofadditional staff and an increase in the use of outside contractors to completecertain stages of development of the E20 edge and B20 back-side inspectionoptions and VersaScope, and further enhancements to both the NSX Series and AXiSeries.  In addition, expenses increaseddue to three acquisitions completed subsequent to the first quarter of2003.  The savings from the Cost CuttingInitiatives will be offset by our commitment to continuing to invest in the continued expansion of our business inthe front-end of the wafer manufacturing process and expansion of our suite ofsoftware solutions.  As a result,we currently anticipate that researchand development expenses, both in dollars and as a percentage of revenues, willremain relatively flat in the fourth quarter of 2004, as compared to the thirdquarter of 2004.

 

*Interest Income.*  Interest income was $204,000 and$594,000 for the three and nine months ended September 30, 2004, compared to$71,000 and $247,000 for the same periods in 2003.  The increase in interest income was primarilydue to an increase in overall investment balances, as a result of the proceedsreceived from a follow-on public offering of our Common Stock that wascompleted on September 23, 2003 and the underwriters’ exercise of the over-allotmentoption on October 21, 2003 (the “Offering”).

 

***Income Taxes. ***As a result of historical operating losses and uncertaintyas to the extent of profitability in future periods, we began to record avaluation allowance against our deferred tax assets in the second quarter of2002 and continue to do so at September 30, 2004.  As a result, we did not reflect a provisionfor income taxes during 2003, and have recorded a provision for income taxes of$100,000 for the nine months ended September 30, 2004, primarily to reflectforeign income tax owed and state registration fees.  Statement of Financial Accounting Standards (“SFAS”)No. 109 “Accounting forIncome Taxes,” requires the establishment of a valuation

 

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**allowance to reflect the likelihood of the realization ofdeferred tax assets.  We do not expect torecord a provision for income taxes during the fourth quarter of 2004.  As of December 31, 2003 the valuationallowance was $7.5 million.**

 

**Liquidity and CapitalResources**

 

Duringthe nine months ended September 30, 2004, working capital increased to $65.5million as compared to $62.8 million at December 31, 2003.  The increase was primarily due to an increasein both accounts receivable and inventories, partially offset by an increase incustomer deposits and deferred revenues. At September 30, 2004 our principal sources of liquidity consisted ofcash, cash equivalents and marketable debt securities of $50.9 million.  During the next twelve months the Companyintends on utilizing these funds for operations, specifically to enhance itsposition in the front-end wafer fabrication process.  We have no outstanding debt at September 30,2004.  Our liquidity is affected by manyfactors, some of which are based on the normal ongoing operations of ourbusiness, the most significant of which includes the timing of the collectionof receivables, the level of inventories, capital expenditures andacquisitions.

 

*AccountsReceivable.*  Our accounts receivable increased $7.2million from December 31, 2003 to September 30, 2004.  Our days sales outstanding (“DSO”) during thethree months ended September 30, 2004 was 79 days.  This compares to a DSO of 59 days in thesecond quarter of 2004.  The increase inthe DSO during the third quarter is primarily due to the high mix ofinternational revenues during current and prior quarters, which generallyrequire a longer time for collection. This increase has resulted in a use of cash of $7.2 million during thenine months ended September 30, 2004, as the Company has funded shipments forincreased revenues prior to receiving payments from customers.  We believe our DSO will be between 60 and 70days in future quarters.

 

*Inventories.*  Inventoriesincreased $8.5 million from December 31, 2003 to September 30, 2004.  The increase is primarily due to the need tosupport new product introductions, increased backlog and increaseddemonstration equipment at customers under evaluation.

 

*Inventories at Customers underPurchase Orders.*  Inventories at customers underpurchase orders increased $2.4 million from December 31, 2003 to September 30,2004, primarily due to shipments of newer models of our NSX Series that havenot yet qualified for revenue recognition. We anticipate that a portion of thisinventory will be recognized as revenue during the fourth quarter of 2004.  We anticipate that this inventory willincrease as shipments of newly introduced products increase.

 

*CapitalExpenditures.*  Our capital expenditures during the firstnine months of 2004 were $4.7 million, consisting primarily of thecapitalization of finished goods that have been transferred to engineering fortest and characterization, to customer service for training and to sales forcustomer application studies.  This equipmentis expected to be utilized for these purposes for its estimated life, generallythree years.  Our total capitalexpenditures, including the capitalization of finished goods, are expected tobe between $5.0 million and $5.5 million in 2004, as we continue to expand the use of internal test anddevelopment equipment and facilities to meet customer demand and better serveour customers.

 

Our liquidity is alsoaffected by factors beyond our control related to the uncertainties of globaleconomies and the cyclical nature of the semiconductor and microelectronicindustries.  Although

 

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liquidity requirements will fluctuate based on the timing and extent ofall of these factors and others, management believes that existing cash andinvestment balances will be adequate to satisfy our existing liquidityrequirements for at least the next twelve months.

 

*Cash Flows*

 

Net cash used inoperating activities for the nine months ended September 30, 2004 was $7.9 million,which resulted primarily from increased accounts receivable and inventoriespartially offset by our net income and increased customer deposits and deferredrevenues.  Net cash used in investingactivities was $698,000, primarily due to $4.7 million used for purchases ofproperty and equipment and $2.3 million used for the purchase of the DMSVisiondivision of Inspex, partially offset by $6.3 million of net proceeds from salesof marketable securities.  Net cash providedby financing activities was $2.0 million from the proceeds received fromissuances of common stock, primarily related to exercises of stock options byemployees.  We currently do not expect togenerate cash flow from operating activities during the remainder of 2004.

 

Net cash provided byoperating activities for the nine months ended September 30, 2003 was $2.1million, which resulted primarily from decreased accounts receivable andincreased customer deposits and accounts payable partially offset by our netloss and increased inventory during the period. Net cash used in investing activities was $35.6 million, primarily dueto $33.4 million of net purchases of marketable securities resulting from theproceeds of the Offering, $1.4 million paid to acquire STI and $739,000 ofpurchases of property and equipment.  Netcash provided by financing activities was $36.7 million, including $36.1million of net proceeds received from the Offering.

 

**NewAccounting Pronouncements**

 

In December 2003, the Financial Accounting Standards Board (“FASB”) issuedFASB Interpretation (“FIN”) No. 46R, “*Consolidationof Variable Interest Entities,”* which addresses how a businessenterprise should evaluate whether it has a controlling financial interest inan entity through means other than voting rights and accordingly shouldconsolidate the entity.  FIN 46R replacesFASB Interpretation No. 46, “*Consolidationof Variable Interest Entities,”* which was issued in January 2003. Weare required to apply FIN 46R to variable interests in variable interestentities (“VIE”) created after December 31, 2003. For variable interests inVIEs created before January 1, 2004, the Interpretation will be appliedbeginning on January 1, 2005. For any VIEs that must be consolidated under FIN46R that were created before January 1, 2004, the assets, liabilities andnoncontrolling interests of the VIE initially would be measured at theircarrying amounts with any difference between the net amount added to thebalance sheet and any previously recognized interest being recognized as the cumulativeeffect of an accounting change. If determining the carrying amounts is notpracticable, fair value at the date FIN 46R first applies may be used tomeasure the assets, liabilities and noncontrolling interest of the VIE. Webelieve that we have no variable interest entities and, therefore, FIN 46R didnot have an impact on our consolidated financial statements.

 

In May 2003, the FASB issued SFAS No. 150, “*Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity.”* The Statement establishes standardsfor the classification and measurement of certain financial instruments withcharacteristics of both liabilities and equity. The Statement also includes required disclosures for financialinstruments within its scope.  For us,the Statement was effective for instruments entered into or modified after May31, 2003, and otherwise will be effective as of January 1, 2004, except formandatorily

 

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redeemablefinancial instruments.  For certainmandatorily redeemable financial instruments, the Statement will be effectivefor us on January 1, 2005.  The effectivedate has been deferred indefinitely for certain other types of mandatorilyredeemable financial instruments.  Wecurrently do not have any financial instruments that are within the scope ofthe Statement and, therefore, SFAS 150 did not have an effect on ourconsolidated financial statements.

 

**Item 3.            Quantitativeand Qualitative Disclosures about Market Risk**

 

*Market Risk*

 

Weare exposed to market risk primarily from changes in interest rates and creditrisk.  We do not have material exposureto market risk from fluctuations in foreign currency exchange rates because allsales are made in U.S. dollars.

 

*Interest RateRisk*

 

Weare exposed to interest rate risk primarily from investments in cashequivalents and short-term and long-term marketable debt securities (the“Investment Portfolio”).  The entireInvestment Portfolio, classified as available-for-sale, is recorded on thebalance sheet at fair market value with unrealized gains or losses excludedfrom earnings and included in “Accumulated other comprehensive income (loss)”until realized.  The entire InvestmentPortfolio is denominated in U.S. dollars. We do not use derivative financial instruments in the InvestmentPortfolio.  Due to the short duration ofour Investment Portfolio, an immediate 100 percent change in interest rates isnot expected to have a material adverse effect on our near-term financialcondition or results of operations.

 

*Credit Risk*

 

Financialinstruments which potentially subject us to credit risk consist principally ofsecurities in the Investment Portfolio and trade receivables.  We limit credit risk related to theInvestment Portfolio by placing all investments with high quality creditissuers and limit the amount of investments with any one issuer.  As of September 30, 2004, 88.7% of theInvestment Portfolio consisted of government securities and corporatecommercial paper and bonds with maturities of one year or less.  We limit credit risk associated with tradereceivables by performing ongoing credit evaluations and believe that there isno additional risk beyond amounts provided for collection losses to be inherentin trade receivables.

 

**Item 4.            Controlsand Procedures**

 

*Evaluation of Disclosure Controlsand Procedures*

 

Asof the end of the period covered by this report, the Company conducted anevaluation under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, regarding the effectiveness of the design and operation of theCompany’s disclosure controls and procedures pursuant to Rules 13a-15(b) of theSecurities Exchange Act of 1934 (the “Exchange Act”).  Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that the Company’sdisclosure controls and procedures are effective to ensure that informationthat is required to be disclosed by the Company in reports that it

 

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files under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in therules of the Securities and Exchange Commission.

 

*Changes in Internal Controls*

 

There were no changes inthe Company’s internal controls over financial reporting that occurred duringthe period covered by this report that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**PART II – OTHERINFORMATION**

 

**Item 6.            Exhibits**

 

Theexhibits listed on the Exhibit Index are filed herewith.

 

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SIGNATURES

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                    | AUGUST TECHNOLOGY  CORPORATION         |
|-------------------------|----------------------------------------|
|                    |                                   |
|                    |                                   |
| Date:  November 1, 2004 | By:                                    | /s/  DAVID L. KLENK |   |
|                    | David L. Klenk                         |
|                    | President and  Chief Operating Officer |
|                    | (Acting  Principal Executive Officer)  |
|                    |                                   |
|                    |                                   |
| Date:  November 1, 2004 | By:                                    | /s/  STANLEY D. PIEKOS |   |
|                    | Stanley D. Piekos                      |
|                    | Chief Financial  Officer               |
|                    | (Principal  Financial Officer)         |
|                    |                                   |
|                    |                                   |
| Date:  November 1, 2004 | By:                                    | /s/  SCOTT A. GABBARD |   |
|                    | Scott A. Gabbard                       |
|                    | Chief Accounting  Officer and          |
|                    | Vice President,  Finance               |
|                    | (Principal  Accounting Officer)        |
|                         |                                        |  |  |  |  |

 

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**SECURITIES AND EXCHANGECOMMISSION**

Washington,D.C.  20549

 

EXHIBIT INDEX TO FORM 10-Q

 
| For the quarter ended: | Commission  File No.: 000-30637 |
|------------------------|---------------------------------|
| September 30, 2004     |                            |

 

**AUGUSTTECHNOLOGY CORPORATION**

** **

 
| **Exhibit Number** | ** ** | **Description**                                                                                           |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------|
|               |       |                                                                                                      |
| 31.1               |       | Certification pursuant  to Exchange Act Rules 13a-14(a) of the Acting Principal Executive Officer         |
|               |       |                                                                                                      |
| 31.2               |       | Certification pursuant  to Exchange Act Rules 13a-14(a) of the Chief Financial Officer                    |
|               |       |                                                                                                      |
| 32.1               |       | Certification Pursuant  to 18 U.S.C. Section 1350, as Adopted Pursuant to the Sarbanes-Oxley Act of  2002 |

 

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