**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

**(MarkOne)**

** **

| **ý** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|----------------------------------------------------------------------------------------------|

** **

**For the quarterly period ended November 26, 2005**

 

**OR**

 

| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES**

**EXCHANGE  ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------------|

 

**For the transition period from        to        **

 

**Commission File Number:  0-12853**

 

**ELECTRO SCIENTIFIC INDUSTRIES, INC.**

** **
| **Oregon**                                           |       | **93-0370304**                       |
|------------------------------------------------------|------------|--------------------------------------|
| (State or other  jurisdiction of incorporation       |       | (I.R.S. Employer Identification No.) |
| or organization)                                     | ** ** |                                 |
|                                                 |       |                                 |
| **13900 N.W. Science Park Drive, Portland,  Oregon** |       | **97229**                            |
| (Address of principal executive offices)             |       | (Zip Code)                           |

 

Registrant’s telephonenumber:  **(503)641-4141**

 

Registrant’s web address: **www.esi.com**

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes ý  No  o

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o  No ý

 

The number of shares outstanding of the Registrant’sCommon Stock at December 20, 2005 was 28,839,891 shares.

 

 

----

 

### **ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES**

### **TABLE OF CONTENTS**

 
| **PART I - FINANCIAL INFORMATION** | ** **                                                                                                                         |
|------------------------------------|------------------------------------------------------------------------------------------------------------------------------------|
|                               |                                                                                                                               |   |
| Item 1.                            | Consolidated Condensed Financial  Statements (unaudited)                                                                           |   |
|                               |                                                                                                                               |   |
|                               | Consolidated Condensed  Balance Sheets – November 26, 2005 and May 28, 2005                                                   |   |
|                               |                                                                                                                               |   |
|                               | Consolidated Condensed  Statements of Operations – Three Months and Six Months Ended November 26,  2005 and November 27, 2004 |   |
|                               |                                                                                                                               |   |
|                               | Consolidated Condensed  Statements of Cash Flows – Six Months Ended November 26, 2005 and November  27, 2004                  |   |
|                               |                                                                                                                               |   |
|                               | Notes to Consolidated  Condensed Financial Statements                                                                              |   |
|                               |                                                                                                                               |   |
| Item 2.                            | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                        |   |
|                               |                                                                                                                               |   |
| Item 3.                            | Quantitative and Qualitative  Disclosures About Market Risk                                                                        |   |
|                               |                                                                                                                               |   |
| Item 4.                            | Controls and Procedures                                                                                                            |   |
|                               |                                                                                                                               |   |
| **PART II - OTHER INFORMATION**    | ** **                                                                                                                         |
|                               |                                                                                                                               |   |
| Item 1.                            | Legal Proceedings                                                                                                             |   |
|                               |                                                                                                                               |   |
| Item 4.                            | Submission of Matters to a  Vote of Security Holders                                                                               |   |
|                               |                                                                                                                               |   |
| Item 6.                            | Exhibits                                                                                                                           |   |
|                               |                                                                                                                               |   |
| Signatures                         |                                                                                                                               |

 

1

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**PART I- FINANCIAL INFORMATION**

** **

**Item 1.****Financial Statements**

 

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSEDBALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                             | ** ** | **November 26,** | ** ** | **May 28,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------|------------|
| ** **                                                                                             | ** ** | **2005**              | ** ** | **2005**         | ** ** |
| ** **                                                                                             | ** ** | ** **            | ** ** | ** **       | ** ** |
| **Assets**                                                                                             | ** ** | ** **            | ** ** | ** **       | ** ** |
| Current assets:                                                                                        |       |                  |       |             |       |
| Cash and cash  equivalents                                                                             |       | $                     | 93,908     |             | $          | 61,314 |   |
| Marketable  securities                                                                                 |       | 129,484               |       | 137,753          |       |
| Total cash and  securities                                                                             |       | 223,392               |       | 199,067          |       |
|                                                                                                   |       |                  |       |             |       |
| Trade  receivables, net of allowances of $659 and $833                                                 |       | 35,307                |       | 36,163           |       |
| Income tax  refund receivable                                                                          |       | 1,418                 |       | 9,227            |       |
| Inventories                                                                                            |       | 59,908                |       | 59,533           |       |
| Shipped systems  pending acceptance                                                                    |       | 3,265                 |       | 4,014            |       |
| Deferred income  taxes                                                                                 |       | 13,107                |       | 10,930           |       |
| Prepaid and  other current assets                                                                      |       | 4,964                 |       | 3,169            |       |
| Total current  assets                                                                                  |       | 341,361               |       | 322,103          |       |
|                                                                                                   |       |                  |       |             |       |
| Long-term  marketable securities                                                                       |       | 7,380                 |       | 19,834           |       |
| Property, plant  and equipment, net of accumulated depreciation of $48,392 and $45,598                 |       | 38,310                |       | 32,959           |       |
| Deferred income  taxes, net                                                                            |       | 14,673                |       | 16,955           |       |
| Other assets                                                                                           |       | 16,213                |       | 11,706           |       |
| Total assets                                                                                           |       | $                     | 417,937    |             | $          | 403,557 |   |
|                                                                                                   |       |                  |       |             |       |
| **Liabilities and shareholders’ equity**                                                          | ** ** | ** **            | ** ** | ** **       | ** ** |
| Current liabilities:                                                                                   |       |                  |       |             |       |
| Accounts payable                                                                                       |       | $                     | 11,291     |             | $          | 3,961 |   |
| Accrued  liabilities                                                                                   |       | 28,747                |       | 29,455           |       |
| Deferred revenue                                                                                       |       | 13,342                |       | 12,986           |       |
| Total current  liabilities                                                                             |       | 53,380                |       | 46,402           |       |
|                                                                                                   |       |                  |       |             |       |
| Commitments and contingencies                                                                          |       |                  |       |             |       |
|                                                                                                   |       |                  |       |             |       |
| Shareholders’ equity:                                                                             |       |                  |       |             |       |
| Preferred stock,  without par value; 1,000 shares authorized; no shares issued                         |       | —                |       | —           |       |
| Common stock,  without par value; 100,000 authorized; 28,737 and 28,615 shares issued and  outstanding |       | 159,943               |       | 156,367          |       |
| Retained  earnings                                                                                     |       | 205,734               |       | 201,199          |       |
| Accumulated  other comprehensive loss                                                                  |       | (1,120                | )          | (411             | )          |
| Total  shareholders’ equity                                                                       |       | 364,557               |       | 357,155          |       |
| Total  liabilities and shareholders’ equity                                                       |       | $                     | 417,937    |             | $          | 403,557 |   |

 

The accompanying notes are an integral part of these statements.

 

2

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSEDSTATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 
| ** **                                        | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                        | ** ** | **November 26, 2005**     | ** ** | **November 27, 2004**   | ** ** | **November 26, 2005** | ** ** | **November 27, 2004** | ** ** |
| ** **                                        | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                         |       | $                              | 48,643     |                         | $          | 66,004 |   | $ | 93,151 |   | $ | 138,624 |   |
| Cost of sales                                     |       | 27,475                         |       | 33,178                       |       | 52,336 |   | 68,912 |   |
| Gross profit                                      |       | 21,168                         |       | 32,826                       |       | 40,815 |   | 69,712 |   |
|                                              |       |                           |       |                         |       |   |   |   |   |
| Operating expenses:                               |       |                           |       |                         |       |   |   |   |   |
| Selling, service  and administration              |       | 11,365                         |       | 15,326                       |       | 22,442 |   | 30,204 |   |
| Research,  development and engineering            |       | 7,983                          |       | 7,746                        |       | 15,812 |   | 14,306 |   |
|                                              |       | 19,348                         |       | 23,072                       |       | 38,254 |   | 44,510 |   |
| Operating income                                  |       | 1,820                          |       | 9,754                        |       | 2,561 |   | 25,202 |   |
|                                              |       |                           |       |                         |       |   |   |   |   |
| Interest income                                   |       | 2,393                          |       | 1,773                        |       | 3,876 |   | 3,323 |   |
| Interest expense                                  |       | (29                            | )          | (1,786                       | )          | (58 | ) | (3,572 | ) |
| Other expense, net                                |       | (94                            | )          | (191                         | )          | (307 | ) | (324 | ) |
|                                              |       | 2,270                          |       | (204                         | )          | 3,511 |   | (573 | ) |
| Income before income taxes                        |       | 4,090                          |       | 9,550                        |       | 6,072 |   | 24,629 |   |
| Provision for income taxes                        |       | 902                            |       | 1,604                        |       | 1,537 |   | 6,037 |   |
| Net income                                        |       | $                              | 3,188      |                         | $          | 7,946 |   | $ | 4,535 |   | $ | 18,592 |   |
|                                              |       |                           |       |                         |       |   |   |   |   |
| Net income per share - basic                      |       | $                              | 0.11       |                         | $          | 0.28 |   | $ | 0.16 |   | $ | 0.66 |   |
|                                              |       |                           |       |                         |       |   |   |   |   |
| Net income per share - fully diluted              |       | $                              | 0.11       |                         | $          | 0.28 |   | $ | 0.16 |   | $ | 0.64 |   |
|                                              |       |                           |       |                         |       |   |   |   |   |
| Weighted average number of shares - basic         |       | 28,705                         |       | 28,443                       |       | 28,674 |   | 28,329 |   |
|                                              |       |                           |       |                         |       |   |   |   |   |
| Weighted average number of shares - fully diluted |       | 28,997                         |       | 28,541                       |       | 28,896 |   | 32,315 |   |

 

The accompanying notes are an integral part of these statements.

 

3

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTSOF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                     | ** ** | **For the six months ended** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                     | ** ** | **November 26, 2005**   | ** ** | **November 27, 2004** | ** ** |
|                                                                           |       |                         |       |   |   |
| **Cash flows from operating activities:**                                      |       |                         |       |   |   |
| Net income                                                                     |       | $                            | 4,535      |   | $ | 18,592 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                         |       |   |   |
| Depreciation and  amortization                                                 |       | 4,261                        |       | 4,593 |   |
| Tax benefit of  stock options exercised                                        |       | 890                          |       | 543 |   |
| Provision for  doubtful accounts                                               |       | (144                         | )          | 200 |   |
| Loss on disposal  of property and equipment                                    |       | 46                           |       | 253 |   |
| Deferred income  taxes                                                         |       | 320                          |       | 5,617 |   |
| Changes in  operating accounts:                                                |       |                         |       |   |   |
| Increase in  trade receivables, net                                            |       | (491                         | )          | (536 | ) |
| (Increase)  decrease in income tax refund receivable                           |       | 7,809                        |       | (1,430 | ) |
| (Increase)  decrease in inventories, net                                       |       | 1,578                        |       | (13,523 | ) |
| Decrease in  shipped systems pending acceptance                                |       | 749                          |       | 2,157 |   |
| Increase in  prepaid and other current assets                                  |       | (1,855                       | )          | (1,617 | ) |
| Increase  (decrease) in accounts payable and other current liabilities         |       | 7,533                        |       | (11,914 | ) |
| Increase  (decrease) in deferred revenue                                       |       | 356                          |       | (2,611 | ) |
| Net cash  provided by operating activities                                     |       | 25,587                       |       | 324 |   |
|                                                                           |       |                         |       |   |   |
| **Cash flows from investing activities:**                                      |       |                         |       |   |   |
| Purchase of  property, plant and equipment                                     |       | (9,478                       | )          | (2,109 | ) |
| Proceeds from  the sale of property and equipment                              |       | —                       |       | 92 |   |
| Proceeds from  the sale of assets held for sale                                |       | —                       |       | 2,361 |   |
| Maturity of  restricted securities                                             |       | —                       |       | 2,955 |   |
| Purchase of  securities                                                        |       | (275,932                     | )          | (248,647 | ) |
| Proceeds from  sales of securities and maturing securities                     |       | 296,507                      |       | 251,833 |   |
| Increase in  other assets                                                      |       | (6,373                       | )          | (780 | ) |
| Net cash  provided by investing activities                                     |       | 4,724                        |       | 5,705 |   |
|                                                                           |       |                         |       |   |   |
| **Cash flows from financing activities:**                                      |       |                         |       |   |   |
| Proceeds from  exercise of stock options and stock plans                       |       | 2,283                        |       | 4,922 |   |
| Net cash  provided by financing activities                                     |       | 2,283                        |       | 4,922 |   |
|                                                                           |       |                         |       |   |   |
| **Net change in cash and cash equivalents**                                    |       | 32,594                       |       | 10,951 |   |
|                                                                           |       |                         |       |   |   |
| **Cash and cash equivalents:**                                                 |       |                         |       |   |   |
| Beginning of  period                                                           |       | 61,314                       |       | 80,358 |   |
| End of period                                                                  |       | $                            | 93,908     |   | $ | 91,309 |   |
|                                                                           |       |                         |       |   |   |
| **Supplemental cash flow information:**                                        |       |                         |       |   |   |
| Cash paid for  interest                                                        |       | $                            | —     |   | $ | (3,082 | ) |
| Income tax  refunds received                                                   |       | 8,603                        |       | 4 |   |
| Cash paid for  income taxes                                                    |       | (1,156                       | )          | (2,795 | ) |

 

The accompanying notes are an integral part of these statements.

 

4

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**ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES**

### **NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS**

**(Unaudited)**

#### ***Note 1 - Basis ofPresentation***

 

These unaudited interim consolidated condensed financial statementshave been prepared pursuant to the rules and regulations of the Securities andExchange Commission.  Certain informationand footnote disclosures normally included in annual financial statementsprepared in accordance with U.S. generally accepted accounting principles havebeen condensed or omitted in these interim statements.  Accordingly, these interim statements includeall adjustments (consisting of only normal recurring adjustments and accruals)necessary for a fair presentation of results for the interim periodspresented.  These consolidated condensedfinancial statements are to be read in conjunction with the financialstatements and notes included in the Company’s Annual Report on Form 10-K.

 

Results of operations for interim periods are not necessarilyindicative of the results to be expected for the full year.

#### * *

**Note 2 - Inventories**

 

Inventories are principally valued atstandard costs, which approximate the lower of cost (on a first-in, first-outbasis) or market.  Components ofinventories were as follows (in thousands):

 
| ** **                        | ** ** | **November 26,  2005** | ** ** | **May 28,  2005** | ** ** |
|-----------------------------------|------------|------------------------|------------|-------------------|------------|
| Raw materials and purchased parts |       | $                      | 38,551     |              | $          | 37,367 |   |
| Work-in-process                   |       | 9,102                  |       | 4,471             |       |
| Finished goods                    |       | 12,255                 |       | 17,695            |       |
|                              |       | $                      | 59,908     |              | $          | 59,533 |   |

 

**Note 3 — Accrued Liabilities**

 

Accrued liabilitiesconsisted of the following (in thousands):

** **
| ** **                               | ** ** | **November 26,  2005** | ** ** | **May 28,  2005** | ** ** |
|------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                               | ** ** | ** **             | ** ** | ** **        | ** ** |
| Payroll-related                          |       | $                      | 6,950      |              | $          | 8,275 |   |
| Product warranty                         |       | 3,278                  |       | 3,625             |       |
| Accrual for loss on purchase commitments |       | 293                    |       | 343               |       |
| Income taxes payable                     |       | 11,426                 |       | 11,623            |       |
| Other                                    |       | 6,800                  |       | 5,589             |       |
|                                     |       | $                      | 28,747     |              | $          | 29,455 |   |

 

See Note 4 for a discussion of the accrualfor product warranty.

 

5

----

 

**Note 4 — Product Warranty**

 

The Company evaluatesobligations related to product warranties quarterly. A standard one-yearwarranty is provided on products. Warranty charges are comprised of costs toservice the warranty, including labor to repair the system and replacementparts for defective items, as well as other costs incidental to therepairs.  Inventory credits resultingfrom the return of repaired parts to inventory and any cost recoveries fromwarranties offered by suppliers for defective components are recorded as acredit to the warranty accrual.  Usinghistorical data, the Company estimates average warranty cost per system or parttype and records the provision for such charges as an element of cost of goodssold.  Additionally, the overall warrantyaccrual balance is separately analyzed using the remaining warranty periodsoutstanding on systems and items under warranty, and any resulting changes inestimates are recorded as an adjustment to cost of sales.  If circumstances change, or if a materialchange in warranty-related incidents occurs, the estimate of the warrantyaccrual could change significantly. Accrued product warranty is included on the balance sheet as a componentof accrued liabilities.

 

Following is areconciliation of the change in the aggregate accrual for product warranty forthe six months ended November 26, 2005 and November 27, 2004 (in thousands):

 
| ** **                          | ** ** | **November 26,  2005** | ** ** | **November 27,  2004** | ** ** |
|-------------------------------------|------------|------------------------|------------|------------------------|------------|
| Product warranty accrual, beginning |       | $                      | 3,625      |                   | $          | 4,720 |   |
| Warranty charges incurred           |       | (4,209                 | )          | (5,006                 | )          |
| Inventory credits                   |       | 1,812                  |       | 1,927                  |       |
| Provision for warranty charges      |       | 2,050                  |       | 2,882                  |       |
| Product warranty accrual, ending    |       | $                      | 3,278      |                   | $          | 4,523 |   |

 

**Note 5 —Deferred Revenue**

 

Revenue isdeferred pending title transfer and fulfillment of acceptance criteria, whichfrequently occur at the time of delivery to a common carrier.  Shipments for which title transfer has notoccurred and/or acceptance criteria cannot be demonstrated at the Company’sfactory include sales to Japanese end-user customers and shipments ofsubstantially new products.  In salesinvolving multiple element arrangements, the fair value of any undeliveredelements, including installation services, is deferred until the elements are deliveredand acceptance criteria are met.  Revenuerelated to maintenance and service contracts is deferred and recognized ratablyover the duration of the contracts.

 

The following is areconciliation of the changes in deferred revenue for the six months endedNovember 26, 2005 and November 27, 2004 (in thousands):

 
| ** **                  | ** ** | **November 26,  2005** | ** ** | **November 27,  2004** | ** ** |
|-----------------------------|------------|------------------------|------------|------------------------|------------|
| Deferred revenue, beginning |       | $                      | 12,986     |                   | $          | 11,985 |   |
| Revenue deferred            |       | 9,547                  |       | 13,124                 |       |
| Revenue recognized          |       | (9,191                 | )          | (15,734                | )          |
| Deferred revenue, ending    |       | $                      | 13,342     |                   | $          | 9,375 |   |

 

6

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**Note 6 - Earnings Per Share**

 

Followingis a reconciliation of weighted average shares outstanding and adjustments tonet income used in the calculation of basic and diluted earnings per share(EPS) for the three months and six months ended November 26, 2005 and November27, 2004 (in thousands):

 
| ** **                                                        | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                        | ** ** | **November 26, 2005**  | ** ** | **November 27, 2004**  | ** ** |
| ** **                                                        | ** ** | **Net Income**         | ** ** | **Shares**             | ** ** | **Net Income** | ** ** | **Shares** | ** ** |
|                                                              |       |                   |       |                   |       |   |   |   |   |
| Net income  available to common shareholders – basic         |       | $                      | 3,188      |                   | 28,705     |   | $ | 7,946 |   | 28,443 |   |
| Effect of dilutive stock options                                  |       | —                 |       | 292                    |       | — |   | 98 |   |
| Net income  available to common shareholders – fully diluted |       | $                      | 3,188      |                   | 28,997     |   | $ | 7,946 |   | 28,541 |   |

 
| ** **                                                               | ** ** | **Six months ended**  | ** ** | **Six months ended**  | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | **November 26, 2005** | ** ** | **November 27, 2004** | ** ** |
| ** **                                                               | ** ** | **Net Income**        | ** ** | **Shares**            | ** ** | **Net Income** | ** ** | **Shares** | ** ** |
|                                                                     |       |                  |       |                  |       |   |   |   |   |
| Net income  available to common shareholders – basic                |       | $                     | 4,535      |                  | 28,674     |   | $ | 18,592 |   | 28,329 |   |
| Effect of  dilutive stock options                                        |       | —                |       | 222                   |       | — |   | 170 |   |
| Effect of 4 1/4  % convertible subordinated notes                        |       | —                |       | —                |       | 2,179 |   | 3,816 |   |
| Net income  available to common common shareholders – fully diluted |       | $                     | 4,535      |                  | 28,896     |   | $ | 20,771 |   | 32,315 |   |

 

The following common stock equivalents were excluded from the dilutedEPS calculations because inclusion would have had an antidilutive effect (inthousands):

 
| ** **                              | ** ** | **Three months ended** | ** ** | **Six months ended**  | ** ** |
|-----------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **November 26, 2005**  | ** ** | **November 27, 2004** | ** ** | **November 26, 2005** | ** ** | **November 27, 2004** | ** ** |
| Employee stock options                  |       | 2,603                  |       | 3,540                 |       | 2,720 |   | 3,531 |   |
| 4 1/4 % convertible  subordinated notes |       | —                 |       | 3,816                 |       | — |   | — |   |
|                                    |       | 2,603                  |       | 7,356                 |       | 2,720 |   | 3,531 |   |

 

#### ***Note 7 - Comprehensive Income***

 

The components ofcomprehensive income, net of tax, are as follows (in thousands):

 
| ** **                                                                 | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                 | ** ** | **November 26,**       | ** ** | **November 27,**     | ** ** | **November 26,** | ** ** | **November 27,** | ** ** |
| ** **                                                                 | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| Net income                                                                 |       | $                      | 3,188      |                 | $          | 7,946 |   | $ | 4,535 |   | $ | 18,592 |   |
| Net unrealized  gain (loss) on foreign exchange hedge contracts            |       | 18                     |       | (21                  | )          | 29 |   | 7 |   |
| Foreign currency translation adjustment                                    |       | (353                   | )          | 594                  |       | (590 | ) | 545 |   |
| Net unrealized  gain (loss) on securities classified as available for sale |       | (81                    | )          | (127                 | )          | (148 | ) | 527 |   |
|                                                                       |       | $                      | 2,772      |                 | $          | 8,392 |   | $ | 3,826 |   | $ | 19,671 |   |

 

7

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#### ***Note 8 — StockBased Compensation Plans***

#  

The Company has elected to use the intrinsic value method under APB No.25, *Accounting for Stock Issued to Employees*,as permitted by SFAS No. 123, *Accounting for Stock-BasedCompensation*, subsequently amended by SFAS No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure*,to account for stock options, stock bonuses, restricted stock, time-basedrestricted stock units or performance-based restricted stock units issued toits employees under its stock compensation plans, and amortizes deferredcompensation, if any, ratably over the vesting period of the awards.

 

Compensation expense resulting from the issuance of fixed term stockoption awards is measured as the difference between the exercise price of theoption and the fair market value of the underlying share of company stocksubject to the option on the measurement date, which is typically the award’sgrant date.  Compensation expense, ifany, is included in operating results over the vesting period of the underlyingoptions using the straight-line method. Compensation expense resulting from the issuance of time-basedrestricted stock and restricted stock units is calculated based on the fairmarket value on the date of grant and is included in operating results over therelated vesting period using the straight line method.  Compensation expense resulting from theissuance of performance-based restricted stock units is recorded whenperformance is probable and can be reasonably estimated, and is calculatedbased upon current fair market values (adjusted each period) until such time asthe number of units an employee is entitled to receive is fixed ordeterminable.  During the first half offiscal 2006 and fiscal 2005, the Company recorded $0.9 million and $0.4million, respectively, of compensation expense related to grants of restrictedstock and restricted stock units on a pre-tax basis.  No compensation cost has been recognized foremployee stock purchase plan (ESPP) shares which are issued at a fifteenpercent discount of the lower of the market price on either the first day ofthe applicable offering period or the purchase date.

 

Pro forma fair value disclosures required by SFAS No. 123 are presentedbelow and reflect the impact on net income and net income per share as if thefair value of stock-based awards to employees had been applied (in thousands,except per share data):

 
| ** **                                                                                                                                             | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                                             | ** ** | **November 26,**       | ** ** | **November 27,**     | ** ** | **November 26,** | ** ** | **November 27,** | ** ** |
| ** **                                                                                                                                             | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                                   |       |                   |       |                 |       |   |   |   |   |
| Net income, as reported                                                                                                                                |       | $                      | 3,188      |                 | $          | 7,946 |   | $ | 4,535 |   | $ | 18,592 |   |
| Add –  Stock-based employee compensation expense included in reported net income, net  of related tax effects                                     |       | 119                    |       | 136                  |       | 599 |   | 262 |   |
| Deduct – Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effect |       | (2,218                 | )          | (1,158               | )          | (4,957 | ) | (13,558 | ) |
| Net income, pro forma                                                                                                                                  |       | $                      | 1,089      |                 | $          | 6,924 |   | $ | 177 |   | $ | 5,296 |   |
| Net income per share – basic, as reported                                                                                                         |       | $                      | 0.11       |                 | $          | 0.28 |   | $ | 0.16 |   | $ | 0.66 |   |
| Net income per share – fully diluted, as reported                                                                                                 |       | $                      | 0.11       |                 | $          | 0.28 |   | $ | 0.16 |   | $ | 0.64 |   |
| Net income per share – basic, pro forma                                                                                                           |       | $                      | 0.04       |                 | $          | 0.24 |   | $ | 0.01 |   | $ | 0.19 |   |
| Net income per share – fully diluted, pro forma                                                                                                   |       | $                      | 0.04       |                 | $          | 0.24 |   | $ | 0.01 |   | $ | 0.16 |   |

 

The Black-Scholes optionpricing model is utilized to determine the fair value of stock options underSFAS No. 123. The following weighted average assumptions were made incalculating the value of all options granted during the periods presented:

 

8

----

 
| ** **              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-------------------------|------------|------------------------|------------|----------------------|------------|
| ** **              | ** ** | **November 26,**       | ** ** | **November 27,**     | ** ** | **November 26,** | ** ** | **November 27,** | ** ** |
| ** **              | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                    |       |                   |       |                 |       |   |   |   |   |
| Risk-free interest rate |       | 4.21                   | %          | 3.38                 | %          | 3.93 | % | 3.58 | % |
| Expected dividend yield |       | 0                      | %          | 0                    | %          | 0 | % | 0 | % |
| Expected lives          |       | 4.9 years              |       | 5.6 years            |       | 5.0 years |   | 5.6 years |   |
| Expected volatility     |       | 57.85                  | %          | 65.82                | %          | 59.33 | % | 65.65 | % |

 

The following weightedaverage assumptions were made in calculating the value of all shares issued underthe ESPP during the periods presented:

 
| ** **              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-------------------------|------------|------------------------|------------|----------------------|------------|
| ** **              | ** ** | **November 26,**       | ** ** | **November 27,**     | ** ** | **November 26,** | ** ** | **November 27,** | ** ** |
| ** **              | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                    |       |                   |       |                 |       |   |   |   |   |
| Risk-free interest rate |       | 4.15                   | %          | 2.30                 | %          | 4.06 | % | 2.28 | % |
| Expected dividend yield |       | 0                      | %          | 0                    | %          | 0 | % | 0 | % |
| Expected lives          |       | 1.1 years              |       | 1.2 years            |       | 1.1 years |   | 1.2 years |   |
| Expected volatility     |       | 39.18                  | %          | 54.40                | %          | 42.15 | % | 54.40 | % |

 

**Note 9 — Legal Proceedings**

 

On August 24, 2005, theCompany executed a Provisional Attachment Order (the Attachment Order) issuedby the Kaohsiung District Court of Taiwan (the Court) directed against All RingTech Co., Ltd. (All Ring) of Taiwan.  In its petition requesting the AttachmentOrder, the Company alleged that All Ring’s Capacitor Tester Model RK-T6600 (theCapacitor Tester) infringes the Company’s Taiwan Patent No. 207469, entitled “CircuitComponent Handler” (the 207469 patent).  This patent corresponds to theCompany’s U.S. Patent No. 5,842,579.  The patented technology is used inthe Company’s Model 3340 Multifunction MLCC Tester. All Ring has filed a bondwith the Court to obtain relief from the attachment of its assets.  Thebond provides security to the Company with respect to its patent infringementclaim against All Ring.

 

On September 19, 2005, theCourt granted the Company’s petition for a Preliminary Injunction, and issued aPreliminary Injunction Order that prohibits All Ring from manufacturing,selling, offering for sale or using the Capacitor Tester, or importing theCapacitor Tester for any of these purposes, until final judgment is entered inthe formal patent infringement action. Pursuant to the Court’s Order, the Company was required to post with theCourt a Taiwan dollar security bond of approximately US$6.8 million, which isincluded in Other Assets on the accompanying consolidated balance sheet atNovember 26, 2005.  The Court thenexecuted the Preliminary Injunction Order in late October 2005.  All Ring appealed the Preliminary InjunctionOrder on November 1, 2005.  The Companyintends to file an opposition to the appeal. On November 10, 2005, All Ring filed a petition to post a counterbond torevoke the execution of the Preliminary Injunction Order. The Court granted thecounterbond petition on December 14, 2005. The Court’s order allows All Ring to obtain relief from the PreliminaryInjunction Order if it posts a bond in the amount of approximatelyUS$6.8million.

 

On October 27, 2005, theCompany filed a formal patent infringement action against All Ring in theCourt.  All Ring filed a defense briefresponding to the complaint in late November 2005.

 

On November 18, 2005, AllRing filed a cancellation action against the Company’s 207469 patent in the TaiwanIntellectual Property Office (the IPO). The IPO has not yet served the Company withAll Ring’s brief.

 

The Company intends tovigorously pursue its patent infringement claims against All Ring and defendagainst the cancellation action.

 

**Note 10 - New AccountingPronouncements**

 

9

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InDecember 2004, the Financial Accounting Standards Board (FASB) issued FASBStatement No. 123 (Revised 2004), *Share-Based Payments*.(SFAS 123R).  The scope of SFAS 123Rincludes a wide range of share-based compensation arrangements including shareoptions, restricted share plans, performance-based awards, share appreciationrights, and employee share purchase plans. SFAS 123R replaces FASB Statement No. 123, Accounting for Stock-BasedCompensation (SFAS 123), and supersedes APB Opinion No. 25, Accounting for StockIssued to Employees (Opinion 25). SFAS 123R requires that the compensation costrelating to share-based payment transactions be recognized in financialstatements and rescinds the ability of companies to elect the intrinsic valuemethod prescribed under Opinion 25. That cost will be measured based on thefair value of the equity or liability instruments issued.  The Company will be required to implementSFAS 123R for the fiscal year beginning June 4, 2006. The Company has notcompleted its analysis of the impact of the adoption of SFAS 123R on itsfinancial position or results of operations.

 

InDecember 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, *Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provision with the American Jobs Creation Act of 2004*.  FSP No. 109-2 provides guidance under SFASNo. 109, *Accounting for Income Taxes*, withrespect to recording the potential impact of the repatriation provisions of theAmerican Jobs Creation Act of 2004 (the Jobs Act) on enterprises’ income taxexpense and deferred tax liability.  TheJobs Act was enacted on October 22, 2004. FSP No. 109-2 states that an enterprise is allowed time beyond thefinancial reporting period of enactment to evaluate the effect of the Jobs Acton its plan for reinvestment or repatriation of foreign earnings for purposesof applying SFAS No. 109. Accordingly, the Company will continue to analyze andassess its options under this provision.

 

10

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

 

**Forward Looking Statements**

 

The statements contained in this report thatare not statements of historical fact, including without limitation statementscontaining the words “believes,” “expects” and similar words, constituteforward-looking statements that are subject to a number of risks anduncertainties.  From time to time we maymake other forward-looking statements. Investors are cautioned that such forward-looking statements are subjectto an inherent risk that actual results may materially differ as a result ofmany factors, including the risks described below under the heading “FactorsThat May Affect Future Results.”

 

**Overview**

 

Electro Scientific Industries, Inc. and its subsidiaries (ESI) providehigh-technology manufacturing equipment to the global electronics market,including advanced laser systems that are used to microengineer electronicdevice features in high-volume production environments.  Our customers are primarily manufacturers ofsemiconductors, passive components and electronic interconnect devices.  Our equipment enables these manufacturers toachieve the yield and productivity gains in their manufacturing processes thatcan be critical to their profitability. The components and devices manufactured by our customers are used in awide variety of end products in the computer, consumer electronics andcommunications industries.

 

We supply advanced laser microengineering systems thatallow electronics manufacturers to physically alter select device featuresduring high-volume production in order to heighten performance and boostproduction yields of semiconductor devices, passive components and circuitry,high-density interconnect (HDI) circuit boards and advanced semiconductorpackaging.  Laser microengineeringcomprises a set of precise fine-tuning processes (laser trimming, link cuttingand via drilling) that require application-specific laser systems able to meetsemiconductor and microelectronics manufacturers’ exacting performance andproductivity requirements.

 

 Additionally, weproduce high-speed test, inspection and termination equipment used in the high-volumeproduction of multi-layer ceramic capacitors and other passive components, aswell as original equipment manufacturer machine vision products.

#### * *

#### *During the first half of fiscal 2006 we experienced marketdemand for our products at slightly improved levels compared to the latter halfof fiscal 2005.  Orders for the secondhalf of fiscal 2005 were $91.8 million.  Ordervolume was $34.8 million in the first quarter of fiscal 2006 and increased to$64.9 million in the second quarter of fiscal 2006 for a total of $99.7million.  The increase in the secondquarter of fiscal 2005 was driven by a significant rise in semiconductor grouporders and an increase in passive component group orders discussed below,offset by a decrease in electronic interconnect group orders.*

#### * *

#### *With respect to our semiconductor group, orders inthe second quarter of fiscal 2006 tripled from the order level in the previousquarter, partially due to the timing of certain large orders received early inthe second quarter.  We experienced anincrease in semiconductor group orders for our IR-based memory link-processingtools from multiple customers.  The firstlarge volume order for our new UV-based tool was also received in the secondquarter.  We anticipate continuedstrength in the memory repair area as our customers ramp their 90nm productioncapability and enjoy growth in higher density memory devices.*

 

11

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#### *The increase in orders also reflected a slightincrease in passive component group orders, with customers reporting highlevels of factory utilization, some of whom are exceeding 90% utilization.  Many manufacturers continue to be cautiousbefore placing equipment orders During the quarter, we also received ordersfrom Japanese customers for our electrical test and visual test solutions.  We hope to build on these successes toachieve greater market penetration in Japan.*

 

#### *Shipments were $48.8 million in the second quarter offiscal 2006, representing a 9.5% increase from shipments of $44.6 million inthe first quarter of fiscal 2006.  Deferredrevenue remained essentially unchanged at the end of the first and secondquarters of fiscal 2006 at approximately $13 million. Accordingly, net salesfor the second quarter were $48.6 million, increasing 9.3% from $44.5 million forthe first quarter of fiscal 2006.*

#### * *

#### *Gross margin on second quarter sales of $48.6 millionwas 43.5%, representing a slight decrease from the prior quarter margin of44.1%, on sales of $44.5 million.  Themargin impact from the sale of previous generation EIG product was partially offsetby favorable overhead absorption on increased production levels. Third quartershipments and net sales are currently estimated to be in the range of $50million to $60 million and related gross margins are expected to be in the mid-40s.*

#### * *

#### *Operating expenses were $19.3 million for the secondquarter compared to $18.9 million in the first quarter of fiscal 2006.  We anticipate operating expenses to increase inthe third quarter of fiscal 2006 by approximately $1 million as we increase ourinvestment in research and development.*

#### * *

Netother income was $2.3 million in the second quarter of fiscal 2006, compared tonet other income of $1.2 million in the first quarter of fiscal 2006.  The increase is attributed to a $0.7 millioninterest payment received on an income tax refund and increasing yields on ourinvestment portfolio.

 

The income tax provision recorded for the secondquarter of fiscal 2006 was $0.9 million on pretax income of $4.1 million,compared to $0.6 million on pretax income of $2.0 million for the first quarterof 2006. The effective tax rate in the second quarter of fiscal 2006 was 22%compared to 32% in the first quarter of fiscal 2006.  Included in the rate this quarter is abenefit for state tax refunds resulting from the settlement of our IRSexaminations as well as a benefit from an adjustment to our accrued taxes onforeign earnings.  These benefits wereoffset by an increase in the valuation allowance on state tax operating losscarryforwards resulting from a change in state tax laws during the quarter.  The effective tax rate for the third quarterof fiscal 2006 is expected to be approximately 20%.

 

Net income for the second quarter of fiscal2006 was $3.2 million or $0.11 per share on a basic and fully diluted basis,compared to $1.3 million, or $0.05 per share on a basic and fully diluted basisfor the first quarter of fiscal 2006.

 

12

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**Resultsof Operations**

 

Thefollowing table sets forth results of operations data as a percentage of netsales.

 
| ** **                            | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **November 26,**       | ** ** | **November 27,**     | ** ** | **November 26,** | ** ** | **November 27,** | ** ** |
| ** **                            | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                  |       |                   |       |                 |       |   |   |   |   |
| Net sales                             |       | 100.0                  | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of sales                         |       | 56.5                   |       | 50.3                 |       | 56.2 |   | 49.7 |   |
| Gross margin                          |       | 43.5                   |       | 49.7                 |       | 43.8 |   | 50.3 |   |
| Selling, service and administrative   |       | 23.4                   |       | 23.2                 |       | 24.1 |   | 21.8 |   |
| Research, development and engineering |       | 16.4                   |       | 11.7                 |       | 17.0 |   | 10.3 |   |
| Operating income                      |       | 3.7                    |       | 14.8                 |       | 2.7 |   | 18.2 |   |
| Total other income (expense), net     |       | 4.7                    |       | (0.3                 | )          | 3.8 |   | (0.4 | ) |
| Income before taxes                   |       | 8.4                    |       | 14.5                 |       | 6.5 |   | 17.8 |   |
| Income tax provision                  |       | 1.9                    |       | 2.5                  |       | 1.7 |   | 4.4 |   |
| Net income                            |       | 6.6                    | %          | 12.0                 | %          | 4.9 | % | 13.4 | % |

 

***Net Sales***

 

Certain information regarding our net sales by productgroup is as follows (net sales in thousands):

 
| ** **                    | ** ** | **Three months ended** | ** ** |
|-------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **November 26, 2005**  | ** ** | **November 27, 2004** | ** ** |
| ** **                    | ** ** | **Net Sales**          | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|                          |       |                   |       |   |   |   |   |   |   |
| Semiconductor (SG)            |       | $                      | 25,237     |   | 52 | % | $ | 35,658 |   | 54 | % |
| Passive Components (PCG)      |       | 12,033                 |       | 25 |   | 17,979 |   | 27 |   |
| Electronic Interconnect (EIG) |       | 11,373                 |       | 23 |   | 12,367 |   | 19 |   |
|                          |       | $                      | 48,643     |   | 100 | % | $ | 66,004 |   | 100 | % |

 
| ** **                    | ** ** | **Six months ended**  | ** ** |
|-------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **November 26, 2005** | ** ** | **November 27, 2004** | ** ** |
| ** **                    | ** ** | **Net Sales**         | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|                          |       |                  |       |   |   |   |   |   |   |
| Semiconductor (SG)            |       | $                     | 53,138     |   | 57 | % | $ | 79,671 |   | 57 | % |
| Passive Components (PCG)      |       | 23,082                |       | 25 |   | 38,582 |   | 28 |   |
| Electronic Interconnect (EIG) |       | 16,931                |       | 18 |   | 20,371 |   | 15 |   |
|                          |       | $                     | 93,151     |   | 100 | % | $ | 138,624 |   | 100 | % |

 

Netsales were $48.6 million for the quarter ended November 26, 2005, a decrease of$17.4 million or 26.3% compared to $66.0 million for the quarter ended November27, 2004.  Sales decreased $10.4 millionor 29.2% for SG, $6.0 million or 33.1% for PCG and $1.0 million or 8.0% forEIG, compared to the same period in the prior year.

 

Thesales decreases in SG are attributed primarily to a decrease in system salesvolumes.   Net sales in the second quarter of the prioryear included higher volumes of memory repair product sales driven by DRAMmanufacturer capacity requirements. SG net sales in the fourth quarter of 2004were $54.1 million followed by sequential volume decreases continuingthroughout fiscal 2005 and fiscal 2006 to date. This decreasing capitalinvestment trend is consistent with the trend in the overall semiconductormarket compared to the prior year.  SG netsales amounts have ranged between $25 and $30 million over the four most recentquarters.

 

13

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Thedecrease in second quarter fiscal 2006 PCG sales compared to the same quarterin the prior year is due to continuing caution by component manufacturers, whoare evaluating the sustainability of utilization rates before placing equipmentorders. In the first quarter of the prior year, PCG sales reached afour-quarter peak, driven by demand for passive components processed by ourlaser trim and passive test systems.   PCG net sales have ranged betweenapproximately $10 million and $12 million for the four most recent quarters.

 

EIGsales levels decreased compared to the same quarter in the prior year as aresult of industry softness.  Sales in thesecond quarter of fiscal 2006 increased over the first quarter of fiscal 2006 dueto customer acceptances received on interconnect package drilling systems and upgradesthat were included in deferred revenue at the beginning of the fiscal year, aswell as higher volume shipments of other drilling systems.  EIG net sales have ranged from approximately$6 million to $7 million for the three most recent fiscal quarters and areapproximately $11 million in the current quarter.

 

Net sales were $93.2 million for the six monthsended November 26, 2005, a decrease of $45.4 million or 32.8% compared to $138.6million for the six months ended November 27, 2004.  Of the decrease, $26.5 million resulted from decreasedsales in the SG product lines, $15.5 million resulted from decreased PCG sales and$3.4 million resulted from decreased EIG sales. The fiscal year-to-date net sales decreases compared to the same periodin fiscal 2005 are the result of peak sales cycles experienced in early fiscal2005.

 

Netsales by geographic region were as follows (net sales in thousands):

 
| ** **    | ** ** | **Three months ended** | ** ** |
|---------------|------------|------------------------|------------|
| ** **    | ** ** | **November 26, 2005**  | ** ** | **November 27, 2004** | ** ** |
| ** **    | ** ** | **Net Sales**          | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|          |       |                   |       |   |   |   |   |   |   |
| Asia          |       | $                      | 38,956     |   | 80.1 | % | $ | 46,142 |   | 69.9 | % |
| United States |       | 7,250                  |       | 14.9 |   | 12,185 |   | 18.5 |   |
| Europe        |       | 2,437                  |       | 5.0 |   | 7,677 |   | 11.6 |   |
|          |       | $                      | 48,643     |   | 100 | % | $ | 66,004 |   | 100 | % |

 
| ** **    | ** ** | **Six months ended**  | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **November 26, 2005** | ** ** | **November 27, 2004** | ** ** |
| ** **    | ** ** | **Net Sales**         | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|          |       |                  |       |   |   |   |   |   |   |
| Asia          |       | $                     | 69,894     |   | 75.0 | % | $ | 104,678 |   | 75.5 | % |
| United States |       | 16,800                |       | 18.1 |   | 20,733 |   | 15.0 |   |
| Europe        |       | 6,457                 |       | 6.9 |   | 13,213 |   | 9.5 |   |
|          |       | $                     | 93,151     |   | 100 | % | $ | 138,624 |   | 100 | % |

 

Total net sales in the second quarter offiscal 2006 to Asia, the United States and Europe decreased $7.2 million, $4.9million and $5.2 million, respectively, compared to the same quarter in theprior fiscal year consistent with the market trends described above.  Asian sales as a percentage of total netsales increased in the second quarter of fiscal 2006 compared to the sameperiod in the prior year due to product acceptances received from EIG customersin Taiwan and PCG customers in Japan.  Forthe six months ended November 26, 2005, compared to the six months endedNovember 27, 2004, sales by region were consistently weighted to Asia.

 

14

----

 

***Gross Profit***

 

Grossprofit was $21.2 million (43.5% of net sales) for the second quarter of fiscal2006 compared to $32.8 million (49.7% of net sales) for the second quarter offiscal 2005.  Shipments in the secondquarter of fiscal 2006 decreased 16.0% compared to the same quarter in fiscal2005.  Decreased shipment levels resultedin lower volume-based manufacturing efficiencies and reduced overheadabsorption resulting in higher costs per unit. Additionally, the second quarter of fiscal 2006 reflects an unfavorable marginimpact from the sale of previous generation EIG product.

 

Grossprofit for the six month period ended November 26, 2005 was $40.8 million (or 43.8%of net sales) compared to $69.7 million (or 50.3% of net sales) for the samesix month period in the prior fiscal year. This represents a 6.5% decline in gross margin rates, which can beattributed to the same factors described in the quarterly comparisonsabove.  In particular, shipments of $93.4million in the first six months of fiscal 2006 were approximately 31.3% lowerthan shipments of $136.0 for the same six months in fiscal 2005.

 

***Operating Expenses***

 

Selling, Service and Administrative Expenses

** **
| ** **                                                                  | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                  | ** ** | **November 26,**       | ** ** | **November 27,**     | ** ** | **November 26,** | ** ** | **November 27,** | ** ** |
| ** **                                                                  | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                        |       |                   |       |                 |       |   |   |   |   |
| Selling, service and administration                                         |       | $                      | 11,365     |                 | $          | 15,326 |   | $ | 22,442 |   | $ | 30,204 |   |
| Included in totals above:                                                   |       |                   |       |                 |       |   |   |   |   |
| Patent  litigation settlement and legal fees                                |       | —                 |       | 2,240                |       | — |   | 2,240 |   |
| Legal and  professional fees — investigation and securities litigation |       | 15                     |       | 359                  |       | 23 |   | 767 |   |
| Impact of  special charges                                                  |       | $                      | 15         |                 | $          | 2,599 |   | $ | 23 |   | $ | 3,007 |   |
|                                                                             |            |                        |            |                      |            |  |  |  |  |  |  |  |  |  |

 

The primary items included in selling, service and administrativeexpenses are employee compensation and other related expenses, travel expenses,professional fees and facilities costs. Selling, service and administrativeexpenses were $11.4 million (23.4% of net sales) in the second quarter offiscal 2006, a decrease of $3.9 million compared to $15.3 million (23.2% of netsales) in the second quarter of fiscal 2005.

 

The second quarter of fiscal 2005 includes $0.4 million in specialcharges for professional fees related to the 2003 audit committee investigationand securities litigation and $2.2 million related to a patent litigationsettlement.  Exclusive of these specialcharges, selling, service and administrative expenses decreased $1.4 million inthe second quarter of fiscal 2006 compared to the second quarter of fiscal 2005and decreased $4.8 million in the six months ended November 26, 2005 comparedto the same period in the prior year. The decrease is primarily due to a reduction in payroll and relatedcosts resulting from restructuring and other cost containment initiativesimplemented in the third quarter of fiscal 2005.  Additionally, commission expenses decreaseddue to the reduction in revenue compared to the second quarter of fiscal2005.  These savings were partiallyoffset by increases in spending related to the enterprise resource planningsystem implementation project.

 

15

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Research, Development and Engineering Expenses

 

Research,development and engineering expenses are primarily comprised of employee compensationand other related expenses, professional fees, project materials, equipment andfacilities costs.  Expenses associatedwith research, development and engineering totaled $8.0 million (16.4% of netsales) for the second quarter of fiscal 2006, representing a $0.3 million increasefrom expenses of $7.7 million (11.7% of net sales) for the second quarter offiscal 2005.  The increase in expenses inthe second quarter compared to the prior year is primarily due to an increasein labor and other employee-related expenses.

 

Forthe six months ended November 26, 2005, research, development and engineeringexpenses increased $1.5 million to $15.8 million (17.0% of net sales) comparedto $14.3 million (10.3% of net sales) for the six months ended November 27, 2004.  In addition to increases in labor andemployee-related expenses on a year-to-date basis, the expenses for this periodreflected an increase in patent registration and maintenance charges andincreased project investments for research and development of new products inexisting and emerging markets.  Weanticipate this trend will continue into the third quarter of fiscal 2006 as wecontinue to increase our investment in research and development projects.

 

Other Income (Expense)

 

Interest income was $2.4 million in thesecond quarter of 2006, compared to $1.8 million in the same quarter of 2005, anincrease of $0.6 million. Interest income was $3.9 million in the first sixmonths of 2006, compared to $3.3 million in the same six months of 2005, an increaseof $0.6 million. The increases are primarily due to the receipt of $0.7 millionof interest relating to income tax refunds received during the second quarterof fiscal 2006 and increased yields on invested assets, consistent withincreases in market interest rates on cash equivalents and debt securities overthe past year.  These increases ininterest income were partially offset by the lower amount of invested assetsresulting from the redemption of our $145.0 million convertible subordinatednotes in March 2005.  Cash, cashequivalents and investments were $231 million at November 26, 2006 compared to $338million at November 27, 2004.

 

Interest expense decreased by $1.8 million or98% in the second quarter of 2006, compared to the same quarter of fiscal 2005,and decreased by $3.5 million or 98% in the first six months of 2006, comparedto the first six months of fiscal 2005, due to the redemption of ourconvertible subordinated notes in March 2005.

 

***Income Taxes***

 

The income tax provision recorded for the secondquarter of fiscal 2006 was $0.9 million on pretax income of $4.1 million. Comparatively, the income tax provision was $1.6 million on pretax income of$9.6 million in the second quarter of fiscal 2005.  The fiscalyear-to-date provision for income taxes at November 26, 2005 is $1.5 million onpretax income of $6.1 million compared to an income tax provision of $6.0million on pretax income of $24.6 million in the six months ended November 27,2004.

 

The effective tax rate in the second quarter was22% compared to 32% in the prior quarter.  Included in the rate thisquarter is a benefit for state tax refunds resulting from the settlement of ourIRS examination and a benefit resulting from an adjustment to the company’saccrued taxes on foreign earnings, both of which were offset by a $1.1 millionincrease in the valuation allowance against state tax operating losscarryforwards resulting from changes in state tax laws during the quarter.

 

16

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As previously disclosed, during the first quarterof fiscal 2006 we received notice from the IRS that the JointCommittee on Taxation accepted, without exception, a special report thatresulted from an examination of the company’s tax years 1996 through 2003.  During the second quarter of fiscal 2006 wereceived $7.2 million in expected tax refunds, plus interest of $0.7 million.

 

The effective tax rate for the third quarter of fiscal 2006 is expectedto be approximately 20%.  The effectivetax rate is subject to fluctuation based upon the occurrence and timing ofnumerous discrete events, including, for example, changes in tax laws or theirinterpretations, extensions or expirations of research and experimentationcredits, closure of tax years subject to examination and finalization of incometax returns.  Based on currentlyavailable information, we are not aware of any such discrete events which arelikely to occur and which would have a materially adverse effect on ourfinancial position, expected cash flows or results of operations.

 

***Net Income***

 

Net income for the three and six months endedNovember 26, 2005 was $3.2 million (6.6% of net sales) or $0.11 per share on abasic and fully diluted basis and $4.5 million (4.9% of net sales) or $0.16 pershare on a fully diluted basis, respectively. For the three and six months ended November 27, 2004, we recorded a net incomeof $7.9 million (12.0% of net sales) or $0.28 per basic and fully diluted shareand $18.6 million (13.4% of net sales) or $0.66 per basic and $0.64 per fullydiluted share, respectively.

 

**Liquidity and CapitalResources**

 

At November 26, 2005, our principal sourcesof liquidity consisted of existing cash, cash equivalents and marketable securitiesof $230.8 million and accounts receivable of $35.3 million.  At November 26, 2005, we had a current ratioof 6.4:1 and no long-term debt.  Workingcapital increased to $288.0 million at November 26, 2005 from $275.7 million atMay 28, 2005.  We believe that ourexisting cash, cash equivalents and marketable securities are adequate to fundour operations for at least the next twelve months.

 

Cash flows from operating activities for the six months ended November26, 2005 totaled $25.6 million.  Cash totaling$9.9 million was provided by net income adjusted for non-cash items. Othersignificant factors impacting cash flows from operations included increases inprepaid and other current assets, receipt of income tax refunds and increasesin current liabilities.

 

Net inventories remained essentiallyunchanged at $59.9 million at the end of the second quarter compared to $59.5million at May 28, 2005.  However, $1.6million in capitalized systems included in other long-term assets at May 28,2005 were sold during the six months ended November 26, 2005 resulting in anincrease in cash flows from inventory transactions.

 

Payables and current liabilities were $40.0million at November 26, 2005 compared to $33.4 million at May 28, 2005, anincrease of $6.6 million. The increase is primarily due to increased inventorypurchases in the second quarter of fiscal 2006 in anticipation of shipments infuture quarters.

 

17

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Cash flows from investing activities totaled$4.7 million for the six months ended November 26, 2005. Capital expenditurestotaled $9.5 million during this period and were principally comprised of costsrelated to the implementation of a new enterprise resource planning system anda major refurbishment of research and development clean rooms and laboratories.We also generated $20.6 million net in cash and cash equivalents through thematurity and sale of investments in our portfolio of marketable securitiesoffset by certain reinvestments. We anticipate remaining capital expendituresrelated to the implementation of the new enterprise resource planning system infiscal 2006 will total approximately $4 million.

 

Cash flows from investing activities alsoincluded a $6.8 million increase in other assets for a Taiwan dollar depositsecurity bond posted with the Kaohsiung Court in Taiwan related to our filingof a patent infringement suit against All Ring Tech Co., Ltd. in that jurisdiction.  This deposit will be held by the courtpending final resolution of the matter.

 

Cash flows from financing activities of $2.3million were comprised of proceeds from the exercise of stock options and ESSPpurchases for the six months ended November 26, 2005.

 

**Critical Accounting Policiesand Estimates**

 

We reaffirm the critical accounting policiesand our use of estimates as reported in our annual report on Form 10-K for ourfiscal year ended May 28, 2005 as filed with the Securities and ExchangeCommission on July 27, 2005.

 

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**FactorsThat May Affect Future Results**

 

The statementscontained in this report that are not statements of historical fact, includingwithout limitation statements containing the words “believes,” “expects” andsimilar words, constitute forward-looking statements that are subject to anumber of risks and uncertainties.  Fromtime to time we may make other forward-looking statements.  Investors are cautioned that such forward-lookingstatements are subject to an inherent risk that actual results may materiallydiffer.  The following informationhighlights some of the factors that could cause actual results to differmaterially from the results expressed or implied by our forward-lookingstatements.  Forward-looking statementsshould be considered in light of these factors. Factors that may result in such variances include, but are not limitedto, the following:

 

***Theindustries that comprise our primary markets are volatile and unpredictable.***

 

Our businessdepends upon the capital expenditures of manufacturers of components andcircuitry used in wireless communications, computers and other electronicproducts.  In the past, the markets forelectronic devices have experienced sharp downturns.  During these downturns, electronicsmanufacturers, including our customers, have delayed or canceled capitalexpenditures, which has had a negative impact on our financial results.

 

After experiencinga significant increase in orders in fiscal 2004, we experienced reduced demandbeginning in the first quarter of fiscal 2005 which continued through the firstquarter of fiscal 2006.  Net salesdecreased each quarter from $81.8 million in the fourth quarter of fiscal 2004to $44.5 million in the first quarter of fiscal 2006.  Net income (loss) decreased each quarter froma peak of $16.2 million in the fourth quarter of fiscal 2004 to ($0.8 million)in the fourth quarter of fiscal 2005.  Wecannot assure you when demand for our products will increase or that demandwill not decrease.  Even if demand forour products does increase, there may be significant fluctuations in ourprofitability and net sales.

 

During anydownturn, it will be difficult for us to maintain our sales levels.  As a consequence, to maintain profitabilitywe will need to reduce our operating expenses. For example, in December 2004 we announced an operational restructuringand reduction in force to reduce our expenses in connection with the mostrecent downturn.  Our ability to quicklyreduce operating expenses is dependent upon the nature of the actions we taketo reduce expense and our subsequent ability to implement those actions andrealize expected cost savings. Additionally, we may be unable to defer capital expenditures and we willneed to continue to invest in certain areas such as research and development.  An economic downturn may also cause us toincur charges related to impairment of assets and inventory write-offs and wemay also experience delays in payments from our customers, which would have anegative effect on our financial results.

 

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***Delaysin manufacturing, shipment or customer acceptance of our products couldsubstantially decrease our sales for a period.***

 

We depend onmanufacturing flexibility to meet the changing demands of our customers.  Any significant delay or interruption inreceiving raw materials or in our manufacturing operations as a result ofsoftware deficiencies, natural disasters, or other causes could result inreduced manufacturing capabilities or delayed product deliveries, any or all ofwhich could materially and adversely affect our results of operations.

 

In addition, wederive a substantial portion of our revenue from the sale of a relatively smallnumber of products.  Consequently,shipment and/or customer acceptance delays, including acceptance delays relatedto new product introductions or customizations, could significantly impact ourrecognition of revenue and could be further magnified by announcements fromus or our competitors of new products and technologies, which announcementscould cause our customers to defer purchases of our systems or purchaseproducts from our competitors.  Any ofthese delays could result in a material adverse change in our results ofoperations for any particular period.

***Failure of criticalsuppliers of parts, components and manufacturing equipment to deliversufficient quantities to us in a timely and cost-effective manner couldnegatively affect our business.***

 

We use a widerange of materials in the production of our products, including customelectronic and mechanical components, and we use numerous suppliers for thosematerials.  We generally do not haveguaranteed supply arrangements with our suppliers.  We seek to reduce the risk of production andservice interruptions and shortages of key parts by selecting and qualifyingalternative suppliers for key parts, monitoring the financial stability of keysuppliers and maintaining appropriate inventories of key parts.  Although we make reasonable efforts to ensurethat parts are available from multiple suppliers, some key parts are availableonly from a single supplier or a limited group of suppliers in the shortterm.  Operations at our suppliers’facilities are subject to disruption for a variety of reasons, includingchanges in business relationships, competitive factors, work stoppages, andfire, earthquake, flooding or other natural disasters.  Such disruption could interrupt ourmanufacturing.  Our business may beharmed if we do not receive sufficient parts to meet our productionrequirements in a timely and cost-effective manner.

 

***Wedepend on a few significant customers and we do not have long-term contractswith any of our customers.***

 

Our top ten customers for fiscal 2005 accounted for approximately 51% oftotal net sales in fiscal 2005, with one customer, Samsung, accounting forapproximately 13% of total net sales in fiscal 2005. No other customer infiscal 2005 accounted for more than 10% of total net sales.  In addition, none of our customers has anylong-term obligation to continue to buy our products or services, and anycustomer could delay, reduce or cease ordering our products or services at anytime.

 

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***Ourmarkets are subject to rapid technological change, and to compete effectivelywe must continually introduce new products that achieve market acceptance.***

 

The markets forour products are characterized by rapid technological change and innovation,frequent new product introductions, changes in customer requirements and evolvingindustry standards.  Our futureperformance will depend on the successful development, introduction and marketacceptance of new and enhanced products that address technological changes aswell as current and potential customer requirements.  The introduction by us or by our competitorsof new and enhanced products may cause our customers to defer or cancel ordersfor our existing products, which may harm our operating results.  In the past we have also experienced delaysin new product development.  Similardelays may occur in the future.  We alsomay not be able to develop the underlying core technologies necessary to createnew products and enhancements or, where necessary, to license thesetechnologies from others.

 

Productdevelopment delays may result from numerous factors, including:

 

•                  Changing product specifications and customerrequirements;

•                  Difficulties in hiring and retaining necessarytechnical personnel;

•                  Difficulties in reallocating engineering resources andovercoming resource limitations;

•                  Difficulties with contract manufacturers;

•                  Changing market or competitive product requirements;and

•                  Unanticipated engineering complexities.

 

The development ofnew, technologically advanced products is a complex and uncertain process,requiring high levels of innovation and highly skilled engineering anddevelopment personnel, as well as the accurate anticipation of technologicaland market trends.  We cannot assure youthat we will be able to identify, develop, manufacture, market or support newor enhanced products successfully, if at all, or on a timely basis.  Further, we cannot assure you that our newproducts will gain market acceptance or that we will be able to respondeffectively to product announcements by competitors, technological changes oremerging industry standards.  Any failureto respond to technological change that may render our current products ortechnologies obsolete could significantly harm our business.

 

***Ourability to reduce costs is limited by our need to invest in research anddevelopment.***

 

Our industry ischaracterized by the need for continued investment in research anddevelopment.  Because of intensecompetition in the industries in which we compete, if we were to fail to investsufficiently in research and development, our products could become lessattractive to potential customers, and our business and financial conditioncould be materially and adversely affected. As a result of our need to maintain our spending levels in this area,our operating results could be materially harmed if our net sales fall belowexpectations.  In addition, as a resultof our emphasis on research and development and technological innovation, ouroperating costs may increase further in the future, and research anddevelopment expenses may increase as a percentage of total operating expensesand as a percentage of net sales.

 

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***Weare exposed to the risks that others may violate our proprietary rights, andour intellectual property rights may not be well protected in foreigncountries.***

 

Our success isdependent upon the protection of our proprietary rights.  In the high technology industry, intellectualproperty is an important asset that is always at risk of infringement.  We incur substantial costs to obtain andmaintain patents and defend our intellectual property.  For example, we have initiated litigationalleging that certain parties have violated various patents of ours, such asthe action we initiated in Taiwan against All Ring Tech Co., Ltd. in August2005.  We rely upon the laws of theUnited States and of foreign countries in which we develop, manufacture or sellour products to protect our proprietary rights. However, these proprietary rights may not provide the competitive advantagesthat we expect or other parties may challenge, invalidate or circumvent theserights.

 

Further, ourefforts to protect our intellectual property may be less effective in someforeign countries where intellectual property rights are not as well protectedas in the United States.  Many U.S.companies have encountered substantial problems in protecting their proprietaryrights against infringement in foreign countries.  If we fail to adequately protect ourintellectual property in these countries, it could be easier for ourcompetitors to sell competing products in foreign countries, which could resultin reduced sales and gross margins.

 

***Wemay be subject to claims of intellectual property infringement.***

 

Several of ourcompetitors hold patents covering a variety of technologies, applications andmethods of use similar to some of those used in our products.  From time to time, we and our customers havereceived correspondence from our competitors claiming that some of ourproducts, as used by our customers, may be infringing one or more of thesepatents.  Competitors or others have inthe past and may in the future assert infringement claims against our customersor us with respect to current or future products or uses, and these assertionsmay result in costly litigation or require us to obtain a license to useintellectual property rights of others. If claims of infringement are asserted against our customers, thosecustomers may seek indemnification from us for damages or expenses they incur.

 

If we becomesubject to infringement claims, we will evaluate our position and consider theavailable alternatives, which may include seeking licenses to use thetechnology in question or defending our position. These licenses, however, maynot be available on satisfactory terms or at all.  If we are not able to negotiate the necessarylicenses on commercially reasonable terms or successfully defend our position,our financial condition and results of operations could be materially andadversely affected.

 

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***Our business is highly competitive, and if we fail to competeeffectively, our business will be harmed.***

 

The industries inwhich we operate are highly competitive. We face substantial competition from established competitors, some ofwhich have greater financial, engineering, manufacturing and marketingresources than we do.  If we are unableto compete effectively with these companies, our market share may decline andour business could be harmed.  Ourcompetitors can be expected to continue to improve the design and performanceof their products and to introduce new products.  New companies may enter the markets in whichwe compete, or industry consolidation may occur, further increasing competitionin those markets.  Furthermore, ourtechnological advantages may be reduced or lost as a result of technologicaladvances by our competitors.

 

Our competitors’greater resources in the areas described above may enable them to:

 

•                  Better withstand periodic downturns;

•                  Compete more effectively on the basis of price andtechnology; and

•                  More quickly develop enhancements to and newgenerations of products.

 

We believe thatour ability to compete successfully depends on a number of factors, including:

 

•                  Performance of our products;

•                  Quality of our products;

•                  Reliability of our products;

•                  Cost of using our products;

•                  Consistent availability of critical components;

•                  Our ability to ship products on the schedule required;

•                  Quality of the technical service we provide;

•                  Timeliness of the services we provide;

•                  Our success in developing new products andenhancements;

•                  Existing market and economic conditions; and

•                  Price of our products as compared to our competitors’products.

 

We may not be ableto compete successfully in the future, and increased competition may result inprice reductions, reduced profit margins and loss of market share.

 

***Theloss of key personnel or our inability to attract, retain and assimilatesufficient numbers of managerial, financial, engineering and other technicalpersonnel could have a material effect upon our results of operations.***

 

Our continuedsuccess depends, in part, upon key managerial, financial, engineering andtechnical personnel as well as our ability to continue to attract, retain andassimilate additional personnel.  Theloss of key personnel could have a material adverse effect on our business orresults of operations.  We may not beable to retain our key managerial, financial, engineering and technicalemployees. For example, our Chief Financial Officer resigned effective December7, 2005 and we are currently in the process of searching for a new ChiefFinancial Officer.  Attracting qualifiedpersonnel may be difficult and our efforts to attract and retain thesepersonnel may not be successful.  Inaddition, we may not be able to assimilate qualified personnel, including anynew members of senior management, which could disrupt our operations.

 

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***Ourworldwide direct sales and service operations expose us to employer-relatedrisks in foreign countries.***

 

We haveestablished direct sales and service organizations throughout the world.  A worldwide direct sales and service model inforeign countries involves certain risks. We are subject to compliance with the labor laws and other lawsgoverning employers in the countries where our operations are located and as aresult we may incur additional costs to comply with these localregulations.  Additionally, we mayencounter labor shortages or disputes that could inhibit our ability toeffectively sell, market and service our products.  If we cannot effectively manage the risksrelated to employing persons in foreign countries, our operating results couldbe adversely affected.

 

***Wemay make acquisitions in the future, and these acquisitions may subject us torisks associated with integrating these businesses into our current business.***

 

Although we haveno commitments or agreements for any acquisitions, in the future we may makeacquisitions of, or significant investments in, businesses with complementaryproducts, services or technologies.

 

Acquisitionsinvolve numerous risks, many of which are unpredictable and beyond our control,including:

 

•                  Difficulties and increased costs in connection withintegration of the personnel, operations, technologies and products of acquiredcompanies;

•                  Diversion of management’s attention from otheroperational matters;

•                  The potential loss of key employees of acquiredcompanies;

•                  Lack of synergy, or inability to realize expectedsynergies, resulting from the acquisition;

•                  Acquired assets becoming impaired as a result oftechnological advancements or worse-than-expected performance by the acquiredcompany; and

•                  Difficulties establishing satisfactory internal controlsat acquired companies.

 

Our inability toeffectively manage these acquisition risks could materially and adverselyaffect our business, financial condition and results of operations.  In addition, if we issue equity securities topay for an acquisition the ownership percentage of our existing shareholderswould be reduced and the value of the shares held by our existing shareholderscould be diluted.  If we use cash to payfor an acquisition the payment could significantly reduce the cash that wouldbe available to fund our operations or to use for other purposes. In addition,the accounting for future acquisitions could result in significant chargesresulting from amortization of intangible assets related to such acquisitions.

 

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***Weare exposed to the risks of operating a global business, including risksassociated with exchange rate fluctuations, legal and regulatory changes andthe impact of regional and global economic disruptions.***

 

International shipmentsaccounted for 85% of net sales in fiscal 2005, with 77% of our net sales tocustomers in Asia.  We expect thatinternational shipments will continue to represent a significant percentage ofnet sales in the future.  Our non-U.S.sales, purchases and operations are subject to risks inherent in conductingbusiness abroad, many of which are outside our control, including thefollowing:

 

•                  Periodic local or geographic economic downturns andunstable political conditions;

•                  Price and currency exchange controls;

•                  Fluctuation in the relative values of currencies;

•                  Difficulties protecting intellectual property;

•                  Local labor disputes;

•                  Shipping delays and disruptions;

•                  Increases in shipping costs, caused by increased fuelcosts or otherwise, which we may not be able to pass on to our customers;

•                  Unexpected changes in trading policies, regulatoryrequirements, tariffs and other barriers; and

•                  Difficulties in managing a global enterprise,including staffing, collecting accounts receivable, managing distributors andrepresentatives and repatriation of earnings.

 

Our business andoperating results are subject to uncertainties arising out of the possibilityof regional or global economic disruptions (including those resulting fromnatural disasters and outbreaks of infectious disease), the economicconsequences of military action or terrorist activities and associatedpolitical instability, and the impact of heightened security concerns ondomestic and international travel and commerce. In particular, due to these uncertainties we are subject to:

 

•                  The risk that future tightening of immigrationcontrols may adversely affect the residence status of non-U.S. engineers andother key technical employees in our U.S. facilities or our ability to hire newnon-U.S. employees in such facilities;

•                  The risk of more frequent instances of shippingdelays; and

•                  The risk that demand for our products may notincrease or may decrease.

 

***Failureto maintain effective internal controls could have a material adverse effect onour business, operating results and stock price.***

 

In connection withour fiscal 2005 audit, we documented and tested our internal control proceduresin order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act,which requires annual management assessments of the effectiveness of ourinternal controls over financial reporting and a report by our independentauditors addressing these assessments. If we fail to maintain the adequacy of our internal controls, we may notbe able to ensure that we can conclude on an ongoing basis that we haveeffective internal controls over financial reporting in accordance with Section404 of the Sarbanes-Oxley Act.  Ourability to maintain internal controls may be negatively impacted by our plannedimplementation of a new enterprise resource planning system in fiscal2006.  Moreover, effective internalcontrols, particularly those related to revenue recognition, are necessary forus to produce reliable financial reports and are important to prevent financialfraud.  If we cannot provide reliablefinancial reports or prevent fraud, our business and operating results could beharmed, investors could lose confidence in our reported financial information,and the trading price of our stock could drop significantly.

 

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***Enterpriseresource planning system (ERP) implementation could have a material adverseeffect on our business.***

 

We are highlydependent on our systems infrastructure in order to process orders, track inventory,ship products in a timely manner, prepare invoices to our customers andotherwise carry on our business in the ordinary course.  Key to the success of our strategy to drivegreater productivity and cost savings is the implementation of a new worldwideERP system expected in fiscal 2006.  Ifwe experience problems with the implementation of this system, the resultingdisruption could adversely affect our business, sales, results of operationsand financial condition. The transition to our new ERP system involves numerousrisks, including:

 

•                  difficulties in integrating the system with ourcurrent operations;

•                  potential delay in the processing of customer ordersfor shipment of products;

•                  diversion of management’s attention away from normaldaily operations of our business;

•                  increased demand on our support operations;

•                  initial dependence on an unfamiliar system whiletraining personnel in its use; and

•                  initial increase in operating expenses for a fewquarters surrounding the implementation date resulting from training,conversion and transition support activities.

 

Further, we mayexperience difficulties in the transition to the new software that could affectour internal control systems, processes, procedures and relateddocumentation.  The ERP implementationwill require significant effort in a compressed timeframe, as well as result inour incurring costs to comply with Section 404 of the Sarbanes-Oxley Act bydocumenting all business processes that have been revised as a result of theimplementation.  This will result incompliance costs that will be in addition to the implementation costs of ournew ERP system.  There can be noassurances that the evaluation required by Section 404 of the Sarbanes-OxleyAct for fiscal 2006 will not result in the identification of significantcontrol deficiencies or that our auditors will be able to attest to theeffectiveness of our internal control over financial reporting subsequent tothe implementation of the new ERP system.

 

***The Company’s tax rates are subject to fluctuation, which could impactour financial position, and our estimates of tax liabilities may be subject toaudit which could result in additional assessments.***

 

Oureffective tax rates are subject to fluctuation as the income tax rates for eachyear are a function of: (a) the effects of a mix of profits (losses) earned byESI and our subsidiaries in numerous tax jurisdictions with a broad range ofincome tax rates, (b) our ability to utilize recorded deferred tax assets, (c)taxes, interest or penalties resulting from tax audits and (d) changes in taxlaws or the interpretation of such tax laws. Changes in the mix of these items may cause our effective tax rates tofluctuate between periods, which could have a material adverse effect on ourfinancial position.

 

Weare subject to income taxes in both the United States and numerous foreignjurisdictions.  During the ordinarycourse of business there are many transactions and calculations for which theultimate tax determination is uncertain. Significant judgment is exercised in determining our world wideprovisions for income taxes. Furthermore, we are regularly under audit by tax authorities.  Although we believe our tax estimates arereasonable, the final outcome of tax audits and examinations could bematerially different than which is reflected in historical income taxaccruals.  If additional taxes are assessedas a result of an examination, a material effect on our financial results, taxpositions or cash flows could occur in the period or periods in which thedetermination is made.

 

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

 

Therehave been no material changes in the market risk disclosure contained in our2005 Annual Report on Form 10-K for our fiscal year ended on May 28, 2005.

 

**Item 4.  Controls andProcedures**

 

Attachedto this quarterly report as exhibits 31.1 and 31.2 are the certifications ofour President and Chief Executive Officer and our Interim Chief Financial Officerrequired by Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302Certifications).  This portion of ourquarterly report on Form 10-Q is our disclosure of the conclusions of ourmanagement, including our President and Chief Executive Officer and our InterimChief Financial Officer, regarding the effectiveness of our disclosure controlsand procedures as of the end of the period covered by this report based onmanagement’s evaluation of those disclosure controls and procedures.  You should read this disclosure inconjunction with the Section 302 Certifications for a more completeunderstanding of the topics presented.

 

***Disclosure Controls and Procedures***

Ourmanagement has evaluated, under the supervision and with the participation ofour President and Chief Executive Officer and Interim Chief Financial Officer,the effectiveness of our disclosure controls and procedures as of the end ofthe period covered by this report pursuant to Rule 13a-15(b) under theSecurities Exchange Act of 1934, as amended (Exchange Act). Based on thatevaluation, our President and Chief Executive Officer and our Interim ChiefFinancial Officer have concluded that, as of the end of the period covered bythis report, our disclosure controls and procedures are effective in ensuringthat information required to be disclosed in our Exchange Act reports is (1)recorded, processed, summarized and reported in a timely manner, and (2)accumulated and communicated to our management, including our President andChief Executive Officer and our Interim Chief Financial Officer, as appropriateto allow timely decisions regarding required disclosure.

 

***Changes in Internal Control Over FinancialReporting***

Therehas been no change in our internal control over financial reporting that occurredduring our fiscal quarter ended November 26, 2005 that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

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**PART II – OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

On August 24, 2005, ESIexecuted a Provisional Attachment Order (the Attachment Order) issued by theKaohsiung District Court of Taiwan (the Court) directed against All Ring TechCo., Ltd. (All Ring) of Taiwan.  In its petition requesting the AttachmentOrder, ESI alleged that All Ring’s Capacitor Tester Model RK-T6600 (theCapacitor Tester) infringes our Taiwan Patent No. 207469, entitled “CircuitComponent Handler” (the 207469 patent).  This patent corresponds to ourU.S. Patent No. 5,842,579.  The patented technology is used in the Model3340 Multifunction MLCC Tester.  All Ring has filed a bond with the Courtto obtain relief from the attachment of its assets.  The bond providessecurity to ESI with respect to its patent infringement claim against All Ring.

 

On September 19, 2005,the Court granted our petition for a Preliminary Injunction, and issued aPreliminary Injunction Order that prohibits All Ring from manufacturing,selling, offering for sale or using the Capacitor Tester, or importing theCapacitor Tester for any of these purposes, until final judgment is entered inthe formal patent infringement action. Pursuant to the Court’s Order, ESI was required to post with the Court aTaiwan dollar security bond of approximately US$6.8 million, which is includedin other assets on the accompanying consolidated balance sheet at November 26,2005.  The Court then executed thePreliminary Injunction Order in late October 2005.  All Ring appealed the Preliminary InjunctionOrder on November 1, 2005.  We intend tofile an opposition to the appeal.  OnNovember 10, 2005, All Ring filed a petition to post a counterbond to revokethe execution of the Preliminary Injunction Order. The Court granted thecounterbond petition on December 14, 2005. The Count’s order allows All Ring to obtain relief from the PreliminaryInjunction Order if it posts a bond in the amount of approximatelyUS$6.8million.

 

On October 27, 2005, wefiled a formal patent infringement action against All Ring in the Court.  All Ring filed a defense brief responding tothe complaint in late November 2005.

 

On November 18, 2005, AllRing filed a cancellation action against the Company’s 207469 patent in theTaiwan Intellectual Property Office (the IPO). The IPO has not yet served theCompany with All Ring’s brief.

 

We intend to vigorouslypursue our patent infringement claims against All Ring and defend against thecancellation action.

 

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**Item 4.Submission of Matters to a Vote of Security Holders**

 

The 2005 Annual Meetingof Shareholders of the Company was held pursuant to notice at 1:00 p.m. Pacifictime on October 20, 2005 at the Company’s offices in Portland, Oregon toconsider and vote upon: 

 
| Proposal 1  |   | To elect three  directors for a term of three years.                                                                                                |
|-------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
| Proposal  2 |   | To ratify the  appointment of KPMG LLP as the Company’s independent registered public  accounting firm for the fiscal year ending June 3, 2006 |

 

The results of thevoting on these proposals were as follows:

 

Proposal 1

 
| **Election of Directors** | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|---------------------------|------------|------------|------------|--------------|------------|
| Barry L. Harmon           |       | 24,607,151 |       | 700,718      |       |
| W. Arthur Porter          |       | 24,570,450 |       | 737,419      |       |
| Gerald F. Taylor          |       | 24,659,212 |       | 648,657      |       |

 
| ** ** | ** ** | **For**    | ** ** | **Against** | ** ** | **Abstentions** | ** ** | **Broker Non-  Votes** | ** ** |
|------------|------------|------------|------------|-------------|------------|-----------------|------------|-----------------------------|------------|
| Proposal 2 |       | 23,850,222 |       | 1,434,765   |       | 22,882          |       | 3,365,773                   |       |

 

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**Item 6.  Exhibits**

 
| This  list is intended to constitute the exhibit index. |
|---------------------------------------------------------|
| 3.1                                                     |   | Restated Articles of  Incorporation. Incorporated by reference to Exhibit 3-A of the Company’s  Annual Report on Form 10-K for the fiscal year ended May 31, 1991. |
| 3.2                                                     |   | Articles of Amendment  of Third Restated Articles of Incorporation. Incorporated by reference to  Exhibit 3-B of the Company’s Annual Report on Form 10-K for the fiscal year  ended May 31, 1999. |
| 3.3                                                     |   | Articles of Amendment  of Third Restated Articles of Incorporation. Incorporated by reference to  Exhibit 3 of the Company’s Quarterly Report on Form 10-Q for the fiscal  quarter ended December 2, 2000. |
| 3.4                                                     |   | 2004 Restated Bylaws,  as amended. Incorporated by reference to Exhibit 3.1 of the Company’s Current  Report on Form 8-K filed on October 21, 2004. |
| 4.1                                                     |   | Amended and Restated  Rights Agreement, dated as of March 1, 2001, between the Company and Mellon  Investor Services, relating to rights issued to all holders of Company common  stock. Incorporated by reference to Exhibit 4-A of the Company’s Annual  Report on Form 10-K for the fiscal year ended June 2, 2001. |
| 31.1                                                    |   | Certification  of the Chief Executive Officer pursuant to Section 302(a) of the  Sarbanes-Oxley Act of 2002. |
| 31.2                                                    |   | Certification  of the Chief Financial Officer pursuant to Section 302(a) of the  Sarbanes-Oxley Act of 2002. |
| 32.1                                                    |   | Certification  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2                                                    |   | Certification  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
| Dated:     December  21, 2005 | ELECTRO  SCIENTIFIC INDUSTRIES, INC.                                                 |
|--------------------------------------------------------|--------------------------------------------------------------------------------------|
|                                                   |                                                                                 |
|                                                   | By                                                                                   | /s/  Nicholas Konidaris |   |
|                                                   | Nicholas Konidaris                                                                   |
|                                                   | President and Chief Executive Officer                                                |
|                                                   | (Principal Executive Officer)                                                        |
|                                                   |                                                                                 |
|                                                   | By                                                                                   | /s/ Kerry Mustoe |   |
|                                                   | Kerry Mustoe                                                                         |
|                                                   | Corporate Controller, Chief Accounting  Officer and  Interim Chief Financial Officer |
|                                                   | (Principal Financial Officer and Principal  Accounting   Officer)                    |
|                                                        |                                                                                      |  |  |  |

 

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