**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

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

 

**For the quarterly period ended August 28, 2004**

 

**OR**

 

**o****  TRANSITION REPORT PURSUANT TO SECTION 13OR 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  or organization) | ** ** | (I.R.S. Employer Identification No.) |
| ** **                                                      | ** ** | ** **                           |
| **13900 N.W. Science Park Drive, Portland, Oregon**             | ** ** | **97229**                            |
| (Address of principal executive offices)                        | ** ** | (Zip Code)                           |

 

Registrant’s telephone number:  **(503) 641-4141**

 

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

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý No  o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).   Yes   ý No o

 

Thenumber of shares outstanding of the Registrant’s Common Stock atSeptember 29, 2004 was 28,424,411 shares.

 

 

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**ELECTRO SCIENTIFIC INDUSTRIES, INC. ANDSUBSIDIARIES**

** **

**TABLE OF CONTENTS**

 
| **PART I - FINANCIAL  INFORMATION** | ** **                                                                                                                |
|-------------------------------------|---------------------------------------------------------------------------------------------------------------------------|
|                                |                                                                                                                      |   |
| Item 1.                             | Consolidated Condensed Financial  Statements (unaudited)                                                                  |   |
|                                |                                                                                                                      |   |
|                                | Consolidated  Condensed Balance Sheets – August 28, 2004 and May 29, 2004                                       |   |
|                                |                                                                                                                      |   |
|                                | Consolidated  Condensed Statements of Operations – Three Months Ended August 28, 2004  and August 30, 2003 |   |
|                                |                                                                                                                      |   |
|                                | Consolidated  Condensed Statements of Cash Flows – Three Months Ended August 28, 2004  and August 30, 2003 |   |
|                                |                                                                                                                      |   |
|                                | 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 6.                             | Exhibits                                                                                                                  |   |
|                                |                                                                                                                      |   |
| Signatures                          |                                                                                                                      |

 

1

----

 

**PART I - FINANCIAL INFORMATION**

 

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

 

ELECTRO SCIENTIFIC INDUSTRIES, INC. ANDSUBSIDIARIES

CONSOLIDATED CONDENSEDBALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                            | ** ** | **August 28,  2004** | ** ** | **May 29,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|-------------------|------------|
|                                                                                                  |       |                      |       |              |       |
| **Assets**                                                                                            |       |                      |       |              |       |
| Current assets:                                                                                       |       |                      |       |              |       |
| Cash and cash equivalents                                                                             |       | $                         | 88,729     |              | $          | 80,358 |   |
| Marketable securities                                                                                 |       | 205,923                   |       | 206,931           |       |
| Restricted securities                                                                                 |       | 3,194                     |       | 6,251             |       |
| Total cash and securities                                                                             |       | 297,846                   |       | 293,540           |       |
|                                                                                                  |       |                      |       |              |       |
| Trade receivables, net of allowances of  $1,000 and $901                                              |       | 61,224                    |       | 51,696            |       |
| Income tax refund receivable                                                                          |       | 7,411                     |       | 7,466             |       |
| Inventories, net                                                                                      |       | 65,574                    |       | 58,627            |       |
| Shipped systems pending acceptance                                                                    |       | 7,169                     |       | 4,391             |       |
| Deferred income taxes                                                                                 |       | 17,336                    |       | 16,096            |       |
| Assets held for sale                                                                                  |       | —                    |       | 2,391             |       |
| Other current assets                                                                                  |       | 7,410                     |       | 3,348             |       |
| Total current assets                                                                                  |       | 463,970                   |       | 437,555           |       |
|                                                                                                  |       |                      |       |              |       |
| Long-term marketable securities                                                                       |       | 39,386                    |       | 39,214            |       |
| Property, plant and equipment, net of  accumulated depreciation of $41,777 and $40,644                |       | 33,822                    |       | 33,531            |       |
| Deferred income taxes                                                                                 |       | 12,095                    |       | 17,630            |       |
| Other assets                                                                                          |       | 8,619                     |       | 9,256             |       |
| Total assets                                                                                          |       | $                         | 557,892    |              | $          | 537,186 |   |
|                                                                                                  |       |                      |       |              |       |
| **Liabilities and  shareholders’ equity**                                                        |       |                      |       |              |       |
| Current liabilities:                                                                                  |       |                      |       |              |       |
| Accounts payable                                                                                      |       | $                         | 14,620     |              | $          | 13,248 |   |
| Accrued liabilities                                                                                   |       | 39,918                    |       | 42,381            |       |
| Deferred revenue                                                                                      |       | 17,187                    |       | 11,985            |       |
| Total current liabilities                                                                             |       | 71,725                    |       | 67,614            |       |
| Convertible subordinated notes                                                                        |       | 142,976                   |       | 142,759           |       |
| Total liabilities                                                                                     |       | 214,701                   |       | 210,373           |       |
|                                                                                                  |       |                      |       |              |       |
| Shareholders’ equity:                                                                            |       |                      |       |              |       |
| Preferred stock, without par value; 1,000  shares authorized; no shares issued                        |       | —                    |       | —            |       |
| Common stock, without par value; 100,000  authorized; 28,411 and 28,175 shares issued and outstanding |       | 152,153                   |       | 147,054           |       |
| Retained earnings                                                                                     |       | 192,008                   |       | 181,362           |       |
| Accumulated other comprehensive loss                                                                  |       | (970                      | )          | (1,603            | )          |
| Total shareholders’ equity                                                                       |       | 343,191                   |       | 326,813           |       |
| Total liabilities and shareholders’ equity                                                       |       | $                         | 557,892    |              | $          | 537,186 |   |

 

The accompanying notes are an integral part of these statements.

 

2

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 
| ** **                                         | ** ** | **For the three months ended** | ** ** |
|----------------------------------------------------|------------|--------------------------------|------------|
| ** **                                         | ** ** | **August 28, 2004**       | ** ** | **August 30, 2003** | ** ** |
|                                               |       |                           |       |   |   |
| Net sales                                          |       | $                              | 72,620     |   | $ | 20,876 |   |
| Cost of sales                                      |       | 35,734                         |       | 16,036 |   |
| Gross profit                                       |       | 36,886                         |       | 4,840 |   |
|                                               |       |                           |       |   |   |
| Operating expenses:                                |       |                           |       |   |   |
| Selling, service and administration                |       | 14,878                         |       | 14,625 |   |
| Research, development and engineering              |       | 6,560                          |       | 5,748 |   |
|                                               |       | 21,438                         |       | 20,373 |   |
| Operating income (loss)                            |       | 15,448                         |       | (15,533 | ) |
|                                               |       |                           |       |   |   |
| Interest income                                    |       | 1,550                          |       | 2,002 |   |
| Interest expense                                   |       | (1,786                         | )          | (1,927 | ) |
| Other income (expense)                             |       | (133                           | )          | 102 |   |
|                                               |       | (369                           | )          | 177 |   |
| Income (loss) before income taxes                  |       | 15,079                         |       | (15,356 | ) |
| Provision for (benefit from) income taxes          |       | 4,433                          |       | (5,989 | ) |
| Net income (loss)                                  |       | $                              | 10,646     |   | $ | (9,367 | ) |
|                                               |       |                           |       |   |   |
| Net income (loss) per share - basic                |       | $                              | 0.38       |   | $ | (0.34 | ) |
| Net income (loss) per share - fully diluted        |       | $                              | 0.36       |   | $ | (0.34 | ) |
|                                               |       |                           |       |   |   |
| Weighted average number of shares - basic          |       | 28,216                         |       | 27,840 |   |
| Weighted average number of shares - fully  diluted |       | 32,279                         |       | 27,840 |   |

 

The accompanying notes are an integral part of these statements.

 

3

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                                      | ** ** | **For the three months ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                      | ** ** | **August 28, 2004**       | ** ** | **August 30, 2003** | ** ** |
|                                                                                            |       |                           |       |   |   |
| **Cash flows from  operating activities:**                                                      |       |                           |       |   |   |
| Net income (loss)                                                                               |       | $                              | 10,646     |   | $ | (9,367 | ) |
| Adjustments to reconcile net income (loss)  to cash provided by (used in) operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                                   |       | 2,255                          |       | 2,664 |   |
| Tax benefit of stock options exercised                                                          |       | 503                            |       | 78 |   |
| Provision for doubtful accounts                                                                 |       | 99                             |       | — |   |
| Loss on disposal of property and equipment                                                      |       | 54                             |       | — |   |
| Deferred income taxes                                                                           |       | 4,303                          |       | (1,155 | ) |
| Changes in operating accounts:                                                                  |       |                           |       |   |   |
| (Increase) decrease in trade receivables                                                        |       | (9,734                         | )          | 4,611 |   |
| (Increase) decrease in income tax refund  receivable                                            |       | 55                             |       | (5,583 | ) |
| Increase in inventories, net                                                                    |       | (7,077                         | )          | (951 | ) |
| Increase in shipped systems pending  acceptance                                                 |       | (2,778                         | )          | (5,163 | ) |
| Increase in other current assets                                                                |       | (1,855                         | )          | (596 | ) |
| Decrease in other current liabilities                                                           |       | (1,041                         | )          | (1,425 | ) |
| Increase in deferred revenue                                                                    |       | 5,202                          |       | 8,462 |   |
| Net cash provided by (used in) operating  activities                                            |       | 632                            |       | (8,425 | ) |
|                                                                                            |       |                           |       |   |   |
| **Cash flows from  investing activities:**                                                      |       |                           |       |   |   |
| Purchase of property, plant and equipment                                                       |       | (882                           | )          | (510 | ) |
| Proceeds from the sale of property and  equipment                                               |       | 76                             |       | — |   |
| Proceeds from the sale of assets held for  sale                                                 |       | 2,361                          |       | — |   |
| Maturity of restricted securities                                                               |       | 3,057                          |       | 3,185 |   |
| Purchase of securities                                                                          |       | (79,311                        | )          | (67,850 | ) |
| Proceeds from sales of securities and  maturing securities                                      |       | 80,801                         |       | 66,564 |   |
| Increase in other assets                                                                        |       | (582                           | )          | (279 | ) |
| Net cash provided by investing activities                                                       |       | 5,520                          |       | 1,110 |   |
|                                                                                            |       |                           |       |   |   |
| **Cash flows from  financing activities:**                                                      |       |                           |       |   |   |
| Proceeds from exercise of stock options and  stock plans                                        |       | 2,219                          |       | 133 |   |
| Net cash provided by financing activities                                                       |       | 2,219                          |       | 133 |   |
|                                                                                            |       |                           |       |   |   |
| **Net change in cash  and cash equivalents**                                                    |       | 8,371                          |       | (7,182 | ) |
|                                                                                            |       |                           |       |   |   |
| **Cash and cash  equivalents:**                                                                 |       |                           |       |   |   |
| Beginning of period                                                                             |       | 80,358                         |       | 31,017 |   |
| End of period                                                                                   |       | $                              | 88,729     |   | $ | 23,835 |   |
|                                                                                            |       |                           |       |   |   |
| **Supplemental cash  flow information:**                                                        |       |                           |       |   |   |
| Cash paid for interest                                                                          |       | $                              | 3,081      |   | $ | 3,334 |   |
| Income tax refunds received                                                                     |       | 3                              |       | 808 |   |
| Cash paid for income taxes                                                                      |       | 274                            |       | 371 |   |

 

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 FINANCIALSTATEMENTS**

**(Unaudited)**

 

**Note 1 - Basis of Presentation**

 

Theseunaudited interim consolidated condensed financial statements have beenprepared pursuant to the rules and regulations of the Securities and ExchangeCommission.  Certain information andfootnote disclosures normally included in annual financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates have been 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.  Certain prior year amounts have beenreclassified to conform to current year presentation.  Additionally, subsequent to the issuance ofthe the Company’s earnings press release on September 23, 2004, theCompany reclassified certain marketable securities from current to long-term onthe balance sheet presentation as of August 28, 2004.

 

Resultsof operations for interim periods are not necessarily indicative of the resultsto be expected for the full year.

 

**Note 2 - Inventories**

 

Inventoriesare principally valued at standard costs, which approximate the lower of cost(on a first-in, first-out basis) or market. Components of inventories were as follows (in thousands):

 
| ** **                        | ** ** | **August 28,  2004** | ** ** | **May 29,  2004** | ** ** |
|-----------------------------------|------------|---------------------------|------------|-------------------|------------|
| Raw materials and purchased parts |       | $                         | 34,542     |              | $          | 34,710 |   |
| Work-in-process                   |       | 14,185                    |       | 11,219            |       |
| Finished goods                    |       | 16,847                    |       | 12,698            |       |
|                              |       | $                         | 65,574     |              | $          | 58,627 |   |

 

**Note 3 – Assets Held For Sale**

 

Assetsheld for sale at May 29, 2004 consisted of an undeveloped parcel of land inTaiwan with a carrying value of $2.4 million. The Company sold this parcel of land in June 2004 and received netcash proceeds substantially equal to the carrying value.

 

5

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**Note 4 – Accrued Liabilities**

 

Accruedliabilities consisted of the following (in thousands):

 
| ** **                               | ** ** | **August 28,  2004** | ** ** | **May 29,  2004** | ** ** |
|------------------------------------------|------------|---------------------------|------------|-------------------|------------|
|                                     |       |                      |       |              |       |
| Payroll-related                          |       | $                         | 10,170     |              | $          | 10,781 |   |
| Product warranty                         |       | 4,854                     |       | 4,720             |       |
| Interest payable                         |       | 1,264                     |       | 2,805             |       |
| Accrual for loss on purchase commitments |       | 536                       |       | 536               |       |
| Legal settlement accrual                 |       | 3,800                     |       | 3,800             |       |
| Income taxes payable                     |       | 11,823                    |       | 12,212            |       |
| Other                                    |       | 7,471                     |       | 7,527             |       |
|                                     |       | $                         | 39,918     |              | $          | 42,381 |   |

 

SeeNote 5 for a discussion of the accrual for product warranty and Note 10 for adiscussion of the accrual for legal settlement.

 

**Note 5 – Product Warranty**

 

TheCompany evaluates obligations related to product warranties quarterly.  Products sold are inclusive of a standardone-year warranty. Warranty charges are comprised of costs to service thewarranty including labor to repair the system and replacement parts fordefective items, as well as other costs incidental to the repairs.  Inventory credits resulting from the returnof repaired parts to inventory and any cost recoveries from warranties offeredby our suppliers for defective components are recorded as a credit to thewarranty accrual.  Using historical data,we estimate average warranty cost per system or part type and record theprovision for such charges as an element of cost of goods sold.  Additionally, the overall warranty accrualbalance is separately analyzed using the remaining warranty periods outstandingon systems and items under warranty, and any resulting changes in estimates arerecorded as an adjustment to cost of sales. If circumstances change, or if a material change in warranty-relatedincidents occurs, the estimate of the warranty accrual could changesignificantly.  Accrued product warrantyis included on the balance sheet as a component of accrued liabilities.

 

Followingis a reconciliation of the change in the aggregate accrual for product warrantyfor the three months ended August 28, 2004 (in thousands):

 
| Product warranty accrual, May 29, 2004          |   | $      | 4,720  |   |
|-------------------------------------------------|--------|--------|--------|--------|
| Warranty charges incurred                       |   | (2,766 | )      |
| Inventory credits                               |   | 1,023  |   |
| Provision for warranty charges                  |   | 1,877  |   |
| Product warranty accrual, August 28,  2004 |   | $      | 4,854  |   |

 

6

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**Note 6 – Deferred Revenue**

 

Revenueis deferred pending title transfer and fulfillment of acceptance criteria,which frequently 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 of substantiallynew products.  In sales involvingmultiple element arrangements, the fair value of any undelivered elements,including installation services, is deferred until delivery.  Revenue related to maintenance and servicecontracts is deferred and recognized ratably over the duration of thecontracts.

 

Thefollowing is a reconciliation of the changes in deferred revenue for the threemonths ended August 28, 2004 (in thousands):

 
| Deferred revenue, May 29, 2004         |   | $      | 11,985 |   |
|----------------------------------------|--------|--------|--------|--------|
| Revenue deferred                       |   | 9,231  |   |
| Revenue recognized                     |   | (4,029 | )      |
| Deferred revenue, August 28, 2004 |   | $      | 17,187 |   |

 

**Note 7 - 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 ended August 28, 2004 (in thousands, except pershare amounts):

 
| ** **                                                  | ** ** | **Income** | ** ** | **Shares** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------|------------|
| Net income available to common shareholders  - basic        |       | $          | 10,646     |       | 28,216     |   |
| Effect of dilutive stock options                            |       | —     |       | 247        |       |
| Effect of 4 1⁄4% convertible subordinated  notes         |       | 1,090      |       | 3,816      |       |
| Net income available to common shareholders  -fully diluted |       | $          | 11,736     |       | 32,279     |   |

 

Inthe diluted EPS calculation for the three months ending August 28, 2004,employee stock options equal to 3,744,000 common stock equivalent shares wereexcluded because inclusion would have had an antidilutive effect.  Basic and diluted EPS were the same for thecomparative three months ended August 30, 2003 because the Company was ina loss position for that period.

 

**Note 8 - Comprehensive Income (Loss)**

 

Thecomponents of comprehensive income (loss), net of tax, are as follows (inthousands):

 
| ** **                                            | ** ** | **Three months ended**    | ** ** |
|-------------------------------------------------------|------------|---------------------------|------------|
| ** **                                            | ** ** | **August 28,  2004** | ** ** | **August 30,  2003** | ** ** |
|                                                  |       |                      |       |   |   |
| Net income (loss)                                     |       | $                         | 10,646     |   | $ | (9,367 | ) |
| Net unrealized gain (loss) on derivative  instruments |       | 28                        |       | (4 | ) |
| Foreign currency translation adjustment               |       | (48                       | )          | (73 | ) |
| Net unrealized gain (loss) on securities              |       | 653                       |       | (1,508 | ) |
|                                                  |       | $                         | 11,279     |   | $ | (10,952 | ) |

 

7

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**Note 9 – Stock Based Compensation Plans**

 

TheCompany 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-Based Compensation”, subsequently amended by SFAS No.148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” toaccount for stock options and restricted stock issued to its employees underits stock compensation plans, and amortizes deferred compensation, 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 fair market value of the underlying share of company stock subjectto the option on the award’s grant date. The calculated total compensation expense, if any, is included inoperating results over the vesting period of the underlying options using thestraight-line method.  However, nocompensation cost has been recognized for employee share purchase plan (ESPP)shares which are issued at fifteen percent discount of the lower of the marketprice on either the first day of the applicable offering period or the purchasedate.

 

Proforma fair value disclosures required by SFAS No. 123 are presented below andreflect the impact on net income (loss) and net income (loss) per share as ifthe fair value of its stock-based awards to employees had been applied:

 
| ** **                                                                                                                                                        | ** ** | **Three months ended**    | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **August 28,  2004** | ** ** | **August 30,  2003** | ** ** |
|                                                                                                                                                              |       |                      |       |   |   |
| Net income (loss), as reported                                                                                                                                    |       | $                         | 10,646     |   | $ | (9,367 | ) |
| Deduct – Recapture of stock-based employee  compensation expense related to cancellations included in reported net income  (loss), net of related tax effect |       | —                    |       | (144 | ) |
| Add – Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects                                          |       | 126                       |       | 40 |   |
| Deduct – total stock-based employee  compensation expense determined under the fair value based method for all  awards, net of related tax effects           |       | (12,400                   | )          | (2,093 | ) |
| Net loss, pro forma                                                                                                                                               |       | $                         | (1,628     | ) | $ | (11,564 | ) |
|                                                                                                                                                              |       |                      |       |   |   |
| Net income (loss) per share – basic, as  reported                                                                                                            |       | $                         | 0.38       |   | $ | (0.34 | ) |
| Net income (loss) per share – fully  diluted, as reported                                                                                                    |       | $                         | 0.36       |   | $ | (0.34 | ) |
| Net loss per share – basic and fully  diluted, pro forma                                                                                                     |       | $                         | (0.06      | ) | $ | (0.42 | ) |

 

OnJune 28, 2004, the compensation committee of the Board of Directorsapproved an acceleration of the vesting of those employee stock options,excluding stock options granted to the Board of Directors and Chief ExecutiveOfficer, with an option price equal to or greater than the closing sale priceof $23.38 per share on that date, as reported on the Nasdaq NationalMarket.  Approximately 1.2 millionoptions with varying remaining vesting schedules were subject to theacceleration provision, and became immediately exercisable.  The total pro forma stock-based employeecompensation expense stated above of $12.4 million includes $9.9 millionresulting from this acceleration provision, as calculated under SFAS no. 123.

 

8

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TheBlack-Scholes option pricing model is utilized to measure compensation expense.The following weighted average assumptions were made in calculating the valueof all options granted during the periods presented:

 
| ** **              | ** ** | **Three months ended**    | ** ** |
|-------------------------|------------|---------------------------|------------|
| ** **              | ** ** | **August 28,  2004** | ** ** | **August 30,  2003** | ** ** |
| Risk-free interest rate |       | 3.62                      | %          | 3.74 | % |
| Expected dividend yield |       | 0                         | %          | 0 | % |
| Expected lives          |       | 5.6 years                 |       | 5.6 years |   |
| Expected volatility     |       | 65.62                     | %          | 68.29 | % |

 

Thefollowing weighted average assumptions were made in calculating the value ofall shares issued under the ESPP during the periods presented:

 
| ** **              | ** ** | **Three months ended**    | ** ** |
|-------------------------|------------|---------------------------|------------|
| ** **              | ** ** | **August 28,  2004** | ** ** | **August 30,  2003** | ** ** |
| Risk-free interest rate |       | 2.11                      | %          | 3.74 | % |
| Expected dividend yield |       | 0                         | %          | 0 | % |
| Expected lives          |       | 1.2 years                 |       | 1.0 years |   |
| Expected volatility     |       | 54.40                     | %          | 68.29 | % |

 

**Note 10 – Legal Claims**

 

Asa result of the Company’s March 2003 announcement that it was reviewingcertain accounting matters and would be restating some of its financialstatements, between March 26, 2003 and May 20, 2003, three purported classaction lawsuits were filed in the United States District Court for the Districtof Oregon against ESI and David F. Bolender (former director, CEO and Chairmanof the Board), James T. Dooley (former President and CEO), and Joseph L.Reinhart (former Acting CFO).  Thecomplaints were filed on behalf of a purported class of persons who purchasedESI’s common stock between September 17, 2002 and at the latestApril 15, 2003, and alleged violations of Section 10(b) of theSecurities Exchange Act of 1934 (the Act) and Rule 10b-5 promulgatedthereunder, as well as Section 20(a) of the Act.  The complaints have been consolidated underthe name In re Electro Scientific Industries, Inc. Securities Litigation, CaseNo. CV 03-404-HA.  Lead plaintiffs andlead counsel for plaintiffs have been appointed. The plaintiffs’ consolidatedclass action complaint (the Consolidated Complaint) was filed onOctober 10, 2003, which shortened the purported class to purchasersbetween September 17, 2002 and March 20, 2003, and added Donald R.VanLuvanee (ESI’s President and CEO from 1992 until April 2002), John R.Kurdock (ESI’s former VP Operations), and James Lorenz (ESI’s former CorporateController) as additional defendants. The Consolidated Complaint alleges that defendants made false and misleadingstatements during the purported class period about ESI’s financial conditionand performance, business prospects, and operations, artificially inflatingESI’s stock price and leading to the restatement first announced onMarch 20, 2003.  In March 2003,the Company’s Audit Committee commenced an investigation into certainaccounting matters.  As a result of theinvestigation, which was completed on July 11, 2003, the Company restatedits financial statements for the fiscal year ended June 1, 2002 and forthe quarters ended August 31, 2002 and November 30, 2002.

 

OnMarch 31, 2003 and April 28, 2003, two separate purported shareholderderivative complaints were filed in the Circuit Court of Oregon in WashingtonCounty.  The complaints were consolidatedunder the name In Re Electro Scientific Industries, Inc. Derivative Litigation,Lead Case No. C 031067 CV.  Aconsolidated complaint (Complaint) was filed on September 24, 2003, andnames as defendants James Dooley (former President and CEO), David Bolender(former director, CEO and Chairman), Joseph Reinhart (former Acting CFO), BarryHarmon (director and former President and CEO), and current or former directorsW. Arthur Porter, Gerald Taylor, Larry Hansen, Vernon Ryles, Keith Thomson, andJon Tompkins.  ESI is named as a “nominaldefendant.”  The Complaint, whichpurports to be brought on

 

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behalfof ESI, alleges that all defendants breached fiduciary duties owed to ESI,abused their alleged control over ESI, wasted corporate assets, are liable forgross mismanagement, and were unjustly enriched by their conduct.  The Complaint seeks an unspecified amount ofmonetary damages and seeks various equitable remedies, including a constructivetrust on the proceeds received by the defendants from trading ESI common stock,and attorneys’ fees and costs.  As filed,the Complaint is derivative in nature and does not seek monetary damages fromESI or the imposition of equitable remedies on ESI.  A special litigation committee of theCompany’s board of directors, with the assistance of independent legal counsel,was appointed to conduct an investigation relating to the allegations assertedin the Complaint.

 

OnApril 22, 2004, the Company announced an agreement in principle to settleboth the class action and derivative actions. The settlement, which received preliminary court approval onSeptember 3, 2004, calls for the payment of $9.3 million of whichapproximately $3.8 million in total will be paid by the Company andapproximately $5.5 million will be paid by the Company’s insurancecarrier.  The Company paid approximately$3.7 million in September 2004 and the remaining $0.1 million payment willbe paid subject to court approval.

 

OnSeptember 23, 2004, the Securities and Exchange Commission announced thatit would not bring an enforcement action against the Company with respect tothe matters resulting in the restatement of our financial statements.

 

OnFebruary 14, 2001, Cognex Corporation (Cognex) filed a lawsuit in theUnited States District Court for the District of Massachusetts (CognexCorporation v. Electro Scientific Industries, Inc., No. 01-10287 WGY).  The lawsuit alleges that the Company’sCorrectPlace product and some of its predecessors infringe United States Patent5,371,690 (the ‘690 patent), which is owned by Cognex.  The ‘690 patent concerns the inspection ofsurface mount devices that are attached to the surface of an electronic circuitboard.  Cognex seeks injunctive relief,damages, costs and attorneys’ fees.  TheCompany filed several counterclaims, including one alleging that the ‘690patent is unenforceable by reason of inequitable conduct and another allegingthat Cognex falsely marked certain products with the ‘690 patent.  The court denied the Company’s motion forsummary judgment on the Cognex claim of infringement and denied the Cognexmotions for summary judgment on the Company’s counterclaims of false markingand unenforceability. The lawsuit is scheduled to go to trial in December 2004. Additionally, certain customers havenotified the Company that, in the event it is subsequently determined thattheir use of CorrectPlace infringes any patent, they may seek indemnificationfrom the Company for damages or expenses resulting from this matter.

 

OnAugust 18, 2003, GSI Lumonics Corporation (GSI) filed a lawsuit in theUnited States District Court for the Central District of California (GSILumonics Inc. v. Electro Scientific Industries, Inc., Case No. CV-03-5863 PA(SHx).  The lawsuit alleges that ESIinfringes three GSI patents:  U.S. PatentNo. 6,181,728, entitled “Controlling Laser Polarization” (the ‘728 patent);U.S. Patent No. 6,337,462, entitled “Laser Processing” (the ‘462 patent);  and U.S. Patent No. 6,573,473, entitled“Method and System for Precisely Positioning a Waist of a Material-ProcessingLaser Beam to Process Microstructures Within a Laser Processing Site” (the ‘473patent).  These claims relate to theCompany’s semiconductor yield improvement systems.  GSI seeks injunctive relief, an unspecifiedamount of damages, costs, and attorneys’ fees. On September 2, 2003, GSI filed a First Amended Complaint which didnot change the substantive allegations of patent infringement.  By court order dated September 18, 2003,the case was transferred to the United States District Court for the NorthernDistrict of California.  The case wasre-assigned to a judge in the Northern District of California and has beenrenumbered CV-03-04302-MHP.  OnOctober 8, 2003, the Company filed its Answer to First Amended Complaintand Counterclaim for Declaratory Judgment of Invalidity andNoninfringement.  On October 24,2003, GSI filed a Reply to the Company’s counterclaim denying the allegationsof invalidity and noninfringement.  OnMay 11, 2004, pursuant to an agreement between the Company and GSI, the courtentered a stipulated dismissal of two

 

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ofGSI’s asserted patents without prejudice: the ‘728 patent and the ‘462 patent.On August 26, 2004, pursuant to an agreement between the parties, thecourt entered a stipulated dismissal with prejudice of the remaining patentasserted by GSI:  U.S. Patent No.6,573,473.  This dismissal resolves theentire controversy between the parties.

 

Inaddition to the legal matters described above, in the ordinary course ofbusiness the Company is involved in various other legal matters, eitherasserted or unasserted, and investigations. In the opinion of management, amounts accrued for awards or assessmentsin connection with these matters are management’s best estimate and ultimateresolution of these matters will not have a material effect on the Company’sconsolidated financial position, results of operations or cash flow.

 

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

 

**Forward Looking Statements**

 

Thestatements contained in this report that are not statements of historical fact,including without limitation, statements containing the words “believes,”“expects,” and similar words, constitute forward-looking statements that aresubject to a number of risks and uncertainties. From time to time we may make other forward-looking statements.  Investors are cautioned that suchforward-looking statements are subject to an inherent risk that actual resultsmay materially differ as a result of many factors, including the risksdescribed below under the heading “Factors That May Affect Future Results.”

 

**Overview**

 

ElectroScientific Industries, Inc. and its subsidiaries (ESI) provide high-technologymanufacturing equipment to the global electronics market, including advancedlaser systems that are used to microengineer electronic device features inhigh-volume production environments.  Ourcustomers are primarily manufacturers of semiconductors, passive components andelectronic interconnect devices.  Ourequipment enables these manufacturers to achieve the yield and productivitygains in their manufacturing processes that can be critical to theirprofitability.  The components anddevices manufactured by our customers are used in a wide variety of endproducts in the computer, consumer electronics and communications industries.

 

Wesupply advanced laser microengineering systems that allow electronicsmanufacturers to physically alter select device features during high-volumeproduction, in order to heighten performance and boost production yields ofsemiconductor devices, passive components and circuitry, high-density interconnect(HDI) circuit boards and advanced semiconductor packaging.  Laser microengineering comprises a set ofprecise fine-tuning processes (laser trimming, link cutting and via drilling)that require application-specific laser systems able to meet semiconductor andmicroelectronics’ manufacturers exacting performance and productivityrequirements.

 

Additionally,we produce high-speed test, inspection and termination equipment used in thehigh-volume production of multi-layer ceramic passives (MLCPs) and other passivecomponents, as well as original equipment manufacturer (OEM) machine visionproducts.

 

In fiscal 2004 we experienced increaseddemand as the worldwide market for electronics and semiconductors and relatedmanufacturing equipment experienced a recovery. In addition to the market recovery, we introduced multiple new productsin the semiconductor, passive component and electronic interconnect businessunits.  Orders increased from $133.0million in fiscal 2003 to $273.5 million in fiscal 2004.  Shipments and revenue increased 42.3% and51.4% in fiscal 2004 compared to fiscal 2003, respectively.  Consistent with the increase in shipments andrevenue, gross margins improved steadily over the year.  In early fiscal 2004 we continued toimplement cost reduction plans to better align our infrastructure and operatingcosts with market demand, while continuing to invest in research anddevelopment and customer support.  Ourfiscal 2004 operating expenses were elevated due to costs related to the 2003audit committee investigation, securities litigation and estimated charge tosettle the class action and derivative lawsuits, totaling approximately $7.6million.  We finished the year with netincome of $11.9 million or $0.42 per share.

 

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Late in the first quarter of fiscal 2005,market demand lessened for our products. Our order volume declined 35.4% to $67.6 million in the first quarter offiscal 2005 compared to the fourth quarter of fiscal 2004.  Orders decreased sequentially across each ofour three businesses, indicative of the broad-based cautiousness in theindustry.  Although a few customers havedelayed orders, industry utilization rates remain high.   Shipments were $77.9 million in the firstquarter of fiscal 2005, up slightly over $77.1 million in the fourth quarter offiscal 2004.  Order volume may continueto decline in the second quarter to an estimated range of $50 million to $60million.  Consistent with this decrease,we estimate shipments and revenues to be in the range of $60 million to $70million.

 

**Results of Operations**

 

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

 
| ** **                                 | ** ** | **Three months ended**   | ** ** |
|--------------------------------------------|------------|--------------------------|------------|
| ** **                                 | ** ** | **August 28, 2004** | ** ** | **August 30, 2003** | ** ** |
|                                       |       |                     |       |   |   |
| **Net sales**                              |       | 100.0                    | %          | 100.0 | % |
| **Cost of sales**                          |       | 49.2                     |       | 76.8 |   |
| **Gross margin**                           |       | 50.8                     |       | 23.2 |   |
| **Selling, service  and administrative**   |       | 20.5                     |       | 70.1 |   |
| **Research,  development and engineering** |       | 9.0                      |       | 27.5 |   |
| **Operating income  (loss)**               |       | 21.3                     |       | (74.4 | ) |
| **Total other income  (expense), net**     |       | (0.5                     | )          | 0.8 |   |
| **Income (loss)  before taxes**            |       | 20.8                     |       | (73.6 | ) |
| **Income tax  provision (benefit)**        |       | 6.1                      |       | (28.7 | ) |
| **Net income (loss)**                      |       | 14.7                     | %          | (44.9 | )% |

 

***Net Sales***

 

Certaininformation regarding our net sales by product group is as follows (net salesin thousands):

 
| ** **                               | ** ** | **Three months ended**   | ** ** |
|------------------------------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **August 28, 2004** | ** ** | **August 30, 2003** | ** ** |
| ** **                               | ** ** | **Net Sales**            | ** ** | **Percent of  Total Net Sales** | ** ** | **Net Sales** | ** ** | **Percent of  Total Net Sales** | ** ** |
| **Semiconductor Group  (SG)**            |       | $                        | 44,013     |   | 60.6 | % | $ | 5,736 |   | 27.5 | % |
| **Passive Components  Group (PCG)**      |       | 20,603                   |       | 28.4 |   | 9,606 |   | 46.0 |   |
| **Electronic  Interconnect Group (EIG)** |       | 8,004                    |       | 11.0 |   | 5,534 |   | 26.5 |   |
|                                     |       | $                        | 72,620     |   | 100.0 | % | $ | 20,876 |   | 100.0 | % |

 

Netsales were $72.6 million for the quarter ended August 28, 2004, anincrease of $51.7 million or 247.9% compared to $20.9 million for the quarterended August 30, 2003.  The increasein net sales was largely driven by sales increases in SG to major DRAMmanufacturers to increase capacity and transition to newer technology.  This trend began in the second quarter offiscal 2004 and has continued through the first quarter of fiscal 2005.  The increase in SG revenues was also drivenby new products introduced in the 9800 model line that received acceptance bycustomers during fiscal 2004.  Theincrease from sales of new SG products was complimented by stronger sales inour other markets; the PCG market saw end user demand improve in the latterhalf of fiscal 2004 for products that require the use of passive componentsprocessed by our laser trim and passive test systems, a trend which continued intothe first quarter of fiscal 2005.  EIGsales levels increased in the first quarter compared to the same period in theprior year, driven by shipments to manufacturers of flex circuits and ICpackages that require the use of UV laser drills to produce highly precisemanufacturing results.

 

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Althoughshipment levels in the first quarter of fiscal 2005 were up slightly comparedto the fourth quarter of fiscal 2004, net sales were down $9.2 millionsequentially.  This decrease primarilyresulted from a net increase in deferred revenue of $5.2 million in the firstquarter of fiscal 2005 compared a net decrease in deferred revenue in thefourth quarter of fiscal 2004 of $4.6 million, as shown in the table below.

 

Deferredrevenue was $17.2 million at August 28, 2004 compared to $12.0 million atMay 29, 2004, an increase of $5.2 million. Revenue is deferred pending title transfer and fulfillment of acceptancecriteria, which frequently occur at the time of delivery to a commoncarrier.  Shipments for which titletransfer has not occurred and/or acceptance criteria cannot be demonstrated atour factory typically include sales to Japanese end-user customers andshipments of substantially new products. Due to these factors, as well as the timing of their occurrence in anygiven quarter, deferred revenue balances may fluctuate significantly fromquarter to quarter.  In sales involvingmultiple element arrangements, the fair value of any undelivered elements,including installation services, is deferred until delivery.  Revenue related to maintenance and servicecontracts is deferred and recognized ratably over the duration of thecontracts.  Changes in deferred revenuewere as follows:

 
| **Deferred revenue,  February 28, 2004** | ** ** | ** ** |   | $      | 16,620 |   |
|-----------------------------------------------|------------|------------|--------|--------|--------|--------|
| Revenue deferred                              |       | 8,200      |   |   |   |
| Revenue recognized                            |       | (12,835    | )      |   |   |
| Net change in deferred revenue                |       | (4,635     | )      |   |   |
| **Deferred revenue,  May 29, 2004**           | ** ** | ** ** |   | 11,985 |   |
| Revenue deferred                              |       | 9,231      |   |   |   |
| Revenue recognized                            |       | (4,029     | )      |   |   |
| Net change in deferred revenue                |       | 5,202      |   |   |   |
| **Deferred revenue,  August 28, 2004**   | ** ** | ** ** |   | $      | 17,187 |   |

 

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

 
| ** **   | ** ** | **Three months ended**   | ** ** |
|--------------|------------|--------------------------|------------|
| ** **   | ** ** | **August 28, 2004** | ** ** | **August 30, 2003** | ** ** |
| ** **   | ** ** | **Net Sales**            | ** ** | **Percent of  Total Net Sales** | ** ** | **Net Sales** | ** ** | **Percent of  Total Net Sales** | ** ** |
| **Asia**     |       | $                        | 58,536     |   | 80.6 |   | $ | 11,406 |   | 54.7 |   |
| **Americas** |       | 8,548                    |       | 11.8 |   | 7,082 |   | 33.9 |   |
| **Europe**   |       | 5,536                    |       | 7.6 |   | 2,388 |   | 11.4 |   |
|         |       | $                        | 72,620     |   | 100.0 | % | $ | 20,876 |   | 100.0 | % |

 

Thepercentage of total net sales to Asia increased to 80.6% for the first quarterof fiscal 2005 compared to 54.7% for the first quarter of fiscal 2004. Thispercentage increase is a result of the dollar-volume increase in sales of SGproducts and PCG products, a substantial portion of which are shipped into theAsian markets.

 

***Gross Profit***

 

Grossprofit was $36.9 million (50.8% of net sales) for the first quarter of fiscal2005 compared to $4.8 million (23.2% of net sales) for the first quarter offiscal 2004.  Shipments in the firstquarter of fiscal 2005 increased 163.2% compared to the same quarter in fiscal2004.  Increased shipment levels resultedin volume-based manufacturing efficiencies and lower costs per unit.  In addition, higher production volumesincrease our ability to negotiate lower material costs with some suppliers,contributing to overall gross margin improvements.  Gross margins also benefited from a morefavorable product sales mix compared to the first quarter of the prior fiscalyear.  Beginning in the first quarter offiscal 2004, the semiconductor group introduced multiple new systems to themarket from its 9800 product line. Revenue from these higher-margin products was initially deferred, butwas included in net sales when the products gained acceptance with customers,beginning in the second quarter of fiscal 2004. Continued sales of these

 

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establishedproducts in the first quarter of fiscal 2005, along with the cost efficienciesdescribed above, contributed to gross margin improvements compared to the firstquarter of fiscal 2004.

 

***Operating Expenses***

 

Selling,Service and Administrative Expenses

Selling,service and administrative expenses were $14.9 million (20.5% of net sales) inthe first quarter of fiscal 2005, an increase of $0.3 million compared to $14.6million (70.1% of net sales) in the first quarter of fiscal 2004.  The primary items included in selling,service and administrative expenses are labor and other employee-relatedexpenses, travel expenses, professional fees and facilities costs.

 

Includedin selling, service and administrative expenses for the first quarter of fiscal2004 were $0.8 million in charges related to our restructuring and costmanagement plans, discussed below.  Alsoincluded in selling, service and administrative expenses are legal andprofessional fees related to the 2003 audit committee investigation andsecurities litigation.  These chargestotaled $0.4 million and $2.1 million in the first quarters of fiscal 2005 and fiscal2004, respectively.  Exclusive of thecharges for restructuring and cost management plans and legal and professionalfees related to the investigation and litigation, selling, service andadministrative expenses increased $2.8 million in the first quarter of fiscal2005 compared to the first quarter of fiscal 2004.  The increase is primarily due to increasedcompensation costs, professional fees and sales commissions.  These expense increases in the first quarterof fiscal 2005 compared to the first quarter of fiscal 2004 are consistent withthe overall growth in business volume experienced sequentially throughoutfiscal 2004.

 

Research,Development and Engineering Expenses

Research,development and engineering expenses are primarily comprised of labor and otheremployee-related expenses, professional fees, project materials, equipment andfacilities costs.  Expenses associatedwith research, development and engineering totaled $6.6 million (9.0% of netsales) for the first quarter of fiscal 2005, representing a $0.9 millionincrease from expenses of $5.7 million (27.5% of net sales) for the firstquarter of fiscal 2004.  Included inresearch and development expenses for the first quarter of fiscal 2004 is $0.2million in severance and other employee-related expenses resulting from ourfiscal 2004 cost management plan. Excluding these charges, the overall increase in research anddevelopment spending was $1.1 million and is primarily due to an increase incompensation costs as we continue to invest in development projects.

 

***Restructuring and Cost Management Plans***

 

Inresponse to the economic climate and resulting decrease in demand for ourproducts in prior fiscal years, we initiated restructuring and other costmanagement plans in early fiscal 2004, 2003 and 2002.  The fiscal 2004 plan consisted of a headcountreduction to reduce expenditures.  Thefiscal 2003 actions primarily related to relocating the manufacturing of ourelectronic component product line from Escondido, California to ourheadquarters in Portland, Oregon.  Thefiscal 2002 actions included a headcount reduction, exiting the mechanicaldrill business and discontinuing the manufacture of certain other products andvacating related facilities.  Allexpenses related to the fiscal 2004 and fiscal 2003 plans have been paid.  As of August 28, 2004, we had aremaining amount accrued of approximately $0.5 million for future payments, netof estimated sublease rentals, for a property in Ann Arbor, Michigan that isleased and sublet through December 2006 and was vacated as a part of the 2002restructuring plan.  There were noexpenses relating to restructuring and cost management plans recorded in thefirst quarter of fiscal 2005.  A detailof expenses by business function for the prior year comparative three monthsended August 30, 2003 is presented below (in thousands):

 

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| ** **                       | ** ** | **Three months ended August 30, 2003** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **Cost of  Goods Sold**                     | ** ** | **Selling, Service and  Administration** | ** ** | **Research, Development  and Engineering** | ** ** | **Total** | ** ** |
| Fiscal 2004 cost management plan |       | $                                           | 123        |   | $ | 457 |   | $ | 191 |   | $ | 771 |   |
| Fiscal 2003 cost management plan |       | 5                                           |       | 276 |   | — |   | 281 |   |
| Fiscal 2002 cost management plan |       | —                                      |       | 84 |   | — |   | 84 |   |
|                             |       | $                                           | 128        |   | $ | 817 |   | $ | 191 |   | $ | 1,136 |   |

 

***Income Taxes***

 

Theincome tax provision recorded for the first quarter of fiscal 2005 was $4.4million on pretax income of $15.1 million, an effective rate of 29.4% comparedto the income tax benefit of 39.0% recorded in the first quarter of fiscal 2004on pretax loss of $15.4 million.  Theeffective tax rate of 29% is lower than our statutory tax rate of 38%,primarily due to incentives for export sales and research credits

 

Wecurrently have an outstanding examination by the Internal Revenue Service forour tax returns for the tax years ending in 1996 through 2003.  Although the examination is substantiallycomplete, the final outcome of the federal tax audit is uncertain.  We believe the ultimate resolutions will nothave a materially adverse effect on our results of operations or financialposition.

 

***Net Income (Loss)***

 

Netincome for the first quarter of fiscal year 2005 was $10.6 million (14.7% ofnet sales), or $0.36 per share on a fully diluted basis, compared to a net lossof $9.4 million (44.9% of net sales), or $0.34 per basic and fully dilutedshare, in the first quarter of fiscal year 2004.

 

**Liquidity and Capital Resources**

 

AtAugust 28, 2004, our principal sources of liquidity consisted of existingcash, cash equivalents and marketable and restricted securities of $337.2million and accounts receivable of $61.2 million.  At August 28, 2004, we had a currentratio of 6.5:1 and long-term debt of $143.0 million.  Working capital increased to $392.2 millionat August 28, 2004 from $369.9 million at May 29, 2004.  We believe that our existing cash, cashequivalents and marketable securities are adequate to fund our operations forat least the next twelve months.

 

Tradereceivables increased $9.5 million to $61.2 million at August 28, 2004from $51.7 million at May 29, 2004 primarily due to a higher percentage of thequarter’s shipments occurring later in the first quarter of fiscal 2005 than inthe fourth quarter of fiscal 2004.

 

Inventorytotaled $65.6 million at August 28, 2004 compared to $58.6 million at May29, 2004.  The increase of $7.0 millionis comprised of additions to both finished goods and work-in-processinventory.  The overall increase was dueto delayed timing of shipments previously anticipated in the first quarter offiscal 2005.

 

Assetsheld for sale of $2.4 million at May 29, 2004 consisted of an undevelopedparcel of land in Taiwan.  This land wassold and cash proceeds were received during the first quarter of fiscal 2005.

 

Deferredrevenue was $17.2 million at August 28, 2004 compared to $12.0 million atMay 29, 2004.  The increase in deferredrevenue is primarily due to shipments for which title transfer has not occurredand/or acceptance criteria cannot be demonstrated at our factory, includingsales to Japanese end-user customers and shipments of substantially newproducts.

 

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Infiscal 2004 we recorded a charge of $3.8 million for the settlement of theclass action and derivative lawsuits arising from the restatement of earningsannounced in fiscal 2003.  Thesettlement, which received preliminary court approval on September 3,2004, calls for the payment of $9.3 million of which approximately $3.8 millionin total will be paid by ESI and approximately $5.5 million will be paid by ourinsurance carrier.  We paid approximately$3.7 million on September 20, 2004 and the remaining $0.1 million paymentwill be paid subject to court approval.

 

AtAugust 28, 2004 we had $143.0 million recorded on our balance sheetrelated to our 4 1⁄4% convertible subordinated notes due December 21,2006.  The difference between the $145.0million face value and the $143.0 million balance at August 28, 2004relates to underwriting discounts, which originally totaled $4.5 million.  These discounts are being amortized asadditional interest expense over the life of the subordinated notes at a rateof $0.9 million per year, resulting in a corresponding accretion to therecorded amount of the notes.  During thefirst quarter of fiscal 2005, we made a semi-annual interest payment of $3.1million which was fully funded by a $3.1 million liquidation of restrictedsecurities.

 

Proceedsfrom stock option exercises and employee stock plans totaled $2.2 millionduring the first quarter of fiscal 2005. Additionally, $2.2 million in proceeds from the exercise of stockoptions at the end of the quarter were received upon settlement early in thesecond quarter of fiscal 2005.

 

**Critical Accounting Policies and Estimates**

 

Wereaffirm the critical accounting policies and our use of estimates as reportedin our annual report on Form 10-K for our fiscal year ended May 29, 2004 asfiled with the Securities and Exchange Commission on July 29, 2004.

 

**Factors That May Affect Future Results**

 

Describedbelow are some of the factors that could cause actual results to differmaterially from the results contemplated by the forward-looking statementscontained in this report.  See “ForwardLooking Statements” at the beginning of this Item 2.

 

***The industries that comprise our primarymarkets are volatile and unpredictable.***

 

Ourbusiness depends upon the capital expenditures of manufacturers of componentsand circuitry used in wireless communications, computers and other electronicproducts.  In the past, the markets forelectronic devices have experienced sharp downturns.  During these downturns, electronics manufacturers,including our customers, have delayed or canceled capital expenditures, whichhas had a negative impact on our financial results.

 

Duringany downturn it will be difficult for us to maintain our sales levels.  As a consequence, to maintain profitabilitywe will need to reduce our operating expenses. However, because there is a lag between actions we take to reduceexpense and the actual reductions of the costs, our ability to quickly reducethese fixed operating expenses is limited. Moreover, we may be unable to defer capital expenditures, and we willneed to continue to invest in certain areas such as research anddevelopment.  An economic downturn mayalso cause us to incur charges related to impairment of assets and inventorywrite-offs and we may also experience delays in payments from our customers,which would have a negative effect on our financial results.

 

Afterexperiencing a significant increase in orders in fiscal 2004, we experiencedreduced demand in the first quarter of fiscal 2005.  We cannot assure you that demand for ourproducts will increase.  Even if

 

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demandfor our products does increase, there may be significant fluctuations in ourprofitability and net sales.

 

***We face risks relating to governmentalinquiries and the results of our internal investigation of accounting matters.***

 

OnMarch 20, 2003, we contacted the SEC in connection with our issuance of apress release announcing the need to restate our financial results for thequarters ended August 31, 2002 and November 30, 2002.  In March 2003, the audit committee ofour board of directors, with the assistance of outside legal counsel andindependent forensic accountants, commenced an internal investigation ofcertain accounting matters.  Theinvestigation involved the review of (1) the circumstances surrounding thereversal of an accrual for employee benefits, (2) unsupported accountingadjustments and clerical errors primarily relating to inventory and cost ofgoods sold, and (3) certain other areas where potential accounting errors couldhave occurred, including revenue recognition and restructuring reserves.  As a result of the investigation, wedetermined that our unaudited consolidated condensed financial statements forthe three months ended August 31, 2002 and November 30, 2002, and ouraudited consolidated financial statements for the year ended June 1, 2002(and the quarters contained therein) required restatement.  We have cooperated with all governmentinvestigations into the matters addressed by the internal investigation, andthe SEC has announced that because of our swift and extensive cooperation inthe SEC’s investigation the SEC will not bring any enforcement action againstus.  Depending on the scope, timing andresult of any other governmental investigation, management’s attention and ourresources could be diverted from operations, which could adversely affect ouroperating results and contribute to future stock price volatility.

 

Wehave entered into indemnification agreements in the ordinary course of businesswith our current and former officers and directors, some of whom may be thesubject of any governmental investigation or party to proceedings brought as aresult of any investigation.  Inaddition, our bylaws contain indemnification provisions with respect to ourdirectors, officers, and employees.  Wemay be obligated throughout any investigation or proceeding to advance paymentof legal fees and costs incurred by any current and former directors, officers,employees and agents pursuant to the indemnification agreements, our bylaws andapplicable Oregon law.  We may also beobligated to indemnify any former and/or current directors, officers, employeesand agents for judgments, fines and amounts paid in settlement if the personacted in good faith and in a manner reasonably believed to be in or not opposedto our best interests.  Payments made byus under these obligations, to the extent not reimbursed by insurance carriers,could have a material adverse impact on our financial condition.

 

***Our ability to reduce costs is limited byour need to invest in research and development.***

 

Ourindustry is characterized 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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***We depend on a few significant customersand we do not have long-term contracts with any of our customers.***

 

Ourtop ten customers for fiscal 2004 accounted for approximately 61% of total netsales in fiscal 2004, with one customer accounting for approximately 26% oftotal net sales in fiscal 2004.  No othercustomer in fiscal 2004 accounted for more than 10% of total net sales.  In addition, none of our customers have 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.

 

***Delays in manufacturing, shipment orcustomer acceptance of our products could substantially decrease our sales fora period.***

 

Wederive a substantial portion of our revenues from the sale of a relativelysmall number of products with high average selling prices, some with prices inexcess of $1 million per unit.

 

Wedepend on manufacturing flexibility to meet the changing demands of ourcustomers.  Any significant delay orinterruption in receiving raw materials or in our manufacturing operations as aresult of software deficiencies, natural disasters, or other causes couldresult in reduced manufacturing capabilities or delayed product deliveries, anyor all of which could materially and adversely affect our results ofoperations.

 

Shipmentand/or customer acceptance delays could significantly impact our recognition ofrevenue and could be further magnified by announcements from us or ourcompetitors of new products and technologies, which announcements could causeour customers to defer purchases of our existing systems or purchase productsfrom our competitors.  Any of thesedelays could result in a material adverse change in our results of operationsfor any particular period.

 

***Failure of critical suppliers of parts,components and manufacturing equipment to deliver sufficient quantities to usin a timely and cost-effective manner could negatively affect our business.***

 

Weuse a wide range of materials in the production of our products, includingcustom electronic and mechanical components, and we use numerous suppliers forthose materials.  We generally do nothave guaranteed 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, key parts are available onlyfrom a single supplier or a limited group of suppliers in the short term.  Operations at our suppliers’ facilities aresubject to disruption for a variety of reasons, including changes in businessrelationships, competitive factors, work stoppages, fire, earthquake, floodingor other natural disasters.  Suchdisruption could interrupt our manufacturing. Our business may be harmed if we do not receive sufficient parts to meetour production requirements in a timely and cost-effective manner.

 

***We may make additional acquisitions in thefuture, and these acquisitions may subject us to risks associated withintegrating these businesses into our current business.***

 

Althoughwe have no commitments or agreements for any acquisitions, in the future we maymake acquisitions of, or significant investments in, businesses withcomplementary products, services or technologies.

 

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

 

•                  Difficulties and increased costs inconnection with integration of the personnel, operations, technologies andproducts of acquired companies;

•                  Diversion of management’s attention fromother operational matters;

•                  The potential loss of key employees ofacquired companies;

•                  Lack of synergy, or inability to realizeexpected synergies, resulting from the acquisition;

•                  The risk that the issuance of our commonstock in a transaction could be dilutive to our shareholders if anticipatedsynergies are not realized; and

•                  Acquired assets becoming impaired as a resultof technological advancements or worse-than-expected performance by theacquired company.

 

Ourinability to effectively manage these acquisition risks could materially andadversely affect our business, financial condition and results ofoperations.  In addition, if we issueequity securities to pay for an acquisition the ownership percentage of ourexisting shareholders would be reduced and the value of the shares held by ourexisting shareholders could be diluted. If we use cash to pay for an acquisition the payment could significantlyreduce the cash that would be available to fund our operations or to use forother purposes. In addition, the accounting for future acquisitions couldresult in significant charges resulting from amortization of intangible assetsrelated to such acquisitions.

 

***Our markets are subject to rapidtechnological change, and to compete effectively we must continually introducenew products that achieve market acceptance.***

 

Themarkets for our products are characterized by rapid technological change andinnovation, frequent new product introductions, changes in customerrequirements and evolving industry standards. Our future performance will depend on the successful development,introduction and market acceptance of new and enhanced products that addresstechnological changes as well as current and potential customerrequirements.  The introduction by us orby our competitors of new and enhanced products may cause our customers todefer or cancel orders for our existing products, which may harm our operatingresults.  We have in the past experienceda slowdown in demand for our existing products and delays in new productdevelopment, and similar delays may occur in the future.  We also may not be able to develop theunderlying core technologies necessary to create new products and enhancementsor, where necessary, to license these technologies from others.  Product development delays may result fromnumerous factors, including:

 

•                  Changing product specifications and customerrequirements;

•                  Difficulties in hiring and retainingnecessary technical personnel;

•                  Difficulties in reallocating engineeringresources and overcoming resource limitations;

•                  Difficulties with contract manufacturers;

•                  Changing market or competitive productrequirements; and

•                  Unanticipated engineering complexities.

 

Thedevelopment of new, technologically advanced products is a complex anduncertain process, requiring high levels of innovation and highly skilledengineering and development personnel, as well as the accurate anticipation oftechnological and market trends.  Wecannot assure you that we will be able to identify, develop, manufacture,market or support new or enhanced products successfully, if at all, or on atimely basis.  Further, we cannot assureyou that our new products will gain market acceptance or that we will be ableto respond effectively to product announcements by competitors, technologicalchanges or emerging industry standards. Any failure to respond to technological change that may render ourcurrent products or technologies obsolete could significantly harm our business.

 

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***We are exposed to the risks that others mayviolate our proprietary rights, and our intellectual property rights may not bewell protected in foreign countries.***

 

Oursuccess is dependent 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 litigation allegingthat certain parties have violated various patents of ours.  We rely upon the laws of the United Statesand of foreign countries in which we develop, manufacture or sell our productsto protect our proprietary rights. However, these proprietary rights may not provide the competitiveadvantages that we expect or other parties may challenge, invalidate orcircumvent these rights.

 

Further,our efforts 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 our intellectualproperty in these countries, it could be easier for our competitors to sellcompeting products in foreign countries.

 

***We may be subject to claims of intellectualproperty infringement.***

 

Severalof our competitors hold patents covering a variety of technologies,applications and methods of use similar to some of those used in ourproducts.  From time to time, we and ourcustomers have received correspondence from our competitors claiming that someof our products, as used by our customers, may be infringing one or more ofthese patents.  For example, inFebruary 2001 and August 2003, Cognex Corporation and GSI Lumonics,respectively, filed lawsuits against us claiming we infringed patents owned byeach of them.  See Part II, Item 1. LegalProceedings.  Competitors or others mayassert infringement claims against our customers or us in the future withrespect to current or future products or uses, and these assertions may resultin costly litigation or require us to obtain a license to use intellectual propertyrights of others.  If claims ofinfringement are asserted against our customers, those customers may seekindemnification from us for damages or expenses they incur.

 

Ifwe become subject to infringement claims, we will evaluate our position and considerthe available 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.

 

***We are exposed to the risks of operating aglobal business, including risks associated with exchange rate fluctuations,legal and regulatory changes and the impact of regional and global economicdisruptions.***

 

Internationalshipments accounted for 88.2% of net sales for the first quarter of fiscal2005, with 80.6% of our net sales to customers in Asia.  We expect that international shipments willcontinue to represent a significant percentage of net sales in the future.  Our non-U.S. sales and operations are subjectto risks inherent in conducting business abroad, many of which are outside ourcontrol, including the following:

 

•                  Periodic local or geographic economicdownturns and unstable political conditions;

•                  Price and currency exchange controls;

•                  Fluctuation in the relative values ofcurrencies;

•                  Difficulties protecting intellectualproperty;

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

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

 

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Ourbusiness and operating results are subject to uncertainties arising out of thepossibility of regional or global economic disruptions, 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 ofimmigration controls may adversely affect the residence status of non-U.S.engineers and other key technical employees in our U.S. facilities or ourability to hire new non-U.S. employees in such facilities;

•                  The risk of more frequent instances ofshipping delays; and

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

 

***The loss of key management or our inabilityto attract, retain and assimilate sufficient numbers of managerial, financial,engineering and other technical personnel could have a material effect upon ourresults of operations.***

 

Ourcontinued success depends, in part, upon key managerial, financial, engineeringand technical personnel as well as our ability to continue to attract, retainand assimilate 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.  Attracting qualifiedpersonnel is difficult, and our efforts to attract and retain these personnelmay not be successful.  In addition, wemay not be able to assimilate qualified personnel, including any new members ofsenior management, which could disrupt our operations.

 

***Our worldwide direct sales and serviceoperations expose us to employer-related risks in foreign countries.***

 

Wehave established direct sales and service organizations throughout theworld.  A worldwide direct sales andservice model in foreign countries involves certain risks.  We are subject to compliance with the laborlaws and other laws governing employers in the countries where our operationsare located and as a result we may incur additional costs to comply with theselocal regulations.  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.

 

***Our business is highly competitive, and ifwe fail to compete effectively, our business will be harmed.***

 

Theindustries in which we operate are highly competitive.  We face substantial competition fromestablished competitors, some of which have greater financial, engineering,manufacturing and marketing resources than we do.  If we are unable to compete effectively withthese companies, our market share may decline and our business could be harmed.  Our competitors can be expected to continueto improve the design and performance of their products and to introduce newproducts.  New companies may enter themarkets in which we compete, or industry consolidation may occur, furtherincreasing competition in those markets. Furthermore, our technological advantages may be reduced or lost as aresult of technological advances by our competitors.

 

Theirgreater resources in these areas may enable them to:

•                  Better withstand periodic downturns;

•                  Compete more effectively on the basis ofprice and technology; and

•                  More quickly develop enhancements to and newgenerations of products.

 

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Webelieve that our ability to compete successfully depends on a number offactors, including:

•                  Performance of our products;

•                  Quality of our products;

•                  Reliability of our products;

•                  Cost of using our products;

•                  Consistent availability of criticalcomponents;

•                  Our ability to ship products on theschedule 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 ourcompetitors’ products.

 

Wemay not be able to compete successfully in the future, and increasedcompetition may result in price reductions, reduced profit margins and loss ofmarket share.

 

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**Item 3****.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

Therehave been no material changes in our reported market risks since we filed our2004 Annual Report on Form 10-K, with the Securities and Exchange Commission onJuly 29, 2004.

 

**Item 4****.  Controls and Procedures**

 

Attachedto this annual report as exhibits 31.1 and 31.2 are the certifications of ourPresident and Chief Executive Officer and our Chief Financial Officer requiredby Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302Certifications).  This portion of our quarterlyreport on Form 10-Q is our disclosure of the conclusions of our management,including our President and Chief Executive Officer and our Chief FinancialOfficer, regarding the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this report based on management’sevaluation 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 Chief Financial Officer, theeffectiveness of our disclosure controls and procedures as of the end of theperiod covered by this report pursuant to Rule 13a-15(b) under the SecuritiesExchange Act of 1934, as amended (Exchange Act). Based on that evaluation, ourPresident and Chief Executive Officer and our Chief Financial Officer haveconcluded that, as of the end of the period covered by this report, ourdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed in our Exchange Act reports is (1) recorded,processed, summarized and reported in a timely manner, and (2) accumulated andcommunicated to our management, including our President and Chief ExecutiveOfficer and our Chief Financial Officer, as appropriate to allow timelydecisions regarding required disclosure.

 

***Internal Control Over Financial Reporting***

Therehas been no change in our internal control over financial reporting thatoccurred during our fiscal quarter ended August 28, 2004 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**PART II – OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

Asa result of our March 2003 announcement that we were reviewing certainaccounting matters and would be restating some of our financial statements,between March 26, 2003 and May 20, 2003, three purported class actionlawsuits were filed in the United States District Court for the District ofOregon against ESI and David F. Bolender (former director, CEO and Chairman ofthe Board), James T. Dooley (former President and CEO), and Joseph L. Reinhart(former Acting CFO).  The complaints werefiled on behalf of a purported class of persons who purchased our common stockbetween September 17, 2002 and at the latest April 15, 2003, and allegedviolations of Section 10(b) of the Securities Exchange Act of 1934 (theAct) and Rule 10b-5 promulgated thereunder, as well as Section 20(a) ofthe Act.  The complaints have beenconsolidated under the name In re Electro Scientific Industries, Inc. SecuritiesLitigation, Case No. CV 03-404-HA.  Leadplaintiffs and lead counsel for plaintiffs have been appointed. The plaintiffs’consolidated class action complaint (the Consolidated Complaint) was filed onOctober 10, 2003, which shortened the purported class to purchasersbetween September 17, 2002 and March 20, 2003, and added Donald R.VanLuvanee (ESI’s President and CEO from 1992 until April 2002), John R.Kurdock (ESI’s former VP Operations), and James Lorenz (ESI’s former CorporateController) as additional defendants. The Consolidated Complaint alleges that defendants made false andmisleading statements during the purported class period about our financialcondition and performance, business prospects, and operations, artificiallyinflating our stock price and leading to the restatement first announced onMarch 20, 2003.  In March 2003,our Audit Committee commenced an investigation into certain accountingmatters.  As a result of theinvestigation, which was completed on July 11, 2003, we restated ourfinancial statements for the fiscal year ended June 1, 2002 and for thequarters ended August 31, 2002 and November 30, 2002.

 

OnMarch 31, 2003 and April 28, 2003, two separate purported shareholderderivative complaints were filed in the Circuit Court of Oregon in WashingtonCounty.  The complaints were consolidatedunder the name In re Electro Scientific Industries, Inc. Derivative Litigation,Lead Case No. C 031067 CV.  Aconsolidated complaint (Complaint) was filed on September 24, 2003, andnames as defendants James Dooley (former President and CEO), David Bolender(former director, CEO and Chairman), Joseph Reinhart (former Acting CFO), BarryHarmon (director and former President and CEO), and current or former directorsW. Arthur Porter, Gerald Taylor, Larry Hansen, Vernon Ryles, Keith Thomson andJon Tompkins.  We are named as a “nominaldefendant.”  The Complaint, whichpurports to be brought on behalf of ESI, alleges that all defendants breachedfiduciary duties owed to ESI, abused their alleged control over ESI, wastedcorporate assets, are liable for gross mismanagement, and were unjustlyenriched by their conduct.  The Complaintseeks an unspecified amount of monetary damages and seeks various equitableremedies, including a constructive trust on the proceeds received by thedefendants from trading ESI common stock, and attorneys’ fees and costs.  As filed, the Complaint is derivative innature and does not seek monetary damages from ESI or the imposition ofequitable remedies on ESI.  A speciallitigation committee of our board of directors, with the assistance ofindependent legal counsel, was appointed to conduct an investigation relatingto the allegations asserted in the Complaint.

 

OnApril 22, 2004, we announced an agreement in principle to settle both theclass action and derivative actions.  Thesettlement, which received preliminary court approval on September 3,2004, calls for the payment of $9.3 million of which approximately $3.8 millionin total will be paid by ESI and approximately $5.5 million will be paid by ourinsurance carrier.  We paid approximately$3.7 million in September 2004 and the remaining $0.1 million payment willbe paid subject to court approval.

 

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OnSeptember 23, 2004, the Securities and Exchange Commission announced thatit would not bring an enforcement action against the Company with respect tothe matters resulting in the restatement of our financial statements.

 

OnFebruary 14, 2001, Cognex Corporation (Cognex) filed a lawsuit in theUnited States District Court for the District of Massachusetts (CognexCorporation v. Electro Scientific Industries, Inc., No. 01-10287 WGY).  The lawsuit alleges that our CorrectPlaceproduct and some of its predecessors infringe United States Patent 5,371,690(the ‘690 patent), which is owned by Cognex. The ‘690 patent concerns the inspection of surface mount devices thatare attached to the surface of an electronic circuit board.  Cognex seeks injunctive relief, damages,costs and attorneys’ fees.  We filedseveral counterclaims, including one alleging that the ‘690 patent isunenforceable by reason of inequitable conduct and another alleging that Cognexfalsely marked certain products with the ‘690 patent.  The Court denied our motion for summaryjudgment on the Cognex claim of infringement and denied the Cognex motions forsummary judgment on our counterclaims of false marking and unenforceability.The lawsuit is scheduled to go to trial in December 2004.  Additionally, certain of our customers havenotified us that, in the event it is subsequently determined that their use ofCorrectPlace infringes any patent, they may seek indemnification from us fordamages or expenses resulting from this matter.

 

OnAugust 18, 2003, GSI Lumonics Corporation (GSI) filed a lawsuit in the UnitedStates District Court for the Central District of California (GSI Lumonics Inc.v. Electro Scientific Industries, Inc., Case No. CV-03-5863 PA (SHx).  The lawsuit alleges that we infringe threeGSI patents:  U.S. Patent No. 6,181,728,entitled “Controlling Laser Polarization” (the ‘728 patent); U.S. Patent No.6,337,462, entitled “Laser Processing” (the ‘462 patent);  and U.S. Patent No. 6,573,473, entitled“Method and System for Precisely Positioning a Waist of a Material-ProcessingLaser Beam to Process Microstructures Within a Laser Processing Site” (the ‘473patent).  These claims relate to oursemiconductor yield improvement systems. GSI seeks injunctive relief, an unspecified amount of damages, costs,and attorneys’ fees.  OnSeptember 2, 2003, GSI filed a First Amended Complaint which did notchange the substantive allegations of patent infringement.  By court order dated September 18, 2003,the case was transferred to the United States District Court for the NorthernDistrict of California.  The case wasre-assigned to a judge in the Northern District of California and has beenrenumbered CV-03-04302-MHP.  OnOctober 8, 2003, we filed our Answer to First Amended Complaint andCounterclaim for Declaratory Judgment of Invalidity and Noninfringement.  On October 24, 2003, GSI filed a Replyto our counterclaim denying the allegations of invalidity andnoninfringement.  On May 11, 2004,pursuant to an agreement between GSI and us, the court entered a stipulateddismissal of two of GSI’s asserted patents without prejudice: the ‘728 patentand the ‘462 patent.  On August 26,2004, pursuant to an agreement between the parties, the court entered astipulated dismissal with prejudice of the remaining patent asserted byGSI:  U.S. Patent No. 6,573,473.  This dismissal resolves the entirecontroversy between the parties.

 

Inaddition to the legal matters described above, in the ordinary course ofbusiness we are involved in various other legal matters, either asserted orunasserted, and investigations.  In the opinionof management, amounts accrued for awards or assessments in connection withthese matters are management’s best estimate, and ultimate resolution of thesematters will not have a material effect on our consolidated financial position,results of operations or cash flows.

 

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**Item 6****.  Exhibits**

 

Thislist is intended to constitute the exhibit index.

 

3.1                     Restated Articles of Incorporation. Incorporated by reference toExhibit 3-A of the Company’s Annual Report on Form 10-K for the fiscal yearended 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 Form10-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 onForm 10-Q for the fiscal quarter ended December 2, 2000.

3.4                     2001 Restated Bylaws. Incorporated by reference to Exhibit 3 of theCompany’s Quarterly Report on Form 10-Q for the fiscal quarter endedMarch 3, 2001.

4.1                   Amended and Restated Rights Agreement, dated as of March 1, 2001,between the Company      and MellonInvestor Services, relating to rights issued to all holders of Company commonstock. Incorporated by reference to Exhibit 4-A of the Company’s Annual Reporton Form 10-K for the fiscal year ended June 2, 2001.

10.1             Noticeof Grant of Stock Options and Option Agreement to John A. Corr and related OptionTerms and Conditions

31.1               Certificationof the Chief Executive Officer pursuant to Section 302 of theSarbanes-Oxley Act of 2002.

31.2               Certificationof the Chief Financial Officer pursuant to Section 302 of theSarbanes-Oxley Act of 2002.

32.1               Certificationof Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2               Certificationof Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed by the undersigned thereunto dulyauthorized.

 

 
| Dated: | October 1,  2004                                                            | ELECTRO  SCIENTIFIC INDUSTRIES, INC. |
|--------|----------------------------------------------------------------------------------|--------------------------------------|
|   |                                                                             |                                 |
|   |                                                                             |                                 |
|   | By                                                                               |  /s/ Nicholas Konidaris         |   |
|   | Nicholas  Konidaris                                                              |
|   | President,  Chief Executive Officer and Director                                 |
|   | (Principal  Executive Officer)                                                   |
|   |                                                                             |                                 |
|   | By                                                                               |  /s/ J. Michael Dodson          |   |
|   | J.  Michael Dodson                                                               |
|   | Senior  Vice President of Administration,  Chief Financial Officer and Secretary |
|   | (Principal  Financial Officer)                                                   |
|   |                                                                             |                                 |
|   | By                                                                               |  /s/ Kerry Mustoe               |   |
|   | Kerry  Mustoe                                                                    |
|   | Corporate  Controller and Chief  Accounting Officer                              |
|   | (Principal  Accounting Officer)                                                  |
|        |                                                                                  |                                      |  |  |  |

 

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