**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 SECURITIESEXCHANGE ACT OF 1934**

 

**For thequarterly period ended August 27, 2005**

 

**OR**

 

**o**** TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIESEXCHANGE 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**

 

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

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).    Yes ý No o

 

Indicate by check mark whetherthe registrant is shell company (as defined in Rule 12b-2 of the ExchangeAct).    Yes o  No ý

 

The number of shares outstandingof the Registrant’s Common Stock at September 21, 2005 was 28,675,704 shares.

 

 

----

 

### **ELECTRO SCIENTIFICINDUSTRIES, INC. AND SUBSIDIARIES**

### **TABLEOF CONTENTS**

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

 

1

----

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

ELECTRO SCIENTIFICINDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSEDBALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                                    | ** ** | **August 27,** | ** ** | **May 28,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|
| ** **                                                                                                    | ** ** | **2005**            | ** ** | **2005**         | ** ** |
| ** **                                                                                                    | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Assets**                                                                                                    | ** ** | ** **          | ** ** | ** **       | ** ** |
| Current assets:                                                                                               |       |                |       |             |       |
| Cash and cash  equivalents                                                                                    |       | $                   | 88,144     |             | $          | 61,314 |   |
| Marketable securities                                                                                         |       | 120,421             |       | 137,753          |       |
| Total cash and  securities                                                                                    |       | 208,565             |       | 199,067          |       |
|                                                                                                          |       |                |       |             |       |
| Trade  receivables, net of allowances of $704 and $833                                                        |       | 37,177              |       | 36,163           |       |
| Income tax  refund receivable                                                                                 |       | 7,977               |       | 9,227            |       |
| Inventories                                                                                                   |       | 53,728              |       | 59,533           |       |
| Shipped systems  pending acceptance                                                                           |       | 4,498               |       | 4,014            |       |
| Deferred income  taxes                                                                                        |       | 13,439              |       | 10,930           |       |
| Prepaid and  other current assets                                                                             |       | 3,322               |       | 3,169            |       |
| Total current  assets                                                                                         |       | 328,706             |       | 322,103          |       |
|                                                                                                          |       |                |       |             |       |
| Long-term marketable securities                                                                               |       | 12,830              |       | 19,834           |       |
| Property, plant  and equipment, net of accumulated depreciation of $47,198 and $45,598                        |       | 35,658              |       | 32,959           |       |
| Deferred income taxes, net                                                                                    |       | 15,112              |       | 16,955           |       |
| Other assets                                                                                                  |       | 12,827              |       | 11,706           |       |
| Total assets                                                                                                  |       | $                   | 405,133    |             | $          | 403,557 |   |
|                                                                                                          |       |                |       |             |       |
| **Liabilities and Shareholders’ Equity**                                                                 | ** ** | ** **          | ** ** | ** **       | ** ** |
| Current liabilities:                                                                                          |       |                |       |             |       |
| Accounts payable                                                                                              |       | $                   | 4,019      |             | $          | 3,961 |   |
| Accrued  liabilities                                                                                          |       | 27,512              |       | 29,455           |       |
| Deferred revenue                                                                                              |       | 13,118              |       | 12,986           |       |
| Total current  liabilities                                                                                    |       | 44,649              |       | 46,402           |       |
|                                                                                                          |       |                |       |             |       |
| Commitments and contingencies                                                                                 |       |                |       |             |       |
|                                                                                                          |       |                |       |             |       |
| Shareholders’ equity:                                                                                    |       |                |       |             |       |
| Preferred stock,  without par value; 1,000 shares authorized; no shares issued                                |       | —              |       | —           |       |
| Common stock,  without par value; 100,000 shares authorized; 28,672 and 28,615 shares issued  and outstanding |       | 158,642             |       | 156,367          |       |
| Retained  earnings                                                                                            |       | 202,546             |       | 201,199          |       |
| Accumulated  other comprehensive loss                                                                         |       | (704                | )          | (411             | )          |
| Total  shareholders’ equity                                                                              |       | 360,484             |       | 357,155          |       |
| Total  liabilities and shareholders’ equity                                                              |       | $                   | 405,133    |             | $          | 403,557 |   |

 

The accompanying notes are an integral part of these statements.

 

2

----

 

ELECTRO SCIENTIFICINDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSEDSTATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 
| ** **                                        | ** ** | **For the three months ended** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **August 27, 2005**       | ** ** | **August 28, 2004** | ** ** |
| ** **                                        | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net sales                                         |       | $                              | 44,508     |   | $ | 72,620 |   |
| Cost of sales                                     |       | 24,861                         |       | 35,734 |   |
| Gross profit                                      |       | 19,647                         |       | 36,886 |   |
|                                              |       |                           |       |   |   |
| Operating expenses:                               |       |                           |       |   |   |
| Selling, service  and administration              |       | 11,077                         |       | 14,878 |   |
| Research,  development and engineering            |       | 7,829                          |       | 6,560 |   |
|                                              |       | 18,906                         |       | 21,438 |   |
| Operating income                                  |       | 741                            |       | 15,448 |   |
|                                              |       |                           |       |   |   |
| Interest income                                   |       | 1,483                          |       | 1,550 |   |
| Interest expense                                  |       | (29                            | )          | (1,786 | ) |
| Other expense, net                                |       | (213                           | )          | (133 | ) |
|                                              |       | 1,241                          |       | (369 | ) |
| Income before income taxes                        |       | 1,982                          |       | 15,079 |   |
| Provision for income taxes                        |       | 635                            |       | 4,433 |   |
| Net income                                        |       | $                              | 1,347      |   | $ | 10,646 |   |
|                                              |       |                           |       |   |   |
| Net income per share - basic                      |       | $                              | 0.05       |   | $ | 0.38 |   |
| Net income per share - fully diluted              |       | $                              | 0.05       |   | $ | 0.36 |   |
| Weighted average number of shares - basic         |       | 28,642                         |       | 28,216 |   |
| Weighted average number of shares - fully diluted |       | 28,799                         |       | 32,279 |   |

 

The accompanying notes are an integral part of these statements.

 

3

----

 

ELECTRO SCIENTIFICINDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSEDSTATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                     | ** ** | **For the three months ended** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                     | ** ** | **August 27, 2005**       | ** ** | **August 28, 2004** | ** ** |
|                                                                           |       |                           |       |   |   |
| **Cash flows from operating activities:**                                      |       |                           |       |   |   |
| Net income                                                                     |       | $                              | 1,347      |   | $ | 10,646 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                           |       |   |   |
| Depreciation and  amortization                                                 |       | 2,602                          |       | 2,255 |   |
| Tax benefit of  stock options exercised                                        |       | 727                            |       | 503 |   |
| Provision for  doubtful accounts                                               |       | (144                           | )          | 99 |   |
| Loss on disposal  of property and equipment                                    |       | 7                              |       | 54 |   |
| Deferred income  taxes                                                         |       | (558                           | )          | 4,303 |   |
| Changes in  operating accounts:                                                |       |                           |       |   |   |
| Increase in  trade receivables, net                                            |       | (1,336                         | )          | (9,734 | ) |
| Decrease in  income tax refund receivable                                      |       | 1,250                          |       | 55 |   |
| (Increase)  decrease in inventories                                            |       | 5,097                          |       | (7,077 | ) |
| Increase in  shipped systems pending acceptance                                |       | (484                           | )          | (2,778 | ) |
| Increase in  other current assets                                              |       | (168                           | )          | (1,855 | ) |
| Decrease in  other current liabilities                                         |       | (1,711                         | )          | (1,041 | ) |
| Increase in  deferred revenue                                                  |       | 132                            |       | 5,202 |   |
| Net cash  provided by operating activities                                     |       | 6,761                          |       | 632 |   |
|                                                                           |       |                           |       |   |   |
| **Cash flows from investing activities:**                                      |       |                           |       |   |   |
| Purchase of  property, plant and equipment                                     |       | (4,645                         | )          | (882 | ) |
| Proceeds from  the sale of property and equipment                              |       | —                         |       | 76 |   |
| Proceeds from  the sale of assets held for sale                                |       | —                         |       | 2,361 |   |
| Maturity of  restricted investments                                            |       | —                         |       | 3,057 |   |
| Purchase of  securities                                                        |       | (101,247                       | )          | (79,311 | ) |
| Proceeds from  sales of securities and maturing securities                     |       | 125,516                        |       | 80,801 |   |
| Increase in  other assets                                                      |       | (425                           | )          | (582 | ) |
| Net cash  provided by investing activities                                     |       | 19,199                         |       | 5,520 |   |
|                                                                           |       |                           |       |   |   |
| **Cash flows from financing activities:**                                      |       |                           |       |   |   |
| Proceeds from  exercise of stock options and stock plans                       |       | 870                            |       | 2,219 |   |
| Net cash  provided by financing activities                                     |       | 870                            |       | 2,219 |   |
|                                                                           |       |                           |       |   |   |
| **Net change in cash and cash equivalents**                                    |       | 26,830                         |       | 8,371 |   |
|                                                                           |       |                           |       |   |   |
| **Cash and cash equivalents:**                                                 |       |                           |       |   |   |
| Beginning of  period                                                           |       | 61,314                         |       | 80,358 |   |
| End of period                                                                  |       | $                              | 88,144     |   | $ | 88,729 |   |
|                                                                           |       |                           |       |   |   |
| **Supplemental cash flow information:**                                        |       |                           |       |   |   |
| Cash paid for  interest                                                        |       | $                              | —     |   | $ | (3,081 | ) |
| Income tax  refunds received                                                   |       | 1,251                          |       | 3 |   |
| Cash paid for  income taxes                                                    |       | (319                           | )          | (274 | ) |

 

The accompanying notes are an integral part of these statements.

 

4

----

 

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

### **NOTES TO CONSOLIDATEDCONDENSED FINANCIAL STATEMENTS**

**(Unaudited)**

 

#### ***Note 1 - Basis of Presentation***

 

These unaudited interimconsolidated condensed financial statements have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission.  Certain information and footnote disclosuresnormally included in annual financial statements prepared in accordance with U.S.generally accepted accounting principles have been condensed or omitted inthese interim statements.  Accordingly,these interim statements include all adjustments (consisting of only normalrecurring adjustments and accruals) necessary for a fair presentation ofresults for the interim periods presented. These consolidated condensed financial statements are to be read inconjunction with the financial statements and notes included in the Company’sAnnual Report on Form 10-K.

 

Results of operations forinterim periods are not necessarily indicative of the results to be expectedfor the full year.

 

**Note 2 -Inventories**

 

Inventories are principallyvalued at standard costs, which approximate the lower of cost (on a first-in,first-out basis) or market.  Componentsof inventories are as follows (in thousands):

 
| ** **                        | ** ** | **August 27,  2005** | ** ** | **May 28,  2005** | ** ** |
|-----------------------------------|------------|---------------------------|------------|------------------------|------------|
| Raw materials and purchased parts |       | $                         | 36,301     |                   | $          | 37,367 |   |
| Work-in-process                   |       | 6,008                     |       | 4,471                  |       |
| Finished goods                    |       | 11,419                    |       | 17,695                 |       |
|                              |       | $                         | 53,728     |                   | $          | 59,533 |   |

 

**Note 3 – AccruedLiabilities**

 

Accruedliabilities consist of the following (in thousands):

 
| ** **                               | ** ** | **August 27,  2005** | ** ** | **May 28,  2005** | ** ** |
|------------------------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                               | ** ** | ** **                | ** ** | ** **             | ** ** |
| Payroll-related                          |       | $                         | 5,421      |                   | $          | 8,275 |   |
| Product warranty                         |       | 3,466                     |       | 3,625                  |       |
| Accrual for loss on purchase commitments |       | 343                       |       | 343                    |       |
| Income taxes payable                     |       | 11,697                    |       | 11,623                 |       |
| Other                                    |       | 6,585                     |       | 5,589                  |       |
|                                     |       | $                         | 27,512     |                   | $          | 29,455 |   |

 

See Note 4 for a discussionof the accrual for product warranty.

 

5

----

 

**Note 4 – ProductWarranty**

 

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

 

Following is areconciliation of the change in the aggregate accrual for product warranty forthe three months ended August 27, 2005 and August 28, 2004 (inthousands):

 
| ** **                          | ** ** | **August 27,  2005** | ** ** | **August 28,  2004** | ** ** |
|-------------------------------------|------------|---------------------------|------------|---------------------------|------------|
|                                |       |                      |       |                      |       |
| Product warranty accrual, beginning |       | $                         | 3,625      |                      | $          | 4,720 |   |
| Warranty charges incurred           |       | (2,173                    | )          | (2,766                    | )          |
| Inventory credits                   |       | 1,076                     |       | 1,023                     |       |
| Provision for warranty charges      |       | 938                       |       | 1,877                     |       |
| Product warranty accrual, ending    |       | $                         | 3,466      |                      | $          | 4,854 |   |

 

**Note 5 – Deferred Revenue**

 

Revenue is deferred pending title transfer andfulfillment of acceptance criteria, which frequently occur at the time ofdelivery to a common carrier.  Shipmentsfor which title transfer has not occurred and/or acceptance criteria cannot bedemonstrated at the Company’s factory include sales to Japanese end-usercustomers and shipments of substantially new products.  In sales involving multiple elementarrangements, the fair value of any undelivered elements, includinginstallation services, is deferred until the elements are delivered andacceptance criteria are met.  Revenuerelated to maintenance and service contracts is deferred and recognized ratablyover the duration of the contracts.

 

The following is a reconciliation of the changes indeferred revenue for the three months ended August 27, 2005 and August 28,2004 (in thousands):

 
| ** **                  | ** ** | **August 27,  2005** | ** ** | **August 28,  2004** | ** ** |
|-----------------------------|------------|---------------------------|------------|---------------------------|------------|
|                        |       |                      |       |                      |       |
| Deferred revenue, beginning |       | $                         | 12,986     |                      | $          | 11,985 |   |
| Revenue deferred            |       | 3,723                     |       | 9,231                     |       |
| Revenue recognized          |       | (3,591                    | )          | (4,029                    | )          |
| Deferred revenue, ending    |       | $                         | 13,118     |                      | $          | 17,187 |   |

 

6

----

 

**Note 6 - EarningsPer Share**

 

Thefollowing is a reconciliation of weighted average shares outstanding andadjustments to net income used in the calculation of basic and diluted earningsper share (EPS) for the three months ended August 27, 2005 and August 28, 2004 (in thousands):

 
| ** **                                                  | ** ** | **Three months ended  August 27, 2005** | ** ** | **Three months ended  August 28, 2004** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                  | ** ** | **Income**                                   | ** ** | **Shares**                                   | ** ** | **Income** | ** ** | **Shares** | ** ** |
|                                                        |       |                                         |       |                                         |       |   |   |   |   |
| Net income available to common shareholders – basic    |       | $                                            | 1,347      |                                         | 28,642     |   | $ | 10,646 |   | 28,216 |   |
| Effect of dilutive stock compensation                       |       | —                                       |       | 157                                          |       | — |   | 247 |   |
| Effect of 4 1/4% convertible  subordinated notes            |       | —                                       |       | —                                       |       | 1,090 |   | 3,816 |   |
| Net income available to common shareholders –  diluted |       | $                                            | 1,347      |                                         | 28,799     |   | $ | 11,736 |   | 32,279 |   |

 

Inthe diluted EPS calculation for the three months ending August 28, 2005and August 27, 2004, employee stock options equal to 2,875,000 and 3,744,000common stock equivalent shares, respectively, were excluded because inclusionwould have had an antidilutive effect.

 

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

 

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

 
| ** **                                                                 | ** ** | **Three months ended** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **August 27,**    | ** ** | **August 28,** | ** ** |
| ** **                                                                 | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                                       |       |                   |       |   |   |
| Net income                                                                 |       | $                      | 1,347      |   | $ | 10,646 |   |
| Net unrealized  gain on foreign exchange hedge contracts                   |       | 11                     |       | 28 |   |
| Foreign currency  translation adjustment                                   |       | (237                   | )          | (48 | ) |
| Net unrealized  gain (loss) on securities classified as available for sale |       | (67                    | )          | 653 |   |
|                                                                       |       | $                      | 1,054      |   | $ | 11,279 |   |

 

7

----

 

#### ***Note 8 – Stock-Based Compensation Plans***

 

The Company has elected touse the intrinsic value method under APB No. 25, *Accountingfor Stock Issued to Employees*, as permitted by SFAS No. 123, *Accounting for Stock-Based Compensation*, subsequentlyamended by SFAS No. 148, *Accounting for Stock-BasedCompensation – Transition and Disclosure*, to account for stockoptions, stock bonuses, restricted stock or performance-based restricted stockunits issued to its employees under its stock compensation plans, and amortizesdeferred compensation, if any, ratably over the vesting period of the awards.

 

Compensation expenseresulting from the issuance of fixed term stock option awards is measured asthe difference between the exercise price of the option and the fair marketvalue of the underlying share of company stock subject to the option on themeasurement date, which is typically the award’s grant date.  Compensation expense, if any, is included inoperating results over the vesting period of the underlying options using thestraight-line method.  Compensationexpense resulting from the issuance of time-based restricted stock andrestricted stock units is calculated based on the fair market value on the dateof grant and is included in operating results over the related vesting periodusing the straight line method. Compensation expense resulting from the issuance of performance-basedrestricted stock units is recorded when performance is probable and can bereasonably estimated, and is calculated based upon current fair market values(adjusted each period) until such time as the number of units an employee isentitled to receive is fixed or determinable. During the first quarter of fiscal 2006 and fiscal 2005, the Companyrecorded $0.7 million and $0.2 million, respectively, of compensation expenserelated to grants of restricted stock and restricted stock units on a pre-taxbasis.  No compensation cost has beenrecognized for employee stock purchase plan (ESPP) shares which are issued at afifteen percent discount of the lower of the market price on either the firstday of the applicable offering period or the purchase date.

 

Pro forma fair valuedisclosures required by SFAS No. 123 are presented below and reflect theimpact on net income (loss) and net income (loss) per share as if the fairvalue of stock-based awards to employees had been applied (in thousands, exceptper share data):

 
| ** **                                                                                                                                                  | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                  | ** ** | **August 27,**    | ** ** | **August 28,** | ** ** |
| ** **                                                                                                                                                  | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                                                                                                                        |       |                   |       |   |   |
| Net income, as reported                                                                                                                                     |       | $                      | 1,347      |   | $ | 10,646 |   |
| Add –  Stock–based employee compensation expense included in reported net income, net  of related tax effect                                      |       | 480                    |       | 126 |   |
| Deduct – Total  stock–based employee compensation expense determined under the fair value  based method for all awards, net of related tax effect |       | (2,658                 | )          | (12,400 | ) |
| Net loss, pro forma                                                                                                                                         |       | $                      | (831       | ) | $ | (1,628 | ) |
| Net income per share – basic, as reported                                                                                                              |       | $                      | 0.05       |   | $ | 0.38 |   |
| Net income per share – fully diluted, as reported                                                                                                      |       | $                      | 0.05       |   | $ | 0.36 |   |
| Net loss per share – basic and fully diluted, pro  forma                                                                                               |       | $                      | (0.03      | ) | $ | (0.06 | ) |

 

8

----

 

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

 
| ** **              | ** ** | **Three months ended** | ** ** |
|-------------------------|------------|------------------------|------------|
| ** **              | ** ** | **August 27,**    | ** ** | **August 28,** | ** ** |
| ** **              | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                    |       |                   |       |   |   |
| Risk-free interest rate |       | 3.92                   | %          | 3.62 | % |
| Expected dividend yield |       | 0                      | %          | 0 | % |
| Expected lives          |       | 5.0 years              |       | 5.6 years |   |
| Expected volatility     |       | 59.37                  | %          | 65.62 | % |

 

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

 
| ** **              | ** ** | **Three months ended** | ** ** |
|-------------------------|------------|------------------------|------------|
| ** **              | ** ** | **August 27,**    | ** ** | **August 28,** | ** ** |
| ** **              | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                    |       |                   |       |   |   |
| Risk-free interest rate |       | 3.88                   | %          | 2.11 | % |
| Expected dividend yield |       | 0                      | %          | 0 | % |
| Expected lives          |       | 1.1 years              |       | 1.2 years |   |
| Expected volatility     |       | 47.92                  | %          | 54.40 | % |

 

**Note 9 – Legal Proceedings**

 

On August 24, 2005, the Company executed aProvisional Attachment Order (the Order) issued by the Kaohsiung District Courtof Taiwan directed against All Ring Tech Co., Ltd. (All Ring) of Taiwan.  In its petition requesting the Order, theCompany alleges that All Ring’s Capacitor Tester Model RK-T6600 infringes theCompany’s Taiwan Patent No. 207469, entitled “Circuit Component Handler”(the 207469 patent).  This patentcorresponds to the Company’s U.S. Patent No. 5,842,579.  The patented technology is used in theCompany’s Model 3340 Multifunction MLCC Tester. The Company filed in support of the petition a copy of a patentinfringement assessment report issued by Yen Tjing Ling Industrial ResearchInstitute, a professional organization appointed by the judicial branch of theTaiwan government, that concludes that the RK-T6600 infringes the 207469 patent.  A copy of the assessment report and anEnglish language translation of the assessment report are available on theCompany’s website.  All Ring has filed abond with the court to obtain relief from the attachment of its assets.  The bond provides security to the Companywith respect to its patent infringement claim against All Ring.  The Company intends to vigorously pursue thispatent infringement claim against All Ring.

 

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**Note 10 – New Accounting Pronouncements**

 

InDecember 2004, the Financial Accounting Standards Board (FASB) issued FASBStatement No. 123 (Revised 2004), *Share-Based Payments*.(SFAS 123R).  The scope of SFAS 123Rincludes a wide range of share-based compensation arrangements including shareoptions, restricted share plans, performance-based awards, share appreciationrights, and employee share purchase plans. SFAS 123R replaces FASB Statement No. 123, Accounting forStock-Based Compensation (SFAS 123), and supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees (Opinion 25). SFAS 123R requires thatthe compensation cost relating to share-based payment transactions berecognized in financial statements and rescinds the ability of companies toelect the intrinsic value method prescribed under Opinion 25. That cost will bemeasured based on the fair value of the equity or liability instrumentsissued.  The Company will be required toimplement SFAS 123R for the fiscal year beginning June 4, 2006. TheCompany has not completed its analysis of the impact of the adoption of SFAS123R on its financial position or results of operations.

 

InDecember 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, *Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provision with the American Jobs Creation Act of 2004*.  FSP No. 109-2 provides guidance underSFAS No. 109, *Accounting for IncomeTaxes*, with respect to recording the potential impact of the repatriationprovisions of the American Jobs Creation Act of 2004 (the Jobs Act) onenterprises’ income tax expense and deferred tax liability.  The Jobs Act was enacted on October 22,2004.  FSP No. 109-2 states that anenterprise is allowed time beyond the financial reporting period of enactmentto evaluate the effect of the Jobs Act on its plan for reinvestment or repatriationof foreign earnings for purposes of applying SFAS No. 109. Accordingly,the Company will continue to analyze and assess its options under thisprovision.

 

**Note 11 – Subsequent Event**

 

In September 2005, anOregon tax law changed resulting in a limitation on the Company’s future use ofcertain state tax operating losses which were generated in prior years.  Accordingly, the Company will record a chargeof $1.1 million to the provision for income taxes in the second quarter offiscal 2006, representing its estimate of the valuation allowance required toreduce these operating losses to the amount expected to be realized.

 

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

 

**Forward Looking Statements**

 

The statements contained inthis report that are not statements of historical fact, including withoutlimitation statements containing the words “believes,” “expects” and similarwords, constitute forward-looking statements that are subject to a number ofrisks and uncertainties.  From time totime 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**

 

Electro ScientificIndustries, 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-densityinterconnect (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 capacitors and other passive components,as well as original equipment manufacturer machine vision products.

 

Duringthe first quarter of fiscal 2006, order volume of $34.8 million decreased 33.1%compared to orders of $52.0 million in the fourth quarter of fiscal 2005.  The decrease in orders in the current quartercompared to the prior quarter was largely influenced by the timing of semiconductororders.

 

#### *Shipmentswere $44.6 million in the first quarter of fiscal 2006, representing an 11.2%decline from shipments of $50.2 million in the fourth quarter of fiscal 2005.Deferred revenue remained essentially unchanged at approximately $13 million. Accordingly,net sales for the quarter were $44.5 million, declining slightly from $45.7 millionin the fourth quarter of fiscal 2005.*

#### * *

#### *Gross marginon first quarter sales of $44.5 million was 44.1%, representing a decrease ofone percentage point from the prior quarter margin on sales of $45.7 million.  Margins were impacted by lower overheadabsorption on reduced production levels. Second quarter shipments and net salesare currently estimated to be in the range of $45 million to $55 million andrelated gross margins are expected to remain in the low to mid-40% range.*

 

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#### *Operatingexpenses were $18.9 million for the first quarter of fiscal 2006, compared to $18.7million in the fourth quarter of fiscal 2005, resulting in operating income of$0.7 million in the first quarter. We anticipate operating expenses in the secondquarter of fiscal 2006 to be in the range of $19 million to $20 million.*

#### * *

Netother income was $1.2 million in the first quarter of fiscal 2006, compared tonet other expense of $3.0 million in the fourth quarter of fiscal 2005.Included in the fourth quarter of fiscal 2005 was a $4.1 million chargeresulting from the redemption of all of our outstanding 4 1⁄4% convertiblesubordinated notes.

 

The income tax provisionrecorded for the first quarter of fiscal 2006 was $0.6 million on pretax incomeof $2.0 million, compared to a tax benefit of $0.3 million on pretax loss of$1.0 million for the fourth quarter of 2005. The effective tax rate for the second quarter of fiscal 2006 is expectedto be approximately 25%, which excludes an income tax charge of approximately$1.1 million to be recorded in the second quarter relating to a recent changein Oregon tax law.

 

Net income for the firstquarter of fiscal 2006 was $1.3 million, or $0.05 per share on a basic andfully diluted basis, compared to a net loss of $0.8 million, or ($0.03) pershare on a basic and fully diluted basis, respectively, in the fourth quarterof fiscal year 2005.

 

**Results of Operations**

 

The following table sets forthresults of operations data as a percentage of net sales.

 
| ** **                            | ** ** | **Three months ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **August 27,**    | ** ** | **August 28,** | ** ** |
| ** **                            | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                  |       |                   |       |   |   |
| Net sales                             |       | 100.0                  | %          | 100.0 | % |
| Cost of sales                         |       | 55.9                   |       | 49.2 |   |
| Gross margin                          |       | 44.1                   |       | 50.8 |   |
| Selling, service and administrative   |       | 24.9                   |       | 20.5 |   |
| Research, development and engineering |       | 17.6                   |       | 9.0 |   |
| Operating income                      |       | 1.7                    |       | 21.3 |   |
| Total other income (expense), net     |       | 2.8                    |       | (0.5 | ) |
| Income before taxes                   |       | 4.5                    |       | 20.8 |   |
| Income tax provision                  |       | 1.4                    |       | 6.1 |   |
| Net income                            |       | 3.0                    | %          | 14.7 | % |

 

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***Net Sales***

 

Certain information regarding ournet sales by product group is as follows (net sales in thousands):

 
| ** **                    | ** ** | **Three months ended**   | ** ** |
|-------------------------------|------------|--------------------------|------------|
| ** **                    | ** ** | **August 27, 2005** | ** ** | **August 28, 2004** | ** ** |
| ** **                    | ** ** | **Net Sales**            | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|                          |       |                     |       |   |   |   |   |   |   |
| Semiconductor (SG)            |       | $                        | 27,901     |   | 62.7 | % | $ | 44,013 |   | 60.6 | % |
| Passive Components (PCG)      |       | 11,049                   |       | 24.8 |   | 20,603 |   | 28.4 |   |
| Electronic Interconnect (EIG) |       | 5,558                    |       | 12.5 |   | 8,004 |   | 11.0 |   |
|                          |       | $                        | 44,508     |   | 100.0 | % | $ | 72,620 |   | 100.0 | % |

 

Net sales were $44.5 million forthe quarter ended August 27, 2005, a decrease of $28.1 million or 38.7%compared to net sales of $72.6 million for the same quarter of the prioryear.  Sales decreased $16.1 million or36.6% for SG, $9.6 million or 46.4% for PCG and $2.4 million or 30.6% for EIG,compared to the same period in the prior year. Sales decreases in SG for thefirst quarter of fiscal 2006 compared to the first quarter of fiscal 2005resulted primarily from a decrease in system sales volumes. Net sales in thefirst quarter of the prior year benefited from a trend of major DRAMmanufacturers increasing capacity, primarily in the memory repair product line,which peaked in the fourth quarter of fiscal 2004.  SG net sales in the fourth quarter of 2004were $54.1 million followed by volume decreases resulting in net sales of $44.0million in the first quarter of fiscal 2005. Volume declines continued throughout fiscal 2005 ending with SG netsales of $29.2 million in the fourth quarter of that year. This decreasingcapital investment trend is consistent with the trend in the overallsemiconductor market. The decrease in PCG sales is due to continuing caution bycomponent manufacturers, who are evaluating the sustainability of utilizationrates before placing equipment orders. In the first quarter of the prior year,PCG sales reached a four-quarter peak, driven by demand for passive componentsprocessed by our laser trim and passive test systems. EIG sales levelsdecreased compared to the prior year as a result of industry softness andresulting sales volume decreases.

 

Net sales by geographic regionwere as follows (net sales in thousands):

 
| ** **    | ** ** | **Three months ended**   | ** ** |
|---------------|------------|--------------------------|------------|
| ** **    | ** ** | **August 27, 2005** | ** ** | **August 28, 2004** | ** ** |
| ** **    | ** ** | **Net Sales**            | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|          |       |                     |       |   |   |   |   |   |   |
| Asia          |       | $                        | 30,938     |   | 69.5 | % | $ | 58,536 |   | 80.6 | % |
| United States |       | 9,550                    |       | 21.5 |   | 8,548 |   | 11.8 |   |
| Europe        |       | 4,020                    |       | 9.0 |   | 5,536 |   | 7.6 |   |
|          |       | $                        | 44,508     |   | 100.0 | % | $ | 72,620 |   | 100.0 | % |

 

Totalnet sales to Asia decreased $27.6 million in the first quarter of fiscal 2006from the comparative quarter of fiscal 2005. This decrease in sales volume to Asia was the primary cause of theoverall net sales decrease of $28.1 million. Shipments to Asia in the first quarter of fiscal 2006 decreased $33.8million from the same comparative period as a result of volume decreases consistentwith overall semiconductor market trends described above.  Net sales to the United States increasedmodestly due to sales volume increases of SG systems to customers in thatregion.  Regional net sales as apercentage of total sales depends heavily upon net sales to SG customers inAsia for any given quarter and can vary depending on the timing of orders,shipments, and product acceptance.

 

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***GrossProfit***

 

Gross profit was $19.6 million (44.1%of net sales) for the first quarter of fiscal 2006 compared to $36.9 million(50.8% of net sales) for the first quarter of fiscal 2005.  Shipments in the first quarter of fiscal 2006decreased 42.8% compared to the same quarter in fiscal 2005.  Decreased shipment levels resulted in lowervolume-based manufacturing efficiencies, reduced overhead absorption and highercosts per unit.

 

***Operating Expenses***

 

Selling, Service andAdministrative Expenses 

 

The primary items includedin selling, service and administrative expenses are labor and otheremployee-related expenses, travel expenses, professional fees and facilitiescosts. Selling, service and administrative expenses were $11.1 million (24.9%of net sales) in the first quarter of fiscal 2006, a decrease of $3.8 millioncompared to $14.9 million (20.5% of net sales) in the first quarter of fiscal2005.

 

The first quarter of fiscal 2005includes $0.4 million in special charges for professional fees related to the2003 audit committee investigation and securities litigation.  Exclusive of these special charges, selling,service and administrative expenses decreased $3.4 million in the first quarterof fiscal 2006 compared to the first quarter of fiscal 2005.  The decrease is primarily due to a reductionin payroll and related costs resulting from restructuring and other costcontainment initiatives implemented in fiscal 2005. Additionally, commissionexpenses decreased due to the reduction in revenue compared to the firstquarter of fiscal 2005.

 

Research, Development andEngineering Expenses

 

Research, development and engineeringexpenses are primarily comprised of labor and other employee-related expenses,professional fees, project materials, equipment and facilities costs.  Expenses associated with research,development and engineering totaled $7.8 million (17.6% of net sales) for the firstquarter of fiscal 2006, representing a $1.2 million increase from expenses of $6.6million (9.0% of net sales) for the first quarter of fiscal 2005. This isprimarily due to an increase in subcontracted and professional services andincreased purchases of materials used in research and development of newproducts in existing and emerging markets.

 

Other Income (Expense)

 

Interest income was $1.5million in the first quarter of 2006, compared to $1.6 million in the firstquarter of 2005, a decrease of $0.1 million. The decrease is partly due to theliquidation of marketable securities on March 10, 2005 to fund the $145million redemption of our 4 1⁄4% convertible subordinated notes due 2006. Theresulting lower amount invested was offset by increased yields on investedassets, consistent with increases in market interest rates on debt securitiesover the past year.

 

Interest expense decreasedby $1.8 million or 98% in the first quarter of 2006, compared to the firstquarter of fiscal 2005, due to the redemption of our convertible subordinatednotes.

 

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***Income Taxes***

 

The income tax provisionrecorded for the first quarter of fiscal 2006 was $0.6 million on pretax incomeof $2.0 million, an effective rate of 32%. The effective tax rate is lower than our statutory tax rate of 36%,primarily due to incentives for export sales and research credits.

 

In October 2003 theInternal Revenue Service (IRS) began an audit of the fiscal tax years ending in1996 through 2003.  During fiscal 2005 wereached an agreement with the IRS on the tax return years under review.  The examination required a special report tobe submitted by the IRS for congressional approval from the Joint Committee onTaxation.  During the first quarter offiscal 2006, we received notice from the IRS that the Joint Committee’s reviewwas completed without exception.  As aresult, we will receive approximately $7.2 million in tax refunds.  Additionally, we are subject to numerous ongoingstate and foreign tax audits.  Althoughthe final outcome of these audits is uncertain, based on currently availableinformation we believe the ultimate resolutions will not have a materiallyadverse effect on the Company’s financial position or results of operations.

 

***Net Income***

 

Net income for the firstquarter of fiscal 2006 was $1.3 million (3.0% of net sales), or $0.05 per shareon a basic and fully diluted basis, compared to a net income of $10.6 million(14.7% of net sales), or $0.38 and $0.36 per share on a basic and fully dilutedbasis, respectively, in the first quarter of fiscal year 2005.

 

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**FinancialCondition and Liquidity**

 

At August 27, 2005, ourprincipal sources of liquidity consisted of cash, cash equivalents andmarketable securities of $221.4 million and accounts receivable of $37.2 million.  At August 27, 2005, we had a currentratio of 7.4:1 and no long-term debt. Working capital increased to $284.1 millionat August 27, 2005 from $275.7 million at May 28, 2005.  We believe that our existing cash, cashequivalents and marketable securities are adequate to fund our operations forat least the next twelve months.

 

Cash flows from operatingactivities totaled $6.8 million in the first quarter of fiscal 2006.  Cash totaling $4.0 million was provided bynet income adjusted for non-cash items. Other significant factors impacting cash flows from operations included increasesin trade receivables, receipt of income tax refunds, decreases in inventories, anddecreases in current liabilities.

 

Net inventories decreased 9.8%to $53.7 million at August 27, 2005, compared to $59.5 million at May 28,2005. The decrease is comprised primarily of decreases in finished goods due tothe implementation of a targeted inventory management program designed toreduce inventory levels.

 

Net trade receivables were $37.2million at August 27, 2005 compared to $36.2 million at May 28, 2005,an increase of $1.0 million. The increase is primarily due to the timing ofacceptances on shipped systems.

 

Payables and currentliabilities were $31.5 million at August 27, 2005 compared to $33.4million at May 28, 2005.  Thedecrease in other liabilities is due primarily to the payment of accruedamounts for annual payroll-related liabilities.

 

Cash flows from investingactivities totaled $19.2 million for the first quarter of fiscal 2006.  Capital expenditures totaled $4.7 millionduring this period and were principally comprised of costs related to theimplementation of a new enterprise resource planning system and a majorrefurbishment of research and development clean rooms and laboratories. We alsogenerated $24.3 million net in cash and cash equivalents through the maturityand sale of investments in our portfolio of marketable securities offset bycertain reinvestments. We anticipate remaining capital expenditures related tothe implementation of the new enterprise resource planning system in fiscal2006 will total approximately $7 million.

 

Cash flows from financingactivities of $0.9 million were comprised of proceeds from the exercise ofstock options and ESPP purchases for the quarter ended August 27, 2005.

 

**CriticalAccounting Policies and Estimates**

 

We reaffirm the criticalaccounting policies and our use of estimates as reported in our annual reporton Form 10-K for our fiscal year ended May 28, 2005 as filed with theSecurities and Exchange Commission on July 27, 2005.

 

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**FactorsThat May Affect Future Results**

 

The statements contained in this report that are notstatements of historical fact, including without limitation statementscontaining the words “believes,” “expects” and similar words, constituteforward-looking statements that are subject to a number of risks anduncertainties.  From time to time we maymake other forward-looking statements. Investors are cautioned that such forward-looking statements are subjectto an inherent risk that actual results may materially differ.  The following information highlights some ofthe factors that could cause actual results to differ materially from theresults expressed or implied by our forward-looking statements.  Forward-looking statements should beconsidered in light of these factors. Factors that may result in such variances include, but are not limitedto, the following:

 

***The industries that comprise ourprimary markets are volatile and unpredictable.***

 

Our business depends upon the capital expenditures ofmanufacturers of components and circuitry used in wireless communications,computers and other electronic products. In the past, the markets for electronic devices have experienced sharpdownturns.  During these downturns,electronics manufacturers, including our customers, have delayed or canceledcapital expenditures, which has had a negative impact on our financial results.

 

After experiencing a significant increase in orders infiscal 2004, we experienced reduced demand beginning in the first quarter offiscal 2005.  Net sales decreased from$81.8 million in the fourth quarter of fiscal 2004 to $72.6 million, $66.0million, $49.1 million and $45.7 million in the first, second, third and fourthquarters of fiscal 2005, respectively. Net income (loss) during those periods decreased from $16.2 million inthe fourth quarter of fiscal 2004 to $10.6 million, $7.9 million, $2.0 millionand ($0.8 million) in the first, second third and fourth quarters of fiscal2005, respectively. In the first quarter of fiscal 2006, net sales remainedfairly level with the prior quarter at $44.5 million and net income increasedto $1.3 million.  We cannot assure youwhen, or if, demand for our products will increase or that demand will notfurther decrease.  Even if demand for ourproducts does increase, there may be significant fluctuations in ourprofitability and net sales.

 

During any downturn, it will be difficult for us tomaintain our sales levels.  As aconsequence, to maintain profitability we will need to reduce our operatingexpenses.  For example, in December 2004we announced an operational restructuring and reduction in force to reduce ourexpenses in connection with the current downturn.  Our ability to quickly reduce operatingexpenses is dependent upon the nature of the actions we take to reduce expenseand our subsequent ability to implement those actions and realize expected costsavings.  Additionally, we may be unableto defer capital expenditures and we will need to continue to invest in certainareas such as research and development. An economic downturn may also cause us to incur charges related toimpairment of assets and inventory write-offs and we may also experience delaysin payments from our customers, which would have a negative effect on ourfinancial results.

 

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***Delays in manufacturing, shipmentor customer acceptance of our products could substantially decrease our salesfor a period.***

 

We depend on manufacturing flexibility to meet thechanging demands of our customers.  Anysignificant delay or interruption in receiving raw materials or in ourmanufacturing operations as a result of software deficiencies, naturaldisasters, or other causes could result in reduced manufacturing capabilitiesor delayed product deliveries, any or all of which could materially andadversely affect our results of operations.

 

In addition, we derive a substantial portion of ourrevenue from the sale of a relatively small number of products.  Consequently, shipment and/or customeracceptance delays could significantly impact ourrecognition of revenueand could be further magnified by announcements from us or our competitors ofnew products and technologies, which announcements could cause our customers todefer purchases of our systems or purchase products from our competitors.  Any of these delays could result in amaterial adverse change in our results of operations for any particular period.

 

***Failure of critical suppliers ofparts, components and manufacturing equipment to deliver sufficient quantitiesto us in a timely and cost-effective manner could negatively affect ourbusiness.***

 

We use a wide range of materials in the production ofour products, including custom electronic and mechanical components, and we usenumerous suppliers for those materials. We generally do not have guaranteed supply arrangements with oursuppliers.  We seek to reduce the risk ofproduction and service interruptions and shortages of key parts by selectingand qualifying alternative suppliers for key parts, monitoring the financialstability of key suppliers and maintaining appropriate inventories of keyparts.  Although we make reasonableefforts to ensure that parts are available from multiple suppliers, some keyparts are available only from a single supplier or a limited group of suppliersin the short term.  Operations at oursuppliers’ facilities are subject to disruption for a variety of reasons,including changes in business relationships, competitive factors, workstoppages, and fire, earthquake, flooding or other natural disasters.  Such disruption could interrupt ourmanufacturing.  Our business may beharmed if we do not receive sufficient parts to meet our productionrequirements in a timely and cost-effective manner.

 

***We depend on a few significantcustomers and we do not have long-term contracts with any of our customers.***

 

Our top ten customers for fiscal2005 accounted for approximately 51% of total net sales in fiscal 2005, withone customer, Samsung, accounting for approximately 13% of total net sales infiscal 2005. No other customer in fiscal 2005 accounted for more than 10% oftotal net sales.  In addition, none ofour customers has any long-term obligation to continue to buy our products orservices, and any customer could delay, reduce or cease ordering our productsor services at any time.

 

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

 

The markets for our products are characterized byrapid technological change and innovation, frequent new product introductions,changes in customer requirements and evolving industry standards.  Our future performance will depend on thesuccessful development, introduction and market acceptance of new and enhancedproducts that address technological changes as well as current and potentialcustomer requirements.  The introductionby us or by our competitors of new and enhanced products may cause our customersto defer or cancel orders for our existing products, which may harm ouroperating results.  In the past we havealso experienced delays in new product development.  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 from numerousfactors, including:

 

•                  Changing product specifications and customer requirements;

•                  Difficulties in hiring and retaining necessary technical personnel;

•                  Difficulties in reallocating engineering resources and overcomingresource limitations;

•                  Difficulties with contract manufacturers;

•                  Changing market or competitive product requirements; and

•                  Unanticipated engineering complexities.

 

The development of new, technologically advancedproducts is a complex and uncertain process, requiring high levels ofinnovation and highly skilled engineering and development personnel, as well asthe accurate anticipation of technological and market trends.  We cannot assure you that we will be able toidentify, develop, manufacture, market or support new or enhanced productssuccessfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain marketacceptance or that we will be able to respond effectively to productannouncements by competitors, technological changes or emerging industrystandards.  Any failure to respond totechnological change that may render our current products or technologiesobsolete could significantly harm our business.

 

***Our ability to reduce costs islimited by our need to invest in research and development.***

 

Our industry is characterized by the need forcontinued investment in research and development.  Because of intense competition in theindustries in which we compete, if we were to fail to invest sufficiently inresearch and development, our products could become less attractive topotential customers, and our business and financial condition could be materiallyand adversely affected.  As a result ofour need to maintain our spending levels in this area, our operating resultscould be materially harmed if our net sales fall below expectations.  In addition, as a result of our emphasis onresearch and development and technological innovation, our operating costs mayincrease further in the future, and research and development expenses mayincrease as a percentage of total operating expenses and as a percentage of netsales.

 

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***We are exposed to the risks thatothers may violate our proprietary rights, and our intellectual property rightsmay not be well protected in foreign countries.***

 

Our success is dependent upon the protection of ourproprietary rights.  In the hightechnology industry, intellectual property is an important asset that is alwaysat risk of infringement.  We incursubstantial costs to obtain and maintain patents and defend our intellectualproperty.  For example, we have initiatedlitigation alleging that 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 intellectualproperty may be less effective in some foreign countries where intellectualproperty rights are not as well protected as in the United States.  Many U.S. companies have encounteredsubstantial problems in protecting their proprietary rights againstinfringement in foreign countries.  If wefail to adequately protect our intellectual property in these countries, itcould be easier for our competitors to sell competing products in foreigncountries, which could result in reduced sales and gross margins.

 

***We may be subject to claims ofintellectual property infringement.***

 

Several of our competitors hold patents covering avariety of technologies, applications and methods of use similar to some ofthose used in our products.  From time totime, we and our customers have received correspondence from our competitorsclaiming that some of our products, as used by our customers, may be infringingone or more of these patents. Competitors or others have in the past and may in the future assertinfringement claims against our customers or us with respect to current orfuture products or uses, and these assertions may result in costly litigationor require us to obtain a license to use intellectual property rights ofothers.  If claims of infringement areasserted against our customers, those customers may seek indemnification fromus for damages or expenses they incur.

 

If we become subject to infringement claims, we willevaluate our position and consider the available alternatives, which mayinclude seeking licenses to use the technology in question or defending ourposition. These licenses, however, may not be available on satisfactory termsor at all.  If we are not able tonegotiate the necessary licenses on commercially reasonable terms orsuccessfully defend our position, our financial condition and results ofoperations could be materially and adversely affected.

 

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***Our business is highlycompetitive, and if we fail to compete effectively, our business will beharmed.***

 

The industries in which we operate are highlycompetitive.  We face substantialcompetition from established 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 beharmed.  Our competitors can be expectedto continue to improve the design and performance of their products and tointroduce new products.  New companiesmay enter the markets in which we compete, or industry consolidation may occur,further increasing competition in those markets.  Furthermore, our technological advantages maybe reduced or lost as a result of technological advances by our competitors.

 

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

 

•                  Better withstand periodic downturns;

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

•                  More quickly develop enhancements to and new generations of products.

 

We believe that our ability to compete successfullydepends on a number of factors, including:

 

•                  Performance of our products;

•                  Quality of our products;

•                  Reliability of our products;

•                  Cost of using our products;

•                  Consistent availability of critical components;

•                  Our ability to ship products on the schedule required;

•                  Quality of the technical service we provide;

•                  Timeliness of the services we provide;

•                  Our success in developing new products and enhancements;

•                  Existing market and economic conditions; and

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

 

We may not be able to compete successfully in thefuture, and increased competition may result in price reductions, reducedprofit margins and loss of market share.

 

***The loss of key personnel or ourinability to attract, retain and assimilate sufficient numbers of managerial,financial, engineering and other technical personnel could have a materialeffect upon our results of operations.***

 

Our continued success depends, in part, upon keymanagerial, financial, engineering and technical personnel as well as our abilityto continue to attract, retain and assimilate additional personnel.  The loss of key personnel could have amaterial adverse effect on our business or results of operations.  We may not be able to retain our keymanagerial, financial, engineering and technical employees. Attractingqualified personnel may be difficult and our efforts to attract and retainthese personnel may not be successful. In addition, we may not be able to assimilate qualified personnel,including any new members of senior management, which could disrupt ouroperations.

 

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

 

We have established direct sales and service organizationsthroughout the world.  A worldwide directsales and service 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.

 

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

 

Although we have no commitments or agreements for anyacquisitions, in the future we may make acquisitions of, or significantinvestments in, businesses with complementary products, services ortechnologies.

 

Acquisitions involve numerous risks, many of which areunpredictable and beyond our control, including:

 

•                  Difficulties and increased costs in connection with integration of thepersonnel, operations, technologies and products of acquired companies;

•                  Diversion of management’s attention from other operational matters;

•                  The potential loss of key employees of acquired companies;

•                  Lack of synergy, or inability to realize expected synergies, resultingfrom the acquisition; and

•                  Acquired assets becoming impaired as a result of technologicaladvancements or worse-than-expected performance by the acquired company.

 

Our inability to effectively manage these acquisitionrisks could materially and adversely affect our business, financial conditionand results of operations.  In addition,if we issue equity securities to pay for an acquisition the ownershippercentage of our existing shareholders would be reduced and the value of theshares held by our existing shareholders could be diluted.  If we use cash to pay for an acquisition thepayment could significantly reduce the cash that would be available to fund ouroperations or to use for other purposes. In addition, the accounting for futureacquisitions could result in significant charges resulting from amortization ofintangible assets related to such acquisitions.

 

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***We are exposed to the risks ofoperating a global business, including risks associated with exchange ratefluctuations, legal and regulatory changes and the impact of regional andglobal economic disruptions.***

 

International shipments accounted for 85% of net salesin fiscal 2005, with 77% 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, purchases and operationsare subject to risks inherent in conducting business abroad, many of which areoutside our control, including the following:

 

•                  Periodic local or geographic economic downturns and unstable politicalconditions;

•                  Price and currency exchange controls;

•                  Fluctuation in the relative values of currencies;

•                  Difficulties protecting intellectual property;

•                  Local labor disputes;

•                  Shipping delays and disruptions;

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

•                  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 and representatives andrepatriation of earnings.

 

Our business and operating results are subject touncertainties arising out of the possibility of regional or global economicdisruptions (including those resulting from natural disasters), 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 thatfuture tightening of immigration controls may adversely affect the residencestatus of non-U.S. engineers and other key technical employees in our U.S.facilities or our ability to hire new non-U.S. employees in such facilities;

•                  The risk of morefrequent instances of shipping delays; and

•                  The risk thatdemand for our products may not increase or may decrease.

 

***Failure to achieve and maintaineffective internal controls could have a material adverse effect on ourbusiness, operating results and stock price.***

 

In connection with our fiscal 2005 audit, we documentedand tested our internal control procedures in order to satisfy the requirementsof Section 404 of the Sarbanes-Oxley Act, which requires annual managementassessments of the effectiveness of our internal controls over financialreporting and a report by our independent auditors addressing theseassessments.  If we fail to achieve andmaintain the adequacy of our internal controls, as such standards are modified,supplemented or amended from time to time, we may not be able to ensure that wecan conclude on an ongoing basis that we have effective internal controls overfinancial reporting in accordance with Section 404 of the Sarbanes-OxleyAct.  Our ability to maintain internalcontrols may be negatively impacted by our planned implementation of newenterprise management software and systems in fiscal 2006.  Moreover, effective internal controls,particularly those related to revenue recognition, are necessary for us toproduce reliable financial reports and are important to prevent financialfraud.  If we cannot provide reliablefinancial reports or prevent fraud, our business and operating results could beharmed, investors could lose confidence in our reported financial information,and the trading price of our stock could drop significantly.

 

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***Enterprise resource planningsystem (ERP) implementation could have a material adverse effect on ourbusiness.***

 

We are highly dependent on our systems infrastructurein order to process orders, track inventory, ship products in a timely manner,prepare invoices to our customers and otherwise carry on our business in theordinary course.  Key to the success ofour strategy to drive greater productivity and cost savings is theimplementation of a new worldwide ERP system expected in fiscal 2006.  If we experience problems with theimplementation of this system, the resulting disruption could adversely affectour business, sales, results of operations and financial condition. Thetransition to our new ERP system involves numerous risks, including:

 

•                  difficulties in integrating the system with our current operations;

•                  diversion of management’s attention away from normal daily operationsof our business;

•                  initial dependence on an unfamiliar system while training personnel inits use;

•                  increased demand on our support operations; and

•                  potential delay in the processing of customer orders for shipment ofproducts.

 

Further, we may experience difficulties in thetransition to the new software that could affect our internal control systems,processes, procedures and related documentation.  The ERP implementation will require significanteffort in a compressed timeframe, as well as result in our incurring costs tocomply with Section 404 of the Sarbanes-Oxley Act by documenting allbusiness processes that have been revised as a result of theimplementation.  This will result incompliance costs that will be in addition to the implementation costs of ournew ERP system.  There can be noassurances that the evaluation required by Section 404 of theSarbanes-Oxley Act for fiscal 2006 will not result in the identification ofsignificant control deficiencies or that our auditors will be able to attest tothe effectiveness of our internal control over financial reporting subsequentto the implementation of the new ERP system.

 

***The Company’s tax rates are subject to fluctuation, which could impactour financial position***

 

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

 

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

 

There have been no materialchanges in the market risk disclosure contained in our 2005 Annual Report on Form 10-Kfor our fiscal year ended on May 28, 2005.

 

**Item 4.  Controls and Procedures**

 

Attached to this quarterly reportas exhibits 31.1 and 31.2 are the certifications of our President and ChiefExecutive Officer and our Chief Financial Officer required by Section 302of the Sarbanes-Oxley Act of 2002 (the Section 302 Certifications).  This portion of our quarterly report on Form 10-Qis our disclosure of the conclusions of our management, including our Presidentand Chief Executive Officer and our Chief Financial Officer, regarding theeffectiveness of our disclosure controls and procedures as of the end of theperiod covered by this report based on management’s evaluation of thosedisclosure controls and procedures.  Youshould read this disclosure in conjunction with the Section 302Certifications for a more complete understanding of the topics presented.

 

***Disclosure Controls andProcedures***

Our management has evaluated, underthe supervision and with the participation of our President and Chief ExecutiveOfficer and Chief Financial Officer, the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this reportpursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934,as amended (Exchange Act). Based on that evaluation, our President and ChiefExecutive Officer and our Chief Financial Officer have concluded that, as ofthe end of the period covered by this report, our disclosure controls andprocedures are effective in ensuring that information required to be disclosedin our Exchange Act reports is (1) recorded, processed, summarized andreported in a timely manner, and (2) accumulated and communicated to ourmanagement, including our President and Chief Executive Officer and our ChiefFinancial Officer, as appropriate to allow timely decisions regarding requireddisclosure.

 

***Changes in InternalControl Over Financial Reporting***

There has been no change in ourinternal control over financial reporting that occurred during our fiscalquarter ended August 27, 2005 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II – OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

On August 24, 2005, we executed a ProvisionalAttachment Order (the Order) issued by the Kaohsiung District Court of Taiwandirected against All Ring Tech Co., Ltd. (All Ring) of Taiwan.  In the petition requesting the Order, ESIalleges that All Ring’s Capacitor Tester Model RK-T6600 infringes our TaiwanPatent No. 207469, entitled “Circuit Component Handler” (the 207469patent).  This patent corresponds to ourU.S. Patent No. 5,842,579.  Thepatented technology is used in our Model 3340 Multifunction MLCC Tester.  We filed in support of the petition a copy ofa patent infringement assessment report issued by Yen Tjing Ling IndustrialResearch Institute, a professional organization appointed by the judicialbranch of the Taiwan government, that concludes that the RK-T6600 infringes the207469 patent.  A copy of the assessmentreport and an English language translation of the assessment report areavailable on ESI’s website.  All Ring hasfiled a bond with the court to obtain relief from the attachment of itsassets.  The bond provides security to uswith respect to our patent infringement claim against All Ring.  We intend to vigorously pursue this patentinfringement claim against All Ring.

 

**Item 6.  Exhibits**

 
| This list is intended to constitute the exhibit index. |
|--------------------------------------------------------|
| 3.1                                                    |   | Restated  Articles of Incorporation. Incorporated by reference to Exhibit 3-A of  the Company’s Annual Report on Form 10-K for the fiscal year ended  May 31, 1991. |
| 3.2                                                    |   | Articles of  Amendment of Third Restated Articles of Incorporation. Incorporated by  reference to Exhibit 3-B of the Company’s Annual Report on  Form 10-K for the fiscal year ended May 31, 1999. |
| 3.3                                                    |   | Articles of  Amendment of Third Restated Articles of Incorporation. Incorporated by  reference to Exhibit 3 of the Company’s Quarterly Report on  Form 10-Q for the fiscal quarter ended December 2, 2000. |
| 3.4                                                    |   | 2004 Restated  Bylaws, as amended. Incorporated by reference to Exhibit 3.1 of the  Company’s Current Report on Form 8-K filed on October 21, 2004. |
| 4.1                                                    |   | Amended and  Restated Rights Agreement, dated as of March 1, 2001, between the  Company and Mellon Investor Services, relating to rights issued to all  holders of Company common stock. Incorporated by reference to Exhibit 4-A  of the Company’s Annual Report on Form 10-K for the fiscal year ended  June 2, 2001. |
| 10.1                                                   |   | Fiscal 2006 Annual Executive Team Bonus Plan summary (incorporated by  reference to Exhibit 10.1 of the Company’s Current Report on  Form 8-K filed July 26, 2005 (the “July 8-K”)). |
| 10.2                                                   |   | Form of Stock Option Agreement (non-directors) (incorporated by  reference to Exhibit 10.2 of the July 8-K). |
| 10.3                                                   |   | Form of Stock Option Agreement (directors) (incorporated by  reference to Exhibit 10.3 of the July 8-K). |
| 31.1                                                   |   | Certification of the Chief Executive Officer pursuant to  Section 302(a) of the Sarbanes-Oxley Act of 2002. |
| 31.2                                                   |   | Certification of the Chief Financial Officer pursuant to  Section 302(a) of the Sarbanes-Oxley Act of 2002. |
| 32.1                                                   |   | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2                                                   |   | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

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

 

 
| Dated:   September 22, 2005 | ELECTRO SCIENTIFIC INDUSTRIES, INC.       |
|-------------------------------------------------|-------------------------------------------|
|                                            |                                      |
|                                            |                                      |
|                                            | By                                        | /s/ Nicholas Konidaris |   |
|                                            | Nicholas Konidaris                        |
|                                            | President and Chief  Executive Officer    |
|                                            | (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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