**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| ý                                                                                                                                                                    | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                      |                                                                                                |
| **For the  quarterly period ended February 26, 2005**                                                                                                                |
|                                                                                                                                                                      |                                                                                                |
| **OR**                                                                                                                                                                    |
|                                                                                                                                                                      |                                                                                                |
| o                                                                                                                                                                         | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|                                                                                                                                                                      |                                                                                                |
| **For the transition period  from           to           ** |

 

**Commission File Number:  0-12853**

 

**ELECTRO SCIENTIFICINDUSTRIES, 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 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.  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

 

The number of shares outstandingof the Registrant’s Common Stock at March 18, 2005 was 28,554,530 shares.

 

 

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

### ** **

### **TABLEOF CONTENTS**

 
| **PART I - FINANCIAL  INFORMATION** | ** **                                                                                                                                    |
|-------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------|
|                                |                                                                                                                                          |   |
| Item 1.                             | Consolidated Condensed  Financial Statements (unaudited)                                                                                      |   |
|                                |                                                                                                                                          |   |
|                                | Consolidated  Condensed Balance Sheets – February 26, 2005 and May 29, 2004                                                         |   |
|                                |                                                                                                                                          |   |
|                                | Consolidated  Condensed Statements of Operations – Three Months and Nine Months Ended February 26,  2005 and February 28, 2004 |   |
|                                |                                                                                                                                          |   |
|                                | Consolidated Condensed  Statements of Cash Flows – Nine Months Ended February 26, 2005 and February 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 6.                             | Exhibits                                                                                                                                      |   |
|                                |                                                                                                                                          |   |
| Signatures                          |                                                                                                                                          |   |
|                                     |                                                                                                                                               |  |  |  |

 

1

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.****FinancialStatements**

 

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATEDCONDENSED BALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                            | ** ** | **February 26,  2005** | ** ** | **May 29,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-------------------|------------|
| ** **                                                                                            | ** ** | ** **                  | ** ** | ** **        | ** ** |
| **Assets**                                                                                            | ** ** | ** **                  | ** ** | ** **        | ** ** |
| Current assets:                                                                                       |       |                        |       |              |       |
| Cash and cash equivalents                                                                             |       | $                           | 147,724    |              | $          | 80,358 |   |
| Marketable securities                                                                                 |       | 159,929                     |       | 206,931           |       |
| Restricted securities                                                                                 |       | —                      |       | 6,251             |       |
| Total cash and securities                                                                             |       | 307,653                     |       | 293,540           |       |
|                                                                                                  |       |                        |       |              |       |
| Trade receivables, net of allowances of $957 and  $901                                                |       | 36,838                      |       | 51,696            |       |
| Income tax refund receivable                                                                          |       | 9,108                       |       | 7,466             |       |
| Inventories                                                                                           |       | 66,788                      |       | 58,627            |       |
| Shipped systems pending acceptance                                                                    |       | 1,332                       |       | 4,391             |       |
| Deferred income taxes                                                                                 |       | 11,358                      |       | 16,096            |       |
| Assets held for sale                                                                                  |       | —                      |       | 2,391             |       |
| Prepaid and other current assets                                                                      |       | 5,031                       |       | 3,348             |       |
| Total current assets                                                                                  |       | 438,108                     |       | 437,555           |       |
|                                                                                                  |       |                        |       |              |       |
| Long-term marketable securities                                                                       |       | 47,853                      |       | 39,214            |       |
| Property, plant and equipment, net of accumulated  depreciation of $44,798 and $40,644                |       | 32,848                      |       | 33,531            |       |
| Deferred income taxes                                                                                 |       | 16,138                      |       | 17,630            |       |
| Other assets                                                                                          |       | 11,827                      |       | 9,256             |       |
| Total assets                                                                                          |       | $                           | 546,774    |              | $          | 537,186 |   |
|                                                                                                  |       |                        |       |              |       |
| **Liabilities and shareholders’ equity**                                                         | ** ** | ** **                  | ** ** | ** **        | ** ** |
| Current liabilities:                                                                                  |       |                        |       |              |       |
| Accounts payable                                                                                      |       | $                           | 5,681      |              | $          | 13,248 |   |
| Accrued liabilities                                                                                   |       | 32,674                      |       | 42,381            |       |
| Deferred revenue                                                                                      |       | 8,573                       |       | 11,985            |       |
| Convertible subordinated notes - current                                                              |       | 143,410                     |       | —            |       |
| Total current liabilities                                                                             |       | 190,338                     |       | 67,614            |       |
| Convertible subordinated notes - long term                                                            |       | —                      |       | 142,759           |       |
| Total liabilities                                                                                     |       | 190,338                     |       | 210,373           |       |
|                                                                                                  |       |                        |       |              |       |
| Shareholders’ equity:                                                                            |       |                        |       |              |       |
| Preferred stock, without par value; 1,000 shares  authorized; no shares issued                        |       | —                      |       | —            |       |
| Common stock, without par value; 100,000 authorized;  28,534 and 28,175 shares issued and outstanding |       | 154,828                     |       | 147,054           |       |
| Retained earnings                                                                                     |       | 201,952                     |       | 181,362           |       |
| Accumulated other comprehensive loss                                                                  |       | (344                        | )          | (1,603            | )          |
| Total shareholders’ equity                                                                       |       | 356,436                     |       | 326,813           |       |
| Total liabilities and shareholders’ equity                                                       |       | $                           | 546,774    |              | $          | 537,186 |   |

 

The accompanying notes are an integral part of these statements.

 

2

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATEDCONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 
| ** **                                        | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                        | ** ** | **February 26, 2005**     | ** ** | **February 28, 2004**    | ** ** | **February 26, 2005** | ** ** | **February 28, 2004** | ** ** |
| ** **                                        | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                         |       | $                              | 49,084     |                          | $          | 58,770 |   | $ | 187,708 |   | $ | 125,399 |   |
| Cost of sales                                     |       | 27,646                         |       | 35,444                        |       | 96,558 |   | 81,570 |   |
| Gross profit                                      |       | 21,438                         |       | 23,326                        |       | 91,150 |   | 43,829 |   |
|                                              |       |                           |       |                          |       |   |   |   |   |
| Operating expenses:                               |       |                           |       |                          |       |   |   |   |   |
| Selling, service and administration               |       | 12,290                         |       | 13,502                        |       | 42,494 |   | 41,408 |   |
| Research, development and engineering             |       | 6,400                          |       | 5,429                         |       | 20,706 |   | 16,593 |   |
|                                              |       | 18,690                         |       | 18,931                        |       | 63,200 |   | 58,001 |   |
| Operating income (loss)                           |       | 2,748                          |       | 4,395                         |       | 27,950 |   | (14,172 | ) |
|                                              |       |                           |       |                          |       |   |   |   |   |
| Interest income                                   |       | 1,867                          |       | 1,764                         |       | 5,190 |   | 5,660 |   |
| Interest expense                                  |       | (1,784                         | )          | (1,786                        | )          | (5,356 | ) | (5,599 | ) |
| Other expense, net                                |       | (161                           | )          | (197                          | )          | (485 | ) | (207 | ) |
|                                              |       | (78                            | )          | (219                          | )          | (651 | ) | (146 | ) |
| Income (loss) before income taxes                 |       | 2,670                          |       | 4,176                         |       | 27,299 |   | (14,318 | ) |
| Provision for (benefit from) income taxes         |       | 672                            |       | (5,798                        | )          | 6,709 |   | (10,050 | ) |
| Net income (loss)                                 |       | $                              | 1,998      |                          | $          | 9,974 |   | $ | 20,590 |   | $ | (4,268 | ) |
|                                              |       |                           |       |                          |       |   |   |   |   |
| Net income (loss) per share - basic               |       | $                              | 0.07       |                          | $          | 0.36 |   | $ | 0.73 |   | $ | (0.15 | ) |
|                                              |       |                           |       |                          |       |   |   |   |   |
| Net income (loss) per share - fully diluted       |       | $                              | 0.07       |                          | $          | 0.34 |   | $ | 0.72 |   | $ | (0.15 | ) |
|                                              |       |                           |       |                          |       |   |   |   |   |
| Weighted average number of shares - basic         |       | 28,492                         |       | 28,030                        |       | 28,383 |   | 27,933 |   |
|                                              |       |                           |       |                          |       |   |   |   |   |
| Weighted average number of shares - fully diluted |       | 28,600                         |       | 32,187                        |       | 28,533 |   | 27,933 |   |

 

The accompanying notes are an integral part of these statements.

 

3

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATEDCONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                                      | ** ** | **For the nine months ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                      | ** ** | **February 26, 2005**    | ** ** | **February 28, 2004** | ** ** |
| ** **                                                                                      | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Cash flows from operating activities:**                                                       |       |                          |       |   |   |
| Net income (loss)                                                                               |       | $                             | 20,590     |   | $ | (4,268 | ) |
| Adjustments to reconcile net income (loss) to cash  provided by (used in) operating activities: |       |                          |       |   |   |
| Depreciation and amortization                                                                   |       | 7,176                         |       | 6,942 |   |
| Tax benefit of stock options exercised                                                          |       | 637                           |       | 703 |   |
| Provision for doubtful accounts                                                                 |       | 199                           |       | 101 |   |
| Loss on disposal of property and equipment                                                      |       | 281                           |       | 57 |   |
| Deferred income taxes                                                                           |       | 6,271                         |       | 461 |   |
| Changes in operating accounts:                                                                  |       |                          |       |   |   |
| (Increase) decrease in trade receivables, net                                                   |       | 16,645                        |       | (6,336 | ) |
| Increase in income tax refund receivable                                                        |       | (1,642                        | )          | (28,490 | ) |
| Increase in inventories, net                                                                    |       | (11,781                       | )          | (7,381 | ) |
| Decrease in shipped systems pending acceptance                                                  |       | 3,059                         |       | 1,615 |   |
| (Increase) decrease in prepaid and other current  assets                                        |       | (1,346                        | )          | 262 |   |
| Increase (decrease) in accounts payable and other  current liabilities                          |       | (18,407                       | )          | 19,520 |   |
| Increase (decrease) in deferred revenue                                                         |       | (3,413                        | )          | 3,398 |   |
| Net cash provided by (used in) operating activities                                             |       | 18,269                        |       | (13,416 | ) |
|                                                                                            |       |                          |       |   |   |
| **Cash flows from investing activities:**                                                       |       |                          |       |   |   |
| Purchase of property, plant and equipment                                                       |       | (3,397                        | )          | (3,328 | ) |
| Proceeds from the sale of property and equipment                                                |       | 92                            |       | 9 |   |
| Proceeds from the sale of assets held for sale                                                  |       | 2,361                         |       | — |   |
| Maturity of restricted securities                                                               |       | 6,251                         |       | 6,244 |   |
| Purchase of securities                                                                          |       | (355,011                      | )          | (162,534 | ) |
| Proceeds from sales of securities and maturing  securities                                      |       | 393,938                       |       | 179,351 |   |
| Increase in other assets                                                                        |       | (827                          | )          | (309 | ) |
| Net cash provided by investing activities                                                       |       | 43,407                        |       | 19,433 |   |
|                                                                                            |       |                          |       |   |   |
| **Cash flows from financing activities:**                                                       |       |                          |       |   |   |
| Proceeds from exercise of stock options and stock  plans                                        |       | 5,690                         |       | 4,840 |   |
| Net cash provided by financing activities                                                       |       | 5,690                         |       | 4,840 |   |
|                                                                                            |       |                          |       |   |   |
| **Net change in cash and cash equivalents**                                                     |       | 67,366                        |       | 10,857 |   |
|                                                                                            |       |                          |       |   |   |
| **Cash and cash equivalents:**                                                                  |       |                          |       |   |   |
| Beginning of period                                                                             |       | 80,358                        |       | 31,017 |   |
| End of period                                                                                   |       | $                             | 147,724    |   | $ | 41,874 |   |
|                                                                                            |       |                          |       |   |   |
| **Supplemental cash flow information:**                                                         |       |                          |       |   |   |
| Cash paid for interest                                                                          |       | $                             | 6,163      |   | $ | 6,542 |   |
| Income tax refunds received                                                                     |       | 4                             |       | 2,183 |   |
| Cash paid for income taxes                                                                      |       | 3,376                         |       | 7,087 |   |

 

The accompanying notes are an integral part of these statements.

 

4

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

### **NOTES TO CONSOLIDATED**CONDENSEDFINANCIAL STATEMENTS

**(Unaudited)**

 

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

 

These unaudited interimconsolidated condensed financial statements have been prepared pursuant to therules and regulations 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.  Certain prioryear amounts have been reclassified to conform to current year presentation.

 

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 were as follows (in thousands):

 
| ** **                        | ** ** | **February 26,  2005** | ** ** | **May 29,  2004** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|-------------------|------------|
| Raw materials and purchased parts |       | $                           | 41,141     |              | $          | 34,710 |   |
| Work-in-process                   |       | 6,569                       |       | 11,219            |       |
| Finished goods                    |       | 19,078                      |       | 12,698            |       |
|                              |       | $                           | 66,788     |              | $          | 58,627 |   |

 

**Note 3 – AccruedLiabilities**

 

Accruedliabilities consisted of the following (in thousands):

 
| ** **                               | ** ** | **February 26,  2005** | ** ** | **May 29,  2004** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|-------------------|------------|
| ** **                               | ** ** | ** **                  | ** ** | ** **        | ** ** |
| Payroll-related                          |       | $                           | 9,159      |              | $          | 10,781 |   |
| Product warranty                         |       | 4,020                       |       | 4,720             |       |
| Interest payable                         |       | 1,264                       |       | 2,805             |       |
| Accrual for loss on purchase commitments |       | 343                         |       | 536               |       |
| Legal settlement accrual                 |       | —                      |       | 3,800             |       |
| Income taxes payable                     |       | 10,900                      |       | 12,212            |       |
| Other                                    |       | 6,988                       |       | 7,527             |       |
|                                     |       | $                           | 32,674     |              | $          | 42,381 |   |

 

See Note 4 for a discussionof the accrual for product warranty.  Thelegal settlement accrual of $3.8 million related to the class action andderivative lawsuit and was paid during the second quarter of fiscal 2005.

 

5

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**Note 4 – ProductWarranty**

 

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

 

Following is areconciliation of the change in the aggregate accrual for product warranty forthe nine months ended February 26, 2005 and February 28, 2004 (inthousands):

 
| ** **                          | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Product warranty accrual, beginning |       | $                           | 4,720      |                        | $          | 3,501 |   |
| Warranty charges incurred           |       | (8,037                      | )          | (5,958                      | )          |
| Inventory credits                   |       | 3,362                       |       | 3,232                       |       |
| Provision for warranty charges      |       | 3,975                       |       | 2,836                       |       |
| Product warranty accrual, ending    |       | $                           | 4,020      |                        | $          | 3,611 |   |

 

**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 delivery of such elements.  Revenue related to maintenance and servicecontracts is deferred and recognized ratably over the duration of thecontracts.

 

The following is a reconciliation of the changes indeferred revenue for the nine months ended February 26, 2005 and February 28,2004 (in thousands):

 
| ** **                  | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Deferred revenue, beginning |       | $                           | 11,985     |                        | $          | 13,222 |   |
| Revenue deferred            |       | 16,847                      |       | 30,442                      |       |
| Revenue recognized          |       | (20,259                     | )          | (27,044                     | )          |
| Deferred revenue, ending    |       | $                           | 8,573      |                        | $          | 16,620 |   |

 

6

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**Note 6 - Earnings Per Share**

 

Followingis a reconciliation of weighted average shares outstanding and adjustments tonet income (loss) used in the calculation of basic and diluted earnings (loss)per share (EPS) for the three months and nine months ended February 26,2005 and February 28, 2004 (inthousands):

 
| ** **                                                   | ** ** | **Three months ended  February 26, 2005** | ** ** | **Three months ended  February 28, 2004** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                   | ** ** | **Income**                                     | ** ** | **Shares**                                     | ** ** | **Income** | ** ** | **Shares** | ** ** |
|                                                         |       |                                           |       |                                           |       |   |   |   |   |
| Net income available to common shareholders – basic     |       | $                                              | 1,998      |                                           | 28,492     |   | $ | 9,974 |   | 28,030 |   |
| Effect of dilutive stock compensation                        |       | —                                         |       | 108                                            |       | — |   | 341 |   |
| Effect of 4 1/4% convertible  subordinated notes             |       | —                                         |       | —                                         |       | 1,090 |   | 3,816 |   |
| Net income available to common shareholders - fully  diluted |       | $                                              | 1,998      |                                           | 28,600     |   | $ | 11,064 |   | 32,187 |   |

 
| ** **                                                                      | ** ** | **Nine months ended  February 26, 2005** | ** ** | **Nine months ended  February 28, 2004** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                      | ** ** | **Income**                                    | ** ** | **Shares**                                    | ** ** | **Loss** | ** ** | **Shares** | ** ** |
|                                                                            |       |                                          |       |                                          |       |   |   |   |   |
| Net income (loss) available to common shareholders –  basic                |       | $                                             | 20,590     |                                          | 28,383     |   | $ | (4,268 | ) | 27,933 |   |
| Effect of dilutive stock compensation                                           |       | —                                        |       | 150                                           |       | — |   | — |   |
| Effect of 4 1/4% convertible  subordinated notes                                |       | —                                        |       | —                                        |       | — |   | — |   |
| Net income (loss) available to common common  shareholders – fully diluted |       | $                                             | 20,590     |                                          | 28,533     |   | $ | (4,268 | ) | 27,933 |   |

 

Thefollowing common stock equivalents were excluded from the diluted EPScalculations because inclusion would have had an antidilutive effect (inthousands):

 
| ** **                             | ** ** | **Three months ended**     | ** ** | **Nine months ended**      | ** ** |
|----------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **February 26, 2005** | ** ** | **February 28, 2004** | ** ** | **February 26, 2005** | ** ** | **February 28, 2004** | ** ** |
| Employee stock options                 |       | 3,316                      |       | 3,395                      |       | 3,462 |   | 3,072 |   |
| 4 1/4% convertible  subordinated notes |       | 3,816                      |       | —                     |       | 3,816 |   | 3,816 |   |
|                                   |       | 7,132                      |       | 3,395                      |       | 7,278 |   | 6,888 |   |

 

#### ***Note 7 - Comprehensive Income (Loss)***

#### * *

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

 
| ** **                                                                 | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                 | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|                                                                       |       |                        |       |                        |       |   |   |   |   |
| Net income (loss)                                                          |       | $                           | 1,998      |                        | $          | 9,974 |   | $ | 20,590 |   | $ | (4,268 | ) |
| Net unrealized gain on foreign exchange hedge  contracts                   |       | 18                          |       | 10                          |       | 24 |   | 5 |   |
| Foreign currency translation adjustment                                    |       | 128                         |       | 108                         |       | 672 |   | 94 |   |
| Net unrealized gain (loss) on securities classified  as available for sale |       | 34                          |       | 363                         |       | 563 |   | (1,135 | ) |
|                                                                       |       | $                           | 2,178      |                        | $          | 10,455 |   | $ | 21,849 |   | $ | (5,304 | ) |

 

7

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#### ***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 and restricted stock issued to its employees under its stock compensationplans, and amortizes deferred compensation, if any, ratably over the vestingperiod 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 iscalculated based on the fair market value on the date of grant and is includedin operating results over the related vesting period using the straight linemethod.  Compensation expense resultingfrom the issuance of performance-based restricted stock is recorded whenperformance can be reasonably estimated, and is calculated based upon currentfair market values (adjusted each period) until such time as the number ofunits an employee is entitled to receive is fixed or determinable.  However, no compensation expense related toperformance-based stock units has been recorded to date because probabilitycannot be assessed that the related three-year performance criteria will be met.  Additionally, 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 the impacton net income (loss) and net income (loss) per share as if the fair value ofstock-based awards to employees had been applied (in thousands, except pershare data) :

 
| ** **                                                                                                                                                        | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|                                                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Net income (loss), as reported                                                                                                                                    |       | $                           | 1,998      |                        | $          | 9,974 |   | $ | 20,590 |   | $ | (4,268 | ) |
| Deduct – Recapture of stock-based employee  compensation expense related to cancellations included in reported net income  (loss), net of related tax effect |       | —                      |       | —                      |       | — |   | (144 | ) |
| Add – Stock-based employee compensation expense  included in reported net income (loss), net of related tax effects                                          |       | 260                         |       | 226                         |       | 531 |   | 308 |   |
| Deduct – total stock-based employee compensation  expense determined under the fair value based method for all awards, net of  related tax effects           |       | (5,590                      | )          | (3,104                      | )          | (19,586 | ) | (7,881 | ) |
| Net income (loss), pro forma                                                                                                                                      |       | $                           | (3,332     | )                           | $          | 7,096 |   | $ | 1,535 |   | $ | (11,985 | ) |
| Net income (loss) per share - basic, as reported                                                                                                                  |       | $                           | 0.07       |                        | $          | 0.36 |   | $ | 0.73 |   | $ | (0.15 | ) |
| Net income (loss) per share – fully diluted, as  reported                                                                                                    |       | $                           | 0.07       |                        | $          | 0.34 |   | $ | 0.72 |   | $ | (0.15 | ) |
| Net income (loss) per share – basic, pro forma                                                                                                               |       | $                           | (0.12      | )                           | $          | 0.25 |   | $ | 0.05 |   | $ | (0.43 | ) |
| Net income (loss) per share – fully diluted pro  forma                                                                                                       |       | $                           | (0.12      | )                           | $          | 0.22 |   | $ | 0.05 |   | $ | (0.43 | ) |

 

8

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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**      | ** ** | **Nine months ended**       | ** ** |
|-------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **              | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|                    |       |                        |       |                        |       |   |   |   |   |
| Risk-free interest rate |       | 3.60                        | %          | 3.25                        | %          | 3.58 | % | 3.34 | % |
| Expected dividend yield |       | 0                           | %          | 0                           | %          | 0 | % | 0 | % |
| Expected lives          |       | 5.7 years                   |       | 5.6 years                   |       | 5.6 years |   | 5.5 years |   |
| Expected volatility     |       | 65.91                       | %          | 68.35                       | %          | 65.66 | % | 67.87 | % |

 

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

 
| ** **              | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** |
|-------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **              | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|                    |       |                        |       |                        |       |   |   |   |   |
| Risk-free interest rate |       | 2.33                        | %          | 2.47                        | %          | 2.30 | % | 2.47 | % |
| Expected dividend yield |       | 0                           | %          | 0                           | %          | 0 | % | 0 | % |
| Expected lives          |       | 1.3 years                   |       | 1.1 year                    |       | 1.2 years |   | 1.1 year |   |
| Expected volatility     |       | 54.39                       | %          | 59.39                       | %          | 54.40 | % | 59.39 | % |

 

OnJanuary 25, 2005, the Compensation Committee of the Board of Directors(the “Compensation Committee”) accelerated the vesting, effective immediately,of all the Company’s unvested stock options awarded to employees, other thanthose awarded to the President and Chief Executive Officer at his time of hire(which are discussed in the next paragraph), having an exercise price greaterthan $20.24.  Except as noted in the followingparagraph, no options were accelerated for members of the Board ofDirectors.  The closing price of theCompany’s common stock on the NASDAQ National Market on January 25, 2005was $17.14.  As a result of theacceleration, options to acquire approximately 220,000 shares of the Company’scommon stock, which otherwise would have vested from time to time over the next42 months, became immediately exercisable.

 

OnJanuary 25, 2005, the Compensation Committee accelerated the vesting of315,000 shares of the Company’s common stock subject to an option granted toNicholas Konidaris, the Company’s President and Chief Executive Officer, sothat the option will become fully exercisable on August 26, 2005.  The option has an exercise price of$25.71.  Under the terms of the originaloption agreement, 105,000 shares would have vested on each of January 7,2006, January 7, 2007 and January 7, 2008.  For book reporting purposes, the Company willbe required to accelerate approximately $1.5 million of unamortized expenserelated to this award ratably over the remaining vesting period, which ends August 26,2005.  This expense would otherwise havebeen expensed ratably through December 2007.  Additionally, a stock option granted to Mr.Konidaris to purchase 40,000 shares of the Company’s common stock wasaccelerated effective January 25, 2005. The option has an exercise price of $25.50.  Under the terms of the original optionagreement, 10,000 shares would have vested on each of July 13, 2005, July 13,2006, July 13, 2007 and July 13, 2008.  In connection with both of theseaccelerations, Mr. Konidaris has agreed that the shares underlying theaccelerated options may not be sold by him until the dates those shares wouldotherwise have been vested under the terms of the original option agreements.

 

OnJune 28, 2004, the Compensation Committee of the Board of Directorsapproved an acceleration of the vesting of those employee stock options,excluding stock options granted to the Board of Directors and Chief ExecutiveOfficer, with an option price equal to or greater than the closing sale priceof $23.38

 

9

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per share on that date, as reported on the NASDAQ National Market.  Options to purchase approximately 1.2 millionshares of stock with varying remaining vesting schedules were subject to theacceleration provision and became immediately exercisable.

 

Thetotal pro forma stock-based employee compensation expense stated above of $19.6million for the nine months ended February 26, 2005 includes $4.0 millionresulting from the January 25, 2005 accelerations and $10.1 millionresulting from the June 28, 2004 acceleration, as calculated under SFASNo. 123.  No compensation has beenrecorded in the statement of operations related to this modification as themarket price of the common stock on the date of the modification was lower thanthe exercise price of the accelerated options.

 

TheCompany has decided to follow the “modified prospective method” in implementingrecent amendments by the Financial Accounting Standards Board in Accounting forStock-Based Compensation upon their effective date (see Note 10).  The Company believes the acceleration of the stockoption vesting schedules as described above will reduce the future amortizationof the Company’s stock option compensation expense for fiscal 2006 and beyondand will enhance comparability of its financial statements with those of priorand future fiscal periods. Additionally, the Compensation Committee has decidedto rely less on stock options for equity-based compensation and evaluate otheralternatives for such compensation in the future.  It believes that the amended vestingprovisions will partially mitigate the effect of this reduction in future stockoption grants on employee retention and incentive.

 

**Note 9 – Restructuringand Cost Management Plans**

 

InDecember 2004, the Company announced a restructuring plan to streamlineits infrastructure.  This plan, which waseffective in early January 2005, resulted in a decrease in workforce of 57employees in the United States and impacted manufacturing, sales, marketing andadministration and research, development and engineering.  Charges incurred of approximately $1.2million related to the plan were primarily comprised of severance and otheremployee-related charges.  These amountswere paid during the third quarter of fiscal 2005 and are included in theconsolidated condensed statements of operations for the three and nine monthsended February 26, 2005 as follows (in thousands):

 
| ** **                                       | ** ** | **Three and nine  months ended  February 26, 2005** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------|------------|
| Cost of goods sold                               |       | $                                                   | 299        |   |
| Selling, service and administrative              |       | 683                                                 |       |
| Research, developments and engineering           |       | 262                                                 |       |
| Total restructuring and cost management expenses |       | $                                                   | 1,244      |   |

 

10

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The Company also initiatedrestructuring and other cost management plans in each of the prior three fiscalyears.  The fiscal 2004 plan consisted ofa headcount reduction to reduce expenditures. The fiscal 2003 actions primarily related to relocating themanufacturing of our electronic component product line from Escondido,California to our headquarters in Portland, Oregon.  The fiscal 2002 actions included a reducingheadcount, exiting the mechanical drill business and discontinuing themanufacture of certain other products and vacating related facilities.  All expenses related to the fiscal 2004 andfiscal 2003 plans have been paid.  As of February 26,2005, we had a remaining amount accrued of approximately $0.4 million forfuture payments, net of estimated sublease rentals, for a property in AnnArbor, Michigan that is leased and sublet through December 2006 and wasvacated as a part of the 2002 restructuring plan.  A detail of expenses by business function forthe three months and nine months ended February 28, 2004 for all plans ispresented below (in thousands):

 
| ** **                                       | ** ** | **Three months ended  February 28, 2004** | ** ** | **Nine months ended  February 28, 2004** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| Cost of goods sold                               |       | $                                              | —     |                                          | $          | 128 |   |
| Selling, service and administrative              |       | 308                                            |       | 1,561                                         |       |
| Research, developments and engineering           |       | —                                         |       | 198                                           |       |
| Total restructuring and cost management expenses |       | $                                              | 308        |                                          | $          | 1,887 |   |

 

**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 123R includes a wide range of share-based compensationarrangements including share options, restricted share plans, performance-basedawards, share appreciation rights, and employee share purchase plans.  SFAS 123R replaces FASB Statement No. 123,Accounting for Stock-Based Compensation (SFAS 123), and supersedes APB OpinionNo. 25, Accounting for Stock Issued to Employees (Opinion 25). SFAS 123Rrequires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements and rescinds the ability ofcompanies to elect the intrinsic value method prescribed under Opinion 25. Thatcost will be measured based on the fair value of the equity or liabilityinstruments issued.  The Company will berequired to implement SFAS 123R for the interim reporting period ending November 26,2005.  If SFAS 123R had been adopted forthe three and nine months ending February 26, 2005, net income would havebeen reduced by $5.3 million ($0.19 per basic and fully diluted share) and $19.1million ($0.68 per basic share and $0.67 per fully diluted share), respectively(see Note 8).

 

InDecember 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, *Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provision with the American Jobs Creation Act of 2004*.  FSP No. 109-2 provides guidance under SFASNo. 109, *Accounting for Income Taxes*, withrespect to recording the potential impact of the repatriation provisions of theAmerican Jobs Creation Act of 2004 (the Jobs Act) on enterprises’ income taxexpense and deferred tax liability.  TheJobs Act was enacted on October 22, 2004. FSP No. 109-2 states that an enterprise is allowed time beyond the financialreporting period of enactment to evaluate the effect of the Jobs Act on itsplan for reinvestment or repatriation of foreign earnings for purposes ofapplying SFAS No. 109.  The Company hasnot yet completed evaluation of the impact of the repatriation provisions.

 

11

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**Note 11 –Subsequent Events**

 

On March 10, 2005, theCompany redeemed the $145.0 million aggregate principal value of theoutstanding 4 1⁄4 % convertible subordinated notes due 2006 (the ConvertibleNotes).  In accordance with the terms ofthe Convertible Note indenture, the redemption price was 101.70% of theprincipal amount of the Convertible Notes, plus accrued and unpaid interest tothe redemption date.  In connection withthe redemption, the Company will record expenses of approximately $4.2 millionin the fourth quarter of fiscal 2005, consisting of the redemption premium, anon-cash charge for unamortized debt issuance costs of approximately $1.6million and other related costs.

 

12

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**Item 2.******** Management’s Discussion and****Analysis of Financial Conditionand 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 yield and productivity gainsin 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 producehigh-speed test, inspection and termination equipment used in the high-volumeproduction of multi-layer ceramic passives (MLCPs) and other passivecomponents, as well as original equipment manufacturer (OEM) machine visionproducts.

 

#### *During thefirst nine months of fiscal 2005, market demand lessened for our productscompared to the levels experienced in the latter half of fiscal 2004.  Order volume was $67.6 million in the firstquarter of fiscal 2005, representing a significant decline from orders of$104.7 million in the fourth quarter of fiscal 2004.  Orders decreased further to $39.8 million in eachof the second and third quarters of fiscal 2005.  Although order levels for the third quarterwere consistent with the second quarter, the mix between product groups changedslightly; decreased orders for passive component products were offset byincreased orders for semiconductor and electronic interconnect group products.*

#### * *

#### *Shipmentswere $48.3 million in the third quarter of fiscal 2005, representing a 16.8%decline from shipments of $58.1 million in the second quarter of fiscal 2005and a 38.0% decline from shipments of $77.9 million in the first quarter.  Accordingly, net sales for the quarterdecreased to $49.1 million from $66.0 million in the second quarter and $72.6million in the first quarter of fiscal 2005.*

#### * *

#### *Grossmargin on sales of $49.1 million was 44%, representing a decrease of 6percentage points from the prior quarter margin on sales of $66.0 million.  Margins were impacted by lower overheadabsorption on reduced production volumes as well as a change in sales mix.  Sales in the current quarter were moreheavily weighted towards established products as customers build capacity onexisting technologies.  Fourth quartershipments and revenues are currently estimated to be in the range of $40million to $50 million and related gross margins are expected to remain in themid-40% range.*

 

13

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#### *Operatingexpenses were $18.7 million for the third quarter compared to $23.1 million inthe second quarter of fiscal 2005, resulting in operating income of $2.7million in the third quarter.  Operatingexpenses in the third quarter include $0.9 million of a total $1.2 million incharges related to a restructuring and cost management plan announced in December 2004and are primarily comprised of severance and other employee-related costs.  The previous quarter’s operating expensesincluded $2.2 million for legal and settlement fees related to a patentinfringement lawsuit.  We anticipateoperating expenses in the fourth quarter to be in the range of $18 million to $19million.*

 

**Results of Operations**

 

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

 
| ** **                            | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** |
|---------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|                                  |       |                        |       |                        |       |   |   |   |   |
| Net sales                             |       | 100.0                       | %          | 100.0                       | %          | 100.0 | % | 100.0 | % |
| Cost of sales                         |       | 56.3                        |       | 60.3                        |       | 51.4 |   | 65.0 |   |
| Gross margin                          |       | 43.7                        |       | 39.7                        |       | 48.6 |   | 35.0 |   |
| Selling, service and administrative   |       | 25.1                        |       | 23.0                        |       | 22.7 |   | 33.0 |   |
| Research, development and engineering |       | 13.0                        |       | 9.2                         |       | 11.0 |   | 13.3 |   |
| Operating income (loss)               |       | 5.6                         |       | 7.5                         |       | 14.9 |   | (11.3 | ) |
| Total other expense, net              |       | (0.2                        | )          | (0.4                        | )          | (0.3 | ) | (0.1 | ) |
| Income (loss) before taxes            |       | 5.4                         |       | 7.1                         |       | 14.6 |   | (11.4 | ) |
| Income tax provision (benefit)        |       | 1.3                         |       | (9.9                        | )          | 3.6 |   | (8.0 | ) |
| Net income (loss)                     |       | 4.1                         | %          | 17.0                        | %          | 11.0 | % | (3.4 | )% |

 

***Net Sales***

 

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

 
| ** **                          | ** ** | **Three  months ended**     | ** ** |
|-------------------------------------|------------|-----------------------------|------------|
| ** **                          | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
| ** **                          | ** ** | **Net Sales**               | ** ** | **% of Net  Sales** | ** ** | **Net Sales** | ** ** | **% of Net  Sales** | ** ** |
|                                |       |                        |       |   |   |   |   |   |   |
| Semiconductor Group (SG)            |       | $                           | 29,712     |   | 61 | % | $ | 37,068 |   | 63 | % |
| Passive Components Group (PCG)      |       | 12,479                      |       | 25 |   | 12,562 |   | 21 |   |
| Electronic Interconnect Group (EIG) |       | 6,893                       |       | 14 |   | 9,140 |   | 16 |   |
|                                |       | $                           | 49,084     |   | 100 | % | $ | 58,770 |   | 100 | % |

 
| ** **                          | ** ** | **Nine  months ended**      | ** ** |
|-------------------------------------|------------|-----------------------------|------------|
| ** **                          | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
| ** **                          | ** ** | **Net Sales**               | ** ** | **% of Net  Sales** | ** ** | **Net Sales** | ** ** | **% of Net  Sales** | ** ** |
|                                |       |                        |       |   |   |   |   |   |   |
| Semiconductor Group (SG)            |       | $                           | 109,383    |   | 58 | % | $ | 70,941 |   | 57 | % |
| Passive Components Group (PCG)      |       | 51,061                      |       | 27 |   | 31,117 |   | 25 |   |
| Electronic Interconnect Group (EIG) |       | 27,264                      |       | 15 |   | 23,341 |   | 18 |   |
|                                |       | $                           | 187,708    |   | 100 | % | $ | 125,399 |   | 100 | % |

 

Net sales were $49.1 million forthe quarter ended February 26, 2005, a decreaseof $9.7 million or 16.5% compared to net sales of $58.8 million for the quarterended February 28, 2004.  Salesdecreased 20% and 25% for SG and EIG respectively, while sales for PCG in thethird quarter of fiscal 2005 were comparable with the same period in the prioryear.  Sales decreases in SG for thethird quarter of fiscal 2005 compared to the third quarter of fiscal 2004resulted primarily from a decrease in system sales volumes.  Shipments and related revenues have decreasedsequentially by quarter during fiscal 2005 after a peak in sales in the fourthquarter of fiscal 2004.  This decreasingcapital equipment investment trend is consistent with the

 

14

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trend in the overall semiconductor market.  PCG sales remained consistent with the samequarter of the prior year as component manufacturers remained cautious aboutequipment purchases and ran factories at less than full capacity.  EIG sales levels decreased in the thirdquarter of fiscal 2005 compared to the same period in the prior year as aresult of industry softness and fewer integrated circuit (IC) packaging systemssold.

 

Revenue is deferred pending title transfer and fulfillmentof acceptance criteria, which frequently occur at the time of delivery to acommon carrier.  Shipments for whichtitle transfer has not occurred and/or acceptance criteria cannot bedemonstrated at our factory include sales to Japanese end-user customers andshipments of substantially new products. Due to these factors, as well as the timing of theiroccurrence in any given quarter, deferred revenue balances may fluctuatesignificantly from quarter to quarter.  In sales involvingmultiple element arrangements, the fair value of any undelivered elements,including installation services, is deferred until delivery of suchelements.  Revenue related to maintenanceand service contracts is deferred and recognized ratably over the duration ofthe contracts.

 

The detail of the activity indeferred revenue for the first three quarters of fiscal 2005 is presented inthe table below (in thousands).  Deferredrevenue recognized in the third quarter of fiscal 2005 consisted primarily ofsystems shipped to Japanese customers in prior quarters gaining acceptance inthe current quarter.  These sales aregenerally associated with PCG customers.

 
| ** **                   | ** ** | **Three Months Ended**      | ** ** |
|------------------------------|------------|-----------------------------|------------|
| ** **                   | ** ** | **February 26,  2005** | ** ** | **November 27,  2004** | ** ** | **August 28,  2004** | ** ** |
|                         |       |                        |       |   |   |   |   |
| Beginning balance            |       | $                           | 9,375      |   | $ | 17,187 |   | $ | 11,985 |   |
| Revenue deferred             |       | 3,723                       |       | 3,893 |   | 9,231 |   |
| Revenue recognized and other |       | (4,525                      | )          | (11,705 | ) | (4,029 | ) |
| Ending balance               |       | $                           | 8,573      |   | $ | 9,375 |   | $ | 17,187 |   |

 

Net sales were $187.7 million forthe nine months ended February 26, 2005, anincrease of $62.3 million or 49.7% compared to net sales of $125.4 million forthe nine months ended February 28, 2004. Of the increase, $38.4 million resulted from increased sales in the SGproduct lines and is attributed to major DRAM manufacturers increasing capacity,primarily in the memory repair product line. This trend with DRAM manufacturers began in the second quarter of fiscal2004 and reached its highest level in the fourth quarter of fiscal 2004.  An additional $19.9 million or 32% of theincrease resulted from PCG sales generated by demand for passive componentsprocessed by our laser trim and passive test systems.  This growth in demand began in the secondhalf of fiscal 2004 and has since softened as PCG manufacturers delay buildingcapacity until factory utilization reaches desired levels.  The remaining increase of $4.0 million wasgenerated by EIG resulting from acceptance of new products in the IC packagesegment shipped in prior quarters.

 

15

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

 
| ** **    | ** ** | **Three  months ended**     | ** ** |
|---------------|------------|-----------------------------|------------|
| ** **    | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
| ** **    | ** ** | **Net Sales**               | ** ** | **% of Net  Sales** | ** ** | **Net Sales** | ** ** | **% of Net  Sales** | ** ** |
|          |       |                        |       |   |   |   |   |   |   |
| Asia          |       | $                           | 35,653     |   | 73 | % | $ | 40,680 |   | 69 | % |
| United States |       | 11,261                      |       | 23 |   | 12,104 |   | 21 |   |
| Europe        |       | 2,170                       |       | 4 |   | 5,986 |   | 10 |   |
|          |       | $                           | 49,084     |   | 100 | % | $ | 58,770 |   | 100 | % |

 
| ** **    | ** ** | **Nine  months ended**      | ** ** |
|---------------|------------|-----------------------------|------------|
| ** **    | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
| ** **    | ** ** | **Net Sales**               | ** ** | **% of Net  Sales** | ** ** | **Net Sales** | ** ** | **% of Net  Sales** | ** ** |
|          |       |                        |       |   |   |   |   |   |   |
| Asia          |       | $                           | 140,331    |   | 75 | % | $ | 86,653 |   | 69 | % |
| United States |       | 31,994                      |       | 17 |   | 26,175 |   | 21 |   |
| Europe        |       | 15,383                      |       | 8 |   | 12,571 |   | 10 |   |
|          |       | $                           | 187,708    |   | 100 | % | $ | 125,399 |   | 100 | % |

 

Regionalsales results in the third quarter of fiscal 2005 shifted slightly from thethird quarter of fiscal 2004. The percentage of total net sales to Asiaincreased 4 percentage points and the percentage of total net sales to theUnited States increased 2 percentage points, while total net sales to Europedecreased 6 percentage points.  Thedecrease in Europe can be attributed to fewer SG system sales into the regionin the current quarter, which is consistent with the general trend ofsemiconductor manufacturing moving from Europe to Asia.  For the nine months ended February 26,2005, compared to the nine months ended February 28, 2004, sales by regionwere also more heavily weighted to Asia and particularly to Taiwan.  This increase in sales resulted from volumeincreases of both SG and PCG products over the prior year.

 

***GrossProfit***

 

Gross profit was $21.4 million(43.7% of net sales) for the third quarter of fiscal 2005 compared to $23.3million (39.7% of net sales) for the third quarter of fiscal 2004.  Althoughshipments in the third quarter of fiscal 2005 decreased 12.8% compared to thesame quarter in fiscal 2004, we were able to maintain improved margin ratesthrough volume-based manufacturing efficiencies and lower overhead costs perunit.

 

Gross profit for the nine monthperiod ended February 26, 2005 was $91.2 million (48.6% of net sales)compared to $43.8 million (35.0% of net sales) for the same nine month periodin the prior fiscal year.  This represents a 13.6% improvement in grossmargin rates.  Shipments of $184.3 million in the first nine months offiscal 2005 were 43.2% higher than the $128.7 million of shipments for the samenine months in fiscal 2004.  Increased shipment levels resulted involume-based manufacturing efficiencies and lower costs per unit.

 

16

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***Operating Expenses***

 

Selling, Service and Administrative Expenses

 
| ** **                                                                  | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **(in thousands)**                                                          | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|                                                                        |       |                        |       |                        |       |   |   |   |   |
| Selling, service and administration                                         |       | $                           | 12,290     |                        | $          | 13,502 |   | $ | 42,494 |   | $ | 41,408 |   |
| Included in totals above:                                                   |       |                        |       |                        |       |   |   |   |   |
| Patent litigation settlement and legal fees                                 |       | —                      |       | —                      |       | 2,240 |   | — |   |
| Legal and professional fees – investigation and  securities litigation |       | 53                          |       | 694                         |       | 820 |   | 3,371 |   |
| Restructuring and cost management plans                                     |       | 683                         |       | 308                         |       | 683 |   | 1,561 |   |
| Impact of special charges                                                   |       | $                           | 736        |                        | $          | 1,002 |   | $ | 3,743 |   | $ | 4,932 |   |

 

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 $12.3 million (25.1%of net sales) in the third quarter of fiscal 2005, a decrease of $1.2 millioncompared to $13.5 million (23.0% of net sales) in the third quarter of fiscal2004.  For the nine months ended February 26,2005, selling, service and administrative expenses increased $1.1 million to$42.5 million (22.7% of net sales) compared to $41.4 million (33.0% of netsales) for the nine months ended February 28, 2004.

 

Other special charges includedin this category consist of charges relating to restructuring actions, patent litigationsettlement and related legal fees and professional fees related to the 2003 auditcommittee investigation and securities litigation.  The amounts and timing of these specialcharges are detailed above for comparative purposes.  Exclusive of these special charges, selling,service and administrative expenses decreased $0.9 million in the third quarterof fiscal 2005 compared to the third quarter of fiscal 2004 and increased $2.3 millionfor the first nine months of fiscal 2005 compared to the first nine months of fiscal2004.

 

The decrease in selling,service and administrative expenses of $0.9 million, exclusive of the specialcharges detailed above, for the three months ended February 26, 2005compared to the same period in the prior year is primarily due to a decrease inprofessional fees. Additionally, expenses decreased due to a one-week plantshutdown in December 2004 and cost containment initiatives implemented infiscal 2005.

 

The increase in selling,service and administrative expenses of $2.3 million, exclusive of the specialcharges detailed above, for the nine months ended February 26, 2005compared to the same period in the prior year is primarily due to increasedcompensation costs resulting from a higher average headcount in fiscal 2005year-to-date compared to fiscal 2004 year-to-date and an increase in salescommissions, offset by a decrease in professional fees.

 

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Research, Development andEngineering Expenses

 
| ** **                              | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **(in thousands)**                      | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** | **February 26,  2005** | ** ** | **February 28,  2004** | ** ** |
|                                    |       |                        |       |                        |       |   |   |   |   |
| Research, development and engineering   |       | $                           | 6,400      |                        | $          | 5,429 |   | $ | 20,706 |   | $ | 16,593 |   |
| Included in totals above:               |       |                        |       |                        |       |   |   |   |   |
| Restructuring and cost management plans |       | 262                         |       | —                      |       | 262 |   | 198 |   |
| Impact of special charges               |       | $                           | 262        |                        | $          | — |   | $ | 262 |   | $ | 198 |   |

 

Research, development andengineering expenses are primarily comprised of labor and otheremployee-related expenses, professional fees, project materials, equipment andfacilities costs.  Expenses associatedwith research, development and engineering totaled $6.4 million (13.0% of netsales) for the third quarter of fiscal 2005, representing a $1.0 millionincrease from expenses of $5.4 million (9.2% of net sales) for the thirdquarter of fiscal 2004.  For the ninemonths ended February 26, 2005, research, development and engineeringexpenses increased $4.1 million to $20.7 million (11.0% of net sales) comparedto $16.6 million (13.3% of net sales) for the nine months ended February 28,2004.

 

Exclusive of special charges for previousrestructuring and cost management plans detailed in the table above, research,development and engineering costs increased $0.7 million and $4.0 million,respectively, for the three and nine month periods ended February 26, 2005compared to the same periods in the prior year.

 

The $0.7 million increase inresearch and development costs, exclusive of the special charges detailedabove, for the three months ended February 26, 2005 compared to the sameperiod in fiscal 2004 is primarily due to an increase in subcontracted andprofessional services and materials used in research and developmentactivities.

 

The $4.0 million increase inresearch and development costs, exclusive of the special charges detailedabove, for the nine months ended February 26, 2005 compared to the sameperiod in fiscal 2004 is primarily due an increase in compensation costs due toa higher average headcount in fiscal 2005 year-to-date compared to fiscal 2004year-to-date, an increase in legal fees related to patent registration andmaintenance, an increase in subcontracted services and materials used in researchand development activities and numerous other cost increases related to ourcontinued investment in funding for development projects, new technicalcapabilities and initiatives.

 

***Restructuring and CostManagement Plans***

 

In December 2004, weinitiated a restructuring plan designed to streamline our technologydevelopment efforts and enhance our customer-centric focus through severalactions, including centralizing our research, development and engineeringfunction, creating a technical marketing solutions group and creating acustomer-centric manufacturing organization. In conjunction with the restructuring, 57 positions were eliminated in ourU.S. operations, impacting all employee groups. The restructuring actions were completed in early January 2005 andwe incurred and paid approximately $1.2 million in charges related to thefiscal 2005 restructuring plan during the third quarter, as detailed below.  Ongoing annual savings related to thisrestructuring are currently estimated to be approximately $6.0 million, ofwhich approximately $4.7 million will impact operating expenses.

 

We also initiatedrestructuring and other cost management plans in fiscal 2004 and the twoprevious fiscal years.  The fiscal 2004plan consisted of a headcount reduction to reduce expenditures.  The fiscal 2003 actions primarily related torelocating the manufacturing of our electronic component product line

 

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from Escondido, Californiato our headquarters in Portland, Oregon. The fiscal 2002 actions included a reducing headcount, exiting themechanical drill business and discontinuing the manufacture of certain otherproducts and vacating related facilities. All expenses related to the fiscal 2005, fiscal 2004 and fiscal 2003plans have been paid.  As of February 26,2005, we had a remaining amount accrued of approximately $0.4 million forfuture payments, net of estimated sublease rentals, for a property in AnnArbor, Michigan that is leased and sublet through December 2006 and wasvacated as a part of the 2002 restructuring plan.  A detail of expenses by business function forthe three months and nine months ended February 26, 2005 and February 28,2004 is presented below (in thousands):

 
| ** **                                          | ** ** | **Three  months ended February 26, 2005** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                          | ** ** | **Cost of  Goods Sold**                        | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development  and Engineering** | ** ** | **Total** | ** ** |
| Fiscal 2005 restructuring and  cost management plan |       | $                                              | 299        |   | $ | 683 |   | $ | 262 |   | $ | 1,244 |   |
|                                                |       | $                                              | 299        |   | $ | 683 |   | $ | 262 |   | $ | 1.244 |   |

 
| ** **                                          | ** ** | **Nine  months ended February 26, 2005** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                          | ** ** | **Cost of  Goods Sold**                       | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development  and Engineering** | ** ** | **Total** | ** ** |
| Fiscal 2005 restructuring and  cost management plan |       | $                                             | 299        |   | $ | 683 |   | $ | 262 |   | $ | 1,244 |   |
|                                                |       | $                                             | 299        |   | $ | 683 |   | $ | 262 |   | $ | 1.244 |   |

 
| ** **                        | ** ** | **Three  months ended February 28, 2004** | ** ** |
|-----------------------------------|------------|------------------------------------------------|------------|
| ** **                        | ** ** | **Cost of  Goods Sold**                        | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development  and Engineering** | ** ** | **Total** | ** ** |
| Fiscal 2004 cost management  plan |       | $                                              | —     |   | $ | 61 |   | $ | — |   | $ | 61 |   |
| Fiscal  2003 cost management plan |       | —                                         |       | 214 |   | — |   | 214 |   |
| Fiscal  2002 cost management plan |       | —                                         |       | 33 |   | — |   | 33 |   |
|                              |       | $                                              | —     |   | $ | 308 |   | $ | — |   | $ | 308 |   |

 
| ** **                        | ** ** | **Nine  months ended February 28, 2004** | ** ** |
|-----------------------------------|------------|-----------------------------------------------|------------|
| ** **                        | ** ** | **Cost of  Goods Sold**                       | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development  and Engineering** | ** ** | **Total** | ** ** |
| Fiscal 2004 cost management  plan |       | $                                             | 123        |   | $ | 679 |   | $ | 191 |   | $ | 993 |   |
| Fiscal  2003 cost management plan |       | 5                                             |       | 524 |   | 7 |   | 536 |   |
| Fiscal  2002 cost management plan |       | —                                        |       | 358 |   | — |   | 358 |   |
|                              |       | $                                             | 128        |   | $ | 1,561 |   | $ | 198 |   | $ | 1,887 |   |

 

***Income Taxes***

 

The income tax provisionrecorded for the third quarter of fiscal 2005 was $0.7 million on pretax incomeof $2.7 million, an effective rate of 25%. The fiscal year-to-date provision for income taxes at February 26,2005 is $6.7 million on pretax income of $27.3 million, an effective annual rateof 25%.  The estimated effective annual taxrate for fiscal 2005 of 25% is lower than our statutory tax rate of 36%,primarily due to incentives for export sales and research credits.

 

The income tax benefit forthe third quarter of fiscal year 2004 was $5.8 million despite recordingpre-tax income of $4.2 million for the quarter. The tax benefit recorded was a result of the dollar amount of permanentincome tax deductions and tax credits relative to estimated pre-tax earnings.  The income tax benefit rate for the ninemonths ended February 28, 2004 was 70%. This effective rate was higher than the statutory tax rate as a resultof the inclusion of certain export tax incentives and increased research anddevelopment tax credits as a result of tax returns filed in fiscal 2004.

 

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We currently have anoutstanding examination by the Internal Revenue Service for our tax returns forthe tax years ending in 1996 through 2003. Although the examination is substantially complete, the final outcome ofthe federal tax audit is uncertain.  Webelieve the ultimate results will not have a materially adverse effect on ourresults of operations or financial position.

 

***Net Income (Loss)***

 

Net income for the threemonths ended February 26, 2005 was $2.0 million (4.1% of net sales) or $0.07per share on a basic and fully diluted basis and for the nine months ended February 26,2005 was $20.6 million (11.0% of net sales) or $0.73 and $0.72 per share on abasic and fully diluted basis, respectively. For the three months ended February 28, 2004, we recorded net incomeof $10.0 million (17.0% of net sales) or $0.36 and $0.34 per share on a basicand fully diluted basis, respectively. For the nine months ended February 28, 2004, we recorded a net lossof $4.3 million (3.4% of net sales) or $0.15 per share on a basic and fullydiluted basis.

 

**Liquidityand Capital Resources**

 

At February 26, 2005,our principal sources of liquidity consisted of existing cash, cash equivalentsand marketable securities of $355.5 million and accounts receivable of $36.8million.  At February 26, 2005, wehad a current ratio of 2.3 and no long-term debt.  The principal value of our convertiblesubordinated notes is classified as a short-term liability at February 26,2005 as the notes were redeemed on March 10, 2005.  As a result, working capital decreased to $247.8million at February 26, 2005 from $369.9 million at May 29, 2004.  We believe that our existing cash, cashequivalents and marketable securities are adequate to fund the redemption ofour notes and our operations for at least the next twelve months.

 

Cash flows from operatingactivities for the nine months ended February 26, 2005 totaled $18.3 million.  Factors impacting cash flows from operationsincluded increases in inventories, decreases in trade receivables, estimatedincome tax payments and decreases in payables and current liabilities.

 

Net inventories increased 13.9%to $66.8 million at the end of the third quarter compared to $58.6 million atMay 29, 2004.  The increase is comprisedprimarily of additions to finished goods due to delayed timing of shipmentspreviously anticipated in the first three quarters of fiscal 2005 and increasesin raw materials due to anticipated production requirements in the fourthquarter of fiscal 2005.

 

Net trade receivables were$36.8 million at February 26, 2005 compared to $51.7 million at May 29,2004, a decrease of $14.9 million inclusive of an increase of $2.0 million dueto non-cash currency translation adjustments resulting from the weakening ofthe U.S. dollar.  The increase due tocurrency translation is substantially offset by currency translationadjustments to current liabilities discussed below, with the differenceincluded as a component of other comprehensive income.  The remaining decrease is due to lowerrevenue levels in the third quarter combined with strong collection activities.

 

Payables and currentliabilities, exclusive of the convertible subordinated notes, were $38.4 millionat February 26, 2005 compared to $55.6 million at May 29, 2004, decreasingby $17.2 million, inclusive of an increase of $1.1 million due to non-cashcurrency translation adjustments resulting from the weakening of the U.S.dollar.  Approximately $7.6 million ofthe decrease was due to a reduction in purchases in response to a softening ofdemand for our products.  The remainingdecrease in other liabilities is due primarily to the litigation settlement andlegal fee payments, reductions in estimated income taxes payable, decreasedpayroll liabilities and various other reductions in operating accruals.

 

Cash flows from investingactivities totaled $43.4 million for the nine months ended February 26,2005.  Capital expenditures totaled $3.4million during this period and were comprised of computer equipment

 

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and systems upgrades, andinvestments in production and test equipment and facilities.  We generated $2.4 million in cash in June of2004 from the sale of an undeveloped parcel of land in Taiwan classified as anasset held for sale at May 29, 2004.  Wealso generated $45.2 million in cash and cash equivalents through theliquidation of restricted investments and sales of investments in our portfolioof marketable securities.  Theseinvestment transactions were undertaken primarily to fund regularly scheduledsemi-annual interest payments on the convertible subordinated notes and theredemption of the notes on March 10, 2005.

 

Cash flows from financingactivities of $5.7 million were comprised of proceeds from the exercise ofstock options for the nine months ended February 26, 2005.

 

At February 26, 2005 wehad $143.4 million recorded on our balance sheet related to our 41⁄4% convertiblesubordinated notes due December 21, 2006 (the Convertible Notes).  The $1.6 million difference between the$145.0 million face value and the $143.4 million balance at February 26,2005 relates to underwriting discounts, which originally totaled $4.5million.  These discounts are beingamortized as additional interest expense over the life of the Convertible Notesat a rate of $0.9 million per year, resulting in a corresponding accretion tothe recorded amount of the notes.  Duringthe first and third quarters of fiscal 2005, we made semi-annual interestpayments of $3.1 million each which were fully funded by the liquidation ofrestricted securities.

 

Subsequent to the end of thethird quarter, on March 10, 2005, we redeemed the $145.0 million aggregateprincipal value of the outstanding Convertible Notes.  In accordance with the terms of theConvertible Note indenture, the redemption price was 101.70% of the principalamount of the Convertible Notes, plus accrued and unpaid interest to theredemption date.  In connection with theredemption, we will record expenses of approximately $4.2 million in the fourthquarter of fiscal 2005, consisting of the redemption premium, a non-cash chargefor unamortized debt issuance costs of approximately $1.6 million and otherrelated costs.

 

Additionally,as a result of the Convertible Notes redemption, quarterly interest income isexpected to decrease due to the related liquidation of marketable securities.  As a result of that impact combined with the$4.2 million in redemption expenses described above and the partial offset by thereduction in related interest expense, net other expense is expected toincrease by approximately $3.2 million in the fourth quarter of fiscal 2005.  Beginning in fiscal year 2006, we expect theimpact of the redemption will increase net other income by approximately $1million per quarter.

 

**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 29, 2004 as filed with theSecurities and Exchange Commission on July 29, 2004.

 

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**FactorsThat May Affect Future Results**

 

Described below are some ofthe factors that could cause actual results to differ materially from theresults contemplated by the forward-looking statements contained in thisreport.  See “Forward Looking Statements”at the beginning of this Item 2.

 

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

 

Our business depends uponthe capital expenditures of manufacturers of components and circuitry used inwireless communications, computers and other electronic products.  In the past, the markets for electronicdevices have experienced sharp downturns. During these downturns, electronics manufacturers, including ourcustomers, have delayed or canceled capital expenditures, which has had anegative impact on our financial results.

 

After experiencing asignificant increase in orders in fiscal 2004, we experienced reduced demandbeginning in the first quarter of fiscal 2005. Net sales decreased from $81.8 million in the fourth quarter of fiscal2004 to $72.6 million, $66.0 million and $49.1 million in the first, second andthird quarters of fiscal 2005, respectively. Net income during those periods decreased from $16.2 million in thefourth quarter of fiscal 2004 to $10.6 million, $7.9 million and $2.0 millionin the first, second and third quarters of fiscal 2005, respectively.  We cannot assure you when, or if, demand forour products will increase or that demand will not further decrease.  Even if demand for our products doesincrease, there may be significant fluctuations in our profitability and netsales.

 

During any downturn,including the current downturn, it will be difficult for us to maintain oursales levels.  As a consequence, tomaintain profitability we will need to reduce our operating expenses.  For example, in December 2004 weannounced an operational restructuring and reduction in force to reduce ourexpenses in connection with the current downturn.  Our ability to quickly reduce fixed 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.

 

***Delays in manufacturing, shipment or customer acceptance of ourproducts could substantially decrease our sales for a period.***

 

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

 

In addition, we derive asubstantial portion of our revenue from the sale of a relatively small numberof products with high average selling prices, some with prices in excess of $1million per unit.  Consequently, shipmentand/or customer acceptance delays could significantly impact our recognition ofrevenue and could be further magnified by announcements from us or ourcompetitors of new products and technologies, which announcements could causeour customers to defer purchases of our existing systems or purchase productsfrom our competitors.  Any of thesedelays could result in a material adverse change in our results of operationsfor any particular period.

 

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***Failure of critical suppliers of parts, components and manufacturingequipment to deliver sufficient quantities to us in a timely and cost-effectivemanner could negatively affect our business.***

 

We use a wide range of materialsin the production of our products, including custom electronic and mechanicalcomponents, and we use numerous suppliers for those materials.  We generally do not have guaranteed supplyarrangements with our suppliers.  We seekto reduce the risk of production and service interruptions and shortages of keyparts by selecting and qualifying alternative suppliers for key parts,monitoring the financial stability of key suppliers and maintaining appropriateinventories of key parts.  Although wemake reasonable efforts to ensure that parts are available from multiplesuppliers, some key parts are available only from a single supplier or alimited group of suppliers in the short term. Operations at our suppliers’ facilities are subject to disruption for avariety of reasons, including changes in business relationships, competitivefactors, work stoppages, 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 significant customers and we do not have long-termcontracts with any of our customers.***

 

Our top tencustomers for fiscal 2004 accounted for approximately 61% of total net sales infiscal 2004, with one customer accounting for approximately 26% of total netsales in fiscal 2004.  No other customerin fiscal 2004 accounted for more than 10% of total net sales.  In addition, none of our customers has anylong-term obligation to continue to buy our products or services, and anycustomer could delay, reduce or cease ordering our products or services at anytime.

 

***Our markets are subject to rapid technological change, and to competeeffectively we must continually introduce new products that achieve marketacceptance.***

 

The markets for our products arecharacterized by rapid technological change and innovation, frequent newproduct introductions, changes in customer requirements and evolving industrystandards.  Our future performance willdepend on the successful development, introduction and market acceptance of newand enhanced products that address technological changes as well as current andpotential customer requirements.  Theintroduction by us or by our competitors of new and enhanced products may causeour customers to defer or cancel orders for our existing products, which mayharm our operating results.  We have inthe past experienced and are currently experiencing a slowdown in demand forour products.  In the past we have alsoexperienced delays in new product development. Similar slowdowns and 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 overcoming resourcelimitations;

•                  Difficulties with contract manufacturers;

•                  Changing market or competitive product requirements; and

•                  Unanticipated engineering complexities.

 

The development of new,technologically advanced products is a complex and uncertain process, requiringhigh levels of innovation and highly skilled engineering and developmentpersonnel, as well as the accurate anticipation of technological and markettrends.  We cannot assure you that wewill be able to identify, develop, manufacture, market or support new orenhanced products successfully, if at all, or on a timely

 

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basis.  Further, we cannot assure you that our newproducts will gain market acceptance or that we will be able to respondeffectively to product announcements by competitors, technological changes oremerging industry standards.  Any failureto respond to technological change that may render our current products ortechnologies obsolete could significantly harm our business.

 

***Our ability to reduce costs is limited by our need to invest in researchand development.***

 

Our industry is characterized bythe need for continued 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 bematerially and adversely affected.  As aresult of our need to maintain our spending levels in this area, our operatingresults could be materially harmed if our net sales fall belowexpectations.  In addition, as a resultof our emphasis on research and development and technological innovation, ouroperating costs may increase further in the future, and research anddevelopment expenses may increase as a percentage of total operating expensesand as a percentage of net sales.

 

***We are exposed to the risks that others may violate our proprietaryrights, and our intellectual property rights may not be well protected inforeign countries.***

 

Our success is dependent upon theprotection of our proprietary rights.  Inthe high technology industry, intellectual property is an important asset thatis always at risk of infringement.  Weincur substantial costs to obtain and maintain patents and defend ourintellectual property.  For example, wehave initiated litigation alleging that certain parties have violated variouspatents of ours.  We rely upon the lawsof the United States and of foreign countries in which we develop, manufactureor sell our products to protect our proprietary rights.  However, these proprietary rights may notprovide the competitive advantages that we expect or other parties maychallenge, invalidate or circumvent these rights.

 

Further, our efforts to protectour intellectual property may be less effective in some foreign countries whereintellectual property rights are not as well protected as in the UnitedStates.  Many U.S. companies haveencountered substantial 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.

 

***We may be subject to claims of intellectual property infringement.***

 

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

 

If we become subject toinfringement claims, we will evaluate our position and consider the availablealternatives, which may include seeking licenses to use the technology inquestion or defending our position. These licenses, however, may not beavailable on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commerciallyreasonable terms or successfully defend our position, our financial conditionand results of operations could be materially and adversely affected.

 

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***Our business ishighly competitive, and if we fail to compete effectively, our business will beharmed.***

 

The industries in which weoperate are highly competitive.  We facesubstantial competition from established competitors, some of which havegreater financial, engineering, manufacturing and marketing resources than wedo.  If we are unable to competeeffectively with these companies, our market share may decline and our businesscould be harmed.  Our competitors can beexpected to continue to improve the design and performance of their productsand to introduce new products.  Newcompanies may enter the markets in which we compete, or industry consolidationmay occur, further increasing competition in those markets.  Furthermore, our technological advantages maybe reduced or lost as a result of technological advances by our competitors.

 

Their greater resources in theseareas may enable them to:

•                  Betterwithstand periodic downturns;

•                  Competemore effectively on the basis of price and technology; and

•                  Morequickly develop enhancements to and new generations of products.

 

We believe that our ability tocompete successfully depends on a number of factors, including:

•                  Performanceof our products;

•                  Qualityof our products;

•                  Reliabilityof our products;

•                  Costof using our products;

•                  Consistentavailability of critical components;

•                  Ourability to ship products on the schedule required;

•                  Qualityof the technical service we provide;

•                  Timelinessof the services we provide;

•                  Oursuccess in developing new products and enhancements;

•                  Existingmarket and economic conditions; and

•                  Priceof our products as compared to our competitors’ products.

 

We may not be able to competesuccessfully in the future, and increased competition may result in pricereductions, reduced profit margins and loss of market share.

 

***The loss of key management or our inability to attract, retain andassimilate sufficient numbers of managerial, financial, engineering and othertechnical personnel could have a material effect upon our results ofoperations.***

 

Ourcontinued success depends, in part, upon key managerial, financial, engineeringand technical personnel as well as our ability to continue to attract, retainand assimilate additional personnel.  Theloss of key personnel could have a material adverse effect on our business orresults of operations.  We may not beable to retain our key managerial, financial, engineering and technicalemployees.  Attracting qualifiedpersonnel is difficult, and our efforts to attract and retain these personnelmay not be successful.  In addition, wemay not be able to assimilate qualified personnel, including any new members ofsenior management, which could disrupt our operations.

 

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***Our worldwide direct sales and service operations expose us toemployer-related risks in foreign countries.***

 

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

 

***We may make additional acquisitions in the future, and theseacquisitions may subject us to risks associated with integrating these businessesinto our current business.***

 

Although we have no commitmentsor agreements for any acquisitions, in the future we may make acquisitions of,or significant investments in, businesses with complementary products, servicesor technologies.

 

Acquisitions involve numerousrisks, many of which are unpredictable 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;

•                  The risk that the issuance of our common stock in a transaction could bedilutive to our shareholders if anticipated synergies are not realized; and

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

 

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

 

26

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***We are exposed to the risks of operating a global business, includingrisks associated with exchange rate fluctuations, legal and regulatory changesand the impact of regional and global economic disruptions.***

 

International shipments accountedfor 83% of net sales for the first nine months of fiscal 2005, with 76% of ournet sales to customers in Asia.  Weexpect that international shipments will continue to represent a significantpercentage of net sales in the future. Our non-U.S. sales and operations are subject to risks inherent inconducting business abroad, many of which are outside our control, includingthe 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;

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

•                  Difficulties in managing a global enterprise, including staffing, collectingaccounts receivable, managing distributors and representatives and repatriationof earnings.

 

Our business and operatingresults are subject to uncertainties arising out of the possibility of regionalor global economic disruptions (including those resulting from naturaldisasters), the economic consequences of military action or terroristactivities and associated political instability, and the impact of heightenedsecurity concerns on domestic and international travel and commerce.  In particular, due to these uncertainties weare subject to:

 

•                  The risk that futuretightening of immigration controls may adversely affect the residence status ofnon-U.S. engineers and other key technical employees in our U.S. facilities orour ability to hire new non-U.S. employees in such facilities;

•                  The risk of morefrequent instances of shipping delays; and

•                  The risk that demandfor our products may not increase or may decrease.

 

***Failure to achieve andmaintain effective internal controls could have a material adverse effect onour business, operating results and stock price.***

 

We are in the process ofdocumenting and testing our internal control procedures in order to satisfy therequirements of Section 404 of the Sarbanes-Oxley Act, which requiresannual management assessments of the effectiveness of our internal controlsover financial reporting and a report by our independent auditors addressingthese assessments. During the course of our testing, we may identifydeficiencies which we may not be able to remediate in time to meet the deadlineimposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404.In addition, if we fail to achieve and maintain the adequacy of our internalcontrols, as such standards are modified, supplemented or amended from time totime, we may not be able to ensure that we can conclude on an ongoing basisthat we have effective internal controls over financial reporting in accordancewith Section 404 of the Sarbanes-Oxley Act. Moreover, effective internalcontrols, particularly those related to revenue recognition, are necessary forus to produce reliable financial reports and are important to prevent financialfraud. If we cannot provide reliable financial reports or prevent fraud, ourbusiness and operating results could be harmed, investors could lose confidencein our reported financial information, and the trading price of our stock coulddrop significantly.

 

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***We face risks relating togovernmental inquiries and the results of our internal investigation ofaccounting matters.***

 

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

 

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

 

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**Item 3. Quantitative and****QualitativeDisclosures About Market Risk**

 

There have been no materialchanges in the market risk disclosure contained in our 2004 Annual Report onForm 10-K for our fiscal year ended on May 29, 2004.

 

**Item 4.  Controls andPro****cedures**

 

Attached to this annual report asexhibits 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 Form10-Q is our disclosure of the conclusions of our management, including ourPresident and Chief Executive Officer and our Chief Financial Officer,regarding the effectiveness of our disclosure controls and procedures as of theend of the period 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,under the supervision and with the participation of our President and ChiefExecutive Officer and Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisreport pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, asamended (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 and reportedin a timely manner, and (2) accumulated and communicated to our management, includingour President and Chief Executive Officer and our Chief Financial Officer, asappropriate to allow timely decisions regarding required disclosure.

 

***Internal Control OverFinancial Reporting***

 

There has been no change in ourinternal control over financial reporting that occurred during our fiscalquarter ended February 26, 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 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                                                   |   | Amendment  No. 1 to Employment Agreement between the Company and Nicholas  Konidaris, dated as of January 25, 2005. Incorporated by reference to  Exhibit 10.1 of the Company’s Current Report on Form 8-K filed on January 31,  2005 (the “January 31 8-K”). |
|   | 10.2                                                   |   | Amendment  No. 1 to Stock Option Agreement between the Company and Nicholas  Konidaris, dated as of January 25, 2005 (January 7, 2004 grant).  Incorporated by reference to Exhibit 10.2 of the January 31 8-K. |
|   | 10.3                                                   |   | Form of  Amendment No. 1 to Stock Option Agreement between the Company and  Nicholas Konidaris dated as of January 25, 2005 (July 13, 2004  grant – Incentive Stock Option). Incorporated by reference to  Exhibit 10.3 of the January 31 8-K. |
|   | 10.4                                                   |   | Form of  Amendment No. 1 to Stock Option Agreement between the Company and  Nicholas Konidaris dated as of January 25, 2005 (July 13, 2004  grant – Nonstatutory Stock Option). Incorporated by reference to  Exhibit 10.4 of the January 31 8-K. |
|   | 10.5                                                   |   | Form of  Restricted Stock Units Award Agreement between the Company and Nicholas  Konidaris, dated as of January 25, 2005. Incorporated by reference to  Exhibit 10.6 of the January 31 8-K. |
|   | 10.6                                                   |   | 2004 Stock  Incentive Plan, as amended. Incorporated by reference to Exhibit 10.8 of  the January 31 8-K. |
|   | 31.1                                                   |   | Certification of the Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |
|   | 31.2                                                   |   | Certification of the Chief Financial Officer pursuant to Section 302  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:  March 22, 2005 |   | ELECTRO SCIENTIFIC INDUSTRIES, INC.              |
|----------------------------------|--------|--------------------------------------------------|
|                             |   |                                             |
|                             |   |                                             |
|                             |   | By                                               | /s/ Nicholas Konidaris |   |
|                             |   | Nicholas Konidaris                               |
|                             |   | President, Chief Executive  Officer and Director |
|                             |   | (Principal Executive  Officer)                   |
|                             |   |                                             |
|                             |   |                                             |
|                             |   | By                                               | /s/ J. Michael Dodson |   |
|                             |   | J. Michael Dodson                                |
|                             |   | Senior Vice President of  Administration,        |
|                             |   | Chief Financial Officer  and Secretary           |
|                             |   | (Principal Financial  Officer)                   |
|                             |   |                                             |
|                             |   |                                             |
|                             |   | By                                               | /s/ Kerry Mustoe |   |
|                             |   | Kerry Mustoe                                     |
|                             |   | Corporate Controller and  Chief                  |
|                             |   | Accounting Officer                               |
|                             |   | (Principal Accounting  Officer)                  |

 

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