**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended November 27, 2004**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For thetransition period from           to      **

 

**Commission File Number:  0-12853**

 

**ELECTRO SCIENTIFIC INDUSTRIES,INC.**

** **

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

 

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

 

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

 

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

 

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

 

The number of shares outstanding of the Registrant’sCommon Stock at December 20, 2004 was 28,469,076 shares.

 

 

----

 

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

### **TABLE OF CONTENTS**

 
| **PART I - FINANCIAL  INFORMATION** | ** **                                                                                                                         |
|-------------------------------------|------------------------------------------------------------------------------------------------------------------------------------|
|                                |                                                                                                                               |   |
| Item 1.                             | Consolidated Condensed  Financial Statements (unaudited)                                                                           |   |
|                                |                                                                                                                               |   |
|                                | Consolidated  Condensed Balance Sheets – November 27, 2004 and May 29, 2004                                                   |   |
|                                |                                                                                                                               |   |
|                                | Consolidated  Condensed Statements of Operations – Three Months and Six Months Ended  November 27, 2004 and November 29, 2003 |   |
|                                |                                                                                                                               |   |
|                                | Consolidated  Condensed Statements of Cash Flows – Six Months Ended November 27, 2004 and  November 29, 2003                  |   |
|                                |                                                                                                                               |   |
|                                | Notes  to Consolidated Condensed Financial Statements                                                                              |   |
|                                |                                                                                                                               |   |
| Item  2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                        |   |
|                                |                                                                                                                               |   |
| Item 3.                             | Quantitative and  Qualitative Disclosures About Market Risk                                                                        |   |
|                                |                                                                                                                               |   |
| Item 4.                             | Controls and  Procedures                                                                                                           |   |
|                                |                                                                                                                               |   |
| **PART II -  OTHER INFORMATION**    | ** **                                                                                                                         |
|                                |                                                                                                                               |   |
| Item 1.                             | Legal Proceedings                                                                                                                  |   |
|                                |                                                                                                                               |   |
| Item  4.                            | Submission  of Matters to a Vote of Security Holders                                                                               |   |
|                                |                                                                                                                               |   |
| Item  6.                            | Exhibits                                                                                                                           |   |
|                                |                                                                                                                               |   |
| Signatures                          |                                                                                                                               |   |

 

1

----

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                             | ** ** | **November 27,** | ** ** | **May 29,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|
| ** **                                                                                             | ** ** | **2004**         | ** ** | **2004**    | ** ** |
| ** **                                                                                             | ** ** | ** **       | ** ** | ** **  | ** ** |
| **Assets**                                                                                             | ** ** | ** **       | ** ** | ** **  | ** ** |
| Current assets:                                                                                        |       |             |       |        |       |
| Cash and cash  equivalents                                                                             |       | $                | 91,309     |        | $          | 80,358 |   |
| Marketable  securities                                                                                 |       | 190,467          |       | 206,931     |       |
| Restricted  securities                                                                                 |       | 3,296            |       | 6,251       |       |
| Total cash and  securities                                                                             |       | 285,072          |       | 293,540     |       |
|                                                                                                   |       |             |       |        |       |
| Trade receivables,  net of allowances of $990 and $901                                                 |       | 53,971           |       | 51,696      |       |
| Income tax  refund receivable                                                                          |       | 8,896            |       | 7,466       |       |
| Inventories, net                                                                                       |       | 68,321           |       | 58,627      |       |
| Shipped systems  pending acceptance                                                                    |       | 2,234            |       | 4,391       |       |
| Deferred income  taxes                                                                                 |       | 12,548           |       | 16,096      |       |
| Assets held for  sale                                                                                  |       | —           |       | 2,391       |       |
| Prepaid and  other current assets                                                                      |       | 5,055            |       | 3,348       |       |
| Total current  assets                                                                                  |       | 436,097          |       | 437,555     |       |
|                                                                                                   |       |             |       |        |       |
| Long-term  marketable securities                                                                       |       | 53,021           |       | 39,214      |       |
| Property, plant  and equipment, net of accumulated depreciation of $43,169 and $40,644                 |       | 33,085           |       | 33,531      |       |
| Deferred income  taxes                                                                                 |       | 15,609           |       | 17,630      |       |
| Other assets                                                                                           |       | 12,464           |       | 9,256       |       |
| Total assets                                                                                           |       | $                | 550,276    |        | $          | 537,186 |   |
|                                                                                                   |       |             |       |        |       |
| **Liabilities  and shareholders’ equity**                                                         | ** ** | ** **       | ** ** | ** **  | ** ** |
| Current  liabilities:                                                                                  |       |             |       |        |       |
| Accounts payable                                                                                       |       | $                | 8,326      |        | $          | 13,248 |   |
| Accrued  liabilities                                                                                   |       | 36,662           |       | 42,381      |       |
| Deferred revenue                                                                                       |       | 9,375            |       | 11,985      |       |
| Total current  liabilities                                                                             |       | 54,363           |       | 67,614      |       |
| Convertible  subordinated notes                                                                        |       | 143,193          |       | 142,759     |       |
| Total  liabilities                                                                                     |       | 197,556          |       | 210,373     |       |
|                                                                                                   |       |             |       |        |       |
| Shareholders’  equity:                                                                            |       |             |       |        |       |
| Preferred stock,  without par value; 1,000 shares authorized; no shares issued                         |       | —           |       | —      |       |
| Common stock,  without par value; 100,000 authorized; 28,463 and 28,175 shares issued and  outstanding |       | 153,290          |       | 147,054     |       |
| Retained  earnings                                                                                     |       | 199,954          |       | 181,362     |       |
| Accumulated  other comprehensive loss                                                                  |       | (524             | )          | (1,603      | )          |
| Total  shareholders’ equity                                                                       |       | 352,720          |       | 326,813     |       |
| Total  liabilities and shareholders’ equity                                                       |       | $                | 550,276    |        | $          | 537,186 |   |

 

The accompanying notesare an integral part of these statements.

 

2

----

 

ELECTRO SCIENTIFICINDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSEDSTATEMENTS OF OPERATIONS

(In thousands, except pershare data)

(Unaudited)

 
| ** **                                         | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                         | ** ** | **November 27, 2004**          | ** ** | **November 29, 2003**        | ** ** | **November 27, 2004** | ** ** | **November 29, 2003** | ** ** |
| ** **                                         | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                          |       | $                              | 66,004     |                         | $          | 45,753 |   | $ | 138,624 |   | $ | 66,629 |   |
| Cost of sales                                      |       | 33,178                         |       | 30,090                       |       | 68,912 |   | 46,126 |   |
| Gross profit                                       |       | 32,826                         |       | 15,663                       |       | 69,712 |   | 20,503 |   |
|                                               |       |                           |       |                         |       |   |   |   |   |
| Operating  expenses:                               |       |                           |       |                         |       |   |   |   |   |
| Selling, service  and administration               |       | 15,326                         |       | 13,281                       |       | 30,204 |   | 27,906 |   |
| Research,  development and engineering             |       | 7,746                          |       | 5,416                        |       | 14,306 |   | 11,164 |   |
|                                               |       | 23,072                         |       | 18,697                       |       | 44,510 |   | 39,070 |   |
| Operating income  (loss)                           |       | 9,754                          |       | (3,034                       | )          | 25,202 |   | (18,567 | ) |
|                                               |       |                           |       |                         |       |   |   |   |   |
| Interest income                                    |       | 1,773                          |       | 1,894                        |       | 3,323 |   | 3,896 |   |
| Interest expense                                   |       | (1,786                         | )          | (1,886                       | )          | (3,572 | ) | (3,813 | ) |
| Other expense,  net                                |       | (191                           | )          | (112                         | )          | (324 | ) | (10 | ) |
|                                               |       | (204                           | )          | (104                         | )          | (573 | ) | 73 |   |
| Income (loss)  before income taxes                 |       | 9,550                          |       | (3,138                       | )          | 24,629 |   | (18,494 | ) |
| Provision for  (benefit from) income taxes         |       | 1,604                          |       | 1,737                        |       | 6,037 |   | (4,252 | ) |
| Net income  (loss)                                 |       | $                              | 7,946      |                         | $          | (4,875 | ) | $ | 18,592 |   | $ | (14,242 | ) |
|                                               |       |                           |       |                         |       |   |   |   |   |
| Net income  (loss) per share - basic               |       | $                              | 0.28       |                         | $          | (0.17 | ) | $ | 0.66 |   | $ | (0.51 | ) |
|                                               |       |                           |       |                         |       |   |   |   |   |
| Net income  (loss) per share - fully diluted       |       | $                              | 0.28       |                         | $          | (0.17 | ) | $ | 0.64 |   | $ | (0.51 | ) |
|                                               |       |                           |       |                         |       |   |   |   |   |
| Weighted average  number of shares - basic         |       | 28,443                         |       | 27,931                       |       | 28,329 |   | 27,885 |   |
|                                               |       |                           |       |                         |       |   |   |   |   |
| Weighted average  number of shares - fully diluted |       | 28,541                         |       | 27,931                       |       | 32,315 |   | 27,885 |   |

 

The accompanying notesare an integral part of these statements.

 

3

----

 

ELECTRO SCIENTIFICINDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTSOF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                                       | ** ** | **For the six months ended** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                       | ** ** | **November 27, 2004**        | ** ** | **November 29, 2003** | ** ** |
| ** **                                                                                       | ** ** | ** **                   | ** ** | ** ** | ** ** |
| **Cash  flows from operating activities:**                                                       |       |                         |       |   |   |
| Net income  (loss)                                                                               |       | $                            | 18,592     |   | $ | (14,242 | ) |
| Adjustments to  reconcile net income (loss) to cash provided by (used in) operating  activities: |       |                         |       |   |   |
| Depreciation and  amortization                                                                   |       | 4,593                        |       | 4,607 |   |
| Tax benefit of  stock options exercised                                                          |       | 543                          |       | 218 |   |
| Provision for  doubtful accounts                                                                 |       | 200                          |       | — |   |
| Loss on disposal  of property and equipment                                                      |       | 253                          |       | 4 |   |
| Deferred income  taxes                                                                           |       | 5,617                        |       | (183 | ) |
| Changes in  operating accounts:                                                                  |       |                         |       |   |   |
| (Increase)  decrease in trade receivables, net                                                   |       | (536                         | )          | 440 |   |
| Increase in  income tax refund receivable                                                        |       | (1,430                       | )          | (22,140 | ) |
| Increase in  inventories, net                                                                    |       | (13,523                      | )          | (5,051 | ) |
| (Increase)  decrease in shipped systems pending acceptance                                       |       | 2,157                        |       | (2,956 | ) |
| (Increase)  decrease in prepaid and other current assets                                         |       | (1,617                       | )          | 617 |   |
| Increase  (decrease) in accounts payable and other current liabilities                           |       | (11,914                      | )          | 19,112 |   |
| Increase (decrease)  in deferred revenue                                                         |       | (2,611                       | )          | 6,655 |   |
| Net cash  provided by (used in) operating activities                                             |       | 324                          |       | (12,919 | ) |
|                                                                                             |       |                         |       |   |   |
| **Cash  flows from investing activities:**                                                       |       |                         |       |   |   |
| Purchase of  property, plant and equipment                                                       |       | (2,109                       | )          | (1,912 | ) |
| 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                                                               |       | 2,955                        |       | 3,111 |   |
| Purchase of  securities                                                                          |       | (248,647                     | )          | (120,782 | ) |
| Proceeds from  sales of securities and maturing securities                                       |       | 251,833                      |       | 130,847 |   |
| (Increase)  decrease in other assets                                                             |       | (780                         | )          | 9 |   |
| Net cash  provided by investing activities                                                       |       | 5,705                        |       | 11,282 |   |
|                                                                                             |       |                         |       |   |   |
| **Cash  flows from financing activities:**                                                       |       |                         |       |   |   |
| Proceeds from  exercise of stock options and stock plans                                         |       | 4,922                        |       | 2,351 |   |
| Net cash  provided by financing activities                                                       |       | 4,922                        |       | 2,351 |   |
|                                                                                             |       |                         |       |   |   |
| **Net  change in cash and cash equivalents**                                                     |       | 10,951                       |       | 714 |   |
|                                                                                             |       |                         |       |   |   |
| **Cash  and cash equivalents:**                                                                  |       |                         |       |   |   |
| Beginning of  period                                                                             |       | 80,358                       |       | 31,017 |   |
| End of period                                                                                    |       | $                            | 91,309     |   | $ | 31,731 |   |
|                                                                                             |       |                         |       |   |   |
| **Supplemental  cash flow information:**                                                         |       |                         |       |   |   |
| Cash paid for  interest                                                                          |       | $                            | 3,082      |   | $ | 3,338 |   |
| Income tax  refunds received                                                                     |       | 4                            |       | 1,162 |   |
| Cash paid for  income taxes                                                                      |       | 2,795                        |       | 6,498 |   |

 

The accompanying notesare an integral part of these statements.

 

4

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**ELECTROSCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES**

### **NOTES TOCONSOLIDATED CONDENSED FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

#### * *

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

 

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

 

**Note 2 - Inventories**

 

Inventories are principally valued at standard costs, which approximatethe lower of cost (on a first-in, first-out basis) or market.  Components of inventories were as follows (inthousands):

 
| ** **                         | ** ** | **November 27,** | ** ** | **May 29,** | ** ** |
|------------------------------------|------------|------------------|------------|-------------|------------|
| ** **                         | ** ** | **2004**         | ** ** | **2004**    | ** ** |
| Raw materials  and purchased parts |       | $                | 36,278     |        | $          | 34,710 |   |
| Work-in-process                    |       | 9,408            |       | 11,219      |       |
| Finished goods                     |       | 22,635           |       | 12,698      |       |
|                               |       | $                | 68,321     |        | $          | 58,627 |   |

 

**Note 3 – Accrued Liabilities**

 

Accrued liabilities consisted of thefollowing (in thousands):

 
| ** **                                | ** ** | **November 27,** | ** ** | **May 29,** | ** ** |
|-------------------------------------------|------------|------------------|------------|-------------|------------|
| ** **                                | ** ** | **2004**         | ** ** | **2004**    | ** ** |
| ** **                                | ** ** | ** **       | ** ** | ** **  | ** ** |
| Payroll-related                           |       | $                | 10,835     |        | $          | 10,781 |   |
| Product warranty                          |       | 4,523            |       | 4,720       |       |
| Interest payable                          |       | 2,805            |       | 2,805       |       |
| Accrual for loss  on purchase commitments |       | 408              |       | 536         |       |
| Legal settlement  accrual                 |       | —           |       | 3,800       |       |
| Income taxes  payable                     |       | 11,225           |       | 12,212      |       |
| Other                                     |       | 6,866            |       | 7,527       |       |
|                                      |       | $                | 36,662     |        | $          | 42,381 |   |

 

See Note 4 for a discussion of the accrual for product warranty.  The legal settlement accrual of $3.8 millionrelated to the class action and derivative lawsuit that was paid during the secondquarter of fiscal 2005.

 

5

----

 

**Note 4 – Product Warranty**

 

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 six months ended November 27, 2004 and November 29, 2003 (in thousands):

 
| ** **                           | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
|--------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                           | ** ** | **2004**         | ** ** | **2003**         | ** ** |
| ** **                           | ** ** | ** **       | ** ** | ** **       | ** ** |
| Product warranty  accrual, beginning |       | $                | 4,720      |             | $          | 3,501 |   |
| Warranty charges  incurred           |       | (5,006           | )          | (4,517           | )          |
| Inventory  credits                   |       | 1,927            |       | 2,234            |       |
| Provision for  warranty charges      |       | 2,882            |       | 2,525            |       |
| Product warranty  accrual, ending    |       | $                | 4,523      |             | $          | 3,743 |   |

 

**Note 5 – Deferred Revenue**

 

Revenue is deferred pending title transfer and fulfillment ofacceptance criteria, which frequently occur at the time of delivery to a commoncarrier.  Shipments for which titletransfer has not occurred and/or acceptance criteria cannot be demonstrated atthe Company’s factory include sales to Japanese end-user customers andshipments of substantially new products. In sales involving multiple element arrangements, the fair value of anyundelivered elements, including installation services, is deferred untildelivery of such elements.  Revenuerelated to maintenance and service contracts is deferred and recognized ratablyover the duration of the contracts.

 

The following is a reconciliation of the changes in deferred revenuefor the six months ended November 27, 2004 and November 29, 2003 (inthousands):

 
| ** **                  | ** ** | **November 27,  2004** | ** ** | **November 29,  2003** | ** ** |
|-----------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                  | ** ** | ** **             | ** ** | ** **             | ** ** |
| Deferred revenue, beginning |       | $                      | 11,985     |                   | $          | 13,222 |   |
| Revenue deferred            |       | 13,124                 |       | 19,756                 |       |
| Revenue  recognized         |       | (15,734                | )          | (13,101                | )          |
| Deferred  revenue, ending   |       | $                      | 9,375      |                   | $          | 19,877 |   |

 

6

----

 

**Note 6 - Earnings Per Share**

 

Following is areconciliation of weighted average shares outstanding and adjustments to netincome used in the calculation of basic and diluted earnings per share (EPS)for the three months and six months ended November 27, 2004 (in thousands):

 
| ** **                                                        | ** ** | **Three months ended  November 27, 2004** | ** ** | **Six months ended  November 27, 2004** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                        | ** ** | **Income**                                | ** ** | **Shares**                              | ** ** | **Income** | ** ** | **Shares** | ** ** |
|                                                              |       |                                      |       |                                    |       |   |   |   |   |
| Net income  available to common shareholders – basic         |       | $                                         | 7,946      |                                    | 28,443     |   | $ | 18,592 |   | 28,329 |   |
| Effect of  dilutive stock compensation                            |       | —                                    |       | 98                                      |       | — |   | 170 |   |
| Effect of 4 1⁄4%  convertible subordinated notes               |       | —                                    |       | —                                  |       | 2,179 |   | 3,816 |   |
| Net income  available to common shareholders – fully diluted |       | $                                         | 7,946      |                                    | 28,541     |   | $ | 20,771 |   | 32,315 |   |

 

Basic and diluted EPSwere the same for the comparative three months and six months ended November29, 2003 because the Company was in a loss position for that period.

 

The following common stock equivalents were excludedfrom the diluted EPS calculations because inclusion would have had anantidilutive effect (in thousands):

 
| ** **                                | ** ** | **Three months ended** | ** ** | **Six months ended**  | ** ** |
|-------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **November 27, 2004**  | ** ** | **November 29, 2003** | ** ** | **November 27, 2004** | ** ** | **November 29, 2003** | ** ** |
| Employee stock  options                   |       | 3,540                  |       | 3,457                 |       | 3,531 |   | 3,528 |   |
| 4 1⁄4% convertible  subordinated notes |       | 3,816                  |       | 3,816                 |       | — |   | 3,816 |   |
|                                      |       | 7,356                  |       | 7,273                 |       | 3,531 |   | 7,344 |   |

 

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

 

The components of comprehensive income (loss), net of tax, are asfollows (in thousands):

 
| ** **                                                                 | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                 | ** ** | **November 27,**       | ** ** | **November 29,**     | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
| ** **                                                                 | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                       |       |                   |       |                 |       |   |   |   |   |
| Net income  (loss)                                                         |       | $                      | 7,946      |                 | $          | (4,875 | ) | $ | 18,592 |   | $ | (14,242 | ) |
| Net unrealized  gain (loss) on foreign exchange hedge contracts            |       | (21                    | )          | (1                   | )          | 7 |   | (5 | ) |
| Foreign currency  translation adjustment                                   |       | 594                    |       | 59                   |       | 545 |   | (14 | ) |
| Net unrealized  gain (loss) on securities classified as available for sale |       | (127                   | )          | 10                   |       | 527 |   | (1,498 | ) |
|                                                                       |       | $                      | 8,392      |                 | $          | (4,807 | ) | $ | 19,671 |   | $ | (15,759 | ) |

 

7

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

#### * *

The Company has elected to use the intrinsicvalue method under APB No. 25, *Accounting for StockIssued 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 stockcompensation plans, and amortizes deferred compensation, if any, ratably overthe vesting period of the awards. Compensation expense resulting from the issuance of fixed term stockoption awards is measured as the difference between the exercise price of theoption and fair market value of the underlying share of company stock subjectto the option on the award’s grant date. The calculated total compensation expense, if any, is included inoperating results over the vesting period of the underlying options using thestraight-line method.  However, nocompensation cost has been recognized for employee share purchase plan (ESPP)shares which are issued at fifteen percent discount of the lower of the marketprice on either the first day of the applicable offering period or the purchasedate.

 

Pro forma fair value disclosures required bySFAS No. 123 are presented below and reflect the impact on net income (loss)and net income (loss) per share as if the fair value of its stock-based awardsto employees had been applied:

 
| ** **                                                                                                                                                         | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                                                         | ** ** | **November 27,**       | ** ** | **November 29,**     | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
| ** **                                                                                                                                                         | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                                               |       |                   |       |                 |       |   |   |   |   |
| Net income  (loss), as reported                                                                                                                                    |       | $                      | 7,946      |                 | $          | (4,875 | ) | $ | 18,592 |   | $ | (14,242 | ) |
| 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                                          |       | 136                    |       | 41                   |       | 262 |   | 82 |   |
| Deduct – total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects            |       | (1,158                 | )          | (2,683               | )          | (13,558 | ) | (4,777 | ) |
| Net income  (loss), pro forma                                                                                                                                      |       | $                      | 6,924      |                 | $          | (7,517 | ) | $ | 5,296 |   | $ | (19,081 | ) |
| Net income  (loss) per share – basic, as reported                                                                                                             |       | $                      | 0.28       |                 | $          | (0.17 | ) | $ | 0.66 |   | $ | (0.51 | ) |
| Net income  (loss) per share – fully diluted, as reported                                                                                                     |       | $                      | 0.28       |                 | $          | (0.17 | ) | $ | 0.64 |   | $ | (0.51 | ) |
| Net income  (loss) per share – basic, pro forma                                                                                                               |       | $                      | 0.24       |                 | $          | (0.27 | ) | $ | 0.19 |   | $ | (0.68 | ) |
| Net income  (loss) per share – fully diluted pro forma                                                                                                        |       | $                      | 0.24       |                 | $          | (0.27 | ) | $ | 0.16 |   | $ | (0.68 | ) |

 

On June 28, 2004, thecompensation committee of the Board of Directors approved an acceleration ofthe vesting of those employee stock options, excluding stock options granted tothe Board of Directors and Chief Executive Officer, with an option price equalto or greater than the closing sale price of $23.38 per share on that date, asreported on the NASDAQ National Market.  Optionsto purchase approximately 1.2 million shares of stock with varying remainingvesting schedules were subject to the acceleration provision and becameimmediately exercisable.  The total proforma stock-based employee compensation expense stated above of $13.6 millionfor the six months ended November 27, 2004 includes $9.9 million resulting fromthis acceleration provision, as calculated under SFAS No. 123.

 

8

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The Black-Scholes optionpricing model is utilized to measure compensation expense. The followingweighted average assumptions were made in calculating the value of all optionsgranted during the periods presented:

 
| ** **               | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------|------------|------------------------|------------|----------------------|------------|
| ** **               | ** ** | **November 27,**       | ** ** | **November 29,**     | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
| ** **               | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                     |       |                   |       |                 |       |   |   |   |   |
| Risk-free  interest rate |       | 3.38                   | %          | 3.29                 | %          | 3.58 | % | 3.38 | % |
| Expected  dividend yield |       | 0                      | %          | 0                    | %          | 0 | % | 0 | % |
| Expected lives           |       | 5.6 years              |       | 5.4 years            |       | 5.6 years |   | 5.4 years |   |
| Expected  volatility     |       | 65.82                  | %          | 67.58                | %          | 65.65 | % | 67.71 | % |

 

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

 
| ** **               | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------|------------|------------------------|------------|----------------------|------------|
| ** **               | ** ** | **November 27,**       | ** ** | **November 29,**     | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
| ** **               | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                     |       |                   |       |                 |       |   |   |   |   |
| Risk-free  interest rate |       | 2.30                   | %          | 3.29                 | %          | 2.28 | % | 3.38 | % |
| Expected  dividend yield |       | 0                      | %          | 0                    | %          | 0 | % | 0 | % |
| Expected lives           |       | 1.2 years              |       | 1.0 year             |       | 1.2 years |   | 1.0 year |   |
| Expected  volatility     |       | 54.40                  | %          | 67.58                | %          | 54.40 | % | 67.71 | % |

 

**Note 9 – Legal Claims**

 

On October 29, 2004, the Company entered into a settlement and licenseagreement with Cognex Corporation (Cognex) resolving a lawsuit filed by Cognexon February 14, 2001 in the United States District Court for the District ofMassachusetts (Cognex Corporation v. Electro Scientific Industries, Inc. No.01-10287 WGY).  The lawsuit, whichalleged that the Company’s CorrectPlace product and some of its predecessorsinfringed United States Patent 5,371,690 owned by Cognex, was dismissed withprejudice on November 1, 2004.  Under thesettlement agreement, Cognex has granted the Company a license to the patent indispute as well as certain covenants not to sue under various other surfacemount placement equipment-related patents, and as consideration for the licensethe Company has agreed to pay Cognex an undisclosed license fee.  As a result of this settlement, the Companyrecorded a charge to operations of $1.8 million in the second quarter of fiscal2005 along with approximately $0.4 million in related legal fees.

 

In addition to the legal matter described above, in the ordinary courseof business the Company is involved in various other legal matters, eitherasserted or unasserted.  In the opinionof management, amounts accrued for awards or assessments in connection withthese matters are management’s best estimate and ultimate resolution of thesematters will not have a material effect on the Company’s consolidated financialposition, results of operations or cash flow.

 

9

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**Note 10 - Recent Accounting Pronouncements**

 

In December 2004, theFASB issued FASB Statement No. 123 (Revised 2004), Share-Based Payment. (SFAS123R).  The scope of SFAS 123R includes awide range of share-based compensation arrangements including share options,restricted share plans, performance-based awards, share appreciation rights,and employee share purchase plans.  SFAS123R replaces FASB Statement No. 123, Accounting for Stock-Based Compensation(SFAS 123), and supersedes APB Opinion No. 25, Accounting for Stock Issued toEmployees (Opinion 25). SFAS 123, as originally issued in 1995, established aspreferable a fair-value-based method of accounting for share-based paymenttransactions with employees. However, that statement permitted entities theoption of continuing to apply the guidance in Opinion 25, as long as thefootnotes to the financial statements disclosed what net income would have beenhad the preferable fair-value-based method been used. SFAS 123R requires thatthe compensation cost relating to share-based payment transactions berecognized in financial statements. That cost will be measured based on thefair value of the equity or liability instruments issued.  The Company will be required to implementSFAS 123R for the interim reporting period ending November 26, 2005.  If SFAS 123R had been adopted for the threeand six months ending November 27, 2004, net income would have been reduced by$1.0 million ($0.04 per basic and fully diluted share) and $13.3 million ($0.47per basic share and $0.48 per fully diluted share), respectively.

 

In December 2004, theFASB issued FASB Statement No. 153,Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29 (SFAS153).  Statement 153 amends APBOpinion No. 29, Accounting forNonmonetary Transactions (Opinion 29). The amendments made by SFAS 153are based on the principle that exchanges of nonmonetary assets should bemeasured based on the fair value of the assets exchanged. Further, theamendments eliminate the narrow exception for nonmonetary exchanges of similarproductive assets, which requires that the accounting for the exchange be basedon the recorded amount of the asset relinquished, and replace it with a broaderexception for exchanges of nonmonetary assets that do not have “commercialsubstance.” The provisions in SFAS 153 are effective for nonmonetary assetexchanges occurring in fiscal periods beginning after June 15, 2005.  Early application is permitted and companiesmust apply the standard prospectively. The Company does not expect the adoption of SFAS 153 to have a materialeffect on its financial statements or results of operations.

 

In November of 2004, theFASB issued SFAS No. 151*, Inventory Costs –An Amendment of ARB No. 43, Chapter 4* (SFAS 151). This newstandard is the result of an effort by the FASB to improve financial reportingby eliminating differences between GAAP in the United States and GAAP developedby the IASB.  SFAS 151 clarifies thatabnormal amounts of idle facility expense, freight, handling costs andspoilage should be expensed as incurred and not included inoverhead.  The new statement also requires that allocation of fixedproduction overheads to conversion costs should be based on normal capacity ofthe production facilities.  The provisions in SFAS 151 are effectivefor inventory costs incurred during fiscal years beginning after June 15,2005.  Companies must apply thestandard prospectively.  The Company does not believe that the impactof this new standard will have a material effect on our prospective financialstatements or results of operations.

 

10

----

 

**Note 11 – Subsequent Events**

 

*Restructuring and cost management plans*

In December of 2004, the Company announced a restructuring plan tostreamline its infrastructure.  This planwill result in a decrease in workforce of approximately nine percent, effectiveearly January 2005.  The plan, which includesother cost control measures, will be implemented throughout the Company.  The Company estimates that it will incurapproximately $1.3 million of charges and cash outlays in the third quarter offiscal 2005.  The restructuring chargewill consist primarily of one-time termination benefits and related costs andis expected to be substantially completed during the third quarter.

 

11

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

 

**Forward Looking Statements**

 

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

 

**Overview**

 

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

 

We supply advanced lasermicroengineering systems that allow electronics manufacturers to physicallyalter select device features during high-volume production in order to heightenperformance and boost production yields of semiconductor devices, passivecomponents and circuitry, high-density interconnect (HDI) circuit boards andadvanced semiconductor packaging.  Lasermicroengineering comprises a set of precise fine-tuning processes (lasertrimming, link cutting and via drilling) that require application-specificlaser systems able to meet semiconductor and microelectronics manufacturers’exacting performance and productivity requirements.  Additionally, we produce high-speed test,inspection and termination equipment used in the high-volume production ofmulti-layer ceramic passives (MLCPs) and other passive components, as well asoriginal equipment manufacturer (OEM) machine vision products.

 

#### *During the first half of fiscal 2005, market demand lessenedfor our products compared to the levels experienced in the latter half of fiscal2004.  Order volume was $67.6 million inthe first quarter of fiscal 2005, representing a significant decline fromorders of $104.7 million in the fourth quarter of fiscal 2004.  Orders continued to decrease in the secondquarter of fiscal 2005 to $39.8 million. The sequential order rate decreased with customers in each of our threebusinesses delaying equipment purchases during the quarter.  Shipments were $58.1 million in the secondquarter of fiscal 2005, representing a 25.4% decline from shipments of $77.9million in the first quarter of fiscal 2005 and a 24.7% decline from shipmentsof $77.1 million in the fourth quarter of fiscal 2004.  Net sales for the quarter decreased from$72.6 million in the first quarter to $66.0 million in the second quarter offiscal 2005.  Shipment declines in thequarter contributed to the 9.1% sequential decrease in revenue, but the revenuedecline was partially offset by recognition of $7.8 million in deferred revenuefrom prior quarters.*

 

12

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#### *Although market conditions declined in the second quarter offiscal 2005, our gross margin rates of 50% were comparable to the prior quarter’srate of 51%.  Third quarter shipments andrevenues are currently estimated to be in the range of $40 million to $55million and related gross margins are expected to decline to a mid-40%range.  Operating expenses were $23.1million for the second quarter compared to $21.4 million in the first quarterof fiscal 2005, resulting in operating income of $9.8 million in the secondquarter.  Operating expenses in thesecond quarter include $2.2 million in charges for legal and settlement feesrelated to a patent infringement lawsuit.*

#### * *

#### *As a result of uncertainty in the industry, we have takenmeasures to streamline our infrastructure and reduce our break-even point.  In December 2004 we announced restructuringactions which will reduce our workforce by approximately 9%.  These actions will become effective inJanuary 2005 and, along with related initiatives, are designed to improve theoperational efficiency of the company and contribute to cost control in the latterhalf of fiscal 2005.  We anticipate thesemeasures will allow us to reduce operating expenses in the third quarter to arange of $19 million to $20 million, representing levels below the firstquarter of fiscal 2005.*

#### * *

**Resultsof Operations**

 

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

 
| ** **                             | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|----------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                             | ** ** | **November 27,**       | ** ** | **November 29,**     | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
| ** **                             | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                   |       |                 |       |   |   |   |   |
| Net sales                              |       | 100.0                  | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of sales                          |       | 50.3                   |       | 65.8                 |       | 49.7 |   | 69.2 |   |
| Gross margin                           |       | 49.7                   |       | 34.2                 |       | 50.3 |   | 30.8 |   |
| Selling, service  and administrative   |       | 23.2                   |       | 29.0                 |       | 21.8 |   | 41.9 |   |
| Research,  development and engineering |       | 11.7                   |       | 11.8                 |       | 10.3 |   | 16.8 |   |
| Operating income  (loss)               |       | 14.8                   |       | (6.6                 | )          | 18.2 |   | (27.9 | ) |
| Total other  income (expense), net     |       | (0.3                   | )          | (0.2                 | )          | (0.4 | ) | 0.1 |   |
| Income (loss)  before taxes            |       | 14.5                   |       | (6.8                 | )          | 17.8 |   | (27.8 | ) |
| Income tax  provision (benefit)        |       | 2.5                    |       | 3.9                  |       | 4.4 |   | (6.4 | ) |
| Net income  (loss)                     |       | 12.0                   | %          | (10.7                | )%         | 13.4 | % | (21.4 | )% |

 

***NetSales***

 

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

 
| ** **                           | ** ** | **Three months ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **November 27, 2004**  | ** ** | **November 29, 2003** | ** ** |
| ** **                           | ** ** | **Net Sales**          | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|                                 |       |                   |       |   |   |   |   |   |   |
| Semiconductor  Group (SG)            |       | $                      | 35,658     |   | 54 | % | $ | 28,137 |   | 61 | % |
| Passive  Components Group (PCG)      |       | 17,979                 |       | 27 |   | 8,949 |   | 20 |   |
| Electronic  Interconnect Group (EIG) |       | 12,367                 |       | 19 |   | 8,667 |   | 19 |   |
|                                 |       | $                      | 66,004     |   | 100 | % | $ | 45,753 |   | 100 | % |

 
| ** **                           | ** ** | **Six months ended**  | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **November 27, 2004** | ** ** | **November 29, 2003** | ** ** |
| ** **                           | ** ** | **Net Sales**         | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|                                 |       |                  |       |   |   |   |   |   |   |
| Semiconductor  Group (SG)            |       | $                     | 79,671     |   | 57 | % | $ | 33,873 |   | 51 | % |
| Passive  Components Group (PCG)      |       | 38,582                |       | 28 |   | 18,555 |   | 28 |   |
| Electronic  Interconnect Group (EIG) |       | 20,371                |       | 15 |   | 14,201 |   | 21 |   |
|                                 |       | $                     | 138,624    |   | 100 | % | $ | 66,629 |   | 100 | % |

 

13

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Netsales were $66.0 million for the quarter ended November 27, 2004, an increaseof $20.3 million or 44.3% compared to $45.8 million for the quarter endedNovember 29, 2003.  Sales increased morethan 25% across all three business units, with the largest increase being animprovement of 101% from PCG.  Salesincreases of $7.5 million for the second quarter of fiscal 2005 compared to thesecond quarter of fiscal 2004 in SG are attributed to major DRAM manufacturersincreasing capacity.  These investmentswere primarily in the memory repair product line.  This trend with DRAM manufacturers began inthe second quarter of fiscal 2004 and reached its highest level in the fourthquarter of fiscal 2004.  PCG sales increased$9.0 million in the second quarter compared to the same period in the prioryear as demand for passive components processed by laser trim and passive testsystems began to increase in the second half of fiscal 2004.  Accordingly, Multi-layer Ceramic Capacitor(MLCC) test processors drove sales for this group during the second quarter offiscal 2005, with a significant portion of sales coming from Japanesecustomers.  EIG sales levels increased$3.7 million in the second quarter of fiscal 2005 compared to the same periodin the prior year.  Acceptance ofsignificantly new products in the integrated circuit (IC) package segment shippedin prior quarters led to the sales increase.

 

Shipmentlevels increased $14.4 million or 33% in the second quarter of fiscal 2005 ascompared to the same quarter in fiscal 2004.  Deferred revenue was $9.4 million at November27, 2004 compared to $17.2 million at August 28, 2004.  Net sales in the second quarter included the positiveimpact of a net $7.8 million of previously deferred revenue activity.  Deferred revenue recognized in the periodrelated primarily to newly accepted IC packaging systems, systems shipped toJapanese customers and the fulfillment of delivery terms for systems shipped atthe end of the first quarter.

 

Revenueis deferred pending title transfer and fulfillment of acceptance criteria,which frequently occur at the time of delivery to a common carrier.  Shipments for which title transfer has notoccurred and/or acceptance criteria cannot be demonstrated at our factoryinclude sales to Japanese end-user customers and shipments of substantially newproducts.  Due to these factors, as wellas the timing of their occurrence in any given quarter, deferred revenuebalances may fluctuate significantly from quarter to quarter.  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.

 

Changesin deferred revenue were as follows:

 
| **Deferred  revenue, May 29, 2004**      | ** ** | ** ** |       | $      | 11,985 |       |
|------------------------------------------|------------|------------|------------|--------|--------|------------|
| Revenue deferred                         |       | $          | 9,231      |   |   |       |
| Revenue  recognized                      |       | (4,029     | )          |   |   |
| Net change in  deferred revenue          |       | 5,202      |       |   |   |
| **Deferred  revenue, August 28, 2004**   | ** ** | ** ** |       | 17,187 |   |
| Revenue deferred                         |       | 3,893      |       |   |   |
| Revenue  recognized                      |       | (11,705    | )          |   |   |
| Net change in  deferred revenue          |       | $          | (7,812     | )      |   |       |
| **Deferred  revenue, November 27, 2004** | ** ** | ** ** | ** ** | $      | 9,375  | ** ** |

 

Netsales were $138.6 million for the six months ended November 27, 2004, anincrease of $72.0 million or 108% compared to $66.6 million for the six monthsended November 29, 2003.  Of theincrease, $45.8 million resulted from increased sales in the SG product lines and$20.0 million resulted from an increase in PCG sales.  The remaining increase of $6.2 million wasgenerated by EIG sales of new products primarily in the IC package market asmentioned above.

 

14

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

 
| ** **    | ** ** | **Three months ended** | ** ** |
|---------------|------------|------------------------|------------|
| ** **    | ** ** | **November 27, 2004**  | ** ** | **November 29, 2003** | ** ** |
| ** **    | ** ** | **Net Sales**          | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|          |       |                   |       |   |   |   |   |   |   |
| Asia          |       | $                      | 46,142     |   | 70 | % | $ | 34,567 |   | 76 | % |
| United States |       | 12,185                 |       | 19 |   | 6,989 |   | 15 |   |
| Europe        |       | 7,677                  |       | 11 |   | 4,197 |   | 9 |   |
|          |       | $                      | 66,004     |   | 100 | % | $ | 45,753 |   | 100 | % |

 
| ** **    | ** ** | **Six months ended**  | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **November 27, 2004** | ** ** | **November 29, 2003** | ** ** |
| ** **    | ** ** | **Net Sales**         | ** ** | **% of Net Sales** | ** ** | **Net Sales** | ** ** | **% of Net Sales** | ** ** |
|          |       |                  |       |   |   |   |   |   |   |
| Asia          |       | $                     | 104,678    |   | 76 | % | $ | 45,973 |   | 69 | % |
| United States |       | 20,733                |       | 15 |   | 14,071 |   | 21 |   |
| Europe        |       | 13,213                |       | 9 |   | 6,585 |   | 10 |   |
|          |       | $                     | 138,624    |   | 100 | % | $ | 66,629 |   | 100 | % |

 

Regional sales results in the secondquarter of fiscal 2005 shifted slightly from the second quarter of fiscal 2004.The percentage of total net sales to Asia decreased 6% while the percentage oftotal net sales to the United States and Europe increased a combined 6%.  For the six months ended November 27, 2004,compared to the six months ended November 29, 2003, sales by region were moreheavily weighted to Asia and particularly to Taiwan.  This resulted from dollar-volume increaseover the prior year in sales of SG products and PCG products.

 

***Gross Profit***

 

Grossprofit was $32.8 million (49.7% of net sales) for the second quarter of fiscal2005 compared to $15.7 million (34.2% of net sales) for the second quarter offiscal 2004.  Shipments in the secondquarter of fiscal 2005 increased 33.1% compared to the same quarter in fiscal2004.  Increased shipment levels resultedin volume-based manufacturing efficiencies and lower costs per unit.  Similarly, higher production volumes increasedour ability to negotiate lower material costs with some suppliers, contributingto overall gross margin improvements.  Inaddition, efforts to reduce warranty costs contributed to higher margins in thecurrent period compared to the second quarter of fiscal 2004.

 

Grossprofit for the six month period ended November 27, 2004 was $69.7 million (or50.3% of net sales) compared to $20.5 million (or 30.8% of net sales) for the samesix month period in the prior fiscal year. This represents a 19.5% improvement in gross margin rates, which can beattributed to the same factors described in the quarterly comparisonsabove.  In particular, shipments of$136.0 million in the first six months of fiscal 2005 were approximately twice the$73.3 million of shipments for the same six months in fiscal 2004.  Resulting volume-based manufacturingefficiencies contributed to lower costs per unit and margin improvements.

 

15

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***OperatingExpenses***

 

Selling, Service andAdministrative Expenses

 
| ** **                                                                  | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                  | ** ** | **November 27,**       | ** ** | **November 29,**     | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
| ** **                                                                  | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                        |       |                   |       |                 |       |   |   |   |   |
| Selling, service  and administration                                        |       | $                      | 15,326     |                 | $          | 13,281 |   | $ | 30,204 |   | $ | 27,906 |   |
| Included in totals  above:                                                  |       |                   |       |                 |       |   |   |   |   |
| Patent  litigation settlement and legal fees                                |       | 2,240                  |       | —               |       | 2,240 |   | — |   |
| Legal and  professional fees – investigation and securities litigation |       | 359                    |       | 561                  |       | 767 |   | 2,677 |   |
| Prior years  restructuring and cost management plans                        |       | —                 |       | 436                  |       | — |   | 1,253 |   |
| Impact of  special charges                                                  |       | $                      | 2,599      |                 | $          | 997 |   | $ | 3,007 |   | $ | 3,930 |   |

 

Selling, service and administrative expenses were $15.3 million (23.2%of net sales) in the second quarter of fiscal 2005, an increase of $2.0 millioncompared to $13.3 million (29.0% of net sales) in the second quarter of fiscal2004.  The primary items included inselling, service and administrative expenses are labor and otheremployee-related expenses, travel expenses, professional fees and facilitiescosts.

 

Other special charges included in this category consist of litigationsettlement and related legal fees, professional fees related to the 2003 auditcommittee investigation and securities litigation, and charges relating torestructuring actions initiated in prior years. See discussion of litigation settlement in Part II. Item I. Legal Proceedings.  The amounts and timing of these specialcharges are detailed above for comparative purposes.  Exclusive of these special charges, selling,service and administrative expenses increased $0.4 million in the secondquarter of fiscal 2005 compared to the second quarter of fiscal 2004 and $3.2million for the first six months of fiscal 2005 compared to fiscal 2004.

 

The increase in selling, service and administrative expenses, exclusiveof the special charges detailed above, for both the three and six months endedNovember 27, 2004 compared to the same periods in the prior year is primarilydue to increased compensation costs, professional fees for subcontractedservices and sales commissions.  Theseexpense increases are consistent with the overall growth in business volume comparedto the same periods in the prior year.

 

16

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Research, Development and Engineering Expenses

 
| ** **                                          | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                          | ** ** | **November 27,**       | ** ** | **November 29,**     | ** ** | **November 27,** | ** ** | **November 29,** | ** ** |
| ** **                                          | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                |       |                   |       |                 |       |   |   |   |   |
| Research,  development and engineering              |       | $                      | 7,746      |                 | $          | 5,416 |   | $ | 14,306 |   | $ | 11,164 |   |
| Included in  totals above:                          |       |                   |       |                 |       |   |   |   |   |
| Prior year restructuring  and cost management plans |       | —                 |       | 7                    |       | — |   | 198 |   |
| Impact of  special charges                          |       | $                      | —     |                 | $          | 7 |   | $ | — |   | $ | 198 |   |

 

Research,development and engineering expenses are primarily comprised of labor and otheremployee-related expenses, professional fees, project materials, equipment andfacilities costs.  Expenses associatedwith research, development and engineering totaled $7.7 million (11.7% of netsales) for the second quarter of fiscal 2005, representing a $2.3 millionincrease from expenses of $5.4 million (11.8% of net sales) for the secondquarter of fiscal 2004.

 

Forthe six months ended November 27, 2004, research, development and engineeringexpenses increased $3.1 million to $14.3 million (10.3% of net sales) comparedto $11.2 million (16.8% of net sales) for the six months ended November 29,2003.  Exclusive of special charges for previousrestructuring and cost management plans detailed in the table above, research,development and engineering costs increased $3.3 million.

 

Theincrease in research and development costs for both the three and six monthsended November 27, 2004 compared to the same periods in fiscal 2004 isprimarily due to an increase in compensation costs, subcontracted services andmaterials used in research and development activities as we continue to investin funding for development projects, new technical capabilities andinitiatives.

 

***Restructuring and Cost Management Plans***

 

We initiated restructuring and other cost management plans in each ofthe previous fiscal years 2004, 2003 and 2002. The fiscal 2004 plan consisted of a headcount reduction to reduceexpenditures.  The fiscal 2003 actionsprimarily related to relocating the manufacturing of our electronic componentproduct line from Escondido, California to our headquarters in Portland,Oregon.  The fiscal 2002 actions includeda headcount reduction, exiting the mechanical drill business and discontinuingthe manufacture of certain other products and vacating related facilities.  All expenses related to the fiscal 2004 and fiscal2003 plans have been paid.  As ofNovember 27, 2004, we had a remaining amount accrued of approximately $0.4million for future payments, net of estimated sublease rentals, for a propertyin Ann Arbor, Michigan that is leased and sublet through December 2006 and wasvacated as a part of the 2002 restructuring plan.  There were no expenses recorded relating to theseprior restructuring and cost management plans in the three or six months endedNovember 27, 2004.  A detail of expensesby business function for the prior year three months and six months endedNovember 27, 2003 is presented below (in thousands):

 

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| ** **                        | ** ** | **Three months ended November 29,  2003** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **Cost of  Goods Sold**                   | ** ** | **Selling, Service and  Administration** | ** ** | **Research, Development  and Engineering** | ** ** | **Total** | ** ** |
| Fiscal 2004 cost management plan  |       | $                                         | —     |   | $ | 161 |   | $ | — |   | $ | 161 |   |
| Fiscal 2003 cost management  plan |       | —                                    |       | 34 |   | 7 |   | 41 |   |
| Fiscal 2002 cost management  plan |       | —                                    |       | 241 |   | — |   | 241 |   |
|                              |       | $                                         | —     |   | $ | 436 |   | $ | 7 |   | $ | 443 |   |

 
| ** **                        | ** ** | **Six months ended November 29,  2003** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **Cost of  Goods Sold**                 | ** ** | **Selling, Service and  Administration** | ** ** | **Research, Development  and Engineering** | ** ** | **Total** | ** ** |
| Fiscal 2004 cost management plan  |       | $                                       | 123        |   | $ | 618 |   | $ | 191 |   | $ | 932 |   |
| Fiscal 2003 cost management  plan |       | 5                                       |       | 310 |   | 7 |   | 322 |   |
| Fiscal 2002 cost management  plan |       | —                                  |       | 325 |   | — |   | 325 |   |
|                              |       | $                                       | 128        |   | $ | 1,253 |   | $ | 198 |   | $ | 1,579 |   |

 

***Income Taxes***

 

The income tax provision recorded for the second quarter of fiscal 2005was $1.6 million on pretax income of $9.6 million, an effective rate of16.8%.  Comparatively, the income taxprovision was $1.7 million in the second quarter of fiscal 2004, despiterecording a pretax loss of $3.1 million. The fiscal year-to-date provision for income taxes at November 27, 2004is $6.0 million on pretax income of $24.6 million, an effective annual rate of24.5%.  The effective tax rate used inthe second quarter to calculate the tax provision was 16.8% compared to 29.4%in the prior quarter.  This decreaseresults from the necessity to adjust, on a quarterly basis, the year-to-dateeffective tax rate to our best estimate of the annual effective tax rate, whichwe now estimate to be 24.5%.  The estimatedeffective annual tax rate for fiscal 2005 of 24.5% is lower than our statutorytax rate of 38%, primarily due to incentives for export sales and researchcredits.

 

We currently have an outstanding examination by the Internal RevenueService for our tax returns for the tax years ending in 1996 through 2003.  Although the examination is substantiallycomplete, the final outcome of the federal tax audit is uncertain.  We believe the ultimate results will not havea materially adverse effect on our results of operations or financial position.

 

***Net Income (Loss)***

 

Net income for the three and six months ended November 27, 2004 was$7.9 million (12.0% of net sales) or $0.28 per share on a basic and fullydiluted basis and $18.6 million (13.4% of net sales) or $0.64 per share on afully diluted basis, respectively.  Forthe three and six months ended November 29, 2003, we recorded a net loss of$4.9 million (10.7% of net sales) or $0.17 per basic and fully diluted shareand $14.2 million (21.4% of net sales) or $0.51 per basic and fully dilutedshare, respectively.

 

**Liquidity and Capital Resources**

 

At November 27, 2004, our principal sources of liquidity consisted ofexisting cash, cash equivalents and marketable and restricted securities of$338.1 million and accounts receivable of $54.0 million.  At November 27, 2004, we had a current ratioof 8:1 and long-term debt of $143.2 million. Working capital increased to $381.7 million at November 27, 2004 from$369.9 million at May 29, 2004.  Webelieve that our existing cash, cash equivalents and marketable securities areadequate to fund our operations for at least the next twelve months.

 

Cash flows from operating activities for the six months ended November27, 2004 totaled $0.3 million.  Cash wasprovided by net income adjusted for deferred tax entries and other non-cashitems, totaling $29.8 million.  Uses ofcash for net working capital were primarily due to increases in inventories($13.5 million), decreases in payables and current liabilities ($11.9 million)and estimated tax payments made during the second quarter of fiscal 2005 ($1.4million).

 

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Net inventories increased 16.5% to $68.3 million at the end of thesecond quarter compared to $58.6 million at May 29, 2004.  The increase is comprised primarily ofadditions to finished goods due to delayed timing of shipments previouslyanticipated in the first two quarters of fiscal 2005.

 

Payables and current liabilities were $45.0 million at November 27,2004 compared to $55.6 million at May 29, 2004, decreasing by $10.6 million,inclusive of $1.3 million in non-cash currency translation adjustmentsresulting from the weakening of the U.S. dollar.  Approximately $4.9 million of the decreasewas due to a reduction in purchases in response to a softening of demand forour products.  The remaining decrease inother liabilities is due primarily to the litigation settlement and legal fee payments,reductions in estimated income taxes payable and various other reductions inoperating accruals.

 

Cash flows from investing activities totaled $5.7 million for the sixmonths ended November 27, 2004.  Capitalexpenditures totaled $2.1 million during this period and were comprised ofcomputer equipment and systems upgrades, and investments in production and testequipment and facilities.  We generated$2.4 million in cash from the sale of an undeveloped parcel of land in Taiwanclassified as an asset held for sale at May 29, 2004.  We also generated $6.1 million in cash andcash equivalents through the liquidation of restricted investments and activityin our portfolio of marketable securities.

 

Cash flows from financing activities of $4.9 million were comprised ofproceeds from the exercise of stock options for the six months ended November27, 2004.

 

At November 27, 2004 we had $143.2 million recorded on our balancesheet related to our 41⁄4% convertible subordinated notes due December 21,2006.  The difference between the $145.0million face value and the $143.2 million balance at November 27, 2004 relatesto underwriting discounts, which originally totaled $4.5 million.  These discounts are being amortized asadditional interest expense over the life of the subordinated notes at a rateof $0.9 million per year, resulting in a corresponding accretion to therecorded amount of the notes.  During thefirst quarter of fiscal 2005, we made a semi-annual interest payment of $3.1million which was fully funded by the liquidation of restrictedsecurities.  Our next semi-annualinterest payment due in December 2004 will be funded by the final liquidationof our restricted securities.  Under theterms of our debt agreement, there are no further requirements to maintainrestricted fund deposits after December 2004.

 

**Critical Accounting Policies and Estimates**

 

We reaffirm the critical accounting policies and our use of estimatesas reported in our annual report on Form 10-K for our fiscal year ended May 29,2004 as filed with the Securities and Exchange Commission on July 29, 2004.

 

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** **

**FactorsThat May Affect Future Results**

 

Described below are some of the factors thatcould cause actual results to differ materially from the results contemplatedby the forward-looking statements contained in this report. See “ForwardLooking Statements” at the beginning of this Item 2.

 

***The industriesthat comprise our primary markets are volatile and unpredictable.***

 

Our business depends upon the capitalexpenditures of manufacturers of components and circuitry used in wirelesscommunications, computers and other electronic products. In the past, themarkets for electronic devices have experienced sharp downturns. During thesedownturns, electronics manufacturers, including our customers, have delayed orcanceled capital expenditures, which has had a negative impact on our financialresults.

 

After experiencing a significant increase inorders in fiscal 2004, we experienced reduced demand beginning in the firstquarter of fiscal 2005. Net sales decreased from $81.8 million in the fourthquarter of fiscal 2004 to $72.6 million and $66.0 million in the first andsecond quarters of fiscal 2005, respectively. Net income during those periodsdecreased from $16.2 million in the fourth quarter of fiscal 2004 to $10.6million and $7.9 million in the first and second quarters of fiscal 2005,respectively. We cannot assure you when, or if, demand for our products willincrease or that demand will not further decrease. Even if demand for ourproducts does increase, there may be significant fluctuations in our profitabilityand net sales.

 

During any downturn, including the currentdownturn, it will be difficult for us to maintain our sales levels. As aconsequence, to maintain profitability we will need to reduce our operatingexpenses. For example, in December 2004 we announced an operationalrestructuring and reduction in force to reduce our expenses in connection withthe current downturn. However, because there is a lag between actions we taketo reduce expense and the actual reductions of the costs, our ability to quicklyreduce these fixed operating expenses is limited. Moreover, we may be unable todefer capital expenditures, and we will need to continue to invest in certainareas such as research and development. An economic downturn may also cause usto incur charges related to impairment of assets and inventory write-offs andwe may also experience delays in payments from our customers, which would havea negative effect on our financial results.

 

***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 a pressrelease announcing the need to restate our financial results for the quartersended August 31, 2002 and November 30, 2002. In March 2003, the audit committeeof our board of directors, with the assistance of outside legal counsel andindependent forensic accountants, commenced an internal investigation ofcertain accounting matters. The investigation involved the review of (1) thecircumstances surrounding the reversal of an accrual for employee benefits, (2)unsupported accounting adjustments and clerical errors primarily relating toinventory and cost of goods sold, and (3) certain other areas where potentialaccounting errors could have occurred, including revenue recognition andrestructuring reserves. As a result of the investigation, we determined thatour unaudited consolidated condensed financial statements for the three monthsended August 31, 2002 and November 30, 2002, and our audited consolidatedfinancial statements for the year ended June 1, 2002 (and the quarterscontained 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 and result of any other governmentalinvestigation, management’s attention and our resources

 

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couldbe diverted from operations, which could adversely affect our operating resultsand 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. In addition, our bylaws contain indemnificationprovisions with respect to our directors, officers, and employees. Two of ourformer employees are currently party to proceedings brought by the SEC as aresult of its investigation. We may be obligated throughout any investigationor proceeding to advance payment of legal fees and costs incurred by anycurrent and former directors, officers, employees and agents pursuant to theindemnification agreements, our bylaws and applicable Oregon law. We may alsobe obligated to indemnify any former and/or current directors, officers,employees and agents for judgments, fines and amounts paid in settlement if theperson acted in good faith and in a manner reasonably believed to be in or notopposed to our best interests. Payments made by us under these obligations, tothe extent not reimbursed by insurance carriers, could have a material adverseimpact on our financial condition.

 

***Our ability toreduce costs is limited by our need to invest in research and development.***

 

Our industry is characterized by the need for continuedinvestment 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 a result of our need to maintain ourspending levels in this area, our operating results could be materially harmedif our net sales fall below expectations. In addition, as a result of ouremphasis 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 depend on afew significant customers and we do not have long-term contracts with any ofour 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 customer in fiscal 2004 accounted for more than10% of total net sales. In addition, none of our customers has any long-termobligation to continue to buy our products or services, and any customer coulddelay, reduce or cease ordering our products or services at any time.

 

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

 

We depend on manufacturing flexibility to meet the changingdemands of our customers. Any significant delay or interruption in receivingraw materials or in our manufacturing operations as a result of softwaredeficiencies, natural disasters, or other causes could result in reducedmanufacturing capabilities or delayed product deliveries, any or all of whichcould materially and adversely affect our results of operations.

 

In addition, we derive a substantial portion of our revenuefrom the sale of a relatively small number of products with high averageselling prices, some with prices in excess of $1 million per unit. Consequently,shipment and/or customer acceptance delays could significantly impact ourrecognition of revenue and could be further magnified by announcements from usor our competitors of new products and technologies, which announcements couldcause our customers to defer purchases of our existing systems or purchaseproducts from our competitors. Any of these delays could result in a materialadverse change in our results of operations for any particular period.

 

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

 

We use a wide range of materials in the production of ourproducts, including custom electronic and mechanical components, and we usenumerous suppliers for those materials. We generally do not have guaranteedsupply arrangements with our suppliers. We seek to reduce the risk ofproduction and service interruptions and shortages of key parts by selectingand qualifying alternative suppliers for key parts, monitoring the financialstability of key suppliers and maintaining appropriate inventories of keyparts. Although we make reasonable efforts to ensure that parts are availablefrom multiple suppliers, some key parts are available only from a singlesupplier or a limited group of suppliers in the short term. Operations at oursuppliers’ facilities are subject to disruption for a variety of reasons,including changes in business relationships, competitive factors, workstoppages, fire, earthquake, flooding or other natural disasters. Suchdisruption could interrupt our manufacturing. Our business may be harmed if wedo not receive sufficient parts to meet our production requirements in a timelyand cost-effective manner.

 

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

 

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

 

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

 

•                  Difficulties and increasedcosts in connection with integration of the personnel, operations, technologiesand products of acquired companies;

•                  Diversion of management’sattention from other operational matters;

•                  The potential loss of keyemployees of acquired companies;

•                  Lack of synergy, orinability to realize expected synergies, resulting from the acquisition;

•                  The risk that the issuanceof our common stock in a transaction could be dilutive to our shareholders ifanticipated synergies are not realized; and

•                  Acquired assets becomingimpaired as a result of technological advancements or worse-than-expected performanceby the acquired company.

 

Our inability to effectively manage these acquisition riskscould materially and adversely affect our business, financial condition andresults of operations. In addition, if we issue equity securities to pay for anacquisition the ownership percentage of our existing shareholders would bereduced and the value of the shares held by our existing shareholders could bediluted. If we use cash to pay for an acquisition the payment couldsignificantly reduce the cash that would be available to fund our operations orto use for other purposes. In addition, the accounting for future acquisitionscould result in significant charges resulting from amortization of intangibleassets related to such acquisitions.

 

***Our markets aresubject to rapid technological change, and to compete effectively we mustcontinually introduce new products that achieve market acceptance.***

 

The markets for our products are characterized by rapidtechnological change and innovation, frequent new product introductions,changes in customer requirements and evolving industry standards. Our futureperformance will depend on the successful development, introduction and marketacceptance of new and enhanced products that address technological changes aswell as current and potential customer requirements. The introduction by us orby our competitors of new and enhanced products may cause our

 

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customers to defer or cancel orders for our existingproducts, which may harm our operating results. We have in the past experiencedand are currently experiencing a slowdown in demand for our products. In thepast we have also experienced delays in new product development. Similar slowdownsand 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. Productdevelopment delays may result from numerous factors, including:

 

•                  Changing productspecifications and customer requirements;

•                  Difficulties in hiring andretaining necessary technical personnel;

•                  Difficulties inreallocating engineering resources and overcoming resource limitations;

•                  Difficulties with contractmanufacturers;

•                  Changing market orcompetitive product requirements; and

•                  Unanticipated engineeringcomplexities.

 

The development of new, technologically advanced productsis a complex and uncertain process, requiring high levels of innovation andhighly skilled engineering and development personnel, as well as the accurateanticipation of technological and market trends. 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 basis. Further, wecannot assure you that our new products will gain market acceptance or that wewill be able to respond effectively to product announcements by competitors,technological changes or emerging industry standards. Any failure to respond totechnological change that may render our current products or technologiesobsolete could significantly harm our business.

 

***We are exposedto the risks that others may violate our proprietary rights, and ourintellectual property rights may not be well protected in foreign countries.***

 

Our success is dependent upon the protection of ourproprietary rights. In the high technology industry, intellectual property isan important asset that is always at risk of infringement. We incur substantialcosts to obtain and maintain patents and defend our intellectual property. Forexample, we have initiated litigation alleging that certain parties haveviolated various patents of ours. We rely upon the laws of the United Statesand of foreign countries in which we develop, manufacture or sell our productsto protect our proprietary rights. However, these proprietary rights may notprovide the competitive advantages that we expect or other parties maychallenge, invalidate or circumvent these rights.

 

Further, our efforts to protect our intellectual propertymay be less effective in some foreign countries where intellectual propertyrights are not as well protected as in the United States. Many U.S. companieshave encountered substantial problems in protecting their proprietary rightsagainst infringement in foreign countries. If we fail to adequately protect ourintellectual property in these countries, it could be easier for ourcompetitors to sell competing products in foreign countries.

 

***We may be subjectto claims of intellectual property infringement.***

 

Several of our competitors hold patentscovering a variety of technologies, applications and methods of use similar tosome of those used in our products. From time to time, we and our customershave received 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 may assert infringement claims against ourcustomers or us in the future with respect to current or future products oruses, and these assertions may result in costly litigation or require us toobtain a license to use intellectual property rights of others. If claims ofinfringement are asserted against our customers, those customers may seekindemnification from us for damages or expenses they incur.

 

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If we become subject to infringement claims,we will evaluate our position and consider the available alternatives, whichmay include seeking licenses to use the technology in question or defending ourposition. These licenses, however, may not be available on satisfactory termsor at all. If we are not able to negotiate the necessary licenses oncommercially reasonable terms or successfully defend our position, ourfinancial condition and results of operations could be materially and adverselyaffected.

 

***We are exposedto the risks of operating a global business, including risks associated withexchange rate fluctuations, legal and regulatory changes and the impact ofregional and global economic disruptions.***

 

International shipments accounted for 85% of net sales forthe first six months of fiscal 2005, with 76% of our net sales to customers inAsia. We expect that international shipments will continue to represent asignificant percentage of net sales in the future. Our non-U.S. sales andoperations are subject to risks inherent in conducting business abroad, many ofwhich are outside our control, including the following:

 

•                  Periodic local orgeographic economic downturns and unstable political conditions;

•                  Price and currencyexchange controls;

•                  Fluctuation in therelative values of currencies;

•                  Difficulties protectingintellectual property;

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

•                  Difficulties in managing aglobal enterprise, including staffing, collecting accounts receivable, managingdistributors and representatives and repatriation of earnings.

 

Our business and operating results are subject touncertainties arising out of the possibility of regional or global economicdisruptions, 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. Inparticular, due to these uncertainties we are 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.

 

***The loss of keymanagement or our inability to attract, retain and assimilate sufficientnumbers of managerial, financial, engineering and other technical personnelcould have a material effect upon our results of operations.***

 

Our continued success depends,in part, upon key managerial, financial, engineering and technical personnel aswell as our ability to continue to attract, retain and assimilate additionalpersonnel. The loss of key personnel could have a material adverse effect onour business or results of operations. We may not be able to retain our keymanagerial, financial, engineering and technical employees. Attractingqualified personnel is difficult, and our efforts to attract and retain thesepersonnel may not be successful. In addition, we may not be able to assimilatequalified personnel, including any new members of senior management, whichcould disrupt our operations.

 

***Our worldwidedirect sales and service operations expose us to employer-related risks inforeign countries.***

 

We have established direct sales and serviceorganizations throughout the world. A worldwide direct sales and service modelin foreign countries involves certain risks. We are subject to compliance withthe labor laws and other laws governing employers in the countries where ouroperations are located and as a result we may incur additional costs to complywith these local regulations. Additionally, we may

 

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encounter labor shortages or disputes thatcould inhibit our ability to effectively sell, market and service our products.If we cannot effectively manage the risks related to employing persons inforeign countries, our operating results could be adversely affected.

 

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

 

The industries in which we operate are highlycompetitive. We face substantial competition from established competitors, someof which have greater financial, engineering, manufacturing and marketingresources than we do. If we are unable to compete effectively with thesecompanies, our market share may decline and our business could be harmed. Ourcompetitors can be expected to continue to improve the design and performanceof their products and to introduce new products. New companies may enter themarkets in which we compete, or industry consolidation may occur, furtherincreasing competition in those markets. Furthermore, our technologicaladvantages may be reduced or lost as a result of technological advances by ourcompetitors.

 

Their greater resources in these areas may enable them to:

•                  Better withstand periodic downturns;

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

•                  More quickly develop enhancements to and newgenerations of products.

 

We believe that our ability to compete successfully dependson a number of factors, including:

•                  Performance of our products;

•                  Quality of our products;

•                  Reliability of our products;

•                  Cost of using our products;

•                  Consistent availability of criticalcomponents;

•                  Our ability to ship products on the schedulerequired;

•                  Quality of the technical service we provide;

•                  Timeliness of the services we provide;

•                  Our success in developing new products andenhancements;

•                  Existing market and economic conditions; and

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

 

We may not be able to compete successfully in the future,and increased competition may result in price reductions, reduced profitmargins and loss of market share.

 

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

 

There have been no material changes in the market riskdisclosure contained in our 2004 Annual Report on Form 10-Kfor our fiscal yearended on May 29, 2004

 

**Item 4****. Controlsand Procedures**

 

Attached to this annual report as exhibits 31.1 and 31.2are the certifications of our President and Chief Executive Officer and ourChief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of2002 (the Section 302 Certifications). This portion of our quarterly report onForm 10-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 ofthose disclosure controls and procedures. You should read this disclosure inconjunction with the Section 302 Certifications for a more completeunderstanding of the topics presented.

 

***Disclosure Controls andProcedures***

Our management has evaluated, under the supervision andwith the participation of our President and Chief Executive Officer and ChiefFinancial Officer, the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this report pursuant to Rule 13a-15(b)under the Securities Exchange Act of 1934, as amended (Exchange Act). Based onthat evaluation, our President and Chief Executive Officer and our ChiefFinancial Officer have concluded that, as of the end of the period covered bythis report, our disclosure controls and procedures are effective in ensuringthat information required to be disclosed in our Exchange Act reports is (1) recorded,processed, summarized and reported in a timely manner, and (2) accumulated andcommunicated to our management, including our President and Chief ExecutiveOfficer and our Chief Financial Officer, as appropriate to allow timelydecisions regarding required disclosure.

 

***Internal Control Over FinancialReporting***

There has been no change in our internal control overfinancial reporting that occurred during our fiscal quarter ended November 27,2004 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II****– OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

On October 29, 2004, we entered into asettlement and license agreement with Cognex Corporation (Cognex) resolving a lawsuitfiled by Cognex on February 14, 2001 in the United States District Court forthe District of Massachusetts (Cognex Corporation v. Electro ScientificIndustries, Inc. No. 01-10287 WGY). The lawsuit, which alleged that ourCorrectPlace product and some of its predecessors infringed United StatesPatent 5,371,690 owned by Cognex, was dismissed with prejudice on November 1,2004. Under the settlement agreement, Cognex has granted us a license to thepatent in dispute as well as certain covenants not to sue under various othersurface mount placement equipment-related patents, and as consideration for thelicense we have agreed to pay Cognex an undisclosed license fee. As a result ofthe settlement, we recorded a charge to operations of $1.8 million in thesecond quarter of fiscal 2005 along with approximately $0.4 million in relatedlegal fees.

 

In addition to the legal matter describedabove, in the ordinary course of business we are involved in various otherlegal matters, either asserted or unasserted, and investigations. In theopinion of management, amounts accrued for awards or assessments in connectionwith these matters are management’s best estimate, and ultimate resolution ofthese matters will not have a material effect on our consolidated financialposition, results of operations or cash flows.

 

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

 

The 2004 Annual Meetingof Shareholders of the Company was held pursuant to notice at 1:00 p.m. Pacifictime on October 15, 2004 at the Company’s offices in Portland, Oregon toconsider and vote upon:

 
| Proposal 1  |   | To elect three  directors for a term of three years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|-------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Proposal  2 |   | To  approve the Company’s proposed 2004 Stock Incentive Plan and reserve 3,000,000  shares for issuance under the plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Proposal 3  |   | To approve the  Company’s proposed Amended and Restated 2000 Stock Option Incentive Plan.** **This Proposal 3 was submitted for  shareholder approval in the event Proposal 2, seeking approval of the 2004  Stock Incentive Plan, was not approved by shareholders at the annual meeting.  If both proposals were approved by shareholders at the annual meeting, the  2004 Stock Incentive Plan would supersede the Amended and Restated 2000 Stock  Option Incentive Plan (the “Amended 2000 Plan”) and, as a result, the  approval of the Amended 2000 Plan would have no effect. |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Proposal  4 |   | To  approve a proposed amendment to the Company’s 1990 Employee Stock Purchase  Plan to increase the number of shares reserved for issuance under the plan  from 900,000 to 1,900,000.                                                                                                                                                                                                                                                                                                                                                                                                               |

 

27

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The results of thevoting on these proposals were as follows:

 

Proposal 1

 
| **Election of Directors** | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|---------------------------|------------|------------|------------|--------------|------------|
| Frederick A.  Ball        |       | 24,846,078 |       | 1,056,863    |       |
| Nicholas  Konidaris       |       | 25,501,297 |       | 401,644      |       |
| Robert R. Walker          |       | 23,854,995 |       | 2,047,946    |       |

 
| ** ** | ** ** | **For**    | ** ** | **Against** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|------------|------------|-------------|------------|-----------------|------------|---------------------------|------------|
| Proposal 2 |       | 11,847,937 |       | 11,073,923  |       | 24,992          |       | 5,295,604                 |       |
| Proposal 3 |       | 16,919,532 |       | 5,966,339   |       | 60,981          |       | 5,295,604                 |       |
| Proposal 4 |       | 15,215,361 |       | 7,570,215   |       | 161,276         |       | 5,295,604                 |       |

 

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**Item 6. Exhibits**

 

Thislist 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 |   | 2004 Stock Incentive  Plan. Incorporated by reference to Exhibit 10.1 of the Company’s Current  Report on Form 8-K filed on October 21, 2004.                                                                                                                                                                          |
| 10.2 |   | 1990 Employee Stock  Purchase Plan, as amended. Incorporated by reference to Exhibit 10.2 of the  Company’s Current Report on Form 8-K filed on October 21, 2004.                                                                                                                                                      |
| 10.3 |   | Form of Notice of Grant  of Stock options and Option Agreement and related Option Terms and Conditions  (Incentive Stock Options) under 2004 Stock Incentive Plan. Incorporated by  reference to Exhibit 10.3 of the Company’s Current Report on Form 8-K filed  on October 21, 2004.                                  |
| 10.4 |   | Form of Notice of Grant  of Stock Options and Option Agreement and related Options Terms and  Conditions (Non-Qualified Stock Options) under 2004 Stock Incentive Plan.  Incorporated by reference to Exhibit 10.4 of the Company’s Current Report on  Form 8-K filed on October 21, 2004.                             |
| 10.5 |   | Resolution adopted by  the Board of Directors of the Company on October 15, 2004. Incorporated by  reference to Exhibit 10.5 of the Company’s Current Report on Form 8-K filed  on October 21, 2004.                                                                                                                   |
| 10.6 |   | Notice of Grant of  Stock Options and Option Agreement to Robert DeBakker and related Option  Terms and Conditions. Incorporated by reference to Exhibit 10.1 of the  Company’s Current Report on Form 8-K filed on October 1, 2004.                                                                                   |
| 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:   December  22, 2004 | ELECTRO  SCIENTIFIC INDUSTRIES, INC.             |
|--------------------------------------------|--------------------------------------------------|
|                                       |                                             |
|                                       |                                             |
|                                       | By                                               |   /s/  Nicholas Konidaris |   |
|                                       | Nicholas Konidaris                               |
|                                       | President, Chief Executive Officer and  Director |
|                                       | (Principal Executive Officer)                    |
|                                       |                                             |
|                                       |                                             |
|                                       | By                                               | /s/ J. Michael Dodson |   |
|                                       | J. Michael Dodson                                |
|                                       | Senior Vice President of Administration,         |
|                                       | Chief Financial Officer and Secretary            |
|                                       | (Principal Financial Officer)                    |
|                                       |                                             |
|                                       | By                                               | /s/ Kerry Mustoe |   |
|                                       | Kerry Mustoe                                     |
|                                       | Corporate Controller and Chief                   |
|                                       | Accounting Officer                               |
|                                       | (Principal Accounting Officer)                   |
|                                            |                                                  |  |  |  |  |  |

 

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