**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20549**

**FORM 10-K**

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x                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe Fiscal Year Ended: May 28, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**CommissionFile Number: 0-12853**

**ELECTRO SCIENTIFIC INDUSTRIES, INC.**

(Exact name of registrantas specified in its charter)

| **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,including area code:** 503-641-4141

Securities registered pursuant to Section 12(b) ofthe Act:

**None**

Securities registered pursuant to Section 12(g) ofthe Act:

**Common Stock, without parvalue**

**PreferredStock Purchase Rights**

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Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K, or any amendment tothis Form 10-K.  x

Indicateby check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2of the Act).

Yes x   No o

The aggregate market valueof the voting and non-voting common equity held by non-affiliates, computed byreference to the last sales price ($19.67) as reported by the NASDAQ NationalMarket System, as of the last business day of the Registrant’s most recentlycompleted second fiscal quarter (November 27, 2004) was $559,872,954.

The number of sharesoutstanding of the Registrant’s Common Stock as of July 25, 2005 was 28,663,534shares.

**DocumentsIncorporated by Reference**

TheRegistrant has incorporated into Part III of this Form 10-K, byreference, portions of its Proxy Statement for its 2005 Annual Meeting ofShareholders.

 

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**ELECTRO SCIENTIFIC INDUSTRIES, INC.2005 FORM 10-K ANNUAL REPORTTABLE OF CONTENTS**
|                   | ** ** | ** **                                                                                                          | ** ** | **Page**   | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **PART I**   | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** |
| Item 1.           |       | Business                                                                                                            |       |       | 2          |   |   |
| Item 2.           |       | Properties                                                                                                          |       |       | 9          |   |   |
| Item 3.           |       | Legal Proceedings                                                                                                   |       |       | 9          |   |   |
| Item 4.           |       | Submission  of Matters to a Vote of Security Holders                                                                |       |       | 9          |   |   |
| **PART II**  | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** |
| Item 5.           |       | Market  for Registrant’s Common Equity, Related Shareholder Matters and Issuer  Purchases of Equity Securities |       |       | 10         |   |   |
| Item 6.           |       | Selected  Financial Data                                                                                            |       |       | 10         |   |   |
| Item 7.           |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |       |       | 12         |   |   |
| Item 7A.          |       | Quantitative  and Qualitative Disclosures About Market Risk                                                         |       |       | 32         |   |   |
| Item 8.           |       | Financial  Statements and Supplementary Data                                                                        |       |       | 33         |   |   |
| Item 9.           |       | Changes  in and Disagreements With Accountants on Accounting and Financial Disclosure                               |       |       | 62         |   |   |
| Item 9A.          |       | Controls  and Procedures                                                                                            |       |       | 62         |   |   |
| Item 9B.          |       | Other  Information                                                                                                  |       |       | 65         |   |   |
| **PART III** | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** |
| Item 10.          |       | Directors  and Executive Officers of the Registrant                                                                 |       |       | 66         |   |   |
| Item 11.          |       | Executive  Compensation                                                                                             |       |       | 66         |   |   |
| Item 12.          |       | Security  Ownership of Certain Beneficial Owners and Management and Related Shareholder  Matters                    |       |       | 66         |   |   |
| Item 13.          |       | Certain  Relationships and Related Transactions                                                                     |       |       | 66         |   |   |
| Item 14.          |       | Principal  Accounting Fees and Services                                                                             |       |       | 66         |   |   |
| **PART IV**  | ** ** | ** **                                                                                                          | ** ** | ** ** | ** ** |
| Item 15.          |       | Exhibits  and Financial Statement Schedules                                                                         |       |       | 67         |   |   |
| Signatures        |       |                                                                                                                | 70         |       |       |

 

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**PART I**

***Item 1.         Business***

This annual report on Form 10-Kcontains forward-looking statements that are subject to risks and uncertainties.Actual results may differ materially from the forward-looking statements. Factorsthat could cause or contribute to such differences include, but are not limitedto, those set forth under the caption “Factors That May Affect FutureResults” included within “Item 7: Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.”

**Where You Can Find More Information**

We file annual, quarterlyand current reports, proxy statements and other information with the Securitiesand Exchange Commission (SEC) under the Securities Exchange Act of 1934 asamended (Exchange Act). You can inspect and copy our reports, proxy statements,and other information filed with the SEC at the SEC’s Public Reference Room inWashington, D.C. Please call the SEC at 1-800-SEC-0330 for further informationon the Public Reference Room. The SEC maintains an Internet site at *www.sec.gov* where you can obtain most of our SEC filings. Wealso make available, free of charge on our website at *www.esi.com*,our annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and amendments to those reports filed or furnishedpursuant to Section 13(a) or 15(d) of the Exchange Act as soonas reasonably practicable after they are filed electronically with the SEC. Theinformation found on our website is not part of this Form 10-K. You canalso obtain copies of these reports by contacting Investor Relations at (503)641-4141.

**Fiscal Year**

Our fiscal year consistsof 52 or 53 weeks ending on the Saturday nearest May 31. Accordingly,fiscal 2005 ended on May 28, 2005, fiscal 2004 ended on May 29, 2004and fiscal 2003 ended on May 31, 2003, and each of those fiscal yearscontained 52 weeks. All references to years relate to fiscal years unlessotherwise noted.

**Business Overview**

Electro Scientific Industries, Inc. and itssubsidiaries (ESI) provide high-technology manufacturing systems to the globalelectronics market, including advanced laser-based systems that are used tomicroengineer electronic device features in high-volume production environments.Our customers are primarily manufacturers of semiconductors, passive electroniccomponents and electronic interconnect devices. Our equipment enables thesemanufacturers to achieve the yield and productivity gains in theirmanufacturing processes that can be critical to their profitability. Thecomponents and devices manufactured by our customers are used in a wide varietyof end products in the computer, consumer electronics, communications andautomotive industries. ESI was founded in 1944 and is headquartered inPortland, Oregon.

We believe we are theleading supplier of advanced laser microengineering systems that allowelectronics manufacturers to physically alter select device features duringhigh-volume production in order to heighten performance and boost productionyields of semiconductor devices, passive electronic components and circuitry,flex circuits, high-density interconnect (HDI) circuit boards and advancedsemiconductor packaging. Laser microengineering comprises a set of precisefine-tuning processes (laser trimming, link cutting and via drilling) thatrequire application-specific laser systems able to meet semiconductor andmicroelectronics manufacturers’ exacting performance and productivityrequirements. Additionally, we produce high-speed test and terminationequipment used in the high-volume production of multi-layer ceramiccapacitors (MLCCs) and other passive components, as well as passive componentinspection systems.

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**Electronics Industry Overview**

The electronic content of everyday items such ascomputers, communication devices, consumer products and automobiles continuesto increase. For example, markets for consumer-oriented electronicproducts such as wireless telephones, computers, personal digital assistants(PDAs), digital audio players, digital video recorders, digital cameras andhome entertainment devices have developed rapidly as increasingly affordableproducts have been introduced that are smaller, lighter and more portable. Inaddition, automobile manufacturers now routinely include electronic ignitionand fuel injection, anti-lock brakes, navigation systems and otherelectronic safety and sensor systems in place of components that in the pastwere predominantly mechanical or hydraulic.

The increasing demand for electronic products has beenaccompanied by the need for faster, smaller, more complex, less expensive andhigher-quality electronic devices and circuits. To achieve these performanceand size improvements, electronic device manufacturers are increasing thecircuit densities in these devices and tuning them to precise electrical values.Manufacturers of cellular telephones, for example, must use miniaturizedcircuits to accommodate the size limitations of their finished products. Thesecircuits must also be tuned to operate within precise frequency specifications,enabling the existing wireless frequency bands to accommodate more userswithout interchannel interference.

Smaller and lighter requirements also decrease thephysical dimensions used in electronic interconnections within the electronicdevice, its surrounding package and the HDI circuit board on which it ismounted. Higher operating speeds of computers and communications products alsorequire more input and output channels within these packages and between thepackages and the HDI circuit board.

The highly competitive consumer markets for electronicproducts drive the demand for lower-cost devices and components. Electronicdevices and components are produced in large unit volumes, and their productionand testing is highly automated, utilizing a variety of manufacturing equipment.Manufacturers continually seek to reduce costs by improving the throughput,yield and quality of device and component production. These manufacturers arealso developing new materials to improve performance and reduce costs of theirdevices. This challenges equipment suppliers to innovate new manufacturingprocess solutions and equipment.

For example, semiconductor device manufacturers arecontinuing the transition from 200mm and smaller silicon wafers to 300mmwafers, which can accommodate a significantly higher number of electronicdevices. In addition, increasing circuit densities enable more devices to beproduced on a silicon wafer by reducing the size of each device on the wafer. Together,larger wafers and smaller device designs significantly reduce the cost ofsemiconductor devices. Increasing circuit densities which result from shrinkingline widths and faster operating speeds require the use of materials such ascopper to create these miniaturized and higher performance electronic circuits.

To improve production yield, or the number ofacceptable devices produced per silicon wafer, device manufacturers areutilizing advanced systems, such as our laser memory repair products, to boostfinal yields in the manufacture of devices. This includes dynamic random accessmemory (DRAM), NAND flash memory and non-memory devices, such as logic withembedded memory, digital signal processors and high-end electronic game chips.

As semiconductor manufacturers move toward higherdensities and more complex architectures, machine vision has also emerged as acritical technology. By allowing manufacturers to achieve greater precision,increased equipment speed and fewer errors, machine vision is enablingtechnology in the semiconductor manufacturing process, from wafer productionthrough final assembly and packaging. Moreover, machine-vision technology isproving to be integral to applications such as wafer identification. As the increasedfunctionality of next-generation chips continues to drive up total wafer cost,the need to accurately track and identify wafers will become even more criticalto chip manufacturers’ bottom line.

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Variations of these advanced technologies and manufacturingprocesses that are routinely used in semiconductor fabs are increasingly beingemployed in the production of passive components, HDI circuit boards andadvanced semiconductor packages. An example is the use of machine vision inpassive component inspection. As device sizes grow ever smaller and criticaldimensions of the electrical contacts become more precise, machine vision,incorporated with high-speed handling and real-time software, allows forinspection of MLCCs at over 50,000 parts per hour. The previous techniqueutilized human inspection at a much slower rate with poorer inspection results.

In the case of HDI circuitboards, consumers’ desire for faster, lighter, ultimately less expensiveproducts with longer battery life drives cell-phone producers and otherconsumer-product manufacturers to design products in which the discretecircuits are closer together. The same increased density concept used insemiconductor manufacturing is also pursued in printed circuit boardproduction.

**Our Solution**

We believe our products address the needs ofelectronics manufacturers by providing them with a high return on theirinvestment due to measurable production benefits, including improved yield,increased throughput, higher performance, smaller component size, greaterreliability and enhanced flexibility. We typically design our productionsystems to be easily upgraded, enabling them to accommodate the next generationof technology and giving customers the flexibility to add capacity or improveproduct performance at a reasonable incremental cost.

Our core technology strengths include a deepunderstanding of laser/materials interaction, high-speed motion controlsystems, small parts handling systems and image processing and opticalcharacter recognition. We combine this technology expertise in unique andinnovative ways with a thorough understanding of our customers’ processes andobjectives to develop new and improved products.

Our customersmanufacture semiconductors, passive components and electronic interconnectdevices—which, in turn, serve a wide range of electronic applications. Thelargest end-market applications for electronic devices and circuits thatare produced using our systems are:

·       Computers;

·       Telecommunications;

·       Consumerelectronics; and

·       Automotiveelectronics.

**Our Strategy**

***Focus on businesses where we are a market leader.***

We intend to expand theapplication of our existing technologies to grow our overall market opportunityin those product markets in which we currently maintain a leadership position,including, but not limited to, those that involve advanced laser systems usedto microengineer electronic device features in high-volume productionenvironments. We also intend to maintain our market leadership by developingnew products that have higher performance, greater throughput and enhancedreliability, thereby lowering the effective cost of ownership to our customers.

***Develop new high-value businesses.***

We plan to leverageexpertise in our core technologies, technology integration and customercollaboration to develop innovative solutions that will enable us to grow intoattractive new markets through internal or external business development.

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***Invest in research and development to maintain ourtechnological leadership.***

We intend to furtherdevelop our technology leadership by maintaining a significant level ofinvestment in research and development. Our key technological capabilitiesinclude laser/materials interaction, high-speed motion control systems, smallparts handling systems and image processing and optical character recognition. Weconsider our continuing ability to develop intellectual property to be animportant component of our future success.

***Increase the value of our products to globalcustomers.***

We are focused onimproving the yield, throughput and productivity of our customers by utilizingour technology, global infrastructure, customer service and ability tointegrate multiple technologies. We work with our market-leading customers towhom we supply equipment, and have created high-level and multi-disciplinarymanagement and employee teams to define and produce the next generationmanufacturing systems. This requires confidential interaction between thecustomer and ESI, sharing technology, product and production roadmaps oftenlooking out over a three- to five-year period. Embracing the industry trendtoward true globalization of our business has enabled us to elevate ourpresence in key world markets, particularly Asia-Pacific.

**Our Products**

Weoperate within one segment, high technology manufacturing equipment, which iscomposed of products grouped according to our three key target markets:semiconductors, passive components and electronic interconnect. Net sales bygroup, as a percentage of total sales, were as follows:
| ** **                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Semiconductor**           |       | $        | 138,574    |     | 59.4       | %        | $          | 125,018 |   | 60.3 | % | $ | 64,236 |   | 47.0 | % |
| **Passive Components**      |       | 61,001   |       | 26.1     |       | 50,759   |       | 24.5 |   | 48,111 |   | 35.1 |   |
| **Electronic Interconnect** |       | 33,796   |       | 14.5     |       | 31,465   |       | 15.2 |   | 24,538 |   | 17.9 |   |
|                        |       | $233,371 |       | 100.0    | %          | $        | 207,242    |   | 100.0 | % | $ | 136,885 |   | 100.0 | % |

 

**Semiconductor Group**

***Semiconductor Yield-Improvement Systems***

Our yield-improvement product line is designed tocost-effectively meet the production challenges faced by semiconductormanufacturers, including shrinking circuit sizes, material changes andincreased wafer sizes. As circuit densities in semiconductor memory devicessuch as DRAM have increased, manufacturers have built redundant cells intotheir memory designs and connected them with small electrical links on thedevice surface. During the manufacturing process, wafers with millions ofindividual memory cells are tested to identify defective cells. Our lasersystems are then used to cut links that reprogram the device to disconnect thedefective portions and replace them with functional redundant cells.

Our semiconductor link-processing equipment isprimarily used in the manufacture of DRAMs, logic integrated circuits (IC),analog ICs and NAND flash memory devices.

Our 92XX and 93XX Series systemsaddress the yield-improvement needs of semiconductor manufacturers that utilizewafers up to 200mm. Our 98XX Series systems are designed specifically forthe 300mm wafer market, but can also handle 200mm wafers. The 98XX series canbe installed initially to process 200mm wafers as a transition tool and canlater be converted to 300mm wafer processing. Our newest model, the 9835, isthe world’s first ultraviolet (UV) laser fuse processing tool. The 9835delivers world-class spot size with greater depth of focus for processing futuregenerations of ICs. Major DRAM 

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manufacturersare currently qualifying the technology on 90nm DRAM designs. Thesehigh-performance systems deliver increased manufacturing productivity andminimize capital requirements. By enabling the replacement of defective memorystructures with redundant cells, these systems drive post-repair yieldimprovements.

***Machine-Vision Systems***

Our machine-vision subsystems are a key moduleintegrated into our systems. Until recently, our machine-vision sub-systemswere sold only to third-party equipment manufacturers for incorporation intoelectronics-manufacturing equipment, performing alignment, identification, partplacement, die and wire bonding and other functions.

Today, we are leveraging our technology expertise in machine vision tobring a much-needed product directly to chipmakers, as well as to equipmentmanufacturers. Our newly-introduced BulletTM wafer-identification (ID)reader combines the industry’s smallest read head with ESI’s patentedtelecentric lighting technology, enabling the Bullet to identify any kind ofwafer by reading all types of ID marks—from hard scribe marks to super-softmarks used in new and emerging optical character recognition wafer-trackingapplications. As the increased functionality of next-generation chips continuesto drive up total wafer cost, the need to accurately track and identify eachwafer will become even more critical to chip manufacturers’ bottom line.

***Thin Film Trimming***

OurModel 2100 thin-film-on-silicon (TFOS) trimming system continues to gain markettraction. Over the past year, multiple leading analog IC makersqualified the Model 2100 for production. This system uses our patented1.3-micron wavelength trimming process to deliver, in a small footprint,superior throughput and yield compared to traditional 1.0-micron laser-basedTFOS systems.

**Passive Components Group**

We design and manufactureproducts that combine high-speed, small parts handling technology withreal-time control systems to provide highly automated, cost-effective solutionsfor manufacturers of MLCCs and other passive components such as capacitorarrays, inductors, resistors and varistors. These components, produced inquantities of hundreds of billions of units per year, process analog, digitaland high-frequency signals in nearly all electronic products.

·       MultilayerCeramic Test Systems:   These products employ high-speed handling andpositioning techniques to precisely load, test and sort MLCCs based on theirelectrical energy storage capacity, or capacitance, and their electrical energyleakage, or dissipation factor.

·       TerminationSystems:   These products apply a conductive material to the ends ofceramic capacitors permitting connection of the device in a circuit on ahigh-density printed wiring board. The latest addition to this line is theModel 753 array termination system, which features ESI’s patented “Soft Grip”diamond belt for greatly improved productivity.

·       VisualInspection Systems:   These systems perform six-sided automated inspectionof MLCCs and arrays for dimensional criteria and defects.

·       ConsumableProducts:   We also produce consumables, such as carrier plates andtermination belts, both of which are used to hold MLCCs in the manufacturingprocess.

·       CircuitFine-Tuning Systems:   We design and manufacture application-specific lasersystems that adjust the electrical performance of a hybrid circuit, or anelectronic assembly containing many circuits, by removing a precise amount ofmaterial from one or more circuit components.

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**ElectronicInterconnect Group**

Our laser microvia engineering systems are targeted atapplications that require the highest accuracy and smallest via dimensions tocreate electrical connections between layers in high-density circuit boards,flexible circuits and IC packages. Our microvia drilling technologyaddresses the rapidly changing applicationsin IC packages, multichip modules and HDI circuit boards. Our UV laserprocessing systems employ state-of-the-art technology in lasers, optics andmotion control. Our products include single-beam and multi-beam systems thatproduce very high quality vias (holes) with the best-in-class placementaccuracy for improved yield of packages and substrates.

·       Our5300 Series single-head laser drills utilize lasers to drill via holes assmall as 25 microns (by comparison, a human hair is approximately 100 micronsin diameter) in a wide variety of materials, including epoxy, resins andresin-coated copper.

·       OurICP5530 employs our high-repetition UV laser to perform high-quality,high-volume drilling of blind microvias in electronic packages. The ICP5530 canproduce more than 50,000 high-quality microvias per minute on chip-scalesubstrates, flip-chip ball-grid arrays and other advanced IC packages.

**Customers**

Ourtop ten customers for fiscal 2005, 2004 and 2003 accounted for approximately51%, 61% and 54%, respectively, of total net sales, with one customer, Samsung,accounting for approximately 13%, 26% and 16% of total net sales in fiscal2005, 2004 and 2003, respectively. No other customer in fiscal 2005, 2004 or2003 accounted for more than 10% of total net sales. Samsung purchases productsfrom all three of our product groups.

Geographicsales, based on the location of the end user, were as follows:
| ** **   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------|------------|----------|------------|----------|------------|----------|------------|
| **Asia**     |       | $        | 180,378    |     | 77.3       | %        | $          | 146,436 |   | 70.7 | % | $ | 91,549 |   | 66.9 | % |
| **Americas** |       | 35,277   |       | 15.1     |       | 41,035   |       | 19.8 |   | 28,207 |   | 20.6 |   |
| **Europe**   |       | 17,716   |       | 7.6      |       | 19,771   |       | 9.5 |   | 17,129 |   | 12.5 |   |
|         |       | $233,371 |       | 100.0    | %          | $        | 207,242    |   | 100.0 | % | $ | 136,885 |   | 100.0 | % |

 

**Sales, Marketingand Service**

Wesell our products worldwide through direct sales and service offices, afranchised distributor, value added resellers and independent representativeslocated around the world. ESI has direct sales and service personnel in Oregon,Texas and several other states; Tokyo, Oita and Nagoya, Japan; Seoul, Korea;Kao Hsiung and Hsin Chu, Taiwan; Singapore; Guangzhou and Shanghai, China;Munich, Germany; West Sussex, England; Kirkcaldy, Scotland; and Graz, Austria.We serve selected customers in the United States, South America, Europe, Israeland additional countries through manufacturers’ representatives. Canon Sales isa distributor for our Semiconductor Group in Japan.

Wehave a substantial base of installed products in use by leading worldwideelectronics manufacturers. We emphasize strong working relationships with thesecustomers to meet their needs for additional systems and to facilitate thesuccessful development and sale of new products to these customers.

We generallymaintain service personnel wherever we have a significant installed base. Weoffer a variety of warranty, maintenance and parts replacement programs.

**Backlog**

Backlogconsists of purchase orders for service, spare parts and products that weexpect to perform or ship within twelve months. Backlog does not includedeferred revenue. Backlog was $43.2 million at 

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May 28, 2005 compared to $78.5 million at May 29,2004.Thestated backlog is not necessarily indicative of sales for any future period noris a backlog any assurance that we will realize a profit from filling theorders.

**Research,Development and Technology**

Webelieve that our ability to compete effectively depends, in part, on ourability to maintain and expand our expertise in core technologies and productapplications. The primary emphasis of our research and development is toadvance our capabilities in:

·       Lasersand laser/material interaction;

·       High-speed,micron-level motion control systems;

·       Precisionoptics;

·       High-speed,small parts handling;

·       Imageprocessing and optical character recognition;

·       Real-timeproduction-line electronic measurement;

·       Real-timeoperating systems; and

·       Systemsintegration.

Our research anddevelopment expenditures for fiscal years 2005, 2004 and 2003 were $28.0million (12.0% of net sales), $23.8 million (11.5% of net sales) and $27.8million (20.3% of net sales), respectively.

**Competition**

Our markets are dynamic,cyclical and highly competitive. The principal competitive factors in ourmarkets are product performance, ease of use, cost of ownership, reliability,service, technical support, a product improvement path, price, established relationshipswith customers and product familiarity. We believe that our products competefavorably with respect to these factors. Some of our competitors have greaterfinancial, engineering and manufacturing resources and larger distributionnetworks than we do. Some of our customers develop, or have the ability todevelop, manufacturing equipment similar to our products. Competition in ourmarkets may intensify and our technological advantages may be reduced or lostas a result of technological advances by competitors or customers or changes inelectronic device processing technology.

The principal competitorfor our semiconductor group is GSI Group. For the passive component group, ourcompetitors include Tokyo Weld, Kanebo, Humo, All Ring Tech and GSI Group aswell as manufacturers that develop systems for internal use. Our electronicinterconnect group competes with laser systems provided by Hitachi ViaMechanics, Mitsubishi Electric and Sumitomo. Cognex is our principal competitorin the field of machine vision.

**Manufacturing andSupply**

Our production facilitiesare located in Portland and Klamath Falls, Oregon. The manufacturing operationslocated in Portland consist of electronic subassembly and final system assemblyfor all products, except for passive component consumable products, which areproduced in our facility in Klamath Falls.

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We use qualifiedmanufacturers to supply many components and sub-system modules of our products.Our systems use high-performance computers, peripherals, lasers and othercomponents from various suppliers. Some of the components we use are obtainedfrom a single source or a limited group of suppliers. An interruption in thesupply of a particular component could require substitutions that would have atemporary adverse impact on us. We believe our relationships with our suppliersare good.

**Patentsand Other Intellectual Property**

We have a policy of seeking patents, when appropriate,on inventions relating to new products and improvements that are discovered ordeveloped as part of our ongoing research, development and manufacturingactivities. We own 86 United States patents and 144 patents issued outside ofthe United States. Additionally, as of May 28, 2005, we had 57 patentapplications pending in the United States and 183 patent applications pendingoutside of the United States. Although our patents are important, we believethat the success of our business also depends on the technical competence andinnovation of our employees.

We rely on copyrightprotection for our proprietary software. We also rely upon trade secretprotection for our confidential and proprietary information. Others mayindependently develop substantially equivalent proprietary information andtechniques, and we may be unable to meaningfully protect our trade secrets.

**Employees**

As of May 28, 2005,we employed 563 people. Many of our employees are highly skilled, and oursuccess will depend in part upon our ability to attract and retain suchemployees, who are in great demand. We have never had a work stoppage orstrike, and no employees are represented by a labor union or covered by a collectivebargaining agreement. We consider our employee relations to be good.

***Item 2.****                          Properties*

Our executive and administrative offices, as well asour system manufacturing facilities, are located in a four-building complexwith 258,500 square feet of space on 15 acres in Portland, Oregon. Our passivecomponent consumable products are manufactured at a 53,000 square foot plant on31 acres in Klamath Falls, Oregon. We own all of these buildings. We believe the productive capacity of thesefacilities to be adequate and suitable for the requirements of our business forthe foreseeable future.

We lease other office and service space in variouslocations throughout the United States and in six foreign countries.

We do not expectcompliance with federal, state and local provisions which have been enacted oradopted related to the discharge of materials into the environment, orotherwise relating to protection of the environment, to have a material effecton our capital expenditures, earnings or competitive position.

***Item 3.****                          LegalProceedings*

In the ordinary course ofbusiness we are involved in various legal matters, either asserted orunasserted, and investigations. In the opinion of management, ultimateresolution of these matters will not have a material effect on our consolidatedfinancial position, results of operations or cash flows.

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

No matters were submittedto a vote of our security holders during the quarter ended May 28, 2005.

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**PART II**

***Item 5.****                          Marketfor Registrant’s Common Equity, Related Shareholder Matters and IssuerPurchases of Equity Securities*

**Common Stock Prices/Dividends**

Ourcommon stock trades on the NASDAQ National Market under the symbol ESIO. Thefollowing table shows, for the fiscal quarters indicated, the high and lowclosing sale prices for the common stock as reported on the NASDAQ NationalMarket.
| **Fiscal 2005** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------|------------|------------|------------|----------|------------|---------|------------|
| Quarter 1            |       | $          | 29.40      |     | $          | 19.91   |       |
| Quarter 2            |       | 22.51      |       | 16.68    |       |
| Quarter 3            |       | 22.60      |       | 16.80    |       |
| Quarter 4            |       | 22.83      |       | 16.42    |       |
|                      |            |            |            |          |            |         |            |  |  |

 
| **Fiscal 2004** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------|------------|------------|------------|----------|------------|---------|------------|
| Quarter 1            |       | $          | 20.29      |     | $          | 13.77   |       |
| Quarter 2            |       | 26.44      |       | 19.60    |       |
| Quarter 3            |       | 30.46      |       | 21.74    |       |
| Quarter 4            |       | 26.63      |       | 19.26    |       |
|                      |            |            |            |          |            |         |            |  |  |

 

We have not paid any cash dividends on our commonstock during the last two fiscal years. We intend to retain any earnings forour business and do not anticipate paying any cash dividends in the foreseeablefuture. The number of shareholders of record at July 25, 2005 was 698.

We did not repurchase any shares of our common stockduring the fourth quarter of fiscal 2005.

Disclosures related tosecurities authorized for issuance under our Equity Compensation Plans areincorporated by reference into Item 12 of this annual report on Form 10-Kfrom our Proxy Statement for our 2005 annual meeting.

***Item 6.****                          SelectedFinancial Data*
| ** **                                                            | ** ** | **2005**                                                              | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Statement of Operations Data**                                      | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                             |       | $                                                                     | 233,371    |       | $          | 207,242    |       | $          | 136,885    |       | $          | 162,885 |   | $ | 471,853 |   |
| Provision (benefit) for  income taxes                                 |       | 6,437                                                                 |       | (9,308     | )          | (29,135    | )          | (16,540    | )          | 49,997     |       |
| Net income (loss)(1),(2),(3),(4)                                      |       | 19,837                                                                |       | 11,887     |       | (50,086    | )          | (17,777    | )          | 99,933     |       |
| Net income (loss) per  share—basic(1),(2),(3),(4)                |       | 0.70                                                                  |       | 0.42       |       | (1.81      | )          | (0.65      | )          | 3.71       |       |
| Net income (loss) per  share—diluted(1),(2),(3),(4)              |       | 0.69                                                                  |       | 0.42       |       | (1.81      | )          | (0.65      | )          | 3.58       |       |
| **Balance Sheet Data**                                                |       |                                                                  |       |       |       |       |       |       |       |       |       |
| Cash, cash equivalents  and marketable and restricted securities |       | $                                                                     | 218,901    |       | $          | 332,754    |       | $          | 308,252    |       | $          | 302,299 |   | $ | 163,106 |   |
| Working capital                                                       |       | 275,701                                                               |       | 369,941    |       | 340,162    |       | 340,774    |       | 264,644    |       |
| Net property, plant and  equipment                                    |       | 32,959                                                                |       | 33,531     |       | 36,592     |       | 58,046     |       | 54,946     |       |
| Total assets                                                          |       | 403,557                                                               |       | 537,186    |       | 502,598    |       | 532,687    |       | 409,621    |       |
| Long-term debt                                                        |       | —                                                                |       | 142,759    |       | 141,891    |       | 145,897    |       | —     |       |
| Shareholders’ equity                                             |       | 357,155                                                               |       | 326,813    |       | 310,317    |       | 355,759    |       | 363,049    |       |

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(1)           Fiscal2005 includes pretax charges of approximately $4.1 million for the redemptionof our 41⁄4% convertible subordinated notes due 2006 and $2.2 million resultingfrom the settlement and related legal costs for a patent infringement lawsuit. SeeNotes 13 and 18.

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(2)           Fiscal 2004 includes apretax charge of $3.8 million for the estimated settlement of the class actionand derivative lawsuits. See Note 18.

(3)           Fiscal 2003 includes apretax charge of $10.1 million related to the write-down of our Klamath Fallspassive components consumable manufacturing site and related equipment and aparcel of land in Taiwan. See Note 7.

(4)           Fiscal 2001 includes apretax gain of $13.9 million in connection with the litigation award from GSI Group(formerly GSI Lumonics), net of $2.5 million of legal fees and expensesdirectly related to the award, and $1.4 million of interest received.

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***Item 7.         Management’sDiscussion and Analysis of Financial Condition and Results of Operations***

**Overview**

Electro Scientific Industries, Inc. and itssubsidiaries (ESI) provide high-technology manufacturing equipment to theglobal electronics market, including advanced laser systems that are used tomicroengineer electronic device features in high-volume production environments.Our customers are primarily manufacturers of semiconductors, passive componentsand electronic interconnect devices. Our equipment enables these manufacturersto achieve the yield and productivity gains in their manufacturing processesthat can be critical to their profitability. The components and devicesmanufactured by our customers are used in a wide variety of end products in thecomputer, consumer electronics and communications industries.

We supply advanced laser microengineering systems thatallow electronics manufacturers to physically alter select device featuresduring high-volume production, in order to heighten performance and boostproduction yields of semiconductor devices, passive components and circuitry,high-density interconnect (HDI) circuit boards and advanced semiconductorpackaging. Laser microengineering comprises a set of precise fine-tuningprocesses (laser trimming, link cutting and via drilling) that requireapplication-specific laser systems able to meet semiconductor andmicroelectronics’ manufacturers exacting performance and productivityrequirements.

Additionally, we produce high-speed test,inspection and termination equipment used in the high-volume productionof MLCCs and other passive components, as well as original equipmentmanufacturer (OEM) machine vision products.

Consistent with marketcycles, we experienced a strong increase in demand for our products duringfiscal 2004. Ending backlog for fiscal 2004 was $78.5 million. In fiscal 2005,however, we experienced decreases in orders as a result of softening marketsfor our products. Orders decreased 27.1% to $199.2 million in fiscal 2005from $273.5 million in fiscal 2004. Despite the decrease in orders, fiscal 2005shipments of $234.5 million increased 13.9% or $28.7 million compared to $205.8million in fiscal 2004 as we shipped orders included in backlog at the end ofthe prior year. Ending backlog was $43.2 million at the close of fiscal 2005. Grossmargins improved to 47.9% in fiscal 2005 compared to 42.2% in fiscal 2004,primarily due to the volume efficiencies related to the increase in shipments. Increasedgross profits, combined with improvements in operating expenses resulting fromour cost management plans and other economies of scale, led to improvements inboth operating and net income, which were $29.9 million and $19.8 million,respectively, in fiscal 2005. Net income in fiscal 2005 included a one-timecharge of approximately $4.1 million for the redemption of our 41⁄4% convertiblesubordinated notes due 2006. Operating income for fiscal 2004 was $2.6 millionwhile net income was $11.9 million, which included a tax benefit of $9.3million. Fiscal 2004 operating and net income also included a $3.8 millioncharge for the settlement of the class action and derivative lawsuits arisingfrom the restatement of earnings announced in fiscal 2003.

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**Results of Operations**

Thefollowing table sets forth results of operations data as a percentage of netsales.
| ** **                                                | ** ** | **Fiscal 2005** | ** ** | **Fiscal 2004** | ** ** | **Fiscal 2003** | ** ** |
|-----------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| **Net sales**                                             |       |                 | 100.0      | %                    |       |                 | 100.0      | % |   |   | 100.0 | % |   |
| **Cost of sales**                                         |       |                 | 52.1       |                 |       |                 | 57.8       |   |   |   | 86.1 |   |   |
| **Gross margin**                                          |       |                 | 47.9       |                 |       |                 | 42.2       |   |   |   | 13.9 |   |   |
| **Selling, service and administrative**                   |       |                 | 22.1       |                 |       |                 | 27.6       |   |   |   | 46.0 |   |   |
| **Research, development and engineering**                 |       |                 | 12.0       |                 |       |                 | 11.5       |   |   |   | 20.3 |   |   |
| **Patent infringement settlement and related legal fees** |       |                 | 1.0        |                 |       |                 | —     |   |   |   | — |   |   |
| **Settlement of class action and derivative lawsuits**    |       |                 | —     |                 |       |                 | 1.8        |   |   |   | — |   |   |
| **Long-lived asset impairment**                           |       |                 | —     |                 |       |                 | —     |   |   |   | 7.4 |   |   |
| **Operating income (loss)**                               |       |                 | 12.8       |                 |       |                 | 1.3        |   |   |   | (59.8 | ) |   |
| **Total other income (expense), net**                     |       |                 | (1.5       | )                    |       |                 | (0.1       | ) |   |   | 1.9 |   |   |
| **Income (loss) before taxes**                            |       |                 | 11.3       |                 |       |                 | 1.2        |   |   |   | (57.9 | ) |   |
| **Income tax provision (benefit)**                        |       |                 | 2.8        |                 |       |                 | (4.5       | ) |   |   | (21.3 | ) |   |
| **Net  income (loss)**                                    |       |                 | 8.5        | %                    |       |                 | 5.7        | % |   |   | (36.6 | )% |   |

 

**FiscalYear 2005 Compared to Fiscal Year 2004**

***Net Sales***

Net sales for fiscal 2005 increased $26.1 million or12.6% to $233.4 million compared to $207.2 million in fiscal 2004.

Netsales by product group are as follows (net sales in thousands):
| ** **                         | ** ** | **2005**           | ** ** | **2004**                                       | ** ** |
|------------------------------------|------------|--------------------|------------|------------------------------------------------|------------|
| ** **                         | ** ** | **Net Sales** | ** ** | **Percent of  Total Net Sales** | ** ** | **Net Sales** | ** ** | **Percent of  Total Net Sales** | ** ** |
| **Semiconductor  (SG)**            |       | $                  | 138,574    |                                           |       | 59.4 | % |   | $ | 125,018 |   |   | 60.3 | % |   |
| **Passive  Components (PCG)**      |       | 61,001             |       |                                           | 26.1       |   |   | 50,759 |   |   | 24.5 |   |   |
| **Electronic  Interconnect (EIG)** |       | 33,796             |       |                                           | 14.5       |   |   | 31,465 |   |   | 15.2 |   |   |
|                               |       | $233,371           |       |                                           | 100.0      | % |   | $ | 207,242 |   |   | 100.0 | % |   |
|                                    |            |                    |            |                                                |            |  |  |  |  |  |  |  |  |  |  |

 

During fiscal 2005, net sales increased across allproduct groups compared to fiscal 2004. SG sales increased $13.6 million or10.8% over the prior fiscal year as major DRAM manufacturers continued to growcapacity and complete their transition to newer technology. This trend began inthe latter half of fiscal 2004 and continued well into the first half of fiscal2005. Strong fiscal 2005 SG sales were complimented by an increase of $10.2million or 20.2% in PCG sales over the prior year. Several key customers placedorders to build capacity late in fiscal 2004 as a response to anticipateddemand for end customer electronics products. Accordingly, fiscal 2005 PCGsales benefited significantly from the shipment of ending fiscal 2004 backlog. EIGsales increased $2.3 million or 7.4% compared to the prior fiscal year.

Total net sales decreasedsequentially each quarter in fiscal 2005, from $72.6 million in the firstquarter to $45.7 million in the fourth quarter as the cycle of increasingdemand experienced over fiscal 2004 softened. The primary cause for thedecrease was a moderate decline in SG sales and a more significant decline insequential PCG sales. SG sales volumesdecreased in the latter half of fiscal 2005 yet remained at levelssignificantly above those experienced prior to the DRAM market upturn in fiscal2004. PCG sales also decreased in the latter half of fiscal 2005 asmanufacturers remained cautious about building capacity. Fourth quarter PCGsales of $9.9 million were similar to those experienced prior to the market 

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upturn in the first quarter of fiscal 2004. In thefirst quarter of fiscal 2006, we estimate net sales to be in the range of $40to $50 million.

***Gross Profit***

Gross profit was $111.8million (47.9% of net sales) for fiscal 2005 compared to $87.5 million (42.2%of net sales) for fiscal 2004. Shipments in fiscal 2005 increased 13.9%compared to fiscal 2004. The primary driver for increased gross marginscompared to fiscal 2004 was a volume increase in production, shipments andrevenues, which allowed for better factory utilization and improved overheadabsorption, which was achieved without an increase in average annual headcount.In addition, gross margin benefited from efficiency improvements in ourmanufacturing processes. The proportionate sales for our three product groupswere fairly consistent in fiscal 2005 as compared with fiscal 2004. As aresult, there was no significant impact on gross margins resulting from changesin sales mix. We estimate gross margins will be approximately 40% in the firstquarter of fiscal 2006 primarily due to a temporary sales mix shift away fromhigher margin products and the impact of lower margin sales resulting from anEIG product transition, as compared to the fourth quarter of fiscal 2005.

***Operating Expenses***

*Selling, Service and Administrative Expenses*
| ** **                                                                | ** ** | **2005**                | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                                                | ** ** | **(in thousands)** | ** ** |
| Selling, service and administration                                       |       | $                       | 51,618     |     | $          | 57,241 |   |
| Included in totals  above:                                                |       |                    |       |     |       |
| Legal and professional fees—investigation and  securities litigation |       | 795                     |       | 3,825    |       |
| Restructuring and cost management plans                                   |       | 642                     |       | 1,659    |       |
| Impact of special  charges                                                |       | $                       | 1,437      |     | $          | 5,484 |   |

 

Selling, service and administrative expenses were$51.6 million (22.1% of net sales) in fiscal 2005, a decrease of $5.6 millioncompared to $57.2 million (27.6% of net sales) in fiscal 2004. The primaryitems included in selling, service and administrative expenses are labor, commissionsand other employee-related expenses, travel expenses, professional fees andfacilities costs.

Included in selling,service and administrative expenses for fiscal 2005 are charges related to ourfiscal 2005 restructuring and cost management plans of $0.6 million, consistingprimarily of employee severance and related costs. Fiscal 2004 expenses of$57.2 million included $1.7 million in expenses related to cost managementplans. Additionally, selling, service and administrative expenses for fiscal2005 included $0.8 million in legal and professional fees related to the2003 audit committee investigation and securities litigation compared to $3.8million for such fees in fiscal 2004. Exclusive of the impact of these specialcharges as detailed above, selling, service and administration expensesdecreased by $1.6 million, primarily due to reduced legal fees resulting fromthe settlement of certain patent litigation matters early in the fiscal year.

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*Research, Development and Engineering Expenses*
| ** **                              | ** ** | **2005**                | ** ** | **2004** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Research, development and engineering   |       | $                       | 28,027     |     | $          | 23,834 |   |
| Included in totals  above:              |       |                    |       |     |       |
| Restructuring and cost management plans |       | 271                     |       | 198      |       |
| Impact of special  charges              |       | $                       | 271        |     | $          | 198 |   |

 

Expenses associated with research, development andengineering totaled $28.0 million (12.0% of net sales) for fiscal 2005,representing a $4.2 million increase from expenses of $23.8 million (11.5% ofnet sales) for fiscal 2004. The increase in research and development isprimarily attributable to costs related to our increased investment in fundingfor development projects, new technical capabilities and initiatives, includingan increase in compensation costs due to a higher average headcount in fiscal2005 compared to fiscal 2004, an increase in patent registration andmaintenance fees and an increase in subcontracted services and materials usedin research and development activities. We will continue to emphasize researchand development investments in the coming year in order to drive productinnovation and new product offerings.

We estimate totaloperating expenses for selling, service and administrative and research,development and engineering activities will be approximately $19 million to $20million in the first quarter of fiscal 2006.

*Patent InfringementSettlement and Related Legal Fees*

On October 29, 2004,we entered into a settlement and license agreement pertaining to allegedinfringement of surface mount placement equipment-related patents. Under thesettlement agreement, we were granted a license to the patent in dispute. As aresult of the settlement, we recorded a charge to operations of $2.2 million infiscal 2005, consisting of $1.8 million related to the settlement payment alongwith approximately $0.4 million in related legal fees.

***Restructuring and Cost Management Plans***

Inresponse to the economic climate and resulting cyclical fluctuations in demandfor our products, we initiated restructuring and other cost management plans infiscal 2005 and the preceding fiscal years. Cumulative charges related torestructuring and other cost management plans recorded in fiscal years 2005,2004 and 2003 are as follows (in thousands):
| ** **   | ** ** | **Cost of  Goods Sold** | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development and  Engineering** | ** ** | **Total** | ** ** |
|--------------|------------|------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------|------------|-----------|------------|
| Fiscal  2005 |       |                         | $          | 311                                            |       |                                             |       | $         | 642        |   |   |   | $ | 271 |   |   | $ | 1,224 |   |
| Fiscal 2004  |       |                         | 128        |                                           |       |                                             | 1,659      |      |       |   | 198 |   |   | 1,985 |   |
| Fiscal 2003  |       |                         | 5,069      |                                           |       |                                             | 6,550      |      |       |   | 1,216 |   |   | 12,835 |   |
|              |            |                              |            |                                                |            |                                                  |            |           |            |  |  |  |  |  |  |  |  |  |  |

 

***Fiscal year 2005 restructuring plan***

In thethird quarter of fiscal 2005, we initiated a restructuring plan designed tostreamline our technology development efforts and enhance our customer-centricfocus through several actions, including centralizing our research, developmentand engineering function, creating a technical marketing solutions group andcreating a customer-centric manufacturing organization. In conjunction with therestructuring, 57 positions were eliminated in our U.S. operations, impactingall employee groups. Ongoing annual savings will be offset by increasedresearch and development spending in fiscal 2006. We started fiscal 2005 

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with 623 employees and ended the year with 563employees, representing a net decrease of 60 employees during fiscal 2005. Therestructuring actions were completed in early January 2005 and we incurredand paid approximately $1.2 million in charges related to the fiscal 2005restructuring plan during the third quarter of fiscal 2005. These amounts are included in theconsolidated statement of operations for fiscal 2005 as follows (in thousands):
| ** **                                                         | ** ** | **Cost of  Goods Sold** | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development and  Engineering** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------|------------|-----------|------------|
| **For the year ended May 28, 2005:** |       |                              |       |                                           |       |                                             |       |      |       |   |   |   |   |   |   |
| Severance  and other employee-related charges                      |       |                              | $          | 311                                            |       |                                             |       | $         | 642        |   |   |   | $ | 271 |   |   | $ | 1,224 |   |
|                                                               |       |                              | $          | 311                                            |       |                                             |       | $         | 642        |   |   |   | $ | 271 |   |   | $ | 1,224 |   |

 

***Fiscal year 2004 cost management plan***

In thefirst quarter of fiscal 2004 we initiated a reduction of 67 employees,impacting all employee groups, in order to reduce expenditures. Charges relatedto the fiscal 2004 plan of approximately $1.0 million were comprised ofseverance and other employee-related charges. The headcount reductionsprimarily occurred in the first quarter and were substantially completed by thesecond quarter of fiscal 2004. As a result, the expense savings realized fromthose actions were included in the expenditure rate for most of fiscal 2004,but were partially offset by headcount additions in the latter part of the yearas we increased our ability to meet increasing product demand. We startedfiscal 2004 with 649 employees and ended the year with 623 employees,representing a net decrease of 26 employees during fiscal 2004. Charges relatedto the fiscal 2004 cost management plan are included in the consolidatedstatement of operations for fiscal 2004 as follows (in thousands):
| ** **                                                         | ** ** | **Cost of  Goods Sold** | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development and  Engineering** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------|------------|-----------|------------|
| **For the year ended May 29, 2004:** |       |                              |       |                                           |       |                                             |       |      |       |   |   |   |   |   |   |
| Severance and other employee-related charges                       |       |                              | $          | 123                                            |       |                                             |       | $         | 713        |   |   |   | $ | 191 |   |   | $ | 1,027 |   |
|                                                               |       |                              | $          | 123                                            |       |                                             |       | $         | 713        |   |   |   | $ | 191 |   |   | $ | 1,027 |   |

 

***Fiscal year 2003 cost management plan***

The fiscal 2003 actions primarily related torelocating the manufacturing of our electronic component product line fromEscondido, California to our headquarters in Portland, Oregon. These actionsresulted in a reduction of 68 employees and the relocation of 37 employees toour headquarters, which were substantially completed by December 31, 2002.Total charges related to the fiscal 2003 actions were $0.6 million infiscal 2004 and $12.3 million in fiscal 2003.

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Adetail of the expenses by type for the fiscal 2003 cost management plan ispresented below (in thousands):
| ** **                                                    | ** ** | **Cost of  Goods Sold** | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development and  Engineering** | ** ** | **Total**  | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|
| **For the year ended May 29, 2004:**      | ** ** | ** **                        | ** ** | ** **                                     | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Severance, relocation and other employee-related charges |       |                              | $          | —                                         |       |                                             |       | $          | 392        |   |   |   | $ | — |   |   | $ | 392 |   |
| Facilities consolidation costs                                |       |                              | 5          |                                           |       |                                             | 188        |       |       |   | 7 |   |   | 200 |   |
|                                                          |       |                              | $          | 5                                              |       |                                             |       | $          | 580        |   |   |   | $ | 7 |   |   | $ | 592 |   |
| **For the year ended May 31, 2003:**                     |       |                              |       |                                           |       |                                             |       |       |       |   |   |   |   |   |   |
| Severance, relocation and other employee-related charges |       |                              | $          | 640                                            |       |                                             |       | $          | 2,698      |   |   |   | $ | 1,088 |   |   | $ | 4,426 |   |
| Facilities consolidation costs                                |       |                              | 324        |                                           |       |                                             | 2,361      |       |       |   | 128 |   |   | 2,813 |   |
| Inventory and other asset write-offs                          |       |                              | 4,105      |                                           |       |                                             | 945        |       |       |   | — |   |   | 5,050 |   |
|                                                          |       |                              | $          | 5,069                                          |       |                                             |       | $          | 6,004      |   |   |   | $ | 1,216 |   |   | $ | 12,289 |   |

 

Additionally,cost reduction actions in fiscal 2002 reduced our work force by a total of 419employees in June and August 2001, with an additional 97-employeereduction in October 2001. These reductions impacted all employee groups. Theactions also included vacating buildings located in California, Massachusetts,Michigan, Minnesota and Texas, as well as exiting the mechanical drill businessand discontinuing the manufacturing of certain other products. Anticipatedfuture lease costs, net of estimated sublease income, of $0.4 million arereflected as a component of other accrued liabilities at May 29, 2004. Adetail of the expenses by type for the fiscal 2002 cost management plan ispresented below (in thousands):
| ** **                                               | ** ** | **Cost of  Goods Sold** | ** ** | **Selling,  Service and  Administration** | ** ** | **Research,  Development and  Engineering** | ** ** | **Total** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------|------------|-----------|------------|
| **For the  year ended May 29, 2004:**                    |       |                              |       |                                           |       |                                             |       |      |       |   |   |   |   |   |   |
| Severance, relocation and other employee-related charges |       |                              | $          | —                                         |       |                                             |       | $         | —     |   |   |   | $ | — |   |   | $ | — |   |
| Facilities consolidation costs                           |       |                              | —     |                                           |       |                                             | 366        |      |       |   | — |   |   | 366 |   |
|                                                     |       |                              | $          | —                                         |       |                                             |       | $         | 366        |   |   |   | $ | — |   |   | $ | 366 |   |
| **For the  year ended May 31, 2003:**               |       |                              |       |                                           |       |                                             |       |      |       |   |   |   |   |   |   |
| Severance, relocation and other employee-related charges |       |                              | $          | —                                         |       |                                             |       | $         | —     |   |   |   | $ | — |   |   | $ | — |   |
| Facilities consolidation costs                           |       |                              | —     |                                           |       |                                             | 546        |      |       |   | — |   |   | 546 |   |
|                                                     |       |                              | $          | —                                         |       |                                             |       | $         | 546        |   |   |   | $ | — |   |   | $ | 546 |   |

 

***Other Income (Expense)***

Interest income was $6.5 million in fiscal 2005compared to $7.8 million in fiscal 2004. The decrease of $1.3 million isprimarily due to the liquidation of marketable securities to fund the $145million redemption of our 41⁄4% convertible subordinated notes due 2006 (theConvertible Notes) completed in March 2005 and to a lesser extent, achange in portfolio mix. Our investment income in the coming year will dependon our ability to generate and invest cash and obtain favorable returns on ourinvestment assets.

Interest expense was $5.5million in fiscal 2005 compared to $7.4 million in fiscal 2004. The decrease of$1.9 million is primarily due to the redemption of the Convertible Notes in March 2005.As a result of 

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theredemption of the Convertible Notes, we recorded charges totaling $4.1 million,comprised of a redemption premium of $2.5 million and a non-cash charge of $1.6million for unamortized debt issuance costs. Interest expense savings as aresult of the redemption are expected to be $6.1 million in fiscal 2006 and$3.6 million in fiscal 2007 based on the original maturity date of December 2006on the $145.0 million principal amount of the Convertible Notes.

***Income Taxes***

The income tax provision recorded for fiscal year 2005was $6.4 million on pretax income of $26.3 million, an effective rate of24.5%. An income tax benefit of $9.3 million was recorded for fiscal 2004 onpretax income of $2.6 million as a result of export tax incentives and researchand foreign tax credits.

In October 2003 theInternal Revenue Service (IRS) began an audit of the fiscal tax years ending in1996 through 2003. During fiscal 2005 we reached an agreement with the IRS onthe tax return years under review. The examination required a special report tobe submitted by the IRS for congressional approval from the Joint Committee onTaxation. Subsequent to the end of fiscal 2005, we received notice from the IRSthat the Joint Committee’s review was completed without exception. As a result,we will receive approximately $7.2 million in tax refunds. Additionally, we aresubject to numerous ongoing state and foreign tax audits. Although the finaloutcome of these audits is uncertain, based on currently available informationwe believe the ultimate resolutions will not have a materially adverse effecton the Company’s financial position or results of operations.

***Net Income (Loss)***

As a result of the factorsdiscussed above, net income was $19.8 million, or $0.70 per basic share and$0.69 per diluted share, compared to fiscal 2004 net income of $11.9 million,or $0.42 per basic and diluted share.

**FiscalYear 2004 Compared to Fiscal Year 2003**

***Net Sales***

Net sales for fiscal 2004 increased $70.3 million or51.4% to $207.2 million compared to $136.9 million in fiscal 2003.

Netsales by product group are as follows (net sales in thousands):
| ** **                        | ** ** | **2004**           | ** ** | **2003**                                       | ** ** |
|-----------------------------------|------------|--------------------|------------|------------------------------------------------|------------|
| ** **                        | ** ** | **Net Sales** | ** ** | **Percent of  Total Net Sales** | ** ** | **Net Sales** | ** ** | **Percent of  Total Net Sales** | ** ** |
| **Semiconductor (SG)**            |       | $                  | 125,018    |                                           |       | 60.3 | % |   | $ | 64,236 |   |   | 47.0 | % |   |
| **Passive Components (PCG)**      |       | 50,759             |       |                                           | 24.5       |   |   | 48,111 |   |   | 35.1 |   |   |
| **Electronic Interconnect (EIG)** |       | 31,465             |       |                                           | 15.2       |   |   | 24,538 |   |   | 17.9 |   |   |
| ** **                        |       | $207,242           |       |                                           | 100.0      | % |   | $ | 136,885 |   |   | 100.0 | % |   |
|                                   |            |                    |            |                                                |            |  |  |  |  |  |  |  |  |  |  |

 

The increase in net saleswas primarily driven by sales increases in SG to major DRAM manufacturers toincrease capacity and transition to newer technology. This trend began in thesecond quarter and continued through the remainder of fiscal 2004. The increasein SG revenues was also driven by new products introduced in the 9800 modelline that received rapid acceptance with customers. The significant increase inSG sales was complimented by stronger sales in our other markets; the PCGmarket saw end user demand improve in the latter half of fiscal 2004 forproducts that require the use of MLCCs processed by our systems. EIG saleslevels increased compared to the prior year driven by sales to manufacturers offlex circuits and IC packages that require the use of UV laser drills toproduce highly precise manufacturing results.

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***Gross Profit***
| ** **                              | ** ** | **2004**                | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Gross Profit                            |       | $                       | 87,480     |     | $          | 19,027 |   |
| Included in totals  above:              |       |                    |       |     |       |
| Restructuring and cost management plans |       | 128                     |       | 5,069    |       |
| Impact of special  charges              |       | $                       | 128        |     | $          | 5,069 |   |

 

Gross profit was $87.5 million (42.2% of net sales)for fiscal 2004 compared to $19.0 million (13.9% of net sales) for fiscal 2003.Shipments in fiscal 2004 increased 42.3% compared to fiscal 2003. Gross marginimprovements over fiscal 2003 were due to these higher shipment levels, lowermaterial costs as well as more favorable product sales mix. In particular, thesemiconductor group introduced multiple new systems to the market from the 9800product line. These higher margin products gained acceptance with customersrapidly, thus contributing to the gross margin improvement in fiscal 2004.

The increase in shipments also allowed forvolume-based manufacturing efficiencies which resulted in lower costs per unitduring the year. Quarterly shipment volumes steadily increased throughoutfiscal 2004, driving increases in gross margin each quarter, from 23.2% in thefirst quarter of fiscal 2004 to 53.3% in the fourth quarter of fiscal 2004. Duringfiscal 2004, we realized a benefit to gross profit of $2.2 million (1.1% of netsales) resulting from sales of previously reserved inventory.

The increase in fiscal2004 gross profit compared to fiscal 2003 was also due to the significantnegative impact to fiscal 2003 gross profit of charges related to the costmanagement plans discussed below. Charges related to cost management plansrecorded in cost of sales for fiscal 2004 and fiscal 2003 totaled $0.1 millionand $5.1 million, respectively. The fiscal 2004 charges were for employeeseverance payments related to the headcount reductions at the beginning of fiscal2004. Cost of sales in fiscal 2003 included $4.1 million in inventorywrite-downs, $0.6 million in employee severance, relocation and related costsand $0.3 million in facilities consolidation costs for the closure of ourEscondido, California facility. Additionally, downward revisions to previouslyprojected product demand resulted in inventory and asset write-offs of $9.7million and $2.5 million in charges related to open purchase order commitmentsin fiscal 2003.

***Operating Expenses***

*Selling, Service and Administrative Expenses*
| ** **                                                                | ** ** | **2004**                | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                                                | ** ** | **(in thousands)** | ** ** |
| Selling, service and administration                                       |       | $                       | 57,241     |     | $          | 63,001 |   |
| Included in totals  above:                                                |       |                    |       |     |       |
| Legal and professional fees—investigation and  securities litigation |       | 3,825                   |       | 1,935    |       |
| Restructuring and cost management plans                                   |       | 1,659                   |       | 6,550    |       |
| Impact of special  charges                                                |       | $                       | 5,484      |     | $          | 8,485 |   |

 

Selling, service and administrative expenses were$57.2 million (27.6% of net sales) in fiscal 2004, a decrease of $5.8 millioncompared to $63.0 million (46.0% of net sales) in fiscal 2003. The primaryitems included in selling, service and administrative expenses are labor andother employee-related expenses, travel expenses, professional fees andfacilities costs.

Included in selling, service and administrative expensesfor fiscal 2004 are charges related to cost management plans of $1.7 million,consisting of employee severance, relocation and related costs 

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of $1.1 millionand facilities consolidation costs of $0.6 million. Fiscal 2003 expenses of$63.0 million included $6.6 million in expenses related to cost managementplans, comprised of $2.7 million in employee severance, relocation and relatedcosts, $2.9 million in facilities consolidation costs and fixed asset write-downsof $0.9 million. Selling, service and administrative expenses also decreased infiscal 2004 compared to fiscal 2003 as the result of reduced employee expensesrelated to our cost management plans implemented during fiscal 2003 and 2004.

The decrease in selling,service and administrative expenses was partially offset by legal andprofessional fees related to the 2003 audit committee investigation andsecurities litigation which increased to $3.8 million in fiscal 2004 from $1.9million in fiscal 2003.

*Research, Development and Engineering Expenses*
| ** **                              | ** ** | **2004**                | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Research, development and engineering   |       | $                       | 23,834     |     | $          | 27,762 |   |
| Included in totals  above:              |       |                    |       |     |       |
| Restructuring and cost management plans |       | 198                     |       | 1,216    |       |
| Impact of special  charges              |       | $                       | 198        |     | $          | 1,216 |   |

 

Research, development and engineeringexpenses are primarily comprised of labor and other employee-related expenses,professional fees, project materials, equipment and facilities costs. Expensesassociated with research, development and engineering totaled $23.8 million forfiscal 2004, representing a $4.0 million decrease from expenses of $27.8million for fiscal 2003. Included in research and development expenses forfiscal 2004 is $0.2 million in severance and other employee-related expensesresulting from our fiscal 2004 cost management plan implemented during thefirst quarter of fiscal 2004. For fiscal 2003, these expenses included $1.1million in severance and other employee-related expenses and $0.1 million infacilities consolidation costs for a total of $1.2 million related to costmanagement plans. Excluding these charges, the overall decrease in research anddevelopment spending was $3.0 million during fiscal 2004 and can be attributedto overall headcount reductions as well as decreases in project spending. Researchand development spending often fluctuates from year to year as engineeringprojects move through their product development life cycles.

*Settlement of Class Actionand Derivative Lawsuits*

In fiscal 2004 we recordeda charge of $3.8 million for the settlement of the class action and derivativelawsuits arising from the restatement of earnings announced in fiscal 2003. Thesettlement required a payment of $9.3 million, of which approximately $3.8million was paid by us and approximately $5.5 million was paid by our insurancecarrier.

*Long-lived AssetImpairment*

Operating expenses infiscal 2004 decreased by $10.1 million from the prior year as a result of theasset impairment charge recorded in fiscal 2003 which included $9.1 millionrelated to the write-down of our Klamath Falls, Oregon components manufacturingsite and related equipment, and $1.0 million related to the write-down of landin Taiwan. The market for consumable products manufactured by our Klamath Fallsoperation experienced a significant reduction in demand in fiscal 2003 as wellas significantly increased competition from foreign manufacturers. Accordingly,during the fourth quarter of fiscal 2003, we determined that the book value ofthese assets exceeded the estimated undiscounted future cash flow. Pursuant toStatement of Financial Accounting Standards (SFAS) No. 144 “Accounting forthe 

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Impairmentor Disposal of Long-Lived Assets,” we wrote down the assets to their estimatedfair values. Based on our annual review of long-lived assets, no impairmentcharges were required in fiscal 2004.

*Other Income(Expense)*

Interest income was $7.8 million in fiscal 2004compared to $9.6 million in fiscal 2003. The decrease is primarily due to lowerinterest rates earned during fiscal 2004 compared to fiscal 2003 on a slightlylower average amount of invested assets, which consist primarily ofmortgage-backed debt securities and corporate debt securities. In addition toslightly lower average investment balances, and consistent with marketconditions, our investment rates of return steadily declined on all assets inour portfolio during fiscal year 2004.

Interest expense was $7.4 millionin fiscal 2004 compared to $7.5 million in fiscal 2003. Annual interestexpense related to the Convertible Notes of approximately $7.1 million includes$0.9 million for the accretion of underwriting discounts.

Net other expense of $0.4million for fiscal 2004 increased $0.9 million when compared with $0.5 millionin other net income in fiscal 2003. For fiscal 2004, other net expense of $0.4million is primarily comprised of bank fees. Net other income of $0.5 millionin fiscal 2003 is primarily comprised of $0.6 million of bank charges, offsetby a gain of $0.6 million related to legal settlements, a gain on sale ofsecurities of $0.4 million and a $0.2 million gain related to the repurchase of$5.0 million principal amount of the Convertible Notes.

***Income Taxes***

The income tax benefitrecorded for fiscal year 2004 was $9.3 million on pretax income of $2.6 million.The tax benefit in fiscal 2004 resulted primarily from export tax incentives ofapproximately $4.8 million and $2.6 million in research and foreign taxcredits, respectively, for current and prior periods resulting from tax returnsfiled in the current year. To a lesser extent, the net tax benefit was alsoimpacted by the effect of foreign income taxed at rates lower than U.S. federalstatutory income tax rates, and the recording of temporary differencespreviously not recognized. The income tax benefit recorded for fiscal 2003 of$29.1 million resulted in an effective benefit rate of 36.8%.

***Net Income (Loss)***

As a result of the factorsdiscussed above, net income was $11.9 million, or $0.42 per basic and dilutedshare, for fiscal 2004 compared to a net loss of $50.1 million, or $1.81 perbasic and diluted share, for fiscal 2003.

**Financial Condition and Liquidity**

At May 28, 2005, our principal sources ofliquidity consisted of cash, cash equivalents and marketable securities of$218.9 million and accounts receivable of $36.2 million. At May 28, 2005,we had a current ratio of 6.9:1 and no long-term debt. We redeemed ourConvertible Notes on March 10, 2005. As a result, working capitaldecreased to $275.7 million at May 28, 2005 from $369.9 million at May 29,2004. We believe that our existing cash, cash equivalents and marketablesecurities are adequate to fund our operations for at least the next twelvemonths.

Cash flows from operating activities totaled $26.6million in fiscal 2005. Cash totaling $38.1 million was provided by net incomeadjusted for non-cash items. Other factors impacting cash flows from operationsincluded increases in inventories and other assets, decreases in tradereceivables and decreases in payables and current liabilities.

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Net inventories increased 1.5% to $59.5 million at May 28,2005 compared to $58.6 million at May 29, 2004. The increase is comprisedprimarily of a $2.7 million addition to raw materials and purchased parts dueto increased spare parts inventories maintained at field service locations in orderto service our larger base of installed systems. The increase in raw materialswas offset by a net decrease of $1.8 million in combined finished goods andwork-in-process inventories due to a tightening of production schedules. Thechange in inventory balances also includes a non-cash transfer of $4.4 millionto property, plant and equipment and other non-current assets for capitalizeddemonstration and research systems.

Net trade receivables were $36.2 million at May 28,2005 compared to $51.7 million at May 29, 2004, a decrease of $15.5million. Net trade receivables at May 28, 2005 includes an increase of$1.4 million due to non-cash currency translation adjustments resulting fromthe weakening of the U.S. dollar. The remaining decrease is due to lowerrevenue levels in the fourth quarter of fiscal 2005 compared to the fourthquarter of fiscal 2004 combined with strong collection activities.

Payables and current liabilities were $33.4 million atMay 28, 2005 compared to $55.6 million at May 29, 2004, a decrease of$22.2 million. Approximately $9.3 million of the decrease was due to areduction in purchases in the latter half of fiscal 2005 in response to asoftening of demand for our products. The remaining decrease in otherliabilities is due primarily to the payment of accrued amounts for legalsettlements and related fees, reductions in estimated income taxes payable,elimination of accrued interest due to the redemption of the Convertible Notes,decreased payroll liabilities and various other reductions in operatingaccruals.

Cash flows from investing activities totaled $92.3million for the fiscal 2005. Capital expenditures totaled $4.7 million duringthis period and were comprised of computer equipment and systems upgrades, andinvestments in production and test equipment and facilities, including majorrefurbishment of a research and development clean room and laboratories. Wegenerated $2.4 million in cash in June 2004 from the sale of anundeveloped parcel of land in Taiwan classified as an asset held for sale at May 29,2004. We also generated a net $95.4 million in cash and cash equivalentsthrough the liquidation, maturity and sale of restricted investments in ourportfolio of marketable securities offset by certain reinvestments. Theseinvestment transactions were undertaken primarily to fund the redemption of theConvertible Notes on March 10, 2005 and regularly scheduled semi-annualinterest payments on the Convertible Notes prior to redemption. We anticipatecapital expenditures related to the implementation of a new enterprise resourceplanning system in fiscal 2006 will total approximately $12 million.

Cash used in financing activities of $137.9 millionwas comprised of the $145.0 million principal value of Convertible Notesredeemed on March 10, 2005 discussed below and $7.1 million in proceedsfrom our stock plans during fiscal 2005.

On March 10, 2005, we redeemed the $145.0 millionaggregate principal value of our 41⁄4% Convertible Notes due December 21,2006. In accordance with the terms of the Convertible Note indenture, theredemption price was 101.70% of the principal amount of the Convertible Notes,plus accrued and unpaid interest to the redemption date. In connection with theredemption, we recorded expenses of approximately $4.1 million in the fourthquarter of fiscal 2005, consisting of the redemption premium, a non-cash chargefor unamortized debt issuance costs of approximately $1.6 million and otherrelated costs.

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A summary of our contractual commitments and obligationsas of May 28, 2005 is as follows (in thousands):
| ** **                            | ** ** | **Payments Due By Period** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation**       | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **  1-3 years  ** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
| Purchase commitments                  |       | $                                         | 27,063     |   | $ | 26,715 |   |   | $ | 348 |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Derivative financial instruments, net |       | 9,293                                     |       | 9,293 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Operating leases                      |       | 1,573                                     |       | 902 |   |   | 661 |   |   |   | 10 |   |   |   | — |   |   |
|                                  |       | $37,929                                   |       | $ | 36,910 |   |   | $ | 1,009 |   |   |   | $ | 10 |   |   |   | $ | — |   |   |
|                                       |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Derivative financialinstruments represent various forward exchange contracts to hedge foreigncurrency transactions. Amounts are presented above in U.S. dollars, translatedat the exchange rate on May 28, 2005 and are a net presentation of amountsexpected to be received and paid upon settlement of these contracts.

**CriticalAccounting Policies and Estimates**

The preparation of our financial statements requiresus to make estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses. Our estimates are based on historicalexperience and on various assumptions that we believe to be reasonable underthe circumstances. These estimates form the basis for judgments about thecarrying values of assets and liabilities that are not readily apparent fromother sources. Refer to Part II, Item 8. Note 1—Summary of SignificantAccounting Policies, in the Notes to Consolidated Financial Statements foradditional information.

Our criticalaccounting policies and estimates include the following:

·       Revenuerecognition;

·       Inventorywrite-downs;

·       Productwarranty reserves;

·       Allowancefor doubtful accounts;

·       Incometax benefits, expenses, deferred taxes and valuation allowances;

·       Losscontingencies; and

·       Long-livedasset valuations.

***Revenue Recognition***

We recognize revenue in accordance with SEC StaffAccounting Bulletin (SAB) No. 104, “Revenue Recognition” (SAB 104). Revenueis recognized when persuasive evidence of an arrangement exists, delivery hasoccurred or the services have been rendered, the sales price is fixed ordeterminable and collection of the related receivable is reasonably assured. Titleand risk of loss generally pass to the customer at the time of delivery of theproduct to a common carrier. Revenue is recognized upon delivery, provided thatfulfillment of acceptance criteria can be demonstrated prior to shipment. Wherethe acceptance criteria cannot be demonstrated prior to shipment, or in thecase of substantially new products, revenue is deferred until acceptance hasbeen received. For multiple element arrangements, the fair values of anyundelivered elements, estimated based on the list price of such elements, aredeferred until the elements are delivered and acceptance criteria are met. Installationservices are not essential to the functionality of the delivered equipment. Beginningin fiscal 2004, and in accordance with SAB 104, installation revenue isdeferred until installation is complete. Prior to fiscal 2004, and inaccordance with 

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SAB 101, “RevenueRecognition in Financial Statements,” the costs of installation service wereaccrued at the time the revenue was recorded. Historically, neither the costsof installation accrued nor the fair value of installation service revenuedeferred has been significant.

Revenues associated with sales to customers underlocal contracts in Japan are recognized upon title transfer, which generallyoccurs upon customer acceptance, with the exception of sales to our distributorin Japan, where revenues are recognized upon title transfer to the distributor.We have no distributor relationships outside of Japan.

Revenues related to spare parts and consumable salesare recognized upon shipment. Revenues related to maintenance and servicecontracts are recognized ratably over the duration of the contracts.

Revenues are difficult topredict, due in part to our reliance on customer acceptance for a portion ofour revenues. Any shortfall in revenue or delay in recognizing revenue couldcause our operating results to vary significantly from quarter to quarter andcould result in future operating losses.

***Inventory Write-downs***

We regularly evaluate thevalue of our inventory based on a combination of factors including, but notlimited to, the following: forecasted sales or usage, historical usage rates,estimated service period, product end-of-life dates, estimated current andfuture market values, service inventory requirements and new product introductions.Purchasing requirements and alternative uses for the inventory are exploredwithin these processes to mitigate inventory exposure. Raw materials withquantities in excess of forecasted usage are reviewed quarterly forobsolescence by our engineering and operating personnel. Raw materialobsolescence write-downs are typically caused by engineering change orders orproduct end-of-life adjustments in the market. Finished goods are reviewedquarterly by product marketing and operating personnel to determine ifinventory carrying costs exceed market selling prices. We record inventorywrite-downs, when necessary, as an increase to cost of sales based on theabove factors and take into account worldwide quantities and demand into ouranalysis. If circumstances related to our inventories change, our estimates ofthe value of inventory could materially change.

***Product Warranty Reserves***

We evaluate obligationsrelated to product warranties quarterly. A standard one-year warranty isprovided on products. Warranty charges are comprised of costs to service thewarranty, including labor to repair the system and replacement parts fordefective items, as well as other costs incidental to the repairs. Inventorycredits resulting from the return of repaired parts to inventory and any costrecoveries from warranties offered by our suppliers for defective componentsare recorded as a credit to the warranty accrual. Using historical data, weestimate average warranty cost per system or part type and record the provisionfor such charges as an element of cost of goods sold. Additionally, the overallwarranty accrual balance is separately analyzed using the remaining warrantyperiods outstanding on systems and items under warranty, and any resultingchanges in estimates are recorded as an adjustment to cost of sales uponshipment. If circumstances change, or if a material change in warranty-relatedincidents occurs, the estimate of the warranty accrual could changesignificantly. Accrued product warranty is included on the balance sheet as acomponent of accrued liabilities. Our warranty expense in fiscal 2005 totaled $5.1million.

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***Allowance for Doubtful Accounts***

Credit limits areestablished by reviewing the financial history and stability of each customer. Whereappropriate, we obtain credit rating reports and financial statements of thecustomer to initiate and modify their credit limits. On certain foreign sales,we require letters of credit. We regularly evaluate the collectibility of ourtrade receivable balances based on a combination of factors. When a customer’saccount becomes past due, we talk with the customer to determine the cause. Ifwe determine that the customer will be unable to fully meet its financialobligation to us, such as in the case of a bankruptcy filing or other materialevents impacting its business, we record a specific reserve for bad debt toreduce the related receivable to the amount we expect to recover given allinformation then available. If circumstances related to specific customerschange, our estimates of the recoverability of receivables could materiallychange. We record estimated bad debts quarterly as an increase to selling,service and administrative expenses. At May 28, 2005, our allowance fordoubtful accounts totaled $0.8 million and our bad debt expense in fiscal 2005was $0.2 million.

***Deferred Taxes and Tax Reserves***

Deferred tax assets and liabilities are measured usingenacted tax rates expected to apply to taxable income in the years in whichthose assets and liabilities are expected to be recovered or settled. UnderSFAS No. 109 “Accounting for Income Taxes,” the effect on deferred taxesof a change in tax rates is recognized in income in the period that includesthe enactment date. When management determines that it is more likely than notthat a deferred tax asset will not be fully realized, a valuation allowance isestablished to reduce deferred tax assets to the amount expected to be realized.Should management’s assumptions and expectations be inaccurate, our results ofoperations and financial condition could be adversely affected in futureperiods. At May 28, 2005, our net deferred tax assets totaled $27.9million, which included a valuation allowance of $3.5 million.

We are subject to incometaxes in the United States and in numerous foreign jurisdictions and in theordinary course of business, there are many transactions and calculations wherethe ultimate tax determination is uncertain. We have reserves for taxes toaddress potential exposures related to tax positions that could be challengedby taxing authorities, even though the Company believes that the positionstaken on previously filed tax returns are appropriate. Tax reserves arereviewed as warranted and adjusted as events occur that affect the Company’spotential liability for additional taxes.

***Loss Contingencies***

Where we can make areasonable estimate of the liability relating to pending litigation, we recorda liability. As additional information becomes available, we assess thepotential liability and revise estimates as appropriate. Because ofuncertainties relating to litigation, however, the amount of our estimates couldbe wrong. Moreover, plaintiffs may not specify an amount of damages sought.

***Long-lived Asset Valuations***

Long-lived assets,principally property and equipment and identifiable intangibles held and usedby us are reviewed for impairment whenever events or circumstances indicatethat the carrying amount of assets may not be recoverable in accordance withSFAS No. 144. We evaluate recoverability of assets to be held and used bycomparing the carrying amount of an asset to estimated future net undiscountedcash flows to be generated by the asset. If such assets are considered to beimpaired, the impairment recognized is measured as the amount by which thecarrying amount of the assets exceeds the fair value of the assets.

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***Factors That May Affect Future Results***

The statements containedin this report that are not statements of historical fact, including withoutlimitation, statements containing the words “believes,” “expects” and similarwords, constitute forward-looking statements that are subject to a numberof risks and uncertainties. From time to time we may make other forward-lookingstatements. Investors are cautioned that such forward-looking statements aresubject to an inherent risk that actual results may materially differ. Thefollowing information highlights some of the factors that could cause actualresults to differ materially from the results expressed or implied by ourforward-looking statements. Forward-looking statements should be considered inlight of these factors. Factors that may result in such variances include, butare not limited to the following:

***The industries that comprise our primary markets arevolatile and unpredictable.***

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

After experiencing a significant increase in orders infiscal 2004, we experienced reduced demand beginning in the first quarter offiscal 2005. Net sales decreased from $81.8 million in the fourth quarter offiscal 2004 to $72.6 million, $66.0 million, $49.1 million and $45.7 million inthe first, second, third and fourth quarters of fiscal 2005, respectively. Netincome (loss) during those periods decreased from $16.2 million in thefourth quarter of fiscal 2004 to $10.6 million, $7.9 million, $2.0 million and($0.8 million) in the first, second third and fourth 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 ourprofitability and net sales.

During any downturn,including the current downturn, it will be difficult for us to maintain oursales levels. As a consequence, to maintain profitability we will need toreduce our operating expenses. For example, in December 2004 we announcedan operational restructuring and reduction in force to reduce our expenses inconnection with the current downturn. Our ability to quickly reduce operatingexpenses is dependent upon the nature of the actions we take to reduce expenseand our subsequent ability to implement those actions and realize expected costsavings. Additionally, we may be unable to defer capital expenditures and wewill need to continue to invest in certain areas such as research anddevelopment. An economic downturn may also cause us to incur charges related toimpairment of assets and inventory write-offs and we may also experience delaysin payments from our customers, which would have a negative effect on ourfinancial results.

***Delays in manufacturing, shipment or customeracceptance of our products could substantially decrease our sales for a period.***

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

In addition, we derive asubstantial portion of our revenue from the sale of a relatively small numberof products. Consequently, shipment and/or customer acceptance delays couldsignificantly impact our recognition of revenue and could be further magnifiedby announcements from us or our competitors of new products and technologies,which announcements could cause our customers to defer purchases of our 

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systemsor purchase products from our competitors. Any of these delays could result ina material adverse change in our results of operations for any particularperiod.

***Failure of critical suppliers of parts, components andmanufacturing equipment to deliver sufficient quantities to us in a timely andcost-effective manner could negatively affect our business.***

We use a wide range ofmaterials in the production of our products, including custom electronic andmechanical components, and we use numerous suppliers for those materials. Wegenerally do not have guaranteed supply arrangements with our suppliers. Weseek to reduce the risk of production and service interruptions and shortagesof key parts by selecting and qualifying alternative suppliers for key parts,monitoring the financial stability of key suppliers and maintaining appropriateinventories of key parts. Although we make reasonable efforts to ensure thatparts are available from multiple suppliers, some key parts are available onlyfrom a single supplier or a limited group of suppliers in the short term. Operationsat our suppliers’ facilities are subject to disruption for a variety ofreasons, 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 depend on a few significant customers and we do nothave long-term contracts with any of our customers.***

Ourtop ten customers for fiscal 2005 accounted for approximately 51% of total netsales in fiscal 2005, with one customer, Samsung, accounting for approximately13%, 26% and 16% of total net sales in fiscal 2005, 2004 and 2003, respectively.No other customer in fiscal 2005, fiscal 2004 or fiscal 2003 accounted for morethan 10% of total net sales. In addition, none of our customers has anylong-term obligation to continue to buy our products or services, and anycustomer could delay, reduce or cease ordering our products or services at anytime.

***Our markets are subject to rapid technological change,and to compete effectively we must continually introduce new products thatachieve market acceptance.***

The markets for our products are characterized byrapid technological change and innovation, frequent new product introductions,changes in customer requirements and evolving industry standards. Our 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 customers todefer or cancel orders for our existing products, which may harm our operatingresults. We have in the past experienced and are currently experiencing aslowdown in demand for our products. In the past we have also experienceddelays in new product development. Similar slowdowns and delays may occur inthe future. We also may not be able to develop the underlying core technologiesnecessary to create new products and enhancements or, where necessary, tolicense these technologies from others.

Product developmentdelays may result from numerous factors, including:

·       Changingproduct specifications and customer requirements;

·       Difficultiesin hiring and retaining necessary technical personnel;

·       Difficultiesin reallocating engineering resources and overcoming resource limitations;

·       Difficultieswith contract manufacturers;

·       Changingmarket or competitive product requirements; and

·       Unanticipatedengineering complexities.

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The development of new,technologically advanced products is a complex and uncertain process, requiringhigh levels of innovation and highly skilled engineering and developmentpersonnel, as well as the accurate anticipation of technological and markettrends. We cannot assure you that we will be able to identify, develop,manufacture, market or support new or enhanced products successfully, if atall, or on a timely basis. Further, we cannot assure you that our new productswill gain market acceptance or that we will be able to respond effectively to productannouncements by competitors, technological changes or emerging industrystandards. Any failure to respond to technological change that may render ourcurrent products or technologies obsolete could significantly harm ourbusiness.

***Our ability to reduce costs is limited by our need toinvest in research and development.***

Our industry ischaracterized by the need for continued investment in research and development.Because of intense competition in the industries in which we compete, if wewere to fail to invest sufficiently in research and development, our productscould become less attractive to potential customers, and our business andfinancial condition could be materially and adversely affected. As a result ofour need to maintain our spending levels in this area, our operating resultscould be materially harmed if our net sales fall below expectations. Inaddition, as a result of our emphasis on research and development andtechnological innovation, our operating costs may increase further in thefuture, and research and development expenses may increase as a percentage oftotal operating expenses and as a percentage of net sales.

***We are exposed to the risks that others may violateour proprietary rights, and our intellectual property rights may not be wellprotected 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 toprotect our intellectual property may be less effective in some foreigncountries where intellectual property rights are not as well protected as inthe United States. Many U.S. companies have encountered substantial problems inprotecting their proprietary rights against infringement in foreign countries. Ifwe fail to adequately protect our intellectual property in these countries, itcould be easier for our competitors to sell competing products in foreigncountries, which could result in reduced sales.

***We may be subject to claims of intellectual propertyinfringement.***

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

If we become subject toinfringement claims, we will evaluate our position and consider the availablealternatives, which may include seeking licenses to use the technology inquestion or defending our 

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position.These licenses, however, may not be available on satisfactory terms or at all. Ifwe are not able to negotiate the necessary licenses on commercially reasonableterms or successfully defend our position, our financial condition and resultsof operations could be materially and adversely affected.

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

The industries in which we operate are highlycompetitive. We face 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.

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

·       Betterwithstand periodic downturns;

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

·       Morequickly develop enhancements to and new generations of products.

We believe that ourability to compete successfully depends on a number of factors, including:

·       Performanceof our products;

·       Qualityof our products;

·       Reliabilityof our products;

·       Costof using our products;

·       Consistentavailability of critical components;

·       Ourability to ship products on the schedule required;

·       Qualityof the technical service we provide;

·       Timelinessof the services we provide;

·       Oursuccess in developing new products and enhancements;

·       Existingmarket and economic conditions; and

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

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

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

Our continued successdepends, in part, upon key managerial, financial, engineering and technicalpersonnel as well as our ability to continue to attract, retain and assimilateadditional personnel. The loss of key personnel could have a material adverseeffect on our business or results of operations. We may not be able to retainour key managerial, financial, engineering and technical employees. Attractingqualified personnel is difficult, and our efforts to attract and retain thesepersonnel may not be successful. In 

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addition,we may not be able to assimilate qualified personnel, including any new membersof senior management, which could disrupt our operations.

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

We have established directsales and service organizations throughout the world. A worldwide direct salesand service model in foreign countries involves certain risks. We are subjectto compliance with the labor laws and other laws governing employers in thecountries where our operations are located and as a result we may incuradditional costs to comply with these local regulations. Additionally, we mayencounter labor shortages or disputes that could inhibit our ability toeffectively sell, market and service our products. If we cannot effectivelymanage the risks related to employing persons in foreign countries, ouroperating results could be adversely affected.

***We may make additional acquisitions in the future, andthese acquisitions may subject us to risks associated with integrating thesebusinesses 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.

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

·       Difficultiesand increased costs in connection with integration of the personnel,operations, technologies and products of acquired companies;

·       Diversionof management’s attention from other operational matters;

·       Thepotential loss of key employees of acquired companies;

·       Lackof synergy, or inability to realize expected synergies, resulting from theacquisition; and

·       Acquiredassets becoming impaired as a result of technological advancements or worse-than-expectedperformance by the acquired company.

Our inability toeffectively manage these acquisition risks could materially and adverselyaffect our business, financial condition and results of operations. Inaddition, if we issue equity securities to pay for an acquisition the ownershippercentage of our existing shareholders would be reduced and the value of theshares held by our existing shareholders could be diluted. If we use cash topay for an acquisition the payment could significantly reduce the cash thatwould be available to fund our operations or to use for other purposes. Inaddition, the accounting for future acquisitions could result in significantcharges resulting from amortization of intangible assets related to suchacquisitions.

***We are exposed to the risks of operating a globalbusiness, including risks associated with exchange rate fluctuations, legal andregulatory changes and the impact of regional and global economic disruptions.***

Internationalshipments accounted for 85% of net sales in fiscal 2005, with 77% of our netsales to customers in Asia. We expect that international shipments willcontinue to represent a significant percentage of net sales in the future. Ournon-U.S. sales, purchases and operations are subject to risks inherent inconducting business abroad, many of which are outside our control, includingthe following:

·       Periodiclocal or geographic economic downturns and unstable political conditions;

·       Priceand currency exchange controls;

·       Fluctuationin the relative values of currencies;

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·       Difficultiesprotecting intellectual property;

·       Locallabor disputes;

·       Shippingdelays and disruptions;

·       Unexpectedchanges in trading policies, regulatory requirements, tariffs and otherbarriers; and

·       Difficultiesin managing a global enterprise, including staffing, collecting accountsreceivable, managing distributors and representatives and repatriation ofearnings.

Our business andoperating results are subject to uncertainties arising out of the possibilityof regional or global economic disruptions (including those resulting fromnatural disasters), 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 future tightening of immigration controls may adverselyaffect the residence status of non-U.S. engineers and other key technicalemployees in our U.S. facilities or our ability to hire new non-U.S. employeesin such facilities;

·       The risk of more frequent instances of shipping delays; and

·       The risk that demand for our products may not increase or may decrease.

***Failure to achieve and maintain effective internalcontrols could have a material adverse effect on our business, operatingresults and stock price.***

We have documented andtested our internal control procedures in order to satisfy the requirements of Section 404of the Sarbanes-Oxley Act, which requires annual management assessments of theeffectiveness of our internal controls over financial reporting and a report byour independent auditors addressing these assessments. If we fail to achieveand maintain the adequacy of our internal controls, as such standards aremodified, supplemented or amended from time to time, we may not be able toensure that we can conclude on an ongoing basis that we have effective internalcontrols over financial reporting in accordance with Section 404 of theSarbanes-Oxley Act. Our ability to maintain internal controls may be negativelyimpacted by our planned implementation of new enterprise management softwareand systems. Moreover, effective internal controls, particularly those relatedto revenue recognition, are necessary for us to produce reliable financialreports and are important to prevent financial fraud. If we cannot providereliable financial reports or prevent fraud, our business and operating resultscould be harmed, investors could lose confidence in our reported financialinformation, and the trading price of our stock could drop significantly.

***Enterprise resource planning system (ERP)implementation could have a material adverse affect on our business.***

We are highlydependent on our systems infrastructure in order to process orders, trackinventory, ship products in a timely manner, prepare invoices to our customersand otherwise carry on our business in the ordinary course. Key to the successof our strategy to drive greater productivity and cost savings is theimplementation of a new worldwide ERP system expected in fiscal 2006. If weexperience problems with the implementation of this system, the resultingdisruption could adversely affect our business, sales, results of operationsand financial condition. The transition to our new ERP system involves numerousrisks including:

·  difficulties in integrating the system withour current operations,

·  diversion of management’s attention away fromnormal daily operations of our business,

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·  initial dependence on an unfamiliar systemwhile training personnel in its use,

·  increased demand on our support operations;and

·  potential delay in the processing of customerorders for shipment of products.

Further, we may experiencedifficulties in the transition to the new software that could affect ourinternal control systems, processes, procedures and related documentation. TheERP implementation will require significant effort in a compressed timeframe,as well as result in our incurring costs to comply with Sarbanes-Oxley Section404 by documenting all business processes that have been revised as a result ofthe implementation. This will result in compliance costs that will be inaddition to the implementation costs of our new system. There can be noassurances that the evaluation required by Sarbanes-Oxley Section 404 forfiscal 2006 will not result in the identification of significant controldeficiencies or that our auditors will be able to attest to the effectivenessof our internal control over financial reporting subsequent to theimplementation of the new ERP system.

***Item 7A.****                  Quantitativeand Qualitative Disclosures About Market Risk*

***Interest Rate Risk***

As of May 28, 2005,our investment portfolio includes marketable debt securities of $157.6 million.These securities are subject to interest rate risk and will decline in value ifinterest rates increase. These securities are classified as SecuritiesAvailable for Sale; therefore, the impact of interest rate changes is reflectedas a separate component of shareholder’s equity. Due to the short duration ofour investment portfolio, an immediate 10% increase in interest rates would nothave a material effect on our financial condition or the results of ouroperations.

***Foreign Currency Exchange Rate Risk***

We have limited involvement with derivative financialinstruments and do not use them for trading purposes. We do, however, usederivatives to manage well-defined foreign currency risks. We enter intoforward exchange contracts to hedge forecasted Japanese sales commitments andthe value of accounts receivable primarily denominated in Japanese yen andother material non-functional monetary asset and liability balances. The effectof an immediate 10% change in exchange rates on the forward exchange contractsand the underlying hedged positions would not be material to our financialposition or the results of our operations.

Thetable below summarizes, by major currency, the notional amounts of our forwardexchange contracts in U.S. dollars as of May 28, 2005 and May 29,2004. The “bought” amounts represent the net U.S. dollar equivalents ofcommitments to purchase foreign currencies, and the “sold” amounts representthe net U.S. dollar equivalent of commitments to sell foreign currencies. Theforeign currency amounts have been translated into a U.S. dollar equivalentvalue using the exchange rate at the reporting date.
| ** **                | ** ** | **Bought (Sold)**  | ** ** |
|---------------------------|------------|-------------------------|------------|
| **Foreign Currency** | ** ** | ** **              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                | ** ** | **(in thousands)** | ** ** |
| Japanese Yen              |       | $                       | (2,331     | ) | $ | (7,846 | ) |
| Taiwan Dollar             |       | 3,270                   |       | (477 | ) |
| Euro                      |       | 3,361                   |       | 3,023 |   |
| British Pound             |       | —                  |       | 549 |   |
| Korean Won                |       | 4,993                   |       | 2,615 |   |
|                           |            |                         |            |  |  |  |  |  |  |

 

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***Item 8.         FinancialStatements and Supplementary Data***

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

The Board of Directors and Shareholders of

Electro ScientificIndustries, Inc.:

We have audited the accompanying consolidated balancesheets of Electro Scientific Industries, Inc. (an Oregon corporation) andsubsidiaries as of May 28, 2005 and May 29, 2004, and the relatedconsolidated statements of operations, shareholders’ equity and cash flows foreach of the years in the three-year period ended May 28, 2005. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Electro Scientific Industries, Inc. and subsidiaries as of May 28,2005 and May 29, 2004, and the results of their operations and their cashflows for each of the years in the three-year period ended May 28, 2005,in conformity with U.S. generally accepted accounting principles.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of ElectroScientific Industries, Inc.’s and subsidiaries internal control overfinancial reporting as of May 28, 2005, based on criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) and ourreport dated July 26, 2005 expressed an unqualified opinion on management’sassessment of, and the effective operation of, internal control over financialreporting.
| /s/ KPMG LLP       |   |
|--------------------|--------|
| Portland, Oregon   |
| July 26, 2005 |

 

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**ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAs of May 28, 2005 and May 29, 2004(in thousands)**
| ** **                                                                                            | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets:                                                                                       |       |       |       |       |       |
| Cash and cash equivalents                                                                             |       | $          | 61,314     |       | $          | 80,358 |   |
| Marketable securities                                                                                 |       | 137,753    |       | 206,931    |       |
| Restricted securities                                                                                 |       | —     |       | 6,251      |       |
| Total cash and securities                                                                             |       | 199,067    |       | 293,540    |       |
| Trade receivables, net of allowances of $833 and  $901                                                |       | 36,163     |       | 51,696     |       |
| Income tax refund receivable                                                                          |       | 9,227      |       | 7,466      |       |
| Inventories                                                                                           |       | 59,533     |       | 58,627     |       |
| Shipped systems pending acceptance                                                                    |       | 4,014      |       | 4,391      |       |
| Deferred income taxes                                                                                 |       | 10,930     |       | 16,096     |       |
| Assets held for sale                                                                                  |       | —     |       | 2,391      |       |
| Prepaid and other current assets                                                                      |       | 3,169      |       | 3,348      |       |
| Total current assets                                                                                  |       | 322,103    |       | 437,555    |       |
| Long-term marketable securities                                                                       |       | 19,834     |       | 39,214     |       |
| Property, plant and equipment, net                                                                    |       | 32,959     |       | 33,531     |       |
| Deferred income  taxes, net                                                                           |       | 16,955     |       | 17,630     |       |
| Other assets                                                                                          |       | 11,706     |       | 9,256      |       |
| Total assets                                                                                          |       | $          | 403,557    |       | $          | 537,186 |   |
| **Liabilities  and Shareholders’ Equity**                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                  |       |       |       |       |       |
| Accounts payable                                                                                      |       | $          | 3,961      |       | $          | 13,248 |   |
| Accrued liabilities                                                                                   |       | 29,455     |       | 42,381     |       |
| Deferred revenue                                                                                      |       | 12,986     |       | 11,985     |       |
| Total current liabilities                                                                             |       | 46,402     |       | 67,614     |       |
| Convertible  subordinated notes                                                                       |       | —     |       | 142,759    |       |
| Total liabilities                                                                                     |       | 46,402     |       | 210,373    |       |
| Commitments and  Contingencies (Notes 12 and 16)                                                      |       |       |       |       |       |
| Shareholders’  equity:                                                                           |       |       |       |       |       |
| Preferred stock, without par value; 1,000 shares authorized;  no shares issued                        |       | —     |       | —     |       |
| Common stock, without par value; 100,000 shares authorized;  28,615 and 28,175 issued and outstanding |       | 156,367    |       | 147,054    |       |
| Retained earnings                                                                                     |       | 201,199    |       | 181,362    |       |
| Accumulated other comprehensive loss                                                                  |       | (411       | )          | (1,603     | )          |
| Total shareholders’ equity                                                                       |       | 357,155    |       | 326,813    |       |
| Total liabilities  and shareholders’ equity                                                      |       | $          | 403,557    |       | $          | 537,186 |   |

 

The accompanying notes are an integral part of these statements.

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**ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF OPERATIONSFor the years ended May 28, 2005, May 29, 2004 and May 31, 2003(in thousands, except per share data)**
| ** **                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net sales                                               |       | $        | 233,371    |     | $          | 207,242  |       | $ | 136,885 |   |
| Cost of sales                                           |       | 121,541  |       | 119,762  |       | 117,858  |       |
| Gross profit                                            |       | 111,830  |       | 87,480   |       | 19,027   |       |
| Operating  expenses:                                    |       |     |       |     |       |     |       |
| Selling, service and administration                     |       | 51,618   |       | 57,241   |       | 63,001   |       |
| Research, development and engineering                   |       | 28,027   |       | 23,834   |       | 27,762   |       |
| Patent infringement settlement and related legal  fees  |       | 2,240    |       | —   |       | —   |       |
| Settlement of class action and derivative lawsuits      |       | —   |       | 3,800    |       | —   |       |
| Long-lived asset impairment                             |       | —   |       | —   |       | 10,140   |       |
|                                                    |       | 81,885   |       | 84,875   |       | 100,903  |       |
| Operating income (loss)                                 |       | 29,945   |       | 2,605    |       | (81,876  | )          |
| Interest income                                         |       | 6,535    |       | 7,772    |       | 9,632    |       |
| Interest expense                                        |       | (5,471   | )          | (7,389   | )          | (7,457   | )          |
| Redemption  charges—convertible subordinated notes |       | (4,149   | )          | —   |       | —   |       |
| Other income  (expense), net                            |       | (586     | )          | (409     | )          | 480      |       |
|                                                    |       | (3,671   | )          | (26      | )          | 2,655    |       |
| Income (loss)  before income taxes                      |       | 26,274   |       | 2,579    |       | (79,221  | )          |
| Provision for  (benefit from) income taxes              |       | 6,437    |       | (9,308   | )          | (29,135  | )          |
| Net income (loss)                                       |       | $        | 19,837     |     | $          | 11,887   |       | $ | (50,086 | ) |
| Net income (loss) per share—basic                  |       | $        | 0.70       |     | $          | 0.42     |       | $ | (1.81 | ) |
| Net income (loss) per share—diluted                |       | $        | 0.69       |     | $          | 0.42     |       | $ | (1.81 | ) |
| Weighted average number of shares—basic            |       | 28,434   |       | 27,983   |       | 27,745   |       |
| Weighted average  number of shares—diluted         |       | 28,572   |       | 28,233   |       | 27,745   |       |

 

The accompanying notes are an integral part of these statements.

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**ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF SHAREHOLDERS’ EQUITYFor the years ended May 28, 2005, May 29, 2004 and May 31, 2003(in thousands)**
| ** **                                                 | ** ** | ** **            | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated**        | ** **        | ** ** | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------------|------------|------------------------|-------------------|------------|------------|
| ** **                                                 | ** ** | ** **            | ** ** | ** **     | ** ** | ** **        | ** ** | **Other**              | ** **        | **Total**  | ** ** |
| ** **                                                 | ** ** | **Common Stock** | ** ** | **Retained**   | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** **        |
| ** **                                                 | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Earnings**      | ** ** | **Income (Loss)**      | ** **        | **Equity** | ** ** |
| **Balance  at June 1, 2002**                          |       | 27,619                |       | $ 136,370 |       | $ 219,561    |       |                   | $  (172 | )          |       |   | $ 355,759 |   |   |
| Stock Plans:                                               |       |                  |       |           |       |              |       |                   |              |       |       |   |   |   |   |
| Employee stock plans                                       |       | 224                   |       | 3,602          |       | —            |       |                   | —            |       |       |   | 3,602 |   |   |
| Tax benefit of stock options exercised                     |       | —                |       | 259            |       | —            |       |                   | —            |       |       |   | 259 |   |   |
| Comprehensive income  (loss):                              |       |                  |       |           |       |              |       |                   |              |       |       |   |   |   |   |
| Net loss                                                   |       | —                |       | —         |       | (50,086           | )          |                   | —            |       |       |   | (50,086 | ) |   |
| Net unrealized gain on securities, net of tax              |       | —                |       | —         |       | —            |       |                   | 558               |       |       |   | 558 |   |   |
| Net unrealized gain on derivative instruments, net  of tax |       | —                |       | —         |       | —            |       |                   | 17                |       |       |   | 17 |   |   |
| Cumulative translation adjustment, net  of tax             |       | —                |       | —         |       | —            |       |                   | 208               |       |       |   | 208 |   |   |
| Annual comprehensive loss                                  |       |                  |       |           |       |              |       |                   |              |       |       |   | (49,303 | ) |   |
| **Balance  at May 31, 2003**                          |       | 27,843                |       | 140,231        |       | 169,475           |       |                   | 611               |       |       |   | 310,317 |   |   |
| Stock Plans:                                               |       |                  |       |           |       |              |       |                   |              |       |       |   |   |   |   |
| Employee stock plans                                       |       | 332                   |       | 5,964          |       | —            |       |                   | —            |       |       |   | 5,964 |   |   |
| Tax benefit of stock options exercised                     |       | —                |       | 859            |       | —            |       |                   | —            |       |       |   | 859 |   |   |
| Comprehensive income  (loss):                              |       |                  |       |           |       |              |       |                   |              |       |       |   |   |   |   |
| Net income                                                 |       | —                |       | —         |       | 11,887            |       |                   | —            |       |       |   | 11,887 |   |   |
| Net unrealized loss on securities, net of tax              |       | —                |       | —         |       | —            |       |                   | (2,256            | )          |       |   | (2,256 | ) |   |
| Net unrealized loss on derivative  instruments, net of tax |       | —                |       | —         |       | —            |       |                   | (37               | )          |       |   | (37 | ) |   |
| Cumulative translation adjustment, net  of tax             |       | —                |       | —         |       | —            |       |                   | 79                |       |       |   | 79 |   |   |
| Annual comprehensive income                                |       |                  |       |           |       |              |       |                   |              |       |       |   | 9,673 |   |   |
| **Balance  at May 29, 2004**                          |       | 28,175                |       | 147,054        |       | 181,362           |       |                   | (1,603            | )          |       |   | 326,813 |   |   |
| Stock Plans:                                               |       |                  |       |           |       |              |       |                   |              |       |       |   |   |   |   |
| Employee stock plans                                       |       | 440                   |       | 9,141          |       | —            |       |                   | —            |       |       |   | 9,141 |   |   |
| Tax benefit of stock options exercised                     |       | —                |       | 172            |       | —            |       |                   | —            |       |       |   | 172 |   |   |
| Comprehensive income:                                      |       |                  |       |           |       |              |       |                   |              |       |       |   |   |   |   |
| Net income                                                 |       | —                |       | —         |       | 19,837            |       |                   | —            |       |       |   | 19,837 |   |   |
| Net unrealized gain on securities, net of tax              |       | —                |       | —         |       | —            |       |                   | 615               |       |       |   | 615 |   |   |
| Net unrealized gain on derivative instruments, net  of tax |       | —                |       | —         |       | —            |       |                   | 23                |       |       |   | 23 |   |   |
| Cumulative translation adjustment, net  of tax             |       | —                |       | —         |       | —            |       |                   | 554               |       |       |   | 554 |   |   |
| Annual comprehensive income                                |       |                  |       |           |       |              |       |                   |              |       |       |   | 21,029 |   |   |
| **Balance at May 28, 2005**                           |       | 28,615                |       | $ 156,367 |       | $ 201,199    |       |                   | $  (411 | )          |       |   | $ 357,155 |   |   |
| ** **                                                 |       |                  |       |           |       |              |       |                   |              |       |       |   |   |   |   |

 

The accompanying notes are an integral part of these statements.

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**ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF CASH FLOWSFor the years ended May 28, 2005, May 29, 2004 and May 31, 2003(in thousands)**
| ** **                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                              |       |     |       |     |       |     |       |
| Net income (loss)                                                                     |       | $        | 19,837     |     | $          | 11,887   |       | $ | (50,086 | ) |
| Adjustments to reconcile net income (loss) to cash  provided by operating activities: |       |     |       |     |       |     |       |
| Depreciation and  amortization                                                        |       | 8,286    |       | 9,224    |       | 10,352   |       |
| Stock based compensation                                                              |       | 1,691    |       | 784      |       | 456      |       |
| Write-off of unamortized  debt issuance costs                                         |       | 1,590    |       | —   |       | —   |       |
| Loss on disposal of  property and equipment                                           |       | 430      |       | —   |       | 1,069    |       |
| Provision for doubtful  accounts                                                      |       | 211      |       | 95       |       | 1,173    |       |
| Tax benefit of stock  options exercised                                               |       | 172      |       | 859      |       | 259      |       |
| Deferred income taxes                                                                 |       | 5,841    |       | (13,774  | )          | (11,679  | )          |
| Impairment of long-lived  assets                                                      |       | —   |       | —   |       | 10,140   |       |
| Changes in operating accounts:                                                        |       |     |       |     |       |     |       |
| (Increase) decrease in  trade receivables                                             |       | 16,895   |       | (14,020  | )          | 20,858   |       |
| (Increase) decrease in  inventories                                                   |       | (5,279   | )          | (15,128  | )          | 24,601   |       |
| (Increase) decrease in  shipped systems pending acceptance                            |       | 377      |       | 2,667    |       | (5,051   | )          |
| (Increase) decrease in  income tax refund receivable                                  |       | (1,761   | )          | 20,329   |       | (6,978   | )          |
| Decrease in prepaid and  other current assets                                         |       | 284      |       | 70       |       | 1,617    |       |
| Increase (decrease) in  deferred revenue                                              |       | 1,001    |       | (1,237   | )          | 7,914    |       |
| Increase (decrease) in  accounts payable and accrued  liabilities                     |       | (23,025  | )          | 17,862   |       | 7,852    |       |
| Net cash provided by  operating activities                                            |       | 26,550   |       | 19,618   |       | 12,497   |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES**                                              |       |     |       |     |       |     |       |
| Purchase of property,  plant and equipment                                            |       | (4,710   | )          | (4,859   | )          | (9,270   | )          |
| Proceeds from sales of  property, plant and equipment                                 |       | 95       |       | 23       |       | 1,183    |       |
| Proceeds from the sale  of assets held for sale                                       |       | 2,361    |       | 6,562    |       | —   |       |
| Maturity of restricted  investments                                                   |       | 6,251    |       | 6,189    |       | 5,960    |       |
| Purchase of securities                                                                |       | (428,265 | )          | (262,362 | )          | (254,134 | )          |
| Proceeds from sales of  securities and maturing securities                            |       | 517,438  |       | 278,756  |       | 242,157  |       |
| (Increase) decrease in  other assets                                                  |       | (848     | )          | 234      |       | 2,516    |       |
| Net cash provided by  (used in) investing activities                                  |       | 92,322   |       | 24,543   |       | (11,588  | )          |
| **CASH FLOWS FROM FINANCING ACTIVITIES**                                              |       |     |       |     |       |     |       |
| Redemption of  convertible subordinated notes                                         |       | (145,000 | )          | —   |       | (4,676   | )          |
| Proceeds from exercise  of stock options and stock plans                              |       | 7,084    |       | 5,180    |       | 3,146    |       |
| Net cash provided by  (used in) financing activities                                  |       | (137,916 | )          | 5,180    |       | (1,530   | )          |
| **NET  CHANGE IN CASH AND CASH EQUIVALENTS**                                          |       | (19,044  | )          | 49,341   |       | (621     | )          |
| **CASH  AND CASH EQUIVALENTS AT BEGINNING OF PERIOD**                            |       | 80,358   |       | 31,017   |       | 31,638   |       |
| **CASH  AND CASH EQUIVALENTS AT END OF PERIOD**                                       |       | $        | 61,314     |     | $          | 80,358   |       | $ | 31,017 |   |
| **SUPPLEMENTAL CASH FLOW INFORMATION**                                                |       |     |       |     |       |     |       |
| Cash paid for interest                                                                |       | $        | (7,516     | )        | $          | (6,546   | )          | $ | (6,419 | ) |
| Cash (paid for) received from income taxes, net                                       |       | (3,296   | )          | 19,157   |       | 15,024   |       |

 

The accompanying notes are an integral part of these statements.

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**ELECTRO SCIENTIFIC INDUSTRIES, INC.NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**NOTE1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

***Principles of Consolidation and Nature of Operations***

The accompanyingconsolidated financial statements include the accounts of Electro ScientificIndustries, Inc. and its subsidiaries, all of which are wholly owned(collectively, the Company). All material intercompany accounts andtransactions have been eliminated. The Company designs and manufactureshigh-technology manufacturing equipment for the global electronics market,including advanced laser systems that are used to microengineer electronicdevice features in high-volume production environments. The Company’s customersare primarily manufacturers of semiconductors, passive electronic componentsand electronic interconnect devices. Principal products include:

·       lasermanufacturing systems for semiconductor yield improvement;

·       production,test and inspection equipment for the manufacture of passive components;

·       lasermicro-via drilling systems used to process high-density interconnect (HDI)circuit boards; flexible circuits, and electronic packages; and

·       machinevision systems.

The Company serves theglobal electronics market from its headquarters in Portland, Oregon and throughsubsidiaries located in the United States, Europe and Asia.

***Fiscal Year***

The Company’s fiscal yearconsists of 52 or 53 weeks ending on the Saturday nearest May 31. Accordingly,fiscal 2005 ended on May 28, 2005, fiscal 2004 ended on May 29, 2004and fiscal 2003 ended on May 31, 2003 and each of those fiscal yearscontained 52 weeks. All references to years relate to fiscal years unlessotherwise noted.

***Reclassifications***

Certain reclassificationshave been made in the accompanying consolidated financial statements for 2004and 2003 to conform to the 2005 presentation.

***Estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of commitments and contingencies at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting periods. Actual results may differ from those estimates. Managementbelieves that the estimates used are reasonable. Significant estimates made bymanagement include: inventory write-downs; allowances for uncollectible tradeaccounts receivables; long-lived asset valuations; product warranty reserves;loss contingency reserves; revenue recognition; and income tax benefits,expenses and deferred taxes.

***Risks and Uncertainties***

The Company uses financial instruments thatpotentially subject it to concentrations of credit risk. Such instruments includecash equivalents, marketable securities available for sale, trade receivablesand 

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financial instruments usedin hedging activities. The Company invests cash in cash deposits, money marketfunds, commercial paper, certificates of deposit and readily marketable debtsecurities. Investments are placed with high credit quality financialinstitutions and the credit exposure from any one institution or instrument isminimized. To date, the amounts of losses experienced on these investments havenot been material.

The Company sells a significant portion of itsproducts to a small number of large electronics manufacturers. In fiscal 2005,ten customers accounted for approximately 51% of total net sales. One customeraccounted for approximately 13%, 26% and 16% of total net sales in fiscal 2005,2004 and 2003, respectively. No other customer accounted for more than 10% oftotal net sales in fiscal 2005, 2004 or 2003. The Company’s operating resultscould be adversely affected if the financial condition and operations of thesekey customers decline.

The Company’s operationsinvolve a number of other risks and uncertainties including but not limited tothose relating to the cyclicality of the electronics market, the availabilityof materials provided by suppliers, the effect of general economic conditions,rapid changes in technology and international operations.

***Cash Equivalents and Marketable Securities***

All highly liquidinvestments with a maturity of 90 days or less at the date of purchase areconsidered to be cash equivalents. Short-term marketable securities havematurities of less than one year or are subject to immediate pre-payment orcall provisions. Marketable securities consist primarily of marketable debtsecurities and are classified as “Available for Sale” and recorded at fairmarket value. Unrealized gains and losses on marketable securities are recordedas a component of accumulated other comprehensive income (loss) withinshareholders’ equity. See Note 3.

***Restricted Securities***

Restricted securities werea required pre-funding of the first six semi-annual interest payments on theCompany’s 41⁄4% convertible subordinated notes due 2006. These securities wereclassified as “Held to Maturity” and recorded at amortized cost. See Note 4. Therewere no restricted securities as of May 28, 2005.

***Accounts Receivable and Allowance for DoubtfulAccounts***

Trade accounts receivableare stated at the amount the Company expects to collect and do not bearinterest. Credit limits are established by reviewing the financial history andstability of each customer. Where appropriate, the Company obtains creditrating reports and financial statements of the customer to initiate and modifytheir credit limits. On certain foreign sales, letters of credit are required. Thecollectibility of trade receivable balances is regularly evaluated based on acombination of factors such as customer credit-worthiness, past transactionhistory with the customer, current economic industry trends, and changes incustomer payment terms. If it is determined that a customer will be unable tofully meet its financial obligation, such as in the case of a bankruptcy filingor other material events impacting its business, a specific reserve for baddebt is recorded to reduce the related receivable to the amount expected to berecovered.

***Inventories***

Inventories areprincipally valued at standard costs, which approximate the lower of cost(first-in, first-out) or market. Costs utilized for inventoryvaluation purposes include material, labor and manufacturing overhead. See Note5.

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***Shipped Systems Pending Acceptance***

Shipped systems pendingacceptance relate to systems that have been ordered and shipped to thecustomer, but have been deferred in accordance with the Company’s revenuerecognition policy. Shipped systems pending acceptance are recognized as costof sales once all criteria for revenue recognition have been met and revenue isrecorded. Shipped systems pending acceptance are valued at standard costs,which approximate the lower of cost (first-in, first-out) or market. Costsutilized in the valuation of shipped systems pending acceptance includematerial, labor and manufacturing overhead and exclude costs of installation.

***Assets Held for Sale***

Property and equipment tobe disposed of by sale are measured at the lower of book value or fair valueless cost to sell in accordance with Statement of Financial Accounting Standard(SFAS) No. 144. See Note 6. There are no assets held for sale at May 28,2005.

***Property and Equipment***

Property and equipment arestated at cost less accumulated depreciation and amortization. Depreciation andamortization are provided using the straight-line method over the estimateduseful lives of the assets. Expenditures for maintenance, repairs and minorimprovements are charged to expense as incurred. Major improvements andadditions are capitalized. When property is sold or retired, the cost andrelated accumulated depreciation are removed from the accounts and theresulting gain or loss is included as a component of operating expenses. SeeNote 7.

***Long-lived Asset Impairment***

Long-lived assets,principally property, equipment and identifiable intangibles are reviewed forimpairment whenever events or circumstances indicate that the carrying amountof assets may not be recoverable in accordance with SFAS No. 144. The Company evaluates recoverability of assetsto be held and used by comparing the carrying amount of an asset to estimatedfuture net undiscounted cash flows generated by the asset. If such assets areconsidered to be impaired, the impairment recognized is measured as the amountby which the carrying amount of the assets exceeds the fair value of the assets.See Note 7.

***Other Assets***

Other assets include goodwill, patents, consignmentand demonstration (demo) equipment and long-term deposits.

The Company accounts for goodwill pursuant to SFAS No. 142,“Goodwill and Other Intangible Assets,” which requires that goodwill no longerbe amortized, but instead be tested for impairment at least annually inaccordance with the provisions of SFAS No. 142. Goodwill was tested forimpairment in the fourth quarter of fiscal 2005 utilizing a fair valuecomparison method that considered the Company’s market capitalization and itwas determined that there was no impairment as of May 28, 2005.

The Company accounts for intangible assets withestimable useful lives in accordance with SFAS No. 142. Intangible assets,which consist primarily of patents, are amortized over their estimated usefullives of 17 years.

Consigned, demo andtraining equipment are recorded at the lower of standard costs or estimatedmarket values, until the assets are sold. These assets are also reviewedquarterly for impairment.

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***Fair Value of Financial Instruments***

The carrying amounts offinancial instruments, including cash and cash equivalents, accountsreceivable, accounts payable and accrued liabilities approximate fair value dueto the short maturities of these financial instruments. Marketable securitiesare classified as available-for-sale and recorded at fair market value based onquoted market prices for those or similar investments.

***Derivative Financial Instruments***

The Company’s primaryobjective for holding derivative financial instruments is to manage currencyrisk. In accordance with SFAS No. 133, the Company’s accounting policiesfor these instruments are based on whether they meet the Company’s criteria fordesignation as hedging transactions, either as cash flow or fair value hedges. Ahedge of the exposure to variability in the cash flows of an asset or a liability,or of a forecasted transaction, is referred to as a cash flow hedge. A hedge ofthe exposure to changes in fair value of an asset or a liability, or of anunrecognized firm commitment, is referred to as a fair value hedge. Thecriteria for designating a derivative as a hedge include the instrument’seffectiveness in risk reduction and, in most cases, a one-to-one matching ofthe derivative instrument to its underlying transaction. See Note 15for further detail on cash flow and remeasurement hedge contracts as of May 28,2005 and May 29, 2004.

***Revenue Recognition***

The Company recognizes revenue in accordance with SECStaff Accounting Bulletin (SAB) No. 104, “Revenue Recognition” (SAB 104). Revenueis recognized when persuasive evidence of an arrangement exists, delivery hasoccurred or the services have been rendered, the sales price is fixed ordeterminable and collection of the related receivable is reasonably assured. Titleand risk of loss generally pass to the customer at the time of delivery of theproduct to a common carrier. Revenue is recognized upon delivery, provided thatfulfillment of acceptance criteria can be demonstrated prior to shipment. Wherethe acceptance criteria cannot be demonstrated prior to shipment, or in thecase of substantially new products, revenue is deferred until acceptance hasbeen received. For multiple element arrangements, the fair value of anyundelivered elements is deferred until the elements are delivered andacceptance criteria are met. Fair value is estimated based upon the list priceof such elements. Installation services are not essential to the functionalityof the delivered equipment. Beginning in fiscal 2004, and in accordance withSAB 104, installation revenue is deferred until installation is complete. Priorto fiscal 2004, and in accordance with SAB 101, “Revenue Recognition inFinancial Statements,” the costs of installation service were accrued at thetime the revenue was recorded. Neither the costs of installation accrued northe fair value of installation service revenue deferred has been significant.

Revenues associated with sales to customers underlocal contracts in Japan are recognized upon title transfer, which generallyoccurs upon customer acceptance. Sales to the Company’s distributor in Japanare recognized upon title transfer to the distributor. The Company has nodistributor relationships outside of Japan.

Revenues related to spareparts and consumable sales are recognized upon shipment. Revenues related tomaintenance and service contracts are recognized ratably over the duration ofthe contracts.

***Product Warranty***

The Company evaluatesobligations related to product warranties quarterly. A standard one-yearwarranty is provided on products. Warranty charges are comprised of costs toservice the warranty, including labor to repair the system and replacementparts for defective items, as well as other costs incidental to the repairs. Inventorycredits resulting from the return of repaired parts to inventory and any costrecoveries from warranties offered by the Company’s suppliers for defectivecomponents are recorded 

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as acredit to the warranty accrual. Using historical data, the Company estimatesaverage warranty cost per system or part type and records the provision forsuch charges as an element of cost of goods sold upon shipment. Additionally,the overall warranty accrual balance is separately analyzed using the remainingwarranty periods outstanding on systems and items under warranty, and anyresulting changes in estimates are recorded as an adjustment to cost of sales. Ifcircumstances change, or if a material change in warranty-relatedincidents occurs, the estimate of the warranty accrual could changesignificantly. Accrued product warranty is included on the balance sheet as acomponent of accrued liabilities. See Note 12.

***Research and Development***

Research and developmentcosts, which include labor and related employee expenses, patent maintenancefees, project materials, project subcontractors, depreciation of engineeringequipment, building costs and other administrative expenses, are expensed asincurred as research, development and engineering expense in the consolidatedstatements of operations.

***Taxes on Unremitted Foreign Income***

Under Accounting Principles Board Opinion (APB) No. 23,“Accounting for Income Taxes—Special Areas,” the Company is required to providefor deferred taxes on the undistributed earnings of a subsidiary which isincluded in consolidated income of the parent, except to the extent that theincome is intended to be indefinitely reinvested or remitted in a tax-freeliquidation.

The Company provides forincome taxes on its foreign subsidiaries’ results based on their effectiveincome tax rates in each respective jurisdiction. There is no additional USincome tax expense recorded for unremitted foreign earnings, as the Companyexpects any additional US tax resulting from the repatriation would besubstantially offset by associated foreign tax credits.

***Comprehensive Income (Loss)***

SFAS No. 130, “ReportingComprehensive Income,” establishes standards for the reporting and presentationof comprehensive income and its components in financial statements. Comprehensiveincome includes net income and “other comprehensive income,” which includescharges or credits to equity that are not the result of transactions withshareholders. Comprehensive income (loss) includes cumulative foreign currencytranslation adjustments, unrealized gains and losses on securities availablefor sale and certain gains or losses on foreign currency forward contracts.

***Net Income (Loss) per Share***

Basic earnings (loss) pershare (EPS) and diluted EPS are computed using the methods prescribed by SFAS No. 128,“Earnings per Share.” Basic EPS is computed utilizing the weighted averagenumber of shares outstanding during the period. Diluted EPS also considerscommon stock equivalents, such as stock options and convertible debt, to theextent that they are not antidilutive. See Note 17.

***Stock Based Compensation Plans***

The Company has elected touse the intrinsic value method under APB No. 25, “Accounting for StockIssued to Employees,” and related interpretations including FinancialAccounting Standards Board (FASB) Interpretation No. 44, “Accounting forCertain Transactions Involving Stock Compensation—an Interpretation of APB No. 25,”as currently permitted by SFAS No. 123, “Accounting for Stock-BasedCompensation”, subsequently amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure,” to account for stockoptions issued to its employees under its stock option plans, and amortizesdeferred compensation, if any, ratably over the vesting period of the options. Compensationexpense resulting from the issuance of time-based restricted stock andrestricted stock units 

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iscalculated based on the fair market value on the date of grant and is includedin operating results over the related vesting period using the straight linemethod. Compensation expense resulting from the issuance of performance-basedrestricted stock units is recorded when performance is probable and can beestimated. The estimated expense is recorded over the service period based uponcurrent fair market values at the end of each period until such time as thenumber of units an employee is entitled to receive is fixed or determinable orthe restricted stock unit award has expired without performance. Previouslyrecorded expense is reversed for restricted stock grants which do not vest. Thecalculated total compensation expense is included in operating results over thevesting period of the underlying shares using the straight-line method. 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. The Company makes pro forma fair value disclosures as required by SFAS No. 123and SFAS No. 148. See Note 20.

***Segment Reporting***

The Company complies withSFAS No. 131, “Disclosures About Segments of an Enterprise and RelatedInformation.” SFAS No. 131, which is based on a management approach tosegment reporting, establishes requirements to report selected segmentinformation quarterly and to report annually entity-wide disclosuresabout products, major customers and the geographies in which the entity holdsmaterial assets and reports revenue. An operating segment is defined as acomponent that engages in business activities whose operating results arereviewed by the chief operating decision maker and for which discrete financialinformation is available. Based on the provisions of SFAS No. 131, theCompany has determined that it operates in one segment. The Company manages its resources and assesses its performance on anenterprise-wide basis. The Company’s product groups qualify for aggregationunder SFAS No. 131 due to their similarities in customer base, economiccharacteristics, nature of products and services, and procurement,manufacturing and distribution processes.

**NOTE2.**   RECENTACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued Statement No. 123(Revised 2004), “Share-Based Payments” (SFAS 123R). The scope of SFAS 123Rincludes a wide range of share-based compensation arrangements including shareoptions, restricted share plans, performance-based awards, share appreciationrights, and employee share purchase plans. SFAS 123R replaces FASB Statement No. 123,“Accounting for Stock-Based Compensation” (SFAS 123), and supersedes APBOpinion No. 25, “Accounting for Stock Issued to Employees” (Opinion 25). SFAS123R requires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements and rescinds the ability ofcompanies to elect the intrinsic value method prescribed under Opinion 25. Thecost of share-based payments will be measured based on the fair value of theequity or liability instruments issued. The Company will be required toimplement SFAS 123R for the fiscal year beginning June 4, 2006. TheCompany intends to adopt the statement using modified prospective application,under which the statement applies to new awards and awards modified,repurchased or cancelled after the effective date. Additionally, compensationcost for the unvested portion of existing awards will be recognized over thevesting period occurring after the date of adoption. The Company has notcompleted its analysis of the impact of the adoption of FAS 123R on itsfinancial position or results of operations.

In November 2004, the FASB issued Statement No. 151, ”InventoryCosts—An Amendment of ARB No. 43, Chapter 4” (SFAS 151). Thisnew standard is the result of an effort by the FASB toimprove financial reporting by eliminating differences between GAAP in theUnited States and GAAP developed by the International Accounting StandardsBoard. SFAS 151 clarifies that abnormal amounts of idle facility expense,freight, handling costs and spoilage should be expensed as incurredand not included in overhead. The new statement also requires that allocation offixed production overheads to conversion 

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costs should be based onnormal capacity of the production facilities. The provisions in SFAS 151 areeffective for inventory costs incurred during our fiscal year beginning June 4,2006. Companies must apply the standard prospectively. The Company currentlyapplies the principles of SFAS 151 when accounting for inventory costs and hasthereby adopted the new standard prior to the effective date. As a result, SFAS 151will not have a material effect on the Company’s financial position or resultsof operations in future periods.

In December 2004, the FASB issued Statement No. 153,“Exchanges of Nonmonetary Assets—An Amendment of APB Opinion No. 29” (SFAS153). Statement 153 amends APB Opinion No. 29, “Accounting for NonmonetaryTransactions” (Opinion 29). The amendments made by SFAS 153 are based on theprinciple that exchanges of nonmonetary assets should be measured based on thefair value of the assets exchanged. Further, the amendments eliminate thenarrow exception for nonmonetary exchanges of similar productive assets, whichrequires that the accounting for the exchange be based on the recorded amountof the asset relinquished, and replace it with a broader exception forexchanges of nonmonetary assets that do not have “commercial substance.” Theprovisions in SFAS 153 are effective for nonmonetary asset exchanges occurringin fiscal periods beginning after June 15, 2005. Early application ispermitted and companies must apply the standard prospectively. The Company doesnot expect the adoption of SFAS 153 to have a material effect on its financialposition or results of operations.

In May 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections” (SFAS 154), which replacesAccounting Principles Board Opinions No. 20 “Accounting Changes” and SFAS No. 3,“Reporting Accounting Changes in Interim Financial Statements-An Amendment ofAPB Opinion No. 28.” SFAS 154 provides guidance on the accounting for andreporting of accounting changes and error corrections. It establishesretrospective application, or the latest practicable date, as the requiredmethod for reporting a change in accounting principle and the reporting of acorrection of an error. SFAS 154 is effective for accounting changes and correctionsof errors made in fiscal years beginning after December 15, 2005. TheCompany does not expect the adoption of SFAS 154 to have a material impact onits financial position or results of operations.

In December 2004, theFASB issued FASB Staff Position (FSP) No. 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision with theAmerican Jobs Creation Act of 2004” (FSP 109-2). FSP 109-2 providesguidance under SFAS No. 109, “Accounting for Income Taxes,” with respectto recording the potential impact of the repatriation provisions of theAmerican Jobs Creation Act of 2004 (the Jobs Act) on enterprises’ income taxexpense and deferred tax liability. The Jobs Act was enacted on October 22,2004. FSP No. 109-2 states that an enterprise is allowed time beyondthe financial reporting period of enactment to evaluate the effect of the JobsAct on its plan for reinvestment or repatriation of foreign earnings forpurposes of applying SFAS No. 109. Accordingly, the Company will continueto analyze and assess its options under this provision.

**NOTE 3.**   MARKETABLESECURITIES

The Company accounts for marketable securities inaccordance with SFAS No. 115, “Accounting for Certain Investments in Debtand Equity Securities.” Marketable securities, other than restricted securitiesas described below, are classified as available-for-sale and,accordingly, they are recorded on the consolidated balance sheet at fair valuewith unrealized gains and losses reported as a component of accumulated othercomprehensive income (loss) within shareholders’ equity.All marketable debtsecurities are invested in high credit quality securities.

Proceeds from the sales and maturities ofavailable-for-sale securities were $517.4 million, $278.8 million and $242.2million during fiscal 2005, 2004 and 2003, respectively. Net realized gains(losses) on those sales during fiscal 2005 and 2003 were ($0.2 million) and$0.4 million, respectively. There were no material net realized gains or losseson sales in fiscal 2004. For purpose of determining gross realized gains 

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and losses, the cost ofsecurities sold is based on specific identification. Net unrealized holdinggains (losses) on available-for-sale securities in the tax-effected amounts of$0.6 million, ($2.3 million) and $0.6 million for fiscal 2005, 2004 and2003, respectively, have been included in accumulated other comprehensiveincome.

During fiscal 2005, the Company generated cash fromsales of available for sale securities totaling $188.2 million. These salestransactions were entered into primarily to fund the redemption of theconvertible subordinated notes.

Certaininformation regarding marketable securities at May 28, 2005 and May 29,2004 (in thousands) is as follows:
| ** **                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Fair market value of  debt securities: |       |     |       |     |       |
| State and local government             |       | $        | 2,032      |     | $          | — |   |
| Federal government                     |       | 139,435  |       | 189,774  |       |
| Mortgage-backed                        |       | —   |       | 2,230    |       |
| Corporate                              |       | 16,120   |       | 54,141   |       |
| Total                                  |       | $        | 157,587    |     | $          | 246,145 |   |
| Net unrealized  loss                   |       | $        | (184       | )        | $          | (1,009 | ) |
| Maturity information:                  |       |     |       |     |       |
| Less than one year                     |       | $        | 137,753    |     | $          | 206,931 |   |
| One to three years                     |       | 19,834   |       | 36,669   |       |
| Greater than three years               |       | —   |       | 2,545    |       |
| Total                                  |       | $        | 157,587    |     | $          | 246,145 |   |

 

**NOTE 4.   RESTRICTEDSECURITIES**

Restrictedsecurities were a required pre-funding of the first six semi-annual interestpayments on the Company’s 41¤4% convertiblesubordinated notes due 2006. Restricted securities were accounted for inaccordance with SFAS No. 115. Restricted securities were classified asheld-to-maturity and, accordingly, were recorded on the consolidated balancesheets at amortized cost. There were no restricted securities as of May 28,2005. Certain information regarding restricted securities at May 29, 2004is as follows (in thousands):
| ** **                          | ** ** | **2004** | ** ** |
|-------------------------------------|------------|----------|------------|
| Fair market value                   |       | $        | 6,357      |   |
| Unrealized gain                     |       | $        | 106        |   |
| Amortized cost of debt  securities: |       |     |       |
| Federal government                  |       | $        | 6,251      |   |
| Total                               |       | $        | 6,251      |   |
| Maturity information:               |       |     |       |
| Less than one year                  |       | $        | 6,251      |   |
| One to three years                  |       | —   |       |
| Total                               |       | $        | 6,251      |   |

 

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**NOTE 5.   INVENTORIES**

Thecomponents of inventories at May 28, 2005 and May 29, 2004 are asfollows (in thousands):
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Raw materials and  purchased parts |       | $        | 37,367     |     | $          | 34,710 |   |
| Work-in-process                    |       | 4,471    |       | 11,219   |       |
| Finished goods                     |       | 17,695   |       | 12,698   |       |
|                               |       | $59,533  |       | $        | 58,627     |   |
|                                    |            |          |            |          |            |  |  |

 

**NOTE 6.   ASSETS HELD FOR SALE**

There were no assets heldfor sale as of May 28, 2005. Assets held for sale of $2.4 million as of May 29,2004 consisted of an undeveloped parcel of land in Taiwan. The Company soldthis parcel of land in June 2004 and received net cash proceedssubstantially equal to the carrying value.

**NOTE 7.   PROPERTY, PLANT AND EQUIPMENT**

Property,plant and equipment consisted of the following as of May 28, 2005 and May 29,2004 (in thousands):
| ** **                     | ** ** | **Estimated Useful  Lives** | ** **     | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------------------------------|----------------|----------|------------|----------|------------|
| Land                           |       |                             | n/a            |     |       | $        | 3,024      |   | $ | 2,974 |   |
| Buildings and  improvements    |       |                             | 3 to  40 years |     |       | 30,946   |       | 29,833 |   |
| Machinery and  equipment       |       |                             | 3 to  10 years |     |       | 44,587   |       | 41,368 |   |
|                           |       |                             |           |     |       | 78,557   |       | 74,175 |   |
| Less accumulated  depreciation |       |                             |           |     |       | (45,598  | )          | (40,644 | ) |
|                           |       |                             |           |     |       | $        | 32,959     |   | $ | 33,531 |   |

 

Depreciation expense totaled $7.2 million, $7.9million and $9.4 million in fiscal 2005, 2004 and 2003, respectively.

Infiscal 2003, the Company determined that the Klamath Falls facility and relatedequipment and a parcel of land in Taiwan had been impaired. The marketconditions for the consumable products manufactured by the Klamath Fallsoperation experienced a significant reduction in demand in fiscal 2003 as wellas significantly increased competition from foreign manufacturers. A charge was recorded to reduce theassets to their estimated fair values based on the discounted future cash flowsin the fourth quarter of fiscal 2003 as follows (in thousands):
| Klamath Falls,  Oregon facility              |   | $     | 5,704  |   |
|----------------------------------------------|--------|-------|--------|--------|
| Equipment at  Klamath Falls, Oregon facility |   | 3,436 |   |
| Land in Taiwan                               |   | 1,000 |   |
|                                         |   | $     | 10,140 |   |

 

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**NOTE 8.   OTHER ASSETS**

Otherassets consisted of the following as of May 28, 2005 and May 29, 2004(in thousands):
| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Goodwill                        |       | $        | 1,442      |     | $          | 1,442 |   |
| Patents, net                    |       | 310      |       | 154      |       |
| Consignment and  demo equipment |       | 8,941    |       | 6,743    |       |
| Other                           |       | 1,013    |       | 917      |       |
|                            |       | $11,706  |       | $        | 9,256      |   |
|                                 |            |          |            |          |            |  |  |

 

Amortization expensetotaled $0.4 million in both fiscal 2005 and 2004. There was no materialamortization expense in fiscal 2003.

**NOTE 9.   INCOME TAXES**

The Company accounts for income taxes under the assetand liability method prescribed by SFAS No. 109, “Accounting forIncome Taxes.” Under this method, deferred income taxes are recognized for thefuture tax consequences attributable to temporary differences between thefinancial statement and tax balances of existing assets and liabilities. Deferredtax assets and liabilities are measured using enacted tax rates expected toapply to taxable income in the years in which those assets and liabilities areexpected to be recovered or settled. Under SFAS No. 109, the effect ondeferred taxes of a change in tax rates is recognized in income in the periodthat includes the enactment date. When management determines that it is morelikely than not that a deferred tax asset will not be fully realized, avaluation allowance is established to reduce deferred tax assets to the amountexpected to be realized.

Netdeferred tax assets at May 28, 2005 and May 29, 2004 consisted of thefollowing (in thousands):
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:               |       |     |       |     |       |
| Receivable and inventory valuation |       | $        | 4,489      |     | $          | 5,728 |   |
| Payroll-related accruals           |       | 667      |       | 1,632    |       |
| Product warranty costs             |       | 1,305    |       | 1,794    |       |
| Deferred revenue                   |       | 2,898    |       | 2,212    |       |
| Property, plant and equipment      |       | 1,183    |       | 2,039    |       |
| Other comprehensive losses         |       | 230      |       | 947      |       |
| Other accrued liabilities          |       | 1,983    |       | 3,780    |       |
| Tax loss and credit carryforwards  |       | 19,442   |       | 18,109   |       |
| Total deferred tax assets          |       | 32,197   |       | 36,241   |       |
| Deferred tax liabilities           |       | (794     | )          | —   |       |
| Valuation allowance                |       | (3,518   | )          | (2,515   | )          |
| Net deferred tax asset             |       | $        | 27,885     |     | $          | 33,726 |   |

 

The net increase (decrease) in the valuation allowancewas $1.0 million, ($0.3 million) and $0.1 million during fiscal 2005,fiscal 2004 and fiscal 2003, respectively.

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As of May 28,2005 the Company had approximately $19.4 million in tax assets resulting fromfederal, state and foreign net operating losses and tax credits. A detailedbreakdown of the carryforward net operating losses (tax-effected) and taxcredits at May 28, 2005 and May 29, 2004 are as follows (inthousands):
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Federal net  operating losses             |       | $        | 7,883      |     | $          | 9,266 |   |
| State net  operating losses               |       | 2,740    |       | 3,102    |       |
| Foreign net  operating losses and credits |       | 2,095    |       | 1,042    |       |
| Federal and state  research credits       |       | 5,556    |       | 3,285    |       |
| Federal minimum  tax credit               |       | 1,168    |       | 1,414    |       |
|                                      |       | $19,442  |       | $        | 18,109     |   |
|                                           |            |          |            |          |            |  |  |

 

Approximately $4.6 million of the federal operatinglosses were acquired as part of prior acquisitions and expire on various datesthrough 2012. The remaining $3.2 million of federal operating losses and allstate operating losses expire on various dates through 2024. Foreign netoperating losses are available indefinitely, while the foreign tax creditsexpire on various dates through 2016. Federal and state research credits expireon various dates through 2025, and the minimum tax credit is availableindefinitely.

These tax losses and credits are subject to certainlimitations caused by the change in ownership. Accordingly, their utilizationin future periods may be restricted. As such some of these losses may not berealizable and valuation allowances of $3.5 million and $2.5 million have beenrecorded as of May 28, 2005 and May 29, 2004, respectively.

Thecomponents of income (loss) before income taxes and the provision for (benefitfrom) income taxes are as follows, all from continuing operations (inthousands):
| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income (loss) before  income taxes:              |       |     |       |     |       |     |       |
| Domestic                                         |       | $        | 22,141     |     | $          | (2,135   | )          | $ | (81,890 | ) |
| Foreign                                          |       | 4,133    |       | 4,714    |       | 2,669    |       |
| Total income (loss) before income taxes          |       | $        | 26,274     |     | $          | 2,579    |       | $ | (79,221 | ) |
| Provision for (benefit  from) income taxes:      |       |     |       |     |       |     |       |
| Current:                                         |       |     |       |     |       |     |       |
| U.S. federal and state                           |       | $        | (941       | )        | $          | 804      |       | $ | (17,369 | ) |
| Foreign                                          |       | 1,985    |       | 1,453    |       | 58       |       |
|                                             |       | 1,044    |       | 2,257    |       | (17,311  | )          |
| Deferred                                         |       | 5,221    |       | (12,424  | )          | (12,083  | )          |
| Tax benefit of stock options                     |       | 172      |       | 859      |       | 259      |       |
| Total provision  for (benefit from) income taxes |       | $        | 6,437      |     | $          | (9,308   | )          | $ | (29,135 | ) |

 

The tax benefit related to stock option exercises hasbeen recorded as an increase to common stock rather than a reduction to theprovision for income taxes.

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Areconciliation of the Company’s effective tax rate to the United States federalstatutory income tax rate is as follows:
| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| U.S. federal  statutory income tax rate          |       | 35.0     | %          | 35.0     | %          | (35.0    | )%         |
| State income  taxes, net of federal benefit      |       | 1.4      |       | 2.9      |       | (2.9     | )          |
| Tax credits                                      |       | (6.7     | )          | (103.4   | )          | (1.3     | )          |
| Export tax  incentives                           |       | (13.4    | )          | (185.1   | )          | (1.6     | )          |
| Non-U.S. income  taxed at different rates        |       | 4.4      |       | (47.4    | )          | (1.2     | )          |
| Temporary  differences previously not recognized |       | —   |       | (73.7    | )          | —   |       |
| Other, net                                       |       | 3.8      |       | 10.8     |       | 5.2      |       |
|                                             |       | 24.5     | %          | (360.9   | )%         | (36.8    | )%         |

 

In October 2003 the Internal Revenue Service(IRS) began an audit of the Company’s tax years ending in 1996 through 2003. Duringfiscal 2005 the Company and the IRS reached agreement on the tax return yearsunder review. The examination process requires a special report to be submittedby the IRS for congressional approval from the Joint Committee on Taxation. Subsequentto the end of fiscal 2005, the Company received notice from the IRS that theJoint Committee’s review was completed without exception. As a result, theCompany will receive approximately $7.2 million in tax refunds relating tothose years. Additionally, the Company is subject to numerous ongoing state andforeign tax audits. Although the final outcome of these audits are uncertain,based on currently available information management believes the ultimateresolutions will not have a materially adverse effect on the Company’sfinancial position or results of operations.

The Company is subject toincome taxes in the United States and in numerous foreign jurisdictions and inthe ordinary course of business, there are many transactions and calculationswhere the ultimate tax determination is uncertain. The Company has reserves fortaxes to address potential exposures related to tax positions that could bechallenged by taxing authorities, even though the Company believes that thepositions taken on previously filed tax returns are appropriate. Tax reservesare reviewed as warranted and adjusted as events occur that affect the Company’spotential liability for additional taxes.

**NOTE 10.   ACCRUED LIABILITIES**

Accruedliabilities consist of the following at May 28, 2005 and May 29, 2004(in thousands):
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Payroll-related                           |       | $        | 8,275      |     | $          | 10,781 |   |
| Product warranty                          |       | 3,625    |       | 4,720    |       |
| Interest payable                          |       | —   |       | 2,805    |       |
| Accrual for loss  on purchase commitments |       | 343      |       | 536      |       |
| Legal settlement  accrual                 |       | —   |       | 3,800    |       |
| Income taxes  payable                     |       | 11,623   |       | 12,212   |       |
| Other                                     |       | 5,589    |       | 7,527    |       |
|                                      |       | $29,455  |       | $        | 42,381     |   |
|                                           |            |          |            |          |            |  |  |

 

See Note 12 for discussionof the accrual for product warranty. As of May 28, 2005 the Company had noaccrued interest due to the redemption of its convertible subordinated notes onMarch 10, 2005.

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**NOTE 11.   DEFERRED REVENUE**

Thefollowing is a reconciliation of the changes in deferred revenue for fiscalyears 2005 and 2004 (in thousands):
| ** **                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| **Beginning  of fiscal year** |       | $        | 11,985     |     | $          | 13,222 |   |
| Revenue deferred              |       | 43,428   |       | 62,060   |       |
| Revenue  recognized           |       | (42,427  | )          | (63,297  | )          |
| **End of fiscal year**        |       | $        | 12,986     |     | $          | 11,985 |   |

 

**NOTE 12.   PRODUCT WARRANTY**

Thefollowing is a reconciliation of the changes in the aggregate product warrantyaccrual for fiscal years 2005, 2004 and 2003 (in thousands):
| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Beginning  of fiscal year**   |       | $        | 4,720      |     | $          | 3,501    |       | $ | 2,183 |   |
| Warranty charges  incurred      |       | (10,837  | )          | (10,611  | )          | (11,357  | )          |
| Inventory credits               |       | 4,639    |       | 6,308    |       | 3,281    |       |
| Provision for  warranty charges |       | 5,103    |       | 5,522    |       | 9,394    |       |
| **End of fiscal year**          |       | $        | 3,625      |     | $          | 4,720    |       | $ | 3,501 |   |

 

Warranty charges incurredinclude labor charges and replacement parts for system repairs under warranty. Inventorycredits, as stated in our warranty policy, primarily represent defective partswhich have been repaired and returned to inventory. These credits result fromperiod activity and can increase as business volumes and our installed baseincrease. Finally, the provision for warranty charges reflects the revisedestimate of future anticipated******net warranty costs to be incurred for all productsunder warranty at fiscal year end and is recorded as an adjustment to cost ofsales.

**NOTE13.   CONVERTIBLE SUBORDINATED NOTES**

In December 2001 and January 2002, theCompany sold $150 million aggregate principal amount of 41¤4%convertible subordinated notes (the Convertible Notes) due in December 2006in a private offering. The Company received proceeds, net of the initialpurchaser’s discount, from these sales of approximately $145.5 million. Asdiscussed below, the Company repurchased or redeemed the aggregate principalamount prior to May 28, 2005.

Interest of $3.1 million was due semi-annually on eachJune 21 and December 21. Interest expense in the accompanyingconsolidated statements of operations also included accretion of underwritingdiscounts and debt issuance costs of $0.7 million in fiscal 2005 and $0.9million per year in fiscal 2004 and 2003, Principal was originally due atmaturity on December 21, 2006. In accordance with the terms of theConvertible Note indenture, the Company was required to place $18.2 million intrust (see Notes 1 and 4). This restricted investment was invested in treasurybills and was sufficient to satisfy the first six interest payments due throughDecember 2004 under the terms of the indenture. The Convertible Notes wereconvertible into shares of common stock at a conversion price of $38.00 pershare, subject to adjustment in certain circumstances.

In the third quarter offiscal 2003, the Company repurchased, in the open market, $5.0 millionprincipal amount of the Convertible Notes. The Company recorded a gain of $0.2million related to this repurchase, which is reflected as other income on theconsolidated statements of operations. In the fourth quarter of fiscal 2005,the Company redeemed the remaining $145.0 million aggregate principal amount ofthe Convertible Notes. In accordance with the terms of the Convertible Noteindenture, the redemption 

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pricewas 101.70% of the principal amount of the Convertible Notes, plus accrued andunpaid interest to the redemption date. In connection with the redemption, theCompany recorded expenses of approximately $4.1 million in the fourth quarterof fiscal 2005, consisting of the redemption premium, a non-cash charge forunamortized debt issuance costs of approximately $1.6 million and other relatedcosts.

**NOTE 14.   EMPLOYEE BENEFIT PLAN**

The Company has anemployee savings plan under the provisions of Section 401(k) of theInternal Revenue Code. Contributions to the plan by the Company were $0.9million, $0.8 million and $1.1 million for fiscal 2005, 2004 and 2003, respectively.

**NOTE15.   DERIVATIVE FINANCIAL INSTRUMENTS**

The Company has limited involvement with derivativefinancial instruments and does not use them for trading purposes. It does,however, use derivatives to manage well-defined foreign currency risks. TheCompany enters into forward exchange contracts to hedge forecasted Japanesesales commitments and the value of accounts receivable primarily denominated inJapanese yen and other material non-functional monetary asset and liabilitybalances. Foreign exchange contracts have gains and losses that are recognizedat the end of each fiscal period. Such gains and losses have been immaterial tothe results of operations and are typically offset by the corresponding changesto the related underlying transactions. Cash flows from derivative financialinstruments are classified in the same category as the cash flows from theitems being hedged.

In accordance with SFAS No. 133, hedges ofanticipated transactions are designated and documented at inception as “cashflow hedges” and are evaluated for effectiveness, excluding time value, on amonthly basis. As a result, the forward contracts designated by us to hedgeforecasted Japanese sales denominated in yen are cash flow hedges. The criticalterms of the forward contract, such as amount and timing, are matched to theforecasted sale. The effectiveness of the cash flow hedge is determined bycomparing the change in value of the anticipated transaction to the change invalue of the related forward contracts, excluding time value. The effectiveportion of the hedge is accumulated in other comprehensive income and anyineffectiveness along with the time value change in the instrument isrecognized immediately in other income and expense. Other comprehensive incomeassociated with the hedges of forecasted sales is reclassified to revenue uponrevenue recognition.

In addition to “cash flow hedges”, the Company uses “remeasurementhedges” to hedge non-functional monetary assets and liabilities heldoutside the U.S. These non-functional monetary balances are reviewed monthlyand, if material, are hedged using the local functional currency value at thecurrent month balance sheet rate. Forward contracts are one month in durationand at the settlement of the contract, any resulting gains or losses arereflected in other income and expense.

At May 28, 2005 and May 29, 2004 the Companyhad net forward exchange contracts totaling $9.3 million and ($2.1million), respectively. In general, these contracts mature in less than oneyear and the counterparties are large, highly rated banks; therefore, theCompany believes that the risk of loss as a result of nonperformance by thebanks is minimal. The use of derivatives has not had, and is not expected tohave, a significant effect on financial position or the results of operations.

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Thetable below summarizes, by major currency, the notional amounts of forwardexchange contracts in U.S. dollars as of May 28, 2005 and May 29,2004. The “bought” amounts represent the net U.S. dollar equivalents ofcommitments to purchase foreign currencies, and the “sold” amounts representthe net U.S. dollar equivalent of commitments to sell foreign currencies.The foreign currency amounts have been translated into a U.S. dollar equivalentvalue using the exchange rate as of May 28, 2005 and May 29, 2004.
| ** **                | ** ** | **Bought (Sold) ** | ** ** |
|---------------------------|------------|------------------------------|------------|
| **Foreign Currency** | ** ** | ** **                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                | ** ** | **(in thousands)**      | ** ** |
| Japanese Yen              |       | $                            | (2,331     | ) | $ | (7,846 | ) |
| Taiwan Dollar             |       | 3,270                        |       | (477 | ) |
| Euro                      |       | 3,361                        |       | 3,023 |   |
| British Pound             |       | —                       |       | 549 |   |
| Korean Won                |       | 4,993                        |       | 2,615 |   |
|                           |            |                              |            |  |  |  |  |  |  |

 

**NOTE16.   COMMITMENTS AND CONTINGENCIES**

TheCompany leases certain equipment, automobiles and office space under operatingleases, which are non-cancelable and expire on various dates through 2009.The aggregate minimum commitment for rentals under operating leases beyond May 28,2005 is as follows (in thousands):
| **Fiscal**                    | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|
| 2006                          |       | $          | 902        |       |
| 2007                          |       | 462        |       |
| 2008                          |       | 164        |       |
| 2009                          |       | 35         |       |
| 2010                          |       | 10         |       |
| Thereafter                    |       | —     |       |
| Total minimum lease  payments |       | $          | 1,573      |       |

 

Rental expense for all operating leases was $0.9million, $1.2 million and $1.4 million in fiscal 2005, 2004 and 2003,respectively. In addition to the operating lease commitments detailed above,the Company had firm purchase order commitments, which are primarily forinventories, totaling $27.1 million at May 28, 2005.

In the normal course ofbusiness the Company indemnifies customers with respect to certain matters. TheCompany has agreed, under certain conditions, to hold these third partiesharmless against specified losses, such as those arising from other third partyclaims that our products, when used for their intended purposes, infringe theintellectual property rights of such other third parties.

**NOTE 17.   EARNINGS PER SHARE**

Followingis a reconciliation of weighted average shares outstanding used in thecalculation of basic and diluted earnings per share for fiscal 2005 and fiscal2004 (in thousands, except per share amounts):
| ** **                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Weighted average  shares outstanding—basic   |       | 28,434   |       | 27,983   |       |
| Effect of  dilutive stock options                 |       | 138      |       | 250      |       |
| Weighted average shares  outstanding—diluted |       | 28,572   |       | 28,233   |       |

 

Basic and diluted EPS are the same for fiscal 2003since we were in a loss position in that period.

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Thefollowing common stock equivalents were excluded from the diluted EPScalculations because inclusion would have had an antidilutive effect (inthousands):
| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Employee stock  options                    |       | 3,306    |       | 3,231    |       | 4,287    |       |
| 41¤4%  convertible subordinated notes |       | —   |       | 3,816    |       | 3,816    |       |
|                                       |       | 3,306    |       | 7,047    |       | 8,103    |       |

 

**NOTE 18.**   LEGALMATTERS

As a result of the March 2003 announcement thatthe Company was reviewing certain accounting matters and would be restatingsome of its financial statements, between March 26, 2003 and May 20,2003, three purported class action lawsuits were filed in the United StatesDistrict Court for the District of Oregon against the Company and David F.Bolender (former director, CEO and Chairman of the Board), James T. Dooley(former President and CEO), and Joseph L. Reinhart (former Acting CFO). The complaintswere filed on behalf of a purported class of persons who purchased the Company’scommon stock between September 17, 2002 and at the latest April 15,2003, and alleged violations of Section 10(b) of the SecuritiesExchange Act of 1934 (the Act) and Rule 10b-5 promulgated thereunder, aswell as Section 20(a) of the Act. The complaints were consolidatedunder the name In re Electro Scientific Industries, Inc. SecuritiesLitigation, Case No. CV 03-404-HA. Lead plaintiffs and lead counsel forplaintiffs were appointed. The plaintiffs’ consolidated class action complaint(the Consolidated Complaint) was filed on October 10, 2003, whichshortened the purported class to purchasers between September 17, 2002 andMarch 20, 2003, and added Donald R. VanLuvanee (ESI’s President and CEOfrom 1992 until April 2002), John R. Kurdock (ESI’s former VP Operations),and James Lorenz (ESI’s former Corporate Controller) as additional defendants. TheConsolidated Complaint alleged that defendants made false and misleadingstatements during the purported class period about the Company’s financialcondition and performance, business prospects, and operations, artificiallyinflating its stock price and leading to the restatement first announced on March 20,2003. In March 2003, the Audit Committee commenced an investigation intocertain accounting matters. As a result of the investigation, which wascompleted on July 11, 2003, the Company restated its financial statementsfor the fiscal year ended June 1, 2002 and for the quarters ended August 31,2002 and November 30, 2002.

On March 31, 2003 and April 28, 2003, twoseparate purported shareholder derivative complaints were filed in the CircuitCourt of Oregon in Washington County. The complaints were consolidated underthe name In re Electro Scientific Industries, Inc. Derivative Litigation,Lead Case No. C 031067 CV. A consolidated complaint (Complaint) wasfiled on September 24, 2003, and named as defendants James Dooley (formerPresident and CEO), David Bolender (former director, CEO and Chairman), JosephReinhart (former Acting CFO), Barry Harmon (director and former President andCEO), and current or former directors W. Arthur Porter, Gerald Taylor, LarryHansen, Vernon Ryles, Keith Thomson and Jon Tompkins. The Company was named asa “nominal defendant.” The Complaint, which purported to be brought on behalfof the Company, alleged that all defendants breached fiduciary duties owed tothe Company, abused their alleged control over the Company, wasted corporateassets, were liable for gross mismanagement, and were unjustly enriched bytheir conduct. The Complaint sought an unspecified amount of monetary damagesand sought various equitable remedies, including a constructive trust on theproceeds received by the defendants from trading the Company’s common stock,and attorneys’ fees and costs. As filed, the Complaint was derivative in natureand did not seek monetary damages from the Company or the imposition ofequitable remedies on the Company. A special litigation committee of the boardof directors, with the assistance of independent legal counsel, was appointedto conduct an investigation relating to the allegations asserted in theComplaint.

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On April 22, 2004, the Company announced anagreement in principle to settle both the class action and derivative actions. Thesettlement called for the payment of $9.3 million of which approximately $3.8 millionwas expensed in fiscal 2004 and paid by the Company during fiscal 2005 andapproximately $5.5 million was paid by its insurance carrier.

On September 23, 2004, the Securities andExchange Commission announced that it would not bring an enforcement actionagainst the Company with respect to the matters resulting in the restatement ofits financial statements.

On October 29, 2004, the Company entered into asettlement and license agreement with Cognex Corporation (Cognex) resolving alawsuit filed by Cognex on February 14, 2001 in the United States DistrictCourt for the District of Massachusetts (Cognex Corporation v. Electro ScientificIndustries, Inc. No. 01-10287 WGY). The lawsuit, which alleged thatthe Company’s CorrectPlace product and some of its predecessors infringedUnited States Patent 5,371,690 owned by Cognex, was dismissed with prejudice onNovember 1, 2004. Under the settlement agreement, Cognex has granted theCompany a license to the patent in dispute as well as certain covenants not tosue under various other surface mount placement equipment-related patents, andas consideration for the license the Company has agreed to pay Cognex anundisclosed license fee. As a result of the settlement, the Company recorded acharge to operations of $2.2 million in fiscal 2005, consisting of $1.8million related to the settlement payment along with approximately $0.4 millionin related legal fees.

On August 18, 2003, GSI Group (formerly GSI LumonicsCorporation) (GSI) filed a lawsuit in the United States District Court for theCentral District of California (GSI Lumonics Inc. v. Electro ScientificIndustries, Inc., Case No. CV-03-5863 PA (SHx). The lawsuitalleges that the Company infringed three GSI patents: U.S. Patent No. 6,181,728,entitled “Controlling Laser Polarization” (the ‘728 patent); U.S. Patent No. 6,337,462,entitled “Laser Processing” (the ‘462 patent); and U.S. Patent No. 6,573,473,entitled “Method and System for Precisely Positioning a Waist of aMaterial-Processing Laser Beam to Process Microstructures Within a LaserProcessing Site” (the ‘473 patent). These claims related to the Company’ssemiconductor yield improvement systems. GSI sought injunctive relief, anunspecified amount of damages, costs, and attorneys’ fees. On September 2,2003, GSI filed a First Amended Complaint which did not change the substantiveallegations of patent infringement. By court order dated September 18,2003, the case was transferred to the United States District Court for theNorthern District of California. The case was re-assigned to a judge inthe Northern District of California and was renumbered CV-03-04302-MHP. On October 8,2003, the Company filed its Answer to First Amended Complaint and Counterclaimfor Declaratory Judgment of Invalidity and Noninfringement. On October 24,2003, GSI filed a Reply to the Company’s counterclaim denying the allegationsof invalidity and noninfringement. On May 11, 2004, pursuant to anagreement between GSI and the Company, the court entered a stipulated dismissalof two of GSI’s asserted patents without prejudice: the ‘728 patent and the ‘462patent. On August 26, 2004, pursuant to an agreement between the parties,the court entered a stipulated dismissal with prejudice of the remaining patentasserted by GSI: U.S. Patent No. 6,573,473. This dismissal resolved theentire controversy between the parties.

In addition to the legalmatters described above, in the ordinary course of business the Company isinvolved in various other legal matters, either asserted or unasserted, andinvestigations. In the opinion of management, ultimate resolution of thesematters will not have a material effect on the Company’s consolidated financialposition, results of operations or cash flow.

**NOTE 19.   SHAREHOLDER RIGHTS PLAN**

The Company renewed itsShareholder Rights Plan in May 1999 and accordingly declared a dividenddistribution of one Right for each outstanding share of common stock, payableto holders of record on June 4, 1999. On March 1, 2001, the RightsAgreement was amended and restated appointing Mellon 

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InvestorServices as the Rights Agent, successor to First Chicago Trust Company of NewYork. Under certain conditions, each right may be exercised to purchase 1/100of a share of Series A No Par Preferred Stock at a purchase price of $270,subject to adjustment. The Rights are not presently exercisable and will onlybecome exercisable following the occurrence of certain specified events. Generally,the Rights become exercisable after a person or group acquires or commences atender offer that would result in beneficial ownership of 15 percent or more ofoutstanding common stock. In addition, the Rights become exercisable if anyparty becomes a beneficial owner of 10 percent or more of outstanding commonstock and is determined by the Board of Directors to be an adverse party. If aperson or group acquires 15 percent of outstanding common stock or theBoard of Directors declares a person to be an Adverse Person, each Right willbe adjusted to entitle its holder to receive, upon exercise, common stock, or,in certain circumstances, other assets of the Company having a value equal totwice the exercise price of the Right. If, after the Rights become exercisable,the Company is acquired in a merger or other business combination, each Rightwill be adjusted to entitle its holder to receive, upon exercise, common stockof the acquiring company having a value equal to twice the exercise price ofthe Right, depending on the circumstances. The Rights expire on May 7,2009 and may be redeemed by us for $0.001 per Right. The Rights do not havevoting or dividend rights and, until they become exercisable, have no dilutiveeffect on the Company’s earnings.

**NOTE20.   STOCK BASED COMPENSATION PLANS**

In October 2004, the shareholders approved theadoption of the 2004 Stock Incentive Plan (the 2004 Plan) that replaced variousstock compensation plans that were previously approved by the shareholders orthe Board of Directors (the Replaced Plans), except with respect to options andother awards previously outstanding. Outstanding options and awards remainedsubject to the terms of the Replaced Plan under which they were originallygranted. At that time, the shareholders also approved the reservation of3,000,000 shares of common stock for issuance under the 2004 Plan. These sharesare in addition to any shares of common stock that, at the time the 2004 Planwas approved by shareholders, were available for grant under the Replaced Plansor that may subsequently become available for grant under any of the ReplacedPlans through the expiration, termination, forfeiture or cancellation of grants.In January 2005, the Board of Directors approved certain amendments to the2004 Plan. These amendments prohibit option grants with an exercise price lessthan fair market value, require that time-based restricted stock awards have aminimum vesting period of at least three years, with the subject shares vestingno more quickly than one-third annually over the three-year period, and expresslyprohibit the reservation of additional shares under the 2004 Plan withoutshareholder approval. In April 2005, the Board of Directors approvedanother amendment to the 2004 Plan extending the period during which an optionmay be exercised following termination of employment or service if an optioneedies following termination.

The 2004 Plan allows for grants of stock options,stock bonuses, restricted stock or performance-based awards. Stock optionsoutstanding under the 2004 Plan and the Replaced Plans vest ratably overvariable periods determined at the grant date, generally one to four years, andexpire ten years from the date of grant. Options issued under the 2004 Plan andthe Replaced Plans are exercisable at prices not less than fair market value onthe date of the grant. The 2004 Plan prohibits repricing of options grantedwithout prior shareholder approval. Restricted stock grants issued under theReplaced Plans vest based on certain performance criteria that are tied to theCompany’s results of operations, stock price and/or length of service. Restrictedstock units awarded under the 2004 Plan vest based on performance criteria thatare tied to the Company’s results of operations, personal performance criteria,and, in certain cases, length of service. During fiscal 2005, 2004 and 2003, werecorded $1.7 million, $0.8 million and $0.5 million, of compensation expenserelated to restricted stock grants and restricted stock units.

During fiscal 2005, the Company granted two options topurchase 25,000 and 50,000 shares, respectively, to certain key executives. Bothof these grants were inducements for joining the Company and 

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were not made under ashareholder approved plan. The exercise price for each option is the fairmarket value of the Company’s stock on the date of the grant. Each optionbecomes exercisable with respect to 25% of the underlying shares over fouryears.

On January 25, 2005, the Compensation Committeeof the Board of Directors (the Compensation Committee) accelerated the vesting,effective immediately, of all the Company’s unvested stock options awarded toemployees, other than those awarded to the President and Chief ExecutiveOfficer at his time of hire (which are discussed in the next paragraph), havingan exercise price greater than $20.24. Except as noted in the followingparagraph, no options were accelerated for members of the Board of Directors. Theclosing price of the Company’s common stock on the NASDAQ National Market on January 25,2005 was $17.14. As a result of the acceleration, options to acquireapproximately 220,000 shares of the Company’s common stock, which otherwisewould have vested from time to time over the following 42 months, becameimmediately exercisable. No compensation expense has been recorded in thestatement of operations related to this modification as the market price of thecommon stock on the date of the modification was lower than the exercise priceof the accelerated options.

On January 25, 2005, the Compensation Committeeaccelerated the vesting of 315,000 shares of the Company’s common stock subjectto an option granted to Nicholas Konidaris, the Company’s President and ChiefExecutive Officer, so that the option will become fully exercisable on August 26,2005. The option has an exercise price of $25.71. Under the terms of theoriginal option agreement, 105,000 shares would have vested on each of January 7,2006, January 7, 2007 and January 7, 2008. For book reportingpurposes, the Company is required to accelerate approximately $1.5 million ofunamortized expense related to this award ratably from the date of change overthe remaining vesting period, which ends August 26, 2005. This expensewould otherwise have been expensed ratably through December 2007. Additionally,a stock option granted to Mr. Konidaris to purchase 40,000 shares of theCompany’s common stock was accelerated effective January 25, 2005. Theoption has an exercise price of $25.50. Under the terms of the original optionagreement, 10,000 shares would have vested on each of July 13, 2005, July 13,2006, July 13, 2007 and July 13, 2008. In connection with both ofthese accelerations, Mr. Konidaris has agreed that the shares underlyingthe accelerated options may not be sold by him until the dates those shareswould otherwise have been vested under the terms of the original optionagreements.

On June 28, 2004, the Compensation Committee ofthe Board of Directors approved an acceleration of the vesting of thoseemployee stock options, excluding stock options granted to the Board of Directorsand Chief Executive Officer, with an option price equal to or greater than theclosing sale price of $23.38 per share on that date, as reported on theNASDAQ National Market. Options to purchase approximately 1.2 million shares ofstock with varying remaining vesting schedules were subject to the accelerationprovision and became immediately exercisable. No compensation expense has beenrecorded in the statement of operations related to this modification as themarket price of the common stock on the date of the modification was lower thanthe exercise price of the accelerated options.

The total pro forma stock-based employee compensationexpense stated below of $20.9 million for fiscal 2005 includes $4.0 millionresulting from the January 25, 2005 accelerations. The total pro formastock-based employee compensation expense stated below of $10.9 million forfiscal 2004 includes $10.1 million resulting from the June 28, 2004acceleration.

The Company has decided to follow the “modifiedprospective method” in implementing recent amendments by the FinancialAccounting Standards Board in Accounting for Stock-Based Compensation upontheir effective date (see Note 2). The Company believes the acceleration of thestock option vesting schedules as described above will reduce the futureamortization of the Company’s stock option compensation expense for fiscal 2007and beyond and will enhance comparability of its financial statements withthose of prior and future fiscal periods.

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At May 28,2005, the Company had 5,344,993 shares of its common stock reserved forissuance under all of the above plans combined. The following table summarizesactivity in the above stock plans (in thousands, except per share amounts):
| ** **                       | ** ** | **Options  Outstanding** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|----------------------------------|------------|--------------------------|------------|------------------------------------------------|------------|
| **Balances,  June 1, 2002** |       |                     | 4,993      |                                           |       |   | $ | 32.17 |   |   |
| Options granted                  |       |                     | 394        |                                           |       |   | 18.54 |   |   |
| Options canceled                 |       |                     | (1,014     | )                                              |       |   | 34.53 |   |   |
| Options exercised                |       |                     | (86        | )                                              |       |   | 14.80 |   |   |
| **Balances,  May 31, 2003** |       |                     | 4,287      |                                           |       |   | $ | 30.71 |   |   |
| Options granted                  |       |                     | 1,697      |                                           |       |   | 23.97 |   |   |
| Options canceled                 |       |                     | (1,011     | )                                              |       |   | 33.41 |   |   |
| Options exercised                |       |                     | (254       | )                                              |       |   | 13.88 |   |   |
| **Balances,  May 29, 2004** |       |                     | 4,719      |                                           |       |   | $ | 28.60 |   |   |
| Options granted                  |       |                     | 897        |                                           |       |   | 19.66 |   |   |
| Options canceled                 |       |                     | (1,377     | )                                              |       |   | 32.75 |   |   |
| Options exercised                |       |                     | (322       | )                                              |       |   | 16.62 |   |   |
| **Balances, May 28, 2005**  |       |                     | 3,917      |                                           |       |   | $ | 26.11 |   |   |

 

The Company had 103,804, 23,400 and 69,300 shares ofrestricted stock outstanding as of May 28, 2005, May 29, 2004 and May 31,2003, respectively, none of which were vested.

Certaininformation about stock options outstanding at May 28, 2005 is as follows:
| **Options Outstanding**            | ** ** | **Options Exercisable**             | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding  at 5/28/05** | ** ** | **Weighted  Average  Remaining  Contractual  Life (years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of Shares  Exercisable  at 5/28/05** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $  8.25  – 16.35         |       |                                     | 242,538    |   |   |   | 4.79 |   |   |   | $ | 13.23 |   |   |   | 207,538 |   |   |   | $ | 13.11 |   |   |
|   16.92  – 16.92         |       |                                     | 519,000    |   |   |   | 9.89 |   |   |   | 16.92 |   |   |   | — |   |   |   | — |   |   |
|   16.93  – 20.25         |       |                                     | 437,694    |   |   |   | 6.90 |   |   |   | 18.07 |   |   |   | 240,944 |   |   |   | 18.58 |   |   |
|   20.38  – 24.94         |       |                                     | 240,200    |   |   |   | 8.16 |   |   |   | 23.68 |   |   |   | 185,200 |   |   |   | 23.64 |   |   |
|   25.00  – 25.00         |       |                                     | 594,650    |   |   |   | 8.21 |   |   |   | 25.00 |   |   |   | 594,650 |   |   |   | 25.00 |   |   |
|   25.49  – 25.71         |       |                                     | 609,706    |   |   |   | 8.76 |   |   |   | 25.65 |   |   |   | 294,706 |   |   |   | 25.58 |   |   |
|   25.75  – 27.63         |       |                                     | 436,741    |   |   |   | 6.58 |   |   |   | 26.73 |   |   |   | 414,241 |   |   |   | 26.78 |   |   |
|   29.03  – 34.57         |       |                                     | 510,005    |   |   |   | 6.82 |   |   |   | 34.35 |   |   |   | 502,505 |   |   |   | 34.39 |   |   |
|   34.57  – 61.63         |       |                                     | 326,550    |   |   |   | 4.92 |   |   |   | 51.99 |   |   |   | 326,550 |   |   |   | 51.99 |   |   |
| $  8.25 – 61.63          |       |                                     | 3,917,084  |   |   |   | 7.52 |   |   |   | $ | 26.11 |   |   |   | 2,766,334 |   |   |   | $ | 28.68 |   |   |

 

At May 29, 2004, the Company had 2,456,057options exercisable at a weighted average exercise price of $31.14 and at May 31,2003, there were 2,429,892 options exercisable at a weighted average exerciseprice of $29.80.

In September 1990, the shareholders approved theadoption of the 1990 Employee Stock Purchase Plan (the ESPP) pursuant to which1,900,000 shares of common stock, as amended in September 1998, October 2003and October 2004, have been reserved for issuance to participatingemployees. Eligible employees may elect to contribute up to 15 percent of theircash compensation during each pay period. Prior to January 8, 2004, theESPP provided for one 12-month offering period beginning January 8 of eachcalendar year and ending with a purchase date on January 7.

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In October 2003, the Board of Directors approvedan amendment to the ESPP to provide that, beginning January 8, 2004, theESPP would have separate overlapping 24-month offerings starting every threemonths. Each offering would have eight purchase dates occurring every threemonths on designated dates. The offerings under the ESPP commence on January 15,April 15, July 15 and October 15 of each calendar year. Anyeligible employee may participate in only one offering at a time and maypurchase shares only through payroll deductions permitted under the ESPP. Eligibleemployees may elect to contribute up to 15 percent of their compensation duringeach pay period. At the end of each three-month purchase period, the purchaseprice is determined and the accumulated funds are used to automaticallypurchase shares of common stock. The purchase price per share is equal to 85%of the lower of the fair market value of the common stock on (a) the firstday of the offering period or (b) the date of purchase. The October 2003amendment also provides that if the fair market value of the common stock onthe first day of the new offering period is less than or equal to the fairmarket value of the common stock on the first date of any ongoing offering,employees participating in any such ongoing offering will be automaticallywithdrawn from it and enrolled in the new offering. A total of 133,562, 101,527and 99,587 shares of common stock were issued under the ESPP during fiscal2005, 2004 and 2003, respectively, and 1,070,038 shares remained reserved forissuance at May 28, 2005.

Proforma fair value disclosures required by SFAS No. 123 are presented belowand reflect the impact on net income (loss) and net income (loss) per share asif the fair value method of accounting for stock-based awards toemployees had been applied. The Company estimates the fair value of its stock-basedawards to employees using a Black-Scholes option pricing model.
| ** **                                                                                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income  (loss), as reported                                                                                                                                 |       | $        | 19,837     |     | $          | 11,887   |       | $ | (50,086 | ) |
| 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                                         |       | 1,082    |       | 482      |       | 283      |       |
| Deduct—Total  stock-based employee compensation expense determined under the fair value  method for all awards, net of related tax effects                 |       | (20,859  | )          | (10,926  | )          | (18,451  | )          |
| Net income  (loss), pro forma                                                                                                                                   |       | $        | 60         |     | $          | 1,299    |       | $ | (68,254 | ) |
| Net income (loss) per share—basic, as reported                                                                                                             |       | $        | 0.70       |     | $          | 0.42     |       | $ | (1.81 | ) |
| Net income (loss) per share—diluted, as reported                                                                                                           |       | $        | 0.69       |     | $          | 0.42     |       | $ | (1.81 | ) |
| Net income (loss) per share—basic, pro forma                                                                                                               |       | $        | 0.00       |     | $          | 0.05     |       | $ | (2.46 | ) |
| Net income (loss)  per share—diluted, pro forma                                                                                                            |       | $        | 0.00       |     | $          | 0.05     |       | $ | (2.46 | ) |

 

TheBlack-Scholes option pricing model is utilized to determine the fair value ofoptions granted. The following weighted average assumptions were used incalculating the fair value during the periods presented:
| ** **               | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|--------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Risk-free  interest rate |       | 3.83      | %          | 3.34      | %          | 3.33      | %          |
| Expected dividend  yield |       | 0         | %          | 0         | %          | 0         | %          |
| Expected lives           |       | 5.7 years |       | 5.5 years |       | 5.6 years |       |
| Expected volatility      |       | 65        | %          | 68        | %          | 69        | %          |

 

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The following weightedaverage assumptions were made in calculating the fair value of all sharesissued under the ESPP during the periods presented:
| ** **               | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003** | ** ** |
|--------------------------|------------|-----------|------------|-----------|------------|----------|------------|
| Risk-free  interest rate |       | 2.33      | %          | 2.37      | %          | 3.33     | %          |
| Expected dividend  yield |       | 0         | %          | 0         | %          | 0        | %          |
| Expected lives           |       | 1.2 years |       | 1.1 years |       | 1.0 year |       |
| Expected volatility      |       | 54        | %          | 57        | %          | 69       | %          |

 

Using the Black-Scholesmethodology, the total value of stock-based awards granted during fiscal 2005,2004 and 2003 was $16.6 million, $30.2 million and $5.8 million, respectively,which would be amortized over the vesting period of the options, typically oneto four years for stock options and two years for shares issued under the ESPP.The weighted average fair value of options granted during fiscal 2005, 2004 and2003 was $12.04, $15.55 and $11.55 per share, respectively. The weightedaverage fair value of shares issued under the ESPP during fiscal 2005, 2004 and2003 was $8.28, $9.78 and $11.40, respectively.

**NOTE21.   GEOGRAPHIC AND PRODUCT INFORMATION**

Netsales by product type were as follows (in thousands):
| ** **                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Semiconductor  Group (SG)            |       | $        | 138,574    |     | $          | 125,018  |       | $ | 64,236 |   |
| Passive  Components Group (PCG)      |       | 61,001   |       | 50,759   |       | 48,111   |       |
| Electronic  Interconnect Group (EIG) |       | 33,796   |       | 31,465   |       | 24,538   |       |
|                                 |       | $233,371 |       | $        | 207,242    |     | $          | 136,885 |   |
|                                      |            |          |            |          |            |          |            |  |  |  |

 

Salesby geographic area, based on the location of the end user, were as follows (inthousands):
| ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Asia       |       | $        | 180,378    |     | $          | 146,436  |       | $ | 91,549 |   |
| Americas   |       | 35,277   |       | 41,035   |       | 28,207   |       |
| Europe     |       | 17,716   |       | 19,771   |       | 17,129   |       |
|       |       | $233,371 |       | $        | 207,242    |     | $          | 136,885 |   |
|            |            |          |            |          |            |          |            |  |  |  |

 

Long-livedassets, exclusive of marketable and restricted securities and deferred taxassets, by geographic area were as follows at May 28, 2005 and May 29,2004 (in thousands):
| ** **    | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------|------------|----------|------------|----------|------------|
| United States |       | $        | 41,476     |     | $          | 41,152 |   |
| Asia          |       | 3,142    |       | 1,547    |       |
| Europe        |       | 47       |       | 88       |       |
|          |       | $44,665  |       | $        | 42,787     |   |
|               |            |          |            |          |            |  |  |

 

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**NOTE22.   RESTRUCTURING AND COST MANAGEMENT PLANS**

Thefollowing table reflects changes in accruals related to restructuring and costmanagement activities, which are reflected in the “other” component of accruedliabilities in the accompanying consolidated balance sheets, for the two yearsended May 28, 2005 (in thousands):
| ** **                                  | ** ** | **Balances at  May 31, 2003** | ** ** | **Expenses  Charged  to Accruals** | ** ** | **Amounts  Paid** | ** ** | **Balances at  May 29, 2004** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------|------------|-------------------|------------|----------------------------------------------|------------|
| Facility  consolidation costs               |       |                                         | $          | 680                                     |       |              |       | 566                                          |       |   |   | (795 | ) |   |   | $ | 451 |   |   |
| Severance and other  employee-related costs |       |                                         | $          | 50                                      |       |              |       | 1,419                                        |       |   |   | (1,469 | ) |   |   | $ | — |   |   |

 
| ** **                                  | ** ** | **Balances at  May 29, 2004** | ** ** | **Expenses  Charged  to Accruals** | ** ** | **Amounts  Paid** | ** ** | **Balances at  May 28, 2005** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------|------------|-------------------|------------|----------------------------------------------|------------|
| Facility  consolidation costs               |       |                                         | $          | 451                                     |       |              |       | —                                       |       |   |   | (98 | ) |   |   | $ | 353 |   |   |
| Severance and other  employee-related costs |       |                                         | $          | —                                  |       |              |       | 1,224                                        |       |   |   | (1,224 | ) |   |   | $ | — |   |   |

 

Of the approximately $1.2million of expenses charged in fiscal 2005, $0.3 million was included in costof goods sold, $0.6 million was included in selling, service and administrativeexpenses, and $0.3 million was included in research, development andengineering expenses. Of the $2.0 million expenses charged in fiscal 2004, $0.1million was included in cost of goods sold, $1.7 million was included inselling, service and administrative expenses, and $0.2 million was included inresearch, development and engineering expenses.

***Fiscal year 2005 restructuring plan***

In December 2004, theCompany initiated a restructuring plan designed to streamline its technologydevelopment efforts and enhance customer-centric focus. This was accomplishedthrough several actions, including centralizing research, development andengineering functions, creating a technical marketing solutions group andcreating a customer-centric manufacturing organization. In conjunction with therestructuring, 57 positions in the U.S. operations were eliminated, impactingall employee groups. The restructuring actions were completed in early January 2005and approximately $1.2 million in charges related to the plan were incurred andpaid in fiscal 2005.

***Fiscal year 2004 cost management plan***

In the first quarter offiscal 2004 the Company initiated a reduction of 67 employees, impacting allemployee groups in order to reduce expenditures. There were no expensesrecorded for the fiscal 2004 plan in fiscal 2005. Charges and payments infiscal 2004 related to the plan of approximately $1.0 million were comprised ofseverance and other employee-related costs. The headcount reductions primarilyoccurred in the first quarter of fiscal 2004 and were substantially complete inthe second quarter of fiscal 2004.

***Fiscal year 2003 cost management plan***

The fiscal 2003 actions primarily related to relocatingthe manufacturing of the electronic component product line included in thepassive components group from Escondido, California to the Company’sheadquarters in Portland, Oregon. These actions resulted in a reduction of 68employees and the relocation of 37 employees to the Company’s headquarters. Reductionsand relocations were substantially completed by December 31, 2002. Therewere no expenses recorded for the fiscal 2003 plan in fiscal 2005. Severanceand other employee-related charges and payments for these activities totaledapproximately $0.4 million and $4.4 million in fiscal 2004 and fiscal 2003,respectively. Facilities consolidation costs and payments related to theseactivities totaled approximately $0.2 million and $2.8 million in fiscal 2004and fiscal 2003, respectively. Fixed asset write-downs totaled approximately$0.9 million in fiscal 2003. As a 

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result of the closure ofthe California facility the Company recorded charges of $4.1 million in fiscal2003 for inventory write-downs related to the discontinuance of certainelectronic component manufacturing product lines.

Additionally, the Company recorded charges in fiscal2003 related to downward revisions to previously projected product demand andthe discontinuance of certain electronic component manufacturing product linesincluded in the passive components group comprising $6.8 million for thewrite-down of excess and obsolete inventory, $2.5 million related to openpurchase order commitments on excess and obsolete inventory, and $3.0 millionin inventory write-downs and long term asset impairments, and a $0.2 milliongain on the disposal of equipment.

Included in accrued liabilities are chargesrelating to the closure of a building located in Ann Arbor, Michigan,initiated in fiscal 2002. This facility is sublet through December 2006,the expiration date of the Company’s lease on the facility. At May 28,2005 and May 29, 2004, an accrual of $0.4 million and $0.5 million,respectively is recorded for remaining lease charges, net of estimated subleaseincome, which will be paid through December 2006.

**NOTE23.   QUARTERLY FINANCIAL INFORMATION (Unaudited)**
| ** **                                 | ** ** | **1st  Quarter**                                                   | ** ** | **2nd  Quarter** | ** ** | **3rd  Quarter** | ** ** | **4th  Quarter** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                 | ** ** | **(in thousands, except per share data)** | ** ** |
| ***Year  ended May 29, 2005***        |       |                                                               |       |             |       |             |       |             |       |
| Net sales                                  |       | $                                                                  | 72,620     |             | $          | 66,004           |       | $                | 49,084     |   | $ | 45,663 |   |
| Gross profit                               |       | 36,886                                                             |       | 32,826           |       | 21,438           |       | 20,680           |       |
| Provision for  (benefit from) income taxes |       | 4,433                                                              |       | 1,604            |       | 672              |       | (272             | )          |
| Net income (loss)(1)                       |       | 10,646                                                             |       | 7,946            |       | 1,998            |       | (753             | )          |
| Basic net income  (loss) per share         |       | 0.38                                                               |       | 0.28             |       | 0.07             |       | (0.03            | )          |
| Diluted net  income (loss) per share       |       | 0.36                                                               |       | 0.28             |       | 0.07             |       | (0.03            | )          |
| ***Year  ended May 29, 2004***        |       |                                                               |       |             |       |             |       |             |       |
| Net sales                                  |       | $                                                                  | 20,876     |             | $          | 45,753           |       | $                | 58,770     |   | $ | 81,843 |   |
| Gross profit                               |       | 4,840                                                              |       | 15,663           |       | 23,326           |       | 43,651           |       |
| Provision for  (benefit from) income taxes |       | (5,989                                                             | )          | 1,737            |       | (5,798           | )          | 742              |       |
| Net income (loss)(2)                       |       | (9,367                                                             | )          | (4,875           | )          | 9,974            |       | 16,155           |       |
| Basic net income  (loss) per share         |       | (0.34                                                              | )          | (0.17            | )          | 0.36             |       | 0.57             |       |
| Diluted net income  (loss) per share       |       | (0.34                                                              | )          | (0.17            | )          | 0.34             |       | 0.54             |       |

 

The sum of the quarterly data presented in the tableabove for fiscal 2005 and 2004 does not equal annual results due to the varyingimpacts of dilutive securities to the annual versus the quarterly EPScalculations (see Note 17) and due to rounding.

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(1)          The second quarter offiscal 2005 includes a pretax charge of approximately $2.2 million resultingfrom the settlement and related legal costs for a patent infringement lawsuit. SeeNote 18. The fourth quarter of fiscal 2005 includes a pretax charge ofapproximately $4.1 million for the redemption of the convertible subordinatednotes. See Note 13.

(2)          Thefourth quarter of fiscal 2004 includes a pretax charge of $3.8 million for theestimated settlement of the class action and derivative lawsuits. See Note 18.

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***Item 9.         Changesin and Disagreements with Accountants on Accounting and Financial Disclosure***

None.

***Item 9A.      Controlsand Procedures***

Attached to this annualreport as exhibits 31.1 and 31.2 are the certifications of our President andChief Executive Officer (CEO) and our Chief Financial Officer (CFO) required bySection 302 of the Sarbanes-Oxley Act of 2002 (the Section 302Certifications). This “Controls and Procedures” section of our annual report onForm 10-K is our disclosure of the conclusions of our management,including our CEO and our CFO, regarding the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this reportbased on management’s evaluation of those disclosure controls and procedures. Thissection of the Annual Report on Form 10-K should be read inconjunction with the Section 302 Certifications for a more completeunderstanding of the topics presented.

***(a) Evaluation of Disclosure Controls andProcedures***

We evaluated the effectiveness of the design andoperation of our disclosure controls and procedures as of the end of the periodcovered by this Annual Report on Form 10-K. This controls evaluationwas performed under the supervision and with the participation of management,including our President and CEO and CFO. Disclosure controls are proceduresthat are designed to ensure that information required to be disclosed in ourreports filed under the Securities Exchange Act of 1934, or the Exchange Act,such as this Annual Report on Form 10-K, is recorded, processed,summarized and reported within the time periods specified by the Securities andExchange Commission, or the SEC. Disclosure controls are also designed toensure that such information is accumulated and communicated to our management,including the CEO and CFO, as appropriate to allow timely decisions regardingrequired disclosure. Our quarterly evaluation of disclosure controls includesan evaluation of some components of our internal control over financialreporting. We also perform a separate annual evaluation of internal controlover financial reporting for the purpose of providing the management reportbelow.

The evaluation of our disclosure controls included areview of their objectives and design, the Company’s implementation of thecontrols and the effect of the controls on the information generated for use inthis Annual Report on Form 10-K. In the course of the controlsevaluation, we determined that process improvements were required to strengthencontrol procedures and confirmed that the appropriate actions were undertaken.This type of evaluation is performed on a quarterly basis so that theconclusions of management, including the CEO and CFO, concerning theeffectiveness of the disclosure controls can be reported in our periodicreports on Form 10-Q and Form 10-K. Many of thecomponents of our disclosure controls are also evaluated on an ongoing basis byour finance organization. The overall goals of these various evaluationactivities are to monitor our disclosure controls and to modify them asnecessary. We intend to maintain the disclosure controls as dynamic systemsthat we adjust as circumstances merit.

Based on the controlsevaluation, our CEO and CFO have concluded that, subject to the limitationsnoted in (c) below, as of the end of the period covered by this Form 10-K,our disclosure controls and procedures were effective to provide reasonableassurance that information required to be disclosed in our Exchange Act reportsis recorded, processed, summarized and reported within the time periodsspecified by the SEC, and that material information relating to the Company ismade known to management, including the CEO and the CFO, particularly duringthe time when our periodic reports are being prepared.

***(b) Management’s Report on Internal Control OverFinancial Reporting***

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(f) and 15d-15(f).Under the 

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supervision and with theparticipation of our management, including our CEO and CFO, we conducted anevaluation of the effectiveness of our internal control over financialreporting as of May 28, 2005 based on the guidelines established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). Based on this evaluation, our management has concluded that ourinternal control over financial reporting was effective as of May 28,2005.

Management’s assessment ofthe effectiveness of our internal control over financial reporting as of May 28,2005, which assessment is described below in the attestation report of KPMGLLP, has been audited by KPMG LLP, an independent registered public accountingfirm, as stated in their report in (e) below.

***(c) Limitations on Effectiveness of Controls***

Our management, includingour CEO and CFO, do not expect that our disclosure controls or our internalcontrols for financial reporting will prevent all error and all fraud. Acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Further, the design of a control system must reflect the fact thatthere are resource constraints, and the benefits of controls must be consideredrelative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within the company have beendetected. These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur because of simpleerror or mistake. Additionally, controls can be circumvented by the individualacts of some persons, by collusion of two or more people, or by managementoverride of the controls. The design of any system of controls also is based inpart upon certain assumptions about the likelihood of future events, and therecan be no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions; over time, controls may becomeinadequate because of changes in conditions, or the degree of compliance withthe policies or procedures may deteriorate. Because of the inherent limitationsin a cost-effective control system, misstatements due to error or fraud mayoccur and not be detected.

***(d) Changes in Internal Control***

Therehas been no change in our internal control over financial reporting that occurredduring our last fiscal quarter that has materially affected or is reasonablylikely to materially affect our internal control over financial reporting.

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***(e) Report of Independent Registered PublicAccounting Firm***

To the Board of Directors and Shareholders

Electro ScientificIndustries, Inc.

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting, that Electro Scientific Industries, Inc. maintained effectiveinternal control over financial reporting as of May 28, 2005, based oncriteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). Electro Scientific Industries, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with U.S. generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Alsoprojections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that ElectroScientific Industries, Inc. maintained effective internal control overfinancial reporting as of May 28, 2005, is fairly stated, in all materialrespects, based on criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). Also, in our opinion, Electro Scientific Industries, Inc.maintained, in all material respects, effective internal control over financialreporting as of May 28, 2005, based on criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).

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We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Electro ScientificIndustries, Inc. and subsidiaries as of May 28, 2005 and May 29,2004 and the related consolidated statements of operations, shareholders’equity and cash flows for each of the years in the three-year period ended May 28,2005, and our report dated July 26, 2005 expressed an unqualified opinionon those consolidated financial statements.
| /s/ KPMG LLP       |
|--------------------|
| Portland, Oregon   |
| July 26, 2005 |

 

***Item 9B.      OtherInformation***

None.

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**PART III**

***Item 10.      Directorsand Executive Officers of the Registrant***

The information required by this item, includinginformation about the Company’s audit committee, is included under the headings“Election of Directors,” “Executive Officers” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our Proxy Statement for our 2005 AnnualMeeting of Shareholders and is incorporated herein by reference.

The Company has adoptedthe ESI Code of Conduct, a code of ethics and business practices with whichevery person who works for the Company is expected to comply. In addition, theCompany has adopted a Code of Ethics for financial managers which was approvedat its July 21, 2005 meeting of the Board of Directors with which allfinancial employees will be expected to comply. The ESI Code of Conduct ispublicly available on the Company’s website under the Investors Section (at *http://www.esi.com/investors/default.asp*). This websiteaddress is intended to be an inactive, textual reference only; none of the materialon this website is part of this report. If any waiver is granted, including anyimplicit waiver, from a provision of the ESI Code of Conduct or the Code ofEthics to the Company’s executive officers, controller or directors, theCompany will disclose the nature of such waiver on that website or in a reporton Form 8-K.

***Item 11.      ExecutiveCompensation***

The information requiredby this item is included under the headings “Board Compensation,” “ExecutiveCompensation,” “Employment Contracts and Severance Agreements,” “CompensationCommittee Report on Executive Compensation” and “Compensation CommitteeInterlocks and Insider Participation” in our Proxy Statement for our 2005Annual Meeting of Shareholders and is incorporated herein by reference.

***Item 12.      SecurityOwnership of Certain Beneficial Owners and Management and Related ShareholderMatters***

Certain informationrequired by this item is included under the headings “Security Ownership ofCertain Beneficial Owners and Management” and “Equity Compensation PlanInformation” in our Proxy Statement for our 2005 Annual Meeting of Shareholdersand is incorporated herein by reference.

***Item 13.      CertainRelationships and Related Transactions***

The information requiredby this item is included under “Certain Relationships and Related Transactions”in our Proxy Statement for our 2005 Annual Meeting of Shareholders and isincorporated herein by reference.

***Item 14.      PrincipalAccounting Fees and Services***

The information requiredby this item is included under “Principal Accounting Fees and Services” in ourProxy Statement for our 2005 Annual Meeting of Shareholders and is incorporatedherein by reference.

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**PART IV**

***Item 15.      Exhibitsand Financial Statement Schedules***

**(a)(1) and(a)(2) Financial Statements and Schedules**

TheConsolidated Financial Statements, together with the reports thereon of ourindependent registered public accounting firm, are included on the pages indicatedbelow:
|                                                                                                                                              | **Page** |
|----------------------------------------------------------------------------------------------------------------------------------------------|----------|
| Report of Independent  Registered Public Accounting Firm                                                                                     |     | 33 |   |
| Consolidated Balance Sheets as of  May 28, 2005 and May 29, 2004                                                                   |     | 34 |   |
| Consolidated Statements of  Operations for the fiscal years ended May 28, 2005, May 29, 2004  and May 31, 2003                |     | 35 |   |
| Consolidated Statements of  Shareholders’ Equity for the fiscal years ended May 28, 2005,  May 29, 2004 and May 31, 2003 |     | 36 |   |
| Consolidated Statements of  Cash Flows for the fiscal years ended May 28, 2005, May 29, 2004  and May 31, 2003                |     | 37 |   |
| Notes  to Consolidated Financial Statements                                                                                                  |     | 38 |   |

 

There are no schedulesrequired to be filed herewith.

**(a)(3) Exhibits**

Thefollowing exhibits are filed herewith and this list is intended to constitutethe exhibit index. An asterisk (*) beside the exhibit number indicates theexhibits containing a management contract, compensatory plan or arrangement,which are required to be identified in this report.
| Exhibit No.         | ** ** | ** **                                                                                                                                                                                                                                                                                                                                      | ** ** | ** ** |
|--------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|     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 (the “October 21 8-K”).                                                                                                                                        |
|     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* |       | ESI 1983 Stock Option Plan, as amended. Incorporated  by reference to Exhibit 10-E of the Company’s Annual Report on  Form 10-K for the fiscal year ended May 31, 1986.                                                                                                                                                     |
|     10.2* |       | ESI 1989 Stock Option Plan, as amended. Incorporated  by reference to Exhibit 10-B of the Company’s Annual Report on  Form 10-K for the fiscal year ended May 31, 1997.                                                                                                                                                     |
|     10.3* |       | Form of Change in Control Agreement between the  Company and each of its appointed officers. Incorporated by reference to  Exhibit 10-C of the Company’s Annual Report on Form 10-K for the  fiscal year ended June 1, 2002.                                                                                           |

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|     10.4*  |   | 1996 Stock Incentive  Plan. Incorporated by reference to Exhibit 10-E of the Company’s Annual  Report on Form 10-K for the fiscal year ended May 31, 1997.                                                                                                                                                                               |   |
|---------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|     10.5*  |   | 2000 Stock Option Plan. Incorporated by reference to  Exhibit 10-F of the Company’s Annual Report on Form 10-K for the  fiscal year ended June 3, 2000.                                                                                                                                                                                  |   |
|     10.6*  |   | Form of Indemnity Agreement between the Company  and each of its corporate officers. Incorporated by reference to  Exhibit 10-F of the Company’s Annual Report on Form 10-K for the  fiscal year ended June 1, 2002.                                                                                                                |   |
|     10.7*  |   | 2000 Stock Option Incentive Plan. Incorporated by  reference to Appendix A of the Company’s definitive Proxy Statement for its  2000 Annual Meeting of Shareholders.                                                                                                                                                                                    |   |
|     10.8*  |   | Change in Control  Agreement by and between Electro Scientific Industries, Inc. and Mr. Bob Chamberlain  dated January 16, 2003. Incorporated by reference to  Exhibit 10.5 to the Company’s previously filed Quarterly Report on  Form 10-Q for the quarter ended March 1, 2003, as filed on  August 11, 2003. |   |
|     10.9*  |   | Change in Control  Agreement by and between Electro Scientific Industries, Inc. and  Mr. Ed Swenson dated January 16, 2003. Incorporated by  reference to Exhibit 10.8 to the Company’s previously filed Quarterly  Report on Form 10-Q for the quarter ended March 1, 2003, as filed  on August 11, 2003.      |
|     10.10* |   | Change in Control  Agreement by and between Electro Scientific Industries, Inc. and  Mr. Keith Taft dated January 16, 2003. Incorporated by  reference to Exhibit 10.9 to the Company’s previously filed Quarterly  Report on Form 10-Q for the quarter ended March 1, 2003, as filed  on August 11, 2003.           |
|     10.11* |   | Employment Agreement by  and between Electro Scientific Industries, Inc. and Mr. J. Michael  Dodson dated May 5, 2003. Incorporated by reference to  Exhibit 10.10 to the Company’s previously filed Quarterly Report on  Form 10-Q for the quarter ended March 1, 2003, as filed on  August 11, 2003.               |
|     10.12* |   | Employment Agreement between the Company and  Nicholas C. Konidaris, dated January 7, 2004. Incorporated by reference  to Exhibit 10.1 to the Company’s previously filed Quarterly Report on  Form 10-Q for the quarter ended February 28, 2004, as filed on April 6,  2004.                                                   |
|     10.13* |   | Amendment No. 1 to Employment Agreement between  the Company and Nicholas Konidaris, dated as of January 25, 2005.  Incorporated by reference to Exhibit 10.1 of the Company’s Current  Report on Form 8-K filed on January 31, 2005 (the “January 31  8-K”).                                                   |
|     10.14* |   | Amendment No. 1 to Stock Option Agreement  between the Company and Nicholas Konidaris, dated as of January 25,  2005. Incorporated by reference to Exhibit 10.2 of the January 31  8-K.                                                                                                                                                  |
|     10.15* |   | Form of Amendment No. 1 to Stock Option  Agreement between the Company and Nicholas Konidaris dated as of  January 25, 2005. Incorporated by reference to Exhibit 10.3 of the  January 31 8-K.                                                                                                                                      |
|     10.16* |   | Form of Amendment No. 1 to Stock Option  Agreement between the Company and Nicholas Konidaris dated as of  January 25, 2005. Incorporated by reference to Exhibit 10.4 of the  January 31 8-K.                                                                                                                                      |
|     10.17* |   | Form of Restricted Stock Units Award Agreement  between the Company and Nicholas Konidaris, dated as of January 25,  2005. Incorporated by reference to Exhibit 10.6 of the January 31  8-K.                                                                                                                                             |
|     10.18* |   | 2004 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                   |
|     10.19* |   | Deferred Compensation Plan. Incorporated by  reference to Exhibit 10.1 of the Company’s Current Report on  Form 8-K filed June 10, 2005.                                                                                                                                                                                                 |
|     10.20* |   | Form of Notice of Grant of Stock Options and  Option Agreement and related Option Terms and Conditions (Incentive Stock  Options) (for awards made prior to July 20, 2005). Incorporated by  reference to Exhibit 10.3 in the October 8-K.                                                                                               |

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|     10.21* |   | Form of Notice of Grant of Stock Options and  Option Agreement and related Option Terms and Conditions (Non-Qualified Stock  Options) (for awards made prior to July 20, 2005). Incorporated by  reference to Exhibit 10.4 in the October 8-K. |
|---------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     10.22* |   | Form of Performance Based Restricted Stock  Units Award Agreement. Incorporated by reference to Exhibit 10.5 of the  January 31 8-K.                                                                                                                |
|     10.23* |   | Form of Restricted Stock Units Award Agreement.  Incorporated by reference to Exhibit 10.7 of the January 31 8-K.                                                                                                                                   |
|     21     |   | Subsidiaries of the Company                                                                                                                                                                                                                                        |
|     23     |   | Consent of Independent Registered Public Accounting  Firm                                                                                                                                                                                                          |
|     24.1   |   | Power of Attorney for Frederick Ball                                                                                                                                                                                                                               |
|     24.2   |   | Power of Attorney for Richard J. Faubert                                                                                                                                                                                                                           |
|     24.3   |   | Power of Attorney for Barry L. Harmon                                                                                                                                                                                                                              |
|     24.4   |   | Power of Attorney for W. Arthur Porter                                                                                                                                                                                                                             |
|     24.5   |   | Power of Attorney for Gerald F. Taylor                                                                                                                                                                                                                             |
|     24.6   |   | Power of Attorney for Keith L. Thomson                                                                                                                                                                                                                             |
|     24.7   |   | Power of Attorney for Jon D. Tompkins                                                                                                                                                                                                                              |
|     24.8   |   | Power of Attorney for Robert R. Walker                                                                                                                                                                                                                             |
|     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 Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| Date: July 26, 2005 | ELECTRO  SCIENTIFIC INDUSTRIES, INC.    |
|--------------------------|-----------------------------------------|
|                     | By:                                     | /s/ NICHOLAS KONIDARIS |
|                     | Nicholas Konidaris                      |
|                     | *President and Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities indicated on July 26, 2005.
|                         | **Signature** | ** **                                                | ** ** | ** ** | **Title** | ** ** |
|-------------------------|---------------|-----------------------------------------------------------|------------|------------|-----------|------------|
| /s/  NICHOLAS KONIDARIS |          | President, Chief  Executive Officer and Director          |
| Nicholas  Konidaris     |          | (Principal Executive Officer)                             |
| /s/  J. MICHAEL DODSON  |          | Senior Vice President of  Administration, Chief Financial |
| J. Michael Dodson       |          | Officer and Secretary (Principal Financial Officer)       |
| /s/  KERRY MUSTOE       |          | Corporate Controller and  Chief Accounting Officer        |
| Kerry Mustoe            |          | (Principal Accounting Officer)                            |
| *FREDERICK A. BALL      |          | Director                                                  |
| Frederick Ball          |          |                                                      |
| *RICHARD J. FAUBERT     |          | Director                                                  |
| Richard J.  Faubert     |          |                                                      |
| *BARRY L. HARMON        |          | Director                                                  |
| Barry L. Harmon         |          |                                                      |
| *W.  ARTHUR PORTER      |          | Director                                                  |
| W. Arthur Porter        |          |                                                      |
| *GERALD F. TAYLOR       |          | Director                                                  |
| Gerald F. Taylor        |          |                                                      |
| *KEITH L. THOMSON       |          | Director                                                  |
| Keith L. Thomson        |          |                                                      |
| *JON D. TOMPKINS        |          | Chairman of the Board                                     |
| Jon D. Tompkins         |          |                                                      |
| *ROBERT R. WALKER       |          | Director                                                  |
| Robert R. Walker        |          |                                                      |

 

 
| * By:                                 | /s/ J. MICHAEL DODSON |   |   |
|---------------------------------------|-----------------------|--------|--------|
| J. Michael Dodson, *Attorney-in-fact* |                  |   |

 

 

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