**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




________________


**FORM
      10-Q**


________________







(Mark One)x
            **QUARTERLY REPORT PURSUANT TO SECTION
                13 OR
                15(d)**
              **OF
                THE SECURITIES EXCHANGE ACT OF 1934****For
                the quarterly period ended September 30,
                2006****or**o
            **TRANSITION REPORT PURSUANT
              TO SECTION
              13 OR 15(d)**
              **OF
                THE SECURITIES EXCHANGE ACT OF 1934**





**Commission
      File Number: 0-26824**





**TEGAL
      CORPORATION**


*(Exact
      Name of Registrant as Specified in Its Charter)*





**Delaware**
            **68-0370244*****(State
                or other jurisdiction of***
            ***(I.R.S.
                Employer Identification No.)******incorporation
                or organization)***





**2201
      South McDowell Blvd.**


**Petaluma,
      California 94954**


*(Address
      of Principal Executive Offices)*





**Telephone
      Number (707) 763-5600**


*(Registrant’s
      Telephone Number, Including Area Code)*


________________







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





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. (See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.) (Check
      One):


Large
      accelerated filer o   Accelerated
      filer o   Non-accelerated
      filer x





As
      of
      November 13, 2006 there were
      7,072,289 shares
      of
      our common stock outstanding. The
      number of shares outstanding reflects a 1 to 12 reverse stock split effected
      by
      the Registrant on July 25, 2006.










1


**TEGAL
      CORPORATION AND SUBSIDIARIES**





**INDEX**





**Page****PART
                I. FINANCIAL INFORMATION**ITEM
                1.
            CONDENSED
                CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)Condensed
                Consolidated Balance Sheets as of September 30, 2006 and March 31,
                2006
            3Condensed
                Consolidated Statements of Operations for the three months ended
                September
                30, 2006 and September 30, 2005
            4Condensed
                Consolidated Statements of Cash Flows as of September 30, 2006 and
                September 30, 2005
            5Notes
                to Condensed Consolidated Financial Statements
            6ITEM
                2.
            MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF
                OPERATIONS
            14ITEM
                3.
            QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
            21ITEM
                4.
            CONTROLS
                AND PROCEDURES
            21**PART
                II. OTHER INFORMATION**ITEM
                1.
            LEGAL
                PROCEEDINGS
            21ITEM
                1A.
            RISK
                FACTORS
            22ITEM
                6.
            EXHIBITS
            22SIGNATURES
            22





2




**TEGAL
        CORPORATION AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS**
 **(Unaudited)**
 **(In
        thousands, except share data)**


**PART
      I — FINANCIAL INFORMATION**





**Item
      1.** ***Condensed
      Consolidated Financial Statements***





**September
                30**
            
            **March
                31****2006**
            
            **2006****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            10,465
            
            $
            13,787Accounts
                receivable, net of allowances for sales returns and doubtful accounts
                of
                $506 and $205 at September 30, 2006, and March 31, 2006,
                respectively
            
            
            4,412
            
            
            5,265Inventories,
                net
            
            
            7,780
            
            
            7,700Prepaid
                expenses and other current assets
            
            
            1,643
            
            
            1,270Total
                current assets
            
            
            24,300
            
            
            28,022Property
                and equipment, net
            
            
            1,088
            
            
            1,849Intangible
                assets, net
            
            
            1,317
            
            
            1,474Other
                assets
            
            
            143
            
            
            146Total
                assets
            
            $
            26,848
            
            $
            31,491**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Notes
                payable and bank lines of credit
            
            $
            25
            
            $
            27Accounts
                payable
            
            
            2,263
            
            
            2,458Accrued
                product warranty
            
            
            799
            
            
            506Deferred
                revenue
            
            
            551
            
            
            477Accrued
                expenses and other current liabilities
            
            
            1,987
            
            
            1,975Total
                current liabilities
            
            
            5,625
            
            
            5,443Long-term
                portion of capital lease obligations
            
            
            —
            
            
            2Other
                long term obligations
            
            
            2
            
            
            6Total
                long term liabilities
            
            
            2
            
            
            8Total
                liabilities
            
            
            5,627
            
            
            5,451Stockholders’
                equity:Preferred
                stock; $ 0.01 par value;
                5,000,000shares authorized; none issued and outstanding
            
            
            —
            
            
            —Common
                stock; $ 0.01 par value;200,000,000shares authorized;
                7,055,623 and 7,021,088shares issued and outstanding at September 30, 2006 and March 31,
                2006
                respectively
            
            
            71
            
            
            70Restricted
                Share Units
            
            
            422
            
            
            810Additional
                paid-in capital
            
            
            120,822
            
            
            119,782Accumulated
                other comprehensive income
            
            
            143
            
            
            532Accumulated
                deficit
            
            
            (100,237
            )
            
            (95,154
            )Total
                stockholders’ equity
            
            
            21,221
            
            
            26,040Total
                liabilities and stockholders’ equity
            
            $
            26,848
            
            $
            31,491





See
      accompanying notes.








3





**TEGAL
      CORPORATION AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(Unaudited)**


**(In
      thousands, except per share data)**





**Three
                Months Ended**
              ******September
                30,**
            
            **Six
                Months Ended**
              ******September
                30,********2006**
            
            ******2005**
            
            ******2006**
            
            ******2005**Revenue
            
            $
            5,113
            
            $
            6,406
            
            $
            11,689
            
            $
            9,458Cost
                of revenue
            
            
            2,713
            
            
            3,963
            
            
            6,791
            
            
            6,340Gross
                profit (loss)
            
            
            2,400
            
            
            2,443
            
            
            4,898
            
            
            3,118Operating
                expenses:Research
                and development
            
            
            1,066
            
            
            1,211
            
            
            2,062
            
            
            2,387Sales
                and marketing
            
            
            964
            
            
            757
            
            
            2,008
            
            
            1,401General
                and administrative
            
            
            3,485
            
            
            3,398
            
            
            5,787
            
            
            4,638Total
                operating expenses
            
            
            5,515
            
            
            5,366
            
            
            9,857
            
            
            8,426Operating
                loss
            
            
            (3,115
            )
            
            (2,923
            )
            
            (4,959
            )
            
            (5,308
            )Other
                income (expense), net
            
            
            (166
            )
            
            242
            
            
            (124
            )
            
            120Net
                loss
            
            $
            (3,281
            )
            $
            (2,681
            )
            $
            (5,083
            )
            $
            (5,188
            )Net
                loss per share, basic and diluted
            
            $
            (0.47
            )
            $
            (0.51
            )
            $
            (0.72
            )
            $
            (1.13
            )Shares
                used in per share computation:Basic
            
            
            7,045
            
            
            5,227
            
            
            7,029
            
            
            4,608Diluted
            
            
            7,045
            
            
            5,227
            
            
            7,029
            
            
            4,608





Note:
      Shares used in per share computation for Basic and Diluted reflect a 1 to12
      reverse stock split effected
      by the Company on July 25, 2006





See
      accompanying notes.




4


**TEGAL
      CORPORATION AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(Unaudited)**


**(In
      thousands)**





**Six****Months Ended**
              **September
                30,****2006**
            
            **2005**Cash
                flows from operating activities:Net
                loss
            
            $
            (5,083
            )
            $
            (5,188
            )Adjustments
                to reconcile net loss to cash used in operating
                activities:Depreciation
                and amortization
            
            
            448
            
            
            678Stock
                Compensation Expense
            
            
            463
            
            
            1,004Fair
                value of warrants issued for services rendered
            
            
            48
            
            
            792Provision
                for doubtful accounts and sales return allowances
            
            
            302
            
            
            (450
            )Excess
                and obsolete inventory provision
            
            
            (2,142
            )
            
            --Non-cash
                valuation of marked to market investor warrants
            
            
            --
            
            
            (326
            )Changes
                in operating assets and liabilities:Accounts
                receivables
            
            
            465
            
            
            (2,788
            )Inventories
            
            
            1,738
            
            
            (769
            )Prepaid
                expenses and other assets
            
            
            (312
            )
            
            (398
            )Accounts
                payable
            
            
            (203
            )
            
            (489
            )Accrued
                expenses and other liabilities
            
            
            (7
            )
            
            277Accrued
                product warranty
            
            
            284
            
            
            77Loss
                on disposal of property and equipment
            
            
            657
            
            
            --Deferred
                revenue
            
            
            74
            
            
            312Net
                cash used in operating activities
            
            
            (3,268
            )
            
            (7,268
            )Cash
                flows used in investing activities:Purchases
                of property and equipment
            
            
            (185
            )
            
            (138
            )Net
                cash used in investing activities:
            
            
            (185
            )
            
            (138
            )Cash
                flows provided by financing activities:Net
                proceeds from issuance of common stock
            
            
            143
            
            
            18,657Borrowings
                under lines of credit
            
            
            2
            
            
            44Repayment
                of borrowings under lines of credit
            
            
            --
            
            
            (157
            )Payments
                on capital lease financing
            
            
            (2
            )
            
            (6
            )Net
                cash provided by financing activities
            
            
            143
            
            
            18,538Effect
                of exchange rates on cash and cash equivalents
            
            
            (12
            )
            
            (24
            )Net
                increase (decrease) in cash and cash equivalents
            
            
            (3,322
            )
            
            11,108Cash
                and cash equivalents at beginning of period
            
            
            13,787
            
            
            7,093Cash
                and cash equivalents at end of period
            
            $
            10,465
            
            $
            18,201





See
      accompanying notes.





5


**TEGAL
      CORPORATION AND SUBSIDIARIES**





**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**(Unaudited)**


**(All
      amounts in thousands, except share data)**





**1.
      Basis of Presentation:**





In
      the
      opinion of management, the unaudited condensed consolidated interim financial
      statements have been prepared on the same basis as the March 31, 2006 audited
      consolidated financial statements and include all adjustments, consisting only
      of normal recurring adjustments, necessary to fairly state the information
      set
      forth herein. The statements have been prepared in accordance with the
      regulations of the Securities and Exchange Commission (the “SEC”), but omit
      certain information and footnote disclosures necessary to present the statements
      in accordance with generally accepted accounting principles. These interim
      financial statements should be read in conjunction with the consolidated
      financial statements and footnotes included in the Company’s Annual Report on
      Form 10-K for the fiscal year ended March 31, 2006. The results of operations
      for the three and six months ended September 30, 2006 are not necessarily
      indicative of results to be expected for the entire year.





The
      consolidated financial statements contemplate the realization of assets and
      the
      satisfaction of liabilities in the normal course of business. The Company
      incurred net losses of $5,083 and
      $5,188 for the six months ended September 30, 2006 and 2005, respectively.
      The
      Company generated negative cash flows from operations of $3,268 and $7,268
      for
      the period ended September 30, 2006 and 2005, respectively. During the fiscal
      2006 the Company raised a net of $18,384 through a private investment placement
      of equity. Management believes that these proceeds, combined with projected
      sales, consolidation of certain operations and continued cost containment will
      be adequate to fund operations through fiscal 2007. However, projected sales
      may
      not materialize and unforeseen costs may be incurred **.** If
      the
      projected sales do not materialize, the Company’s ability to achieve its
      intended business objectives may be adversely affected. The condensed
      consolidated financial statements do not include any adjustments relating to
      the
      recoverability and classification of recorded assets or the amount or
      classification of liabilities or any other adjustments that might be necessary
      should the Company be unable to continue as a going concern.





On
      July
      21, 2006, Tegal Corporation filed with the Secretary of State of the State
      of
      Delaware a Certificate of Amendment to the Company’s Certificate of
      Incorporation to affect a 1-for-12 reverse stock split of the Company’s common.
      The condensed consolidated financial statements for current and prior periods
      have been adjusted to reflect the change in number of shares.





**Concentration
      of Credit Risk**





Financial
      instruments that potentially subject the Company to significant concentrations
      of credit risk consist primarily of temporary cash investments and accounts
      receivable. Substantially all of the Company’s temporary investments are
      invested in money market funds. The Company’s accounts receivable are derived
      primarily from sales to customers located in the U.S., Europe and Asia. The
      Company performs ongoing credit evaluations of its customers and generally
      requires no collateral. The Company maintains reserves for potential credit
      losses. Write-offs during the periods presented have been insignificant. As
      of
      March 31, 2006 one customer accounted for approximately 63.4% of the accounts
      receivable balance.





During
      the three months ending September 30, 2006 three (3) customers accounted for
      49%
      of total revenue. During the three months ending September 30, 2005 two (2)
      customers accounted for 78% of total revenue. During the six months ending
      September 30, 2006 and September 30, 2005, three (3) customers accounted for
      53%
      and two (2) customers accounted for 69% of total revenue respectively.





As
      of
      September 30, 2006 four (4) customers accounted for 54% of outstanding accounts
      receivable balance. As of September 30, 2005 one (1) customer accounted for
      69%
      of outstanding accounts receivable balance.





**Stock
      Based Compensation**





**Adoption
      of SFAS 123R**





The
      Company has adopted several stock plans that provide equity instruments to
      our
      employees and non-employee directors. Our plans include incentive and
      non-statutory stock options and restricted stock awards. Stock options generally
      vest ratably over a four-year period on the anniversary date of the grant,
      and
      expire ten years after the grant date. Restricted stock awards generally vest
      on
      the achievement of specific performance targets. The Company also has employee
      stock purchase plans that allow qualified employees to purchase Company shares
      at 85% of the fair market value on specified dates.




6





Prior
      to
      April 1, 2006 we accounted for these stock-based employee compensation plans
      under the measurement and recognition provisions of Accounting Principles Board
      Opinion No. 25, “Accounting for Stock Issued to Employees” or APB 25, and
      related Interpretations, as permitted by SFAS No. 123, “Accounting for Stock
      Based Compensation,” or SFAS 123. With the exception of grants of restricted
      stock awards, we generally recorded no stock-based compensation expense during
      periods prior to April 1, 2006 as all stock-based grants had exercise prices
      equal to the fair market value of our common stock on the date of grant. We
      also
      recorded no compensation expense in connection with our employee stock purchase
      plans as they qualified as non-compensatory plans following the guidance
      provided by APB 25. In accordance with SFAS 123 and SFAS 148 “Accounting for
      Stock-Based Compensation-Transition and Disclosure,” appearing later in this
      Note we disclose our net loss and net loss per share for the quarter and six
      (6)
      months ended September 30, 2005 as if we had applied the fair value-based method
      in
      measuring compensation expense for our stock-based compensation
      plans.





Effective
      April 1, 2006, we adopted the fair value recognition provisions of SFAS No.
      123R
“Accounting for Stock Based Compensation”, using the modified prospective
      transition method. Under that transition method, compensation expense that
      we
      recognized for the three and six months ended September 30, 2006 was $233 and
      $463 included: (a) compensation expense for all share-based payments granted
      prior to but not yet vested as of April 1, 2006, based on the grant date fair
      value estimated in accordance with the original provisions of SFAS 123, and
      (b)
      compensation expense for all share-based payments granted or modified on or
      after April 1, 2006, based on the grant date fair value estimated in accordance
      with the provisions of SFAS 123R. Compensation expense is recognized only for
      those awards that are expected to vest, whereas prior to the adoption of SFAS
      123R, we recognized forfeitures as they occurred. In addition, we elected the
      straight-line attribution method as our accounting policy for recognizing
      stock-based compensation expense for all awards that are granted on or after
      April 1, 2006. Results in prior periods have not been restated.





Total
      compensation expense for the period ended September 30, 2006 was $463, for
      the
      three months ended September 30, 2006, the compensation expense was $233. The
      total compensation expense related to non-vested awards not yet recognized
      is
      $1,010. The weighted average period for which it is expected to be recognized
      is
      2 years.





Had
      the
      Company adopted SFAS No 123R during the fiscal year ended March 31, 2006,
      compensation expense of approximately $1,770 would have been recognized in
      the
      consolidated statements of operations for the year ended March 31, 2006.




The
      following assumptions are included in the estimated grant date fair value
      calculations for the Company’s stock option awards and Employee Qualified Stock
      Purchase Plan (“ESPP”):




**September
                30, 2006**
            
            **September
                30, 2005**Expected
                life (years):Stock
                options
            
            
            4.0
            
            
            4.0ESPP
            
            
            0.5
            
            
            0.5Volatility:Stock
                options
            
            
            55
            %
            
            60
            %ESPP
            
            
            55
            %
            
            60
            %Risk-free
                interest rate
            
            
            4.85
            %
            
            3.52
            %Dividend
                yield
            
            
            0.00
            %
            
            0
            %





During
      the period ended September 30, 2006, there were 16,664 stock option
      grants.





The
      following table illustrates on a post reverse stock split basis, the effect
      on
      net income (loss) and net income (loss) per share if the Company had applied
      the
      fair value recognition provisions of SFAS No. 123 to stock-based compensation
      (in thousands, except per share data):





7





**Three
                Months**
              **September
                30**
            
            **Six
                Months**
              **September
                30****2005**
            
            **2005**Net
                loss as reported
            
            $
            (2,681
            )
            $
            (5,188
            )Add:
                Stock-based employee compensation expense included in
              Reported
                net loss
            
            
            1,004
            
            
            1,004Deduct:
                Total stock-based employee compensation expense
              Determined
                under fair value method for all awards
            
            
            (1,533
            )
            
            (2,084
            )Proforma
                net loss
            
            $
            (3,210
            )
            $
            (6,268
            )Basic
                net loss per share:As
                reported
            
            $
            (0.51
            )
            $
            (1.13
            )Proforma
            
            $
            (0.61
            )
            $
            (1.36
            )




The
      disclosure provisions of SFAS No. 123R and SFAS No. 148 require judgments by
      management as to the estimated lives of the outstanding options. Management
      has
      based the estimated life of the options on historical option exercise patterns.
      If the estimated life of the options increases, the valuation of the options
      will increase as well.








***Stock
      Options & Warrants***





A
      summary
      of stock option and warrant activity during the quarter ended September 30,
      2006
      is as follows:








**Shares**
            
            **Weighted**
                    **Average**
                    **Exercise
                      Price**
            
            **Weighted
                        Average Remaining Contractual**
                      **Term
                        (in Years)**
            
            **Aggregate**
                  **Intrinsic
                    Value****BEGINNING
                OUTSTANDING**
            
            
            2,280,208
            
            $
            13.54229**GRANTED******Price
                < Market Value
            
            
            0
            
            $
            0.00000****Price
                = Market Value
            
            
            16,664
            
            $
            4,68000****Price
                > Market Value
            
            
            0
            
            $
            0.00000****Total
            
            
            16,664
            
            $
            4,68000**EXERCISED**
            
            
            
            
            $
            0.00000**CANCELLED**Forfeited
            
            
            (2,777
            )
            $
            8.28000Expired
            
            
            (21,464
            )
            $
            20.65380Total
            
            
            (24,241
            )
            $
            19.23628**ENDING
                OUTSTANDING**
            
            
            2,272,631
            
            $
            13.41657
            
            
            4.88
            
            $
            0.00**ENDING
                VESTED + EXPECTED TO VEST**
            
            
            2,260,911
            
            $
            13.42443
            
            
            0.09
            
            $
            0.00**ENDING
                EXERCISABLE**
            
            
            2,092,357
            
            $
            13.61673
            
            
            4.69
            
            $
            0.00





8





The
      aggregate intrinsic value of options and warrants outstanding at September
      30,
      2006 is calculated as the difference between the exercise price of the
      underlying options and the market price of our common stock as of September
      30,
      2006.





The
      following table summarizes information with respect to stock options and
      warrants outstanding as of September 30, 2006:





**Range
                of**
              **Exercise
                Prices**
            
            **Number**
                  **Outstanding**
                  **As
                    of**
                  **September
                    30, 2006**
            
            **Weighted**
                    **Average**
                    **Remaining**
                    **Contractual**
              **Term****(in
                years)**
            
            **Weighted
                Average**
              **Exercise
                Price**
            
            **Number**
                  **Exercisable**
                  **As
                    of**
              **September
                30, 2006**
            **Weighted**
                    **Average
                      Exercise**
                    **Price**
                    **As
                      of**
                    **September
                      30, 2006**$4.20
            $7.08
            
            228,412
            
            5.34
            
            $6.05
            
            176,192
            $5.957.20
            9.60
            
            147,632
            
            8.38
            
            8.31
            
            101,107
            8.3212.00
            12.00
            
            1,284,990
            
            3.93
            
            12.00
            
            1,284,990
            12.0012.36
            12.96
            
            242,335
            
            7.26
            
            12.43
            
            196,783
            12.4313.20
            25.68
            
            236,044
            
            6.84
            
            16.74
            
            200,067
            16.1727.00
            82.56
            
            124,476
            
            1.41
            
            37.38
            
            124,476
            37.3892.26
            92.26
            
            416
            
            3.44
            
            92.25
            
            416
            92.2692.52
            92.52
            
            4,165
            
            3.38
            
            92.52
            
            4,165
            92.5299.00
            99.00
            
            2,498
            
            3.49
            
            99.00
            
            2,498
            99.00105.00
            105.00
            
            1,663
            
            2.23
            
            105.00
            
            1,663
            105.00$4.20
            $105.00
            
            2,272,631
            
            4.88
            
            $13.42
            
            2,092,357
            $13.61673








**Restricted
      Stock Units**





The
      following table summarizes our restricted stock award activity for the period
      ended September 30, 2006:





**Number**
              **of**
              **Shares**
            
            **Weighted
                Avg.**
              **Grant
                Date**
              **Fair
                Value**Balance,
                June 30, 2006
            
            
            62,500
            
            $
            9.82Granted
            
            
            —
            
            
            —Vested
            
            
            16,666
            
            
            —Forfeited
            
            
            —
            
            
            —Released
            
            
            (33,333
            )
            $
            9.96Balance,
                September 30,2006
            
            
            45,833
            
            $
            9.68





**Unvested
      restricted stock at September 30, 2006**





As
      of
      September 30, 2006, there was $51 of total unrecognized compensation cost
      related to restricted stock which is expected to be recognized during the
      current fiscal year. As of September 30, 2006, there were a total
      of
      6,250 restricted
      shares subject to performance conditions that will result in forfeiture if
      the
      conditions are not realized.





9





**2.
      Inventories:**





Inventories
      are stated at the lower of cost or market, reduced by provisions for excess
      and
      obsolescence. Cost is computed using standard cost, which approximates actual
      cost on a first-in, first-out basis and includes material, direct labor and
      manufacturing overhead costs.





The
      estimate of the effect of excess and obsolescence on the carrying values of
      our
      inventories is based upon projected future demand and market conditions. A
      provision has been established for related inventories in excess of production
      demand. Should actual production demand differ from estimates, additional
      inventory write-downs may be required. The status of this reserve is reviewed
      on
      an on-going basis, any excess and obsolete provision is released only if and
      when the related inventory is sold or scrapped. During the six months ending
      September 30, 2006 the reserve was reduced by $2,594, the Company sold or scrapped
      previously reserved inventory of $2,255 and adjusted the reserve balance for
      a
      change in manufacturing overhead related to improved plant efficiencies by
      $339.
      The reserve balance at September 2006 is $4,542. At March of 2006 the reserve
      was at $7,136.








Inventories
      for the periods presented consisted of:





**September
                30**
              **2006**
            
            **March
                31**
              **2006**Raw
                materials
            
            $
            704
            
            $
            1,692Work
                in progress
            
            
            5,324
            
            
            4,173Finished
                goods and spares
            
            
            1,752
            
            
            1,835$
            7,780
            
            $
            7,700





We
      periodically analyze any systems that are in finished goods inventory to
      determine if they are suitable for current customer requirements. At the present
      time, our policy is that, if after approximately 18 months, we determine that
      a
      sale will not take place within the next 12 months and the system would be
      useable for customer demonstrations or training, it is transferred to fixed
      assets. Otherwise, it is expensed.





**3.
      Product Warranty:**





The
      Company provides warranty on all system sales based on the estimated cost of
      product warranties at the time revenue is recognized. The warranty obligation
      is
      affected by product failure rates, material usage rates, and the efficiency
      by
      which the product failure is corrected. Should actual product failure rates,
      material usage rates and labor efficiencies differ from estimates, revisions
      to
      the estimated warranty liability may be required.





Warranty
      activity for the three and six month periods ended September 30, 2006 and 2005
      was:





**Warranty
                Activity for the**
              **Three
                Months Ended**
              **September
                30,**
            
            **Warranty
                Activity for the**
              **Six
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Balance
                at the beginning of the period
            
            $
            668
            
            $
            238
            
            $
            723
            
            $
            252Additional
                warranty accruals for warranties issued during the period
            
            
            247
            
            
            166
            
            
            498
            
            
            211Settlements
                made during the period
            
            
            (116
            )
            
            (89
            )
            
            (422
            )
            
            (148
            )Balance
                at the end of the period
            
            $
            799
            
            $
            315
            
            $
            799
            
            $
            315





Certain
      of the Company's sales contracts include provisions under which customers would
      be indemnified by the Company in the event of, among other things, a third-party
      claim against the customer for intellectual property rights infringement related
      to the Company's products. There are no limitations on the maximum potential
      future payments under these guarantees. The Company has accrued no amounts
      in
      relation to these provisions as no such claims have been made and the Company
      believes it has valid, enforceable rights to the intellectual property embedded
      in its products.





10




**4.
      Net Loss per Common Share:**





Basic
      net
      loss per common share is computed using the weighted-average number of shares
      of
      common stock outstanding.


The
      following table represents the calculation of basic and diluted net loss per
      common share (in thousands, except per share data):




**Three
                Months Ended**
              **September
                30, 2006**
            
            **Six
                Months Ended**
              **September
                30, 2006**
            
            **Three
                Months**
              **Ended**
              **September
                30, 2005**
            
            **Six
                Months**
              **Ended**
              **September
                30, 2005**Net
                loss applicable to common stockholders
            
            $
            (3,281
            )
            $
            (5,083
            )
            $
            (2,681
            )
            $
            (5,188
            )Basic
                and diluted:Weighted-average
                common sharesoutstanding
                (adjusted to reflect 1 to 12 reverse stock split)
            
            
            7,045
            
            
            7,029
            
            
            5,227
            
            
            4,608Weighted-average
                common shares used in computing basic and diluted net loss per common
                share
            
            
            7,045
            
            
            7,029
            
            
            5,227
            
            
            4,608Basic
                and diluted net loss per common share
            
            $
            (0.47
            )
            $
            (0.72
            )
            $
            (0.51
            )
            $
            (1.13
            )





Outstanding
      options, warrants and restricted stock equivalent of 2,318,464 and
      2,410,092 shares
      of common stock at a weighted-average exercise price of $13.54 and $15.04 per
      share on September 30, 2006 and 2005 respectively, were not included in the
      computation of diluted net loss per common share for the periods presented
      as a
      result of their anti-dilutive effect. Such securities could potentially dilute
      earnings per share in future periods.





**5.
      Stock-Based Transactions:**





***Issuance
      of Warrants to Consultants***





The
      Company is party to a contract with certain consultants pursuant to which the
      Company will issue warrants on a monthly basis in lieu of cash payments through
      January 2008, depending upon the continuation of the contract and the
      achievement of certain performance goals. The maximum number of warrants to
      be
      issued under these agreements is
      33,333 shares.
      During the three months ended September 30, 2006, and September 30, 2005, 4,165
      and 7,083 warrants respectively, were granted to be purchased valued at $13
      and
      $53 respectively. During the six months ended September 30, 2006 and September
      30, 2005, 10,832 and 14,167 shares valued at $47 and $137 respectively. These
      values were calculated using the Black-Scholes model with an exercise price
      at
      the market value on the day of the grant. The life of the warrants is five
      and
      seven years with an interest rate of 4.51% and volatility of 118% and 115%
      respectively. None of these warrants have been exercised as of September 30,
      2006.




**6.
      Lines of Credit:**





As
      of
      September 30, 2006, our Japanese subsidiary had $20 outstanding under its lines
      of credit which is collateralized by Japanese customer promissory notes held
      by
      such subsidiary in advance of payment on customers’ accounts receivable. The
      credit line has a total borrowing capacity of 150 million yen (approximately
      $1,271 at exchange rates prevailing on September 30, 2006), which are secured
      by
      Japanese customer promissory notes held by such subsidiary in advance of payment
      on customers’ accounts receivable. The Japanese bank line bears interest at
      Japanese prime (1.625% as of September 30, 2006) plus 0.875%.





Notes
      payable as of September 30, 2006 consisted of capital lease obligations on
      fixed
      assets totaling $7.





11


**7.
        Legal Proceedings**
 
 Sputtered
        Films Inc. v. Advanced Modular Sputtering , et al., filed in Santa Barbara
        County Superior Court.


On
      December 22, 2003, Sputtered Films, Inc. ("SFI"), a wholly owned subsidiary
      of
      the Company, filed an action against two former employees, Sergey Mishin and
      Rose Stuart-Curran, and a company they formed after leaving their employment
      with SFI named Advanced Modular Sputtering, Inc. ("AMS"). Sergey Mishin and
      Rose
      Stuart-Curran had each signed confidentiality and non-disclosure agreements
      regarding information obtained while employed by SFI. The action contains causes
      of action for specific performance, breach of contract, breach of the covenant
      of good faith and fair dealing, misappropriation of trade secrets, unfair
      competition, unfair business practices, interference with prospective economic
      advantage, conversion, unjust enrichment, and declaratory relief. These claims
      arise out of information SFI received evidencing that AMS possessed and used
      SFI's confidential, proprietary and trade secret drawings, specifications and
      technology to manufacture the sputtering tool marketed by AMS.




During
      2004 and 2005, this litigation was largely stalled while AMS and Agilent
      Technologies, Inc. contested SFI's right to conduct discovery. This dispute
      was
      resolved in late 2005 when the California Court of Appeal affirmed SFI's trade
      secrete identification as statutorily sufficient. On November 18, 2005, SFI
      requested leave to add Agilent Technologies, Inc. ("Agilent") as a defendant
      based on evidence that Agilent and AMS co-developed the machines which SFI
      contends were built using SFI proprietary information. The Court granted SFI's
      request and Agilent was served as a Doe defendant on December 12, 2005. In
      early
      December, SFI learned that Agilent transferred its Semiconductor Products Group
      to a number of Avago entities effective December 1, 2005, and accordingly SFI
      sought and received court approval to add Avago Technologies U.S., Inc. and
      Avago Technologies Wireless (U.S.A.) Manufacturing, Inc (collectively the "Avago
      Entities") as defendant in this action. On April 25, 2006, the Avago Entities
      filed a Cross-Complaint against SFI and Tegal Corporation alleging causes of
      action for breach of contract, trade secret misappropriation, unfair
      competition, conversion, unjust enrichment and declaratory relief. The
      Cross-Complaint alleges on information and belief that SFI misused information
      obtained from Hewlett-Packard in connection with Hewlett-Packard's request
      to
      purchase SFI machines or to upgrade SFI machines Hewlett-Packard already owned.




On
      November 13, 2006, following commencement of the trial, all the parties in
      the
      litigation agreed on terms of a settlement, which was filed with the court.
      The
      settlement terms provide for a payment to the Company of approximately $13
      million, net of fees and certain expenses associated with the litigation. The
      settlement also calls for the transfer of assets related to PVD technology
      from
      AMS to SFI and the dissolution of AMS as of March 1, 2007. The Avago
      Cross-Complaint was also dismissed as part of the settlement.







**8.
      Geographical Information**





Tegal
      operates in one segment for the manufacture, marketing and servicing of
      integrated circuit fabrication equipment. In accordance with SFAS No. 131 (SFAS
      131) “Disclosures about Segments of an Enterprise and Related Information,”
Tegal’s chief operating decision-maker has been identified as the President and
      Chief Executive Officer, who reviews operating results to make decisions about
      allocating resources and assessing performance for the entire company. All
      material operating units qualify for aggregation under SFAS 131 due to their
      identical customer base and similarities in: economic characteristics; nature
      of
      products and services; and procurement, manufacturing and distribution
      processes. Since Tegal operates in one segment and in one group of similar
      products and services, all financial segment and product line information
      required by SFAS 131 can be found in the condensed consolidated financial
      statements.





For
      geographical reporting, revenues are attributed to the geographic location
      in
      which the customers’ facilities are located. Long-lived assets consist primarily
      of property, plant and equipment, and are attributed to the geographic location
      in which they are located. Net sales and long-lived assets by geographic region
      were as follows:





**Revenue
                for the**
              **Three
                Months Ended**
              **September
                30,**
            
            **Revenue
                for the**
              **Six
                Months Ended************September 30,********2006**
            
            ******2005**
            
            ******2006**
            
            ******2005**Sales
                to customers located in:United
                States
            
            $
            1,414
            
            $
            1,416
            
            $
            3,762
            
            $
            1,743Asia,
                excluding Japan
            
            
            1,737
            
            
            199
            
            
            4,612
            
            
            339Japan
            
            
            1,152
            
            
            500
            
            
            1,676
            
            
            1,078Europe
            
            
            810
            
            
            4,291
            
            
            1,639
            
            
            6,298Total
                sales
            
            $
            5,113
            
            $
            6,406
            
            $
            11,689
            
            $
            9,458





12





**Long-lived**
              **Assets
                as of****September
                30,****2006**
            
            **2005**Long-lived
                assets at period-end:United
                States
            
            $
            2,461
            
            $
            4,573Europe
            
            
            13
            
            
            12Japan
            
            
            9
            
            
            9Asia,
                excluding Japan
            
            
            0
            
            
            4Total
                long-lived assets
            
            $
            2,483
            
            $
            4,598








**9.
      Comprehensive Income (Loss):**





The
      components of comprehensive loss for the three and six months ended September
      30, 2006 and 2005 are as follows:





**Three
                Months****Ended**
              **September
                30,**
            
            **Six
                Months****Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                loss
            
            $
            (2,901
            )
            $
            (2,681
            )
            $
            (4,703
            )
            $
            (5,188
            )Foreign
                currency translation adjustment
            
            
            (50
            )
            
            219
            
            
            (389
            )
            
            393Total
                comprehensive loss
            
            $
            (2,951
            )
            $
            (2,462
            )
            $
            (5,092
            )
            $
            (4,795
            )




**10.
      Recent Accounting Pronouncements**




I n
      February 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 155 *“Accounting
      for Certain Hybrid Financial Instruments”* (“SFAS
      155”), an amendment of FASB Statements No. 133 and 140. SFAS 155 will be
      effective for the Company beginning in the first quarter of 2007. SFAS 155
      permits interests in hybrid financial instruments that contain an embedded
      derivative that would otherwise require bifurcation, to be accounted for as
      a
      single financial instrument at fair value, with changes in fair value recognized
      in earnings. This election is permitted on an instrument-by-instrument basis
      for
      all hybrid financial instruments held, obtained, or issued as of the adoption
      date. The Company is assessing the impact of the adoption of SFAS
      155.





In
      June
      2006, the FASB ratified the consensus reached on Emerging Issues Task Force
      (“EITF”) Issue No. 06-3, *“How
      Taxes Collected from Customers and Remitted to Governmental Authorities Should
      Be Presented in the Income Statement (That Is, Gross Versus Net
      Presentation)”* .
      The
      scope of EITF Issue No. 06-3 includes any transaction-based tax assessed by
      a
      governmental authority that is imposed concurrent with or subsequent to a
      revenue-producing transaction between a seller and a customer. The scope does
      not include taxes that are based on gross receipts or total revenues imposed
      during the inventory procurement process. Gross versus net income statement
      classification of that tax is an accounting policy decision and a voluntary
      change would be considered a change


in
      accounting policy requiring the application of SFAS No. 154, *“Accounting
      Changes and Error Corrections* ”.
      The
      following disclosures will be required for taxes within the scope of this issue
      that are significant in amount: (1) the accounting policy elected for these
      taxes and (2) the amounts of the taxes reflected gross (as revenue) in the
      income statement on an interim and annual basis for all periods presented.
      The
      EITF Issue No. 06-3 ratified consensus is effective for interim and annual
      periods beginning after December 15, 2006. We do not expect the adoption of
      EITF
      Issue No. 06-3 to have a material impact on our Condensed Consolidated Financial
      Statements.





13


In
      June
      2006, the FASB issued FASB Interpretation No. 48 *“Accounting
      For Uncertain Tax Positions”.* An
      Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the
      accounting for uncertainty in income taxes recognized in an enterprise’s
      financial statements in accordance with FASB Statement No. 109 *“Accounting
      for Income Taxes.”* It
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. FIN 48 also provides guidance on derecognition,
      classification, interest and penalties, accounting in interim periods,
      disclosure, and transition. FIN 48 is effective for fiscal years beginning
      after
      December 15, 2006. The Company is currently evaluating the impact of FIN 48
      to
      its financial position and results of operations.





In
      September 2006, the FASB issued SFAS No. 157, *“Fair
      Value Measurements”* (“SFAS
      157”). SFAS 157 defines fair value, establishes a framework for measuring fair
      value in accordance with generally accepted accounting principles, and expands
      disclosures about fair value measurements. SFAS 157 does not require any new
      fair value measurements; rather, it applies under other accounting
      pronouncements that require or permit fair value measurements. The provisions
      of
      SFAS 157 are to be applied prospectively as of the beginning of the fiscal
      year
      in which it is initially applied, with any transition adjustment recognized
      as a
      cumulative-effect adjustment to the opening balance of retained earnings. The
      provisions of SFAS 157 are effective for fiscal years beginning after November
      15, 2007; therefore, the Company anticipates adopting SFAS 157 as of January
      1,
      2008. The Company is assessing the impact of the adoption of SFAS
      157.





In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108 (“SAB 108”), *“Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements.”* SAB 108
      is effective for fiscal years ending on or after November 15, 2006 and addresses
      how financial statement errors should be considered from a materiality
      perspective and corrected. The literature provides interpretive guidance on
      how
      the effects of the carryover or reversal of prior year misstatements should
      be
      considered in quantifying a current year misstatement. Historically, there
      have
      been two approaches commonly used to quantify such errors: (i) the “rollover”
approach, which quantifies the error as the amount by which the current year
      income statement is misstated, and (ii) the “iron curtain” approach, which
      quantifies the error as the cumulative
      amount by which the current year balance sheet is misstated. The SEC Staff
      believes that companies should quantify errors using both approaches and
      evaluate whether either of these approaches results in quantifying a
      misstatement that, when all relevant quantitative and qualitative factors are
      considered, is material. The Company is currently evaluating the impact, if
      any,
      of adopting the provisions of SAB 108 on our consolidated financial position,
      results of operations and liquidity.


**11.**  **Subsequent Events**
  On
        November 13, 2006, Sputtered Films, Inc. ("SFI"), a wholly owned subsidiary
        of
        the Company, agreed to the terms of a settlement of its trade secrets case
        against Sergey Mishin, Advanced Modular Sputtering (AMS), Agilent Technologies,
        Inc., Avago Technologies U.S., Inc., Avago Technologies Wireless (U.S.A)
        Manufacturing, Inc. and other defendants. All the parties in the litigation
        agreed on the terms of a settlement, which was filed with the Santa
        Barbara County Superior Court .
        The
        settlement terms provide for a payment to the Company of approximately $13
        million, net of fees and certain expenses associated with the litigation.
        The
        settlement also calls for the transfer of assets related to PVD technology
        from
        AMS to SFI and the dissolution of AMS as of March 1, 2007. The Avago
        Cross-Complaint was also dismissed as part of the settlement.






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





**Special
      Note Regarding Forward Looking Statements**





Information
      herein contains “forward-looking statements” within the meaning of the Private
      Securities Litigation Reform Act of 1995, which can be identified by the use
      of
      forward-looking terminology such as “may,” “will,” “expect,” “anticipate,”
“estimate,” or “continue” or the negative thereof or other variations thereon or
      comparable terminology or which constitute projected financial information.
      The
      forward-looking statements relate to the near-term semiconductor capital
      equipment industry outlook, demand for our products, our quarterly revenue
      and
      earnings prospects for the near-term future and other matters contained herein.
      Such statements are based on current expectations and beliefs and involve a
      number of uncertainties and risks that could cause the actual results to differ
      materially from those projected. Such uncertainties and risks include, but
      are
      not limited to, cyclicality of the semiconductor industry, impediments to
      customer acceptance of our products, fluctuations in quarterly operating
      results, competitive pricing pressures, the introduction of competitor products
      having technological and/or pricing advantages, product volume and mix and
      other
      risks detailed from time to time in our SEC reports, including in the section
      entitled “Risk Factors” elsewhere in this report. For further information, refer
      to the business description and risk factors described below. All
      forward-looking statements are expressly qualified in their entirety by the
      cautionary statements in this paragraph.





Tegal
      designs, manufactures, markets and services plasma etch and deposition systems
      that enable the production of integrated circuits (“ICs”), memory and related
      microelectronics devices used in personal computers, wireless voice and data
      telecommunications, contact-less transaction devices, radio frequency
      identification devices (“RFID’s”), smart cards, data storage and micro-level
      actuators. Etching and deposition constitute two of the principal IC and related
      device production process steps and each must be performed numerous times in
      the
      production of such devices.




14


**Semiconductor
      Industry Background**





Over
      the
      past twenty years, the semiconductor industry has experienced significant
      growth. This growth has resulted from the increasing demand for ICs from
      traditional IC markets, such as personal computers, telecommunications, consumer
      electronics, automotive electronics and office equipment, as well as developing
      markets, such as wireless communications, multimedia and portable and network
      computing. As a result of this increased demand, semiconductor device
      manufacturers have periodically expended significant amounts of capital to
      build
      new semiconductor fabrication facilities (“fabs”) and to expand existing fabs.
      More recently, growth has slowed, and there are signs that the industry is
      beginning to mature. While unit demand for semiconductor devices continue to
      rise, the average selling prices of chips continue to decline. There is growing
      pressure on semiconductor device manufacturers to reduce manufacturing costs
      while increasing the value of their products. The semiconductor industry has
      also been historically cyclical, with periods of rapid expansion followed by
      periods of over-capacity.





Growth
      in
      the semiconductor industry has been driven, in large part, by advances in
      semiconductor performance at a decreasing cost per function. Advanced
      semiconductor processing technologies increasingly allow semiconductor
      manufacturers to produce ICs with smaller features, thereby increasing
      processing speed and expanding device functionality and memory capacity. As
      ICs
      have become more complex, however, both the number and price of state of the
      art
      process tools required to manufacture ICs have increased significantly. As
      a
      result, the cost of semiconductor manufacturing equipment has become an
      increasingly large part of the total cost of producing advanced ICs.





To
      create
      an IC, semiconductor wafers are subjected to a large number of complex process
      steps. The three primary steps in manufacturing ICs are (1) deposition, in
      which
      a layer of insulating or conducting material is deposited on the wafer surface,
      (2) photolithography, in which the circuit pattern is projected onto a light
      sensitive material (the photoresist), and (3) etch, in which the unmasked parts
      of the deposited material on the wafer are selectively removed to form the
      IC
      circuit pattern.





Each
      step
      of the manufacturing process for ICs requires specialized manufacturing
      equipment. Today, plasma-based systems are used for the great majority of both
      deposition and etching processes. During physical vapor deposition (also known
      as “PVD”), the semiconductor wafer is exposed to a plasma environment that forms
      continuous thin films of electrically insulating or electrically conductive
      layers on the semiconductor wafer. During a plasma etch process (also known
      as
“dry etch”), a semiconductor wafer is exposed to a plasma composed of a reactive
      gas, such as chlorine, which etches away selected portions of the layer
      underlying the patterned photoresist layer.





**Business
      Strategy**





Our
      business objective is to utilize the unique technologies that we have developed
      internally or acquired externally in order to increase our market share in
      process equipment for both semiconductor manufacturing and nanotechnology device
      fabrication. The following are key elements of our strategy:





*Maintain
      our Technology Leadership Position in New Materials Etch* - We
      have become a leading provider of etch process solutions for a set of new
      materials central to the production of an array of advanced semiconductor and
      nanotechnology devices in emerging markets. Incorporation of these new materials
      is essential to achieving the higher device densities, lower power consumption
      and novel functions exhibited by the newest generation of cell phones, computer
      memories, fiber optic switches and remote sensors. Currently, we are the leading
      supplier of etch solutions to makers of advanced “non-volatile” ferro-electric
      (“FeRAM”), magnetic (“MRAM”) devices, and virtually all other types of
      non-volatile memories. FeRAM is just now entering commercial production with
      chips for the newest generation of cell phones, PDA’s, smart cards and RFIDs,
      used for applications such as railway passes and ink jet cartridge tracking.
      Our
      new materials expertise also includes the etching of so-called “compound-semi”
materials, such as GaAs, GaN and InP, widely used in telecom device production.
      In addition, we are known for our capability to etch certain noble metals,
      such
      as gold and platinum, as well as certain proprietary compound metals. This
      capability is increasingly important in advanced memory development and in
      the
      production of Micro-Electrical Mechanical Systems (“MEMS”), a type of
      commercially produced nanotechnology device, especially useful to the automotive
      industry.





*Strengthen
      our Position in Deposition Process Equipment for Advanced Packaging Applications
      --* Since
      2002, we have completed two acquisitions of deposition products incorporating
      the same unique “sputter-up” technology. This technology is directed principally
      at so-called “back-end” semiconductor manufacturing processes, including
      backside metallization and underbump metal processes, for both 200-mm and 300-mm
      wafer sizes. These processes are important to advanced, wafer-level packaging
      schemes, which are increasingly being used for high-pin-count logic and memory
      devices.





*Introduce
      a New Product into Established Equipment Market --* The
      continued development of our recently acquired NLD technology represents our
      belief that we have a compelling solution to a critical process need in
      present-day and future semiconductor device fabrication. As device geometries
      continue to shrink, conventional chemical vapor deposition (“CVD”) process
      equipment is increasingly incapable of depositing thin conformal films in
      high-aspect ratio trenches and vias. Atomic Level Deposition (“ALD”) is one
      technology for satisfying this deposition requirement. However, ALD has several
      shortcomings, including low throughput and limitations on film type and quality,
      which we believe our NLD technology overcomes.





15


*Maintain
      our Service Leadership Position* -- Tegal
      has been consistently recognized by our customers for providing a high level
      of
      customer support, a fact that has been noted by our top rankings for several
      consecutive years in the annual survey conducted by VLSI Research, Inc. We
      expect to maintain and build on this reputation as we seek new customers in
      both
      emerging and established markets.





**Critical
      Accounting Policies**





Our
      discussion and analysis of the financial condition and results of operations
      are
      based upon our condensed consolidated financial statements, which have been
      prepared in accordance with accounting principles generally accepted in the
      United States of America. The preparation of these financial statements requires
      us to make estimates and judgments that affect the reported amounts of assets,
      liabilities, revenues and expenses, and related disclosure of contingent assets
      and liabilities. On an on-going basis, we evaluate our estimates, including
      those related to inventory, warranty obligations, purchase order commitments,
      bad debts, income taxes, intangible assets, restructuring and contingencies
      and
      litigation. We base our estimates on historical experience and on various other
      assumptions that we believe to be reasonable under the circumstances, the
      results of which form the basis for making judgments about the carrying values
      of assets and liabilities that are not readily apparent from other sources.
      Actual results may differ from these estimates under different assumptions
      or
      conditions.





We
      believe the following critical accounting policies affect our more significant
      judgments and estimates used in the preparation of our condensed consolidated
      financial statements:





**Accounting
      for Stock-Based Compensation**





Prior
      to
      April 1, 2006, we accounted for stock-based employee compensation plans under
      the measurement and recognition provisions of Accounting Principles Board
      Opinion No.25, “Accounting for Stock Issued to Employees,” or APB25, and related
      Interpretations, as permitted by SFAS No.123, “Accounting for Stock-Based
      Compensation”, or SFAS No.123. With the exception of certain warrants granted
      and grants of restricted stock awards, we generally, recorded no stock-based
      compensation expenses during periods prior to April 1, 2006 as all stock-based
      grants had exercise prices equal to the fair market value of our common stock
      on
      the date of grant. We also recorded no compensation expense in connection with
      our employee stock purchase plan as it qualified as a non-compensatory plan
      following the guidance provided by APB25. In accordance with SFAS123 and SFAS
      148, “Accounting for Stock-Based Compensation - Transition and Disclosure”, we
      disclosed our net loss per share as if we had applied the fair value based
      method in measuring compensation expense for our stock-based compensation
      programs. Under SFAS 123, we elected to calculate our compensation expense
      by
      applying the Black-Scholes valuation method,





Effective
      April 1, 2006, we adopted the fair value recognition provisions of SFAS No.123R
      “Accounting for Stock-Based Compensation”, using the modified prospective
      transition method. Under that method, compensation expense that we recognized
      for the three months ended September 30, 2006 included: (a) compensation expense
      for all share-based payment granted prior to but not yet vested as of April
      1,
      2006, based on the grant date fair value estimated in accordance with the
      original provisions of SFAS 123, and (b) compensation expense for all
      share-based payments granted on or modified after April 1, 2006, based on the
      grant date fair value estimated in accordance with the provisions of SFAS123R.
      Compensation expense is recognized only for those awards that are expected
      to
      vest, whereas prior to the adoption of SFAS123R, we recognized forfeitures
      as
      they occurred. In addition, we elected the straight-line attribution method
      as
      our accounting policy for recognizing stock-based compensation expense for
      all
      awards granted.





We
      estimate the fair value of options granted using the Black Scholes option
      valuation and the assumptions shown in Note.1 to our condensed consolidated
      financial statements. All options are amortized over the requisite service
      periods of the awards, which are generally the vesting periods.





**Revenue
      Recognition**





Each
      sale
      of our equipment is evaluated on an individual basis in regard to revenue
      recognition. We have integrated in our evaluation the related interpretative
      guidance included in Topic 13 of the codification of staff accounting bulletins,
      and recognize the role of the FASB’s Emerging Issues Task Force (“EITF”)
      consensus on Issue 00-21. We first refer to EITF 00-21 in order to determine
      if
      there is more than one unit of accounting and then we refer to SAB104 for
      revenue recognition topics for the unit of accounting. We recognize revenue
      when
      persuasive evidence of an arrangement exists, the seller’s price is fixed or
      determinable and collectibility is reasonably assured.





16


For
      products produced according to our published specifications, where no
      installation is required or installation is deemed perfunctory and no
      substantive customer acceptance provisions exist, revenue is recognized when
      title passes to the customer, generally upon shipment. Installation is not
      deemed to be essential to the functionality of the equipment since installation
      does not involve significant changes to the features or capabilities of the
      equipment or building complex interfaces and connections. In addition, the
      equipment could be installed by the customer or other vendors and generally
      the
      cost of installation approximates only 1% of the sales value of the related
      equipment.





For
      products produced according to a particular customer’s specifications, revenue
      is recognized when the product has been tested and it has been demonstrated
      that
      it meets the customer’s specifications and title passes to the customer. The
      amount of revenue recorded is reduced by the amount (generally 10%), which
      is
      not payable by the customer until installation is completed and final customer
      acceptance is achieved.





For
      new
      products, new applications of existing products, or for products with
      substantive customer acceptance provisions where performance cannot be fully
      assessed prior to meeting customer specifications at the customer site, 100%
      of
      revenue is recognized upon completion of installation and receipt of final
      customer acceptance. Since title to goods generally passes to the customer
      upon
      shipment and 90% of the contract amount becomes payable at that time, inventory
      is relieved and accounts receivable is recorded for the entire contract amount.
      The revenue on these transactions is deferred and recorded as deferred revenue.
      We reserve for warranty costs at the time the related revenue is
      recognized.





Revenue
      related to sales of spare parts is recognized upon shipment. Revenue related
      to
      maintenance and service contracts is recognized ratably over the duration of
      the
      contracts. Unearned maintenance and service revenue is included in other accrued
      liabilities.





**Accounts
      Receivable - Allowance for Sales Returns and Doubtful
      Accounts**





We
      maintain an allowance for doubtful accounts receivable for estimated losses
      resulting from the inability of our customers to make required payments. If
      the
      financial conditions of our customers were to deteriorate, or even a single
      customer was otherwise unable to make payments, additional allowances may be
      required.





Our
      return policy is for spare parts and components only. Customers are allowed
      to
      return spare parts if they are defective upon receipt, in accordance with SFAS
      48. The potential returns are offset against gross revenue on a monthly basis.
      Management reviews outstanding requests for returns on a quarterly basis to
      determine that the reserves are adequate.





**Inventories**





Inventories
      are stated at the lower of cost or market, reduced by provisions for excess
      and
      obsolescence. Cost is computed using standard cost, which approximates actual
      cost on a first-in, first-out basis and includes material, labor and
      manufacturing overhead costs. We estimate the effects of excess and obsolescence
      on the carrying values of our inventories based upon estimates of future demand
      and market condition. We establish provisions for related inventories in excess
      of production demand. Should actual production demand differ from our estimates,
      additional inventory write-downs may be required, as was the case in the current
      quarter and  the
      fourth quarter of fiscal 2006. Any excess and obsolete provision is released
      only if and when the related inventories is sold or scrapped. The inventory
      provision balance at September 30, 2006 and March 31, 2006 was $4,542 and
      $7,136, respectively. The inventory provision expense for the period ended
      September 30, 2006 and March 31, 2006 was $( 2,142)
      and $(1,146), respectively.





We
      periodically analyze any systems that are in finished goods inventory to
      determine if they are suitable for current customer requirements. At the present
      time, our policy is that if after approximately 18 months we determine that
      a
      sale will not take place within the next 12 months, and the system would be
      useable for customer demonstrations or training, it is transferred to fixed
      assets. Otherwise, it is expensed.





The
      carrying value of systems used for demonstrations or training is determined
      by
      assessing the cost of the components that are suitable for sale. Any parts
      that
      may be rendered not saleable as a result of such use are removed from the system
      and are not included in finished goods inventory. The remaining saleable parts
      are valued at the lower of cost or market, representing the system’s net
      realizable value. The depreciation period for systems that are transferred
      to
      fixed assets is determined based on the age of the system and its remaining
      useful life (typically five to eight years).





17


**Impairment
      of Long-Lived Assets**





Long-lived
      assets are reviewed for impairment whenever events or changes in circumstances
      indicate that the carrying amount may not be recoverable. If undiscounted
      expected future cash flows are less than the carrying value of the assets,
      an
      impairment loss is recognized based on the excess of the carrying amount over
      the fair value of the assets.





**Warranty
      Obligations**





We
      provide for the estimated cost of our product warranties at the time revenue
      is
      recognized. Our warranty obligation is affected by product failure rates,
      material usage rates and the efficiency by which the product failure is
      corrected. Should actual product failure rates, material usage rates and labor
      efficiencies differ from our estimates, revisions to the estimated warranty
      liability may be required.





**Deferred
      Taxes**





We
      record
      a valuation allowance to reduce our deferred tax assets to the amount that
      is
      more likely than not to be realized. Based on the uncertainty of future taxable
      income, we have fully reserved our deferred tax assets. In the event we were
      to
      determine that we would be able to realize our deferred tax assets in the
      future, an adjustment to the deferred tax asset would increase income in the
      period such determination was made.





**Results
      of Operations**





The
      following table sets forth certain financial items as a percentage of revenue
      for the three and six months ended September 30, 2006 and 2005:





**Three
                Months****Ended**
              **September
                30,**
            
            **Six
                Months****Ended**
              **September
                30,********2006**
            
            ******2005**
            
            ******2006**
            
            **2005**Revenue
            
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %
            
            100.0
            %Cost
                of revenue
            
            
            53.1
            
            
            61.9
            
            
            58.1
            
            
            67.0Gross
                profit
            
            
            46.9
            
            
            38.1
            
            
            41.9
            
            
            33.0Operating
                expenses:Research
                and development
            
            
            20.8
            
            
            18.9
            
            
            17.6
            
            
            25.3Sales
                and marketing
            
            
            18.9
            
            
            11.8
            
            
            17.2
            
            
            14.8General
                and administrative
            
            
            68.2
            
            
            53.0
            
            
            49.5
            
            
            49.0Total
                operating expenses
            
            
            107.9
            
            
            83.7
            
            
            84.3
            
            
            89.1Operating
                (Loss)
            
            
            (61.0
            )
            
            (45.6
            )
            
            (42.4
            )
            
            (56.1
            )Other
                expense (Income)
            
            
            (3.0
            )
            
            (1.3
            )
            
            (1.1
            )
            
            (2.2
            )Net
                loss
            
            
            (64.0
            %)
            
            (46.9
            %)
            
            (43.5
            %)
            
            (58.3
            %)








The
      foll owing
      table sets forth certain financial items for the three and six month periods
      ended September 30, 2006.




18





**Three
                Months ended**
              **September
                30,**
            
            **Six
                Months ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenue
            
            $
            5,113
            
            $
            6,406
            
            $
            11,689
            
            $
            9,458Cost
                of revenue
            
            
            2,713
            
            
            3,963
            
            
            6,791
            
            
            6,340Gross
                profit
            
            
            2,400
            
            
            2,443
            
            
            4,898
            
            
            3,118Operating
                expenses:Research
                and development
            
            
            1,066
            
            
            1,211
            
            
            2,062
            
            
            2,387Sales
                and marketing
            
            
            964
            
            
            757
            
            
            2,008
            
            
            1,401General
                and administrative
            
            
            3,485
            
            
            3,398
            
            
            5,787
            
            
            4,638Total
                operating expenses
            
            
            5,515
            
            
            5,366
            
            
            9,857
            
            
            8,426Operating
                Profit (loss)
            
            
            (3,115
            )
            
            (2,923
            )
            
            (4,959
            )
            
            (5,308
            )Non-operating
                expenses
            
            
            (166
            )
            
            242
            
            
            (124
            )
            
            120Net
                income (loss)
            
            $
            (3,281
            )
            $
            (2,681
            )
            $
            (5,083
            )
            $
            (5,188
            )Earnings
                per share
            
            
            (0.47
            )
            
            (0.51
            )
            
            (0.72
            )
            
            (1.13
            )Number
                of shares outstandingBasic
            
            
            7,045
            
            
            5,227
            
            
            7,029
            
            
            4,608Diluted
            
            
            7,045
            
            
            5,227
            
            
            7,029
            
            
            4,608





***Revenue*** **




** The
      changes in revenue for the three and six months ended September 30, 2006 was
      principally due to the product mix of systems sold during the period.




International
      sales as a percentage of the Company’s revenue for the three
      and
      six months ended
      September 30, 2006 were 68% and 74%, respectively. We believe that international
      sales will continue to represent a significant portion of our
      revenue.




***Gross
      profit (loss*** *)*




** Gross
      profit as a percentage to revenue for the six months ended September 30, 2006
      increased to 42 %
      compared to 33% for the same period last year. During the three months ended
      September 30, 2006 gross
      profit as a percentage to revenue was 47% an increase from the 38% for the
      same
      period last year. The increase in gross profit as a percentage to revenue is
      due
      to the successful reductions in manufacturing overhead and favorable product
      mix.




***Research
      and Development*** **




** Research
      and development expenses consist primarily of salaries, prototype material
      and
      other costs associated with our ongoing systems and process technology
      development, applications and field process support efforts. Spending has been
      consistent in total dollars, $1,066 for the three months and $2,062 for the
      six
      months ending September 30, 2006. Prior year spending was $1,211 and $2,387
      respectively.




***Sales
      and Marketing*** **




** Sales
      and
      marketing expenses consist primarily of salaries, commissions, trade show
      promotion and travel and living expenses associated with those functions. Sales
      and marketing spending for the three and six months ended September 30, 2006
      was
      $964 and $2,008, respectively. This increase over the prior year periods of
      $757
      and $1,401 respectively represents increased efforts that are being placed
      on
      increasing world wide sales.







***General
      and Administrative***




General
      and administrative expenses consist primarily of compensation for general
      management, accounting and finance, human resources, information systems and
      investor relations functions and for legal, consulting and accounting fees
      of
      the Company.  The $87 increase over the prior year’s three month period and
      the $1,149 over the prior year’s six month period were primarily due to the
      legal fees relating directly to the litigation against AMS, Agilent, and Avago
      Technologies. Other factors to the increase relate to a one time lease
      termination expense of $500 for the reduction of space in the Petaluma facility
      and the costs associated with moving portions of the operations to San
      Jose.





19


***Other
      income (expense), net***




** Other
      income (expense), net consists principally of, interest income, interest
      expense, other income, (expense), gains and losses on the disposal of fixed
      assets, and gains and losses on foreign exchange. We recorded net non-operating
      expense of $124 for the six months and $166 for the three months ending
      September 2006. The major component of these expenses was the loss on the
      disposal of fixed assets.




***Contractual
      obligation*** **





The
      following summarizes our contractual obligations at September 30, 2006, and
      the
      effect such obligations are expected to have on our liquidity and cash flows
      in
      future periods.




Contractual
                obligations:
            
            **Total**
            
            **Less
                than**
              **1
                Year**
            
            **1-3
                Years**
            
            **3-5
                Years**
            
            **After**
              **5
                Years**Non-cancelable
                capital lease obligations
            
            $
            7
            
            $
            7
            
            $
            0
            
            $
            0
            
            $
            0Non-cancelable
                operating lease obligations
            
            
            1,404
            
            
            675
            
            
            654
            
            
            75
            
            
            0Notes
                payable and bank lines of credit
            
            
            56
            
            
            54
            
            
            2
            
            
            0
            
            
            0Total
                contractual cash obligations
            
            $
            1
                ,467
            
            $
            736
            
            $
            656
            
            $
            75
            
            $
            0





Certain
      sales contracts of the Company include provisions under which customers would
      be
      indemnified by the Company in the event of, among other things, a third-party
      claim against the customer for intellectual property rights infringement related
      to the Company's products. There are no limitations on the maximum potential
      future payments under these indemnities. The Company has accrued no amounts
      in
      relation to these provisions as no such claims have been made and the Company
      believes it has valid, enforceable rights to the intellectual property embedded
      in its products.





**Liquidity
      and Capital Resources**





For
      the
      six month period ended September 30, 2006, we financed our operations through
      the use of outstanding cash balances, borrowings against our credit facilities
      in Japan and net proceeds from the 2005 PIPE.





As
      of
      September 30, 2006, our Japanese subsidiary had $20 outstanding under its lines
      of credit which is collateralized by Japanese customer promissory notes held
      by
      such subsidiary in advance of payment on customers’ accounts receivable. The
      credit line has a total borrowing capacity of 150 million yen (approximately
      $1,271 at exchange rates prevailing on September 30, 2006), which are secured
      by
      Japanese customer promissory notes held by such subsidiary in advance of payment
      on customers’ accounts receivable. The Japanese bank line bears interest at
      Japanese prime (1.625% as of September 30, 2006) plus 0.875%.





Notes
      payable as of September 30, 2006 consisted of capital lease obligations on
      fixed
      assets totaling $7.





The
      consolidated financial statements contemplate the realization of assets and
      the
      satisfaction of liabilities in the normal course of business. We incurred net
      losses of $3,281 and $5,083 and $2,681 and $5,188 for the three and six months
      ended September 30, 2006 and 2005, respectively. We generated negative cash
      flows from operations of $3,268 and $7,268 for the period ended September 30,
      2006 and September 30, 2005, respectively. During the prior fiscal year 2006,
      we
      raised a net of $18,161 through the 2005 PIPE. Management believes that these
      proceeds, combined with projected sales, consolidation of certain operations
      and
      continued cost containment will be adequate to fund operations through fiscal
      2007. However, projected sales may not materialize and unforeseen costs may
      be
      incurred **.** If
      the
      projected sales do not materialize, our ability to achieve our intended business
      objectives may be adversely affected. The consolidated financial statements
      do
      not include any adjustments relating to the recoverability and classification
      of
      recorded assets or the amount or classification of liabilities or any other
      adjustments that might be necessary should we be unable to continue as a going
      concern.





20





**Item
      3.** ***Quantitative
      and Qualitative Disclosures about Market Risk***





Our
      cash
      equivalents are principally comprised of money market accounts. As of September
      30, 2006 ,
      we had
      cash and cash equivalents of $10,465 .
      These
      accounts are subject to interest rate risk and may fall in value if market
      interest rates increase. We attempt to limit this exposure by investing
      primarily in short-term securities having a maturity of three months or less.
      Due to the nature of our cash and cash equivalents, we have concluded that
      there
      is no material market risk exposure.





We
      have
      foreign subsidiaries that operate and sell our products in various global
      markets. As a result, our cash flow and earnings are exposed to fluctuations
      in
      interest and foreign currency exchange rates. We attempt to limit these
      exposures through the use of various hedge instruments, primarily forward
      exchange contracts and currency option contracts (with maturities of less than
      three months) to manage our exposure associated with firm commitments and net
      asset and liability positions denominated in non-functional currencies. There
      have been no material changes regarding market risk since the disclosures made
      in our Form 10-K for the fiscal year ended March 31, 2006.





At
      September 30, 2006, the Company had forward exchange contracts maturing at
      various dates to exchange 64,947
      yen into $586.





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





We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed in our Exchange Act reports is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms, and that such information is accumulated and communicated
      to our management, including our Chief Executive Officer and Chief Financial
      Officer, as appropriate, to allow for timely decisions regarding required
      disclosure. In designing and evaluating our disclosure controls and procedures,
      our management recognizes that any controls and procedures, no matter how well
      designed and operated, can provide only reasonable assurance of achieving the
      desired control objectives, and our management is required to apply its judgment
      in evaluating the cost-benefit relationship of possible controls and procedures.





(a)  *Evaluation
      of Disclosure Controls and Procedures.* Based
      on
      their evaluation as of a date at the end of the quarter covered by this
      quarterly report on Form 10-Q, the Company’s Chief Executive Officer and Chief
      Financial Officer have concluded that the Company’s disclosure controls and
      procedures (as defined in Rules 13a-14(c) under the Securities Exchange Act
      of
      1934) are effective at the reasonable assurance level.




(b)  *Changes
      in Internal Controls* .
      There
      has been no change in the Company’s internal control over financial reporting
      during the fiscal quarter ended September 30, 2006 that has materially affected,
      or is reasonably likely to materially affect, the Company’s internal controls
      over financial reporting





**PART
      II — OTHER INFORMATION**





**Item
      1.** ***Legal
      Proceedings***





Sputtered
      Films, Inc. v. Advanced Modular Sputtering, et al., filed in Santa Barbara
      County Superior Court.




On
      December 22, 2003, Sputtered Films, Inc. ("SFI"), a wholly owned subsidiary
      of
      the Company, filed an action against two former employees, Sergey Mishin and
      Rose Stuart-Curran, and a company they formed after leaving their employment
      with SFI named Advanced Modular Sputtering, Inc. ("AMS"). Sergey Mishin and
      Rose
      Stuart-Curran had each signed confidentiality and non-disclosure agreements
      regarding information obtained while employed by SFI. The action contains causes
      of action for specific performance, breach of contract, breach of the covenant
      of good faith and fair dealing, misappropriation of trade secrets, unfair
      competition, unfair business practices, interference with prospective economic
      advantage, conversion, unjust enrichment, and declaratory relief. These claims
      arise out of information SFI received evidencing that AMS possessed and used
      SFI's confidential, proprietary and trade secret drawings, specifications and
      technology to manufacture the sputtering tool marketed by AMS.




During
      2004 and 2005, this litigation was largely stalled while AMS and Agilent
      Technologies, Inc. contested SFI's right to conduct discovery. This dispute
      was
      resolved in late 2005 when the California Court of Appeal affirmed SFI's trade
      secrete identification as statutorily sufficient. On November 18, 2005, SFI
      requested leave to add Agilent Technologies, Inc. ("Agilent") as a defendant
      based on evidence that Agilent and AMS co-developed the machines which SFI
      contends were built using SFI proprietary information. The Court granted SFI's
      request and Agilent was served as a Doe defendant on December 12, 2005. In
      early
      December, SFI learned that Agilent transferred its Semiconductor Products Group
      to a number of Avago entities effective December 1, 2005, and accordingly SFI
      sought and received court approval to add Avago Technologies U.S., Inc. and
      Avago Technologies Wireless (U.S.A.) Manufacturing, Inc (collectively the "Avago
      Entities") as defendant in this action. On April 25, 2006, the Avago Entities
      filed a Cross-Complaint against SFI and Tegal Corporation alleging causes of
      action for breach of contract, trade secret misappropriation, unfair
      competition, conversion, unjust enrichment and declaratory relief. The
      Cross-Complaint alleges on information and belief that SFI misused information
      obtained from Hewlett-Packard in connection with Hewlett-Packard's request
      to
      purchase SFI machines or to upgrade SFI machines Hewlett-Packard already owned.




21




On
      November 13, 2006, following commencement of the trial, all the parties in
      the
      litigation agreed on terms of a settlement, which was filed with the court.
      The
      settlement terms provide for a payment to the Company of approximately $13
      million, net of fees and certain expenses associated with the litigation. The
      settlement also calls for the transfer of assets related to PVD technology
      from
      AMS to SFI and the dissolution of AMS as of March 1, 2007. The Avago
      Cross-Complaint was also dismissed as part of the settlement.




**Item
      1A.** ***Risk
      Factors***  ****




*We
      wish to caution you that there are risks and uncertainties that could affect
      our
      business. These risks and uncertainties include, but are not limited to, the
      risks described below and elsewhere in this report, particularly in
“Forward-Looking Statements.” The following is not intended to be a complete
      discussion of all potential risks or uncertainties, as it is not possible to
      predict or identify all risk factors. The risk factors set forth below are
      also
      set forth in Part 1, Item 1A of our Annual Report on Form 10-K for the fiscal
      year ended March 31, 2006.  Except for the deletion of the risk factor
      entitled "If we fail to meet the continued listing requirements of the NASDAQ
      Stock Market, our stock could be delisted," there have been no material changes
      made.*




**We
      have incurred operating losses and may not be profitable in the future; our
      plans to maintain and increase liquidity may not be successful.**





We
      incurred net losses of $8.9 million; $15.4 million and $12.6 million for the
      years ended March 31, 2006, 2005 and 2004, respectively, and generated negative
      cash flows from operations of $11.7 million, $7.5 million and $3.2 million
      in
      these respective years. . If the projected sales do not materialize, we will
      need to reduce expenses further and raise capital through the issuance of debt
      or equity securities. If additional funds are raised through the issuance of
      preferred stock or debt, these securities could have rights, privileges or
      preferences senior to those of our common stock, and debt covenants could impose
      restrictions on our operations. Moreover, such financing may not be available
      to
      us on acceptable terms, if at all. Failure to raise additional funds may
      adversely affect our ability to achieve our intended business objectives.





**The
      exercise of outstanding warrants, options and other rights to obtain additional
      shares will dilute the value of our shares of common stock and could cause
      the
      price of our shares of common stock to decline.**





As
      of
      September 30, 2006, there were
      7,055,623 sh ares
      of
      our common stock issued and outstanding.





As
      of
      September 30, 2006, there were warrants, stock options and restricted stock
      awards outstanding for approximately 2,318,464 shares
      of
      our common stock and there were
      1,918,221 shares of
      common stock reserved for issuance under our equity incentive and stock purchase
      plans.





The
      exercise of these warrants and options and the issuance of the common stock
      pursuant to our equity incentive plans will result in dilution in the value
      of
      the shares of our outstanding common stock and the voting power represented
      thereby. In addition, the exercise price of the warrants may be lowered under
      the price adjustment provisions in the event of a “dilutive issuance,” that is,
      if we issue common stock at any time prior to their maturity at a per share
      price below such conversion or exercise price, either directly or in connection
      with the issuance of securities that are convertible into, or exercisable for,
      shares of our common stock. A reduction in the exercise price may result in
      the
      issuance of a significant number of additional shares upon the exercise of
      the
      warrants.





The
      warrants do not establish a “floor” that would limit reductions in such
      conversion price or exercise price. The downward adjustment of the exercise
      price of these warrants could result in further dilution in the value of the
      shares of our outstanding common stock and the voting power represented
      thereby.





No
      prediction can be made as to the effect, if any, that future sales of shares
      of
      our common stock, or the availability of shares for future sale, will have
      on
      the market price of our common stock prevailing from time to time. Sales of
      substantial amounts of shares of our common stock in the public market, or
      the
      perception that such sales could occur, may adversely affect the market price
      of
      our common stock and may make it more difficult for us to sell our equity
      securities in the future at a time and price which we deem appropriate.




22




To
      the
      extent our stockholders and the other holders of our warrants and options
      exercise such securities and then sell the shares of our common stock they
      receive upon exercise, our stock price may decrease due to the additional amount
      of shares available in the market. The subsequent sales of these shares could
      encourage short sales by our security holders and others, which could place
      further downward pressure on our stock price. Moreover, holders of these
      warrants and options may hedge their positions in our common stock by shorting
      our common stock, which could further adversely affect our stock
      price.




**The
      semiconductor industry is cyclical and may experience periodic downturns that
      may negatively affect customer demand for our products and result in losses
      such
      as those experienced in the past.**





Our
      business depends upon the capital expenditures of semiconductor manufacturers,
      which in turn depend on the current and anticipated market demand for integrated
      circuits. The semiconductor industry is highly cyclical and historically has
      experienced periodic downturns, which often have had a detrimental effect on
      the
      semiconductor industry’s demand for semiconductor capital equipment, including
      etch and deposition systems manufactured by us. Despite a moderate recovery
      in
      the industry, we have continued to implement a cost containment program and
      have
      completed a corporate-wide restructuring to preserve our cash. However, the
      need
      for continued investment in research and development, possible capital equipment
      requirements and extensive ongoing customer service and support requirements
      worldwide will continue to limit our ability to reduce expenses in response
      to
      any future downturns. As a result, we may continue to experience operating
      losses such as those we have experienced in the past, which could materially
      adversely affect us.





**Our
      competitors have greater financial resources and greater name recognition than
      we do and therefore may compete more successfully in the semiconductor capital
      equipment industry than we can.**





We
      believe that to be competitive, we will require significant financial resources
      in order to offer a broad range of systems, to maintain customer service and
      support centers worldwide and to invest in research and development. Many of
      our
      existing and potential competitors, including, among others, Applied Materials,
      Inc., Lam Research Corporation, Novellus and Tokyo Electron Limited, have
      substantially greater financial resources, more extensive engineering,
      manufacturing, marketing and customer service and support capabilities, larger
      installed bases of current generation etch, deposition and other production
      equipment and broader process equipment offerings, as well as greater name
      recognition than we do. We cannot assure you that we will be able to compete
      successfully against these companies in the United States or
      worldwide.





**Our
      potential customers may not adopt our products because of their significant
      cost
      or because our potential customers are already using a competitor’s tool.**





A
      substantial investment is required to install and integrate capital equipment
      into a semiconductor production line. Additionally, we believe that once a
      device manufacturer has selected a particular vendor’s capital equipment, that
      manufacturer generally relies upon that vendor’s equipment for that specific
      production line application and, to the extent possible, subsequent generations
      of that vendor’s systems. Accordingly, it may be extremely difficult to achieve
      significant sales to a particular customer once that customer has selected
      another vendor’s capital equipment unless there are compelling reasons to do so,
      such as significant performance or cost advantages. Any failure to gain access
      and achieve sales to new customers will adversely affect the successful
      commercial adoption of our products and could have a detrimental effect on
      us.




**We
      depend on sales of our advanced products to customers that may not fully adopt
      our product for production use.**





We
      have
      designed our advanced etch and deposition products for customer applications
      in
      emerging new films, polysilicon and metal which we believe to be the leading
      edge of critical applications for the production of advanced semiconductor
      and
      other microelectronic devices. Revenues from the sale of our advanced etch
      and
      deposition systems accounted for 69%, 30% and 40% of total revenues in fiscal
      2006, 2005 and 2004, respectively. Our advanced systems are currently being
      used
      primarily for research and development activities or low volume production.
      For
      our advanced systems to achieve full market adoption, our customers must utilize
      these systems for volume production. We cannot assure you that the market for
      devices incorporating emerging films, polysilicon or metal will develop as
      quickly or to the degree we expect. If our advanced systems do not achieve
      significant sales or volume production due to a lack of customer adoption,
      our
      business, financial condition, results of operations and cash flows will be
      materially adversely affected.





23





**Our
      customers are concentrated and therefore the loss of a significant customer
      may
      harm our business.**





The
      composition of our top five customers has changed from year to year, but net
      system sales to our top five customers in each of fiscal 2006, 2005, and 2004
      accounted for 68.9%, 80.0% and 84.8%, respectively, of our total net system
      sales. ST Microelectronics accounted for 54.3% of our total revenue in fiscal
      2006. Fujitsu, Western Digital, and RF Micro Devices accounted for 38.2%, 12.8%
      and 10.1% respectively, of our net system sales in fiscal year 2005. Intel,
      Fuji
      Film, and Matsushita accounted for 31.4%, 22.9% and 12.6% respectively, of
      our
      net system sales in 2004. ST Microelectronics accounted for 47% of total revenue
      in the quarter ended September 30, 2006. Other than these customers, no single
      customer represented more than 10% of our total revenue in fiscal 2006, 2005,
      and 2004. Although the composition of the group comprising our largest customers
      may vary from year to year, the loss of a significant customer or any reduction
      in orders by any significant customer, including reductions due to market,
      economic or competitive conditions in the semiconductor and related device
      manufacturing industry, may have a material adverse effect on us.




**Our
      quarterly operating results may continue to fluctuate.**





Our
      revenue and operating results have fluctuated and are likely to continue to
      fluctuate significantly from quarter to quarter, and we cannot assure you that
      we will achieve profitability in the future.





Our
      900
      series etch systems typically sell for prices ranging between $250,000 and
      $600,000, while prices of our 6500 series critical etch systems and our Endeavor
      deposition systems typically range between $1,500,000 and
      $3,000,000. To the extent we are successful in selling our 6500 and Endeavor
      series systems, the sale of a small number of these systems will probably
      account for a substantial portion of revenue in future quarters, and a
      transaction for a single system could have a substantial impact on revenue
      and
      gross margin for a given quarter.





Other
      factors that could affect our quarterly operating results include:




·
            our
                timing of new systems and technology announcements and releases and
                ability to transition between product
                versions;





·
            seasonal
                fluctuations in sales;





·
            changes
                in the mix of our revenues represented by our various products and
                customers;





·
            adverse
                changes in the level of economic activity in the United States or
                other
                major economies in which we do
                business;





·
            foreign
                currency exchange rate
                fluctuations;





·
            expenses
                related to, and the financial impact of, possible acquisitions of
                other
                businesses; and





·
            changes
                in the timing of product orders due to unexpected delays in the
                introduction of our customers’ products, due to lifecycles of our
                customers’ products ending earlier than expected or due to market
                acceptance of our customers’
products.




**Some
      of our sales cycles are lengthy, exposing us to the risks of inventory
      obsolescence and fluctuations in operating results.**





Sales
      of
      our systems depend, in significant part, upon the decision of a prospective
      customer to add new manufacturing capacity or to expand existing manufacturing
      capacity, both of which typically involve a significant capital commitment.
      We
      often experience delays in finalizing system sales following initial system
      qualification while the customer evaluates and receives approvals for the
      purchase of our systems and completes a new or expanded facility. Due to these
      and other factors, our systems typically have a lengthy sales cycle (often
      12 to
      18 months in the case of critical etch and deposition systems) during which
      we
      may expend substantial funds and management effort. Lengthy sales cycles subject
      us to a number of significant risks, including inventory obsolescence and
      fluctuations in operating results over which we have little or no
      control.





24





**Because
      technology changes rapidly, we may not be able to introduce our products in
      a
      timely manner.**





The
      semiconductor manufacturing industry is subject to rapid technological change
      and new system introductions and enhancements. We believe that our future
      success depends on our ability to continue to enhance our existing systems
      and
      their process capabilities, and to develop and manufacture in a timely manner
      new systems with improved process capabilities. We may incur substantial
      unanticipated costs to ensure product functionality and reliability early in
      our
      products’ life cycles. We cannot assure you that we will be successful in the
      introduction and volume manufacture of new systems or that we will be able
      to
      develop and introduce, in a timely manner, new systems or enhancements to our
      existing systems and processes which satisfy customer needs or achieve market
      adoption.





**Our
      financial performance may adversely affect the morale and performance of our
      personnel and our ability to hire new personnel.**





Our
      common stock has declined in value below the exercise price of many options
      granted to employees pursuant to our stock option plans. Thus, the intended
      benefits of the stock options granted to our employees, the creation of
      performance and retention incentives, may not be realized. As a result, we
      may
      lose employees whom we would prefer to retain. As a result of these factors,
      our
      remaining personnel may seek employment with larger, more established companies
      or companies perceived as having less volatile stock prices.





**We
      may not be able to protect our intellectual property or obtain licenses for
      third parties’ intellectual property and therefore we may be exposed to
      liability for infringement or the risk that our operations may be adversely
      affected.**





Although
      we attempt to protect our intellectual property rights through patents,
      copyrights, trade secrets and other measures, we may not be able to protect
      our
      technology adequately and competitors may be able to develop similar technology
      independently. Additionally, patent applications that we may file may not be
      issued and foreign intellectual property laws may not protect our intellectual
      property rights. There is also a risk that patents licensed by or issued to
      us
      will be challenged, invalidated or circumvented and that the rights granted
      there under will not provide competitive advantages to us. Furthermore, others
      may independently develop similar systems, duplicate our systems or design
      around the patents licensed by or issued to us.





Litigation
      could result in substantial cost and diversion of effort by us, which by itself
      could have a detrimental effect on our financial condition, operating results
      and cash flows. Further, adverse determinations in such litigation could result
      in our loss of proprietary rights, subject us to significant liabilities to
      third parties, and require us to seek licenses from third parties or prevent
      us
      from manufacturing or selling our systems. In addition, licenses under third
      parties’ intellectual property rights may not be available on reasonable terms,
      if at all.





**We
      are exposed to additional risks associated with international sales and
      operations.**





International
      sales accounted for 76%, 70% and 67% of total revenue for fiscal 2006, 2005
      and
      2004, respectively. International sales are subject to certain risks, including
      the imposition of government controls, fluctuations in the U.S. dollar (which
      could increase the sales price in local currencies of our systems in foreign
      markets), changes in export license and other regulatory requirements, tariffs
      and other market barriers, political and economic instability, potential
      hostilities, restrictions on the export or import of technology, difficulties
      in
      accounts receivable collection, difficulties in managing representatives,
      difficulties in staffing and managing international operations and potentially
      adverse tax consequences. We cannot assure you that any of these factors will
      not have a detrimental effect on our operations, financial results and cash
      flows.





We
      generally attempt to offset a portion of our U.S. dollar denominated balance
      sheet exposures subject to foreign exchange rate re-measurement by purchasing
      forward currency contracts for future delivery. We cannot assure you that our
      future results of operations and cash flows will not be adversely affected
      by
      foreign currency fluctuations. In addition, the laws of certain countries in
      which our products are sold may not provide our products and intellectual
      property rights with the same degree of protection as the laws of the United
      States.




25




**Evolving
      regulation of corporate governance and public disclosure may result in
      additional expenses and continuing uncertainty.**




Changing
      laws, regulations and standard relating to corporate governance and public
      disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and
      Nasdaq Market rules are creating uncertainty for public companies. We
      continually evaluate and monitor developments with respect to new and proposed
      rules and cannot predict or estimate the amount of the additional costs we
      may
      incur or the timing of such costs. These new or changed laws, regulations and
      standards are subject to varying interpretations, in many cases due to their
      lack of specificity, and as a result, their application in practice may evolve
      over time as new guidance is provided by regulatory and governing bodies. This
      could result in continuing uncertainty regarding compliance matters and higher
      costs necessitated by ongoing revisions to disclosure and governance practices.
      We are committed to maintaining high standards of corporate governance and
      public disclosure. As a result, we have invested resources to comply with
      evolving laws, regulations and standards, and this investment may result in
      increased general and administrative expenses and a diversion of management
      time
      and attention from revenue-generating activities to compliance activities.
      If
      our efforts to comply with new or changed laws, regulations and standards differ
      from the activities intended by regulatory or governing bodies due to
      ambiguities related to practice, regulatory authorities may initiate legal
      proceedings against us and we may be harmed.





**Our
      stock price is volatile and could result in a material decline in the value
      of
      your investment in Tegal.**





We
      believe that factors such as announcements of developments related to our
      business, fluctuations in our operating results, sales of our common stock
      into
      the marketplace, failure to meet or changes in analysts’ expectations, general
      conditions in the semiconductor industry or the worldwide economy, announcements
      of technological innovations or new products or enhancements by us or our
      competitors, developments in patents or other intellectual property rights,
      developments in our relationships with our customers and suppliers, natural
      disasters and outbreaks of hostilities could cause the price of our common
      stock
      to fluctuate substantially. In addition, in recent years the stock market in
      general, and the market for shares of small capitalization stocks in particular,
      have experienced extreme price fluctuations, which have often been unrelated
      to
      the operating performance of affected companies. We cannot assure you that
      the
      market price of our common stock will not experience significant fluctuations
      in
      the future, including fluctuations that are unrelated to our
      performance.





**Potential
      disruption of our supply of materials required to build our systems could have
      a
      negative effect on our operations and damage our customer
      relationships.**





Materials
      delays have not been significant in recent years. Nevertheless, we procure
      certain components and sub-assemblies included in our systems from a limited
      group of suppliers, and occasionally from a single source supplier. For example,
      we depend on MECS Corporation, a robotic equipment supplier, as the sole source
      for the robotic arm used in all of our 6500 series systems. We currently have
      no
      existing supply contract with MECS Corporation, and we currently purchase all
      robotic assemblies from MECS Corporation on a purchase order basis. Disruption
      or termination of certain of these sources, including our robotic sub-assembly
      source, could have an adverse effect on our operations and damage our
      relationship with our customers.





**Any
      failure by us to comply with environmental regulations imposed on us could
      subject us to future liabilities.**





We
      are
      subject to a variety of governmental regulations related to the use, storage,
      handling, discharge or disposal of toxic, volatile or otherwise hazardous
      chemicals used in our manufacturing process. We believe that we are currently
      in
      compliance in all material respects with these regulations and that we have
      obtained all necessary environmental permits generally relating to the discharge
      of hazardous wastes to conduct our business. Nevertheless, our failure to comply
      with present or future regulations could result in additional or corrective
      operating costs, suspension of production, and alteration of our manufacturing
      processes or cessation of our operations.





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





On
      July
      21, 2006, the Company held its annual meeting of the stockholders. There were
      present at the meeting, in person or by proxy, the holders of 78,027,980 shares
      of common stock of the Company, representing 92.61% of the total votes eligible
      to be cast, constituting a majority and more than a quorum of the outstanding
      shares entitled to vote. All shares are presented on a pre-reverse stock split
      basis.





26


The
                  following individuals were re-elected to the board of
                  directors:
  Votes
                  for
              
              Votes
                  WithheldEdward
                  A. Dohring
              74,169,000
              
              3,858,980Jeffrey
                  M. Krauss
              74,173,970
              
              3,854,010Brad
                  Mattson
              74,222,650
              
              3,805,330H.
                  Duane Wadsworth
              74,090,024
              
              3,937,956Ralph
                  S. Martin
              74,207,070
              
              3,820,910




To
      approve a series of amendments to our Certificate of Incorporation to effect
      a
      reverse stock split of our common stock, whereby each outstanding 8 or 12 shares
      would be combined into one share and to grant authorization to the Board of
      Directors to determine, at its discretion, the timing and the actual ratio
      of
      the reverse stock split; was approved by the stockholders as
      follows:




For
              74,226,512Against
              5,672,299Abstain
              133,662Broker
                  Non Vote
              39,987,396





To
      approve our Eighth Amended and Restated 1998 Equity Participation Plan pursuant
      to which the plan will be amended to allow for the repricing of issued but
      unexercised stock options and awards held by employees and consultants; was
      approved by stockholders as follows:


For
              32,234,623Against
              5,672,299Abstain
              133,662Broker
                  Non Vote
              39,987,396


To
      ratify
      the appointment of Moss Adams LLP as our Independent Registered Public
      Accounting Firm for the fiscal year ending March 31, 2007; was approved by
      stockholders as follows:




For
              75,808,068Against
              679,817Abstain
              1,540,095


To
      transact such other business as may properly come before the meeting or any
      adjournment or postponement of the meeting.




For
              71,029,607Against
              5,010,227Abstain
              1,988,146





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


(a)  *Exhibits*


31.1
            Certifications
                of the Chief Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002.31.2
            Certifications
                of the Chief Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002.32
            Certifications
                of the Chief Executive Officer and Chief Financial Officer pursuant
                to
                Section 906 of the Sarbanes-Oxley Act of
                2002.





**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.




TEGAL
                CORPORATION
              (Registrant)/s/
              CHRISTINE HERGENROTHERChristine
                Hergenrother
              *Chief
                Financial Officer*Dated:
                November 14 , 2006




27