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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended July 31, 2005



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to



Commission file number 0-22366



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CREDENCE SYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 94-2878499                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)



1421 California
Circle, Milpitas, California

95035

(Address of principal executive offices)

(Zip Code)



(408) 635-4300

(Registrants telephone number, including area code)





Former name, former address and former fiscal year, if changed since last
report.



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



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



Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



At August 31, 2005, there were
99,422,575 shares of the Registrants common stock, $0.001 par value per share, outstanding.



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##### Table of Contents

CREDENCE SYSTEMS CORPORATION



INDEX



|           |  |                                                                                       |  |   
|---------- |  | ------------------------------------------------------------------------------------- |  | --
|           |  | PAGE NO.                                                                             
|PART I.    |  | FINANCIAL INFORMATION                                                                 |  |   
|           |  |                                                                                      
|Item 1.    |  | Financial Statements:                                                                 |  | 3 
|           |  |                                                                                      
|           |  | Condensed Consolidated Balance Sheets                                                 |  | 3 
|           |  |                                                                                      
|           |  | Condensed Consolidated Statements of Operations                                       |  | 4 
|           |  |                                                                                      
|           |  | Condensed Consolidated Statements of Cash Flows                                       |  | 5 
|           |  |                                                                                      
|           |  | Notes to Condensed Consolidated Financial Statements                                  |  | 6 
|           |  |                                                                                      
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 21
|           |  |                                                                                      
|Item 3.    |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 48
|           |  |                                                                                      
|Item 4.    |  | Controls and Procedures                                                               |  | 49
|           |  |                                                                                      
|PART II.   |  | OTHER INFORMATION                                                                     |  |   
|           |  |                                                                                      
|Item 1.    |  | Legal Proceedings                                                                     |  | 50
|           |  |                                                                                      
|Item 2.    |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 50
|           |  |                                                                                      
|Item 3.    |  | Defaults Upon Senior Securities                                                       |  | 50
|           |  |                                                                                      
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                   |  | 50
|           |  |                                                                                      
|Item 5.    |  | Other Information                                                                     |  | 50
|           |  |                                                                                      
|Item 6.    |  | Exhibits                                                                              |  | 50
|           | 
|SIGNATURES |  | 51                                                                                   





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##### Table of Contents

PART I - FINANCIAL INFORMATION



Item 1. - FINANCIAL STATEMENTS



CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                               |  |               |           |                    |   |          
|---------------------------------------------- |  | ------------- | --------- | ------------------ | - | ---------
|                                               |  | July 31, 2005 |           | October 31, 2004a)
|ASSETS                                         |  |               |           |                    |   |          
|Current assets:                                |  |               |           |                    |   |          
|Cash and cash equivalents                      |  | $             | 86,361    |                    | $ | 94,052   
|Short-term investments                         |  |               | 49,086    |                    |   | 69,954   
|Accounts receivable, net                       |  |               | 125,419   |                    |   | 124,393  
|Inventories                                    |  |               | 89,261    |                    |   | 127,951  
|Income tax receivable                          |  |               | 1,071     |                    |   | 26       
|Deferred income taxes                          |  |               | 20,544    |                    |   | 20,544   
|Prepaid expenses and other current assets      |  |               | 13,880    |                    |   | 20,962   
|                                               |  |               |           |                    |   |          
|Total current assets                           |  |               | 385,622   |                    |   | 457,882  
|Property and equipment, net                    |  |               | 97,232    |                    |   | 108,707  
|Goodwill                                       |  |               | 426,349   |                    |   | 422,960  
|Other intangible assets, net                   |  |               | 100,693   |                    |   | 116,882  
|Other assets                                   |  |               | 54,850    |                    |   | 66,675   
|                                               |  |               |           |                    |   |          
|Total assets                                   |  | $             | 1,064,746 |                    | $ | 1,173,106
|                                               |  |               |           |                    |   |          
|LIABILITIES AND STOCKHOLDERS EQUITY           |  |               |           |                    |   |          
|Current liabilities:                           |  |               |           |                    |   |          
|Bank loans and notes payable  leased products |  | $             | 5,000     |                    | $ | 6,058    
|Accounts payable                               |  |               | 38,933    |                    |   | 51,742   
|Accrued payroll and related liabilities        |  |               | 21,240    |                    |   | 17,755   
|Deferred revenue                               |  |               | 18,087    |                    |   | 14,654   
|Income taxes payable                           |  |               | 17,396    |                    |   | 13,103   
|Accrued warranty                               |  |               | 12,282    |                    |   | 15,314   
|Deferred profit                                |  |               | 8,822     |                    |   | 9,718    
|Accrued expenses and other liabilities         |  |               | 37,444    |                    |   | 51,651   
|                                               |  |               |           |                    |   |          
|Total current liabilities                      |  |               | 159,204   |                    |   | 179,995  
|Convertible subordinated notes                 |  |               | 180,000   |                    |   | 180,000  
|Long-term deferred income taxes                |  |               | 20,645    |                    |   | 20,544   
|Other liabilities                              |  |               | 3,598     |                    |   | 4,359    
|Stockholders equity                           |  |               | 701,299   |                    |   | 788,208  
|                                               |  |               |           |                    |   |          
|Total liabilities and stockholders equity     |  | $             | 1,064,746 |                    | $ | 1,173,106
|                                               |  |               |           |                    |   |          

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|a) | Derived from the audited consolidated balance sheet included in the Companys Form 10-K
for the year ended October 31, 2004.
|-- | ----------------------------------------------------------------------------------------------------------------------------



See
accompanying notes.



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##### Table of Contents

CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------- |  | -------------------------- | ------- | - | -------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                    |  | Three Months EndedJuly 31, |         |   | Nine Months Ended July 31, |  
|                                                                    |  | 2005                       |         |   | 2004                       |   |         | 2005 |  |   | 2004    |  
|Net sales                                                           |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Systems, upgrades and software                                      |  | $                          | 80,912  |   |                            | $ | 137,980 |      |  | $ | 222,381 |   |  | $ | 277,489 |  
|Services and spare parts                                            |  |                            | 31,013  |   |                            |   | 25,738  |      |  |   | 85,371  |   |  |   | 49,491  |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Total net sales                                                     |  |                            | 111,925 |   |                            |   | 163,718 |      |  |   | 307,752 |   |  |   | 326,980 |  
|Cost of goods sold                                                  |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Systems, upgrades and software                                      |  |                            | 41,898  |   |                            |   | 68,372  |      |  |   | 124,334 |   |  |   | 135,732 |  
|Services and spare parts                                            |  |                            | 17,284  |   |                            |   | 17,158  |      |  |   | 52,326  |   |  |   | 31,675  |  
|Special charges                                                     |  |                            | 23,000  |   |                            |   | 46,206  |      |  |   | 29,090  |   |  |   | 46,206  |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Total cost of goods sold                                            |  |                            | 82,182  |   |                            |   | 131,736 |      |  |   | 205,750 |   |  |   | 213,613 |  
|Gross margin                                                        |  |                            | 29,743  |   |                            |   | 31,982  |      |  |   | 102,002 |   |  |   | 113,367 |  
|Operating expenses:                                                 |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Research and development                                            |  |                            | 23,849  |   |                            |   | 23,856  |      |  |   | 68,905  |   |  |   | 54,945  |  
|Selling, general and administrative                                 |  |                            | 31,317  |   |                            |   | 36,977  |      |  |   | 94,552  |   |  |   | 87,646  |  
|In-process research and development                                 |  |                            |        |   |                            |   | 7,900   |      |  |   |        |   |  |   | 7,900   |  
|Restructuring charges                                               |  |                            | 9,654   |   |                            |   | 2,969   |      |  |   | 11,445  |   |  |   | 3,622   |  
|Amortization of purchased intangibles and deferred compensation (1) |  |                            | 5,663   |   |                            |   | 5,345   |      |  |   | 18,664  |   |  |   | 10,589  |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Total operating expenses                                            |  |                            | 70,483  |   |                            |   | 77,047  |      |  |   | 193,566 |   |  |   | 164,702 |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Operating loss                                                      |  |                            | (40,740 | ) |                            |   | (45,065 | )    |  |   | (91,564 | ) |  |   | (51,335 | )
|Interest income                                                     |  |                            | 725     |   |                            |   | 245     |      |  |   | 2,000   |   |  |   | 2,770   |  
|Interest expense                                                    |  |                            | (767    | ) |                            |   | (1,695  | )    |  |   | (2,236  | ) |  |   | (3,349  | )
|Other income, net                                                   |  |                            | 1,080   |   |                            |   | 14,828  |      |  |   | 2,950   |   |  |   | 15,539  |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Loss before income tax provision                                    |  |                            | (39,702 | ) |                            |   | (31,687 | )    |  |   | (88,850 | ) |  |   | (36,375 | )
|Income tax                                                          |  |                            | 1,975   |   |                            |   | 1,479   |      |  |   | 8,602   |   |  |   | 3,904   |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Loss before minority interest                                       |  |                            | (41,677 | ) |                            |   | (33,166 | )    |  |   | (97,452 | ) |  |   | (40,279 | )
|Minority interest (benefit)                                         |  |                            |        |   |                            |   | (1      | )    |  |   |        |   |  |   | 103     |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Net loss                                                            |  | $                          | (41,677 | ) |                            | $ | (33,165 | )    |  | $ | (97,452 | ) |  | $ | (40,382 | )
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Net loss per share                                                  |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Basic                                                               |  | $                          | (0.43   | ) |                            | $ | (0.42   | )    |  | $ | (1.06   | ) |  | $ | (0.58   | )
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Diluted (see Note 11)                                               |  | $                          | (0.43   | ) |                            | $ | (0.42   | )    |  | $ | (1.06   | ) |  | $ | (0.58   | )
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Number of shares used in computing per share amount                 |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Basic                                                               |  |                            | 96,638  |   |                            |   | 78,647  |      |  |   | 92,010  |   |  |   | 69,407  |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Diluted                                                             |  |                            | 96,638  |   |                            |   | 78,647  |      |  |   | 92,010  |   |  |   | 69,407  |  
|                                                                    |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  

---

|(1) | Amortization of deferred compensation related to the following expense categories by period:
|--- | --------------------------------------------------------------------------------------------



|                                            |  |   |     |  |   |     |  |   |       |  |   |      
|------------------------------------------- |  | - | --- |  | - | --- |  | - | ----- |  | - | -----
|Cost of goods sold                          |  | $ | 95  |  | $ | 84  |  | $ | 291   |  | $ | 106  
|Research and development                    |  |   | 153 |  |   | 129 |  |   | 470   |  |   | 129  
|Selling, general and administrative         |  |   | 709 |  |   | 498 |  |   | 1,748 |  |   | 893  
|                                            |  |   |     |  |   |     |  |   |       |  |   |      
|Total amortization of deferred compensation |  | $ | 957 |  | $ | 711 |  | $ | 2,509 |  | $ | 1,128
|                                            |  |   |     |  |   |     |  |   |       |  |   |      



See accompanying notes.



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CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                            |  |                           |          |   |      |   |          |  
|--------------------------------------------------------------------------- |  | ------------------------- | -------- | - | ---- | - | -------- | -
|                                                                            |  | Nine Months EndedJuly 31, |         
|                                                                            |  | 2005                      |          |   | 2004 |  
|Cash flows from operating activities:                                       |  |                           |          |   |      |   |          |  
|Net loss                                                                    |  | $                         | (97,452  | ) |      | $ | (40,382  | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                           |          |   |      |   |          |  
|Depreciation and amortization                                               |  |                           | 47,949   |   |      |   | 39,626   |  
|Non-cash restructuring and special charges                                  |  |                           | 28,720   |   |      |   | 43,872   |  
|In-process research and development                                         |  |                           |         |   |      |   | 7,900    |  
|Inventory write downs                                                       |  |                           | 4,653    |   |      |   | 6,130    |  
|Provision for allowance for doubtful accounts                               |  |                           | 2,764    |   |      |   | (939     | )
|(Gain) loss on disposal of property and equipment                           |  |                           | 238      |   |      |   | (1,166   | )
|Realized loss on available-for-sale securities                              |  |                           |         |   |      |   | 369      |  
|Minority interest                                                           |  |                           |         |   |      |   | 55       |  
|Changes in operating assets and liabilities:                                |  |                           |          |   |      |   |          |  
|Accounts receivable                                                         |  |                           | (4,929   | ) |      |   | (67,424  | )
|Inventories                                                                 |  |                           | 5,484    |   |      |   | (42,373  | )
|Income tax receivable and payable                                           |  |                           | 3,774    |   |      |   | (10,788  | )
|Prepaid expenses and other current assets                                   |  |                           | 6,612    |   |      |   | (2,237   | )
|Other assets                                                                |  |                           | 4,595    |   |      |   | 1,479    |  
|Accounts payable                                                            |  |                           | (12,584  | ) |      |   | 22,187   |  
|Accrued expenses and other current liabilities                              |  |                           | (7,851   | ) |      |   | 24,597   |  
|Deferred profit                                                             |  |                           | (2,514   | ) |      |   | 10,541   |  
|                                                                            |  |                           |          |   |      |   |          |  
|Net cash used in operating activities                                       |  |                           | (20,541  | ) |      |   | (8,553   | )
|Cash flows from investing activities:                                       |  |                           |          |   |      |   |          |  
|Purchases of available-for-sale securities                                  |  |                           | (100,775 | ) |      |   | (187,251 | )
|Sales and maturities of available-for-sale securities                       |  |                           | 121,270  |   |      |   | 464,506  |  
|Acquisition of property and equipment                                       |  |                           | (13,028  | ) |      |   | (16,742  | )
|Acquisition of business, net of cash and cash equivalents                   |  |                           |         |   |      |   | (159,866 | )
|Acquisition of other assets                                                 |  |                           |         |   |      |   | (919     | )
|Proceeds from sale of property and equipment and leased equipment           |  |                           | 583      |   |      |   | 1,612    |  
|                                                                            |  |                           |          |   |      |   |          |  
|Net cash provided by investing activities                                   |  |                           | 8,050    |   |      |   | 101,340  |  
|Cash flows from financing activities:                                       |  |                           |          |   |      |   |          |  
|Issuance of common and treasury stock                                       |  |                           | 5,561    |   |      |   | 11,547   |  
|Payments of bank loans and notes payable related to leased products         |  |                           | (1,058   | ) |      |   | (2,815   | )
|Other                                                                       |  |                           |         |   |      |   | (213     | )
|                                                                            |  |                           |          |   |      |   |          |  
|Net cash provided by financing activities                                   |  |                           | 4,503    |   |      |   | 8,519    |  
|                                                                            |  |                           |          |   |      |   |          |  
|Effects of exchange rate on cash and cash equivalents                       |  |                           | 297      |   |      |   | 528      |  
|                                                                            |  |                           |          |   |      |   |          |  
|Net (decrease) increase in cash and cash equivalents                        |  |                           | (7,691   | ) |      |   | 101,834  |  
|Cash and cash equivalents at beginning of period                            |  |                           | 94,052   |   |      |   | 27,318   |  
|                                                                            |  |                           |          |   |      |   |          |  
|Cash and cash equivalents at end of period                                  |  | $                         | 86,361   |   |      | $ | 129,152  |  
|                                                                            |  |                           |          |   |      |   |          |  
|Supplemental disclosures of cash flow information:                          |  |                           |          |   |      |   |          |  
|Interest paid                                                               |  | $                         | 2,777    |   |      | $ | 2,573    |  
|Income taxes paid                                                           |  | $                         | 4,072    |   |      | $ | 252      |  
|Noncash investing activities:                                               |  |                           |          |   |      |   |          |  
|Net transfers of inventory to property and equipment                        |  | $                         | 269      |   |      | $ | 1,296    |  
|Acquisition of NPTest using Credence common stock                           |  | $                         |         |   |      | $ | 414,622  |  
|Schlumbergers liability settlement using Credence common stock             |  | $                         | 5,000    |   |      |   |         |  
|Unrealized loss on available-for-sale investments                           |  | $                         | 295      |   |      | $ | 594      |  



See accompanying notes.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



1. Quarterly Financial Statements



The
condensed consolidated financial statements and related notes for the three and nine month periods ended July 31, 2005 and 2004 are unaudited but include all adjustments (consisting solely of normal recurring adjustments except for acquisition,
special charges related to cost of goods sold and restructuring charges adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations of Credence Systems Corporation
(Credence or the Company) for the interim periods, in accordance with U.S. generally accepted accounting principles. The results of operations for the three and nine month periods ended July 31, 2005 and 2004 are not necessarily indicative of the
operating results to be expected for the full fiscal year. The information included in this report should be read in conjunction with the Companys audited consolidated financial statements and notes thereto for the fiscal year ended October
31, 2004 included in the Companys most recent Annual Report on Form 10-K and the additional risk factors contained herein and therein, including, without limitation, risks relating to the importance of timely product introduction, successful
integration of acquisitions, fluctuations in the Companys quarterly net sales and operating results, limited systems sales, backlog, cyclicality of the semiconductor industry, management of fluctuations in the Companys operating results,
expansion of Credences product lines, limited sources of supply, reliance on the Companys subcontractors, Credences highly competitive industry, customization of products, rapid technological change, customer concentration, lengthy
sales cycles, changes in financial accounting standards and accounting estimates, dependence on key personnel, international sales, proprietary rights, legal proceedings, volatility of Credences stock price, terrorist attacks and other
geopolitical instability, effects of the Sarbanes-Oxley Act of 2002, and effects of certain anti-takeover provisions, as set forth in this Report. Any party interested in receiving a free copy of the Form 10-K or the Companys other publicly
available documents should write to the Chief Financial Officer of the Company.



Description of Business - Credence was incorporated in California in March 1982 to succeed a sole proprietorship and was reincorporated in Delaware in October 1993. The principal business activity of the
Company is the design, development, manufacture, sale and service of engineering validation test equipment, diagnostic and failure analysis products, and automatic test equipment (ATE) used for testing semiconductor integrated circuits, or ICs. The
Company serves a broad spectrum of the semiconductor industrys testing needs through a wide range of products that test digital logic, mixed-signal, system-on-a-chip, radio frequency, volatile and static and non-volatile memory semiconductors.



Basis of Presentation  The accompanying unaudited
condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. Certain prior year amounts in the condensed consolidated
financial statements and related notes have been reclassified to conform to the current years presentation. During the second quarter of fiscal 2005, the Company reclassified its product consignment from inventory to other assets. The amount
reclassified as of October 31, 2004 was $18.8 million. This reclassification had no effect on the financial position, results of operations, or cash flows for any of the periods presented.



Use of Estimates  The preparation of the accompanying unaudited
condensed consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates.



2. Revenue Recognition



Under Securities and Exchange Commissions Staff Accounting Bulletin No. 104 (SAB 104), the Company recognizes revenue
on the sale of semiconductor manufacturing equipment when title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the sales price is fixed or
determinable, collectibility is reasonably assured and customer acceptance criteria have been successfully demonstrated. Revenue recognition policies are applied consistently among the Companys semiconductor manufacturing equipment product
lines. Product revenue is recognized upon shipment only when achieving the customer acceptance criteria can be demonstrated prior to shipment, which generally occurs with mature product. Revenue related to the fair value of the installation
obligation is recognized upon completion of the installation. Products are classified as mature after several different customers have accepted similar systems. When the customer acceptance criteria cannot be demonstrated prior to shipment, revenue
and the related cost of goods sold are deferred until customer acceptance. For some customers in certain countries where collections may be an issue, the Company may require a letter of credit to be established or cash receipt in advance before
revenue can be recognized. Lease revenue is recorded in accordance with Statement of Financial Accounting Standard No. 13, Accounting for Leases (SFAS No. 13), which requires that a lessor accounts for each lease by either the direct
financing, sales-type or operating method. Revenue from sales-type leases is recognized at the net present value of future lease payments. Revenue from operating leases is recognized over the lease period.



During fiscal 2003, 2004 and 2005, the Company introduced several new systems
and products. Certain revenues from sales of these new systems and products during fiscal 2004 and the nine months of fiscal 2005 were deferred until the revenue recognition requirements of the Companys revenue recognition policy are
satisfied. This practice will continue in



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the future. In the past, the Company experienced significant delays in the introduction and acceptance of new testers as well as certain enhancements to the
Companys existing testers. As a result, some customers have experienced significant delays in receiving and accepting the Companys testers in production. Delays in introducing a product or delays in the Companys ability to obtain
customer acceptance, if they occur in the future, will delay the recognition of revenue and gross profit by the Company.



When the Company is able to separate multiple deliverables from one another, it recognizes revenue for each deliverable, based on each deliverables
fair value, when the revenue recognition criteria for that specific deliverable is achieved. In the vast majority of cases orders are shipped complete. In rare instances when there are multiple shipments due to materials shortages, revenue and
related cost of sales are recognized only for the line items that are physically shipped. If the items not shipped on an order are required for the functionality of the delivered items, revenue and related cost of sales are deferred on the delivered
items and recognized only upon the shipment of the required items.



Sales in the United States are principally made through the Companys direct sales organization consisting of direct sales employees and representatives. Sales outside the United States utilize both direct sales employees and
distributors. There are no significant differences in revenue recognition policies based on the sales channel, due to the business practices that have been adopted with the Companys distributor relationships. Because of these business
circumstances, the Company does not use price protection, stock rotation or similar programs with its distributors. It does not typically sell inventory into its distributors for eventual sale to end-users, but rather the
Company sells product to the distributors on the basis of a purchase order received from an end-user. The Company evaluates any revenue recognition issues with respect to the end customer in light of its revenue recognition policy.



The Company sells stand-alone software products and the revenue recognition
policies related to these sales fall within the scope of AICPA Statement of Position No. 97-2 Software Revenue Recognition (SOP 97-2). The stand-alone software products are applications for IC manufacturers and test and assembly
contractors to help improve quality and shorten development lead times. The Company also has embedded software in its semiconductor manufacturing equipment. The Company believes this embedded software is incidental to its products and therefore it
is excluded from the scope of SOP 97-2 since the embedded software in the Companys products is not sold separately, cannot be used on another vendors products, and the Company cannot fundamentally enhance or expand the capability of the
equipment with new or revised embedded software. In addition, the equipments principal performance characteristics are governed by digital speed and pin count, which are primarily a function of the hardware.



Deferred revenue includes deferred revenue related to maintenance contracts
(and other undelivered services) and to extended warranties where products were sold with more than the standard one-year warranty. Deferred profit is related to equipment that was shipped to certain customers, but the revenue and cost of goods sold
were not recognized because the customer-specified acceptance criteria has not been met as of the fiscal period end or because the customer is deemed to be a high credit risk and payment has not been received as of the fiscal period end.



The Company warrants its products to its customers generally for one year
from the date of shipment. In addition to the provision of standard warranties, the Company may offer customer paid extended warranty services with a fixed fee. The fixed fees are recognized as revenue on a straight-line basis over the applicable
term of the contract. Costs related to extended warranty services are recorded as incurred.



For certain customers, typically those with whom the Company has long-term relationships, the Company may grant extended payment terms. Certain of the Companys receivables have due dates in excess of 90 days and
the Company has a history of successfully collecting these extended payment term accounts receivable.



3. Accounts Receivable Sales without Recourse



The Company had an agreement with a commercial bank to sell certain of its trade receivables in non-recourse transactions. Under the terms of the agreement, the Company could sell up to $30.0 million of its trade
receivables at any one time. The Company was retained by the bank to service the collection aspect of the trade receivables sold. The trade receivables were sold at a discount plus administrative and other fees. The discount amount, administrative
and other fees for the nine-month period ended July 31, 2005 of approximately $0.1 million were accounted for in other income, net in the condensed consolidated statements of operations. Sales of trade receivables were reflected as a reduction of
accounts receivable in the accompanying condensed consolidated balance sheets. The proceeds received were included as cash in the accompanying condensed consolidated balance sheets and as operating activities in the condensed consolidated statements
of cash flows. During the first three months of fiscal 2005, the Company recorded approximately $7.2 million in gross cash proceeds from the sale of trade receivables. This facility was terminated during the quarter ended July 31, 2005 and no sales
of trade receivables occurred during the quarters ended April 30, 2005 and July 31, 2005.



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4. Bank Note



The bank note, which has an annual interest rate of prime (approximately 6.25% at July 31, 2005), was re-negotiated during the third quarter of fiscal
2005. The note expires in November 2005 and has a covenant requiring the Company to maintain a minimum aggregated balance of cash, cash equivalents, and short and long term investments of $100.0 million. As of July 31, 2005, the Company was in
compliance with the covenant and this bank note has a balance of $5.0 million. See the maturity schedule for this obligation in Note 13 Contingencies and Guarantees.



5. Guarantees



The Company accounts for guarantees in accordance with FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34 (FIN 45). Accordingly, the Company evaluates its guarantees to determine whether (a) the
guarantee is specifically excluded from the scope of FIN 45, (b) the guarantee is subject to FIN 45 disclosure requirements only, but not subject to the initial recognition and measurement provisions, or (c) the guarantee is required to be recorded
in the financial statements at fair value. The Company has evaluated its guarantees and has concluded that they are either not within the scope of FIN 45 or do not require recognition in the financial statements. These guarantees which are not under
FIN 45 generally include certain indemnifications to its lessors under operating lease agreements for environmental matters, residual value guarantees to lessors, non-recourse provisions related to sales of accounts receivable, indemnification of
the Companys customers for certain infringement of third-party intellectual property rights by its products and services, and the Companys warranty obligations for sales of its products. See Note 12, Contingencies and
Guarantees for additional information on the Companys guarantees. However, the Company has obligations to allow trade-in rights. As of July 31, 2005, the Company has approximately $1.6 million, the estimated fair value of the trade-in
rights included in the condensed consolidated balance sheet under current liabilities.



6. Stock-Based Compensation



At July 31, 2005,
the Company had several stock-based employee compensation plans. The Company accounts for stock-based compensation under Accounting Principles Boards Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related
interpretations, using the intrinsic value method. In addition, the Company applies the disclosure requirements of Financial Accounting Standard Board (FASB) Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based
Compensation, (SFAS 123), as amended by Statement of Financial Accounting Standard No. 148 Accounting for Stock-Based Compensation-Transition and Disclosure (SFAS 148). Under APB 25, the Company does not recognize compensation
expense unless the exercise price of the Companys employee stock options is less than the market price of the underlying stock on the date of grant. The Company generally grants its stock options at the fair market value of the underlying
stock on the date of grant. Consequently, the Company has not recorded such expense in the periods presented.



In calculating pro forma compensation, the fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton options
pricing model. The Black-Scholes-Merton options pricing model requires the input of highly subjective assumptions including the expected stock price volatility. Stock based compensation expense already included in the reported net income (loss) is
primarily a result of amortization of deferred compensation related to acquisitions.



The following table illustrates the effect on reported net loss and loss per share for the three and nine months ended July 31, 2005 and 2004, respectively, as if the Company had applied the fair value recognition
provisions of FAS 123 to stock-based compensation (in thousands, except per share data):



|                                                                                                                     |  |                            |         |   |                            |   |         |      |  |   |          |   |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------- | - | -------------------------- | - | ------- | ---- |  | - | -------- | - |  | - | ------- | -
|                                                                                                                     |  | Three Months EndedJuly 31, |         |   | Nine Months Ended July 31, |  
|                                                                                                                     |  | 2005                       |         |   | 2004                       |   |         | 2005 |  |   | 2004     |  
|Net loss as reported                                                                                                 |  | $                          | (41,677 | ) |                            | $ | (33,165 | )    |  | $ | (97,452  | ) |  | $ | (40,382 | )
|Stock-based employee compensation expense included in reported net loss, net of tax                                  |  |                            | 957     |   |                            |   | 711     |      |  |   | 2,509    |   |  |   | 1,128   |  
|Less: Stock-based employee compensation expense determined under fair value based methods for all awards, net of tax |  |                            | (5,663  | ) |                            |   | (7,085  | )    |  |   | (19,425  | ) |  |   | (22,915 | )
|                                                                                                                     |  |                            |         |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Net loss, pro forma                                                                                                  |  | $                          | (46,383 | ) |                            | $ | (39,539 | )    |  | $ | (114,368 | ) |  | $ | (62,169 | )
|                                                                                                                     |  |                            |         |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Basic net loss per share as reported                                                                                 |  | $                          | (0.43   | ) |                            | $ | (0.42   | )    |  | $ | (1.06    | ) |  | $ | (0.58   | )
|Basic net loss per share pro forma                                                                                   |  | $                          | (0.48   | ) |                            | $ | (0.50   | )    |  | $ | (1.24    | ) |  | $ | (0.90   | )
|Diluted net loss per share, as reported                                                                              |  | $                          | (0.43   | ) |                            | $ | (0.42   | )    |  | $ | (1.06    | ) |  | $ | (0.58   | )
|Diluted net loss per share pro forma                                                                                 |  | $                          | (0.48   | ) |                            | $ | (0.50   | )    |  | $ | (1.24    | ) |  | $ | (0.90   | )



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7. Inventories



Inventories are stated at the lower of standard cost (which approximates first-in, first-out cost) or market. Inventories consist of the following (in
thousands):



|                |  |              |        |                 |   |        
|--------------- |  | ------------ | ------ | --------------- | - | -------
|                |  | July 31,2005 |        | October 31,2004
|Raw materials   |  | $            | 44,612 |                 | $ | 80,922 
|Work-in-process |  |              | 23,450 |                 |   | 29,388 
|Finished goods  |  |              | 21,199 |                 |   | 17,641 
|                |  |              |        |                 |   |        
|                |  | $            | 89,261 |                 | $ | 127,951
|                |  |              |        |                 |   |        



8. Balance Sheet Components



Prepaid expenses and other current assets consist of the
following (in thousands):



|                                                 |  |              |        |                 |   |       
|------------------------------------------------ |  | ------------ | ------ | --------------- | - | ------
|                                                 |  | July 31,2005 |        | October 31,2004
|Short-term lease receivables                     |  | $            | 1,058  |                 | $ | 1,692 
|Receivable from contract equipment manufacturers |  |              | 2,780  |                 |   | 3,851 
|Other prepaid expenses                           |  |              | 10,042 |                 |   | 15,419
|                                                 |  |              |        |                 |   |       
|Total                                            |  | $            | 13,880 |                 | $ | 20,962
|                                                 |  |              |        |                 |   |       



Property and
equipment, net (in thousands):



|                              |  |              |          |   |                  |   |          |  
|----------------------------- |  | ------------ | -------- | - | ---------------- | - | -------- | -
|                              |  | July 31,2005 |          |   | October 31, 2004 |  
|Land                          |  | $            | 26,838   |   |                  | $ | 26,908   |  
|Buildings                     |  |              | 35,765   |   |                  |   | 36,823   |  
|Machinery and equipment       |  |              | 103,236  |   |                  |   | 102,783  |  
|Software                      |  |              | 30,435   |   |                  |   | 28,980   |  
|Leasehold improvements        |  |              | 37,575   |   |                  |   | 39,511   |  
|Furniture and fixtures        |  |              | 10,481   |   |                  |   | 10,792   |  
|                              |  |              |          |   |                  |   |          |  
|                              |  |              | 244,330  |   |                  |   | 245,797  |  
|Less accumulated depreciation |  |              | (147,098 | ) |                  |   | (137,090 | )
|                              |  |              |          |   |                  |   |          |  
|Total                         |  | $            | 97,232   |   |                  | $ | 108,707  |  
|                              |  |              |          |   |                  |   |          |  



Other assets consist
of the following (in thousands):



|                            |  |              |        |                 |   |       
|--------------------------- |  | ------------ | ------ | --------------- | - | ------
|                            |  | July 31,2005 |        | October 31,2004
|Long-term lease receivables |  | $            | 2,979  |                 | $ | 6,553 
|Equipment on lease          |  |              | 492    |                 |   | 3,089 
|Field service spares        |  |              | 29,504 |                 |   | 29,488
|Product consignment         |  |              | 14,265 |                 |   | 18,790
|Other assets                |  |              | 7,610  |                 |   | 8,755 
|                            |  |              |        |                 |   |       
|Total                       |  | $            | 54,850 |                 | $ | 66,675
|                            |  |              |        |                 |   |       



Field service spares
used in the Companys service business are classified as long-term assets and are amortized using the straight-line method over five years. The amortization expense of spares is charged to service and spare parts cost of goods sold.
Amortization expense was approximately $2.4 million and $1.0 million for the third quarter of fiscal 2005 and 2004, respectively. Amortization expense was approximately $6.4 million and $2.9 million for the nine months ended July 31, 2005 and 2004,
respectively.



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Product consignments used in the Companys marketing efforts are classified as long-term assets and
are depreciated during the period that they are held on consignment over periods ranging from 18 to 36 months. The depreciation expense for product consignments is charged to selling, general and administrative expense. Depreciation expense was
approximately $2.9 million and $3.2 million for the third quarter of fiscal 2005 and 2004, respectively. Depreciation expense was approximately $7.7 million and $6.6 million for the nine months ended July 31, 2005 and 2004, respectively.



Accrued expenses and other liabilities consist of the following (in
thousands):



|                                   |  |               |        |                 |   |       
|---------------------------------- |  | ------------- | ------ | --------------- | - | ------
|                                   |  | July 31, 2005 |        | October 31,2004
|Accrued distributor commissions    |  | $             | 1,499  |                 | $ | 3,412 
|Accrued bonuses                    |  |               | 3,335  |                 |   | 10,083
|Accrued restructuring expenses     |  |               | 12,862 |                 |   | 6,522 
|Accrued value added taxes          |  |               | 1,514  |                 |   | 2,650 
|Contingent payable to Schlumberger |  |               |       |                 |   | 10,266
|Accrued interest expense           |  |               | 563    |                 |   | 1,252 
|Other accrued liabilities          |  |               | 17,671 |                 |   | 17,466
|                                   |  |               |        |                 |   |       
|Total                              |  | $             | 37,444 |                 | $ | 51,651
|                                   |  |               |        |                 |   |       



9. Acquisitions



NPTest Holding Corporation:



In May 2004, the Company acquired 100% of the outstanding common stock of
NPTest Holding Corporation (NPTest), a company that designed, developed and manufactured advanced semiconductor test and diagnostic systems and provided related services for the semiconductor industry. The addition of NPTest expands the
Companys customer base and enables the Company to provide customers with a broader portfolio of solutions. The acquisition resulted in a total cash payment to shareholders of NPTest of approximately $230 million and the right to receive
approximately 32 million shares of the Companys common stock, including the assumed conversion of 203,036 shares of the Companys preferred stock at a conversion ratio of 100 to 1, with an aggregate fair value at the acquisition date of
approximately $376.5 million. As of July 31, 2005, all of the 32 million shares were issued and outstanding as common stock. In fiscal year 2004, the former majority shareholder of NPTest converted 79,754 shares of the Companys non-voting
convertible preferred stock into 7,975,400 shares of the Companys common stock. During the first quarter of fiscal 2005, 56,708 shares of the preferred stock were converted into approximately 5,670,800 shares of common stock and during the
third quarter of fiscal 2005, 66,574 shares of the preferred stock were converted into approximately 6,657,400 shares of common stock for a total of 123,282 shares of the preferred stock being converted into approximately 12,328,200 shares of common
stock in the nine months ended July 31, 2005. The common stock issued in the acquisition was valued using the average closing price of the Companys common stock over a five-day trading period beginning two days before and ending two days after
the date the transaction was announced. The Company also assumed all of the outstanding NPTest stock options with a fair value of approximately $38.1 million. The options were valued using the Black-Scholes-Merton options pricing model with the
following assumptions: dividend of $0, volatility of 0.77, expected life of 6.35 years, risk-free interest rate of 3.45% and a market value of the Companys common stock of $11.77 per share, which was determined as described above. The Company
also incurred direct costs associated with the acquisition of approximately $5.9 million. Below is a summary of the total purchase price (in thousands):



|                           |  |   |        
|-------------------------- |  | - | -------
|Cash                       |  | $ | 229,950
|Common and preferred stock |  |   | 376,514
|Outstanding stock options  |  |   | 38,108 
|Direct acquisition costs   |  |   | 5,910  
|                           |  |   |        
|Total purchase price       |  | $ | 650,482
|                           |  |   |        



The majority owner of
NPTest, who owned approximately 63% of NPTests common stock, received 203,036 shares of non-voting convertible preferred stock of the Company as a result of the acquisition. Each share of NPTest common stock held by this majority owner was
exchanged for 0.008 of a share of the Companys non-voting convertible stock. Each share of the non-voting convertible stock was convertible into 100 shares of the Companys common stock. The non-voting convertible stock was identical in
all respects to the Companys common stock except that, prior to conversion, it had no voting rights, but had a liquidation preference of $0.001 per share. The non-voting convertible stock is classified as preferred stock. As of July 31, 2005,
the majority owner had converted all the 203,036 shares of the Companys non-voting convertible preferred stock into 20,303,600 shares of the Companys common stock.



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The Company allocated the purchase price to the tangible and intangible assets acquired, including
in-process research and development, and liabilities assumed based on their estimated fair values, and to deferred stock compensation. The excess purchase price over those fair values was recorded as goodwill. The fair value assigned to tangible and
intangible assets acquired and liabilities assumed were based on estimates and assumptions provided by management, and other information compiled by management, including valuations that utilize established valuation techniques appropriate for the
high technology industry. Goodwill recorded as a result of these acquisitions is not expected to be deductible for tax purposes. In accordance with Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets
(SFAS 142), goodwill and purchased intangible assets with indefinite lives are not amortized but reviewed at least annually for impairment. Purchased intangible assets with finite lives will be amortized on a straight-line basis over their
respective estimated useful lives. The total purchase price has been allocated as follows (in thousands, except years):



|                                                |  |        |         |   |                    |   |                    |  |     
|----------------------------------------------- |  | ------ | ------- | - | ------------------ | - | ------------------ |  | ----
|                                                |  | Amount |         |   | AnnualAmortization |   | UsefulLives(Years)
|Purchase Price Allocation:                      |  |        |         |   |                    |   |                    |  |     
|Cash and cash equivalents                       |  | $      | 76,103  |   |                    | $ |                   |  |    
|Short-term investments                          |  |        | 19,481  |   |                    |   |                   |  |    
|Accounts receivable                             |  |        | 37,704  |   |                    |   |                   |  |    
|Inventories                                     |  |        | 60,027  |   |                    |   |                   |  |    
|Prepaid expenses and other current assets       |  |        | 34,923  |   |                    |   |                   |  |    
|Property and equipment                          |  |        | 18,238  |   |                    |   |                   |  |    
|Other assets                                    |  |        | 22,790  |   |                    |   |                   |  |    
|Accounts payable                                |  |        | (19,916 | ) |                    |   |                   |  |    
|Other accrued expenses and liabilities          |  |        | (46,609 | ) |                    |   |                   |  |    
|Contingent payable to Schlumberger              |  |        | (29,450 | ) |                    |   |                   |  |    
|Other long-term liabilities                     |  |        | (695    | ) |                    |   |                   |  |    
|                                                |  |        |         |   |                    |   |                    |  |     
|Net tangible assets assumed                     |  |        | 172,596 |   |                    |   |                   |  |    
|Intangible assets acquired:                     |  |        |         |   |                    |   |                    |  |     
|Developed technology                            |  |        | 70,300  |   |                    |   | 7,030              |  | 10  
|Maintenance agreements                          |  |        | 13,800  |   |                    |   | 2,760              |  | 5   
|Customer relationships                          |  |        | 12,100  |   |                    |   | 1,729              |  | 7   
|Product backlog                                 |  |        | 4,900   |   |                    |   | 4,900              |  | 1   
|                                                |  |        |         |   |                    |   |                    |  |     
|Total amortizable intangible assets             |  |        | 101,100 |   |                    |   | 16,419             |  |    
|In-process research and development             |  |        | 7,900   |   |                    |   |                   |  |    
|Deferred compensation on unvested stock options |  |        | 9,967   |   |                    |   | 3,067              |  | 3.25
|Deferred tax                                    |  |        | (29,362 | ) |                    |   |                   |  |    
|Goodwill                                        |  |        | 388,281 |   |                    |   |                   |  |    
|                                                |  |        |         |   |                    |   |                    |  |     
|Total purchase price                            |  | $      | 650,482 |   |                    | $ | 19,486             |  |     
|                                                |  |        |         |   |                    |   |                    |  |     



The purchase price
allocation changed by $1.1 million and $3.4 million during the three and nine months ended July 31, 2005, respectively, primarily due to additional accrued expenses and liabilities recognized. The write up of additional accrued liabilities of $1.1
million during the three months ended July 31, 2005 was primarily due to $1.0 million accrued clean-up costs for the Simi Valley facility. The write up of additional accrued liabilities of $3.4 million during the nine months ended July 31, 2005
consisted of severance and related charges of approximately $1.7 million, relocation charges of approximately $0.6 million for the Simi Valley facility, and $1.0 million for the Simi Valley facility clean-up costs. These charges are recognized in
accordance with EITF Issue No. 95-3, Recognition of Liabilities in Connection with Purchase Business Combinations (EITF Issue No. 95-3).



In November 2004, the Board of Directors approved managements plan to close the Simi Valley, California facility and move all manufacturing
activities at this site to Hillsboro, Oregon. As a part of the approved plan, during the nine months ended July 31, 2005, the Company accrued for charges of $2.1 million primarily for severance and related charges for 100 employees, $1.1 million for
facilities, and $0.7 million for relocation expenses. In the first quarter of fiscal year 2005, the Company made adjustments to the previously accrued severance and relocation accruals by $0.1 million. During the second quarter of fiscal 2005, the
Company recorded additional charges of $0.3 million related to severance, and $0.1 million related to property taxes for the Simi Valley facility. During the third quarter of fiscal 2005, the Company recorded additional charges of $1.0 million
related to clean-up costs for the Simi Valley facility. The Company also paid out $2.0 million in severance, $0.4 million in facilities, and $0.2 million in relocation costs that were previously accrued. The Company recognized these costs in
accordance with EITF 95-3. The remaining severance and related charges are expected to be paid by the end of fiscal year 2005. The related facility lease charges will be paid through the end of the lease terms, which extend through June 2008, of
which the majority of the payment related to the Simi Valley facility which ends in January 2007. As of July 31, 2005, $3.5 million remained to be paid for these charges. The following table illustrates the charges and the estimated timing of future
payouts at July 31, 2005 (in thousands):



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|                                    |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|----------------------------------- |  | -------------------------- | ------ | - | ------- | - | ------ | -------- |  | ----------- | ----- | ------------------------ | - | --- |  | - | ------ | -
|                                    |  | Balance atOctober 31, 2004 |        |   | Charges |   |        | Utilized |  | Adjustments |       | Balance at July 31, 2005 |  
|Severance                           |  | $                          | (409   | ) |         | $ | (2,085 | )        |  | $           | 1,914 |                          | $ | 29  |  | $ | (551   | )
|Facilities                          |  |                            | (1,969 | ) |         |   | (1,119 | )        |  |             | 362   |                          |   | 60  |  |   | (2,666 | )
|Relocation                          |  |                            | (113   | ) |         |   | (652   | )        |  |             | 237   |                          |   | 232 |  |   | (296   | )
|                                    |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Total                               |  | $                          | (2,491 | ) |         | $ | (3,856 | )        |  | $           | 2,513 |                          | $ | 321 |  | $ | (3,513 | )
|                                    |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Estimated timing of future payouts: |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Remainder of fiscal 2005            |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  | $ | 2,152  |  
|Fiscal 2006                         |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   | 1,050  |  
|Fiscal 2007                         |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   | 261    |  
|Fiscal 2008                         |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   | 50     |  
|                                    |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Total                               |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  | $ | 3,513  |  
|                                    |  |                            |        |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  



As a result of the
NPTest acquisition, the Company was required to make a payment to Schlumberger Limited (Schlumberger), the former parent of NPTest, at a date in the future pursuant to a provision in the acquisition agreement between NPTest and Schlumberger under
which NPTest was acquired by Francisco Partners, L.P. from Schlumberger. The future payment date could have been triggered by various events, including certain distributions by NPTest Holding, LLC (an entity controlled by Francisco Partners, L.P.)
to its members, or, at Schlumbergers option, it could have been triggered on May 28, 2005. The payment amount was contingent upon the value of the Companys common stock at the time of distribution. If payment was triggered at
Schlumbergers option, the Company could have generally settled this payment in cash or stock. If payment was triggered by a distribution by NPTest Holding, LLC to its members, the payment to Schlumberger was required to be in the same form and
could have been made in cash, stock or both. This contingent liability was required to be marked to market at the end of each fiscal period until settled using the Companys closing stock price on the last day of the fiscal period, and the
changes in carrying value flow through other income and expense, net in the condensed consolidated statements of operations. In May 2005, the Company and Schlumberger reached a settlement, which required the Company to pay Schlumberger $4.0 million
in cash and 615,157 shares of the Companys common stock valued at $5.0 million. As of July 31, 2005, the Company had fulfilled its obligation to Schlumberger and there were no outstanding liabilities related to this transaction.



10. Goodwill and Other Intangible Assets



Effective November 1, 2002, the Company adopted Statement of Financial
Accounting Standard No. 142, Goodwill and Other Intangible Assets, (SFAS 142), which was issued by the FASB in July 2001. Under this standard, the Company ceased amortizing goodwill effective November 1, 2002.



SFAS 142 makes use of the concept of reporting units. All acquisitions must
be assigned to a reporting unit or units. Reporting units have been defined under the standards to be the same as or one level below an operating segment, as defined in Statement of Financial Accounting Standard No. 131, Disclosures About
Segments of an Enterprise and Related Information, (SFAS 131). A reporting unit would be one level below the operating segment if a component of an operating segment is a business as described under U.S. Generally Accepted Accounting
Principles and (1) is a separable unit that engages in business activities for which discrete financial information is available, (2) has economic characteristics different from other components of the operating segment, and (3) operating results of
the component are reviewed regularly by the segment manager. The Company operates in one industry segment, ATE. The Company also has a single reporting unit for purposes of SFAS 142, ATE, primarily because all of the components of the Companys
ATE segment are subject to similar economic characteristics. In addition, all the Companys products have common production processes, customers, and product life cycles.



The Company tests goodwill for possible impairment on an annual basis and at any other time if events occur or circumstances
indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business climate or legal factors; unanticipated
competition; loss of key personnel, a significant change in direction with respect to investment in a product or market segment; the likelihood that a significant portion of the business will be sold or disposed of; or the results of testing for
recoverability of a significant asset group within a reporting unit determined in accordance with SFAS 142.



The impairment test for goodwill involves a two-step process: step one consists of a comparison of the fair value of a reporting unit with its carrying
amount, including the goodwill allocated to each reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied fair value of the reporting unit goodwill with the carrying amount of the
reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair value of the reporting unit goodwill will be recorded as an impairment loss.



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As mandated by SFAS 142, the Company completed its annual goodwill impairment test as of July 31, 2004
during the fourth quarter of the fiscal year. The Company most recently reviewed goodwill for impairment again at the end of January 2005, largely as a result of lower revenues than in the preceding two quarters. In all such tests to date, the
Company determined that the sum of the expected future discounted cash flows from the assets exceeded the carrying value of those assets; therefore, no impairment of goodwill was recognized.



The determination as to whether a write-down of goodwill is necessary
involves significant judgment based on short-term and long-term projections of the future performance of the reporting unit to which the goodwill is attributed. The assumptions supporting the estimated future cash flows of the reporting unit,
including discount rate used and estimated terminal value, reflect the Companys best estimates.



The Company evaluates the carrying value of its long-lived assets, consisting primarily of its facilities, purchased intangible assets, and property and
equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Such events or circumstances include, but are not limited to, a prolonged industry downturn, a significant
decline in the Companys market value, or significant reductions in projected future cash flows. In assessing the recoverability of the Companys long-lived assets, the Company compares the carrying value to the undiscounted future cash
flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, such assets are written down based on the excess of the carrying amount over the fair value of the assets.
Fair value is generally determined by calculating the discounted future cash flows using a discount rate based upon the Companys weighted average cost of capital. Significant judgments and assumptions are required in the forecast of future
operating results used in the preparation of the estimated future cash flows, including profit margins, long-term forecasts of the amounts and timing of overall market growth and the Companys percentage of that market, groupings of assets,
discount rates and terminal growth rates. In addition, significant estimates and assumptions are required in the determination of the fair value of the Companys tangible long-lived assets, including replacement cost, economic obsolescence, and
the value that could be realized in liquidation. Changes in these estimates could have a material adverse effect on the assessment of the Companys long-lived assets, thereby requiring the Company to write down the assets. The purchased
intangibles consist of purchased technology, customer relations, trademarks, patents and non-compete agreements and they typically have estimated useful lives of one to ten years.



Other intangible assets subject to amortization were as follows (in thousands):



|                       |  |      |         |                          |   |         |     |  |   |        
|---------------------- |  | ---- | ------- | ------------------------ | - | ------- | --- |  | - | -------
|July 31, 2005          |  | Cost |         | Accumulated Amortization |   |         | Net
|Developed technology   |  | $    | 125,206 |                          | $ | (45,451 | )   |  | $ | 79,755 
|Customer relations     |  |      | 19,802  |                          |   | (9,444  | )   |  |   | 10,358 
|Maintenance contracts  |  |      | 13,800  |                          |   | (3,220  | )   |  |   | 10,580 
|Product backlog        |  |      | 4,900   |                          |   | (4,900  | )   |  |   |       
|Trademarks             |  |      | 2,053   |                          |   | (2,053  | )   |  |   |       
|Patents                |  |      | 862     |                          |   | (862    | )   |  |   |       
|Non-compete agreements |  |      | 750     |                          |   | (750    | )   |  |   |       
|                       |  |      |         |                          |   |         |     |  |   |        
|Total                  |  | $    | 167,373 |                          | $ | (66,680 | )   |  | $ | 100,693
|                       |  |      |         |                          |   |         |     |  |   |        



|                       |  |      |         |                         |   |         |     |  |   |        
|---------------------- |  | ---- | ------- | ----------------------- | - | ------- | --- |  | - | -------
|October 31, 2004       |  | Cost |         | AccumulatedAmortization |   |         | Net
|Developed technology   |  | $    | 125,206 |                         | $ | (36,328 | )   |  | $ | 88,878 
|Customer relations     |  |      | 19,802  |                         |   | (7,735  | )   |  |   | 12,067 
|Maintenance contracts  |  |      | 13,800  |                         |   | (1,150  | )   |  |   | 12,650 
|Product backlog        |  |      | 4,900   |                         |   | (2,042  | )   |  |   | 2,858  
|Trademarks             |  |      | 2,053   |                         |   | (1,848  | )   |  |   | 205    
|Patents                |  |      | 862     |                         |   | (732    | )   |  |   | 130    
|Non-compete agreements |  |      | 750     |                         |   | (656    | )   |  |   | 94     
|                       |  |      |         |                         |   |         |     |  |   |        
|Total                  |  | $    | 167,373 |                         | $ | (50,491 | )   |  | $ | 116,882
|                       |  |      |         |                         |   |         |     |  |   |        



Amortization expenses
for the other intangible assets were $4.7 million and $4.7 million for the third quarter of fiscal 2005 and 2004, respectively. Amortization expenses for the other intangible assets were $16.2 million and $9.6 million for the nine months ended July
31, 2005 and 2004, respectively.



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The following schedule represents the breakdown of amortization expenses by intangible assets (in
thousands):



|                           |  |                            |       |                           |   |       |  |      |        |  |   |      
|-------------------------- |  | -------------------------- | ----- | ------------------------- | - | ----- |  | ---- | ------ |  | - | -----
|                           |  | Three Months EndedJuly 31, |       | Nine Months EndedJuly 31,
|                           |  | 2005                       |       | 2004                      |   | 2005  |  | 2004
|Developed technology       |  | $                          | 2,995 |                           | $ | 2,762 |  | $    | 9,123  |  | $ | 6,193
|Customer relations         |  |                            | 570   |                           |   | 425   |  |      | 1,709  |  |   | 1,457
|Maintenance contracts      |  |                            | 690   |                           |   | 460   |  |      | 2,070  |  |   | 460  
|Product backlog            |  |                            | 408   |                           |   | 817   |  |      | 2,859  |  |   | 817  
|Trademarks                 |  |                            |      |                           |   | 103   |  |      | 205    |  |   | 308  
|Patents                    |  |                            | 43    |                           |   | 43    |  |      | 129    |  |   | 129  
|Non-compete agreements     |  |                            |      |                           |   | 94    |  |      | 94     |  |   | 281  
|                           |  |                            |       |                           |   |       |  |      |        |  |   |      
|Total amortization expense |  | $                          | 4,706 |                           | $ | 4,704 |  | $    | 16,189 |  | $ | 9,645
|                           |  |                            |       |                           |   |       |  |      |        |  |   |      



The estimated future
amortization expense of purchased intangible assets with definite lives for the next five years is as follows (in thousands):



|                         |  |        |        
|------------------------ |  | ------ | -------
|Year Ending October 31,  |  | Amount
|Remainder of fiscal 2005 |  | $      | 4,254  
|2006                     |  |        | 16,604 
|2007                     |  |        | 16,466 
|2008                     |  |        | 14,518 
|2009                     |  |        | 12,718 
|Thereafter               |  |        | 36,133 
|                         |  |        |        
|Total                    |  | $      | 100,693
|                         |  |        |        



11. Net Loss Per Share



Basic net income (loss) per share is based upon the
weighted average number of common shares outstanding during the period. Diluted net income per share is based upon the weighted average number of common shares and dilutive-potential common shares outstanding during the period.



The following table sets forth the computation of basic and diluted income
(loss) per share for periods indicated (in thousands, except per share amounts):



|                                                              |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------- |  | -------------------------- | ------- | - | ------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                              |  | Three Months EndedJuly 31, |         |   | Nine Months EndedJuly 31, |  
|                                                              |  | 2005                       |         |   | 2004                      |   |         | 2005 |  |   | 2004    |  
|Numerator:                                                    |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Numerator for basic and diluted net loss per share  net loss |  | $                          | (41,677 | ) |                           | $ | (33,165 | )    |  | $ | (97,452 | ) |  | $ | (40,382 | )
|                                                              |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Denominator:                                                  |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Denominator for basic and diluted net loss per share          |  |                            | 96,638  |   |                           |   | 78,647  |      |  |   | 92,010  |   |  |   | 69,407  |  
|                                                              |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Basic net loss per share                                      |  | $                          | (0.43   | ) |                           | $ | (0.42   | )    |  | $ | (1.06   | ) |  | $ | (0.58   | )
|                                                              |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Diluted net loss per share                                    |  | $                          | (0.43   | ) |                           | $ | (0.42   | )    |  | $ | (1.06   | ) |  | $ | (0.58   | )
|                                                              |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  



At July 31, 2005 and
2004, there were options to purchase 18,712,261 and 18,398,552 shares of common stock outstanding at a weighted average exercise price of $12.90 and $15.61, respectively, which were excluded from the diluted net loss per share calculation for the
three and nine months ended July 31, 2005 and 2004 as their effect was anti-dilutive in each respective period. There were also 15,915,119 shares issuable under the terms of the convertible subordinated notes issued in June 2003 that were excluded
from the diluted net loss per share calculation for the three and nine months ended July 31, 2005 and 2004 as their effect would be anti-dilutive. The Company excluded 1,953,802 and 6,090,141 shares of the converted preferred stock from the diluted
net loss per share calculation for the three and nine months ended July 31, 2005 as their effect would be anti-dilutive. For the three and nine months ended July 31, 2004, the Company excluded 8,710,141 and 2,924,573 shares of the non-voting
convertible preferred stock from the diluted net loss per share calculation as their effect would be anti-dilutive.



12. Recent Accounting Pronouncements



In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123R, Share-Based Payment, (SFAS 123R). SFAS 123R revised
SFAS 123. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107) which provides the Staffs views regarding interactions between SFAS No. 123(R) and certain SEC rules and regulations and
provides interpretations of the valuation of share-based payments for public companies. SFAS No. 123(R) requires that the costs resulting from share-based payment transactions be recognized in the



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financial statements. The statement requires companies to use a fair-value-based payment measurement method in accounting for share-based payment with
employees as well as for goods and services received from non-employees. SFAS 123R is effective for annual reporting periods that begin after June 15, 2005, with early adoption permitted. The Company expects to adopt SFAS 123R using the modified
prospective method effective November 1, 2005.



SFAS 123R
permits companies to adopt its requirements using either a modified prospective method, or a modified retrospective method. Under the modified prospective method, compensation cost is recognized in the financial
statements beginning with the effective date, based on the requirements of SFAS 123R for all share-based payments granted after that date, and based on the requirements of SFAS 123 for all unvested awards granted or modified after the effective date
of SFAS 123 (December 15, 1994). Under the modified retrospective method, the requirements are the same as under the modified prospective method, but it also requires entities to restate financial statements of previous
periods based on proforma disclosures made in accordance with SFAS 123. The Company currently utilizes a standard option pricing model (i.e., Black-Scholes-Merton) to measure the fair value of stock options granted to employees. While SFAS 123R
permits entities to continue to use such a model, the standard also permits the use of open form models such as lattice model. The Company has not yet determined which model it will use to estimate the fair value of employee stock
options upon the adoption of SFAS 123R. The Company believes that the adoption of SFAS 123R will have a material effect on its results of operations. See Note 6, Stock-Based Compensation for the possible effect of adopting SFAS 123R on
the Companys financial position and results of operations. The Company, however, has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosure under FAS No. 123.



In December 2004, the FASB issued FASB Staff Position No. FAS 109-2,
Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP FAS 109-2). The American Jobs Creation Act introduces a special one-time dividends received
deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. The Company currently has no plans to repatriate foreign earnings.



In May 2005, the FASB issued Statement of Financial Accounting Standard No.
154, Accounting Changes and Error Corrections (SFAS 154) effective with fiscal years beginning after December 15, 2005. This statement replaces APB Opinion No. 20,Accounting Changes, and Statement of Financial Accounting
Standard No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in
accounting principle and changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. Under this pronouncement changes are required to be retrospectively applied to
prior financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Retrospective application means the application of a different accounting principle to prior accounting
periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity. This statement requires that the retrospective application of a change in accounting
principle be limited to the direct effects of the change. This statement also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected
by a change in accounting principle. The Company does not believe the adoption of SFAS 154 will have a material effect on its consolidated financial position or results of operations.



13. Contingencies and Guarantees



The Companys corporate by-laws require that the Company indemnifies its officers and directors, as well as those who act as directors and officers
of other entities at the Companys request, against expenses, judgments, fines, settlements and other amounts actually and reasonably incurred in connection with any proceedings arising out of their services to Credence. In addition, the
Company has entered into separate indemnification agreements with each director and each executive officer of Credence that provide for indemnification of these directors and officers under similar circumstances and under additional circumstances.
The indemnification obligations are more fully described in the by-laws and the indemnification agreements. The Company purchases standard directors and officers insurance to cover claims or a portion of the claims made against its directors and
officers. Since a maximum obligation is not explicitly stated in the Companys by-laws or in the indemnification agreements and will depend on the facts and circumstances that arise out of any future claims, the overall maximum amount of the
obligations cannot be reasonably estimated. Historically, no claims have arisen that would have required the Company to make payments related to these obligations, and the Company is not aware of any such claims pending as of July 31, 2005.



As is customary in the Companys industry and as provided
for under local law in the U.S. and other jurisdictions, many standard contracts provide remedies to customers and others with whom the Company enters into contracts, such as defense, settlement, or payments of judgments for intellectual property
claims related to the use of the Companys products. From time to time, the Company indemnifies customers, as well as the Companys suppliers, contractors, lessors, lessees, companies that purchase the Companys businesses or assets
and others with whom the Company enters into contracts, against combinations of loss, expense, or liability arising from various triggering events related to the sale and the use of the



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Companys products and services, the use of their goods and services, the use of facilities and state of the Companys owned facilities, the state
of the assets and businesses that the Company sells and other matters covered by such contracts, usually up to a specified maximum amount. Based on past experience, claims made under such indemnifications are rare and the associated estimated fair
value of the liability is not material.



The Company has
obligations to allow trade-in rights. As of July 31, 2005, the Company had approximately $1.6 million, the estimated fair value of these obligations, included in the condensed consolidated balance sheet under current liabilities.



The Company leases some of its facilities and equipment under operating
leases that expire periodically through 2013 of which $9.3 million represented the net present value of the lease commitment for the San Jose, California lease and $0.7 million for the Austin, Texas lease commitment have been written-off to special
operating charges during the third quarter of fiscal 2005 and first quarter of fiscal 2004, respectively, net of estimated sublease income. See Note 15, Restructuring and Special Charges for further discussion.



Some of the components that the Company purchases are unique to the Company
and must be purchased in relatively high minimum quantities with long (in excess of three months) lead times. These business circumstances can lead to the Company holding relatively high inventory levels and associated risks. In addition, purchase
commitments for unique components are relatively inflexible in terms of deferral or cancellation. At July 31, 2005, the Company had open and committed purchase orders totaling approximately $44.9 million.



The following summarizes the Companys minimum contractual cash
obligations and other commitments at July 31, 2005, and the effect of such obligations in future periods (in thousands):



|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      
|------------------------------------------------------------------------------------------- |  | ----- | ------- | ---------------------- | - | ----------- |  | ----------- | ------ | ----------- | - | ----------- |  | ---------- | ------- |  | - | ----- |  | - | -----
|                                                                                            |  | Total |         | Remainderof Fiscal2005 |   | Fiscal 2006 |  | Fiscal 2007 |        | Fiscal 2008 |   | Fiscal 2009 |  | Thereafter
|Contractual Obligations:                                                                    |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      
|Facilities and equipment operating leases(1)                                                |  | $     | 26,163  |                        | $ | 1,698       |  | $           | 6,617  |             | $ | 5,711       |  | $          | 4,868   |  | $ | 4,696 |  | $ | 2,573
|Bank note(2)                                                                                |  |       | 5,000   |                        |   |            |  |             | 5,000  |             |   |            |  |            |        |  |   |      |  |   |     
|Interest on bank note                                                                       |  |       | 78      |                        |   | 52          |  |             | 26     |             |   |            |  |            |        |  |   |      |  |   |     
|Convertible subordinated notes(3)                                                           |  |       | 180,000 |                        |   |            |  |             |       |             |   |            |  |            | 180,000 |  |   |      |  |   |     
|Interest on convertible subordinated notes                                                  |  |       | 6,863   |                        |   | 675         |  |             | 2,700  |             |   | 2,700       |  |            | 788     |  |   |      |  |   |     
|Residual value guarantees(4)                                                                |  |       | 780     |                        |   | 780         |  |             |       |             |   |            |  |            |        |  |   |      |  |   |     
|Trade-in commitments(4)                                                                     |  |       | 1,600   |                        |   | 1,600       |  |             |       |             |   |            |  |            |        |  |   |      |  |   |     
|Minimum payable for information technology outsourcing including fees for early termination |  |       | 2,635   |                        |   | 1,173       |  |             | 1,462  |             |   |            |  |            |        |  |   |      |  |   |     
|Open and non-cancelable purchase order commitments                                          |  |       | 44,923  |                        |   | 20,375      |  |             | 21,324 |             |   | 3,224       |  |            |        |  |   |      |  |   |     
|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      
|Total contractual cash and other obligations                                                |  |       | 268,042 |                        |   | 26,353      |  |             | 37,129 |             |   | 11,635      |  |            | 185,656 |  |   | 4,696 |  |   | 2,573
|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      

---

|(1) | Approximately $10.5 million of this total has been accrued for as restructuring charges in the condensed consolidated balance sheets as accrued expenses and other
liabilities.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | This amount is recorded in the condensed consolidated balance sheets as bank note.
|--- | ----------------------------------------------------------------------------------

|(3) | This amount is recorded in the condensed consolidated balance sheets as convertible subordinated notes.
|--- | -------------------------------------------------------------------------------------------------------

|(4) | This amount is recorded in the condensed consolidated balance sheets as accrued expenses and other liabilities and deferred profit.
|--- | -----------------------------------------------------------------------------------------------------------------------------------



The Company provides reserves for the estimated costs of product warranties
at the time revenue is recognized. The Company estimates the costs of warranty obligations based on historical experience of known product failure rates, use of materials to repair or replace defective products, and service delivery costs incurred
in correcting product failures. The warranty accrual is included in the accrued expenses and other liabilities in the condensed consolidated balance sheets.



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The following table represents the activity in the warranty accrual for the nine months ended July 31,
2005 and 2004 (in thousands):



|                                                 |  |                   |         |   |              |   |        |  
|------------------------------------------------ |  | ----------------- | ------- | - | ------------ | - | ------ | -
|                                                 |  | Nine Months Ended |        
|                                                 |  | July 31,2005      |         |   | July 31,2004 |  
|Beginning balance, November 1, 2004 and 2003     |  | $                 | 15,314  |   |              | $ | 5,501  |  
|Accruals for warranties issued during the period |  |                   | 11,753  |   |              |   | 13,882 |  
|Acquired pre-existing warranty obligations       |  |                   |        |   |              |   | 7,110  |  
|Adjustments of prior period accrual estimates    |  |                   |        |   |              |   | (464   | )
|Warranty claims made during the period           |  |                   | (14,785 | ) |              |   | (9,079 | )
|                                                 |  |                   |         |   |              |   |        |  
|Ending balance                                   |  | $                 | 12,282  |   |              | $ | 16,950 |  
|                                                 |  |                   |         |   |              |   |        |  



The Company
occasionally offers warranties in excess of one year. Revenues associated with warranties beyond one year are deferred and recognized over the relevant period. Costs that are directly related to services performed for warranties in excess of one
year are charged to expense as incurred.



Legal Proceedings



In March 2005, Roy Schmidt, a former employee, filed a complaint in the
Superior Court of Santa Clara County, California against the Company, alleging fraud and various other contractual and tort claims in connection with the termination of his employment by the Company. Mr. Schmidt alleges damages in excess of $3.0
million and seeks in addition punitive damages. Formal discovery has not yet commenced in this litigation. The Company intends to vigorously defend these claims and believe it possesses meritorious defenses to the claims.



The Company also is involved in various claims arising in the ordinary course
of business, none of which, in the opinion of management, if determined adversely against the Company, will have a material adverse effect on the Companys business, financial condition or results of operations.



14. Comprehensive Income (Loss)



The components of comprehensive income (loss), net of tax, are as follows
for the periods indicated (in thousands):



|                                                           |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|---------------------------------------------------------- |  | -------------------------- | ------- | - | -------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                           |  | Three Months EndedJuly 31, |         |   | Nine Months Ended July 31, |  
|                                                           |  | 2005                       |         |   | 2004                       |   |         | 2005 |  |   | 2004    |  
|Net loss                                                   |  | $                          | (41,677 | ) |                            | $ | (33,165 | )    |  | $ | (97,452 | ) |  | $ | (40,382 | )
|                                                           |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Unrealized gains (losses) on available-for sale securities |  |                            | 35      |   |                            |   | 239     |      |  |   | (295    | ) |  |   | (578    | )
|Currency translation adjustment                            |  |                            | (2,517  | ) |                            |   | 498     |      |  |   | (2,035  | ) |  |   | 478     |  
|                                                           |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Other comprehensive (loss) income                          |  |                            | (2,482  | ) |                            |   | 737     |      |  |   | (2,330  | ) |  |   | (100    | )
|                                                           |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  
|Total comprehensive loss                                   |  | $                          | (44,159 | ) |                            | $ | (32,428 | )    |  | $ | (99,782 | ) |  | $ | (40,482 | )
|                                                           |  |                            |         |   |                            |   |         |      |  |   |         |   |  |   |         |  



15. Restructuring and Special
Charges



Special charges  cost of goods sold



The Company reviews excess and obsolete inventory annually based on
information available from the strategic planning process and also on a quarterly basis identifying and addressing significant events that might have an impact on inventories and related reserves. See Note 1, Organization and Summary of
Significant Accounting Policies of the Notes to Consolidated Financial Statements in the Companys Annual Report on Form 10-K under the heading Inventories for further discussion of the Companys reserve methodology.



In the third quarter of fiscal
2005, the Company recorded special charges to cost of good sold of $23.0 million of which $17.6 million related to the write-downs of flash memory inventory (Kalos II) which resulted from the Companys decision to invest in the next generation
of the flash memory platform as well as the significant volatility in the flash memory market. In addition, in connection with the closure of the Companys Simi Valley manufacturing plant, the Company identified and wrote off $5.4 million for
certain components being phased out of the bill of materials of the Sapphire product that was not economical to rework. The Companys decision to market the Sapphire product as its sole solution for the high end SoC market required early
speculative investment, some of which became obsolete as market and product definitions evolved.



In the nine months ended July 31, 2005, the Company recorded special charges to cost of goods sold of $29.1 million of which $17.6 million related to the
write-downs of excess and obsolete Kalos II inventory, $5.4 million for certain components being phased out of the bill of materials of the Sapphire product that was not economical to rework, $4.8 million related to excess and obsolete Octet and
Vanguard II inventory, $1.6 million related to inventory liabilities, $0.6 million related to the write-off of Octet and Vanguard II property and equipment and $0.6 million related to the write-off of obsolete Duo inventory offset by sales of fully
reserved inventory of $1.5 million.



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In fiscal 2004, the Company recorded special charges to cost of goods sold of $49.6 million. Of this
$49.6 million, $45.0 million was directly related to inventory write-downs. These write-downs were made in connection with the acquisition of NPTest which resulted in duplicate product lines in the combined company. The Company evaluated the
redundant product lines using internal and external marketing data, the development roadmap for each product line, existing and potential customers and demand for the product. As a result of the evaluation, the Company identified production
inventory, finished goods and consignment and demonstration inventory in excess of estimated future customer demand of approximately $35.2 million; write-downs of inventory to estimated current market value of approximately $9.8 million; purchase
commitments of approximately $1.0 million; field service spares of approximately $0.9 million and other assets and expenses of approximately $2.7 million.



The total charges related to inventory write-downs from the fourth quarter of fiscal 2001, the fourth quarter of fiscal 2003, the third and fourth quarter
of fiscal 2004, and the first and third quarter of fiscal 2005 are approximately $120.2 million. Of this, approximately $36.2 million was scrapped, $1.2 million was written off and largely disposed of, $34.9 million was written down for lower of
cost or market provisions and $5.5 million was sold and the remaining $42.4 million was still on hand as of July 31, 2005.



|                                                                                  |  |         |        |   |         |   |        |         |  |   |         |   |         |   |       |         |   |       |   |  |   |       
|--------------------------------------------------------------------------------- |  | ------- | ------ | - | ------- | - | ------ | ------- |  | - | ------- | - | ------- | - | ----- | ------- | - | ----- | - |  | - | ------
|                                                                                  |  | Q4 FY01 |        |   | Q4 FY03 |   |        | Q3 FY04 |  |   | Q4 FY04 |   | Q1 FY05 |   |       | Q3 FY05
|Special charges                                                                   |  | $       | 38,003 |   |         | $ | 9,440  |         |  | $ | 41,620  |   |         | $ | 3,359 |         | $ | 4,774 |   |  | $ | 23,000
|FY02 Scrapping                                                                    |  |         | (6,205 | ) |         |   |       |         |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|FY02 Write-off and largely disposed                                               |  |         | (1,150 | ) |         |   |       |         |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|FY02 Donation                                                                     |  |         | (91    | ) |         |   |       |         |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|                                                                                  |  |         |        |   |         |   |        |         |  |   |         |   |         |   |       |         |   |       |   |  |   |       
|10/31/02 Balance                                                                  |  |         | 30,557 |   |         |   | 9,440  |         |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|FY03 Scrapping                                                                    |  |         | (7,538 | ) |         |   | (3,134 | )       |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|                                                                                  |  |         |        |   |         |   |        |         |  |   |         |   |         |   |       |         |   |       |   |  |   |       
|10/31/03 Balance                                                                  |  |         | 23,019 |   |         |   | 6,306  |         |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|FY04 Scrapping                                                                    |  |         | (7,989 | ) |         |   |       |         |  |   | (6,090  | ) |         |   |      |         |   |      |   |  |   |      
|FY04 Sale of fully reserved inventory                                             |  |         | (2,341 | ) |         |   |       |         |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|FY04 Kalos lower of cost or market adjustment on fully reserved inventory         |  |         | (7,215 | ) |         |   |       |         |  |   |        |   |         |   |      |         |   |      |   |  |   |      
|FY04 Octet-Quartet lower of cost or market adjustment on fully reserved inventory |  |         |       |   |         |   |       |         |  |   | (21,123 | ) |         |   |      |         |   |      |   |  |   |      
|                                                                                  |  |         |        |   |         |   |        |         |  |   |         |   |         |   |       |         |   |       |   |  |   |       
|10/31/04 Balance                                                                  |  |         | 5,474  |   |         |   | 6,306  |         |  |   | 14,407  |   |         |   | 3,359 |         |   |      |   |  |   |      
|FY05 Scrapping                                                                    |  |         | (1,914 | ) |         |   | (223   | )       |  |   | (2,806  | ) |         |   |      |         |   | (300  | ) |  |   |      
|FY05 Sale of fully reserved inventory                                             |  |         | (220   | ) |         |   | (106   | )       |  |   | (2,815  | ) |         |   |      |         |   |      |   |  |   |      
|FY05 Octet lower of cost or market adjustment on fully reserved inventory         |  |         |       |   |         |   |       |         |  |   | (6,523  | ) |         |   |      |         |   |      |   |  |   |      
|                                                                                  |  |         |        |   |         |   |        |         |  |   |         |   |         |   |       |         |   |       |   |  |   |       
|07/31/05 Balance                                                                  |  | $       | 3,340  |   |         | $ | 5,977  |         |  | $ | 2,263   |   |         | $ | 3,359 |         | $ | 4,474 |   |  | $ | 23,000
|                                                                                  |  |         |        |   |         |   |        |         |  |   |         |   |         |   |       |         |   |       |   |  |   |       



Restructuring  operating
expenses



During the third quarter of fiscal 2005, the
Company recorded restructuring charges of approximately $9.7 million as operating expenses. Of these charges, $9.6 million related primarily to the San Jose, California building lease, which we vacated during the quarter and $1.2 million related to
headcount reduction of 47 employees. The additional charges were offset by the Companys adjustment of the previous over accrued restructuring charges of $0.6 million and $0.7 million of deferred rent write-off for the San Jose lease. The
severance charges of $1.2 million included $1.1 million resulted from transferring the Companys Taiwan employees in May 2005 into Credence Spirox Integration Corporation, an operation owned 90% by the Companys Taiwan distributor and 10%
by the Company.



For the nine months ended July 31, 2005, the
Company recorded restructuring charges of approximately $11.4 million as operating expenses related to headcount reductions, the write-off of property and equipment, and facilities. The severance and other related charges amounted to $2.1 million,
which accounted for headcount reduction of 66 employees. The affected employees were primarily in research and development and selling general and administrative functions. The property and equipment write off, amounting to $1.1 million, resulted
from the Companys decision to halt additional research and development investment in one of its products that was rendered redundant by the acquisition of NPTest. The operating lease charges of $9.6 million, which are net of expected sublease
rentals, resulted from vacating the former NPTest headquarters facilities in San Jose. The lease on these facilities expires in October 2009. The additional charges were offset by the Companys adjustment of the previous over accrued
restructuring charges of $0.6 million and $0.7 million of deferred rent write-off for the San Jose lease.



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In January 2004, the Company relocated its corporate headquarters to its owned facilities in Milpitas,
California and vacated its previously leased buildings in Fremont, California. The lease for three of the buildings expired at the end of December 2003. The lease on the final building, consisting of 27,000 square feet, expired in June 2005. During
the quarter ended January 31, 2004, a special charge was recorded in the amount of $0.7 million to write-off the remaining lease payments for this lease, net of expected sublease income.



The following table illustrates the activity for the nine-month period ended July 31, 2005 and the estimated timing of
future payouts for major restructuring categories (in thousands):



|                                    |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   |        |  
|----------------------------------- |  | -------------------------- | ------ | - | ------- | - | ------- | -------- |  | - | ----------- | - |  | ------------------------ | --- | - |  | - | ------ | -
|                                    |  | Balance atOctober 31, 2004 |        |   | Charges |   |         | Utilized |  |   | Adjustments |   |  | Balance at July 31, 2005 |    
|Severance                           |  | $                          | (3,019 | ) |         | $ | (2,080  | )        |  | $ | 3,981       |   |  | $                        | 618 |   |  | $ | (500   | )
|Operating leases                    |  |                            | (1,043 | ) |         |   | (9,561  | )        |  |   | 1,799       |   |  |                          | (44 | ) |  |   | (8,849 | )
|Property and equipment              |  |                            |       |   |         |   | (1,089  | )        |  |   | 1,089       |   |  |                          |    |   |  |   |       |  
|Other liabilities                   |  |                            | (32    | ) |         |   | (30     | )        |  |   | 30          |   |  |                          | 32  |   |  |   |       |  
|Deferred rent write-off             |  |                            |       |   |         |   | 709     |          |  |   | (709        | ) |  |                          |    |   |  |   |       |  
|                                    |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   |        |  
|Total                               |  | $                          | (4,094 | ) |         | $ | (12,051 | )        |  | $ | 6,190       |   |  | $                        | 606 |   |  | $ | (9,349 | )
|                                    |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   |        |  
|Estimated timing of future payouts: |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   |        |  
|Fiscal 2005                         |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   | 1,403  |  
|Fiscal 2006                         |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   | 2,662  |  
|Fiscal 2007                         |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   | 1,880  |  
|Fiscal 2008                         |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   | 1,853  |  
|Fiscal 2009                         |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   | 1,551  |  
|                                    |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   |        |  
|Total                               |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  | $ | 9,349  |  
|                                    |  |                            |        |   |         |   |         |          |  |   |             |   |  |                          |     |   |  |   |        |  



16. Employee Benefit Plans



Outside of the U.S., the Company also assumed several
defined benefit and defined contribution plans that cover substantially all employees as part of its acquisition of NPTest in May 2004. Where applicable, employees are covered by statutory plans. For defined benefit plans, charges to expense are
based upon costs computed by independent actuaries. These plans are substantially fully funded with trustees in respect to past and current service. At July 31, 2005, the pension asset and liability was $0.7 million. The expenses associated with
these plans were not material for the nine months ended July 31, 2005.



The Company has a deferred compensation plan for certain employees. The assets in the plan consisting of cash equivalents and debt and equity securities, are recorded at current market prices. The plan assets are available to satisfy claims
of the Companys general creditors in the event of its bankruptcy. The plans assets of approximately $2.6 million at July 31, 2005 are included in other assets, and the corresponding deferred compensation liability is included in the
other liabilities in the accompanying condensed consolidated balance sheets.



17. Industry Segment



Operating segments are
business units that have separate financial information and are separately reviewed by the Companys chief decision makers. The Companys chief decision makers are the Chief Executive Officer and Chief Financial Officer. The Company and
its subsidiaries currently operate in a single industry segment: the design, development, manufacture, sale and service of advanced semiconductor test and diagnostic systems used in the production of semiconductors. The Company has a single
reporting unit for purposes of SFAS No. 131, Disclosure About Segments of an Enterprise and Related Information, ATE, primarily because all of the components of the Companys ATE segment are subject to similar economic
characteristics, have similar production processes, have common customers, and are distributed using the same channels. The acquisition of NPTest did not change the Company products economic characteristics; thus, the Company determined that
it still operates as a single reporting unit.



Starting in the
second quarter of fiscal 2005, the Companys chief decision makers reviewed the breakdown of revenues using different product line groupings; therefore, the table below represents the Companys revised revenue by product line. The
Companys net sales by product line consisted of:



|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|----------------------------- |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                              |  | Three Months Ended July 31, |   |  | Nine Months Ended July 31, |  
|                              |  | 2005                        |   |  | 2004                       |   |  | 2005 |   |  | 2004 |  
|SoC                           |  | 36                          | % |  | 27                         | % |  | 37   | % |  | 23   | %
|Analog Mixed Signal           |  | 21                          |   |  | 25                         |   |  | 20   |   |  | 34   |  
|Memory                        |  | 3                           |   |  | 31                         |   |  | 3    |   |  | 24   |  
|Design Characterization Group |  | 12                          |   |  | 1                          |   |  | 12   |   |  | 4    |  
|Service                       |  | 28                          |   |  | 16                         |   |  | 28   |   |  | 15   |  
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|Total                         |  | 100                         | % |  | 100                        | % |  | 100  | % |  | 100  | %
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  



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Most of the Companys products are manufactured in the U.S. Export sales from the U.S. are primarily
denominated in U.S. dollars but occasionally denominated in Japanese Yen or in the Euro. The Automotive product, which is included in Analog Mixed Signal product line, is manufactured in Germany and these sales are denominated in U.S. dollars,
Japanese Yen and the Euro. All of the Companys products are shipped to the Companys customers throughout North America, Asia Pacific, Europe, and the Middle East. Sales by the Company to customers in different geographic areas, expressed
as a percentage of revenue, for the periods ended were:



|                     |  |                            |   |  |                            |   |  |      |   |  |      |  
|-------------------- |  | -------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                     |  | Three Months EndedJuly 31, |   |  | Nine Months Ended July 31, |  
|                     |  | 2005                       |   |  | 2004                       |   |  | 2005 |   |  | 2004 |  
|North America        |  | 28                         | % |  | 21                         | % |  | 34   | % |  | 25   | %
|Taiwan               |  | 11                         |   |  | 25                         |   |  | 7    |   |  | 23   |  
|China                |  | 7                          |   |  | 6                          |   |  | 6    |   |  | 7    |  
|Southeast Asia       |  | 24                         |   |  | 21                         |   |  | 18   |   |  | 21   |  
|Rest of Asia Pacific |  | 9                          |   |  | 4                          |   |  | 12   |   |  | 5    |  
|Europe & Middle East |  | 21                         |   |  | 23                         |   |  | 23   |   |  | 19   |  
|                     |  |                            |   |  |                            |   |  |      |   |  |      |  
|Total net sales      |  | 100                        | % |  | 100                        | % |  | 100  | % |  | 100  | %
|                     |  |                            |   |  |                            |   |  |      |   |  |      |  



For the three months
ended July 31, 2005, two customers accounted for 25% and 17% of the Companys net sales. For the nine months ended July 31, 2005, two customers accounted for 28% and 14% of the Companys net sales. For the three months ended July 31, 2004,
one customer accounted for 19% of the Companys net sales. For the nine months ended July 31, 2004, two customers accounted for 14% and 11% of the Companys net sales.



As of July 31, 2005, three customers accounted for 18%, 17%, and 13% of the Companys gross accounts receivable,
respectively. As of October 31, 2004, one customer accounted for 12% of the Companys gross accounts receivable.



As of July 31, 2005 and 2004, the majority of the Companys long-lived assets were attributable to its U.S. operations.



18. Subsequent Event



In August 2005, the Companys Board of Directors approved the accelerated vesting of certain unvested and
out-of-the-money non-qualified stock options previously awarded to employees and officers with option exercise prices equal to or greater than $9.15. Options held by non-employee directors are excluded from the vesting acceleration. In
addition, in order to prevent executive officers from unintended personal benefits, the Companys executive officers have agreed to the imposition of restrictions on any shares received through the exercise of accelerated options. Those
restrictions will prevent the sale of any shares received from the exercise of an accelerated option until the earlier of the original vesting date of the option or the executive officers termination of employment. The $9.15 price was selected
because it was higher than the closing price of the Companys common stock of $8.84 on August 29, 2005, the date of this acceleration. The accelerated options represent approximately 15 percent or approximately 5.5 million shares of the total
of all outstanding Credence options.



Under the recently
revised Financial Accounting Standards Board Statement No. 123R, Share-based Payment, Credence will be required to recognize the expense associated with its outstanding unvested stock options beginning in the first quarter of fiscal year
2006. As a result of the acceleration, the Company expects to reduce the stock option expense it otherwise would be required to record in connection with the accelerated options by approximately $12.6 million over the original option vesting period
subsequent to the effective date of FAS 123R. In making the decision to accelerate these options, the Board of Directors considered the interest of the stockholders in not having earnings materially affected and the impact that this may have on
Credences market value. In addition, because these options have exercise prices in excess of current market values, they are not fully achieving their original objectives of incentive compensation and employee retention.



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ITEM 2. - MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS



This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements
using terminology such as may, will, expects, plans, anticipates, goals, estimates, potential, or continue, or the negative thereof or other
comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. Forward-looking statements include statements regarding the continuing of certain revenue recognition practices; estimated future restructuring
payments; minimum contractual cash obligations and the effect of such obligations in future periods; sales, gross margins and operating results fluctuating in the future; our belief that the ability to effectively integrate NPTest will affect our
future sales, gross margins and operating results; our intention to continue to evaluate goodwill on an annual basis; our intention to evaluate other intangibles at such times as events and changes in circumstances suggest that the carrying amount
may not be recoverable from its estimated future undiscounted cash flow; our intention to vigorously defend claims brought by a former employee of the Company in connection with his termination and our belief that we possess meritorious defenses
against such claims; our belief that claims that have arisen in the ordinary course of business will not have a material adverse effect on our business, financial condition or results of operations; our anticipation that net sales will remain flat
or increase up to approximately to 7% for the fourth quarter of fiscal 2005, compared to the third quarter; our belief that gross margins will increase in the next several quarters; investment of significant resources in the development and
completion of new products and product enhancements; research and development expenses remaining approximately flat for the fourth quarter of fiscal 2005 as compared to the third quarter; selling, general and administrative expenses remaining
approximately flat in the next quarter as compared to the third quarter; our quarterly net sales and operating results depending upon our obtaining orders for systems to be shipped in the same quarter in which the order was received; remaining
estimated annual amortization expenses for purchased intangible assets and deferred compensation for the remainder of fiscal years ending in 2005 through 2007; our expectation that our top ten customers in the aggregate continue to account for a
large portion of our net sales for the foreseeable future; recording a full valuation allowance on domestic tax benefits; not recognizing any significant tax benefits in the future; investments in inventories continuing to represent a significant
portion of our working capital; the highly competitive nature of the automatic test equipment industry which is subject to rapid technological change; our belief that our current cash, investment positions and ability to borrow funds will be
sufficient to meet anticipated business requirements for the next 12 months and the foreseeable future; future minimum lease payments; minimum contractual cash obligations, other commitments and the effect of such obligations in future periods; the
impact of the adoption of certain accounting pronouncements on the Companys financial positions or results of operations; the Companys plan not to repatriate foreign earnings; our intention to introduce new products and product
enhancements in the future; our need for continued significant expenditures for research and development, marketing and other expenses for new products; our intention to pursue additional acquisitions of product lines, technologies and businesses;
our intention to develop new products that combine NPTests products and intellectual property with our products; our expectation that our existing cash and marketable securities will be sufficient to meet out cash requirements to fund
operations and expected capital expenditures for the foreseeable future; our expectation of continuing volatility in order activity; our expectation that our net revenues will decline during fiscal 2005 and may decline thereafter; our expectation
that we will adopt SFAS 123R, relating to share-based payments, effective November 1, 2005, and that such adoption will have a material effect on our results of operations; our belief that the adoption of SFAS 154, relating to retrospective changes
in accounting principles, will not have a material effect on our consolidated financial position or results of operations; our expectation that a 10% change in interest rate would not have any material effect on the Companys interest expense;
our anticipation that a significant portion of new orders may depend upon demand from semiconductor device manufacturers building or expanding fabrication facilities; our belief that it is probable that orders will be canceled and delayed in the
future; our intention to continue to devote significant resources to new products and technologies; our intention to continue to invest significant resources in property, plant and equipment, purchased and leased facilities, inventory, personnel and
other costs; our anticipation that international sales will continue to account for a significant portion of our total net sales; and those described under the heading Risk Factors as well as risks described immediately prior to or
following some forward-looking statements.



These
forward-looking statements involve important factors that could cause our actual results to differ materially from those in the forward-looking statements. Such important factors involve risks and uncertainties including, but not limited to,
difficulties in integrating NPTest technology with Credence technology; difficulties in utilizing different technologies; delays in bringing products to market due to development problems; difficulties in developing new engineering validation test
systems; the possibility that our existing systems will become obsolete; excessively high costs in the future related to enhancing our existing systems; significant changes in customer preferences; difficulties in integrating acquired technology
with our software product lines; the possibility that competitors will introduce products faster than us; unanticipated difficulties in building close working relationships with vendors; difficulties in developing the Sapphire platform; less sales
of the Sapphire platform products than anticipated; product defects sustained during the manufacturing process; the risk that we may not be successful in obtaining new orders from major customers; unanticipated decreases in demand for our products
in foreign countries; difficulties in providing extensive support to major customers; unanticipated difficulties in manufacturing and delivering new products, enhancements and related software tools; unanticipated difficulties in integrating



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our products with customers operations; unanticipated difficulties in integrating developed technology; substantial technological changes in the
semiconductor industry; increased competition with regards to our software solutions; a lack of the required resources to invest in the development of new products; uncertainties as to the current products provided by our competitors; unanticipated
difficulties in locating and evaluating potential product lines, technologies and business to acquire; the viability of legal claims brought against us; our failure to accurately predict the effect of the ultimate outcome of claims on our business,
financial condition or results of operations; unanticipated difficulties in implementing the reduction in force and the Facilities Restructuring Plan; unanticipated costs arising from the implementation of the Facilities Restructuring Plan; delays
in executing the Facilities Restructuring Plan; the need for additional restructuring actions; lower than expected revenues; the risk that we may be required to expend more cash in the future than anticipated; difficulties in obtaining orders from
manufacturers of semiconductors and companies that specialize in contract packaging and/or testing of semiconductors; the timing of orders; unanticipated order cancellations for the Kalos II product; an unanticipated lack of resources to invest in
property, plant and equipment, purchased and leased facilities, inventory, personnel and other costs; changing market conditions in Taiwan; uncertainties as to the nature and extent of any potential cyclical downturn in the semiconductor industry;
uncertainties of the assumptions regarding anticipated amortization of intangible assets as a result of the NPTest acquisition; uncertainties as to the prospect of future orders and sales levels; changes in laws applicable to us regarding revenue
recognition practices relating to our new products; uncertainties as to the future level of sales and revenues; unanticipated budgetary constraints; uncertainties as to the assumptions underlying our calculations regarding estimated annual
amortization expenses for purchased intangible assets and deferred compensation; uncertainties as to the effects of the adoption by us of certain accounting policies; the risk that our future working capital will not be sufficient to invest
significant portions of such working capital in inventories; uncertainties as to the effect of the adoption of certain accounting pronouncements; unanticipated difficulties in the remediation of internal control deficiencies; ability of the Company
to maintain the requisite level of assets under its deferred compensation plan; increased fragmentation in the ATE industry and other factors set forth in Risk Factors and elsewhere herein. Reference is made to the discussion of risk
factors detailed in our filings with the Securities and Exchange Commission, including our reports on Form 10-K and 10-Q. All projections in this quarterly report on Form 10-Q are based on limited information currently available to us, which is
subject to change. Although any such projections and the factors influencing them will likely change, we will not necessarily update the information, since we are only to provide guidance at certain points during the year. Actual events or results
could differ materially and no reader of this Form 10-Q should assume that the information provided today would still be valid in the future. Such information speaks only as of the date of this Form 10-Q.



OVERVIEW



We design, manufacture, sell and service engineering validation test equipment, diagnostics and failure analysis products
and automatic test equipment, or ATE, used for testing semiconductor integrated circuits, or ICs. We serve a broad spectrum of the semiconductor industrys testing needs through a wide range of products that test digital logic, mixed-signal,
system-on-a-chip, radio frequency, volatile, and static and non-volatile memory semiconductors. We utilize our proprietary technologies to design products which are intended to provide a lower total cost of ownership than many competing products
currently available while meeting the increasingly demanding performance requirements of todays engineering validation test, diagnostics and failure analysis and ATE markets. Our hardware products are designed to test semiconductors at two
stages of their lifecycle: first, at the prototype stage; and second, as they are produced in high volume. Our software products enable design and test engineers to develop and troubleshoot production test programs prior to fabrication of the device
prototype. Our customers include major semiconductor manufacturers, fabless design houses, foundries and assembly and test services companies.



Major business developments during the third quarter of fiscal 2005 included:



| |  |  | Completion of the transfer of all our manufacturing from the Simi Valley, California facility to Hillsboro, Oregon;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | Completion of the move of personnel from the former NPTest headquarters in San Jose to our Milpitas facilities;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | Settled a liability with Schlumberger for $4.0 million in cash and 615,157 shares of our common stock, which was valued at $5.0 million for a total settlement value of $9.0 million;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Executed an agreement to combine the Companys Taiwan operations with Spiroxs T1 test division into Credence Spirox Integration Corporation, an operation owned 90% by our
Taiwan distributor and 10% by us;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Continued growth in revenue from our Design and Characterization Group;
| | - |  | -----------------------------------------------------------------------



| |  |  | Improvement in revenue from our Analog Mixed Signal and Service product lines;
| | - |  | ------------------------------------------------------------------------------



| |  |  | Write down of Flash memory (Kalos II) and Sapphire inventories in the amount of $23.0 million;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | Incurred significant development costs on our next generation flash memory tester; and
| | - |  | --------------------------------------------------------------------------------------



| |  |  | Incurred significant increases in Sarbanes-Oxley related costs.
| | - |  | ---------------------------------------------------------------



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The ATE industry is a very competitive marketplace mired in a cyclical downturn of unprecedented length
and depth. Our revenue remained relatively weak throughout fiscal 2002 and began to grow sequentially beginning in the second quarter of fiscal 2003; however, the down turn started again in the fourth quarter of fiscal 2004 and continued through the
first quarter of fiscal 2005. There have been recent sequential improvements in the business environment; however, there is uncertainty as to the strength and length of the next cyclical growth phase. Due to continued low visibility, until such time
as we return to a period of sustainable profitability, we maintain a cautious outlook for future orders and sales levels.



Our sales, gross margins and operating results have in the past fluctuated significantly and will, in the future, fluctuate significantly depending upon a
variety of factors. The factors that have caused and we believe will continue to cause our results to fluctuate include cyclicality or downturns in the semiconductor market and the markets served by our customers, the timing of new product
announcements and releases by us or our competitors, market acceptance of new products and enhanced versions of our products, manufacturing inefficiencies associated with the start up of new products, changes in pricing by us, our competitors,
customers or suppliers, the ability to volume produce systems and meet customer requirements, excess and obsolete inventory, patterns of capital spending by customers, delays, cancellations or rescheduling of orders due to customer financial
difficulties or otherwise, expenses associated with acquisitions and alliances, our ability to effectively integrate acquisitions, product discounts, product reliability, the proportion of direct sales and sales through third parties, including
distributors and original equipment manufacturers, the mix of products sold, the length of manufacturing and sales cycles, natural disasters, political and economic instability, regulatory changes and outbreaks of hostilities. Due to these and
additional factors, historical results and percentage relationships discussed in this Report on Form 10-Q will not necessarily be indicative of the results of operations for any future period. For a further discussion of our business, and risk
factors affecting our results of operations, please refer to the section entitled Risk Factors included elsewhere herein.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been
prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, as
well as the disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, investments, leased equipment residual values, intangible assets including the potential
for impairment, income taxes, warranty obligations, restructuring, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed 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
discuss the development and selection of the critical accounting estimates with the audit committee of our board of directors on a quarterly basis, and the audit committee has reviewed our disclosure relating to them in this quarterly report on Form
10-Q.



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



Revenue Recognition



Under Securities and Exchange Commissions Staff Accounting Bulletin No. 104, (SAB 104), we recognize revenue on the sale of semiconductor
manufacturing equipment when title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the sales price is fixed or determinable, collectibility is
reasonably assured and customer acceptance criteria have been successfully demonstrated. Revenue recognition policies are applied consistently among our semiconductor manufacturing equipment product lines. Product revenue is recognized upon shipment
only when achieving the customer acceptance criteria can be demonstrated prior to shipment, which generally occurs with mature products. Revenue related to the fair value of the installation obligation is recognized upon completion of the
installation. Products are classified as mature after several different customers have accepted similar systems. When the customer acceptance criteria cannot be demonstrated prior to shipment, revenue and the related cost of goods sold are deferred
until customer acceptance. For some customers in certain countries where collection may be an issue, we may require a letter of credit to be established or cash receipt in advance before revenue can be recognized. Lease revenue is recorded in
accordance with Statement of Financial Accounting Standard No. 13, Accounting for Leases, (SFAS No. 13), which requires that a lessor account for each lease by either the direct financing, sales-type or operating method. Revenue from
sales-type leases is recognized at the net present value of future lease payments. Revenue from operating leases is recognized over the lease period.



During fiscal 2003, 2004 and 2005, we introduced several new systems and products. Certain revenues from sales of these new systems and products during
fiscal 2004 and the nine months ended July 31, 2005 were deferred until the revenue recognition requirements of our revenue recognition policy are satisfied. This practice will continue in the future. In the past, we experienced significant delays
in the introduction and acceptance of new testers as well as certain enhancements to our



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existing testers. As a result, some customers have experienced significant delays in receiving and accepting our testers in production. Delays in introducing
a product or delays in our ability to obtain customer acceptance, if they occur in the future, will delay the recognition of revenue and gross profit by us.



When we are able to separate multiple deliverables from one another, we recognize revenue for each deliverable, based on each deliverables fair
value, when the revenue recognition criteria for that specific deliverable is achieved. In the vast majority of cases orders are shipped complete. In rare instances when there are multiple shipments due to materials shortages, revenue and related
cost of sales are recognized only for the line items that are physically shipped. If the items not shipped on an order are required for the functionality of the delivered items, revenue and related cost of sales are deferred on the delivered items
and recognized only upon the shipment of the required items.



Sales in the United States are principally through our direct sales organization consisting of direct sales employees and representatives. Sales outside the United States utilize both direct sales employees and distributors. There are no
significant differences in revenue recognition policies based on the sales channel, due to the business practices that have been adopted with our distributor relationships. Because of these business circumstances, we do not use price
protection, stock rotation or similar programs with its distributors. We do not typically sell inventory into our distributors for eventual sale to end-users, but rather we sell product to the distributors on the basis of a
purchase order received from an end-user. We evaluate any revenue recognition issues with respect to the end customer in light of our revenue recognition policy.



We sell stand-alone software products and the revenue recognition policies related to these sales fall within the scope of
AICPA Statement of Position No. 97-2, Software Revenue Recognition, (SOP 97-2). The stand-alone software products are applications for IC manufacturers and test and assembly contractors to help improve quality and shorten development
lead times. We also have embedded software in our semiconductor manufacturing equipment. We believe this embedded software is incidental to our products and therefore it is excluded from the scope of SOP 97-2 since the embedded software in our
products is not sold separately, cannot be used on another vendors products, and we cannot fundamentally enhance or expand the capability of the equipment with new or revised embedded software. In addition, the equipments principal
performance characteristics are governed by digital speed and pin count which are primarily a function of the hardware.



Deferred revenue includes deferred revenue related to maintenance contracts (and other undelivered services) and to extended warranties where products
were sold with more than the standard one-year warranty. Deferred profit is related to equipment that was shipped to certain customers, but the revenue and cost of goods sold were not recognized because the customer-specified acceptance criteria has
not been met as of the fiscal period end or because the customer is deemed to be a high credit risk and payment has not been received as of the fiscal period end.



We warrant our products to our customers generally for one year from the date of shipment. In addition to the provision of
standard warranties, we may offer customer paid extended warranty services with a fixed fee. The fixed fees are recognized as revenue on a straight-line basis over the applicable term of the contract. Related costs are recorded either as incurred or
when related liabilities are determined to be probable and estimable.



For certain customers, typically those with whom we have long-term relationships, we may grant extended payment terms. Certain of our receivables have due dates in excess of 90 days, and we have a history of successfully collecting these
extended payment term accounts receivable.



Accounts Receivable Sales
without Recourse



In July 2004, we entered into a
non-recourse receivables purchase agreement with a commercial bank to sell certain of our trade receivables in non-recourse transactions. These receivables are not included in our consolidated balance sheet as the criteria for sale treatment
established by Statement of Financial Accounting Standard No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, (SFAS 140) had been met. Under SFAS 140, after a transfer of financial
assets, an entity stops recognizing the financial assets when the control has been surrendered. We believe our factoring agreement meets the criteria of a true sale of these assets since the acquiring party retains the title to these receivables and
has assumed the risk that the receivables will be collectible. The trade receivables are sold at a discount plus administrative and other fees. The discount amount, administrative and other fees are accounted for in other income and expenses, net in
the condensed consolidated statements of operations. The proceeds received are included as cash in the accompanying condensed consolidated balance sheets and as operating activities in the condensed consolidated statements of cash flows. The
facility was terminated in the quarter ended July 31, 2005.



Allowance for
Doubtful Accounts



Our sales and distribution partners and
we perform ongoing credit evaluations of our customers financial condition. We maintain allowances for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments. We record
our bad debt expenses as selling, general and administrative expenses. When we become aware that a specific customer is unable to meet its financial obligations to us, for example, because of bankruptcy or deterioration in the customers
operating results or financial position, we record a specific allowance to reflect the level of credit risk in the customers outstanding receivable balance. In addition, we record additional allowances based



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on certain percentages of our aged receivable balances. These percentages are determined by a variety of factors including, but not limited to, current
economic trends, historical payment and bad debt write-off experience. We are not able to predict changes in the financial condition of our customers or changes in general economic conditions, and if circumstances related to our customers
deteriorate, our estimates of the recoverability of our trade receivables could be materially affected and we may be required to record additional allowances. Alternatively, if we provide more allowances than we need, we may reverse a portion of
such provisions in future periods based on our actual collection experience.



Inventory Valuation and Residual Values Related to Leased Products



We evaluate our inventory levels and valuations based on our estimates and forecasts of the next cyclical period in our industry. These forecasts require us to estimate our ability to sell current and future products
in the next cyclical industry period and compare those estimates with our current inventory levels. If these forecasts or estimates change, or our product roadmaps change, then we would need to adjust our assessment of the inventory valuations. Once
inventories are written down, we carry that inventory at its reduced value until it is scrapped or otherwise disposed of.



Due to the dramatic decline in the semiconductor business cycle and corresponding impact on revenue in the period 2001 through today and continued
uncertainty regarding the timing and strength of the recovery in semiconductor equipment sales, we continue to monitor our inventory levels in light of product development changes and expectations of the cyclical period ahead. Since fiscal 2001
through the third quarter of fiscal 2005, we have recorded a total of $165.2 million in charges for the write-offs of excess and obsolete inventories. We do not as a matter of course scrap all inventory that is identified as excess or obsolete. Our
products are capital goods with potentially long economic lives and, historically, the opportunity to sell these products has arisen unexpectedly. We have occasionally encountered unexpected demand for old products as well as inability to transition
customers to newer products. We closely monitor the inventories that have been written down but not scrapped, so that if any sales of these items occur and affect our reported gross margins, the effect, if material, is disclosed. We may be required
to take additional charges for excess and obsolete inventory if a downturn causes further reductions to our current inventory valuations or our current product development plans change.



We consign a portion of our finished goods to both external and internal customers primarily for the purpose of customer
demonstration or applications development. This inventory is categorized as other long-term assets on the balance sheet. We depreciate all consigned inventories during the period that they are held on consignment over periods ranging from 18 months
to 36 months. The depreciation expense for consigned inventory is charged to selling, general and administrative expense.



Residual values assigned to our products that are leased to customers are based on their remaining economic life at the end of the lease terms. The
amounts assigned to the residual values are evaluated periodically based on technological change and the forecasted business cycle.



Long-Lived Asset Valuation



Our long-lived assets consist of property and equipment, goodwill and identified intangible assets.



Effective November 1, 2002, we adopted Statement of Financial Accounting
Standard No. 142, Goodwill and Other Intangible Assets, (SFAS 142) which was issued by the FASB in July 2001. Under this standard, we ceased amortizing goodwill and acquired workforce effective November 1, 2002.



We test goodwill for possible impairment on an annual basis and at any other
time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: our market value falling below our net book value for a
significant period of time; a significant adverse change in the business climate or legal factors; unanticipated competition; loss of key personnel; a significant change in direction with respect to investment in a product or market segment; the
likelihood that a significant portion of the business will be sold or disposed of; or the results of testing for recoverability of a significant asset group within a reporting unit determined in accordance with SFAS 142.



The impairment test for goodwill involves a two-step process: step one
consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to each reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied
fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair value of the reporting unit goodwill will be recorded as an
impairment loss.



As mandated by SFAS 142, we completed our
annual goodwill impairment test as of July 31, 2004. We most recently reviewed goodwill for impairment again at the end of January 2005, largely because of lower revenues than in the preceding two quarters. In all such tests to date, we determined
that the sum of the expected future discounted cash flows from the assets exceeded the carrying value of those assets; therefore, no impairment of goodwill was recognized. However, no assurances can be given that future evaluations of goodwill will
not result in future impairment charges. We will continue to evaluate goodwill on an annual basis and at such other times as events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future
discounted cash flow.



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The determination as to whether a write down of goodwill is necessary involves significant judgment based
on the short-term and long-term projections of our future performance. The assumptions supporting the estimated future cash flows of the reporting unit, including the discount rate used and estimated terminal value, reflect our best estimates.



We evaluate the carrying value of our long-lived assets,
consisting primarily of purchased intangible assets, and property and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, or at least annually, in accordance with
Statement of Financial Accounting Standard No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, (SFAS 144). Such events or circumstances include, but are not limited to, a prolonged industry downturn, a significant
decline in our market value, or significant reductions in projected future cash flows. In assessing the recoverability of our long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate.
If the total of the undiscounted future cash flows is less than the carrying amount of the assets, we write down such assets based on the excess of the carrying amount over the fair value of the assets. Fair value is generally determined by
calculating the discounted future cash flows using a discount rate based upon our weighted average cost of capital. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of the
estimated future cash flows, including profit margins, long-term forecasts of the amounts and timing of overall market growth and our percentage of that market, groupings of assets, discount rates and terminal growth rates. In addition, significant
estimates and assumptions are required in the determination of the fair value of our tangible long-lived assets, including replacement cost, economic obsolescence, and the value that could be realized in liquidation. Changes in these estimates could
have a material adverse effect on the assessment of our long-lived assets, thereby requiring us to write down the assets. We made certain assessments with respect to the determination of all identifiable assets to be used in the business as well as
research and development activities as of an acquisition date. Each of these activities was evaluated by both interviews and data analysis to determine our state of development and related fair value. The purchased intangibles consist of purchased
technology, customer relations, trademarks, patents and non-compete agreements, and they typically have estimated useful lives of one to ten years.



Warranty Accrual



We provide reserves for the estimated costs of product warranties at the time revenue is recognized. We estimate the costs of our warranty obligations
based on our historical experience of known product failure rates, use of materials to repair or replace defective products and service delivery costs incurred in correcting product failures. In addition, from time to time, specific warranty
accruals may be made if unforeseen technical problems arise. Should our actual experience relative to these factors differ from our estimates, we may be required to record additional warranty reserves. Alternatively, if we provide more reserves than
we need, we may reverse a portion of such provisions in future periods.



In addition to the provision of standard warranties, we may offer customer-paid extended warranty services with a fixed fee. The fixed fees are recognized as revenue on a straight-line basis over the term of the contract. Related costs for
extended warranty services are recorded as incurred.



Deferred Taxes



When we prepare our consolidated financial statements, we
calculate our income taxes based on the various jurisdictions where we conduct business. This requires us to calculate our actual current tax exposure and to assess temporary differences that result from different treatment of certain items for tax
and accounting purposes. These differences result in deferred tax assets and liabilities, which we show on our condensed consolidated balance sheets. The net deferred tax assets are reduced by a valuation allowance if, based upon weighted available
evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.



Our net deferred tax liability balance as of July 31, 2005 was $0.1 million that relates to our foreign subsidiaries that are currently generating taxable
income. Our domestic deferred tax assets have a full valuation allowance against them due to uncertainties surrounding our ability to generate future taxable income and our corresponding ability to utilize our deferred tax assets.



Restructuring Charges



Over the past years, we have recorded restructuring charges as we rationalized operations in light of customer demand
declines and the economic downturn. These measures, which included major changes in senior management, workforce reduction, facilities consolidation and changes to the strategic focus of a number of sites, were largely intended to align our capacity
and infrastructure to anticipate customer demand and to transition our operations to lower cost regions. The restructuring charges include employee severance and benefit costs, write-offs of property and equipment and costs related to leased
facilities vacated and subleased. Severance and benefit costs and other costs associated with restructuring activities were recorded in compliance with Statement of Financial Accounting Standard No. 146, Accounting for Costs Associated with
Exit or Disposal Activities, (SFAS 146). As applicable, we also record severance and benefit costs in accordance with



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Statement of Financial Accounting Standard No. 112, Employers Accounting for Postemployment Benefits (SFAS 112), as we concluded that (a)
we had a substantive postemployment benefit obligation that is attributed to prior services rendered, (b) rights to those benefits vested, and (c) payment is probable and the amount can be reasonably estimated. The current accounting for
restructuring costs requires us to record provisions and charges when we have a formal and committed restructuring plan.



Given the significance of, and the timing of the execution of such activities, this process is complex and involves periodic reassessments of original
estimates. We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives and other special charges. Although we believe that these estimates accurately reflect the costs of our restructuring and other plans,
actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.



RESULTS OF OPERATIONS



The following table sets forth items from the condensed consolidated statements of operations as a percentage of net sales for the periods indicated
(unaudited):



|                                                                |  |                             |    |  |                            |    |  |       |    |  |       |   
|--------------------------------------------------------------- |  | --------------------------- | -- |  | -------------------------- | -- |  | ----- | -- |  | ----- | --
|                                                                |  | Three Months Ended July 31, |    |  | Nine Months Ended July 31, |   
|                                                                |  | 2005                        |    |  | 2004                       |    |  | 2005  |    |  | 2004  |   
|Net sales                                                       |  | 100.0                       | %  |  | 100.0                      | %  |  | 100.0 | %  |  | 100.0 | % 
|Cost of goods sold  on net sales                               |  | 52.9                        |    |  | 52.2                       |    |  | 57.4  |    |  | 51.2  |   
|Cost of goods sold  special charges                            |  | 20.5                        |    |  | 28.2                       |    |  | 9.5   |    |  | 14.1  |   
|                                                                |  |                             |    |  |                            |    |  |       |    |  |       |   
|Gross margin                                                    |  | 26.6                        |    |  | 19.6                       |    |  | 33.1  |    |  | 34.7  |   
|Operating expenses                                              |  |                             |    |  |                            |    |  |       |    |  |       |   
|Research and development                                        |  | 21.3                        |    |  | 14.6                       |    |  | 22.4  |    |  | 16.8  |   
|Selling, general and administrative                             |  | 28.2                        |    |  | 22.6                       |    |  | 30.8  |    |  | 26.8  |   
|In-process research and development                             |  |                            |    |  | 4.8                        |    |  |      |    |  | 2.4   |   
|Restructuring charges                                           |  | 8.6                         |    |  | 1.8                        |    |  | 3.7   |    |  | 1.1   |   
|Amortization of purchased intangibles and deferred compensation |  | 4.9                         |    |  | 3.3                        |    |  | 6.0   |    |  | 3.2   |   
|                                                                |  |                             |    |  |                            |    |  |       |    |  |       |   
|Total operating expenses                                        |  | 63.0                        |    |  | 47.1                       |    |  | 62.9  |    |  | 50.3  |   
|                                                                |  |                             |    |  |                            |    |  |       |    |  |       |   
|Operating loss                                                  |  | (36.4                       | )  |  | (27.5                      | )  |  | (29.8 | )  |  | (15.6 | ) 
|                                                                |  |                             |    |  |                            |    |  |       |    |  |       |   
|Net loss                                                        |  | (37.2                       | )% |  | (20.2                      | )% |  | (31.7 | )% |  | (12.3 | )%
|                                                                |  |                             |    |  |                            |    |  |       |    |  |       |   



Net sales consist of
revenues from systems sales, upgrades, spare parts sales, maintenance contracts and capital and operating lease sales. Net sales were $111.9 million for the third quarter of fiscal 2005 representing a decrease of 32% from net sales of $163.7 million
during the third quarter of fiscal 2004. Net sales decreased $19.2 million, or 6%, to $307.8 million for the nine months ended July 31, 2005 from $327.0 million for the nine months ended July 31, 2004. For the quarter, revenue from our design and
characterization group increased over the prior years third quarter by more than $11.3 million reflecting market acceptance of the Emiscope and IREM products, and service revenues increased nearly $4.9 million as the result of a much larger
Integrated Device Manufacturer (IDM) installed base. SoC revenue remained relatively flat. Revenue from our analog mixed signal product line declined $17.1 million from the third quarter of 2004 and flash memory revenues declined $47.7 million. Both
declines reflect the cyclically low demand in those markets. For the nine months ended July 31, 2005 and 2004, revenue from our SoC, design characterization group and service products increased to $235.0 million from $136.9 million, respectively,
constituting 30% of the total increase in our overall net sales. This increase results primarily from the June 2004 acquisition of NPTest, offset by the decrease in revenue from our analog mixed signal and memory products to $72.8 million during the
nine months ended July 31, 2005 from $190.1 million during the same period of fiscal 2004, representing a decrease of 36% of the total net sales. This again reflects the cyclically low demand in those markets. Sustainability of the revenue levels is
dependent upon the economic and geopolitical climate as well as other risks described under the title Risk Factors herein. We anticipate net sales will remain flat or increase up to approximately 7% for the fourth quarter of fiscal year
2005 compared to the third quarter.



International net sales
accounted for approximately 72% of total net sales in the third quarter of fiscal 2005 compared with 79% in the third quarter of fiscal 2004. International net sales accounted for approximately 66% and 75% of total net sales for the nine months
ended July 31, 2005 and July 31, 2004, respectively. Our net sales to the Asia Pacific region accounted for approximately 50% and 56% of total net sales in the third quarter of fiscal 2005 and 2004, respectively, and thus are subject to the risk of
economic instability in that region that may materially adversely affect the demand for our products. Capital markets in Asia historically have been highly volatile, resulting in economic instabilities. Instabilities may recur which could materially
adversely affect demand for our products. In addition, the economic impact of geopolitical instabilities on the Korean peninsula may affect future orders from this region and the timing of or payment for shipments made to this region.



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Starting in the second quarter of fiscal 2005, our chief decision makers reviewed the breakdown of
revenues by different product line groupings. The table below represents our revenue by product line. Our net sales by product line for the three and nine months ended July 31, 2005 and July 31, 2004 consisted of:



|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|----------------------------- |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                              |  | Three Months Ended July 31, |   |  | Nine Months Ended July 31, |  
|                              |  | 2005                        |   |  | 2004                       |   |  | 2005 |   |  | 2004 |  
|SoC                           |  | 36                          | % |  | 27                         | % |  | 37   | % |  | 23   | %
|Analog Mixed Signal           |  | 21                          |   |  | 25                         |   |  | 20   |   |  | 34   |  
|Memory                        |  | 3                           |   |  | 31                         |   |  | 3    |   |  | 24   |  
|Design Characterization Group |  | 12                          |   |  | 1                          |   |  | 12   |   |  | 4    |  
|Service                       |  | 28                          |   |  | 16                         |   |  | 28   |   |  | 15   |  
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|Total                         |  | 100                         | % |  | 100                        | % |  | 100  | % |  | 100  | %
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  



Gross Margin



Our gross margin has been and will continue to be affected by a variety of
factors, including manufacturing efficiencies, excess and obsolete inventory write-downs, sell-through of previously written-down inventory, pricing by competitors or suppliers, new product introductions, product sales mix, production volume,
customization and reconfiguration of systems, international and domestic sales mix, special charges, and field service margins. Our gross margin was 27% and 33% for the three and nine months ended July 31, 2005, respectively. For the comparable
periods ended July 31, 2004 the gross margins were 20% and 35%, respectively. The decrease in gross margins primarily reflects the effect of $23.0 million and $29.1 million of costs of sales in special charges during the three and nine months ended
July 31, 2005, respectively. The special charges were for the write down of Kalos II inventory due to our decision to invest in the next generation memory product as well as to lack of demand, obsolete revisions of Sapphire inventory resulting from
our decision to market Sapphire as our sole solution for the high end SoC market and excess and obsolete Octet and Vanguard II inventory and assets due to our decision to discontinue significant future investment in these redundant product lines
stemming from the acquisition of NPTest. The remaining decrease is primarily attributable to lower margin product mix. In addition, during the three and nine month periods ended July 31, 2005 our gross margin benefited by approximately 3.7% and
4.1%, respectively, from the sale of fully reserved inventory. For the comparable periods ended July 31, 2004 the gross margins benefited by approximately 5.5% and 1.9%, respectively, from the sale of fully reserved inventory. Excluding the effect
of any future special charges, we believe gross margins will remain flat in the next several quarters compared to the third quarter of fiscal 2005.



Research and Development



Research and Development or R&D expenses remained flat at $23.8 million in the three months ended July 31, 2005, compared to $23.9 million for the
same period in the prior fiscal year. R&D expenses were $68.9 million for the nine months ended July 31, 2005, compared to $54.9 million from the same period in the prior fiscal year, an increase of 25%. R&D expenses increased during the
nine months ended July 31, 2005 compared to the same period of fiscal 2004 due primarily to the purchase of NPTest in the third quarter of fiscal 2004 which contributed additional R&D expenses of approximately $13.7 million. We will continue to
invest significant resources in the development and completion of new products and product enhancements. Accordingly, we anticipate that R&D expenses will remain approximately flat for the fourth quarter of fiscal year 2005 compared to the third
quarter.



Selling, General and Administrative



Selling, general, and administrative, or SG&A, expenses were $31.5
million in the three months ended July 31, 2005, compared to $37.0 million for the same period in the prior fiscal year, a decrease of 15%. SG&A expenses were $94.7 million during the nine months ended July 31, 2005, compared to $87.6 million
for the same period in the prior fiscal year, an increase of 8%. The decrease in G&A expenses for the third quarter of fiscal 2005 as compared to the same period in fiscal 2004 is primarily due to decreases in field operation expenses from
NPTest integration headcount reductions, decrease in sales commission expenses due to decrease in commission rates and lower revenue, and decrease in distributor commission expenses due to lower sales, which more than offset the significant
increases in Sarbanes-Oxley related costs. SG&A expenses increased during the nine months ended July 31, 2005 as compared to the same period of fiscal 2004 due primarily to the acquisition of NPTest in June 2004 and significant increases in
audit and Sarbanes-Oxley compliance related costs which more than offset reductions in commissions and other variable compensation expenses. We expect SG&A expenses will be flat in the fourth quarter of fiscal year 2005 compared to the third
quarter.



Amortization of Purchased Intangibles and Deferred Compensation



Amortization of purchased intangible and deferred
compensation expenses were $5.5 million for the three months ended July 31, 2005, compared to $5.3 million for the same period of the prior fiscal year, an increase of 2%. Amortization of



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purchased intangible and deferred compensation expenses were $18.5 million for the nine months ended July 31, 2005, compared to $10.6 million for the same
period in the prior fiscal year, an increase of 74%. The increase in amortization expense for the nine month period is primarily due to the additional amortization resulting from the purchase of NPTest during the third quarter of fiscal 2004.
Remaining estimated annual amortization expense for purchased intangible assets and deferred compensation is expected to be $5.0 million, $19.2 million, and $18.7 million, for the remainder of fiscal years ending in 2005 through 2007, respectively.
See Note 10, Goodwill and Other Intangible Assets of the notes to condensed consolidated financial statements for a detailed breakdown of purchased intangible amortization expense by category. As of November 1, 2002 we adopted SFAS 142.
Under SFAS 142, goodwill and indefinite lived intangible assets are no longer amortized, but are reviewed annually (or more frequently if impairment indicators arise) for impairment. We completed our annual goodwill impairment test as of July 31,
2004 during the fourth quarter of the fiscal year and most recently as of January 31, 2005 primarily as a result of lower revenues. Under all such tests, we determined that no potential impairment existed and as a result, we have not recognized any
impairment losses in connection with SFAS 142.



Restructuring Charges



During the third quarter of fiscal 2005, we recorded a
restructuring charge of approximately $9.7 million primarily for severance and related charges and the closure of our San Jose facility. Of these charges, $9.6 million related primarily to the San Jose, California building lease which we vacated
during the quarter and $1.2 million related to headcount reduction of 47 employees. The additional charges were offset by our adjustment of the previous over-accrued restructuring charges of $0.6 million and the write-off of the San Jose deferred
rent of $0.7 million. During the nine months ended July 31, 2005, we recorded a restructuring charge of approximately $11.4 million for severance and related charges, and property and equipment write-offs. The severance and other related charges
amounted to $2.1 million which accounted for headcount reduction of 67 employees. The affected employees were primarily in research and development and selling general and administrative functions. The property and equipment write off, amounting to
$1.1 million, resulted from the Companys decision to halt additional research and development investment in one of its products that was rendered redundant by the acquisition of NPTest. The operating lease charges of $9.6 million, which are
net of expected sublease rentals, resulted from vacating the former NPTest headquarters facilities in San Jose.



In January 2004, we relocated our corporate headquarters to our owned facilities in Milpitas, California and vacated our previously leased buildings in
Fremont, California. The lease for three of the buildings expired at the end of December 2003. This lease expired in June 2005. During the quarter ended January 31, 2004, we recorded a restructuring charge in the amount of $0.7 million to write-off
the remaining lease payments for this lease, net of expected sublease income for a lease in Austin, Texas.



Interest Income



We
generated interest income of $0.7 million and $0.2 million in the third quarter of fiscal 2005 and 2004, respectively. For the nine months ended July 31, 2005 and 2004, interest income was $2.0 million and $2.8 million. The increase in interest
income for the three months ended July 31, 2005 was primarily due to the increase in interest rate. The decline in interest income for the nine months ended July 31, 2005 was primarily due to lower cash and investment balances in fiscal 2005 offset
somewhat by the rise in interest rates.



Interest Expense



Interest expenses were $0.8 million and $1.7 million for the third quarter
of fiscal year 2005 and 2004, respectively. For the nine months ended July 31, 2005 and 2004, interest expenses were $2.3 million and $3.3 million, respectively. The decrease in interest expense in fiscal 2005 is primarily attributable to the
pay-off of three notes payable related to leased products during the first quarter of 2005.



Other Income, Net



Other income, net was $1.1 million and $14.8 million of income for the third quarter of fiscal 2005 and 2004, respectively. For the nine months ended July 31, 2005 and 2004, other income, net was $3.0 million and $15.5 million,
respectively. The decrease in other income, net, for the three and nine months of fiscal 2005 as compared to the same period of the prior year was primarily due to the fair value adjustment of an acquired liability owed to the former parent of
NPTest, Schlumberger Limited (Schlumberger). This liability was settled during the third quarter of 2005 for a total settlement value of $9.0 million. See Note 9 Acquisitions, of the Notes to the Consolidated Financial Statements for
further discussion.



Income Taxes



We recorded an income tax provision of $2.0 million and $8.6 million for the
three and nine months ended July 31, 2005, respectively, as compared to $1.5 million and $3.9 million for the same periods of fiscal 2004, respectively. The income tax expense for the periods consist of foreign tax expense on earnings generated from
our foreign operations. We expect to record a full valuation allowance on domestic tax benefits from ongoing losses generated in the U.S. until we can sustain a consistent level of profitability. Until such time, we would not expect to recognize any
significant tax benefits in our results of operations.



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LIQUIDITY AND CAPITAL RESOURCES



In the nine months ended July 31, 2005, net cash used in operating activities was $20.5 million. The primary use of this
cash resulted from increases in working capital of $7.4 million and a net loss of $97.5 million, offset by depreciation and amortization of $47.9 million, non-cash charges of $28.7 million related to the inventory write-off, facility consolidation
and property and equipment write-off, and approximately $7.6 million related to inventory write down, bad debt expense and loss on disposal of property and equipment.



Investing activities provided cash of $8.1 million in the nine month period ended July 31, 2005, primarily attributable to
$20.5 million of cash received from net sales of available-for-sale securities and proceeds from sales of property and equipment and leased equipment of $0.6 million offset by $13.0 million of cash used for purchases of property and equipment to
support our business. The majority of the property and equipment expenditures resulted from our facilities consolidation efforts.



Financing activities provided net cash of $4.5 million in the nine month ended July 31, 2005. The cash provided was primarily due to $5.6 million received
from the issuance of common stock relating to our employee equity plans offset by payments of bank loans and notes payable related to leased products of $1.1 million.



As of July 31, 2005, we had working capital of $226.4 million, including cash and short-term investments of $135.4 million,
and accounts receivable and inventories totaling $214.7 million. We believe that because of the relatively long manufacturing cycles of many of our testers and the new products we presently offer and plan to introduce, investments in inventories
will also continue to represent a significant portion of our working capital. The semiconductor industry has historically been highly cyclical and has experienced downturns, which have had a material adverse effect on the semiconductor
industrys demand for automatic test equipment, including equipment manufactured and marketed by us. In addition, the automatic test equipment industry is highly competitive and subject to rapid technological change. Events related to these
factors may occur in the near term, which would cause a change to our estimate of the net realizable value of receivables, inventories or other assets, and the adequacy of accrued liabilities.



As a result of the NPTest acquisition, we were required to make a payment to
Schlumberger Limited at a date in the future pursuant to a provision in the acquisition agreement between NPTest and Schlumberger under which NPTest was acquired by Francisco Partners, L.P. from Schlumberger Limited. The payment amount was
contingent upon the value of our common stock at the time of distribution. In May 2005, the parties reached a settlement, which required us to pay Schlumberger approximately $4.0 million in cash and 615,157 shares of our common stock which was
valued at $5.0 million for a total settlement value of $9.0 million. As of July 31, 2005, we had fulfilled our obligations to Schlumberger and there were no outstanding liabilities in relation to this transaction.



We believe our current cash and investment positions combined with the
ability to borrow funds will be sufficient to meet our anticipated business requirements for the next 12 months and in the foreseeable future, including potential acquisitions or strategic investments, capital expenditures, and working capital
requirements.



We lease some of our facilities and equipment
under operating leases that expire through 2013 of which $9.3 million represented the net present value of the lease commitment for the San Jose, California lease and $0.7 million for the Austin, Texas lease commitment have been written-off to
special operating charges during the third quarter of fiscal 2005 and first quarter of fiscal 2004, respectively, net of estimated sublease income. The approximate future minimum lease payments at July 31, 2005 are as follows (in thousands):



|                         |  |                             |        |                                    |   |                                 |  |   |       
|------------------------ |  | --------------------------- | ------ | ---------------------------------- | - | ------------------------------- |  | - | ------
|                         |  | CommittedGrossLeasePayments |        | LeasesWritten Offin SpecialCharges |   | NetEstimatedFuture LeaseExpense
|Remainder of fiscal 2005 |  | $                           | 1,698  |                                    | $ | 1,341                           |  | $ | 357   
|Fiscal 2006              |  |                             | 6,617  |                                    |   | 4,317                           |  |   | 2,300 
|Fiscal 2007              |  |                             | 5,711  |                                    |   | 3,568                           |  |   | 2,143 
|Fiscal 2008              |  |                             | 4,868  |                                    |   | 3,448                           |  |   | 1,420 
|Fiscal 2009              |  |                             | 4,696  |                                    |   | 3,487                           |  |   | 1,209 
|Thereafter               |  |                             | 2,573  |                                    |   |                                |  |   | 2,573 
|                         |  |                             |        |                                    |   |                                 |  |   |       
|                         |  | $                           | 26,163 |                                    | $ | 16,161                          |  | $ | 10,002
|                         |  |                             |        |                                    |   |                                 |  |   |       



The leases written off
in special charges of $10.5 million are accounted for in our accrued expenses and other liabilities balance on the condensed consolidated balance sheets at July 31, 2005.



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The following summarizes our minimum contractual cash obligations and other commitments at July 31, 2005,
and the effect of such obligations in future periods (in thousands):



|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      
|------------------------------------------------------------------------------------------- |  | ----- | ------- | ---------------------- | - | ----------- |  | ----------- | ------ | ----------- | - | ----------- |  | ---------- | ------- |  | - | ----- |  | - | -----
|                                                                                            |  | Total |         | Remainderof Fiscal2005 |   | Fiscal 2006 |  | Fiscal 2007 |        | Fiscal 2008 |   | Fiscal 2009 |  | Thereafter
|Contractual Obligations:                                                                    |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      
|Facilities and equipment operating leases(1)                                                |  | $     | 26,163  |                        | $ | 1,698       |  | $           | 6,617  |             | $ | 5,711       |  | $          | 4,868   |  | $ | 4,696 |  | $ | 2,573
|Bank note(2)                                                                                |  |       | 5,000   |                        |   |            |  |             | 5,000  |             |   |            |  |            |        |  |   |      |  |   |     
|Interest on bank note                                                                       |  |       | 78      |                        |   | 52          |  |             | 26     |             |   |            |  |            |        |  |   |      |  |   |     
|Convertible subordinated notes(3)                                                           |  |       | 180,000 |                        |   |            |  |             |       |             |   |            |  |            | 180,000 |  |   |      |  |   |     
|Interest on convertible subordinated notes                                                  |  |       | 6,863   |                        |   | 675         |  |             | 2,700  |             |   | 2,700       |  |            | 788     |  |   |      |  |   |     
|Residual value guarantees(4)                                                                |  |       | 780     |                        |   | 780         |  |             |       |             |   |            |  |            |        |  |   |      |  |   |     
|Trade-in commitments(4)                                                                     |  |       | 1,600   |                        |   | 1,600       |  |             |       |             |   |            |  |            |        |  |   |      |  |   |     
|Minimum payable for information technology outsourcing including fees for early termination |  |       | 2,635   |                        |   | 1,173       |  |             | 1,462  |             |   |            |  |            |        |  |   |      |  |   |     
|Open and non-cancelable purchase order commitments                                          |  |       | 44,923  |                        |   | 20,375      |  |             | 21,324 |             |   | 3,224       |  |            |        |  |   |      |  |   |     
|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      
|Total contractual cash and other obligations                                                |  |       | 268,042 |                        |   | 26,353      |  |             | 37,129 |             |   | 11,635      |  |            | 185,656 |  |   | 4,696 |  |   | 2,573
|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |         |  |   |       |  |   |      

---

|(1) | Approximately $10.5 million of this total has been accrued for as restructuring charge in the condensed consolidated balance sheets as accrued expenses and other
liabilities.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|(2) | This amount is recorded in the condensed consolidated balance sheets as bank note.
|--- | ----------------------------------------------------------------------------------

|(3) | This amount is recorded in the condensed consolidated balance sheets as convertible subordinated notes.
|--- | -------------------------------------------------------------------------------------------------------

|(4) | This amount is recorded in the condensed consolidated balance sheets as accrued expenses and other liabilities and deferred profit.
|--- | -----------------------------------------------------------------------------------------------------------------------------------



Some of the components that we purchase are unique to us and must be
purchased in relatively high minimum quantities with long (in excess of three months) lead times. These business circumstances can lead to us holding relatively high inventory levels and associated risks. In addition, purchase commitments for unique
components are relatively inflexible in terms of deferral or cancellation. At July 31, 2005, we had open and committed non-cancelable purchase orders totaling approximately $44.9 million. The contractual cash obligations and commitments table
presented above contains our minimum obligations at July 31, 2005 under these arrangements and others. Actual expenditures will vary based on the volume of transactions and length of contractual service provided. In addition to minimum spending
commitments, certain of these arrangements provide for potential cancellation charges.



Net transfer of inventory to property and equipment was $0.3 for the nine months ended July 31, 2005. Mature product spare parts that are used in our service business are classified as other assets. In addition, we
capitalize a small number of finished systems into the manufacturing function for use in de-bug, quality control, and software development as well as the sales function for use in demonstrations and application development which we classify as
product consignment and include in other assets.



As of July
31, 2005, our principal sources of liquidity consisted of approximately $86.4 million of cash and cash equivalents, and short-term investments of $49.1 million.



RECENT ACCOUNTING PRONOUNCEMENTS



In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123R, Share-Based Payment, or SFAS 123R. SFAS 123R revised
SFAS 123. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107) which provides the Staffs views regarding interactions between SFAS No. 123(R) and certain SEC rules and regulations and
provides interpretations of the valuation of share-based payments for public companies. SFAS No. 123(R) requires that the costing resulting from share-based payment transactions be recognized in the financial statements. The statement requires
companies to use a fair-value-based payment measurement method in accounting for share-based payment with employees as well as for goods and services received from non-employees. SFAS 123R is effective for all annual reporting period that begins
after June 15, 2005, with early adoption permitted. We expect to adopt SFAS 123R using the modified prospective method effective November 1, 2005.



SFAS 123R permits companies to adopt its requirements using either a modified prospective method, or a modified retrospective
method. Under the modified prospective method, compensation cost is recognized in the financial statements beginning with the effective date, based on the requirements of SFAS 123R for all share-based payments granted after that date,
and based on the requirements of SFAS 123 for all unvested awards granted or modified after the effective date of SFAS 123 (December 15, 1994). Under the modified retrospective method, the requirements are the same as under the
modified prospective method, but also requires entities to restate financial statements of previous periods based on proforma disclosures made in accordance with SFAS 123. We currently utilize a standard option pricing model (i.e.,
Black-Scholes-Merton) to measure the fair value of stock options granted to employees. While SFAS 123R permits entities to continue to use such a model, the standard also permits the use of a lattice model. We have not yet determined
which model we will use to estimate the fair value of employee stock options upon the adoption of SFAS 123R. We believe that the adoption of SFAS 123R will have a material effect on our results of operations. See Note 6, Stock-Based
Compensation of the notes to the condensed consolidated financial statements for the possible effect of adopting SFAS 123R on our financial position and results of operations. We, however, have not determined whether the adoption will result
in amounts that are similar to the current pro forma disclosure under FAS No. 123.



In December 2004, the FASB issued FASB Staff Position No. FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP
FAS 109-2). The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. We currently have
no plans to repatriate foreign earnings.



In May 2005, the FASB
issued Statement of Financial Accounting Standard No. 154, Accounting Changes and Error Corrections, (SFAS 154) effective with fiscal years beginning after December 15, 2005. This statement replaces APB Opinion No. 20,Accounting
Changes, and Statement of Financial Accounting Standard No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle.
SFAS No. 154 applies to all voluntary changes in accounting principle and changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. Under this pronouncement
changes are required to be retrospectively applied to prior financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Retrospective application



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means the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of
previously issued financial statements to reflect a change in the reporting entity. This statement requires that the retrospective application of a change in accounting principle be limited to the direct effects of the change. This statement also
requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected by a change in accounting principle. We do not believe the adoption of SFAS
154 will have a material effect on its consolidated financial position or results of operations.



RISK FACTORS



Our operating results
have fluctuated significantly which has adversely affected and may continue to adversely affect our stock price.



LOGO



A variety of factors affect our
results of operations. The above graph illustrates that our quarterly net sales and operating results have fluctuated significantly. We believe they will continue to fluctuate for several reasons, including:



| |  |  | worldwide economic conditions in the semiconductor industry in general and capital equipment industry specifically;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | loss of certain key customers who account for large portion of our revenue;
| | - |  | ---------------------------------------------------------------------------



| |  |  | patterns of capital spending by our customers, delays, cancellations or reschedulings of customer orders due to customer financial difficulties or otherwise;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | market acceptance of our new products and enhanced versions of existing products;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | changes in overhead absorption levels due to changes in the number of systems manufactured, the timing and shipment of orders, availability of components including custom integrated
circuits, or ICs, subassemblies and services, customization and reconfiguration of our systems and product reliability;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | manufacturing capacity and ability to volume produce systems, including our newest systems, and meet customer requirements;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



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| |  |  | manufacturing inefficiencies associated with the start-up of our new products, changes in our pricing or payment terms and cycles, and those of our competitors, customers and
suppliers;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to attract and retain qualified employees in a competitive market;
| | - |  | ------------------------------------------------------------------------------



| |  |  | timing of new product announcements and new product releases by us or our competitors;
| | - |  | --------------------------------------------------------------------------------------

| |  |  | write-offs of excess and obsolete inventories and accounts receivable that are not collectible;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | labor and materials supply constraints;
| | - |  | ---------------------------------------



| |  |  | expenses associated with acquisitions and alliances, including expenses charged for any impaired acquired intangible assets and goodwill;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | difficulties integrating NPTest into our organization;
| | - |  | ------------------------------------------------------



| |  |  | operating expense reductions associated with cyclical industry downturns, including costs relating to facilities consolidations and related expenses;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the proportion of our direct sales and sales through third parties, including distributors and OEM, the mix of products sold, the length of manufacturing and sales cycles, and
product discounts; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | natural disasters, political and economic instability, currency fluctuations, regulatory changes and outbreaks of hostilities, especially in Asia.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



We intend to introduce new products and product enhancements in the future,
the timing and success of which will affect our business, financial condition and results of operations. Our gross margins on system sales have varied significantly and will continue to vary significantly based on a variety of factors including:



| |  |  | long-term pricing concessions by us and our competitors and pricing by our suppliers;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | manufacturing volumes;
| | - |  | ----------------------



| |  |  | manufacturing inefficiencies;
| | - |  | -----------------------------



| |  |  | hardware and software product sales mix;
| | - |  | ----------------------------------------



| |  |  | absorption levels and the rate of capacity utilization;
| | - |  | -------------------------------------------------------



| |  |  | inventory write-downs;
| | - |  | ----------------------



| |  |  | new product introductions;
| | - |  | --------------------------



| |  |  | product reliability;
| | - |  | --------------------



| |  |  | customization and reconfiguration of systems;
| | - |  | ---------------------------------------------



| |  |  | the possible sale of inventory previously written-off;
| | - |  | ------------------------------------------------------



| |  |  | international and domestic sales mix and field service margins;
| | - |  | ---------------------------------------------------------------



| |  |  | facility relocations and closures; and
| | - |  | --------------------------------------



| |  |  | ceasing investment in underperforming or redundant product lines.
| | - |  | -----------------------------------------------------------------



New and enhanced products typically have lower gross margins in their early stages of commercial introduction and production, and we may build substantial
finished goods inventories of such new products. If delays in or cancellations of orders for those products occur, it may require future inventory write-offs, which would negatively affect our future financial performance. Although we have recorded
and continue to record inventory write-offs, product warranty costs, and deferred revenue, we cannot be certain that our estimates will be adequate.



We cannot forecast with any certainty the impact of these and other factors on our sales and operating results in any future period. Results of operations
in any period, therefore, should not be considered indicative of the results to be expected for any future period. Because of this difficulty in predicting future performance, our operating results may fall below the expectations of securities
analysts or investors in some future quarter or quarters. Our failure in the past to meet these expectations has adversely affected the market price of our common stock and may continue to do so. In addition, our need for continued significant
expenditures for research and development, marketing and other expenses for new products, capital equipment purchases and worldwide training and customer service and support will impact our sales and operations results in



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the future. Other significant expenditures may make it difficult for us to reduce our significant fixed expenses in a particular period if we do not meet our
net sales goals for that period. Many of these expenses are fixed and will be difficult to reduce in a particular period if our net sales goal for that period is not met. As a result, we cannot be certain that we will be profitable in the future.



Some of our revenue is generated from a small number of key customers and
the loss of a key customer could substantially reduce our revenues and be perceived as a loss of momentum in our business.



Over time, we have expanded our base of customers; however, large portion of our revenues are generated from a small number of key customers. In
particular, two customers accounted for 25% and 17% of our net sales for the three months ended July 31, 2005. Our top ten customers accounted for 70% of our net sales for the three months ended July 31, 2005. We expect that our top ten customers in
the aggregate will continue to account for a large portion of our net sales for the foreseeable future, and the loss of one or more of these customers or collaborative partners would harm our business and operating results. The loss of a significant
customer could also be perceived as a loss of momentum in our business and an adverse impact on our financial results, and this may cause the market price of our common stock to fall.



When we engage in acquisitions, we will incur a variety of costs, and the anticipated benefits of the acquisitions may never be realized.



We have developed in large part through mergers and
acquisitions of other companies and businesses. We intend in the future to pursue additional acquisitions of product lines, technologies and businesses. We may utilize cash or we may continue to issue debt or equity securities to pay for future
acquisitions, which may be dilutive to then current stockholders. We have also incurred and may continue to incur certain liabilities or other expenses in connection with acquisitions, which have affected and could continue to materially adversely
affect our business, financial condition and results of operations. In May 2005, we reached a settlement with Schlumberger, which required us to pay Schlumberger approximately $4.0 million in cash and 615,157 shares of our common stock which was
valued at $5.0 million under the settlement terms. As of July 31, 2005, we had fulfilled our obligations to Schlumberger and there were no outstanding liabilities in relation to this transaction.



In addition, acquisitions involve numerous other risks, including:



| |  |  | demonstrating to customers and distributors that the transaction will not result in adverse changes in client service standards or business focus and helping customers conduct
business easily;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | difficulties assimilating the domestic and international operations, personnel, research and development, technologies, sales channels, manufacturing, products and corporate
information technology and administrative infrastructure of the acquired companies;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | diversion of our managements attention from other business concerns;
| | - |  | ---------------------------------------------------------------------



| |  |  | increased complexity and costs associated with international and domestic internal management structures;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | the potential loss of key employees or key distributing, marketing, customer and other business relationships of the acquired companies;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | risks of entering markets in which we have no or limited experience; and
| | - |  | ------------------------------------------------------------------------



| |  |  | integrating processes and controls to effectively monitor, control, and manage our financial statement close process.
| | - |  | ---------------------------------------------------------------------------------------------------------------------



In May 2004, we consummated the purchase of NPTest. The size and scope of
this transaction with NPTest increases both the scope and consequence of these ongoing integration risks. Even if the acquisition is successfully integrated, we may not receive all of the expected benefits of the transaction.



For these reasons, we cannot be certain what effect acquisitions may have on
our business, financial condition and results of operations.



If we are not
successful in efficiently and promptly integrating NPTest into our organization, the anticipated benefits of the merger may not be realized.



Achieving the anticipated benefits of the merger will depend, in part, on the integration of technology, operations and personnel of Credence and NPTest.
We cannot assure you that the integration will be successful or that the anticipated benefits of the merger will be fully realized. The challenges involved in this integration include the following:



| |  |  | satisfying the needs of the combined companys customers in a timely and efficient manner;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | persuading the employees that our business culture is compatible with NPTests business culture and retaining the combined companys key personnel;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | maintaining the dedication of the combined companys management resources to integration activities without diverting attention from the day-to-day business of the combined
company;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | maintaining the combined companys managements ability to focus on anticipating, responding to or utilizing changing technologies in the IC test equipment industry;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | maintaining NPTests key supplier relationships;
| | - |  | ------------------------------------------------



| |  |  | introduction by competitors of new, disruptive technologies to the marketplace which reduce NPTests market share prior to the successful integration of the two companies; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | integrating processes and controls to effectively monitor, control, and manage our financial statement close process.
| | - |  | ---------------------------------------------------------------------------------------------------------------------



In order to effectively deal with the changes brought on by the scale of the
NPTest acquisition, we are implementing and improving a variety of operating, financial, and other systems, processes, procedures, and controls. However, we cannot be certain that any existing or new implementation of our systems, processes or
controls, including the implementation of the NPTest processes and controls on our primary business applications (including our SAP ERP system) will be adequate to support potential fluctuations in our operations during the transition or will be
accomplished without disruptions in our business. In addition, during our fiscal 2004 year end close and audit processes, our independent registered public accounting firm and we identified certain material weaknesses in our internal controls and
certain additional internal control deficiencies. Although we have implemented changes in our internal controls over financial reporting, we have not completely remediated the noted material weaknesses and internal control deficiencies as of July
31, 2005, and such deficiencies may continue for one or more quarters. There can be no assurance that we will completely remediate the noted material weaknesses and internal control deficiencies. Any failure to implement, improve and expand such
systems, processes, or controls efficiently or to completely remediate the noted internal control deficiencies could have a material adverse effect on our business, financial condition or results of operations.



In addition, we intend to develop new products that combine NPTests
products and intellectual property with our products and intellectual property. This may result in longer product development cycles, which may cause the revenue and operating income of our businesses to fluctuate and fail to meet expectations. To
date, we have not completed our investigation into the challenges (technological, market-driven or otherwise) of developing and marketing these new products. There can be no assurance that we will be able to overcome these challenges, or that a
market for such new products will develop after the merger.



It
is not certain that we can successfully integrate NPTest in a timely manner or at all or that any of the anticipated benefits will be realized. In addition, we cannot assure you that there will not be substantial unanticipated costs associated with
the integration process, that integration activities will not result in a decrease in revenues, a decrease in the value of our common stock, or that there will not be other material adverse effects from our integration efforts.



If we are unable to successfully integrate NPTest, or if the benefits of the
merger do not meet the expectations of financial or industry analysts, the market price of our common stock may decline.



Employee uncertainty related to the NPTest acquisition could harm us.



Our employees may experience uncertainty about their future role with the combined company until or after strategies with regard to the combined company
are announced or fully executed. This may adversely affect the combined companys ability to attract and retain key management, marketing, sales, customer support and technical personnel, which could harm the combined company.



As a result of our acquisition of NPTest, we expect to incur significant costs and may be
required to take additional charges.



To date, the
combined company has incurred approximately $5.9 million in direct costs associated with the merger which was capitalized as part of the overall purchase price. In addition, we recorded a charge of $7.9 million for the write off of in-process
research and development and incurred $13.2 million of restructuring charges resulting from the purchase of NPTest. We believe the combined entity may incur additional charges to operations, which cannot be reasonably estimated at this time. There
is no assurance that the combined company will not incur additional material charges in subsequent quarters to reflect additional costs associated with the merger.



Under our inventory valuation policy, we review excess and obsolete inventory on a quarterly basis for significant events
that might have an impact on inventory valuations. We believe the decisions regarding future product development stemming from the NPTest acquisition are a significant event and thus we evaluated the current inventory valuations of our products to
determine if the inventory values have been impaired. The primary area of market segment overlap is in the higher-end system-on-a-chip marketplace where we have chosen to focus future investment on the development of the



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NPTest Sapphire product rather than our Octet product. The review and evaluation resulted in a special charge of $49.6 million in fiscal 2004 and $5.4
million for the nine months ended July 31, 2005. Of the combined amount, $49.1 million was directly related to inventory write-downs. The remaining $5.9 million related to vendors liabilities, spare part write-downs, long-lived assets
write-offs, the scrapping of existing work orders and workforce reductions.



In November 2004 we announced a Facilities Restructuring Plan that resulted in the closure of both NPTests major North American facilities as well as a reduction in force. Our manufacturing operations in
Milpitas, California and Simi Valley, California were moved to Hillsboro, Oregon. By consolidating our manufacturing operations into a single facility, we believe we will be better able to reduce overhead and infrastructure costs, focus on product
innovation, and maintain a higher level of quality and customer service. We expect to execute this Facilities Restructuring Plan primarily in the May to October 2005 time period. Approximately 8% or 160 employees, primarily in manufacturing, will be
leaving us as result of this Plan. In connection with the Facilities Restructuring Plan, we expect to record total charges of approximately $27.8 million, consisting of approximately $2.7 million in charges related to severance and related costs,
approximately $5.9 million in expenses for relocation, retention and other, approximately $8.8 million in charges related to the write-off or accelerated depreciation of tenant improvements, and approximately $10.4 million in charges related to the
write-off of lease liabilities. We expect to payout approximately $8.1 million of the total charges associated with the Facilities Restructuring Plan during fiscal 2005. We also expect to payout approximately $9.5 million in fiscal 2006 through
fiscal 2009 for lease liability payments.



We may be required
to take additional charges for excess and obsolete inventory and impairment of property and equipment as a result of this integration in the future.



We operate in a volatile industry  indicator of goodwill and other long-lived assets impairment under SFAS 142 and SFAS 144 may be present from time to time.



Effective November 1, 2002, we adopted Statement of
Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, or SFAS 142, which was issued by the FASB in July 2001. Under this standard, we ceased amortizing goodwill and acquired workforce effective November 1, 2002.
During the nine months ended July 31, 2005 and July 31, 2004, goodwill increased by approximately $3.4 million and $381.7 million, respectively, due to our acquisition of NPTest.



We test goodwill for possible impairment on an annual basis and at any other time if events occur or circumstances indicate
that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: our market value falling below our net book value for a significant period of time, a significant
adverse change in the business climate or legal factors; unanticipated competition; loss of key personnel, a significant change in direction with respect to investment in a product or market segment; the likelihood that a significant portion of the
business will be sold or disposed of; or the results of testing for recoverability of a significant asset group within a reporting unit determined in accordance with SFAS 142.



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As mandated by SFAS 142, we completed our annual goodwill impairment test as of July 31, 2004 during the
fourth quarter of the fiscal year. We most recently reviewed goodwill for impairment again at the end of January 2005, largely because of lower revenues than in the preceding two quarters. In all such tests to date, we determined that the sum of the
expected future discounted cash flows from the assets exceeded the carrying value of those assets; therefore, no impairment of goodwill was recognized. However, no assurances can be given that future evaluations of goodwill will not result in future
impairment charges. We will continue to evaluate goodwill on an annual basis and at such other times as events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future discounted cash flow. If we
determine our goodwill or intangible assets to be impaired, the result of non-cash charges could be substantial.



We also reviewed other intangibles for impairment at the end of January 2005, largely because of lower revenues than in the preceding two quarters. We
determined that the sum of the expected future undiscounted cash flows from the assets exceeded the carrying value of those assets; therefore, no impairment of other intangibles was recognized. However, no assurances can be given that future
evaluations of other intangibles will not result in future impairment charges. We will continue to evaluate other intangibles at such times as events and changes in circumstances suggest that the carrying amount may not be recoverable from its
estimated future undiscounted cash flow.



We have substantial indebtedness
and if we need additional financing, it could be difficult to obtain.



We have $180 million principal amount of 1.5% Convertible Subordinated Notes, (Notes), due in 2008. We may incur substantial additional indebtedness in the future. The level of indebtedness, among other things, could:



| |  |  | make it difficult for us to make payments on our debt and other obligations, particularly upon maturity in 2008 if we were unable to cause the conversion of this debt into equity;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | make it difficult for us to obtain any necessary future financing for working capital, capital expenditures, debt service requirements or other purposes;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | require the dedication of a substantial portion of any cash flow from operations to service the indebtedness, thereby reducing the amount of cash flow available for other purposes,
including capital expenditures;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | limit our flexibility in planning for, or reacting to changes in our business and the industries in which we compete;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | place us at a possible competitive disadvantage with respect to less leveraged competitors and competitors that have better access to capital resources; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | make us more vulnerable in the event of a further downturn in our business.
| | - |  | ---------------------------------------------------------------------------



There can be no assurance that we will be able to meet our debt service obligations, including our obligations under the Notes.



We expect that our existing cash, marketable securities, and borrowing and
receivable factoring facilities will be sufficient to meet our cash requirements to fund operations and expected capital expenditures for the foreseeable future. In the event we may need to raise additional funds, we cannot be certain that we will
be able to obtain such additional financing on favorable terms if at all. Further, if we issue additional equity securities, stockholders may experience additional dilution or the new equity securities may have rights, preferences or privileges
senior to those of existing holders of common stock. Future financings may place restrictions on how we operate our business. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and
services, take advantage of future business opportunities, grow our business or respond to competitive pressures, which could seriously harm our business.



The semiconductor industry is cyclical.



Our revenue growth has been materially adversely affected by the cyclical downturn in the semiconductor industry and its resulting impact upon the
semiconductor equipment sector. Although the test and assembly sector of the semiconductor equipment industry has been recovering from a severe downturn, there is current evidence of a slowing in the business and uncertainty as to the strength and
length of the current cyclical phase. The downturn contributed to weakened order activity, order cancellation activity, and customer-requested shipment delays from our backlog. Until such time as we return to a sustained growth period, we expect a
continuing volatility in order activity. Though revenue levels have generally improved during fiscal 2004, we expect that our net revenues will decline during fiscal 2005 and may decline thereafter due to the uncertainty of a sustainable recovery in
the semiconductor and related capital equipment industry. As a result of cyclical downturns, in fiscal 2001 we reduced our worldwide workforce by approximately 23%, or more than 400 people. In fiscal 2002, we reduced our worldwide workforce by 21%,
or about 225 people. During fiscal 2003, we reduced our worldwide workforce by 233 people, excluding the effect of the acquisitions for a total of 20% over the 2003 fiscal year. We took charges related to these reductions in force of $3.2 million
during fiscal 2001, $5.7 million during fiscal 2002 and $3.4 million during fiscal 2003. Additionally, remaining employees were required to take time off during certain periods throughout fiscal 2001-2004. Other initiatives during fiscal years 2001
 2003 included a temporary domestic and European



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pay cut during 2001 and 2002, a domestic salary realignment in 2003, a four-day work week for most manufacturing and some operating employees, the
consolidation and reorganization of certain functions and operations, and the curtailment of discretionary expenses. If we continue to reduce our workforce or adopt additional cost-saving measures, it may adversely impact our ability to respond
rapidly to any renewed growth opportunities in the future should they occur.



To better align our business model with the cyclicality of our business, in November 2004 we announced a Facilities Restructuring Plan that resulted in the closure of both NPTests major North American facilities
as well as a reduction in force. Our manufacturing operations in Milpitas, California and Simi Valley, California were moved to Hillsboro, Oregon. By consolidating our manufacturing operations into a single facility, we believe we will be better
able to reduce overhead and infrastructure costs, focus on product innovation, and maintain a higher level of quality and customer service. We expect to execute this Facilities Restructuring Plan primarily during the May to October 2005 time period.
Approximately 8% or 160 employees, primarily in manufacturing, will be leaving us as result of this Plan. In connection with the Facilities Restructuring Plan, we expect to record total charges of approximately $27.8 million, consisting of
approximately $2.7 million in charges related to severance and related costs, approximately $5.9 million in expenses for relocation, retention and other, approximately $8.8 million in charges related to the write-off or accelerated depreciation of
tenant improvements, and approximately $10.4 million in charges related to the write-off of lease liabilities. We expect to payout approximately $8.1 million of the total charges associated with the Facilities Restructuring Plan during fiscal 2005.
We also expect to payout approximately $9.5 million in fiscal 2006 through fiscal 2009 for lease liability payments. A reduction in force affecting approximately 138 positions or 7% of our employees and contract workers occurred on November 18,
2004. This action, combined with the Facilities Restructuring Plan, will result in the elimination of approximately 298 positions or 14% of our global work force. We recorded a severance charge in the fourth fiscal quarter ended October 31, 2004 of
approximately $2.5 million in connection with the employee reduction taken on November 18, 2004. There can be no assurance that we will achieve all of the cost savings contemplated by these cost reduction measures.



As a result of the rapid and steep decline in revenue during the 2001 to 2002
period, we continue to monitor our inventory levels in light of product development changes and a possible eventual upturn. We recorded a charge of $9.4 million in the fourth fiscal quarter of 2002 for the write-off of excess inventories. In
addition, during the third quarter of fiscal 2003, we recorded special charges in cost of goods sold of $1.9 million related to a settlement with an inventory supplier and spare part write-offs associated with a discontinued product line. In
connection with new products, we typically build up substantial finished goods inventories. If we cannot sell some of these products, we may be required to make further inventory write-offs, which would negatively impact our future financial
performance.



We have approximately $44.9 million of open and
non-cancelable purchase order commitments outstanding at July 31, 2005. These are primarily for inventory purchases being made to support the anticipated revenues for the fourth quarter of fiscal 2005 and first quarter of fiscal 2006.



Our business and results of operations depend largely upon the capital
expenditures of manufacturers of semiconductors and companies that specialize in contract packaging and/or testing of semiconductors. This includes manufacturers and contractors that are opening new or expanding existing fabrication facilities or
upgrading existing equipment, which in turn depend upon the current and anticipated market demand for semiconductors and products incorporating semiconductors. The semiconductor industry has been highly cyclical with recurring periods of oversupply,
which often has had a severe effect on the semiconductor industrys demand for test equipment, including the systems we manufacture and market. We believe that the markets for newer generations of semiconductors will also be subject to similar
fluctuations.



As a result of the cyclical nature of the
semiconductor industry, we have experienced shipment delays, delays in commitments and restructured purchase orders by customers and we expect this activity to continue. Accordingly, we cannot be certain that we will be able to achieve or maintain
our current or prior level of sales or rate of growth. We anticipate that a significant portion of new orders may depend upon demand from semiconductor device manufacturers building or expanding fabrication facilities and new device testing
requirements that are not addressable by currently installed test equipment, and there can be no assurance that such demand will develop to a significant degree, or at all. In addition, our business, financial condition or results of operations may
continue to be materially adversely affected by any factor materially adversely affecting the semiconductor industry in general or particular segments within the semiconductor industry.



We have a limited backlog and obtain most of our net sales from products that typically range in price from $0.2 million to $5.0 million
and we generally ship products generating most of our net sales near the end of each quarter, which can result in fluctuations of quarterly results.



Other than certain memory products and software products, for which the price range is typically below $50,000, we obtain most of our net sales from the
sale of a relatively few number of systems that typically range in selling price from $0.2 million to $5.0 million. This has resulted and could continue to result in our net sales and operating results for a particular period being significantly
impacted by the timing of recognition of revenue from a single transaction. Our net sales and operating results for a particular period could also be materially adversely affected if an anticipated order from just one customer is not received in
time to permit shipment during that period. Backlog at the beginning of a quarter typically does



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not include all orders necessary to achieve our sales objectives for that quarter. Orders in backlog are subject to cancellation, delay, deferral or
rescheduling by customers with limited or no penalties. Throughout the recent fiscal years, we have experienced customer-requested shipment delays and order cancellations, and we believe it is probable that orders will be canceled and delayed in the
future. Consequently, our quarterly net sales and operating results have in the past, and will in the future, depend upon our obtaining orders for systems to be shipped in the same quarter in which the order is received.



In the past, some of our customers have placed orders with us for more
systems than they ultimately required. We believe that in the future some of our customers may, from time to time, place orders with us for more systems than they will ultimately require, or they will order a more rapid delivery than they will
ultimately require. For this reason, our backlog may include customer orders in excess of those that will actually be delivered.



Furthermore, we generally ship products generating most of our net sales near the end of each quarter. Accordingly, our failure to receive an anticipated
order or a delay or rescheduling in a shipment near the end of a particular period or a delay in receiving customer acceptance from a customer may cause net sales in a particular period to fall significantly below expectations, which could have a
material adverse effect on our business, financial condition or results of operations. The relatively long manufacturing cycle of many of our testers has caused and could continue to cause future shipments of testers to be delayed from one quarter
to the next. Furthermore, as our competitors announce new products and technologies, and as we complete acquisitions of similar technologies, such as certain product offerings of NPTest, customers may defer or cancel purchases of our existing
systems. We cannot forecast the impact of these and other factors on our sales and operating results.



We may continue to experience delays in development, introduction, production in volume, and recognition of revenue from sales of our product.



We have in the past experienced significant delays in the development, introduction, volume production and sales of our new
systems and related feature enhancements. In the past, we experienced significant delays in the introduction of our Octet, ValStar 2000 and Kalos series testers as well as certain enhancements to our other testers. The Octet tester was first shipped
in October 2002 and minimal revenue has been recognized from the Octet product family through July 31, 2005. Following the acquisition of NPTest, we have chosen to focus future investment on the Sapphire product rather than our Octet product. We
have historically experienced some delays related to our inability to successfully complete product hardware and software engineering within the time frame originally anticipated, including design errors and redesigns of ICs. As a result, some
customers have experienced significant delays in receiving and using our testers in production. In addition, under our revenue recognition policy that is in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition (SAB
104), we defer revenue for transactions that involve newly introduced products or when customers specify acceptance criteria that cannot be demonstrated prior to the shipment. This results in a delay in the recognition of revenue as compared to the
historic norm of generally recognizing revenue upon shipment. We introduced several new systems and products during fiscal 2003. Revenues from sales of those new systems and products may be deferred until the revenue recognition requirements of our
revenue recognition policy are satisfied. Delays in introducing a product or delays in our ability to obtain customer acceptance, if they occur in the future, will delay the recognition of revenue and gross profit by us. We cannot be certain that
these or additional difficulties will not continue to arise or that delays will not continue to materially adversely affect customer relationships and future sales. Moreover, we cannot be certain that we will not encounter these or other
difficulties, including difficulties resulting from the integration of NPTest that could delay future introductions or volume production or sales of our systems or enhancements and related software tools. In the past, we have incurred and we may
continue to incur substantial unanticipated costs to ensure the functionality and reliability of our testers and to increase feature sets. If our systems continue to have reliability, quality or other problems, or the market perceives our products
to be feature deficient, we may continue to suffer reduced orders, higher manufacturing costs, delays in collecting accounts receivable and higher service, support and warranty expenses, and/or inventory write-offs, among other effects. Our failure
to have a competitive tester and related software tools available when required by a customer could make it substantially more difficult for us to sell testers to that customer for a number of years. We believe that the continued acceptance, volume
production, timely delivery and customer satisfaction of our newer digital, mixed signal and non-volatile memory testers are of critical importance to our future financial results. As a result, our inability to correct any technical, reliability,
parts shortages or other difficulties associated with our systems or to manufacture and ship the systems on a timely basis to meet customer requirements could damage our relationships with current and prospective customers and would continue to
materially adversely affect our business, financial condition and results of operations. In addition, the consolidation of our manufacturing operations in a single site exposes us to the increased risk of manufacturing delays or disruption in the
event of natural disasters or other calamities at the site. Any delays or disruptions could materially adversely affect our business, financial condition and results of operations.



Competition in the ATE market requires rapid technological enhancements and new products and services.



Our ability to compete in the Automatic Test Equipment or ATE market depends
upon our ability to successfully develop and introduce new hardware and software products and enhancements and related software tools with enhanced features on a timely and cost-effective basis, including products under development internally as
well as products obtained in acquisitions. Our customers require testers and software products with additional features and higher performance and other capabilities. Therefore, it is necessary for us to enhance the performance and other
capabilities of our existing systems and software products and related software tools, or develop new systems and software products and related software tools, to adequately address these requirements. Any success we may have in developing new and
enhanced systems and software products and new features to our existing systems and software products will depend upon a variety of factors, including:



| |  |  | product selection;
| | - |  | ------------------



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| |  |  | timely and efficient completion of product design;
| | - |  | --------------------------------------------------



| |  |  | implementation of manufacturing and assembly processes;
| | - |  | -------------------------------------------------------



| |  |  | successful coding and debugging of software;
| | - |  | --------------------------------------------



| |  |  | product performance;
| | - |  | --------------------



| |  |  | reliability in the field;
| | - |  | -------------------------



| |  |  | effective worldwide sales and marketing; and
| | - |  | --------------------------------------------



| |  |  | labor and supply constraints.
| | - |  | -----------------------------



Because we must make new product development commitments well in advance of sales, new product decisions must anticipate both future demand and the
availability of technology to satisfy that demand. We cannot be certain that we will be successful in selecting, developing, manufacturing and marketing new hardware and software products or enhancements and related software tools. Our inability to
introduce new products and related software tools that contribute significantly to net sales, gross margins and net income would have a material adverse effect on our business, financial condition and results of operations. New product or technology
introductions by our competitors could cause a decline in sales or loss of market acceptance of our existing products. If we introduce new products, existing customers may curtail purchases of the older products resulting in inventory write-offs and
they may delay new product purchases. In addition, capacity utilization at outsourced assembly and test houses continues at low levels which is likely to depress our non-integrated device manufacturers, or IDM business until such time that demand
and supply conditions improve. Any decline in demand for our hardware or software products could have a materially adverse effect on our business, financial condition or results of operations.



The fluctuations in our sales and operations have placed and are continuing to place a
considerable strain on our management, financial, manufacturing and other resources.



Over the last several years we have experienced significant fluctuations in our operating results. In fiscal 2004, our net sales increased by 141% from those recorded in fiscal 2003, and in fiscal 2003, our net sales
increased by 11% from those recorded in fiscal 2002; however, in fiscal 2002, our net sales fell 46% from those recorded in fiscal 2001 as the semiconductor industry continued in a steep cyclical downturn. Since 1993, except for the recent and
current cost-cutting efforts and those during fiscal 1998 and the first half of fiscal 1999, we have overall significantly increased the scale of our operations to support periods of generally increased sales levels and expanded product offerings
and have expanded operations to address critical infrastructure and other requirements, including the hiring of additional personnel, significant investments in research and development to support product development, acquisition of the facilities
in Oregon and California, further investments in our ERP system and numerous acquisitions. These fluctuations in our sales and operations have placed and are continuing to place a considerable strain on our management, financial, manufacturing and
other resources. In order to effectively deal with the changes brought on by the cyclical nature of the industry, we have been required to implement and improve a variety of highly flexible operating, financial and other systems, procedures and
controls capable of expanding or contracting consistent with our business. However, we cannot be certain that any existing or new systems, procedures or controls, including our ERP system, will be adequate to support fluctuations in our operations
or that our systems, procedures and controls will be cost-effective or timely. Any failure to implement, improve and expand or contract such systems, procedures and controls efficiently and at a pace consistent with our business could have a
material adverse effect on our business, financial condition or results of operations.



We are continuing to invest significant resources in the expansion of our product lines and there is no certainty that our net sales will increase or remain at historical levels or that new products will contribute to revenue growth.



We are currently devoting and intend to continue to
devote significant resources to the development, production and commercialization of new products and technologies. During fiscal 2004, we introduced several products that are evolutions or derivatives of existing products as well as products that
were largely new. Under our revenue recognition policy adopted in accordance with SAB 104, we defer revenue for transactions that involve newly introduced products or when customers specify acceptance criteria that cannot be demonstrated prior to
the shipment. This results in a delay in the recognition of revenue as compared to the historic norm of recognizing revenue upon shipment. Product introduction delays, if they occur in the future, will delay the recognition of revenue and gross
profit and may result in delayed cash receipts by us that could materially adversely affect our business, financial condition and results of operations. We invested and continue to invest significant resources in property, plant and equipment,
purchased and leased facilities, inventory, personnel and other costs to begin or prepare to increase production of these products. A significant portion of these investments will provide the marketing, administration and after-sales service and
support required for these new hardware and software products.



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Accordingly, we cannot be certain that gross profit margin and inventory levels will not continue to be materially adversely affected by delays in new
product introductions or start-up costs associated with the initial production and installation of these new product lines. We also cannot be certain that we can manufacture these systems per the time and quantity required by our customers. The
start-up costs include additional manufacturing overhead, additional inventory and warranty reserve requirements and the enhancement of after-sales service and support organizations. In addition, the increases in inventory on hand for new product
development and customer support requirements have increased and will continue to increase the risk of significant inventory write-offs. We cannot be certain that our net sales will increase or remain at historical levels or that any new products
will be successfully commercialized or contribute to revenue growth or that any of our additional costs will be covered.



The ATE industry is intensely competitive which can adversely affect our ability to maintain our current net sales and our revenue growth.



With the substantial investment required to develop test application
software and interfaces, we believe that once a semiconductor manufacturer has selected a particular ATE vendors tester, the manufacturer is likely to use that tester for a majority of its testing requirements for the market life of that
semiconductor and, to the extent possible, subsequent generations of similar products. As a result, once an ATE customer chooses a system for the testing of a particular device, it is difficult for competing vendors to achieve significant ATE sales
to such customer for similar use. Our inability to penetrate any particular large ATE customer or achieve significant sales to any ATE customer could have a material adverse effect on our business, financial condition or results of operations.



We face substantial competition from ATE manufacturers
throughout the world. A substantial portion of our net sales is derived from sales of mixed-signal testers. We face in some cases five and in other cases seven competitors in our primary market segments of digital, mixed signal, and RF wireless ATE.
We believe that the ATE industry in total has not been profitable for the last three years, indicating a very competitive and volatile marketplace. Several of these competitors have substantially greater financial and other resources with which to
pursue engineering, manufacturing, marketing and distribution of their products. Certain competitors have introduced or announced new products with certain performance or price characteristics equal or superior to products we currently offer. These
competitors have introduced products that compete directly against our products. We believe that if the ATE industry continues to consolidate through strategic alliances or acquisitions, we will continue to face significant additional competition
from larger competitors that may offer product lines and services more complete than ours. Our competitors are continuing to improve the performance of their current products and to introduce new products, enhancements and new technologies that
provide improved cost of ownership and performance characteristics. New product introductions by our competitors could cause a decline in our sales or loss of market acceptance of our existing products.



Moreover, our business, financial condition or results of operations will
continue to be materially adversely affected by continuing competitive pressure and continued intense price-based competition. We have experienced and continue to experience significant price competition in the sale of our products. In addition,
pricing pressures typically have become more intense during cyclical downturns when competitors seek to maintain or increase market share, at the end of a products life cycle and as competitors introduce more technologically advanced products.
We believe that, to be competitive, we must continue to expend significant financial resources in order to, among other things, invest in new product development and enhancements and to maintain customer service and support centers worldwide. We
cannot be certain that we will be able to compete successfully in the future.



We may not be able to deliver custom hardware options and software applications to satisfy specific customer needs in a timely manner.



We must develop and deliver customized hardware and software to meet our customers specific test requirements. The market requires us to manufacture
these systems on a timely basis. Our test equipment may fail to meet our customers technical or cost requirements and may be replaced by competitive equipment or an alternative technology solution. Our inability to meet such hardware and
software requirements could impact our ability to recognize revenue on the related equipment. Our inability to provide a test system that meets requested performance criteria when required by a device manufacturer would severely damage our
reputation with that customer. This loss of reputation may make it substantially more difficult for us to sell test systems to that manufacturer for a number of years, which could have a material adverse effect on our business, financial condition
or results of operations.



We rely on Spirox Corporation and customers in
Taiwan for a significant portion of our revenues and the termination of this distribution relationship would materially adversely affect our business.



Spirox Corporation, a distributor in Taiwan that sells to end-user customers in Taiwan and China, accounted for approximately 10%, 23% and 19% of our net
sales in the nine-month period ended July 31, 2005 and fiscal years ended October 31, 2004 and 2003, respectively. Our agreement with Spirox has no minimum purchase commitment and can be terminated for any reason on 180 days prior written notice. On
May 31, 2005, we entered into an agreement with Spirox to combine our Taiwan operation with Spiroxs T1 division into a corporation named Credence Spirox, an operation owned 90% by Spirox and 10% by us. This new corporation is dedicated to
support our products in the Taiwan region. Consequently, our business, financial condition and results of operations could be materially adversely affected by the loss of or any reduction in orders by Spirox, any termination of the



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Spirox relationship, or the loss of any significant Spirox customer, including the potential for reductions in orders by assembly and tester service
companies due to technical, manufacturing or reliability problems with our products or continued slow-downs in the semiconductor industry or in other industries that manufacture products utilizing semiconductors. Our ability to maintain or increase
sales levels in Taiwan will depend upon:



| |  |  | our ability with Spirox to obtain orders from existing and new customers;
| | - |  | -------------------------------------------------------------------------



| |  |  | our ability to manufacture systems on a timely and cost-effective basis;
| | - |  | ------------------------------------------------------------------------



| |  |  | our ability to timely complete the development of our new hardware and software products;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | Spirox and its end-user customers financial condition and success;
| | - |  | -------------------------------------------------------------------



| |  |  | general economic conditions; and
| | - |  | --------------------------------



| |  |  | our ability to meet increasingly stringent customer performance and other requirements and shipment delivery dates.
| | - |  | -------------------------------------------------------------------------------------------------------------------



We require a significant amount of cash, and our ability to generate cash may be affected
by factors beyond our control.



Our business may not
generate cash flow in an amount sufficient to enable us to fund our liquidity needs, including payment of the principal of, or interest on, our indebtedness, working capital, capital expenditures, product development efforts, strategic acquisitions,
investments and alliances and other general corporate requirements. Our ability to generate cash is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot be assured that
our business will generate sufficient cash flow from operations or that future borrowings or other sources of funding will be available to us, in amounts sufficient to enable us to fund our liquidity needs or with terms that are favorable to us.



Our long and variable sales cycle depends upon factors outside of our
control and could cause us to expend significant time and resources prior to earning associated revenues.



Sales of our systems depend in part upon the decision of semiconductor manufacturers to develop and manufacture new semiconductor devices or to increase
manufacturing capacity. As a result, sales of our products are subject to a variety of factors we cannot control. The decision to purchase our products generally involves a significant commitment of capital, with the attendant delays frequently
associated with significant capital expenditures. For these and other reasons, our systems have lengthy sales cycles during which we may expend substantial funds and management effort to secure a sale, subjecting us to a number of significant risks,
including a risk that our competitors may compete for the sale, a further downturn in the economy or other economic factors causing our customers to withdraw or delay their orders or a change in technological requirements of the customer. As a
result, our business, financial condition and results of operations would be materially adversely affected by our long and variable sales cycle and the uncertainty associated with expending substantial funds and effort with no guarantee that a sale
will be made.



Changes to financial accounting standards may affect our
reported results of operations.



We prepare our financial
statements to conform to generally accepted accounting principles, or GAAP. GAAP are subject to interpretation by the American Institute of Certified Public Accountants, the SEC and various bodies formed to interpret and create appropriate
accounting policies. A change in those policies can have a significant effect on our reported results and may even affect our reporting of transactions completed before a change is announced. Accounting rules affecting many aspects of our business,





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including rules relating to accounting for business combinations, asset impairment, revenue recognition, restructuring or disposal of long-lived assets,
arrangements involving multiple deliverables, consolidation of variable interest entities, employee stock purchase plans and stock option grants have recently been revised or are currently under review. Changes to those rules or current
interpretation of those rules may have a material adverse effect on our reported financial results or on the way we conduct our business. For example, in 1999, we changed our method of accounting for systems revenue based on guidance provided in SAB
101. Adoption of SAB 101 required us to restate our quarterly results for the seven fiscal quarters ended July 31, 2001 (see Note 1, Organization and Summary of Significant Accounting Policies, of the notes to the consolidated financial
statements in our Annual Report on Form 10-K for further discussion). In addition, the preparation of our financial statements in accordance with GAAP requires that we make estimates and assumptions that affect the recorded amounts of assets and
liabilities, disclosure of those assets and liabilities at the date of the financial statements and the recorded amounts of expenses during the reporting period. A change in the facts and circumstances surrounding those estimates could result in a
change to our estimates and could impact our future operating results.



In addition, Statement on Financial Accounting Standard No. 123R Share-Based Payment requires that employee stock option and employee stock purchase plans shares be treated as a compensation expense. SFAS 123R is effective for
all annual reporting period that begins after June 15, 2005. We expect to adopt SFAS 123R effective November 1, 2006. The adoption of this statement is expected to result in significant compensation charges. For example, for the nine months ended
July 31, 2005 and fiscal year ended October 31, 2004, had we accounted for stock-based compensation plans using FAS 123 as amended by FAS 148, diluted loss per share would have been increased by $0.18 and $0.41, respectively. We believe that the
adoption of SFAS 123R will have a material effect on our results of operations. We, however, have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosure under FAS No. 123.



There are limitations on our ability to find the supplies and services necessary to run
our business.



We obtain certain components, subassemblies
and services necessary for the manufacture of our testers from a limited group of suppliers. We do not maintain long-term supply agreements with most of our vendors, and we purchase most of our components and subassemblies through individual
purchase orders. The manufacture of certain of our components and subassemblies is an extremely complex process. We also rely on outside vendors to manufacture certain components and subassemblies and to provide certain services. We have experienced
and continue to experience significant reliability, quality and timeliness problems with several critical components including certain custom ICs. We cannot be certain that these or other problems will not continue to occur in the future with our
suppliers or outside subcontractors. Our reliance on a limited group of suppliers and on outside subcontractors involves several risks, including an inability to obtain an adequate supply of required components, subassemblies and services and
reduced control over the price, timely delivery, reliability and quality of components, subassemblies and services. Shortages, delays, disruptions or terminations of the sources for these components and subassemblies have delayed and in the future
may delay shipments of our systems and new products and could have a material adverse effect on our business. Our continuing inability to obtain adequate yields or timely deliveries or any other circumstance that would require us to seek alternative
sources of supply or to manufacture such components internally could also have a material adverse effect on our business, financial condition or results of operations. Such delays, shortages and disruptions would also damage relationships with
current and prospective customers and have and could continue to allow competitors to penetrate our customer accounts. We cannot be certain that our internal manufacturing capacity or that of our suppliers and subcontractors will be sufficient to
meet customer requirements.



Our international business exposes us to
additional risks.



International sales accounted for
approximately 66%, 72% and 64% of our total net sales for the nine months ended July 31, 2005 and fiscal years 2004 and 2003, respectively. We anticipate that international sales will continue to account for a significant portion of our total net
sales in the foreseeable future. These international sales will continue to be subject to certain risks, including:



| |  |  | changes in regulatory requirements;
| | - |  | -----------------------------------



| |  |  | tariffs and other barriers;
| | - |  | ---------------------------



| |  |  | political and economic instability;
| | - |  | -----------------------------------



| |  |  | the adverse effect of fears surrounding any health risks on our business and sales and that of our customers, especially in Taiwan, Hong Kong and China;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | an outbreak of hostilities in markets where we sell our products including Korea and Israel;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | integration and management of foreign operations of acquired businesses;
| | - |  | ------------------------------------------------------------------------



| |  |  | foreign currency exchange rate fluctuations;
| | - |  | --------------------------------------------



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| |  |  | difficulties with distributors, joint venture partners, original equipment manufacturers, foreign subsidiaries and branch operations;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------



| |  |  | potentially adverse tax consequences;
| | - |  | -------------------------------------



| |  |  | the possibility of difficulty in accounts receivable collection;
| | - |  | ----------------------------------------------------------------



| |  |  | greater difficulty in maintaining U.S. accounting standards; and
| | - |  | ----------------------------------------------------------------



| |  |  | greater difficulty in protecting intellectual property rights.
| | - |  | --------------------------------------------------------------



We are also subject to the risks associated with the imposition of domestic and foreign legislation and regulations relating to the import or export of
semiconductor equipment and software products. We cannot predict whether the import and export of our products will be adversely affected by changes in or new quotas, duties, taxes or other charges or restrictions imposed by the United States or any
other country in the future. Any of these factors or the adoption of restrictive policies could have a material adverse effect on our business, financial condition or results of operations. Net sales to the Asia-Pacific region accounted for
approximately 42%, 52% and 38% of our total net sales in the nine months ended July 31, 2005 and fiscal years 2004 and 2003, respectively, and thus demand for our products is subject to the risk of economic instability in that region and fears
surrounding SARS or other health risks could continue to be materially adversely affected. Countries in the Asia-Pacific region, including Korea and Japan, have experienced weaknesses in their currency, banking and equity markets in the recent past.
These weaknesses could continue to adversely affect demand for our products, the availability and supply of our product components and our consolidated results of operations. Further, many of our customers in the Asia-Pacific region built up
capacity in ATE during fiscal 2000 in anticipation of a steep ramp up in wafer fabrication. However, this steep ramp up in output has not fully materialized leaving some customers with excess capacity.



No single Asian end-user customer accounted for more than 10% of our net
sales during the first nine months 2005 and 2004 or 2003. However, one end-user customer headquartered in Europe, STMicroelectronics N.V., accounted for 15% and 10% of our net sales in fiscal 2004 and 2003, respectively. Two customers headquartered
in the U.S. accounted for 28% and 14% of our net sales in the nine-month period of fiscal 2005. One customer headquartered in the U.S. accounted for 11% of our net sales in fiscal 2004.



In addition, one of our major distributors, Spirox Corporation, which accounted for 10%, 23% and 19% of our net sales in the
first nine months of fiscal 2005, fiscal 2004 and 2003, respectively, is a Taiwan-based company. This subjects a significant portion of our receivables and future revenues to the risks associated with doing business in a foreign country, including
political and economic instability, currency exchange rate fluctuations, fears related to health risks and regulatory changes. Disruption of business in Asia caused by the previously mentioned factors could continue to have a material impact on our
business, financial condition or results of operations.



If the protection
of our proprietary rights is inadequate, our business could be harmed.



We attempt to protect our intellectual property rights through patents, copyrights, trademarks, maintenance of trade secrets and other measures, including entering into confidentiality agreements. However, we cannot
be certain that others will not independently develop substantially equivalent intellectual property or that we can meaningfully protect our intellectual property. Nor can we be certain that our patents will not be invalidated, deemed unenforceable,
circumvented or challenged, or that the rights granted thereunder will provide us with competitive advantages, or that any of our pending or future patent applications will be issued with claims of the scope we seek, if at all. Furthermore, we
cannot be certain that others will not develop similar products, duplicate our products or design around our patents, or that foreign intellectual property laws, or agreements into which we have entered will protect our intellectual property rights.
Inability or failure to protect our intellectual property rights could have a material adverse effect upon our business, financial condition and results of operations. In addition, from time to time we encounter disputes over rights and obligations
concerning intellectual property, including disputes with parties with whom we have licensed technologies. We cannot assume that we will prevail in any such intellectual property disputes. We have been involved in extensive, expensive and
time-consuming reviews of, and litigation concerning, patent infringement claims.



Our business may be harmed if we are found to infringe proprietary rights of others.



We have at times been notified that we may be infringing intellectual property rights of third parties and we have litigated patent infringement claims in
the past. We expect to continue to receive notice of such claims in the future. We cannot be certain of the success in defending patent infringement claims or claims for indemnification resulting from infringement claims.



Some of our customers have received notices from the foundation of Mr. Jerome
Lemelson alleging that the manufacture of semiconductor products and/or the equipment used to manufacture semiconductor products infringes certain patents issued to Mr. Lemelson. We have been notified by customers that we may be obligated to defend
or settle claims that



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our products infringe Mr. Lemelsons patents, and that if it is determined that the customers infringe Mr. Lemelsons patents, those customers may
intend to seek indemnification from us for damages and other related expenses. In January 2004, Judge Pro of the U.S. District Court in Nevada issued a decision in the Symbol/Cognex v. Lemelson case finding the Lemelson patents invalid,
unenforceable and not infringed. The Lemelson foundation has appealed this decision and we cannot be certain of the ultimate outcome.



We cannot be certain of success in defending current or future patent or other infringement claims or claims for indemnification resulting from
infringement claims. Our business, financial condition and results of operations could be materially adversely affected if we must pay damages to a third party or suffer an injunction or if we expend significant amounts in defending any such action,
regardless of the outcome. With respect to any claims, we may seek to obtain a license under the third partys intellectual property rights. We cannot be certain, however, that the third party will grant us a license on reasonable terms or at
all. We could decide, in the alternative, to continue litigating such claims. Litigation has been and could continue to be extremely expensive and time consuming, and could materially adversely affect our business, financial condition or results of
operations, regardless of the outcome.



We may be materially adversely
affected by legal proceedings.



We have been and may in
the future be subject to various legal proceedings, including claims that involve possible infringement of patent or other intellectual property rights of third parties. It is inherently difficult to assess the outcome of litigation matters, and
there can be no assurance that we will prevail in any litigation. Any such litigation could result in substantial cost and diversion of our efforts, which by itself could have a material adverse effect on our financial condition and operating
results. Further, adverse determinations in such litigation could result in loss of our property rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties or prevent us from manufacturing or
selling our products, any of which could materially adversely affect our business, financial condition or results of operations.



Recently enacted and proposed changes in securities laws and regulations are likely to increase our costs.



The Sarbanes-Oxley Act of 2002 that became law in 2002 has required changes
in some of our corporate governance and securities disclosure or compliance practices. That Act also required the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made, and Nasdaq has revised and continues
to revise its requirements for companies that are Nasdaq-listed. These developments have increased our legal compliance and financial reporting costs. We expect these developments to make it more difficult and more expensive for us to obtain
director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments could make it more difficult for us to attract and retain qualified members of our
board of directors, or qualified executive officers. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.



Our executive officers and certain key personnel are critical to our business.



Our future operating results depend substantially upon
the continued service of our executive officers and key personnel. Our future operating results also depend in significant part upon our ability to attract and retain qualified management, manufacturing, technical, engineering, marketing, sales and
support personnel. Competition for qualified personnel is intense, and we cannot ensure success in attracting or retaining qualified personnel. There may be only a limited number of persons with the requisite skills to serve in these positions and
it may be increasingly difficult for us to hire personnel over time. Our business, financial condition and results of operations could be materially adversely affected by the loss of any of our key employees, by the failure of any key employee to
perform in his or her current position, or by our inability to attract and retain skilled employees.



Terrorist attacks, terrorist threats, geopolitical instability and government responses thereto, may negatively impact all aspects of our operations, revenues, costs and stock price.



The terrorist attacks in September 2001 in the United States and ensuing
events and the resulting decline in consumer confidence has had a material adverse effect on the economy. If consumer confidence does not fully recover, our revenues and profitability will continue to be adversely impacted in fiscal 2005 and beyond.



In addition, any similar future events may disrupt our
operations or those of our customers and suppliers. Our markets currently include Taiwan, Korea and Israel, which are experiencing political instability. In addition, these events have had and may continue to have an adverse impact on the U.S. and
world economy in general and consumer confidence and spending in particular, which could harm our sales. Any of these events could increase volatility in the U.S. and world financial markets, which could harm our stock price and may limit the
capital resources available to us and our customers or suppliers. This could have a significant impact on our operating results, revenues and costs and may result in increased volatility in the market price of our common stock.



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Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act
could have a material adverse effect on our business and stock price.



We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the
effectiveness of our internal controls over financial reporting and a report by our Independent Registered Public Accounting Firm addressing these assessments. With the scale of the NPTest acquisition, we are implementing and improving a variety of
operating, financial, and other systems, processes, procedures, and controls. This work includes the implementation of the NPTest activities on our primary business applications including the SAP ERP system. In addition, during our fiscal 2004 year
end close and audit processes, our independent registered public accounting firm and we identified certain material weaknesses in our internal controls and certain additional internal control deficiencies. Although we have implemented changes in our
internal controls over financial reporting, we have not completely remediated the noted material weaknesses and internal control deficiencies as of July 31, 2005, and such deficiencies may continue for one or more quarters. There can be no assurance
that we will completely remediate the noted material weaknesses and internal control deficiencies. Any failure to implement, improve and expand such systems, processes, or controls efficiently or to completely remediate the noted internal control
deficiencies could have a material adverse effect on our business and our ability to achieve and maintain an effective internal control environment. During the course of our testing we may identify deficiencies which we may not be able to remediate
in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended
from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an
effective internal control environment could have a material adverse effect on our stock price.



We are subject to anti-takeover provisions that could delay or prevent an acquisition of our company.



Provisions of our amended and restated certificate of incorporation, equity incentive plans, bylaws and Delaware law may discourage transactions involving
a change in corporate control. In addition to the foregoing, our classified board of directors and the ability of our board of directors to issue preferred stock without further stockholder approval could have the effect of delaying, deferring or
preventing a third party from acquiring us and may adversely affect the voting and other rights of holders of our common stock.





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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Our exposure to market risk from changes in interest rates relates primarily to our cash equivalents and investment portfolio. We maintain a strict
investment policy, which ensures the safety and preservation of our invested funds by limiting default risk, market risk, and reinvestment risk. Our investments consist primarily of commercial paper, medium term notes, asset backed securities, U.S.
Treasury notes and obligations of U.S. Government agencies, bank certificates of deposit, auction rate preferred securities, corporate bonds and municipal bonds. The table below presents notional amounts and related weightedaverage interest
rates by year of maturity for our investment portfolio (in thousands, except percent amounts).



|                       |  |                          |         |   |                                                        |   |         |      |  |   |         |   |      |   |      |   |            |   |  |  
|---------------------- |  | ------------------------ | ------- | - | ------------------------------------------------------ | - | ------- | ---- |  | - | ------- | - | ---- | - | ---- | - | ---------- | - |  | -
|                       |  |                          |         |   | Future maturities of investments held at July 31, 2005
|                       |  | Balance October 31, 2004 |         |   | Balance July 31, 2005                                  |   |         | 2005 |  |   | 2006    |   | 2007 |   | 2008 |   | Thereafter
|Cash equivalents       |  |                          |         |   |                                                        |   |         |      |  |   |         |   |      |   |      |   |            |   |  |  
|Amounts                |  | $                        | 94,052  |   |                                                        | $ | 86,361  |      |  | $ | 86,361  |   |      |  |      |  |            |  |  | 
|Average rate           |  |                          | 0.80    | % |                                                        |   | 2.15    | %    |  |   | 2.15    | % |      |  |      |  |            |  |  | 
|Short term investments |  |                          |         |   |                                                        |   |         |      |  |   |         |   |      |   |      |   |            |   |  |  
|Amounts                |  | $                        | 69,182  |   |                                                        | $ | 48,652  |      |  | $ | 48,652  |   |      |  |      |  |            |  |  | 
|Average rate           |  |                          | 5.54    | % |                                                        |   | 2.29    | %    |  |   | 2.29    | % |      |  |      |  |            |  |  | 
|                       |  |                          |         |   |                                                        |   |         |      |  |   |         |   |      |   |      |   |            |   |  |  
|Total investment       |  | $                        | 163,234 |   |                                                        | $ | 135,013 |      |  | $ | 135,013 |   |      |  |      |  |            |  |  | 
|Average rate           |  |                          | 2.80    | % |                                                        |   | 2.21    | %    |  |   | 2.21    | % |      |  |      |  |            |  |  | 
|Equity instruments     |  | $                        | 772     |   |                                                        | $ | 434     |      |  | $ | 434     |   |      |  |      |  |            |  |  | 



We mitigate default
risk by attempting to invest in high credit quality securities and by constantly positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor. The portfolio includes only
marketable securities with active secondary or resale markets to ensure portfolio liquidity and maintains a prudent amount of diversification.



We mitigate default risk by attempting to invest in high credit quality securities and by constantly positioning our portfolio to respond appropriately to
a significant reduction in a credit rating of any investment issuer or guarantor. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity and maintains a prudent amount of
diversification.



The sensitivity analysis model used by us for
interest rate exposure compares interest income on current investment interest rates versus current investment levels at current interest rates with a 10% increase. Based on this model, a 10% increase or decrease would result in an increase or a
decrease in interest income of approximately $31,250. There can be no assurances that the above projected interest rate increase will materialize. Fluctuations of interest rates are beyond our control.



Foreign Exchange



We generate a significant portion of our sales from customers located
outside the United States, principally in Asia and, to a lesser extent, Europe. International sales are made mostly to foreign distributors and some foreign subsidiaries and are typically denominated in U.S. dollars, but occasionally are denominated
in the local currency for European and Japanese customers. The subsidiaries also incur most of their expenses in the local currency. Our SZ product line is developed and manufactured in Germany and, thus, those expenses are Euro based. Accordingly,
some of our foreign subsidiaries use the local currency as their functional currency. Foreign currency gains/losses were approximately $1.2 million gain and $0.3 million loss for the nine months ended July 31, 2005 and 2004, respectively and
included in other income, net on the condensed consolidated statements of operations. The gain during the nine months July 31, 2005 primarily due to the U.S. dollar became stronger.



Our international business is subject to risks typical of an international business including, but not limited to: differing
economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our future results could be materially adversely impacted by changes in these or
other factors. We do not currently use derivatives, but will continue to assess the need for these instruments in the future.



Interest Rate Risk



The Convertible Subordinated Notes bear interest at a fixed rate of 1.5%, and therefore changes in interest rates do not impact our interest expense on
this debt. We, from time to time, have outstanding short-term borrowings with variable interest rates. The total average amount of these borrowings outstanding annually has been insignificant. Therefore, we expect that a 10% change in interest rate
will not have any material effect on our interest expense.



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ITEM 4.  CONTROLS AND PROCEDURES



Evaluation of Disclosure Controls and Procedures.Based on our managements evaluation (with the participation of our chief executive officer and chief financial officer), as of the end of the period covered by this report, our
chief executive officer and chief financial officer have concluded that, subject to limitations described below, our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) are effective to provide
reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms.



Identification of
Material Weaknesses.During the fourth quarter of fiscal 2004, our financial resources became significantly strained due to the integration of the recently acquired NPTest business. In addition to the considerable integration activities, we
suffered significant financial staff turnover in the NPTest business. These conditions resulted in our risk assessment and management process not being effective in planning and overseeing the integration of the financial processes related to this
newly acquired business. As a result, during the year-end close, our financial statement close process did not effectively monitor, control, and manage certain related sub-processes especially in connection with our newly acquired business. In
particular, the communication, analysis, and review elements of the enterprise wide financial statement close process did not reduce to a relatively low level of risk the potential that errors or fraud in amounts that would be material in relation
to the consolidated financial statements may occur and not be detected within a timely period by management in the normal course of business. Throughout the fiscal 2004 year end close and audit processes, a number of issues were discovered by us and
our independent auditors which resulted in adjustments in our financial statements. Upon discovery of these issues, we performed additional procedures to ensure the accuracy of the fiscal 2004 financial statements. In addition, we analyzed the
nature of the adjustments and identified the associated internal control weaknesses. Additionally, our independent registered public accounting firm have reviewed the internal controls associated with these processes and have concluded that the
adjustments discovered throughout the year end close and audit process were the result of material weaknesses in our internal control over the financial close process. The material weaknesses consist of failures to ensure:



| |  |  | an appropriate level of review of those significant financial statement accounts requiring a higher degree of judgment and estimates, in part due to the need for more personnel as
well as personnel more highly skilled, trained and familiar with the newly acquired business;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a more formal review process of certain elements of the financial statements and supporting schedules; and
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | adequate information technology general controls for user access.
| | - |  | -----------------------------------------------------------------



In addition to the material weaknesses identified above, we also identified a number of internal control deficiencies that we have concluded do not
constitute material weaknesses.



During the course of the
fiscal 2004 year end audit, most of the differences between amounts recorded by us in the financial statements and amounts that our independent registered public accounting firm believed were required to be recorded under U.S. generally accepted
accounting principles in our financial statements were recorded by management.



We are currently searching for qualified candidates for those positions identified as being advisable additions and strengthening the controls around those processes determined to be material weaknesses or internal
control deficiencies. We currently are unable to determine when the above noted material weaknesses and internal control deficiencies will be fully remediated. However, because remediation will not be completed until we have completed staffing
changes and strengthened the pertinent controls, we believe that the material weaknesses and internal control deficiencies noted above continued to exist at July 31, 2005.



Changes in Internal Control over Financial Reporting.During the nine months ended July 31, 2005, we have made the
following changes in our internal control over our financial reporting:



| |  |  | Implemented improved controls over our financial close process including increased management review of account reconciliations and subsidiary trial balances; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Enhanced revenue recognition management process.
| | - |  | ------------------------------------------------



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Limitations on the Effectiveness of Disclosure Controls and Procedures.Our management, including
the chief executive officer and chief financial officer, do not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all error and all fraud. A control system no matter how well designed and
implemented, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls
must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within a company are detected. The inherent limitations include
the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people or by
management override of the controls. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.



PART II.  OTHER INFORMATION



Item 1. Legal Proceedings.



In
March 2005, Roy Schmidt, a former employee, filed a complaint in the Superior Court of Santa Clara County, California against us, alleging fraud and various other contractual and tort claims in connection with the termination of his employment by
Credence. Mr. Schmidt alleges damages in excess of $3.0 million and seeks in addition punitive damages. Formal discovery has not yet commenced in this litigation. We intend to vigorously defend these claims and believe we possess meritorious
defenses to the claims.



We also are involved in various claims
arising in the ordinary course of business, none of which, in the opinion of management, if determined adversely against us, will have a material adverse effect on our business, financial condition or results of operations.



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.



Private Placement Transaction



On May 26, 2005, the Company entered into a settlement agreement with Schlumberger Technology Corporation, a Texas corporation (STC), Schlumberger Technologies, Inc., a Delaware corporation (STI), and Schlumberger
B.V., a corporation organized under the laws of The Netherlands (together with STC and SIT, Schlumberger), pursuant to which the Company issued 615,157 shares of the Companys common stock in a private placement transaction.
The settlement agreement arose out of the Companys obligation to make a future payment to Schlumberger in connection with the Companys acquisition of NPTest. Under the terms of the settlement agreement, the Company agreed to pay
Schlumberger $4.0 million in cash and issue 615,157 shares of the Companys common stock valued at $5.0 million. The offer, sale and issuance of the securities in the private placement was exempt from registration under the Securities Act,
pursuant to Section 4(2) thereof. As of July 31, 2005, the Company had fulfilled its obligations to Schlumberger and there were no outstanding liabilities related to this transaction.



Item 3. Defaults upon Senior Securities.



None



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



None



Item 5. Other Information.



None



Item 6. Exhibits.



(a) See
Exhibit Index



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SIGNATURES



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



|                       |  |                                                                                
|---------------------- |  | -------------------------------------------------------------------------------
|                       |  | CREDENCE SYSTEMS CORPORATION                                                   
|                       |  | (Registrant)                                                                   
|                       | 
|September 9, 2005 Date |  | /S/ JOHN BATTY                                                                 
|                       |  | John Batty Chief Financial Officer (Principal Financial and Accounting Officer)





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EXHIBIT INDEX



|              |  |                                                                                                                                      
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  |                                                                                                                                      
|3.1(1)        |  | Amended and Restated Certificate of Incorporation of the Company, as currently in effect.                                            
|              | 
|3.2(2)        |  | Amended and Restated Bylaws of the Company, as currently in effect.                                                                  
|              | 
|4.2(3)        |  | Resale Restriction Agreement with respect to certain stock option award agreements issued under the Companys 1993 Stock Option Plan.
|              | 
|31.1          |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002               
|              | 
|31.2          |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002               
|              | 
|32.1          |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002               
|              | 
|32.2          |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002               

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|(1) | Incorporated by reference to Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q for the quarterly period ended April 30, 2000.
|--- | --------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to Exhibit 3.01 to the Companys Current Report on Form 8-K (File No. 000-22366) filed on August 29, 2005.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to Exhibit 1.01 to the Companys Current Report on Form 8-K (File No. 000-22366) filed on September 1, 2005.
|--- | --------------------------------------------------------------------------------------------------------------------------------------