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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



(Mark One)



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



For the quarterly period ended January 31, 2004



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)



|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|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 ̈



At February 29, 2004, there were 64,248,977 shares of the Registrants common stock, $0.001 par value per share, outstanding.



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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 |  | 14
|Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 34
|Item 4.                       |  | Controls and Procedures                                                               |  | 34
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                      
|                              |  |                                                                                      
|Item 1.                       |  | Legal Proceedings                                                                     |  | 35
|Item 2.                       |  | Changes in Securities and Use of Proceeds                                             |  | 35
|Item 3.                       |  | Defaults Upon Senior Securities                                                       |  | 35
|Item 4.                       |  | Submission of Matters to a Vote of Security holders                                   |  | 35
|Item 5.                       |  | Other Information                                                                     |  | 35
|Item 6.                       |  | Exhibits and Reports on Form 8-K                                                      |  | 35



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PART I - FINANCIAL INFORMATION



Item 1. - FINANCIAL STATEMENTS



CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                               |  |                  |         |                   |   |        
|---------------------------------------------- |  | ---------------- | ------- | ----------------- | - | -------
|                                               |  | January 31, 2004 |         | October 31, 2003a
|ASSETS                                         |  |                  |         |                   |   |        
|Current assets:                                |  |                  |         |                   |   |        
|Cash and cash equivalents                      |  | $                | 33,396  |                   | $ | 27,318 
|Short-term investments                         |  |                  | 257,131 |                   |   | 258,578
|Accounts receivable, net                       |  |                  | 68,781  |                   |   | 65,627 
|Inventories                                    |  |                  | 83,287  |                   |   | 83,356 
|Prepaid expenses and other current assets      |  |                  | 13,973  |                   |   | 15,981 
|                                               |  |                  |         |                   |   |        
|Total current assets                           |  |                  | 456,568 |                   |   | 450,860
|Long-term investments                          |  |                  | 49,722  |                   |   | 50,682 
|Property and equipment, net                    |  |                  | 102,049 |                   |   | 102,111
|Goodwill                                       |  |                  | 37,531  |                   |   | 37,531 
|Other intangible assets, net                   |  |                  | 28,815  |                   |   | 31,285 
|Other assets                                   |  |                  | 23,355  |                   |   | 26,024 
|                                               |  |                  |         |                   |   |        
|Total assets                                   |  | $                | 698,040 |                   | $ | 698,493
|                                               |  |                  |         |                   |   |        
|LIABILITIES AND STOCKHOLDERS EQUITY           |  |                  |         |                   |   |        
|Current liabilities:                           |  |                  |         |                   |   |        
|Bank loans and notes payable  leased products |  | $                | 7,172   |                   | $ | 9,350  
|Accounts payable                               |  |                  | 27,124  |                   |   | 23,303 
|Accrued expenses and other liabilities         |  |                  | 52,101  |                   |   | 45,770 
|Deferred profit                                |  |                  | 4,715   |                   |   | 4,556  
|                                               |  |                  |         |                   |   |        
|Total current liabilities                      |  |                  | 91,112  |                   |   | 82,979 
|Convertible subordinated notes                 |  |                  | 180,000 |                   |   | 180,000
|Notes payable  leased products                |  |                  |        |                   |   | 1,058  
|Other liabilities                              |  |                  | 3,953   |                   |   | 3,829  
|Stockholders equity                           |  |                  | 422,975 |                   |   | 430,627
|                                               |  |                  |         |                   |   |        
|Total liabilities and stockholders equity     |  | $                | 698,040 |                   | $ | 698,493
|                                               |  |                  |         |                   |   |        



|a) | Derived from the audited consolidated balance sheet included in our Form 10-K for the year
ended October 31, 2003.
|-- | ------------------------------------------------------------------------------------------------------------------



See accompanying notes.



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CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)



|                                                                |  |                                |         |   |      |    |         |  
|--------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | -- | ------- | -
|                                                                |  | Three Months Ended January 31, |        
|                                                                |  | 2004                           |         |   | 2003 |   
|Net sales:                                                      |  |                                |         |   |      |    |         |  
|Systems, upgrades, software                                     |  | $                              | 57,331  |   |      | $  | 26,475  |  
|Service, spare parts                                            |  |                                | 10,794  |   |      |    | 10,197  |  
|                                                                |  |                                |         |   |      |    |         |  
|Total net sales                                                 |  |                                | 68,125  |   |      |    | 36,672  |  
|Cost of goods sold                                              |  |                                |         |   |      |    |         |  
|Systems, upgrades, software                                     |  |                                | 29,842  |   |      |    | 17,820  |  
|Service, spare parts                                            |  |                                | 6,380   |   |      |    | 6,388   |  
|                                                                |  |                                |         |   |      |    |         |  
|Gross margin                                                    |  |                                | 31,903  |   |      |    | 12,464  |  
|Operating expenses:                                             |  |                                |         |   |      |    |         |  
|Research and development                                        |  |                                | 15,239  |   |      |    | 19,496  |  
|Selling, general and administrative                             |  |                                | 23,716  |   |      |    | 20,566  |  
|Amortization of purchased intangibles and deferred compensation |  |                                | 2,622   |   |      |    | 1,590   |  
|In-process research and development                             |  |                                |        |   |      |    | 1,510   |  
|Restructuring charges                                           |  |                                | 653     |   |      |    | 1,392   |  
|                                                                |  |                                |         |   |      |    |         |  
|Total operating expenses                                        |  |                                | 42,230  |   |      |    | 44,554  |  
|                                                                |  |                                |         |   |      |    |         |  
|Operating loss                                                  |  |                                | (10,327 | ) |      |    | (32,090 | )
|Interest and other income, net                                  |  |                                | 294     |   |      |    | 1,927   |  
|                                                                |  |                                |         |   |      |    |         |  
|Loss before income tax provision                                |  |                                | (10,033 | ) |      |    | (30,163 | )
|Income tax                                                      |  |                                | 1,359   |   |      |    | 82      |  
|                                                                |  |                                |         |   |      |    |         |  
|Loss before minority interest                                   |  |                                | (11,392 | ) |      |    | (30,245 | )
|Minority interest (benefit)                                     |  |                                | 77      |   |      |    | (81     | )
|                                                                |  |                                |         |   |      |    |         |  
|Net loss                                                        |  | ($                             | 11,469  | ) |      | ($ | 30,164  | )
|                                                                |  |                                |         |   |      |    |         |  
|Net loss per share                                              |  |                                |         |   |      |    |         |  
|Basic                                                           |  | ($                             | 0.18    | ) |      | ($ | 0.49    | )
|                                                                |  |                                |         |   |      |    |         |  
|Diluted                                                         |  | ($                             | 0.18    | ) |      | ($ | 0.49    | )
|                                                                |  |                                |         |   |      |    |         |  
|Number of shares used in computing per share amount             |  |                                |         |   |      |    |         |  
|Basic                                                           |  |                                | 63,936  |   |      |    | 61,145  |  
|                                                                |  |                                |         |   |      |    |         |  
|Diluted                                                         |  |                                | 63,936  |   |      |    | 61,145  |  
|                                                                |  |                                |         |   |      |    |         |  



See accompanying notes.



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CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Increase (decrease) in cash and cash equivalents

(in thousands)

(unaudited)



|                                                                              |  |                                |         |   |      |   |         |  
|----------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                              |  | Three Months Ended January 31, |        
|                                                                              |  | 2004                           |         |   | 2003 |  
|Cash flows from operating activities:                                         |  |                                |         |   |      |   |         |  
|Net loss                                                                      |  | $                              | (11,469 | ) |      | $ | (30,164 | )
|Adjustments to reconcile net income to net cash used in operating activities: |  |                                |         |   |      |   |         |  
|Depreciation and amortization                                                 |  |                                | 9,725   |   |      |   | 7,496   |  
|In-process research and development                                           |  |                                |        |   |      |   | 1,510   |  
|(Gain) loss on disposal of property and equipment                             |  |                                | (275    | ) |      |   | 227     |  
|Realized net loss from sale of available-for-sale securities                  |  |                                | 2       |   |      |   | 899     |  
|Minority interest (benefit)                                                   |  |                                | 77      |   |      |   | (81     | )
|Changes in operating assets and liabilities:                                  |  |                                |         |   |      |   |         |  
|Accounts receivable, net                                                      |  |                                | (2,995  | ) |      |   | (153    | )
|Inventories                                                                   |  |                                | (114    | ) |      |   | (85     | )
|Income tax receivable and payable                                             |  |                                | 1,835   |   |      |   | (2,789  | )
|Prepaid expenses and other current assets                                     |  |                                | 1,460   |   |      |   | (133    | )
|Other assets                                                                  |  |                                | 1,772   |   |      |   |        |  
|Accounts payable                                                              |  |                                | 3,821   |   |      |   | 2,771   |  
|Accrued expenses and other current liabilities                                |  |                                | 5,191   |   |      |   | (2,728  | )
|Deferred profit                                                               |  |                                | 159     |   |      |   | (2,591  | )
|                                                                              |  |                                |         |   |      |   |         |  
|Net cash provided by (used in) operating activities                           |  |                                | 9,189   |   |      |   | (25,821 | )
|Cash flows from investing activities:                                         |  |                                |         |   |      |   |         |  
|Purchases of available-for-sale securities                                    |  |                                | (55,777 | ) |      |   | (45,398 | )
|Sales and maturities of available-for-sale securities                         |  |                                | 58,211  |   |      |   | 53,236  |  
|Acquisition of property and equipment                                         |  |                                | (5,358  | ) |      |   | (1,697  | )
|Acquisition of other assets and other                                         |  |                                | (919    | ) |      |   | (5,880  | )
|Proceeds from sale of property and equipment and leased equipment             |  |                                | 971     |   |      |   |        |  
|                                                                              |  |                                |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                           |  |                                | (2,872  | ) |      |   | 261     |  
|Cash flows from financing activities:                                         |  |                                |         |   |      |   |         |  
|Issuance of common and treasury stock                                         |  |                                | 2,597   |   |      |   | 242     |  
|Payments of bank loans and notes payable related to leased products           |  |                                | (2,815  | ) |      |   |        |  
|Other                                                                         |  |                                | (21     | ) |      |   |        |  
|                                                                              |  |                                |         |   |      |   |         |  
|Net cash provided by (used in) financing activities                           |  |                                | (239    | ) |      |   | 242     |  
|                                                                              |  |                                |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                          |  |                                | 6,078   |   |      |   | (25,318 | )
|Cash and cash equivalents at beginning of period                              |  |                                | 27,318  |   |      |   | 50,192  |  
|                                                                              |  |                                |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                    |  | $                              | 33,396  |   |      | $ | 24,874  |  
|                                                                              |  |                                |         |   |      |   |         |  
|Supplemental disclosures of cash flow information:                            |  |                                |         |   |      |   |         |  
|Interest paid                                                                 |  | $                              | 1,412   |   |      | $ |        |  
|Income taxes paid (received)                                                  |  | $                              | 82      |   |      | $ | 2,912   |  
|Noncash investing activities:                                                 |  |                                |         |   |      |   |         |  
|Net transfers of inventory to property and equipment                          |  | $                              | 395     |   |      | $ | 304     |  
|Acquisition of Optonics using Credence common stock                           |  | $                              |        |   |      | $ | 21,066  |  



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 month periods ended January 31, 2004 and 2003 are unaudited but include all adjustments (consisting solely of normal recurring 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. The results of operations for the
three-month periods ended January 31, 2004 and 2003 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, 2003 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 our quarterly net sales and operating results, limited systems sales, backlog, cyclicality of semiconductor
industry, management of fluctuations in our operating results, expansion of our product lines, limited sources of supply, reliance on our subcontractors, highly competitive industry, customization of products, rapid technological change, customer
concentration, lengthy sales cycle, changes in financial accounting standards and accounting estimates, dependence on key personnel, international sales, proprietary rights, legal proceedings, volatility of our stock price, terrorist attack and
other geopolitical instability, effect of Sarbanes-Oxley, 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.



Basis of Presentation  The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned and majority-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.



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 when the product is classified as mature and the customer acceptance criteria can be demonstrated prior to shipment. 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. For sales of new products or when the customer acceptance criteria cannot be demonstrated prior to shipment, revenue and the
related cost of goods sold are deferred until customer acceptance. 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.



Under the SAB 104 revenue recognition policy, the
Company defers revenue for transactions that involve newly introduced products or when customers specify acceptance criteria that cannot be demonstrated prior to the shipment. During fiscal 2002 and 2003, the Company introduced several new systems
and products. Certain revenues from sales of these new systems and products during fiscal 2003 and the first quarter of fiscal 2004 were deferred until the revenue recognition requirements of our revenue recognition policy are satisfied. This
practice will continue in the future. In the past, the Company experienced significant delays in the introduction and acceptance of new testers as well as certain enhancements to our 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 us.



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. If there are specific customer acceptance criteria, revenue
is deferred until the specified performance



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has been completed in accordance with our revenue recognition policy. Installation in the majority of the cases occurs within two weeks of shipment.
Installation is considered to be inconsequential and perfunctory. The cost of installation can be reliably estimated and is accrued at shipment. In order to comply with Emerging Issues Task Force Accounting for Revenue Arrangements with
Multiple Deliverables, (EITF 00-21), beginning in the fourth quarter of fiscal 2003, revenue related to the total value of installations not completed at the end of the period was deferred.



Sales in the United States are principally 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 and in accordance with SAB 104.



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 (SOP 97-2), Software Revenue Recognition. 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 our 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 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.



3. Stock-Based Compensation



At January 31, 2004 the Company had several stock-based employee compensation plans. The Company follows the intrinsic value method to account for its employee stock options because, as discussed below, the alternative fair value accounting
requires the use of option valuation models that were not developed for use in valuing employee stock options. Because the exercise price of the Companys employee stock options equals the market price of the underlying stock on the date of the
grant, no compensation expense is recognized in the Companys financial statements.



In calculating pro forma compensation, the fair value of each option grant is estimated on the date of grant using the Black-Scholes options pricing model. The Black-Scholes option valuation model was developed for
use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, the Black-Scholes model requires the input of highly subjective assumptions including the expected stock price volatility.
Because the Companys stock-based awards to employees have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in
managements opinion, the existing models do not necessarily provide a reliable single measure of its stock-based awards to its employees. Stock based compensation expense already included in the reported net loss is primarily a result of
amortization of deferred compensation related to acquisitions.



Had the Company determined stock-based compensation costs based on the estimated fair value at the grant date for its stock options and the estimated fair value at the issuance date for its Employee Stock Purchase Plan, the Companys
net loss and net loss per share for the three months ended January 31, 2004 and 2003, respectively, would have been as follows (in thousands, except per share data):



|                                                                                                                                       |  |                                |         |   |      |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                                                                                       |  | Three Months Ended January 31, |        
|                                                                                                                                       |  | 2004                           |         |   | 2003 |  
|Net (loss) as reported                                                                                                                 |  | $                              | (11,469 | ) |      | $ | (30,164 | )
|Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects(1)                            |  |                                | 218     |   |      | $ | 69      |  
|Less: Stock-based employee compensation expense determined under fair value based methods for all awards net of related tax effects(1) |  |                                | (5,714  | ) |      |   | (7,884  | )
|                                                                                                                                       |  |                                |         |   |      |   |         |  
|Pro forma net loss                                                                                                                     |  | $                              | (16,965 | ) |      | $ | (37,979 | )
|                                                                                                                                       |  |                                |         |   |      |   |         |  
|Basic loss per share as reported                                                                                                       |  | $                              | (0.18   | ) |      | $ | (0.49   | )
|Basic loss per share pro forma                                                                                                         |  | $                              | (0.27   | ) |      | $ | (0.62   | )
|Diluted loss per share as reported                                                                                                     |  | $                              | (0.18   | ) |      | $ | (0.49   | )
|Diluted loss per share pro forma                                                                                                       |  | $                              | (0.27   | ) |      | $ | (0.62   | )

---

|(1) | The Company has established a full valuation allowance for its net deferred tax assets. Therefore, for the three months ended January 31, 2004 and 2003, total stock
based compensation expense has not been tax affected.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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4. 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):



|                |  |                  |        |                  |   |       
|--------------- |  | ---------------- | ------ | ---------------- | - | ------
|                |  | January 31, 2004 |        | October 31, 2003
|Raw materials   |  | $                | 47,471 |                  | $ | 54,344
|Work-in-process |  |                  | 15,438 |                  |   | 14,009
|Finished goods  |  |                  | 20,378 |                  |   | 15,003
|                |  |                  |        |                  |   |       
|                |  | $                | 83,287 |                  | $ | 83,356
|                |  |                  |        |                  |   |       



5. Goodwill and Other Intangibles



Effective November 1, 2002, the Company 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, the Company ceased amortizing goodwill effective November 1, 2002. In addition,
on adoption, the Company reclassified certain intangibles with a net book value of $0.4 million, consisting of acquired workforce, which is no longer defined as an acquired intangible under SFAS 142 to goodwill.



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 SFAS No. 131, Disclosures About Segments of an Enterprise and Related
Information. 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 econcomic 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 two industry segments: (1) the design, development, manufacture, sale and service of Automatic Test Equipment, or ATE, and (2) the design, development, sale and service of software that assists in the development of
test programs used in ATE. Revenues from the software segment were not material to the Companys operations in fiscal years 2002, 2001, and 2000. During 2003, the software segment was significantly decreased in size and the remaining software
operations were merged with the ATE segment. Currently, the Company operates in one industry segment, ATE. We also have 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.



As mandated by SFAS No. 142, the Company evaluates 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 cash flow. The Company completed its first annual goodwill impairment test as of July 31, 2003 and determined that no potential impairment existed. As a result, no impairment loss
was recognized in connection with the adoption of SFAS No. 142 or during the first three months of fiscal 2004. However, no assurances can be given that future evaluations of goodwill will not result in charges as a result of future impairment.



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, identifiable intangible assets, and property,
plant 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 our market value, or significant reductions in projected future cash flows. In assessing the recoverability of our 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 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



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realized in liquidation. Changes in these estimates could have a material adverse effect on the assessment of our 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 two to ten years.



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



|                       |  |      |        |                          |   |         |     |  |   |       
|---------------------- |  | ---- | ------ | ------------------------ | - | ------- | --- |  | - | ------
|January 31, 2004       |  | Cost |        | Accumulated Amortization |   |         | Net
|Purchased technology   |  | $    | 54,906 |                          | $ | (28,716 | )   |  | $ | 26,190
|Customer relations     |  |      | 7,702  |                          |   | (6,224  | )   |  |   | 1,478 
|Trademarks             |  |      | 2,053  |                          |   | (1,540  | )   |  |   | 513   
|Patents                |  |      | 862    |                          |   | (603    | )   |  |   | 259   
|Non-compete agreements |  |      | 750    |                          |   | (375    | )   |  |   | 375   
|                       |  |      |        |                          |   |         |     |  |   |       
|Total                  |  | $    | 66,273 |                          | $ | (37,458 | )   |  | $ | 28,815
|                       |  |      |        |                          |   |         |     |  |   |       
|                       |  |      |       
|October 31, 2003       |  | Cost |        | Accumulated Amortization |   |         | Net
|Purchased technology   |  | $    | 54,906 |                          | $ | (27,001 | )   |  |   | 27,905
|Customer relations     |  |      | 7,702  |                          |   | (5,708  | )   |  |   | 1,994 
|Trademarks             |  |      | 2,053  |                          |   | (1,437  | )   |  |   | 616   
|Patents                |  |      | 862    |                          |   | (560    | )   |  |   | 302   
|Non-compete agreements |  |      | 750    |                          |   | (282    | )   |  |   | 468   
|                       |  |      |        |                          |   |         |     |  |   |       
|Total                  |  | $    | 66,273 |                          | $ | (34,988 | )   |  | $ | 31,285
|                       |  |      |        |                          |   |         |     |  |   |       



6. Net Loss Per Share



Basic net loss per share is based upon the weighted
average number of common shares outstanding during the period. Diluted net loss 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 loss per
share for periods indicated (in thousands, except per share amounts):



|                                                                                                    |  |                                |         |   |      |   |         |  
|--------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                                                    |  | Three Months Ended January 31, |        
|                                                                                                    |  | 2004                           |         |   | 2003 |  
|Numerator:                                                                                          |  |                                |         |   |      |   |         |  
|Numerator for basic and diluted net income per share-net loss                                       |  | $                              | (11,469 | ) |      | $ | (30,164 | )
|                                                                                                    |  |                                |         |   |      |   |         |  
|Denominator:                                                                                        |  |                                |         |   |      |   |         |  
|Denominator for basic net loss per share - weighted-average shares outstanding                      |  |                                | 63,936  |   |      |   | 61,145  |  
|Effect of dilutive securities - employee stock options                                              |  |                                |        |   |      |   |        |  
|Effect of dilutive securities  convertible notes                                                   |  |                                |        |   |      |   |        |  
|                                                                                                    |  |                                |         |   |      |   |         |  
|Denominator for diluted earnings per share-adjusted weighted-average shares and assumed conversions |  |                                | 63,936  |   |      |   | 61,145  |  
|                                                                                                    |  |                                |         |   |      |   |         |  
|Basic net loss per share                                                                            |  | $                              | (0.18   | ) |      | $ | (0.49   | )
|                                                                                                    |  |                                |         |   |      |   |         |  
|Diluted net loss per share                                                                          |  | $                              | (0.18   | ) |      | $ | (0.49   | )
|                                                                                                    |  |                                |         |   |      |   |         |  



At January 31, 2004
and 2003, there were options to purchase 14,283,829 and 14,484,833 shares of common stock outstanding at a weighted average exercise price of $16.01 and $16.43, respectively, which were excluded from the diluted loss per share calculation for the
three months ended January 31, 2004 and 2003 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 loss per share calculation for the three months ended January 31, 2004 because they were anti-dilutive.



7. Recent Accounting Pronouncements



In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable
Interest Entities. FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as Variable Interest Entities (VIEs) must be consolidated by the primary
beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks or rewards arising from the VIE. For VIEs in which a significant (but not majority) variable interest is held, certain disclosures are
required. The Company has not entered into any arrangements or made any investments which qualify as a VIE after January 31, 2003 and therefore the initial implementation of FIN



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46 had no impact on the Companys financial statements. For VIEs acquired before February 1, 2003, FIN 46 required the Company to apply the accounting
and disclosure rules in the first quarter of fiscal 2004. This requirement was superseded by issuance of revision to Interpretation No. 46, as noted below.



In December 2003, the FASB issued revision to Interpretation No. 46 (FIN 46R) which replaced FIN 46. The revised interpretation further
refines the definition of VIEs and provides guidelines on identifying them and assessing an enterprises interests in a VIE to decide whether to consolidate that entity. FIN 46R applies at different dates to different types of enterprises and
entities, and special provisions apply to enterprises that have fully or partially applied FIN 46 prior to issuance of FIN 46R. Generally, application of FIN 46R is required in financial statements of public entities that have interests in VIEs or
potential VIEs commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004.
The adoption of FIN 46R is not expected to have a material impact on the results of operations or financial condition of the Company.



On December 17, 2003, the Staff of the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 104 (SAB 104),
Revenue Recognition, which supersedes Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB No. 101). SAB 104s primary purpose is to rescind the accounting guidance contained in
SAB No. 101 related to multiple-element revenue arrangements that was superseded as a result of the issuance of EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. Additionally, SAB 104 rescinds the SECs related Revenue
Recognition in Financial Statements Frequently Asked Questions and Answers issued with SAB No. 101 that had been codified in SEC Topic 13, Revenue Recognition. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the
revenue recognition principles of SAB No. 101 remain largely unchanged by the issuance of SAB 104, which was effective upon issuance. The adoption of SAB 104 did not have a material effect on the Companys financial position or results of
operations.



8. Contingencies and Guarantees



The Companys corporate by-laws require that the Company indemnify 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, the Company has not made payments related to these obligations, and the fair value for these obligations is zero on the
consolidated balance sheet as of January 31, 2004 and October 31, 2003.



As is customary in the Companys industry and as provided for under local law in the U.S. and other jurisdictions, many of standard contracts provide remedies to customers and others with whom the Company enters into contracts, such as
defense, settlement, or payment of judgment 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 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 sell 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 leases some of its facilities and equipment under operating
leases that expire periodically through 2010 of which $0.7 million and $0.2 million have been written-off to special operating charges during the first quarter of fiscal 2004 and 2003, respectively. See Note 10 to the Condensed Consolidated
Financial Statements 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 (four and five month) 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 January 31, 2004, the Company had open and committed purchase orders totaling
approximately $58.9 million.



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The following summarizes our minimum contractual cash obligations and other commitments at January 31,
2004, and the effect of such obligations in future periods (in thousands):



|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |       |  |   |         |  |   |    
|------------------------------------------------------------------------------------------- |  | ----- | ------- | ---------------------- | - | ----------- |  | ----------- | ------ | ----------- | - | ----------- |  | ---------- | ----- |  | - | ------- |  | - | ---
|                                                                                            |  | Total |         | Remainderof Fiscal2004 |   | Fiscal 2005 |  | Fiscal 2006 |        | Fiscal 2007 |   | Fiscal 2008 |  | Thereafter
|Contractual Obligations:                                                                    |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |       |  |   |         |  |   |    
|Facilities and equipment operating leases                                                   |  | $     | 5,829   |                        | $ | 2,228       |  | $           | 2,167  |             | $ | 698         |  | $          | 524   |  | $ | 69      |  | $ | 143
|Bank loans and notes payable related to leased products                                     |  |       | 7,158   |                        |   | 6,101       |  |             | 1,057  |             |   |            |  |            |      |  |   |        |  |   |   
|Interest on liabilities related to leased products                                          |  |       | 191     |                        |   | 183         |  |             | 8      |             |   |            |  |            |      |  |   |        |  |   |   
|Convertible subordinated notes                                                              |  |       | 180,000 |                        |   |            |  |             |       |             |   |            |  |            |      |  |   | 180,000 |  |   |   
|Interest on convertible subordinated notes                                                  |  |       | 11,588  |                        |   | 2,025       |  |             | 2,700  |             |   | 2,700       |  |            | 2,700 |  |   | 1,463   |  |   |   
|Minimum payable for information technology outsourcing including fees for early termination |  |       | 14,400  |                        |   | 5,088       |  |             | 9,312  |             |   |            |  |            |      |  |   |        |  |   |   
|Open non-cancelable purchase order commitments                                              |  |       | 58,905  |                        |   | 58,905      |  |             |       |             |   |            |  |            |      |  |   |        |  |   |   
|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |       |  |   |         |  |   |    
|Total contractual cash and other obligations                                                |  | $     | 278,071 |                        | $ | 74,530      |  | $           | 15,244 |             | $ | 3,398       |  | $          | 3,224 |  | $ | 181,532 |  | $ | 143
|                                                                                            |  |       |         |                        |   |             |  |             |        |             |   |             |  |            |       |  |   |         |  |   |    



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 following table represents the activity in the warranty accrual for the three months ended January 31, 2004 (in thousands):



|                                                 |  |   |        |  
|------------------------------------------------ |  | - | ------ | -
|Balance at October 31, 2003                      |  | $ | 5,501  |  
|Accruals for warranties issued during the period |  |   | 3,137  |  
|Adjustments of prior period accrual estimates    |  |   | (105   | )
|Warranty claims made during the period           |  |   | (1,740 | )
|                                                 |  |   |        |  
|Balance at January 31,2004                       |  | $ | 6,793  |  
|                                                 |  |   |        |  



9. Comprehensive Income (Loss)



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



|                                                           |  |                                |         |   |      |   |         |  
|---------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                           |  | Three Months Ended January 31, |        
|                                                           |  | 2004                           |         |   | 2003 |  
|Net loss                                                   |  | $                              | (11,469 | ) |      | $ | (30,164 | )
|                                                           |  |                                |         |   |      |   |         |  
|Unrealized gains (losses) on available-for-sale securities |  |                                | 82      |   |      |   | (616    | )
|Currency translation adjustment                            |  |                                | 786     |   |      |   | 1,515   |  
|                                                           |  |                                |         |   |      |   |         |  
|Other comprehensive income (loss)                          |  |                                | 868     |   |      |   | 899     |  
|                                                           |  |                                |         |   |      |   |         |  
|Total comprehensive loss                                   |  | $                              | (10,601 | ) |      | $ | (29,265 | )
|                                                           |  |                                |         |   |      |   |         |  



10. 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 in the Companys Annual Report on
Form 10-K under the heading Inventories for further discussion of the Companys reserve methodology.



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There were no special charges recorded in cost of goods sold since October 31, 2003. The schedule below
shows all transactions relating to inventory that were originally expensed as a special charge to cost of goods sold. The total charges from the second and fourth quarter of fiscal 2001 and the fourth quarter of fiscal 2002 are approximately $92.5
million. Of this, approximately $42.4 million was scrapped, $19.6 million was written off and largely disposed of, $7.2 million was written down for lower of cost or market provisions, $1.3 million was donated and the remaining $22.1 million was
still on hand as of January 31, 2004.



|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|------------------------------------------------ |  | ------- | ------- | - | ------- | - | ------ | ------- |  | - | ------ | -
|                                                 |  | Q2 FY01 |         |   | Q4 FY01 |   |        | Q4 FY02 | 
|Special Charges                                  |  | $       | 45,020  |   |         | $ | 38,003 |         |  | $ | 9,440  |  
|FY01 Capacity Write-off                          |  |         | (3,904  | ) |         |   |       |         |  |   |       |  
|FY01 Scrapping                                   |  |         | (24,118 | ) |         |   |       |         |  |   |       |  
|FY01 ValStar write-off and disposal              |  |         | (7,868  | ) |         |   |       |         |  |   |       |  
|FY01 Write-off and largely disposed              |  |         | (6,410  | ) |         |   |       |         |  |   |       |  
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|10/31/01 Balance                                 |  |         | 2,720   |   |         |   | 38,003 |         |  |   |       |  
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|FY02 Scrapping                                   |  |         | (1,326  | ) |         |   | (6,205 | )       |  |   |       |  
|FY02 Write-off and largely disposed              |  |         | (221    | ) |         |   | (1,150 | )       |  |   |       |  
|FY02 Donation                                    |  |         | (1,173  | ) |         |   | (91    | )       |  |   |       |  
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|10/31/02 Balance                                 |  |         |        |   |         |   | 30,557 |         |  |   | 9,440  |  
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|FY03 Scrapping                                   |  |         |        |   |         |   | (7,538 | )       |  |   | (3,134 | )
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|10/31/03 Balance                                 |  |         |        |   |         |   | 23,019 |         |  |   | 6,306  |  
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|Q1 FY04 Scrapping                                |  |         |        |   |         |   | (48    | )       |  |   |       |  
|Q1 FY04 Kalos lower of cost or market write-down |  |         |        |   |         |   | (7,215 | )       |  |   |       |  
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  
|1/31/04 Balance                                  |  |         |        |   |         |   | 15,756 |         |  |   | 6,306  |  
|                                                 |  |         |         |   |         |   |        |         |  |   |        |  



During the first
quarter of fiscal 2004 the Companys gross margin benefited by $0.3 million from the sale of Kalos components previously written-down for a lower of cost or market provision.



Restructuring  operating expenses



For the quarter ended January 31, 2003, the Company recorded restructuring charges of approximately $1.4 million as operating expenses related to
headcount reductions and facility consolidations, which the Company implemented in the quarter. During this period, the Company reduced headcount by approximately 70 persons. The bulk of the affected employees were in SG&A functions and a
smaller number were in R&D. Also, during the quarter, the Company completed its plans to exit the IMS facility in Beaverton, Oregon and consolidated the remaining Oregon employees into its Hillsboro, Oregon facility. In addition to these
restructuring charges, the Company also recorded a charge of $1.5 million in the first quarter of fiscal 2003 for in-process research development resulting from the purchase of Optonics in January 2003.



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 Company will attempt to sublease the final building,
consisting of 27,000 square feet. This lease expires 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.



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##### Table of Contents

The following table illustrates the activity for the three-month period ended January 31, 2004 and the
estimated timing of future payouts for major restructuring categories (in thousands):



|                                    |  |           |      |   |                 |   |        |       |  |   |        |  
|----------------------------------- |  | --------- | ---- | - | --------------- | - | ------ | ----- |  | - | ------ | -
|                                    |  | Severance |      |   | OperatingLeases |   |        | Total | 
|Balance at October 31, 2003         |  | $         | (233 | ) |                 | $ | (2,368 | )     |  | $ | (2,601 | )
|Operating leases written off        |  |           |     |   |                 |   | (653   | )     |  |   | (653   | )
|Cash Payments                       |  |           | 223  |   |                 |   | 457    |       |  |   | 680    |  
|                                    |  |           |      |   |                 |   |        |       |  |   |        |  
|Balance at January 31, 2004         |  | $         | (10  | ) |                 | $ | (2,564 | )     |  | $ | (2,574 | )
|                                    |  |           |      |   |                 |   |        |       |  |   |        |  
|Estimated timing of future payouts: |  |           |      |   |                 |   |        |       |  |   |        |  
|Balance of fiscal 2004              |  |           | 10   |   |                 |   | 1,278  |       |  |   | 1,288  |  
|Fiscal 2005                         |  |           |     |   |                 |   | 918    |       |  |   | 918    |  
|Fiscal 2006 and beyond              |  |           |     |   |                 |   | 368    |       |  |   | 368    |  
|                                    |  |           |      |   |                 |   |        |       |  |   |        |  
|Total                               |  | $         | 10   |   |                 | $ | 2,564  |       |  | $ | 2,574  |  
|                                    |  |           |      |   |                 |   |        |       |  |   |        |  



The opening balances
at October 31, 2003 in the above table are associated with headcount reductions and facility consolidations implemented by the Company.



11. Subsequent Event



On February 23, 2004, the Company announced a definitive agreement pursuant to which Credence would acquire NPTest Holding Corporation
(NPTest). Under the terms of the agreement, Credence will acquire NPTest in a combined stock-for-stock and cash transaction valued at approximately $660 million based on the closing price of Credence stock on February 20, 2004. Each
NPTest common share outstanding as of the closing date would be converted into the right to acquire 0.80 shares of Credence common stock and $5.75 in cash, resulting in an estimated $230 million of cash to be paid by Credence for the acquisition.
The acquisition will be accounted for as a purchase transaction. The transaction is subject to various closing conditions, including approval by Credence and NPTest stockholders and expiration of the waiting period under the Hart-Scott-Rodino
Antitrust Improvements Act. In the event the definitive agreement is terminated under certain circumstances, the terminating party may be required to pay a termination fee of $20 million to the other party. Credence anticipates the acquisition will
close in its third fiscal quarter.



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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 anticipated closing of the acquisition of NPTest, the fluctuation
of sales, gross margins and operating results, the deferral of revenue recognition, the review of value of inventory, the improvement of gross margins, the investment of significant resources in the development and completion of new products and
product enhancements, SG&A expenses remaining flat, estimated annual amortization expenses, the sublease of the Fremont facility, recordation of full valuation allowance on tax benefits and the recognition of tax benefits, investments in
inventory representing a significant portion of working capital, sufficiency of cash and investments to meet anticipated business requirements, the introduction of new products and product enhancements in the future, revenue levels remaining under
pressure, the dependence of new orders upon demand from semiconductor device manufacturers building or expanding fabrication facilities and new device testing requirements, the intent to pursue additional acquisitions and international sales
accounting for a significant portion of total net sales. These forward-looking statements involve risks and uncertainties and actual results could differ materially from those discussed in the forward-looking statements. These risks and
uncertainties include, but are not limited to, those described under the heading Risk Factors as well as risks described immediately prior to or following some forward-looking statements. All forward-looking statements and risk factors
included in this document are made as of the date hereof, based on information available to us as of the date thereof, and we assume no obligation to update any forward-looking statement or risk factors.



We believe that most of the major ATE industry participants have not been
profitable for the last three years, indicating 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. The test and assembly sector of the semiconductor equipment industry continues to be impacted by a severe downturn that began in fiscal 2001. Although there have been recent sequential improvements in the business
environment, there is uncertainty as to the strength and length of the next cyclical growth phase. Until such time as we return to a period of sustainable growth and due to continued low visibility, 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 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, 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 accounting principles generally accepted in the United States. 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,
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.



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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. Our revenue recognition policies
are applied consistently among our semiconductor manufacturing equipment product lines. Product revenue is recognized upon shipment when the product is classified as mature and the customer acceptance criteria can be demonstrated prior to shipment.
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. For sales of new products or when
the customer acceptance criteria cannot be demonstrated prior to shipment, revenue and the related cost of goods sold are deferred until customer acceptance. 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.



Under the SAB 104 revenue recognition policy, we defer revenue for transactions that involve newly introduced products or when customers specify
acceptance criteria that cannot be demonstrated prior to the shipment. During fiscal 2002 and 2003, we introduced several new systems and products. Certain revenues from sales of these new systems and products during fiscal 2003 and the first
quarter of fiscal 2004 have been 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 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 related 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, our 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. If there are specific customer acceptance criteria, revenue is deferred until the specified performance has been completed in accordance with our revenue recognition policy.
Installation in the majority of the cases occurs within two weeks of shipment. Installation is considered to be inconsequential and perfunctory. The cost of installation can be reliably estimated and is accrued at shipment. In order to comply with
Emerging Issues Task Force Accounting for Revenue Arrangements with Multiple Deliverables, (EITF 00-21), beginning in the fourth quarter of fiscal 2003, revenue related to the total value of installations not completed at the end of the
period was deferred.



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 our revenue
recognition policies based on the sales channel, due to the business practices that we have adopted with our distributor relationships. Because of these business circumstances we do not use price protection, stock rotation or
similar programs with our 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 and in accordance with SAB 104.



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 (SOP 97-2), Software Revenue Recognition. The stand-alone software products are applications for Integrated Circuit, or 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 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.



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



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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 deteriorations 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 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 industry upturn. These forecasts require us to estimate our ability to sell current and future products in the next industry upturn
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 off, we
carry that inventory at its reduced value until it is scrapped or otherwise disposed of. At January 31, 2004, approximately 15% and 9% of the net inventory balances were for our older Quartet mixed signal and Kalos non-volatile memory product
families, respectively. With the recent introduction of the Kalos II, the Company intends to continue to review the value of the current Kalos I inventory in light of the anticipated product transition to Kalos II. In particular, the value of the
Kalos inventory will depend on factors such as the economic condition of the Flash memory IC market, product development schedules for the production versions of the Kalos II and, ultimately, the success of the Kalos II product in the marketplace.



Due to the dramatic decline in the semiconductor business
cycle and corresponding impact on revenue since early in fiscal 2001 and continued uncertainty regarding the timing of the upturn, if any, in semiconductor equipment sales, we continue to monitor our inventory levels in light of product development
changes and expectations of an eventual market upturn. In the third quarter of fiscal 2003, we recorded special charges to cost of goods sold of $1.3 million due to a legal settlement on cancelled purchase contracts with an inventory vendor and $0.6
million due to spare parts write-offs related to our Valstar product line. In addition, over the past three years we have recorded a total of $92.5 million in charges for the write-offs of excess and obsolete inventories. We may be required to take
additional charges for excess and obsolete inventory if the current industry downturn causes further reductions to our current inventory valuations or our current product development plans change.



Residual values assigned to the Companys products that are leased to
customers are based on their remaining useful 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 plant, 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, or SFAS 142, which was issued by the FASB in July 2001. Under this standard, we ceased amortizing goodwill effective November 1, 2002. In
addition, on adoption, we reclassified certain intangibles with a net book value of $0.4 million, consisting of acquired workforce, which is no longer defined as an acquired intangible under SFAS 142 to goodwill.



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 SFAS No. 131, Disclosures About Segments of an Enterprise and Related
Information. 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 econcomic characteristics different from other components of the operating segment, and (3) operating results of the component are reviewed regularly by the segment
manager. We operate in two industry segments: (1) the design, development, manufacture, sale and service of Automatic Test Equipment, or ATE, and (2) the design, development, sale and service of software that assists in the development of test
programs used in ATE. Revenues from the software segment were not material to our operations in fiscal years 2002, 2001 and 2000. During 2003, the software segment was significantly decreased in size and the remaining software operations were merged
with the ATE segment. Currently, we operate in one industry segment, ATE. We also have a single reporting unit for purposes of SFAS 142, ATE, primarily because all of the components of our ATE segment are subject to similar economic characteristics.
In addition, all of our products have common production processes, customers, and product life cycles.



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



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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.



As mandated by
SFAS 142, we 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 cash flow. We completed our first annual goodwill
impairment test as of July 31, 2003 and determined that no potential impairment existed. As a result, no impairment loss has been recognized in connection with the adoption of SFAS 142 or during the first three months of fiscal 2004. However, no
assurances can be given that future evaluations of goodwill will not result in charges as a result of future impairment.



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 units, including discount rate used and estimated terminal value reflect our best estimates.



We evaluate the carrying value of our long-lived assets,
consisting primarily of our facilities, identifiable intangible assets, and property, plant 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 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 the 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 two 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.



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 estimate our actual current tax exposure and to assess temporary differences that result from differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which
we show on our consolidated balance sheet. The net deferred tax assets are reduced by a valuation allowance if, based upon 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 asset balance as of January 31, 2004 was subject to a full valuation allowance due to uncertainties surrounding our ability to generate future taxable income and our corresponding ability to utilize our deferred tax assets.



Restructuring Charges



The current accounting for restructuring costs requires us to record
provisions and charges when we have a formal and committed restructuring plan. In connection with restructuring activities, we recorded estimated restructuring charges in our operating expenses for relocating our corporate headquarters in the amount
of $0.7 million, net of expected sublease income, during the first quarter of fiscal 2004, and restructuring charges for severance and facility consolidations of approximately $1.4 million in the first



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quarter of fiscal 2003. 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 EndedJanuary 31, |   
|                                                                |  | 2004                          |    |  | 2003  |   
|Net sales                                                       |  | 100.0                         | %  |  | 100.0 | % 
|Cost of goods sold                                              |  | 53.2                          |    |  | 66.0  |   
|                                                                |  |                               |    |  |       |   
|Gross margin                                                    |  | 46.8                          |    |  | 34.0  |   
|Operating expenses                                              |  |                               |    |  |       |   
|Research and development                                        |  | 22.4                          |    |  | 53.2  |   
|Selling, general and administrative                             |  | 34.8                          |    |  | 56.1  |   
|Amortization of purchased intangibles and deferred compensation |  | 3.8                           |    |  | 4.3   |   
|Restructuring charges and IPR&D                                 |  | 1.0                           |    |  | 7.9   |   
|                                                                |  |                               |    |  |       |   
|Total operating expenses                                        |  | 62.0                          |    |  | 121.5 |   
|                                                                |  |                               |    |  |       |   
|Operating loss                                                  |  | (15.2                         | )  |  | (87.5 | ) 
|                                                                |  |                               |    |  |       |   
|Net loss                                                        |  | (16.8                         | )% |  | (82.2 | )%
|                                                                |  |                               |    |  |       |   



Net sales consist of
revenues from systems sales, upgrades, spare parts sales, maintenance contracts, lease and rental income and software sales. Net sales were $68.1 million for the first quarter of fiscal 2004 representing an increase of 86% from sales of $36.7
million during the first quarter of fiscal 2003. This increase is due primarily to a general upturn in the industry. In particular, revenue from our digital and mixed signal products increased from $19.3 million during the first quarter of fiscal
2003 to $41.0 million during the same period of 2004, constituting 69% of the total increase in net sales. Sustainability of the revenue levels during the first quarter of fiscal 2004 is dependent upon the economic and geopolitical climate as well
as other risks described under the title Risk Factors herein.



International net sales accounted for approximately 62% of total net sales in the first quarter of fiscal 2004 compared with 56% in the first quarter of fiscal 2003. Our net sales to the Asia Pacific region accounted
for approximately 42% and 39% of total net sales in the first quarter of fiscal 2004 and 2003, respectively, and thus are subject to the risk of economic instability in that region that materially adversely affected the demand for our products in
1998 and early 1999. Capital markets in Korea and other areas of Asia have been historically highly volatile, resulting in economic instabilities. These instabilities may reoccur which could materially adversely affect demand for our products. In
addition, the economic impact of geopolitical instabilities on the Korean peninsula as well as recurrence the Severe Acute Respiratory Syndrome health risks in the Asian region may affect future orders to this region and the timing of or payment for
shipments made to this region.



Our net sales by product line
in the first three months of fiscal 2004 and fiscal years 2003 and 2002 consisted of:



|                               |  |                                       |      |  |                                |      |  |     |  
|------------------------------ |  | ------------------------------------- | ---- |  | ------------------------------ | ---- |  | --- | -
|                               |  | Fiscal Quarter Ended January 31, 2004 |      |  | Fiscal Years Ended October 31, |     
|                               |  |                                       | 2003 |  |                                | 2002 | 
|Digital and Mixed-Signal       |  | 60                                    | %    |  | 51                             | %    |  | 56  | %
|Memory                         |  | 15                                    |      |  | 17                             |      |  | 18  |  
|Service                        |  | 16                                    |      |  | 23                             |      |  | 22  |  
|Emission Based Optical Probers |  | 7                                     |      |  | 4                              |      |  |    |  
|Software and Other             |  | 2                                     |      |  | 5                              |      |  | 4   |  
|                               |  |                                       |      |  |                                |      |  |     |  
|Total                          |  | 100                                   | %    |  | 100                            | %    |  | 100 | %
|                               |  |                                       |      |  |                                |      |  |     |  



Revenues from software
were not material to our operations in the first three months of 2004 or during fiscal years 2003 and 2002, representing less than 4% of our net sales in each respective period.



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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-offs, sell-through of previously written-off 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 as a percentage of net sales increased to 46.8% during the first quarter of fiscal 2004 from 34.0% during the same period of fiscal 2003. The increase in gross margin reflects the higher
utilization we have at higher production levels, as well as a better mix of both newer products and also higher margin products. In addition, during the first quarter of fiscal 2004 our gross margin benefited by $0.3 million from the sale of Kalos
components previously written-down for a lower of cost or market provision. We expect gross margins to improve for the foreseeable future primarily due to sales of a mix of higher gross margin products and better manufacturing efficiencies resulting
from higher business levels.



Research and Development



Research and development, or R&D, expenses as a percentage of net sales
were 22.4% and 53.2% during the first quarter of fiscal 2004 and 2003, respectively. The decrease in R&D expenses as a percentage of net sales is primarily attributable to the higher sales levels during the first quarter of 2004 as compared with
2003. R&D expenses also decreased in absolute dollars to $15.2 million during the first quarter of fiscal 2004 from $19.5 million during the comparable period of fiscal 2003. This decrease is primarily due to the 163 person reduction in
headcount made by the Company in the third quarter of fiscal 2003, of which 77 were in R&D. In addition, there are several products, including ASL3000 and Kalos2, that have either been released or are nearing release to manufacturing, resulting
in less non recurring engineering (NRE) expenses associated with the development of those products. These savings were partially offset by the ongoing investment in new products and R&D expenses associated with the products obtained
in the acquisition of Optonics, Inc., or Optonics, and the purchase of the net assets of SZ Testsysteme AG and SZ Testsysteme GmbH, or collectively SZ, in January 2003. SZ and Optonics added a total of approximately 174 employees to the Company, of
which about 30 percent perform R&D. The R&D expenses associated with the acquired products represented approximately $1.5 million of the R&D during the first quarter of fiscal 2004 as compared with $0.2 million during the same period of
the previous fiscal year. We currently intend to 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 relatively flat in
absolute dollars for the rest of the fiscal year.



Selling, General and
Administrative



Selling, general and administrative, or
SG&A, expenses decreased as a percentage of net sales from 56.1% during the first quarter of fiscal 2003 to 34.8% during the first quarter of fiscal 2004, reflecting the increase in business levels during fiscal 2004. In absolute dollars
SG&A expenses increased to $23.7 million during the first quarter of fiscal 2004 from $20.6 during the same period of the previous fiscal year. This increase is primarily due to a $2.3 million increase in commissions paid to distributors
relating to an overall increase in sales as well as a function of product mix and geographic mix. In addition, we acquired Optonics and purchased the net assets of SZ in January of 2003. During fiscal 2004, we have recorded a full quarter of
SG&A expenses for these entities, versus expenses for only January or a portion of January during the previous year, offset partially by some acquisition costs in the previous year, causing a net increase in SG&A expenses for these entities
of $0.5 million as compared with the first quarter of fiscal 2003. In the third quarter of fiscal 2003, the Company accelerated the remaining depreciation for leasehold improvements and other fixed assets related to buildings located in Fremont that
the Company vacated in the first quarter of fiscal 2004 when the Company moved to its new headquarters in Milpitas. The amount of the accelerated depreciation related to these leasehold improvements recognized during the first quarter of fiscal 2004
was $0.6 million and is recorded in SG&A expenses. Due to expenses associated with higher sales we expect SG&A expenses for the remainder of fiscal 2004 to be slightly higher in absolute dollars when compared to those expenses recorded in
fiscal 2003.



Amortization of Purchased Intangibles and Deferred
Compensation



Amortization of purchased intangible and
deferred compensation expenses was $2.6 million in the first three months of fiscal 2004, compared to $1.6 million for the same period in fiscal 2003 due to the additional amortization resulting from the purchase of Optonics. As of November 1, 2002,
we adopted Statements of Financial Accounting Standards Goodwill and Other Intangible Assets No. 142, or 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. Remaining estimated annual amortization expense for purchased intangibles and deferred compensation is expected to be $6.6 million, $6.7 million, $5.2 million, $4.9 million, $3.0
million, $2.3 million, and $1.2 million for the remaining three quarters of fiscal 2004 and for fiscal years 2005, 2006, 2007, 2008, 2009 and 2010, respectively.



Restructuring Charges and In-process Research and Development



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. We will



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attempt to sublease the final building, consisting of 27,000 square feet. This lease expires in June 2005. During the quarter ended January 31, 2004 we
recorded a restructure charge in the amount of $0.7 million to write-off the remaining lease payments for this lease, net of expected sublease income.



During the first quarter of fiscal 2003, we recorded a restructure charge of approximately $1.4 million for severance charges, and a lease write-off that
was included in operating expenses. These charges were associated with headcount reductions and the completion of the consolidation of our Integrated Measurement Systems, Inc., or IMS, facility in Beaverton, Oregon into our Hillsboro, Oregon site.
During the first fiscal quarter of fiscal 2003, we reduced our headcount by approximately 70 persons. The bulk of the affected employees were in SG&A functions and a smaller number were in R&D. In addition, we recorded a charge of $1.5
million in the first quarter of fiscal 2003 for the write-off of in-process research and development resulting from the purchase of Optonics. The charge was recorded as an operating expense.



Interest and Other Income Expenses, Net



We generated net interest and other income of $0.3 million for the first
three months of fiscal 2004, as compared to $1.9 million for the same period of fiscal 2003. The decrease was primarily attributable to $0.7 million of interest expenses related to the convertible subordinated notes that we issued in June 2003. In
addition, we recorded $0.8 million lower interest income during the first quarter of fiscal 2004 as compared with 2003 due to decreasing returns on our cash investments as longer-term investments mature and are re-invested at currently lower
short-term rates partially offset by higher average cash and investment balances.



Income Taxes



The Company recorded an income
tax provision of $1.4 million and $0.1 million for the three months ended January 31, 2004 and 2003, respectively. The income tax expense for the periods consist of foreign tax on earnings and foreign withholding taxes generated from our foreign
operations. We expect to record a full valuation allowance on domestic tax benefits until we can sustain an appropriate level of profitability. Until such time, we would not expect to recognize any significant tax benefits in our results of
operations.



LIQUIDITY AND CAPITAL RESOURCES



In the first fiscal quarter of fiscal 2004 net cash provided by operating
activities was $9.2 million. The primary source of this cash resulted from reductions in net working capital in the amount of $11.1 million. This cash source was partially offset by the use of cash to fund our net loss after non-cash adjustments
during the quarter, totaling $1.9 million.



Investing
activities used cash of $2.9 million during the first quarter of fiscal 2004, primarily attributable to $5.4 million cash used for purchases of structural and tenant improvements of our new Milpitas headquarters and other property and equipment to
support our business, partially offset by $2.4 million of cash received from net sales of available-for-sale securities.



Financing activities used net cash of $0.2 million during the first quarter of fiscal 2004. The cash used was primarily for payments of bank loans and
notes payable related to leased products of $2.8 million. This use of cash was largely offset by $2.6 million received from the issuance of common stock relating to our employee equity plans during the quarter.



As of January 31, 2004, we had working capital of $365.5 million, including
cash and short-term investments of $290.5 million, and accounts receivable and inventories totaling $152.1 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. It is reasonably possible that 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.



On February 23, 2004, we announced a definitive
agreement pursuant to which we would acquire NPTest Holding Corporation (NPTest). Under the terms of the agreement, we will acquire NPTest in a combined stock-for-stock and cash transaction valued at approximately $660 million based on
the closing price of our stock on February 20, 2004. Each NPTest common share outstanding as of the closing date would be converted into the right to acquire 0.80 shares of our common stock and $5.75 in cash, resulting in an estimated $230 million
of cash to be paid by us for the acquisition. The acquisition will be accounted for as a purchase transaction. The transaction is subject to various closing conditions, including approval by our and NPTest



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stockholders and expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act. In the event the definitive agreement is terminated
under certain circumstances, the terminating party may be required to pay a termination fee of $20 million to the other party. We anticipate the acquisition will close in our third fiscal quarter.



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 foreseeable future, including potential acquisitions or strategic investments, capital expenditures, and working capital
requirements.



We lease our facilities and equipment under
operating leases that expire periodically through 2010 of which $0.7 million have been written-off to special operating charges during the first quarter of fiscal 2004, net of expected sublease income. The approximate future minimum lease payments
at January 31, 2004 are as follows (in thousands):



|                         |  |                             |       |                                    |   |                                |  |   |      
|------------------------ |  | --------------------------- | ----- | ---------------------------------- | - | ------------------------------ |  | - | -----
|                         |  | CommittedGrossLeasePayments |       | LeasesWritten Offin SpecialCharges |   | NetEstimatedFutureLeaseExpense
|Remainder of fiscal 2004 |  | $                           | 2,228 |                                    | $ | 1,375                          |  | $ | 853  
|Fiscal 2005              |  |                             | 2,167 |                                    |   | 820                            |  |   | 1,347
|Fiscal 2006              |  |                             | 698   |                                    |   | 368                            |  |   | 330  
|Fiscal 2007              |  |                             | 524   |                                    |   |                               |  |   | 524  
|Fiscal 2008 to 2010      |  |                             | 212   |                                    |   |                               |  |   | 212  
|                         |  |                             |       |                                    |   |                                |  |   |      
|                         |  | $                           | 5,829 |                                    | $ | 2,563                          |  | $ | 3,266
|                         |  |                             |       |                                    |   |                                |  |   |      



The following
summarizes our minimum contractual cash obligations and other commitments at January 31, 2004, and the effect of such obligations in future periods (in thousands):



|                                                                                            |  |       |         |                        |   |            |  |            |        |            |   |            |  |            |       |  |   |         |  |   |    
|------------------------------------------------------------------------------------------- |  | ----- | ------- | ---------------------- | - | ---------- |  | ---------- | ------ | ---------- | - | ---------- |  | ---------- | ----- |  | - | ------- |  | - | ---
|                                                                                            |  | Total |         | Remainderof Fiscal2004 |   | Fiscal2005 |  | Fiscal2006 |        | Fiscal2007 |   | Fiscal2008 |  | Thereafter
|Contractual Obligations:                                                                    |  |       |         |                        |   |            |  |            |        |            |   |            |  |            |       |  |   |         |  |   |    
|Facilities and equipment operating leases                                                   |  | $     | 5,829   |                        | $ | 2,228      |  | $          | 2,167  |            | $ | 698        |  | $          | 524   |  | $ | 69      |  | $ | 143
|Bank loans and notes payable related to leased products                                     |  |       | 7,158   |                        |   | 6,101      |  |            | 1,057  |            |   |           |  |            |      |  |   |        |  |   |   
|Interest on liabilities related to leased products                                          |  |       | 191     |                        |   | 183        |  |            | 8      |            |   |           |  |            |      |  |   |        |  |   |   
|Convertible subordinated notes                                                              |  |       | 180,000 |                        |   |           |  |            |       |            |   |           |  |            |      |  |   | 180,000 |  |   |   
|Interest on convertible subordinated notes                                                  |  |       | 11,588  |                        |   | 2,025      |  |            | 2,700  |            |   | 2,700      |  |            | 2,700 |  |   | 1,463   |  |   |   
|Minimum payable for information technology outsourcing including fees for early termination |  |       | 14,400  |                        |   | 5,088      |  |            | 9,312  |            |   |           |  |            |      |  |   |        |  |   |   
|Open non-cancelable purchase order commitments                                              |  |       | 58,905  |                        |   | 58,905     |  |            |       |            |   |           |  |            |      |  |   |        |  |   |   
|                                                                                            |  |       |         |                        |   |            |  |            |        |            |   |            |  |            |       |  |   |         |  |   |    
|Total contractual cash and other obligations                                                |  | $     | 278,071 |                        | $ | 74,530     |  | $          | 15,244 |            | $ | 3,398      |  | $          | 3,224 |  | $ | 181,532 |  | $ | 143
|                                                                                            |  |       |         |                        |   |            |  |            |        |            |   |            |  |            |       |  |   |         |  |   |    



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Net transfer of inventory to property and equipment was $0.4 million. Mature product spare parts that are
used in our service business are classified as property and equipment. 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. When capitalized spare parts and finished goods are sold to third parties, the transaction is recorded as a sale of a fixed asset.



As of January 31, 2004, our principal sources of liquidity consisted of
approximately $33.4 million of cash and cash equivalents, and short-term investments of $257.1 million. In addition, we had $49.7 million of available-for-sale securities, classified as long-term investments at January 31, 2004.



RECENT ACCOUNTING PRONOUNCEMENTS



In January 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as Variable
Interest Entities (VIEs) must be consolidated by the primary beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks or rewards arising from the VIE. For VIEs in which a significant
(but not majority) variable interest is held, certain disclosures are required. We have not entered into any arrangements or made any investments which qualify as a VIE after January 31, 2003 and therefore the initial implementation of FIN 46 had no
impact on our financial statements. For VIEs acquired before February 1, 2003, FIN 46 required us to apply the accounting and disclosure rules in the first quarter of fiscal 2004. This requirement was superseded by issuance of revision to
Interpretation No. 46, as noted below.



In December 2003, the FASB issued
revision to Interpretation No. 46 (FIN 46R) which replaced FIN 46. The revised interpretation further refines the definition of VIEs and provides guidelines on identifying them and assessing an enterprises interests in a VIE to
decide whether to consolidate that entity. FIN 46R applies at different dates to different types of enterprises and entities, and special provisions apply to enterprises that have fully or partially applied FIN 46 prior to issuance of FIN 46R.
Generally, application of FIN 46R is required in financial statements of public entities that have interests in VIEs or potential VIEs commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public
entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The adoption of FIN 46R is not expected to have a material impact on our results of operations or financial condition.



On December 17, 2003, the Staff of the Securities and Exchange Commission
(SEC) issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue Recognition, which supersedes Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB No. 101). SAB
104s primary purpose is to rescind the accounting guidance contained in SAB No. 101 related to multiple-element revenue arrangements that was superseded as a result of the issuance of EITF 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables. Additionally, SAB 104 rescinds the SECs related Revenue Recognition in Financial Statements Frequently Asked Questions and Answers issued with SAB No. 101 that had been codified in SEC Topic 13, Revenue Recognition.
While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB No. 101 remain largely unchanged by the issuance of SAB 104, which was effective upon issuance. The adoption of SAB 104 did not
have a material effect on our financial position or results of operations.



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RISK FACTORS



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



[GRAPHIC]



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;
| | - | -------------------------------------------------------------------------------------------------------------------



| |  | 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;
| | - | ---------------------------------------------------------------------------------



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



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



| |  | 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;
| | - | -----------------------------------------------------------------------------------------------



| |  | 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;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | 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 OEMS, 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 and of Severe Acute Respiratory Syndrome, or SARS,
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:



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



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



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



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



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



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



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



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



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



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



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



| |  | facility relocations and closures.
| | - | ----------------------------------



New and enhanced products typically have lower gross margins in the early stages of commercial introduction and production. 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 have fallen and may continue to fall below the
expectations of securities analysts or investors in some future quarter or quarters. Our failure 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 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.



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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 addition, acquisitions involve numerous other risks, including:



| |  | 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;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



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



We have entered into a definitive purchase agreement to acquire NPTest that
is pending completion. 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 future acquisitions may have on our business, financial condition and results of operations.



The semiconductor industry has been 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. There is uncertainty as to if and when the next cyclical growth phase will occur. The downturn has contributed to weakened order activity, order cancellation activity, and customer-requested shipment delays from our
existing backlog. This business weakness is worldwide, but we see it in particular with customers in Asia. Until such time as we return to a growth period, we expect a continuing volatility in order activity. We anticipate revenue levels to continue
to remain under pressure throughout fiscal 2004 due to the prolonged cyclical downturn and uncertainty over the start of the next cyclical growth phase. Revenues may decline thereafter due to the uncertainty of a sustainable recovery in the
semiconductor and related capital equipment industry. As a result of the cyclical downturn, 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. Throughout 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 throughout 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 2001-2003. Other initiatives during these
three fiscal years included a temporary domestic and European 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.



As a result of
the rapid and steep decline in revenue during this latest downturn, 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. At January 31, 2004, approximately 15% and 9% of the net inventory balances are for our older Quartet mixed signal and Kalos non-volatile memory product families, respectively. With the recent
introduction of the Kalos II, we will continue to scrutinize the value of the current Kalos I inventory in light of the upcoming product transition to Kalos II. In particular, the value of the Kalos inventory will depend on factors such as the
general economic conditions of the Flash memory IC market, product development schedules for the production versions of the Kalos II and, ultimately, the success of the Kalos II product in the marketplace. We may



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be required to take additional charges for excess and obsolete inventory and impairment of fixed assets if this prolonged industry downturn causes further
reductions to our current inventory valuations, value of our long-term assets, or changes our current product development plans.



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 downturn 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 $2 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 $2.0 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 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, 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 was recognized from the Octet product family through
October 31, 2003. These delays have been primarily 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 SAB 104, we defer revenue for



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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 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.



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.



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;
| | - | ------------------



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



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



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



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



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| |  | 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, weakness in IC demand may cause integrated device manufacturers, or IDMs, to curtail or discontinue the outsourcing of testing to test houses, relying instead on in-house testing. Because less of
our market share is from the IDMs, this trend may reduce the demand for our products. 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 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 new 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 2001, we primarily introduced products that are either evolutions or derivatives of existing products. During fiscal
2002 and 2003, we introduced several products that are evolutions or derivatives of existing products as well as products that are 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 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. 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.



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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. We do not currently compete in the production testing of high-end microprocessors or DRAMs. Moreover, a substantial portion of our net sales is derived from sales of mixed-signal testers. We
face in some cases six 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 18%, 19%, 20% and 13% of our
net sales in the first quarter of fiscal 2004 and the fiscal years ended October 31, 2003, 2002 and 2001, respectively. Our agreement with Spirox has no minimum purchase commitment and can be terminated for any reason on 180 days prior written
notice. 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 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;
| | - | ------------------------------------------------------------------------



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| |  | 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.
| | - | -------------------------------------------------------------------------------------------------------------------



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, 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, effective November 1, 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 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.



Also, on June 29, 2001, the Financial Accounting Standards Board (FASB) pronounced under Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets (FAS 142) that purchased goodwill should not be amortized, but rather, it should be periodically reviewed for impairment. Such impairment could be caused by internal factors as well as external
factors beyond our control. The FASB has further determined that at the time goodwill is considered impaired an amount equal to the impairment loss should be charged as an operating expense in the statement of operations. The timing of such an
impairment (if any) of goodwill acquired in past and future transactions is uncertain and difficult to predict. Our results of operations in periods following any such impairment could be materially adversely affected.



In addition, there has been an ongoing public debate whether employee stock
option and employee stock purchase plans shares should be treated as a compensation expense and, if so, how to properly value such charges. If we were to elect or were required to record an expense for our stock-based compensation plans using the
fair value method, we could have significant compensation charges. Although we are currently not required to record any compensation expense using the fair value method in connection with option grants that have an exercise price at or above fair
market value and for shares issued under our employee stock purchase plan, it is possible that future laws or regulations will require us to treat all stock-based compensation as a compensation expense using the fair value method. See Notes 1 and 7
of the Notes to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2003 and Note 3 of the Notes to the Condensed Consolidated Financial Statements included in this Form 10-Q for a discussion of
stock-based compensation.



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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, none of whom are bound by an employment or non-competition agreement. 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.



Our international business exposes us to additional risks.



International sales accounted for approximately 62%, 64%, 55%, and 61% of our total net sales for the first quarter of fiscal 2004, and for the fiscal
years 2003, 2002 and 2001, 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 recurrence of SARS 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;
| | - | --------------------------------------------



| |  | 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% of our total net sales during the first quarter of fiscal 2004 and 38%, 42% and 38% of our total net sales in fiscal years 2003, 2002 and 2001, respectively, and thus demand for our products is subject to the risk of economic
instability in that region and fears surrounding SARS and 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 foreign end-user customer accounted for more than 10% of our net
sales during the first quarter of fiscal 2004 or 2003. However, one end-user customer headquartered in Europe accounted for 10% of our net sales in fiscal 2003.



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In addition, one of our major distributors, Spirox Corporation, 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 SARS 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 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 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.



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.



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 2004 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



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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.



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 July 2002 requires changes in some of our corporate governance and securities disclosure or compliance
practices. That Act also requires 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.



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,
shareholders rights plan, 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, our shareholder rights plan 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).



|                            |  |                    |         |   |                                                           |      |         |   |      |   |        |      |  |            |        |   |  |   |  |  
|--------------------------- |  | ------------------ | ------- | - | --------------------------------------------------------- | ---- | ------- | - | ---- | - | ------ | ---- |  | ---------- | ------ | - |  | - |  | -
|                            |  | Balance at10/31/03 |         |   | Future maturities of investments held at January 31, 2004
|                            |  |                    | 2004    |   |                                                           | 2005 |         |   | 2006 |   |        | 2007 |  | Thereafter
|Cash equivalents            |  |                    |         |   |                                                           |      |         |   |      |   |        |      |  |            |        |   |  |   |  |  
|Fixed rate                  |  | $                  | 27,318  |   |                                                           | $    | 33,396  |   |      |   |       |      |  |            |       |   |  |  |  | 
|Average rate                |  |                    | 0.46    | % |                                                           |      | 0.33    | % |      |   |       |      |  |            |       |   |  |  |  | 
|Short term investments      |  |                    |         |   |                                                           |      |         |   |      |   |        |      |  |            |        |   |  |   |  |  
|Fixed rate                  |  | $                  | 258,578 |   |                                                           | $    | 256,606 |   |      |   |       |      |  |            |       |   |  |  |  | 
|Average rate                |  |                    | 2.94    | % |                                                           |      | 2.65    | % |      |   |       |      |  |            |       |   |  |  |  | 
|Long term investments       |  |                    |         |   |                                                           |      |         |   |      |   |        |      |  |            |        |   |  |   |  |  
|Fixed rate                  |  | $                  | 50,184  |   |                                                           |      |        |   |      | $ | 38,343 |      |  | $          | 11,379 |   |  |  |  | 
|Average rate                |  |                    | 4.08    | % |                                                           |      |        |   |      |   | 4.68   | %    |  |            | 6.57   | % |  |  |  | 
|                            |  |                    |         |   |                                                           |      |         |   |      |   |        |      |  |            |        |   |  |   |  |  
|Total investment securities |  | $                  | 336,080 |   |                                                           | $    | 290,002 |   |      | $ | 38,343 |      |  | $          | 11,379 |   |  |  |  | 
|Average rate                |  |                    | 2.91    | % |                                                           |      | 2.38    | % |      |   | 4.68   | %    |  |            | 6.57   | % |  |  |  | 
|Equity instruments          |  | $                  | 498     |   |                                                           | $    | 525     |   |      |   |       |      |  |            |       |   |  |  |  | 



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.



Foreign Exchange



We generate a significant portion of our sales from sales to 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 and occasionally are denominated in the local currency for European and Japanese customers. The
subsidiaries also incur most of their expenses in the local currency. Accordingly, some of our foreign subsidiaries use the local currency as their functional currency.



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.



ITEM 4.  CONTROLS AND PROCEDURES



As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer of the effectiveness of the design and operation
of our disclosure controls and procedures. While our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, the design of any system of controls is based in part upon certain assumptions about
the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions regardless of how remote. However, based on the evaluation of the effectiveness of the
design and operation of our disclosure controls and procedures, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective in timely alerting them to material information required to
be included in our periodic SEC filings at the reasonable assurance level.



There has been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal
control over financial reporting.



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PART II.  OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------



We 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. | Changes in Securities and Use of Proceeds.
|------- | ------------------------------------------



On February 19, 2004, our board of directors voted to amend its existing Rights Agreement dated June 1, 1998 by and between the Company and Equiserve
Trust Company, N.A. to exclude from the definition of an acquiring person any person who acquires 15% or more of the Companys common stock in a transaction approved by the board of directors of the Company. The First Amendment to
the Rights Agreement dated as of February 19, 2004 is attached hereto as Exhibit 4.1 and is incorporated in its entirety herein by reference.



|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 and Reports on Form 8-K
|------- | --------------------------------



(a) See Exhibit Index



(b) Reports on Form 8-K



1) The Company furnished a report on Form 8-K on November 13, 2003, containing a press release that was issued reporting better than
expected revenue and bookings for the Companys fiscal quarter ended October 31, 2003.



2) The Company furnished a report on Form 8-K on November 24, 2003, containing the Companys preliminary results for its fourth
quarter and year ended October 31, 2003.



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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)                                                                     
|               |  | 
|March 15, 2004 |  |  |  | /S/ JOHN R. DETWILER                                                             
|Date           |  |  |  | John R. Detwiler John R. Detwiler, Senior Vice President, Chief Financial Officer



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EXHIBIT INDEX



|              |  |                                                                                                                                       
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  |                                                                                                                                       
|              | 
|4.1           |  | Form of First Amendment to Rights Agreement dated as of February 19, 2004 by and between the Company and Equiserve Trust Company, N.A.
|              | 
|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