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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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(Mark One)

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

For the quarterly period ended July 31, 2006

OR



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

For the transition period from  to

Commission file number 0-22366



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CREDENCE
SYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)



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

1421 California Circle, Milpitas, California

95035

(Address of principal
executive offices)

(Zip Code)

(408) 635-4300

(Registrants telephone number, including area code)

N/A

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of
accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.    Large accelerated filer ̈Accelerated filer  x    Non-accelerated filer ̈

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

At August 31, 2006, there were 100,610,772 shares of the Registrants common stock, $0.001 par
value per share, outstanding.



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##### Table of Contents

CREDENCE SYSTEMS CORPORATION

INDEX



|                              |  |                                                                                       |  |   
|----------------------------- |  | ------------------------------------------------------------------------------------- |  | --
|                              |  | PAGE NO.                                                                             
|PART I.
FINANCIAL INFORMATION |  |                                                                                      
|                              |  |                                                                                      
|Item 1.                       |  | Financial Statements (unaudited):                                                     |  | 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 |  | 25
|                              |  |                                                                                      
|Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 40
|                              |  |                                                                                      
|Item 4.                       |  | Controls and Procedures                                                               |  | 41
|                              | 
|PART II.
OTHER INFORMATION    |  |                                                                                      
|                              |  |                                                                                      
|Item 1.                       |  | Legal Proceedings                                                                     |  | 41
|                              |  |                                                                                      
|Item 1A.                      |  | Risk Factors                                                                          |  | 41
|                              |  |                                                                                      
|Item 2.                       |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 53
|                              |  |                                                                                      
|Item 3.                       |  | Defaults Upon Senior Securities                                                       |  | 53
|                              |  |                                                                                      
|Item 4.                       |  | Submission of Matters to a Vote of Security Holders                                   |  | 53
|                              |  |                                                                                      
|Item 5.                       |  | Other Information                                                                     |  | 53
|                              |  |                                                                                      
|Item 6.                       |  | Exhibits                                                                              |  | 54
|                              | 
|SIGNATURES                    |  | 55                                                                                   



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##### Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                           |  |               |         |                    |   |          
|------------------------------------------ |  | ------------- | ------- | ------------------ | - | ---------
|                                           |  | July 31, 2006 |         | October 31, 2005a)
|ASSETS                                     |  |               |         |                    |   |          
|Current assets:                            |  |               |         |                    |   |          
|Cash and cash equivalents                  |  | $             | 113,606 |                    | $ | 142,180  
|Short-term investments                     |  |               | 15,681  |                    |   | 7,816    
|Accounts receivable, net                   |  |               | 106,680 |                    |   | 114,042  
|Inventories                                |  |               | 56,966  |                    |   | 79,054   
|Deferred income taxes                      |  |               | 9,878   |                    |   | 9,473    
|Prepaid expenses and other current assets  |  |               | 13,506  |                    |   | 18,506   
|                                           |  |               |         |                    |   |          
|Total current assets                       |  |               | 316,317 |                    |   | 371,071  
|Property and equipment, net                |  |               | 90,048  |                    |   | 96,691   
|Goodwill                                   |  |               |        |                    |   | 424,080  
|Other intangible assets, net               |  |               | 88,831  |                    |   | 96,439   
|Other assets                               |  |               | 52,320  |                    |   | 58,024   
|                                           |  |               |         |                    |   |          
|Total assets                               |  | $             | 547,516 |                    | $ | 1,046,305
|                                           |  |               |         |                    |   |          
|LIABILITIES AND STOCKHOLDERS EQUITY       |  |               |         |                    |   |          
|Current liabilities:                       |  |               |         |                    |   |          
|Bank loans                                 |  | $             |        |                    | $ | 5,000    
|Accounts payable                           |  |               | 28,707  |                    |   | 45,846   
|Accrued expenses and other liabilities     |  |               | 35,199  |                    |   | 39,756   
|Accrued payroll and related liabilities    |  |               | 21,024  |                    |   | 18,336   
|Deferred revenue                           |  |               | 19,510  |                    |   | 17,716   
|Income taxes payable                       |  |               | 15,517  |                    |   | 18,800   
|Accrued warranty                           |  |               | 13,172  |                    |   | 13,419   
|Deferred profit                            |  |               | 3,977   |                    |   | 5,112    
|                                           |  |               |         |                    |   |          
|Total current liabilities                  |  |               | 137,106 |                    |   | 163,985  
|Convertible subordinated notes             |  |               | 180,000 |                    |   | 180,000  
|Long-term restructuring liabilities        |  |               | 3,969   |                    |   | 7,261    
|Long-term deferred income taxes            |  |               | 9,473   |                    |   | 9,473    
|Other liabilities                          |  |               | 4,275   |                    |   | 3,557    
|Stockholders equity                       |  |               | 212,693 |                    |   | 682,029  
|                                           |  |               |         |                    |   |          
|Total liabilities and stockholders equity |  | $             | 547,516 |                    | $ | 1,046,305
|                                           |  |               |         |                    |   |          

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|a) | Derived from the audited consolidated balance sheet included in the Companys Form 10-K
for the year ended October 31, 2005.
|-- | ----------------------------------------------------------------------------------------------------------------------------

See accompanying notes.



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##### Table of Contents

CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)



|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|----------------------------------------------------------------------------------------------------------- |  | --------------------------- | -------- | - | -------------------------- | - | ------- | ---- |  | - | -------- | - |  | - | ------- | -
|                                                                                                            |  | Three Months Ended July 31, |          |   | Nine Months Ended July 31, |  
|                                                                                                            |  | 2006                        |          |   | 2005                       |   |         | 2006 |  |   | 2005     |  
|Net sales                                                                                                   |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Systems, upgrades and software                                                                              |  | $                           | 80,619   |   |                            | $ | 80,912  |      |  | $ | 266,086  |   |  | $ | 222,381 |  
|Services and spare parts                                                                                    |  |                             | 28,973   |   |                            |   | 31,013  |      |  |   | 86,441   |   |  |   | 85,371  |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Total net sales                                                                                             |  |                             | 109,592  |   |                            |   | 111,925 |      |  |   | 352,527  |   |  |   | 307,752 |  
|Cost of goods sold                                                                                          |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Systems, upgrades and software (including stock-based compensation expense of $313 and $492(1))             |  |                             | 43,892   |   |                            |   | 41,898  |      |  |   | 140,996  |   |  |   | 124,334 |  
|Services and spare parts                                                                                    |  |                             | 17,653   |   |                            |   | 17,284  |      |  |   | 53,276   |   |  |   | 52,326  |  
|Inventory write-downs                                                                                       |  |                             | 24,233   |   |                            |   | 23,000  |      |  |   | 36,062   |   |  |   | 29,090  |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Total cost of goods sold                                                                                    |  |                             | 85,778   |   |                            |   | 82,182  |      |  |   | 230,334  |   |  |   | 205,750 |  
|Gross margin                                                                                                |  |                             | 23,814   |   |                            |   | 29,743  |      |  |   | 122,193  |   |  |   | 102,002 |  
|Operating expenses:                                                                                         |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Research and development (including stock-based compensation expense of $615 and $1,545(1))                 |  |                             | 22,576   |   |                            |   | 23,849  |      |  |   | 70,847   |   |  |   | 68,905  |  
|Selling, general and administrative (including stock-based compensation expense of $822 and $2,357(1))      |  |                             | 28,988   |   |                            |   | 31,317  |      |  |   | 84,422   |   |  |   | 94,552  |  
|Amortization of purchased intangibles and deferred compensation(2)                                          |  |                             | 4,338    |   |                            |   | 5,663   |      |  |   | 12,709   |   |  |   | 18,664  |  
|Reduction of goodwill                                                                                       |  |                             | 423,875  |   |                            |   |        |      |  |   | 423,875  |   |  |   |        |  
|Restructuring charges                                                                                       |  |                             | 1,792    |   |                            |   | 9,654   |      |  |   | 3,166    |   |  |   | 11,445  |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Total operating expenses                                                                                    |  |                             | 481,569  |   |                            |   | 70,483  |      |  |   | 595,019  |   |  |   | 193,566 |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Operating loss                                                                                              |  |                             | (457,755 | ) |                            |   | (40,740 | )    |  |   | (472,826 | ) |  |   | (91,564 | )
|Interest income                                                                                             |  |                             | 979      |   |                            |   | 725     |      |  |   | 2,758    |   |  |   | 2,000   |  
|Interest expense                                                                                            |  |                             | (677     | ) |                            |   | (767    | )    |  |   | (2,056   | ) |  |   | (2,236  | )
|Other income (expense) , net                                                                                |  |                             | (1,803   | ) |                            |   | 1,080   |      |  |   | (2,675   | ) |  |   | 2,950   |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Loss before income tax provision                                                                            |  |                             | (459,256 | ) |                            |   | (39,702 | )    |  |   | (474,799 | ) |  |   | (88,850 | )
|Income tax provision                                                                                        |  |                             | 2,110    |   |                            |   | 1,975   |      |  |   | 4,844    |   |  |   | 8,602   |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Net loss                                                                                                    |  | $                           | (461,366 | ) |                            | $ | (41,677 | )    |  | $ | (479,643 | ) |  | $ | (97,452 | )
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Net loss per share                                                                                          |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Basic                                                                                                       |  | $                           | (4.61    | ) |                            | $ | (0.43   | )    |  | $ | (4.81    | ) |  | $ | (1.06   | )
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Diluted (see Note 12)                                                                                       |  | $                           | (4.61    | ) |                            | $ | (0.43   | )    |  | $ | (4.81    | ) |  | $ | (1.06   | )
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Number of shares used in computing per share amount                                                         |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Basic                                                                                                       |  |                             | 100,017  |   |                            |   | 96,638  |      |  |   | 99,798   |   |  |   | 92,010  |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Diluted                                                                                                     |  |                             | 100,017  |   |                            |   | 96,638  |      |  |   | 99,798   |   |  |   | 92,010  |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|(1)For the three and nine months ended July 31, 2006 resulting from SFAS No. 123(R)
adoption, respectively. | 
|(2)Amortization of deferred compensation related to the following expense categories by period:             | 
|                                                                                                            |  |                             |          |  
|Cost of goods sold                                                                                          |  | $                           |         |   |                            | $ | 95      |      |  | $ |         |   |  | $ | 291     |  
|Research and development                                                                                    |  |                             |         |   |                            |   | 153     |      |  |   |         |   |  |   | 470     |  
|Selling, general and administrative                                                                         |  |                             |         |   |                            |   | 709     |      |  |   |         |   |  |   | 1,748   |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Total amortization of deferred compensation                                                                 |  | $                           |         |   |                            | $ | 957     |      |  | $ |         |   |  | $ | 2,509   |  
|                                                                                                            |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  

See accompanying notes.



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CREDENCE SYSTEMS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                            |  |                            |          |   |      |   |          |  
|--------------------------------------------------------------------------- |  | -------------------------- | -------- | - | ---- | - | -------- | -
|                                                                            |  | Nine Months Ended July 31, |         
|                                                                            |  | 2006                       |          |   | 2005 |  
|Cash flows from operating activities:                                       |  |                            |          |   |      |   |          |  
|Net loss                                                                    |  | $                          | (479,643 | ) |      | $ | (97,452  | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                            |          |   |      |   |          |  
|Depreciation and amortization                                               |  |                            | 39,729   |   |      |   | 45,440   |  
|Inventory write-downs and non-cash restructuring charges                    |  |                            | 37,485   |   |      |   | 33,373   |  
|Reduction of goodwill                                                       |  |                            | 423,875  |   |      |   |         |  
|Provision for allowance for doubtful accounts                               |  |                            | 561      |   |      |   | 2,764    |  
|Stock-based compensation charges(1)                                         |  |                            | 4,523    |   |      |   | 2,509    |  
|Loss (gain) on disposal of property and equipment                           |  |                            | 1,076    |   |      |   | 238      |  
|Loss on impaired investment                                                 |  |                            | 945      |   |      |   |         |  
|Realized loss on available-for-sale securities                              |  |                            | (302     | ) |      |   |         |  
|Changes in operating assets and liabilities:                                |  |                            |          |   |      |   |          |  
|Accounts receivable                                                         |  |                            | 7,892    |   |      |   | (4,929   | )
|Inventories                                                                 |  |                            | (13,970  | ) |      |   | 5,484    |  
|Income tax receivable and payable                                           |  |                            | (3,994   | ) |      |   | 3,774    |  
|Prepaid expenses and other current assets                                   |  |                            | 5,214    |   |      |   | 6,612    |  
|Other assets                                                                |  |                            | (11,356  | ) |      |   | 4,595    |  
|Accounts payable                                                            |  |                            | (17,595  | ) |      |   | (12,584  | )
|Accrued expenses and other current liabilities                              |  |                            | (4,631   | ) |      |   | (7,851   | )
|Deferred profit                                                             |  |                            | (1,135   | ) |      |   | (2,514   | )
|                                                                            |  |                            |          |   |      |   |          |  
|Net cash used in operating activities                                       |  |                            | (11,326  | ) |      |   | (20,541  | )
|Cash flows from investing activities:                                       |  |                            |          |   |      |   |          |  
|Purchases of available-for-sale securities                                  |  |                            | (28,581  | ) |      |   | (100,775 | )
|Sales and maturities of available-for-sale securities                       |  |                            | 20,770   |   |      |   | 121,270  |  
|Acquisition of property and equipment                                       |  |                            | (7,368   | ) |      |   | (13,028  | )
|Acquisition of business, net of cash and cash equivalents                   |  |                            | (4,643   | ) |      |   |         |  
|Proceeds from sale of property and equipment                                |  |                            | 2,364    |   |      |   | 583      |  
|                                                                            |  |                            |          |   |      |   |          |  
|Net cash (used by) provided by investing activities                         |  |                            | (17,458  | ) |      |   | 8,050    |  
|Cash flows from financing activities:                                       |  |                            |          |   |      |   |          |  
|Issuance of common and treasury stock                                       |  |                            | 3,942    |   |      |   | 5,561    |  
|Payments of bank loans and notes payable related to leased products         |  |                            | (5,000   | ) |      |   | (1,058   | )
|                                                                            |  |                            |          |   |      |   |          |  
|Net cash (used by) provided by financing activities                         |  |                            | (1,058   | ) |      |   | 4,503    |  
|                                                                            |  |                            |          |   |      |   |          |  
|Effects of exchange rate on cash and cash equivalents                       |  |                            | 1,268    |   |      |   | 297      |  
|                                                                            |  |                            |          |   |      |   |          |  
|Net decrease in cash and cash equivalents                                   |  |                            | (28,574  | ) |      |   | (7,691   | )
|Cash and cash equivalents at beginning of period                            |  |                            | 142,180  |   |      |   | 94,052   |  
|                                                                            |  |                            |          |   |      |   |          |  
|Cash and cash equivalents at end of period                                  |  | $                          | 113,606  |   |      | $ | 86,361   |  
|                                                                            |  |                            |          |   |      |   |          |  
|Supplemental disclosures of cash flow information:                          |  |                            |          |   |      |   |          |  
|Interest paid                                                               |  | $                          | 2,732    |   |      | $ | 2,777    |  
|Income taxes paid                                                           |  | $                          | 9,111    |   |      | $ | 4,072    |  
|Noncash investing activities:                                               |  |                            |          |   |      |   |          |  
|Net transfers of inventory to property and equipment                        |  | $                          | 1,679    |   |      | $ | 269      |  
|Schlumbergers liability settlement using Credence common stock             |  | $                          |         |   |      | $ | 5,000    |  
|Unrealized loss on available-for-sale investments                           |  | $                          | 230      |   |      | $ | 295      |  

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|(1) | During the nine-month period ended July 31, 2006, the Company recorded a total of $4,523,000 in stock-based compensation expense, of which $129,000 was capitalized as inventory
at July 31, 2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

See accompanying notes.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Quarterly Financial Statements

The unaudited condensed consolidated financial statements and related notes for the three and nine-month periods ended July 31, 2006 and 2005 are
unaudited but include all adjustments (consisting solely of normal recurring adjustments except for reduction of goodwill and restructuring charges) which are, in the opinion of management, necessary for a fair presentation of the financial position
and results of operations of Credence Systems Corporation (Credence or the Company) for the interim periods, in accordance with United States generally accepted accounting principles. The results of operations for the three and nine-month periods
ended July 31, 2006 and 2005 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, 2005 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, fluctuations in the Companys quarterly net sales and operating results, limited systems sales, backlog, cyclicality of the semiconductor industry, management of fluctuations in
the Companys operating results, expansion of the Companys product lines, limited sources of supply, reliance on the Companys subcontractors, the Companys highly competitive industry, customization of products, rapid
technological change, customer concentration, lengthy sales cycles, changes in financial accounting standards and accounting estimates, dependence on key personnel, international sales, proprietary rights, legal proceedings, volatility of the
Companys stock price, terrorist attacks and other geopolitical instability, effects of the Sarbanes-Oxley Act of 2002, and effects of certain anti-takeover provisions, as set forth in this Report. Any party interested in receiving a free copy
of the Form 10-K or the Companys other publicly available documents should write to the Chief Financial Officer of the Company.

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

Basis of Presentation  The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. Certain prior year amounts in the unaudited condensed consolidated financial statements and related notes have been reclassified to conform to
the current years presentation. These reclassifications had no effect on the financial position, results of operations, or cash flows for any of the periods presented.

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

2. Revenue Recognition

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



6



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##### Table of Contents

During fiscal 2006 and 2005, the Company introduced several new enhancements, systems and products.
Certain revenue from sales of these new systems and products during the nine months in fiscal 2006 and fiscal 2005 were deferred until the revenue recognition requirements of the Companys 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 the Companys existing testers. Delays in introducing a product or delays
in the Companys ability to obtain customer acceptance, if they occur in the future, will delay the recognition of revenue and gross profit by the Company.

With respect to arrangements with multiple deliverables, the Company follows the guidance in Emerging Issue Task Force No. 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21), to determine
whether there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units of accounting, the Company then allocates the total fee on such arrangements to the individual units of accounting using the
residual method. The Company then recognizes revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting (principally following SAB 104).

Sales in the United States are principally made through the Companys direct sales organization consisting of direct sales employees and
representatives. Sales outside the United States utilize both direct sales employees and distributors. There are no significant differences in revenue recognition policies based on the sales channel, due to the business practices that have been
adopted with the Companys distributor relationships. Because of these business circumstances, the Company does not use price protection, stock rotation or similar programs with its distributors. In general, the Company
sells products to the distributor on the basis of a purchase order received from an end customer. The Company evaluates any revenue recognition issues, in such cases, based on the characteristics of the end customer.

The Company 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 Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), since the embedded software in the Companys products is not sold separately, cannot be used on another
vendors products, and the Company cannot fundamentally enhance or expand the capability of the equipment with new or revised embedded software. In addition, the equipments principal performance characteristics are governed by digital
speed and pin count, which are primarily a function of the hardware.

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

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

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

3. Accounts Receivable Sales without Recourse

The
Company had an agreement with a commercial bank to sell certain of its trade receivables in non-recourse transactions. Under the terms of the agreement, the Company could sell up to $30.0 million of its trade receivables at any one time. The Company
was retained by the bank to service the collection aspect of the trade receivables sold. The trade receivables were sold at a discount plus administrative and other fees. The discount amount, administrative and other fees for the nine-month period
ended July 31, 2005 of approximately $0.1 million were accounted for in other income (expense), net in the unaudited condensed consolidated statements of operations. The proceeds received were included as operating activities in the unaudited
condensed consolidated statements of cash flows. This facility was terminated during the quarter ended July 31, 2005.

4. Investment

Investment consists of an equity investment in a privately-held company that develops products that are strategic to the Company.
During July 2006, events and circumstances arose which caused the Company to evaluate the carrying value of the investment. Based on the evaluation, the Company recorded impairment charges of $0.9 million in the three and nine months ended
July 31, 2006, respectively. At July 31, 2006, the remaining carrying value of the investment of $0.8 million is included in other assets in the unaudited condensed consolidated balance sheets.



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5. Bank Loan

The bank loan had an annual interest rate of prime (approximately 7.0% at November 2, 2005). The loan had a covenant requiring the Company to maintain a minimum aggregated balance of cash, cash equivalents, and short and long-term
investments of $100.0 million. The bank loan expired and was paid in full in November 2005 and was not renewed.

6. Guarantees

The Company accounts for guarantees in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34 (FIN 45). Accordingly, the Company
evaluates its guarantees to determine whether (a) the guarantee is specifically excluded from the scope of FIN 45, (b) the guarantee is subject to FIN 45 disclosure requirements only, but not subject to the initial recognition and
measurement provisions, or (c) the guarantee is required to be recorded in the financial statements at fair value. The Company has evaluated its guarantees and has concluded that they are either not within the scope of FIN 45 or do not require
recognition in the financial statements.

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 the Company. In addition, the Company has entered into separate indemnification agreements with each director and each executive officer of the Company 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 been required to make payments related to these obligations, and the fair value for these obligations is
zero on the unaudited condensed consolidated balance sheet as of July 31, 2006.

As is customary in the Companys industry and as
provided for under local law in the United States. and other jurisdictions, many of the Companys standard contracts provide remedies to customers and others with whom the Company does business, 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 under operating lease agreements for
environmental matters, 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 such as warranty, the use of their goods and services, the use of facilities and state of the Companys owned facilities, the state of the assets and businesses that
the Company sells and other matters covered by such contracts, usually up to a specified maximum amount. Based on past experience, claims made under such indemnifications are rare and the associated estimated fair value of the liability is not
material.

7. Stock-Based Compensation

The Company has a stock-based compensation program that provides its Board of Directors broad discretion in creating employee equity incentives. This program includes incentive and non-statutory stock options, restricted stock units and
other types of equity granted under various plans, the majority of which are stockholder approved. Stock options are generally time-based, vesting 25% on each annual anniversary of the hire date over four years and expire up to ten years from the
grant date. Additionally, the Company has an Employee Stock Purchase Plan (ESPP) that allows employees to purchase shares of common stock at 85% of the fair market value at the lower of either the date of enrollment or the date of purchase. Shares
issued as a result of stock option exercises and the Companys ESPP are generally from the Companys new and treasury shares. As of July 31, 2006, the Company had approximately 5.2 million shares of common stock reserved for
future issuance under the stock option plans and ESPP.

On November 1, 2005, the Company adopted Statement of Financial Accounting
Standard No. 123(R) (SFAS 123(R)), Share-Based Payment, for its share-based compensation plans. Under SFAS 123(R), the Company is required to recognize



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stock-based compensation costs based on the estimated fair value at the grant date for its share-based awards. In
accordance with this standard, the Company has elected to recognize the compensation cost of all share-based awards that ultimately vest on a straight-line basis over the vesting period of the award.

The Company previously accounted for its employee stock option and ESPP under the recognition and measurement principles of Accounting Principles Board
Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related Interpretations, and adopted the disclosure-only provisions of Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based
Compensation, (SFAS 123), as amended by Statement of Financial Accounting Standard No. 148, Accounting for Stock-Based Compensation  Transition and Disclosures, (SFAS 148). As the ESPP was not compensatory under APB 25,
no compensation expense was recorded in earnings for the awards granted under the ESPP. Compensation expense was recorded in earnings for the Companys stock options if they were awarded with an exercise price less than the market price of the
Companys stock on the date of grant. The pro forma effects on net loss and net loss per share for stock options and ESPP awards were instead disclosed in a footnote to the unaudited condensed consolidated financial statements.

The Company has elected to use the modified prospective transition method as permitted by SFAS 123(R) and therefore has not restated its financial
results for prior periods. Under this transition method, in the three and nine months ended July 31, 2006, the compensation cost recognized included the cost for all stock-based compensation awards granted prior to, but not yet vested as of
November 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123 and the grant date fair value estimated in accordance with the provisions of SFAS 123(R) for awards granted or modified on or
after November 1, 2005 whose requisite service period was rendered during the nine months ended July 31, 2006. The Company determines the fair value of stock options using the single option approach under SFAS 123(R). Prior to the adoption
of SFAS 123(R), the Company determined the fair value of stock options using the multiple option approach. In conjunction with the adoption of SFAS 123(R), the Company changed its method of attributing the value of stock-based compensation to
expense from the accelerated multiple-option approach to the straight-line single option approach for awards granted or modified on or after November 1, 2005. Compensation expense for all share-based payment awards granted prior to
November 1, 2005 will continue to be recognized using the accelerated multiple-option approach.

In calculating the compensation cost,
the Company estimates the fair value of each option grant on the date of grant using the Black-Scholes-Merton options pricing model. The Black-Scholes-Merton option pricing 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-Merton model requires the input of highly subjective assumptions including the expected stock price volatility.

As a result of adopting SFAS 123(R), the Companys loss before income taxes provision and net loss for the three and nine months ended July 31,
2006 were $1.2 million and $2.6 million higher, respectively, than if it had continued to account for share-based compensation under APB 25. Basic and diluted net loss per share for the three and nine months ended July 31, 2006 would have been
$0.01 and $0.05 lower, respectively, if the Company had not adopted SFAS 123(R). There was no effect on the unaudited condensed consolidated statements of cash flows from adopting SFAS 123(R).

The following table illustrates the stock-based compensation expense resulting from stock options and ESPP included in the unaudited condensed
consolidated statement of operations for the three and nine months ended July 31, 2006 (in thousands):



|                                                             |  |                                  |       |                                 |   |      
|------------------------------------------------------------ |  | -------------------------------- | ----- | ------------------------------- | - | -----
|                                                             |  | Three Months Ended July 31,
2006 |       | Nine Months Ended July 31, 2006
|Cost of goods sold                                           |  | $                                | 313   |                                 | $ | 492  
|Research and development                                     |  |                                  | 615   |                                 |   | 1,545
|Selling, general and administrative                          |  |                                  | 822   |                                 |   | 2,357
|                                                             |  |                                  |       |                                 |   |      
|Stock-based compensation expense before income taxes benefit |  | $                                | 1,750 |                                 | $ | 4,394
|Income tax benefit                                           |  |                                  |      |                                 |   |     
|                                                             |  |                                  |       |                                 |   |      
|Stock-based compensation expense after income taxes benefit  |  | $                                | 1,750 |                                 | $ | 4,394
|                                                             |  |                                  |       |                                 |   |      

At July 31, 2006, the Company capitalized $0.1 million of stock-based compensation expense as
inventory.



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



|                                                                                                                                     |  |                                  |         |   |                                 |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------ |  | -------------------------------- | ------- | - | ------------------------------- | - | -------- | -
|                                                                                                                                     |  | Three Months Ended July 31,
2005 |         |   | Nine Months Ended July 31, 2005 |  
|Net loss as reported                                                                                                                 |  | $                                | (41,677 | ) |                                 | $ | (97,452  | )
|Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects                             |  |                                  | 957     |   |                                 |   | 2,509    |  
|Less: Stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax
effects |  |                                  | (5,663  | ) |                                 |   | (19,425  | )
|                                                                                                                                     |  |                                  |         |   |                                 |   |          |  
|Pro forma net loss                                                                                                                   |  | $                                | (46,383 | ) |                                 | $ | (114,368 | )
|                                                                                                                                     |  |                                  |         |   |                                 |   |          |  
|Basic and diluted net loss per share as reported                                                                                     |  | $                                | (0.43   | ) |                                 | $ | (1.06    | )
|                                                                                                                                     |  |                                  |         |   |                                 |   |          |  
|Basic and diluted net loss per share pro forma                                                                                       |  | $                                | (0.48   | ) |                                 | $ | (1.24    | )
|                                                                                                                                     |  |                                  |         |   |                                 |   |          |  

Prior to the adoption of SFAS 123(R), in August 2005, the Companys Board of Directors
approved the accelerated vesting of certain unvested and out-of-the-money non-qualified stock options previously awarded to employees and officers with option exercise prices equal to or greater than $9.15. Options held by non-employee
directors were excluded from the vesting acceleration. In addition, in order to prevent executive officers from unintended personal benefits, the Companys executive officers have agreed to the imposition of restrictions on any shares received
through the exercise of accelerated options. Those restrictions will prevent the sale of any shares received from the exercise of an accelerated option until the earlier of the original vesting date of the option or the executive officers
termination of employment. The $9.15 price was selected because it was higher than the closing price of the Companys common stock of $8.84 on August 29, 2005, the date of this acceleration. The accelerated options represented
approximately 15 percent or approximately 2.8 million shares of the total of all the Companys outstanding options on August 29, 2005. The acceleration was intended to reduce the stock option expense the Company would be required to
record after the adoption of SFAS 123(R). This acceleration reduced approximately $10.0 million of stock option expenses under SFAS 123(R) which would have been recognized as an expense through December 2008.

Stock Option Plans

The stock option plans program is
a broad-based, long-term retention program that is intended to attract and retain qualified management and employees, and align stockholder and employee interest. The stock option plans program consists of two plans: one under which non-employee
directors may be granted options to purchase shares of the Companys stock, and another in which non-employee directors, employees and consultants may be granted options to purchase shares of the Companys stock, restricted stock,
restricted stock units and other types of equity awards. Under this program, stock options generally have a vesting period of four years, are exercisable for a period not to exceed ten years from the date of issuance and are generally granted at
prices not less than the fair market value of the Companys common stock at the grant date. Restricted stock or restricted stock units may be granted with varying criteria such as time based or performance based vesting. In addition, the
Companys Board of Directors has the discretion to use a different vesting schedule and has done so from time to time.

In fiscal
2005, the Companys Board of Directors and stockholders approved the 2005 Stock Incentive Plan (the 2005 Plan), which provides for the grant of options to purchase shares of the Companys common stock, stock appreciation rights
and restricted stock to employees, members of the Board of Directors and consultants. The maximum number of shares available for grant under the 2005 Plan was 4.3 million shares as of July 31, 2006.

During fiscal 2005, the 1993 Stock Option Plan (the 1993 Plan), under which the Company previously granted options to employees and members
of the Board of Directors, expired. However, outstanding options granted under the 1993 Plan remain exercisable in accordance with the terms of the original grant agreements.

The following is a summary of activity under stock option plans for the nine months ended July 31, 2006:



|                                            |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|------------------------------------------- |  | ------------------------------------------ | - |  | -------------------------------------------- | - |  | ----------------------------------------- | ----- | ---------------------------------------- | - | ------------------------------------------------------ |  | ----
|                                            |  | Options Available for Grant (In thousands) |   |  | Number of Options Outstanding (In thousands) |   |  | Weighted Average Exercise Price per share |       | Aggregate Intrinsic Value (In
thousands) |   | Weighted Average Remaining Contractual Life (In
years)
|Balance at October 31, 2005                 |  | 6,091                                      |   |  | 18,158                                       |   |  | $                                         | 12.87 |                                          |   |                                                        |  |     
|Options granted                             |  | (2,118                                     | ) |  | 2,067                                        |   |  |                                           | 7.49  |                                          |   |                                                        |  |     
|Options canceled/forfeited/expired          |  | 345                                        |   |  | (1,937                                       | ) |  |                                           | 11.99 |                                          |   |                                                        |  |     
|Options exercised                           |  |                                           |   |  | (307                                         | ) |  |                                           | 6.63  |                                          |   |                                                        |  |     
|                                            |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Balance at July 31, 2006                    |  | 4,318                                      |   |  | 17,981                                       |   |  | $                                         | 12.48 |                                          | $ | 11,998                                                 |  | 5.66
|                                            |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Vested or expected to vest at July 31, 2006 |  |                                            |   |  | 14,646                                       |   |  | $                                         | 13.56 |                                          | $ | 7,579                                                  |  | 5.51
|                                            |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Exercisable at July 31, 2006                |  |                                            |   |  | 14,646                                       |   |  | $                                         | 13.56 |                                          | $ | 7,579                                                  |  | 5.51
|                                            |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     



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Restricted stock units are granted from the pool of options available for grant. The Companys plan
requires that for every share of restricted stock unit issued, the Company will use 1.4 stock options.

The weighted-average grant date
fair value per options granted during the three and nine months ended July 31, 2006 was $2.01 and $3.50, respectively. The weighted-average grant date fair value per options granted during the three and nine months ended July 31, 2005 was
$4.73 and $5.58, respectively. The total intrinsic value of options exercised during the three and nine months ended July 31, 2006 was approximately $5,200 and $0.5 million, respectively. The total intrinsic value of options exercised during
the three and nine months ended July 31, 2005 was $0.5 million and $0.8 million, respectively. Cash proceeds from the exercise of stock options were $39,000 and $2.0 million for the three and nine months ended July 31, 2006, respectively.
Cash proceeds from the exercise of stock options were $2.0 million and $3.2 million for the three and nine months ended July 31, 2005, respectively. No income tax benefit was realized from the stock option exercises during the three and
nine-month period ended July 31, 2006 and 2005. Stock-based compensation expense related to stock options recognized under SFAS 123(R) for the three and nine months ended July 31, 2006 was $1.3 million and $3.2 million, respectively. The
Company generally settles employee stock option exercises with newly issued common shares. At July 31, 2006, there was $10.0 million of unrecognized stock-based compensation expense related to non-vested options and is expected to be recognized
over a weighted-average period of 3.0 years.

The fair value of option grants was estimated by using the Black-Scholes-Merton model with
the following weighted-average assumptions for the three and nine months ended July 31, 2006 and 2005, respectively:



|                         |  |                            |   |  |                           |   |  |      |   |  |      |  
|------------------------ |  | -------------------------- | - |  | ------------------------- | - |  | ---- | - |  | ---- | -
|                         |  | Three Months EndedJuly 31, |   |  | Nine Months EndedJuly 31, |  
|                         |  | 2006                       |   |  | 2005                      |   |  | 2006 |   |  | 2005 |  
|Expected volatility      |  | 54                         | % |  | 62                        | % |  | 54   | % |  | 74   | %
|Dividend yield           |  |                           |   |  |                          |   |  |     |   |  |     |  
|Risk-free interest rate  |  | 5.0                        | % |  | 3.8                       | % |  | 4.8  | % |  | 3.5  | %
|Expected term (in years) |  | 4.0                        |   |  | 5.5                       |   |  | 4.0  |   |  | 5.1  |  

Expected Volatility: The Companys computation of expected volatility for the three
and nine month periods ended July 31, 2006 is based on a combination of implied volatilities from traded options on the Companys stock and historical volatility. Prior to the three and nine months ended July 31, 2006, the Company had
used its historical stock price volatility in accordance with SFAS 123 for purposes of its pro forma information. The selection of a combination of the implied and historical volatility approach was based upon the availability of actively traded
options on the Companys stock and the Companys assessment that this combination is more representative of future stock price trends than historical volatility alone.

Dividend Yield: The dividend yield assumption is based on the Companys history and expectation of dividend payouts.

Risk-Free Interest Rate:The risk-free interest rate is based on the United States Treasury yield curve in effect at the time of grant for the
expected term of the option.

Expected Term:The Companys expected term represents the period that the Companys
stock-based awards are expected to be outstanding and was determined for the three and nine month periods ended July 31, 2006 based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based
awards, vesting schedules and expectations of future employee behavior.

Forfeitures Rate: Compensation expense recognized in the
unaudited condensed consolidated statement of operations for the three and nine months ended July 31, 2006 are based on awards ultimately expected to vest and it reflects estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated
at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to adoption of SFAS 123(R), the Company accounted for forfeitures as they occurred.



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Employee Stock Purchase Plan (ESPP)

In 1994, the Company adopted the 1994 Employee Stock Purchase Plan (the 1994 Plan), which provides direct employees, employed with the Company for at least thirty consecutive days as of the entry date into
any offering period, with the opportunity to acquire shares of the Companys common stock. Employees may contribute up to 10% of their base salary to the plan. The Company has a one-year rolling plan with two six-month purchases within the
offering period. The purchase price is 85% of the fair market value per share of common stock at the beginning of the offering period or the end of the purchase period, whichever is lower. If the fair market value per share is lower on the purchase
date than the beginning of the offering period, the current offering period will terminate and a new one-year offering period will commence. The plan restricts the maximum number of shares that an employee can purchase to 1,500 shares each
semi-annual period and to $25,000 worth of common stock each year. At July 31, 2006, there were 899,000 shares reserved for issuance under the 1994 Plan.

The fair value of issuances under the 1994 Plan is estimated on the issuance date by applying the principles of FASB Technical Bulletin 97-1 (FTB 97-1), Accounting under Statement 123 for Certain Employee Stock
Purchase Plan with a Look Back Option and using the Black-Scholes-Merton options pricing model. During the nine months ended July 31, 2006 and 2005, the Company issued 263,044 shares and 347,033 shares, respectively, under the 1994 Plan.
Total cash received for the issuance of shares under the employee stock purchase plan was approximately $1.9 million and $2.1 million during the nine months ended July 31, 2006 and 2005, respectively. Stock-based compensation expense related to
the 1994 Plan recognized under SFAS 123(R) in the three and nine months ended July 31, 2006 was $0.5 million and $1.2 million, respectively. At July 31, 2006, there was $1.0 million of unrecognized stock-based compensation expense related
to outstanding ESPP shares and is expected to be recognized over a six-month period.

The fair value of awards granted under the 1994 Plan
stock-based compensation was estimated by using the Black-Scholes-Merton model with the following weighted-average assumptions for the three and nine months ended July 31, 2006 and 2005, respectively:



|                         |  |                             |   |  |                            |   |  |      |   |  |      |  
|------------------------ |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                         |  | Three Months Ended July 31, |   |  | Nine Months Ended July 31, |  
|                         |  | 2006                        |   |  | 2005                       |   |  | 2006 |   |  | 2005 |  
|Expected volatility      |  | 50                          | % |  | 62                         | % |  | 50   | % |  | 57   | %
|Dividend yield           |  |                            |   |  |                           |   |  |     |   |  |     |  
|Risk-free interest rate  |  | 4.7                         | % |  | 3.5                        | % |  | 4.4  | % |  | 2.6  | %
|Expected term (in years) |  | 0.5                         |   |  | 0.5                        |   |  | 0.5  |   |  | 0.5  |  

8. Inventories

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



|                |  |               |        |                  |   |       
|--------------- |  | ------------- | ------ | ---------------- | - | ------
|                |  | July 31, 2006 |        | October 31, 2005
|Raw materials   |  | $             | 24,251 |                  | $ | 43,790
|Work-in-process |  |               | 17,649 |                  |   | 21,121
|Finished goods  |  |               | 15,066 |                  |   | 14,143
|                |  |               |        |                  |   |       
|                |  | $             | 56,966 |                  | $ | 79,054
|                |  |               |        |                  |   |       

9. Balance Sheet Components

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



|                                                  |  |               |        |                  |   |       
|------------------------------------------------- |  | ------------- | ------ | ---------------- | - | ------
|                                                  |  | July 31, 2006 |        | October 31, 2005
|Short-term lease receivables                      |  | $             | 152    |                  | $ | 1,227 
|Receivables from contract equipment manufacturers |  |               | 2,038  |                  |   | 4,383 
|Other prepaid expenses                            |  |               | 11,316 |                  |   | 12,896
|                                                  |  |               |        |                  |   |       
|Total                                             |  | $             | 13,506 |                  | $ | 18,506
|                                                  |  |               |        |                  |   |       



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Property and equipment, net (in thousands):



|                              |  |               |          |   |                  |   |          |  
|----------------------------- |  | ------------- | -------- | - | ---------------- | - | -------- | -
|                              |  | July 31, 2006 |          |   | October 31, 2005 |  
|Land                          |  | $             | 24,384   |   |                  | $ | 26,835   |  
|Buildings                     |  |               | 35,899   |   |                  |   | 35,746   |  
|Machinery and equipment       |  |               | 106,448  |   |                  |   | 104,626  |  
|Software                      |  |               | 33,717   |   |                  |   | 30,705   |  
|Leasehold improvements        |  |               | 40,607   |   |                  |   | 39,106   |  
|Furniture and fixtures        |  |               | 10,644   |   |                  |   | 10,456   |  
|                              |  |               |          |   |                  |   |          |  
|                              |  |               | 251,699  |   |                  |   | 247,474  |  
|Less accumulated depreciation |  |               | (161,651 | ) |                  |   | (150,783 | )
|                              |  |               |          |   |                  |   |          |  
|Total                         |  | $             | 90,048   |   |                  | $ | 96,691   |  
|                              |  |               |          |   |                  |   |          |  
|                              |  |               |          |   |                  |   |          |  

Other assets consist of the following (in thousands):



|                            |  |               |        |                  |   |       
|--------------------------- |  | ------------- | ------ | ---------------- | - | ------
|                            |  | July 31, 2006 |        | October 31, 2005
|Long-term lease receivables |  | $             | 631    |                  | $ | 3,489 
|Equipment on lease          |  |               | 239    |                  |   | 415   
|Field service spares        |  |               | 33,902 |                  |   | 30,001
|Product consignment         |  |               | 12,140 |                  |   | 16,439
|Other assets                |  |               | 5,408  |                  |   | 7,680 
|                            |  |               |        |                  |   |       
|Total                       |  | $             | 52,320 |                  | $ | 58,024
|                            |  |               |        |                  |   |       

Field service spares used in the Companys service business are classified as long-term
assets and are amortized using the straight-line method over five years. The amortization expense of spares is charged to service and spare parts cost of goods sold. Amortization expense was approximately $2.8 million and $2.4 million for the third
quarter of fiscal 2006 and 2005, respectively. Amortization expense was approximately $8.3 million and $6.4 million for the nine months ended July 31, 2006 and 2005, respectively.

Product consignments used in the Companys marketing efforts are classified as long-term assets and are depreciated during the period that they are
held on consignment over periods ranging from 18 to 36 months. The depreciation expense for product consignments is charged to selling, general and administrative expense. Depreciation expense was approximately $2.1 million and $3.2 million for the
third quarter of fiscal 2006 and 2005, respectively. Depreciation expense was approximately $6.4 million and $9.6 million for the nine months ended July 31, 2006 and 2005, respectively.

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



|                                |  |               |        |                  |   |       
|------------------------------- |  | ------------- | ------ | ---------------- | - | ------
|                                |  | July 31, 2006 |        | October 31, 2005
|Accrued distributor commissions |  | $             | 1,990  |                  | $ | 2,010 
|Accrued bonuses                 |  |               | 3,954  |                  |   | 5,073 
|Accrued restructuring expenses  |  |               | 5,617  |                  |   | 10,178
|Accrued sales taxes             |  |               | 412    |                  |   | 165   
|Accrued value added taxes       |  |               | 2,583  |                  |   | 2,062 
|Accrued interest expense        |  |               | 563    |                  |   | 1,238 
|Other accrued liabilities       |  |               | 20,080 |                  |   | 19,030
|                                |  |               |        |                  |   |       
|Total                           |  | $             | 35,199 |                  | $ | 39,756
|                                |  |               |        |                  |   |       

10. Acquisitions

Hypervision, Inc.:

In May 2006, the Company acquired Hypervision, Inc. (Hypervision). Hypervision designed,
developed and manufactured system solutions, which involved emission emiscope and laser signal injection technology. The Company believes that the acquisition of Hypervision enables the Company to provide customers with various emission microscopy



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products, supplementing the Companys current diagnostic and characterization products. Under the term of the
agreement, the Company will pay Hypervision $4.7 million in cash, of which $3.2 million was paid at closing. In addition, the Company assumed approximately $1.8 million of liabilities, offset by $1.0 million in assets assumed. The Company has
retained the remaining amount of $1.5 million for possible breach of general representations and warranties and payment of $1.0 million of the retained amount is due approximately one year after the closing date, and the remaining $0.5 million
approximately two years after the closing date in the event no such breach of general representations or warranties exists. Of the $4.7 million paid, approximately $0.5 million was accounted for as goodwill. The goodwill was subsequently written off
as part of the goodwill impairment analysis performed by the Company at July 31, 2006. See Note 11, Goodwill and Other Intangible Assets, for further discussion.

The acquisition was accounted for as a purchase transaction in accordance with Statement of Financial Accounting Standard No. 141, Business Combination, (SFAS 141), and accordingly, the tangible
assets acquired and liabilities assumed were recorded at their estimated fair value at the date of the acquisition. The results of operations of Hypervision have been included in the Companys financial statements subsequent to the date of
acquisition. Pro forma results of operations have not been presented because the effect of the acquisition was not material.

The
preliminary purchase price was allocated as follows (in thousands):



|                                            |  |   |       |  
|------------------------------------------- |  | - | ----- | -
|Goodwill                                    |  | $ | 479   |  
|Developed technology                        |  |   | 3,700 |  
|Customer relationship                       |  |   | 1,400 |  
|Liabilities assumed, net of assets acquired |  |   | (813  | )
|                                            |  |   |       |  
|Total purchase price                        |  | $ | 4,766 |  
|                                            |  |   |       |  

The developed technology will be amortized on a straight-line basis over a three-year period. The
customer relationship will be amortized on a straight-line basis over an eight-year period.

NPTest Holding Corporation:

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



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



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The purchase price of NPTest was negotiated during a period in which market valuations of semiconductor
capital equipment companies, and semiconductor test equipment companies in particular, had increased significantly due to favorable net sales and operating results. For example, the market value of the Companys stock had increased from a
low of $6.44 per share in March 2003 to a value of $15.00 per share on January 15, 2004, the date the Company negotiated transaction terms with representatives of NPTest. Market valuations of the Companys competitors similarly had
risen significantly during this period. In addition, NPTest was the subject of an acquisition proposal by a Company competitor during the acquisition negotiations which contributed to the purchase price negotiated by the
parties. Furthermore, the Company received from its financial advisor, an opinion as to the fairness, from a financial point of view, of the consideration to be paid by the Company to the holders of NPTest common stock in the merger. Such
advisor informed the Company that, as of such date, and based upon and subject to the assumptions, limitations and qualifications set forth in its written opinion, the consideration to be paid by the Company to the holders of NPTest common stock in
the merger was fair.

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

In accordance with Statement of Financial Accounting Standard
No. 141, Business Combination, (SFAS 141), the purchase was accounted for as a purchase transaction. The Company allocated the purchase price to the tangible and intangible assets acquired, including in-process research and
development, and liabilities assumed based on their estimated fair values, and to deferred stock compensation. The excess purchase price over those fair values was recorded as goodwill. The fair value assigned to tangible and intangible assets
acquired and liabilities assumed were based on estimates and assumptions provided by management, and other information compiled by management, including valuations that utilize established valuation techniques appropriate for the high technology
industry. Goodwill recorded as a result of these acquisitions is not expected to be deductible for tax purposes. In accordance with Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, (SFAS
142), goodwill and purchased intangible assets with indefinite lives are not amortized but reviewed at least annually for impairment. Purchased intangible assets with finite lives will be amortized on a straight-line basis over their respective
estimated useful lives. The total purchase price has been allocated as follows (in thousands, except years):



|                                                |  |        |         |   |                    |   |                      |  |     
|----------------------------------------------- |  | ------ | ------- | - | ------------------ | - | -------------------- |  | ----
|                                                |  | Amount |         |   | AnnualAmortization |   | Useful Lives (Years)
|Purchase Price Allocation:                      |  |        |         |   |                    |   |                      |  |     
|Net tangible assets assumed                     |  | $      | 175,552 |   |                    | $ |                     |  |    
|Intangible assets acquired:                     |  |        |         |   |                    |   |                      |  |     
|Developed technology                            |  |        | 70,300  |   |                    |   | 7,030                |  | 10  
|Maintenance agreements                          |  |        | 13,800  |   |                    |   | 2,760                |  | 5   
|Customer relationships                          |  |        | 12,100  |   |                    |   | 1,729                |  | 7   
|Product backlog                                 |  |        | 4,900   |   |                    |   | 4,900                |  | 1   
|                                                |  |        |         |   |                    |   |                      |  |     
|Total amortizable intangible assets             |  |        | 101,100 |   |                    |   | 16,419               |  |    
|In-process research and development             |  |        | 7,900   |   |                    |   |                     |  |    
|Deferred compensation on unvested stock options |  |        | 9,967   |   |                    |   | 3,067                |  | 3.25
|Deferred tax                                    |  |        | (29,362 | ) |                    |   |                     |  |    
|Goodwill                                        |  |        | 385,325 |   |                    |   |                     |  |    
|                                                |  |        |         |   |                    |   |                      |  |     
|Total purchase price                            |  | $      | 650,482 |   |                    | $ | 19,486               |  |     
|                                                |  |        |         |   |                    |   |                      |  |     

The purchase price allocation changed by $0.7 million during the three and nine months ended July
31, 2006 due to the write down of other accrued expenses and liabilities related to relocation charges, estimated sublease proceeds from the Simi Valley facility and early termination of a lease. These amounts were credited to goodwill in accordance
with EITF Issue No. 95-3, Recognition of Liabilities in Connection with Purchase Business Combinations (EITF Issue 95-3).

In November 2004, the Board of Directors approved moving forward with a major component of managements original integration plan, which involved closing the Simi Valley, California facility and moving all manufacturing activities



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at this site to Hillsboro, Oregon. The Company recognized these costs in accordance with EITF 95-3. The related facility
lease charges will be paid through the end of the lease terms, which extend through June 2008, of which the majority of the payment related to the Simi Valley facility, which ends in January 2007. As of July 31, 2006, $0.4 million remained to
be paid for these charges.



|                                    |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   |      |  
|----------------------------------- |  | --------------------------- | ------ | - | ------- | - | -------- |  | ----------- | ----- | ------------------------ | - | --- |  | - | ---- | -
|                                    |  | Balance at October 31, 2004 |        |   | Charges |   | Utilized |  | Adjustments |       | Balance at July 31, 2005 |  
|Severance                           |  | $                           | (231   | ) |         | $ |         |  | $           | 154   |                          | $ | 41  |  | $ | (35  | )
|Facilities                          |  |                             | (2,348 | ) |         |   |         |  |             | 1,404 |                          |   | 574 |  |   | (371 | )
|Relocation                          |  |                             | (182   | ) |         |   |         |  |             | 26    |                          |   | 112 |  |   | (44  | )
|                                    |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   |      |  
|Total                               |  | $                           | (2,761 | ) |         | $ |         |  | $           | 1,584 |                          | $ | 727 |  | $ | (450 | )
|                                    |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   |      |  
|Estimated timing of future payouts: |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   |      |  
|Remainder of fiscal 2006            |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  | $ | 221  |  
|Fiscal 2007                         |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   | 178  |  
|Fiscal 2008                         |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   | 51   |  
|                                    |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   |      |  
|Total                               |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  | $ | 450  |  
|                                    |  |                             |        |   |         |   |          |  |             |       |                          |   |     |  |   |      |  

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

11. Goodwill and Other Intangible Assets

Goodwill Impairment

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

SFAS 142 makes use of the concept of reporting units. All acquisitions must be assigned to a reporting unit or units. Reporting units have been defined under the standards to be the same as or one level below an
operating segment, as defined in Statement of Financial Accounting Standard No. 131, Disclosures About Segments of an Enterprise and Related Information, (SFAS 131). A reporting unit would be one level below the operating segment if
a component of an operating segment is a business as described under United States Generally Accepted Accounting Principles and (1) is a separable unit that engages in business activities for which discrete financial information is available,
(2) has economic characteristics different from other components of the operating segment, and (3) operating results of the component are reviewed regularly by the segment manager. The Company operates in one industry segment, advanced
semiconductor test and diagnostic systems. The Company also has a single reporting unit for purposes of SFAS 142, automated test equipment (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.



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

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
Company. The assumptions supporting the estimated future cash flows of the reporting unit, including profit margins, long-term forecasts of the amounts and timing of overall market growth and the Companys percentage of that market, discount
rates and terminal growth rates, reflect the Companys best estimates.

As mandated by SFAS 142, the Company completed its annual
goodwill impairment test as of July 31, 2005 during the fourth quarter of the 2005 fiscal year. The Company determined that, based on market capitalization and on the test which indicated that the sum of the expected future discounted cash
flows from the assets exceeded the carrying value of those assets, the goodwill was not impaired.

Based on a combination of factors
identified during the third quarter of fiscal 2006, particularly: (1) the Companys changed current and projected operating results reflecting lower demand from major customers; and (2) the Companys current market capitalization
which was significantly less than its book value for the preceding 10 weeks, the Company concluded there were sufficient indicators to require it to assess whether any portion of its recorded goodwill balance was impaired. The Company determined,
based on its estimates of forecasted discounted cash flows and its market capitalization, that its goodwill was impaired at July 31, 2006. Further analysis indicated that goodwill impairment charges of $423.9 million were necessary in the third
quarter of fiscal 2006. Other long-lived assets were assessed for impairment prior to the performance of the SFAS 142 analysis and were determined not to be impaired.

The Company has performed the first step of the interim SFAS 142 analysis, consisting of a comparison of the fair value of the reporting unit with its carrying amount, including the goodwill. The fair value of the
reporting units was determined based on a combination of the Income Approach, which estimates the fair value based on the future discounted cash flows, and Market Approach, which estimates the fair value based on market prices of comparable
companies. Under the Income Approach, the Company assumed a forecasted cash flow period of 5 years, long-term annual growth rates of 0% to 12%, a discount rate of 20% and terminal value growth rates of 5%. The Company also considered its total
market capitalization as of July 31, 2006, and its average market capitalization for the quarter in order to assess volatility of its market capitalization on that day. Based on the first step analysis, the Company determined that the carrying
amount of the reporting unit was in excess of its fair value. As such, the Company was required to perform the second step analysis on the reporting unit that has failed the first step test to determine the amount of the impairment loss. The second
step analysis consisted of comparing the implied fair value of the goodwill with the carrying amount of the goodwill, with an impairment charge resulting from any excess of the carrying value of the goodwill over the implied fair value of the
goodwill based on a hypothetical allocation of the estimated fair value of the Company to the Companys tangible and intangible assets (other than goodwill). Based on the second step analysis, the Company concluded that all of its recorded
goodwill ($423.9 million) was impaired and as such recorded a noncash charge to continuing operations during the third quarter of fiscal 2006.

Other Acquisition-Related Intangible Assets Impairment

Prior to assessing goodwill for impairment, the Company evaluates
the carrying value of its long-lived assets, consisting primarily of its facilities, purchased intangible assets, and property and equipment, in accordance with SFAS 144, Accounting for the Impairment or Disposal for Long-Lived Assets,
whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Such events or circumstances include, but are not limited to, a prolonged industry downturn, a significant decline in the
Companys market value, or significant reductions in projected future cash flows. In assessing the recoverability of the Companys long-lived assets, the Company compares the carrying value to the undiscounted future cash flows the assets
are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, such assets are written down based on the excess of the carrying amount over the fair value of the assets. Fair value is
generally determined by calculating the discounted future cash flows using a discount rate based upon the Companys weighted average cost of capital. Significant judgments and assumptions are required in the forecast of future operating results
used in the preparation of the estimated future cash flows, including profit margins, long-term forecasts of the amounts and timing of overall market growth and the Companys percentage of that market, groupings of assets, discount rates and
terminal growth rates. In addition, significant estimates and assumptions are required in the determination of the fair value of the Companys tangible long-lived assets, including replacement cost, economic obsolescence, and the value that
could be realized in liquidation. Changes in these estimates could have a material adverse effect on the assessment of the Companys long-lived assets, thereby requiring the Company to write down the assets. The purchased intangibles consist of
purchased technology, customer relations, trademarks, patents and non-compete agreements and they typically have estimated useful lives of one to ten years.



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Based on the considerations outlined in the previous discussion on goodwill, in July 2006, the Company
also concluded that sufficient indicators existed to require it to perform an analysis to assess whether a portion of its other acquisition-related intangible assets was impaired. This analysis differs from the goodwill analysis in that an
impairment is only deemed to have occurred if the sum of the forecasted undiscounted future cash flows related to the asset are less than the carrying value of the intangible asset being tested for impairment. Since the forecasted cash flows
exceeded the carrying value, the Company concluded that there was no impairment to its long-lived assets at July 31, 2006.

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



|                       |  |      |         |                          |   |         |     |  |   |       
|---------------------- |  | ---- | ------- | ------------------------ | - | ------- | --- |  | - | ------
|July 31, 2006          |  | Cost |         | Accumulated Amortization |   |         | Net
|Developed technology   |  | $    | 128,906 |                          | $ | (57,608 | )   |  | $ | 71,298
|Customer relations     |  |      | 21,202  |                          |   | (11,489 | )   |  |   | 9,713 
|Maintenance contracts  |  |      | 13,800  |                          |   | (5,980  | )   |  |   | 7,820 
|Product backlog        |  |      | 4,900   |                          |   | (4,900  | )   |  |   |      
|Trademarks             |  |      | 2,053   |                          |   | (2,053  | )   |  |   |      
|Patents                |  |      | 862     |                          |   | (862    | )   |  |   |      
|Non-compete agreements |  |      | 750     |                          |   | (750    | )   |  |   |      
|                       |  |      |         |                          |   |         |     |  |   |       
|Total                  |  | $    | 172,473 |                          | $ | (83,642 | )   |  | $ | 88,831
|                       |  |      |         |                          |   |         |     |  |   |       



|                       |  |      |         |                          |   |         |     |  |   |       
|---------------------- |  | ---- | ------- | ------------------------ | - | ------- | --- |  | - | ------
|October 31, 2005       |  | Cost |         | Accumulated Amortization |   |         | Net
|Developed technology   |  | $    | 125,206 |                          | $ | (48,446 | )   |  | $ | 76,760
|Customer relations     |  |      | 19,802  |                          |   | (10,013 | )   |  |   | 9,789 
|Maintenance contracts  |  |      | 13,800  |                          |   | (3,910  | )   |  |   | 9,890 
|Product backlog        |  |      | 4,900   |                          |   | (4,900  | )   |  |   |      
|Trademarks             |  |      | 2,053   |                          |   | (2,053  | )   |  |   |      
|Patents                |  |      | 862     |                          |   | (862    | )   |  |   |      
|Non-compete agreements |  |      | 750     |                          |   | (750    | )   |  |   |      
|                       |  |      |         |                          |   |         |     |  |   |       
|Total                  |  | $    | 167,373 |                          | $ | (70,934 | )   |  | $ | 96,439
|                       |  |      |         |                          |   |         |     |  |   |       

Amortization expenses for the other intangible assets were $4.3 million and $4.7 million for the
third quarter of fiscal 2006 and 2005, respectively. Amortization expenses for the other intangible assets were $12.7 million and $16.2 million for the nine months ended July 31, 2006 and 2005, respectively.

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



|                           |  |                             |       |                            |   |       |  |      |        |  |   |       
|-------------------------- |  | --------------------------- | ----- | -------------------------- | - | ----- |  | ---- | ------ |  | - | ------
|                           |  | Three Months Ended July 31, |       | Nine Months Ended July 31,
|                           |  | 2006                        |       | 2005                       |   | 2006  |  | 2005
|Developed technology       |  | $                           | 3,174 |                            | $ | 2,995 |  | $    | 9,162  |  | $ | 9,123 
|Customer relations         |  |                             | 474   |                            |   | 570   |  |      | 1,476  |  |   | 1,709 
|Maintenance contracts      |  |                             | 690   |                            |   | 690   |  |      | 2,070  |  |   | 2,070 
|Product backlog            |  |                             |      |                            |   | 408   |  |      |       |  |   | 2,859 
|Trademarks                 |  |                             |      |                            |   |      |  |      |       |  |   | 205   
|Patents                    |  |                             |      |                            |   | 43    |  |      |       |  |   | 129   
|Non-compete agreements     |  |                             |      |                            |   |      |  |      |       |  |   | 94    
|                           |  |                             |       |                            |   |       |  |      |        |  |   |       
|Total amortization expense |  | $                           | 4,338 |                            | $ | 4,706 |  | $    | 12,708 |  | $ | 16,189
|                           |  |                             |       |                            |   |       |  |      |        |  |   |       

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



|                         |  |        |       
|------------------------ |  | ------ | ------
|Year Ending October 31,  |  | Amount
|Remainder of fiscal 2006 |  | $      | 4,518 
|2007                     |  |        | 17,875
|2008                     |  |        | 15,926
|2009                     |  |        | 13,584
|2010                     |  |        | 10,109
|Thereafter               |  |        | 26,819
|                         |  |        |       
|Total                    |  | $      | 88,831
|                         |  |        |       



18



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12. Net Loss Per Share

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



|                                                              |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|------------------------------------------------------------- |  | --------------------------- | -------- | - | -------------------------- | - | ------- | ---- |  | - | -------- | - |  | - | ------- | -
|                                                              |  | Three Months Ended July 31, |          |   | Nine Months Ended July 31, |  
|                                                              |  | 2006                        |          |   | 2005                       |   |         | 2006 |  |   | 2005     |  
|Numerator:                                                    |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Numerator for basic and diluted net loss per share  net loss |  | $                           | (461,366 | ) |                            | $ | (41,677 | )    |  | $ | (479,643 | ) |  | $ | (97,452 | )
|                                                              |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Denominator:                                                  |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Denominator for basic and diluted net loss per share          |  |                             | 100,017  |   |                            |   | 96,638  |      |  |   | 99,798   |   |  |   | 92,010  |  
|                                                              |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Basic net loss per share                                      |  | $                           | (4.61    | ) |                            | $ | (0.43   | )    |  | $ | (4.81    | ) |  | $ | (1.06   | )
|                                                              |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Diluted net loss per share                                    |  | $                           | (4.61    | ) |                            | $ | (0.43   | )    |  | $ | (4.81    | ) |  | $ | (1.06   | )
|                                                              |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  

At July 31, 2006 and 2005, there were options to purchase 17,991,486 and 18,712,261 shares of
common stock outstanding at a weighted average exercise price of $13.56 and $12.90, respectively, which were excluded from the diluted net loss per share calculation for the three and nine months ended July 31, 2006 and 2005 as their effect
would be anti-dilutive in each respective period. There were also 15,915,119 shares issuable under the terms of the convertible subordinated notes issued in June 2003 that were excluded from the diluted net loss per share calculation for the three
and nine months ended July 31, 2006 and 2005 as their effect would be anti-dilutive. The Company further excluded 1,953,802 and 6,090,141 shares of the converted preferred stock from the diluted net loss per share calculation for the three and
nine months ended July 31, 2005 as their effect would be anti-dilutive.

13. Contingencies and Guarantees

The Company leases some of its facilities and equipment under operating leases that expire periodically through 2010.

Some of the components that the Company purchases are unique to the Company and must be purchased in relatively high minimum quantities with long (in
excess of three months) lead times. These business circumstances can lead to the Company holding relatively high inventory levels and associated risks. In addition, purchase commitments for unique components are relatively inflexible in terms of
deferral or cancellation. At July 31, 2006, the Company had open and committed purchase orders totaling approximately $57.8 million.

The following summarizes the Companys minimum contractual cash obligations and other commitments at July 31, 2006, and the effect of such obligations in future periods (in thousands):



|                                                          |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      
|--------------------------------------------------------- |  | ----- | ------- | ------------------------ | - | ----------- |  | ----------- | ------ | ----------- | - | ----------- |  | ---------- | ----- |  | - | --- |  | - | -----
|                                                          |  | Total |         | Remainder of Fiscal 2006 |   | Fiscal 2007 |  | Fiscal 2008 |        | Fiscal 2009 |   | Fiscal 2010 |  | Thereafter
|Contractual Obligations:                                  |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      
|Facilities and equipment operating leases(1)              |  | $     | 8,952   |                          | $ | 997         |  | $           | 3,114  |             | $ | 1,713       |  | $          | 1,269 |  | $ | 631 |  | $ | 1,228
|Convertible subordinated notes(2)                         |  |       | 180,000 |                          |   |            |  |             |       |             |   | 180,000     |  |            |      |  |   |    |  |   |     
|Interest on convertible subordinated notes                |  |       | 4,838   |                          |   | 675         |  |             | 2,700  |             |   | 1,463       |  |            |      |  |   |    |  |   |     
|Minimum commitment under Technology Development Agreement |  |       | 940     |                          |   | 940         |  |             |       |             |   |            |  |            |      |  |   |    |  |   |     
|Open and non-cancelable purchase order commitments        |  |       | 57,791  |                          |   | 41,602      |  |             | 16,189 |             |   |            |  |            |      |  |   |    |  |   |     
|                                                          |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      
|Total contractual cash obligations                        |  |       | 252,521 |                          |   | 44,214      |  |             | 22,003 |             |   | 183,176     |  |            | 1,269 |  |   | 631 |  |   | 1,228
|                                                          |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      

---

|(1) | Approximately $0.4 million of this total has been accrued for as restructuring charges in the
condensed consolidated balance sheets as accrued expenses and other liabilities.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | This amount is recorded in the condensed consolidated balance sheets as convertible
subordinated notes.
|--- | -------------------------------------------------------------------------------------------------------



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

The
following table represents the activity in the warranty accrual for the nine months ended July 31, 2006 and 2005 (in thousands):



|                                                 |  |                   |         |   |               |   |         |  
|------------------------------------------------ |  | ----------------- | ------- | - | ------------- | - | ------- | -
|                                                 |  | Nine Months Ended |        
|                                                 |  | July 31,2006      |         |   | July 31, 2005 |  
|Beginning balance, November 1, 2005 and 2004     |  | $                 | 13,419  |   |               | $ | 15,314  |  
|Accruals for warranties issued during the period |  |                   | 13,291  |   |               |   | 11,753  |  
|Adjustments of prior period accrual estimates    |  |                   | (150    | ) |               |   |        |  
|Warranty claims made during the period           |  |                   | (13,388 | ) |               |   | (14,785 | )
|                                                 |  |                   |         |   |               |   |         |  
|Ending balance                                   |  | $                 | 13,172  |   |               | $ | 12,282  |  
|                                                 |  |                   |         |   |               |   |         |  

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

Legal Proceedings

In March 2005, Roy Schmidt, a
former employee, filed a complaint in the Superior Court of Santa Clara County, California against the Company, alleging fraud and various other contractual and tort claims in connection with the termination of his employment by the Company. The
Company and Mr. Schmidt settled this dispute in early May 2006.

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

14. Comprehensive Income (Loss)

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



|                                                           |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|---------------------------------------------------------- |  | --------------------------- | -------- | - | -------------------------- | - | ------- | ---- |  | - | -------- | - |  | - | ------- | -
|                                                           |  | Three Months Ended July 31, |          |   | Nine Months Ended July 31, |  
|                                                           |  | 2006                        |          |   | 2005                       |   |         | 2006 |  |   | 2005     |  
|Net loss                                                   |  | $                           | (461,366 | ) |                            | $ | (41,677 | )    |  | $ | (479,643 | ) |  | $ | (97,452 | )
|                                                           |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Unrealized (losses) gains on available-for sale securities |  |                             | (6       | ) |                            |   | 35      |      |  |   | (230     | ) |  |   | (295    | )
|Currency translation adjustment                            |  |                             | 763      |   |                            |   | (2,517  | )    |  |   | 2,073    |   |  |   | (2,035  | )
|                                                           |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Other comprehensive income (loss)                          |  |                             | 757      |   |                            |   | (2,482  | )    |  |   | 1,843    |   |  |   | (2,330  | )
|                                                           |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  
|Total comprehensive loss                                   |  | $                           | (460,609 | ) |                            | $ | (44,159 | )    |  | $ | (477,800 | ) |  | $ | (99,782 | )
|                                                           |  |                             |          |   |                            |   |         |      |  |   |          |   |  |   |         |  



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##### Table of Contents

15. Inventory and Restructuring Charges

Inventory Write-Downs  cost of goods sold

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

During the three and nine months ended July 31, 2006, the Company recorded $9.7 million and $19.6 million, respectively,
of inventory charges related to excess and obsolete inventory of under-performing product lines and the decrease in demand for the memory product line. The total charges related to inventory write-downs since October 31, 2001 through
July 31, 2006 was $141.7 million. Of this amount, approximately $50.5 million was scrapped, $14.9 million was written down for lower of cost or market provisions, $26.4 million was sold and the remaining $47.6 million was still on hand as of
July 31, 2006.

The table below summarized the activities of the inventory write-downs (in thousands):



|                                                                                  |  |   |         |  
|--------------------------------------------------------------------------------- |  | - | ------- | -
|10/31/02 Balance                                                                  |  | $ | 39,997  |  
|FY03 Scrapping                                                                    |  |   | (10,672 | )
|                                                                                  |  |   |         |  
|10/31/03 Balance                                                                  |  |   | 29,325  |  
|FY04 Additional inventory charges                                                 |  |   | 44,979  |  
|FY04 Scrapping                                                                    |  |   | (14,079 | )
|FY04 Sale of fully reserved inventory                                             |  |   | (2,341  | )
|FY04 Kalos lower of cost or market adjustment on fully reserved inventory         |  |   | (7,215  | )
|FY04 Octet-Quartet lower of cost or market adjustment on fully reserved inventory |  |   | (21,123 | )
|                                                                                  |  |   |         |  
|10/31/04 Balance                                                                  |  |   | 29,546  |  
|FY05 Additional inventory charges                                                 |  |   | 27,774  |  
|FY05 Scrapping                                                                    |  |   | (16,717 | )
|FY05 Sale of fully reserved inventory                                             |  |   | (1,633  | )
|FY05 Octet lower of cost or market adjustment on fully reserved inventory         |  |   | (6,523  | )
|                                                                                  |  |   |         |  
|10/31/05 Balance                                                                  |  | $ | 32,447  |  
|FY06 Additional inventory charges                                                 |  |   | 19,620  |  
|FY06 Sale of fully reserved inventory                                             |  |   | (214    | )
|FY06 Scrapping                                                                    |  |   | (4,286  | )
|                                                                                  |  |   |         |  
|7/31/06 Balance                                                                   |  | $ | 47,567  |  
|                                                                                  |  |   |         |  

Restructuring  operating expenses

During previous years, the Company has recorded restructuring charges as it rationalized operations in light of customer demand declines and economic
downturns. The measures, which included reducing the workforce, consolidating facilities and changing the strategic focus of a number of sites, was largely intended to align the Companys capacity and infrastructure to anticipated customer
demand and transition its operations for higher utilization of facility space. The restructuring charges include employee severance and benefit costs, and costs related to leased facilities vacated, net of estimated sublease income. Severance and
benefit costs and other costs associated with restructuring activities were recorded in compliance with Statement of Financial Accounting Standard No. 146, Accounting for Costs Associated with Exit or Disposal Activities, (SFAS
146). During October 2004, the Company also adopted Statement of Financial Accounting Standard No. 112, Employers Accounting for Post Employment Benefits, (SFAS 112), for severance and benefit costs as the Company concluded
that (a) the Company has a substantive post employment benefit obligation that is attributed to prior services rendered, (b) rights to those benefits have vested, and (c) payment is probable and the amount can be reasonably estimated.
This accounting for restructuring costs requires the Company to record provisions and charges when it has a formal and committed restructuring plan.



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##### Table of Contents

The following table illustrates the activity for the nine-month period ended July 31, 2006 and the
estimated timing of future payouts for major restructuring categories (in thousands):



|                                    |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|----------------------------------- |  | --------------------------- | ------- | - | ------- | - | ------ | -------- |  | ----------- | ----- | ------------------------ | - | --- |  | - | ------ | -
|                                    |  | Balance at October 31, 2005 |         |   | Charges |   |        | Utilized |  | Adjustments |       | Balance at July 31, 2006 |  
|Severance                           |  | $                           | (2,892  | ) |         | $ | (2,201 | )        |  | $           | 3,318 |                          | $ | 245 |  | $ | (1,530 | )
|Operating leases                    |  |                             | (10,415 | ) |         |   | (600   | )        |  |             | 3,143 |                          |   | 266 |  |   | (7,606 | )
|Property and equipment              |  |                             |        |   |         |   | (168   | )        |  |             | 168   |                          |   |    |  |   |       |  
|Other liabilities                   |  |                             | (1,369  | ) |         |   | (727   | )        |  |             | 2,077 |                          |   | 19  |  |   |       |  
|                                    |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Total                               |  | $                           | (14,676 | ) |         | $ | (3,696 | )        |  | $           | 8,706 |                          | $ | 530 |  | $ | (9,136 | )
|                                    |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Estimated timing of future payouts: |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Remainder of fiscal 2006            |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   | 2,941  |  
|Fiscal 2007                         |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   | 3,894  |  
|Fiscal 2008                         |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   | 1,226  |  
|Fiscal 2009                         |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   | 1,075  |  
|                                    |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  
|Total                               |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  | $ | 9,136  |  
|                                    |  |                             |         |   |         |   |        |          |  |             |       |                          |   |     |  |   |        |  

For the three and nine months ended July 31, 2006, the Company recorded restructuring charges
of approximately $1.8 million and $3.2 million, respectively, as operating expenses related to headcount reductions, facilities, fixed assets write-off and other liabilities related to the discontinuation of the memory products.

In July 2006, the Company entered into a lease buyout agreement with the landlord for the vacant San Jose building. The agreement terminated the initial
lease arrangement whereby the Company would occupy and pay for the space through 2009. According to the terms of the agreement, the Company will pay $8.0 million over a three years period of which $2.0 million was paid in early August 2006.

16. Employee Benefit Plans

The
Company maintains a 401(k) retirement savings plan for its full-time domestic employees, which allows them to contribute up to 20% of their pre-tax wages subject to IRS limits. The Companys contribution to this plan for the three and nine
months ended July 31, 2006 was approximately $0.4 million and $1.6 million, respectively. The Companys contribution to this plan for the three and nine months ended July 31, 2005 was approximately $0.5 million and $1.6 million,
respectively.

Outside of the United States, the Company also assumed several defined benefit and defined contribution plans that cover
substantially all employees as part of its acquisition of NPTest in May 2004. Where applicable, employees are covered by statutory plans. For defined benefit plans, charges to expense are based upon costs computed by independent actuaries. These
plans are substantially fully funded with trustees in respect to past and current service. At July 31, 2006 and October 31, 2005, the pension liability was $0.6 million. The expenses associated with these plans were not material for the
nine months ended July 31, 2006 and 2005.

The Company has a deferred compensation plan for certain employees (a Rabbi
Trust or trust). The assets in the Rabbi Trust, consisting of cash equivalents and debt and equity securities, are recorded at current market prices. The trust assets are available to satisfy claims of the Companys general
creditors in the event of its bankruptcy. The trusts assets of approximately $2.0 million and $2.4 million at July 31, 2006 and October 31, 2005, respectively, are included in other assets, and the corresponding deferred compensation
liability is included in the other liabilities in the accompanying unaudited condensed consolidated balance sheets.

17. Industry Segment

Operating segments are business units that have separate financial information and are separately reviewed by the Companys chief
decision makers. The Companys chief decision makers are the Chief Executive Officer and Chief Financial Officer. The Company and its subsidiaries currently operate in a single industry segment: the design, development, manufacture, sale and
service of advanced semiconductor test and diagnostic systems used in the production of semiconductors. The Company has a single reporting unit for purposes of Statement of Financial Accounting Standard No. 131, Disclosure About Segments
of an Enterprise and Related Information, (SFAS 131), advanced semiconductor test and diagnostic systems, primarily because all of the components of the Companys advanced semiconductor test and diagnostic systems segment are subject to
similar economic characteristics, have similar production processes, have common customers, and are distributed using the same channels.



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##### Table of Contents

The Companys net sales by product line consisted of:



|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|----------------------------- |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                              |  | Three Months Ended July 31, |   |  | Nine Months Ended July 31, |  
|                              |  | 2006                        |   |  | 2005                       |   |  | 2006 |   |  | 2005 |  
|SoC                           |  | 30                          | % |  | 36                         | % |  | 33   | % |  | 37   | %
|Analog Mixed Signal           |  | 36                          |   |  | 21                         |   |  | 32   |   |  | 20   |  
|Memory                        |  | 3                           |   |  | 3                          |   |  | 2    |   |  | 3    |  
|Design Characterization Group |  | 5                           |   |  | 12                         |   |  | 8    |   |  | 12   |  
|Service                       |  | 26                          |   |  | 28                         |   |  | 25   |   |  | 28   |  
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|Total                         |  | 100                         | % |  | 100                        | % |  | 100  | % |  | 100  | %
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  

Most of the Companys products are manufactured in the United States Export sales from the
United States are primarily denominated in United States dollars but are occasionally denominated in Japanese Yen or Euros. The Automotive products are manufactured in Germany and these sales are denominated in United States dollars, Japanese Yen or
Euros. All of the Companys products are shipped to the Companys customers throughout North America, Asia Pacific, Europe, and the Middle East. Sales by the Company to customers in different geographic areas, expressed as a percentage of
net sales, for the periods ended were:



|                             |  |                             |   |  |                            |   |  |      |   |  |      |  
|---------------------------- |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                             |  | Three Months Ended July 31, |   |  | Nine Months Ended July 31, |  
|                             |  | 2006                        |   |  | 2005                       |   |  | 2006 |   |  | 2005 |  
|North America                |  | 26                          | % |  | 28                         | % |  | 31   | % |  | 34   | %
|Taiwan                       |  | 10                          |   |  | 11                         |   |  | 12   |   |  | 7    |  
|China                        |  | 4                           |   |  | 7                          |   |  | 5    |   |  | 6    |  
|Southeast Asia               |  | 35                          |   |  | 24                         |   |  | 26   |   |  | 18   |  
|Japan & Rest of Asia Pacific |  | 5                           |   |  | 9                          |   |  | 5    |   |  | 12   |  
|Europe & Middle East         |  | 20                          |   |  | 21                         |   |  | 21   |   |  | 23   |  
|                             |  |                             |   |  |                            |   |  |      |   |  |      |  
|Total net sales              |  | 100                         | % |  | 100                        | % |  | 100  | % |  | 100  | %
|                             |  |                             |   |  |                            |   |  |      |   |  |      |  

For the three months ended July 31, 2006, three customers accounted for 11%, 13% and 17% of
the Companys net sales. For the nine months ended July 31, 2006, two customers accounted for 14% and 20% of the Companys net sales. For the three months ended July 31, 2005, two customers accounted for 25% and 17% of the
Companys net sales. For the nine months ended July 31, 2005, two customers accounted for 28% and 14% of the Companys net sales.

As of July 31, 2006, three customers accounted for 11%, 19%, and 19% of the Companys gross accounts receivable. As of October 31, 2005, two customers accounted for 20% and 22% of the Companys gross accounts receivable.

As of July 31, 2006 and October 31, 2005, the majority of the Companys long-lived assets were attributable to its United
States operations.

18. Recent Accounting Pronouncements

In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (FSP
115-1), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1 also includes accounting
considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP115-1 is effective for reporting
periods beginning after December 15, 2005. The adoption of FSP 115-1 on February 1, 2006 did not have a material impact on its financial statements.

In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, (FIN 47) which clarifies that the term conditional asset retirement
obligation as used in Statement of Financial Accounting Standard No. 143, Accounting for Asset Retirement Obligations (SFAS 143), refers to a legal obligation to perform an asset retirement activity in which the timing and/or
method of settlement are conditional on a future event that may or may not be within the control of the entity. However, the obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or
method of settlement. FIN 47 requires that the uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation be factored into the measurement of the liability when sufficient information exists. FIN 47 also
clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The Company does not
believe the adoption of FIN 47 will have a material impact on its financial statements.



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In April 2006, the FASB issued FASB Staff Position No. FIN 46(R)-6 (FSP FIN 46(R)-6), which addresses how
a reporting enterprise should determine the variability to be considered in applying FASB Interpretation No. 46, Consolidation of Variable Interest Entities, as amended (FIN 46(R)). The variability that is considered in applying FIN
46(R) affects the determination of (a) whether the entity is a variable interest entity, (b) which interests are variable interests in the entity and (c) which party, if any, is the primary beneficiary of the variable interest entity.
That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP FIN 46(R)-6 provides additional guidance to consider for determining variability. FSP FIN 46(R)-6 is effective
beginning the first day of the first reporting period beginning after June 15, 2006. The Company is currently in the process of evaluating the impact that the adoption of FSP FIN 46(R)-6 will have on its financial position, results of
operations and cash flows.

In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes, which
clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold
and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on de-recognition, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of adopting this interpretation.

19. Subsequent Event

In August 2006, the Company
announced plans to reduce its workforce by approximately 14% to focus the Company on higher growth opportunities and modify its business model to strengthen the Companys financial position for the long term. The Company anticipates that this
action will result in restructuring and other charges of approximately $8.0 to $10.0 million in the fourth quarter of fiscal 2006.



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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 international business continuing to account for a significant portion of our net sales; our
belief that orders will be cancelled and delayed in the future; our dedication to continue to invest significant resources in the development, enhancement, production and commercialization of new products and technologies; our dependence on
continued significant expenditures related to new products, capital equipment purchases and worldwide training and customer service and support; our belief that our sales, gross margins and operating results will continue to fluctuate; utilization
of our proprietary technologies to design products which are intended to provide a lower total cost of ownership than competing products; our intention to introduce new products and product enhancements; our belief that our gross margin on systems
sales will continue to vary significantly; our expectation that our top ten customers in the aggregate continue to account for a large portion of our net sales for the foreseeable future, and the loss of one or more of these customers or a material
reduction in capital spending by one or more of these customers will harm our business and operating results; our belief that customers may order more systems or more rapid delivery time than they require; our intent to continue to address the need
to develop new products and enhance existing products through acquisitions of other companies, product lines, technologies and personnel; our belief that the acquisition of Hypervision provides customers with additional products; existing cash,
short-term and long-term investments being sufficient to meet our cash requirements for the foreseeable future; our dependence on the capital expenditures of manufacturers of semiconductors and other companies; a significant portion of new orders
depending upon demand from semiconductor device manufacturers building or expanding fabrication facilities and new device testing requirements; dependence of our quarterly net sales upon our obtaining orders for systems to be shipped in the same
quarter in which the order is received; continued acceptance, volume production, timely delivery and customer satisfaction of our newer digital and mixed signal products being of critical importance to our future financial results; investing
significant resources in property, plant and equipment, purchased and leased facilities, inventory and other cost; the possibility that we may repatriate cash from our foreign subsidiaries; the factors upon which our ability to maintain or increase
sales levels in Taiwan depend; our expectation that we will continue to receive notice of third party claims for infringement and that litigation expenses with respect to those claims may continue to be an expensive and time consuming process for
us; our expectation that the Sarbanes-Oxley Act of 2002 will increase our expenses as we evaluate the implications of new rules and devote resources to respond to the new requirements; our expectation that the Sarbanes-Oxley Act of 2002 will make it
more difficult and more expensive for us to obtain director and officer liability insurance; our dependence on the continued service of our executive officers and key personnel; our dependence upon our ability to attract and retain qualified
personnel; the belief that our tax positions are consistent with the tax positions in the jurisdictions in which we conduct business; our intention to continue to evaluate the impact of SFAS 123(R) on our operating results and financial condition;
our belief that claims brought in the ordinary course of business will not have a material adverse effect on our business, financial condition or results of operation; our anticipation that net sales will be flat in the fourth quarter of fiscal year
2006 compared to third quarter of fiscal 2006; our belief that potential economic instabilities could materially adversely affect demand of our products; our anticipation that R&D expenses will flat or be slightly lower in the fourth quarter of
fiscal year 2006 compared to third quarter of fiscal 2006; our expectation that SG&A expenses will be flat or be slightly lower in the fourth quarter of fiscal year 2006 compared to third quarter of fiscal 2006; our expectation to record a full
valuation allowance on domestic tax benefits; our belief that investment in inventory will continue to represent a significant portion of our working capital; the highly cyclical semiconductor industry which experiences downturns; our expectation
that a 10% change in the interest rate will not have any material effect on our interest expense; our revenue recognition practices regarding new products; recognition of compensation expense; our expectation that we will not recognize any
significant tax benefits in our results of operations; our belief that 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;
estimated future restructuring payments and charges; future minimum lease payments; minimum contractual cash obligations and the effect of such obligations in future periods; our expectation that goodwill from acquisition will not be deductible for
tax purposes; our intention to evaluate other intangibles and long lived assets at such times as events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future undiscounted cash flow; the highly
competitive nature of the automatic test equipment industry which is subject to rapid technological change; the impact of the adoption of certain accounting pronouncements on our financial statements; our need for continued significant expenditures
for research and development, marketing and other expenses for new products; and our plans to reduce our workforce by 14% and anticipated restructuring and other charges associated with such action.



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These forward-looking statements involve important factors that could cause our actual results to differ
materially from those in the forward-looking statements. Such important factors involve risks and uncertainties including, but not limited to difficulties in utilizing different technologies; delays in bringing products to market due to development
problems; difficulties in developing new engineering validation test systems; the possibility that our existing systems will become obsolete; excessively high costs in the future related to enhancing our existing systems; significant changes in
customer preferences; difficulties in integrating acquired technology with our product lines; the possibility that competitors will introduce products faster than us; unanticipated difficulties in building close working relationships with vendors;
difficulties in developing the Sapphire platform; less sales of the Sapphire platform products than anticipated; product defects sustained during the manufacturing process; the risk that we may not be successful in obtaining new orders from major
customers; unanticipated decreases in demand for our products in foreign countries; difficulties in providing extensive support to major customers; unanticipated difficulties in manufacturing and delivering new products, enhancement tools;
unanticipated difficulties in integrating our products with customers operations; unanticipated difficulties in integrating developed technology; substantial technological changes in the semiconductor industry; a lack of the required resources
to invest in the development of new products; uncertainties as to the current products provided by our competitors; unanticipated difficulties in locating and evaluating potential product lines, technologies and business to acquire; the viability of
legal claims brought against us; our failure to accurately predict the effect of the ultimate outcome of claims on our business, financial condition or results of operations; lower than expected revenues; the risk that we may be required to expend
more cash in the future than anticipated; difficulties in obtaining orders from manufacturers of semiconductors and companies that specialize in contract packaging and/or testing of semiconductors; underestimate of the expenses associated with
implementation of the requirements of the Sarbanes-Oxley Act of 2002; difficulty in filling customer orders in a timely manner; an unanticipated lack of resources to invest in property, plant and equipment, purchased and leased facilities,
inventory, personnel and other costs; changing market conditions in Taiwan; inaccuracies in our assumptions regarding our tax positions; uncertainties as to the nature and extent of any potential cyclical downturn in the semiconductor industry;
inability to effectively utilize our proprietary technology for product design; inaccuracies in determining our compensation expenses; uncertainties as to the prospect of future orders and sales levels; changes in laws applicable to us regarding
revenue recognition practices relating to our new products; uncertainties as to the future level of sales and revenues; unanticipated budgetary constraints; uncertainties as to the assumptions underlying our calculations regarding estimated annual
amortization expenses for purchased intangible assets and deferred compensation; uncertainties as to the effects of the adoption by us of certain accounting policies; the risk that our future working capital will not be sufficient to invest
significant portions of such working capital inventories; uncertainties as to the effect of the adoption of certain accounting pronouncements; our ability to maintain the requisite level of assets under its deferred compensation plan; increased
fragmentation in the ATE industry; inability to successfully discontinue the memory product lines; unanticipated difficulties associated with implementation of our workforce reduction plan and other factors set forth in Risk Factors and
elsewhere herein. Reference is made to the discussion of risk factors detailed in our filings with the Securities and Exchange Commission, including our reports on Form 10-K and 10-Q. All projections in this Quarterly Report on Form 10-Q are based
on limited information currently available to us, which is subject to change. Although any such projections and the factors influencing them will likely change, we will not necessarily update the information, since we are only to provide guidance at
certain points during the year. Actual events or results could differ materially and no reader of this Form 10-Q should assume that the information provided today would still be valid in the future. Such information speaks only as of the date of
this Form 10-Q.

OVERVIEW

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

Major business developments during
the nine months ended July 31, 2006 and through the date of this Form 10-Q included:



| |  |  | David House, a forty-year veteran of the computing, communication and semiconductor industries with twenty-two years in management positions at Intel Corporation, was appointed
executive chairman of our board of directors, effective December 9, 2005.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | We adopted Statement of Financial Accounting Standard No. 123(R), Share-Based Payment, (SFAS 123(R)).
| | - |  | -------------------------------------------------------------------------------------------------------



| |  |  | We made a decision to discontinue development of our next generation memory product due to the continued weakening in demand for these products and the decision by one of our large
customers to significantly decrease capital spending. As a result, we wrote down approximately $11.8 million of inventory during the second quarter of fiscal year 2006.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We reviewed and evaluated our inventory against our forecast and determined that some of our legacy products demands have decreased. As a result, we recorded charges of
approximately $24.2 million associated with the write-down of inventory and order cancellation charges during the third quarter of fiscal year 2006.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Based on a combination of factors identified during the third quarter of fiscal 2006, particularly: (1) our changed current and projected operating results reflecting lower
demand from major customers; and (2) our current market capitalization which was significantly less than our book value for the preceding 10 weeks, we concluded there were sufficient indicators to require us to assess whether any portion of its
recorded goodwill balance was impaired. We determined, based on our estimates of forecasted discounted cash flows and our market capitalization, that our goodwill was impaired at July 31, 2006. Further analysis indicated that goodwill
impairment charges of $423.9 million were necessary in the third quarter of fiscal 2006. Other long-lived assets were assessed for impairment prior to the performance of the SFAS 142 analysis and were determined not to be impaired.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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, our ability to effectively integrate acquisitions, product discounts, product reliability, the proportion of direct sales and sales through third parties,
including distributors and original equipment manufacturers, the mix of products sold, the length of manufacturing and sales cycles, natural disasters, political and economic instability, new accounting pronouncements (e.g., FAS 123(R)), 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 unaudited condensed consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including
those related to revenue recognition, allowance for doubtful accounts, inventory valuation and residual values related to leased products, long-lived assets valuation, warranty accrual, deferred taxes, restructuring charges and stock-based
compensation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We discuss the development and selection of the critical accounting estimates with the audit
committee of our board of directors on a quarterly basis, and the audit committee has reviewed our disclosure relating to them in this Quarterly Report on Form 10-Q.

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



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Revenue Recognition:

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

During fiscal 2005, we introduced several new enhancements, systems and products. Certain revenues from sales of these new enhancements, systems and
products during the nine months in fiscal 2006 and fiscal 2005 were deferred until the revenue recognition requirements of our revenue recognition policy are satisfied. This practice will continue in the future. In the past, we experienced
significant delays in the introduction and acceptance of new testers as well as certain enhancements to our existing testers. 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.

With respect to arrangements with multiple deliverables, we follow the guidance
in Emerging Issue Task Force No. 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21), to determine whether there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units
of accounting, we then allocate the total fee on such arrangements to the individual units of accounting using the residual method. We then recognize revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the
unit of accounting (principally following SAB 104).

Sales in the United States are principally through our direct sales organization
consisting of direct sales employees and representatives. Sales outside the United States utilize both direct sales employees and distributors. There are no significant differences in revenue recognition policies based on the sales channel, due to
the business practices that have been adopted with our distributor relationships. Because of these business practices, we do not use price protection, stock rotation or similar programs with our distributors. In general, we
sell product to the distributor on the basis of a purchase order received from an end customer. We evaluate any revenue recognition issues, in such cases, based on the characteristics of the end customer.

Our semiconductor manufacturing equipment includes embedded software. We believe this embedded software is incidental to our products and therefore it is
excluded from the scope of Statement of Position 97-2, Software Revenue Recognition, (SOP 97-2). Also, the embedded software in our products is not sold separately, cannot be used on another vendors products, and we cannot
fundamentally enhance or expand the capability of the equipment with new or revised embedded software. In addition, the equipments principal performance characteristics are governed by digital speed and pin count which are primarily a function
of the hardware.

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

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

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



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Allowance for Doubtful Accounts:

We, along with our sales and distribution partners, perform ongoing credit evaluations of our customers financial condition. We maintain allowances
for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments. We record our bad debt expenses as selling, general and administrative expenses. When we become aware that a
specific customer is unable to meet its financial obligations to us, generally because of bankruptcy or deterioration in the customers operating results or financial position, we record a specific allowance to reflect the level of credit risk
in the customers outstanding receivable balance. In addition, we record additional allowances based on certain percentages of our aged receivable balances. These percentages are determined by a variety of factors including, but not limited to,
current economic trends, historical payment and bad debt write-off experience. We are not able to predict changes in the financial condition of our customers or changes in general economic conditions, and if circumstances related to our customers
deteriorate, our estimates of the recoverability of our trade receivables could be materially affected and we may be required to record additional allowances. Alternatively, if we provide more allowances than we need, we may reverse a portion of
such provisions in future periods based on our actual collection experience.

Inventory Valuation and Residual Values Related to Leased
Products:

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

We monitor our inventory levels in light of product development changes and expectations of the cyclical period ahead. For the three years ended
October 31, 2005 and nine months ended July 31, 2006, we have recorded a total of $80.6 million and $36.1 million, respectively, in write down of excess and obsolete inventories. We do not as a matter of course scrap all inventory that is
identified as excess or obsolete. Our products are capital goods with potentially long economic lives and, historically, the opportunity to sell these products has both arisen and fallen unexpectedly. We have occasionally encountered unexpected
demand for old products as well as the inability to transition customers to newer products. We closely monitor the inventories that have been written down but not scrapped, so that if any sales of these items occur and affect our reported gross
margins, the effect, if material, is disclosed. We may be required to take additional charges for excess and obsolete inventory if a downturn causes further reductions to our current inventory valuations or if our current product development plans
change.

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

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

Long-Lived Asset Valuation:

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

As required by Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, (SFAS 142), we test goodwill
for possible impairment on an annual basis and at any other time events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to:
our market value falling below our net book value for a significant period of time; a significant adverse change in the business climate or legal factors; unanticipated competition; loss of key personnel; a significant change in direction with
respect to investment in a product or market segment; the likelihood that a significant portion of the business will be sold or disposed of; or the results of testing for recoverability of a significant asset group within a reporting unit determined
in accordance with SFAS 142.

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



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The determination as to whether a write down of goodwill is necessary involves significant judgment based
on the short-term and long-term projections of our operations. The assumptions supporting the estimated future cash flows of the reporting unit, including profit margins, long-term forecasts of the amounts and timing of overall market growth and our
percentage of that market, discount rates and terminal growth rates, reflect our best estimates.

As mandated by SFAS 142, we completed our
annual goodwill impairment test as of July 31, 2005 during the fourth quarter of the fiscal year. We determined that, based on market capitalization and on the test which indicated that the sum of the expected future discounted cash flows from
the assets exceeded the earning value of those assets, the goodwill was not impaired.

Based on a combination of factors identified during
the third quarter of fiscal 2006, particularly: (1) our changed current and projected operating results reflecting lower demand from major customers; and (2) our current market capitalization which was significantly less than our book
value for the preceding 10 weeks, we concluded there were sufficient indicators to require us to assess whether any portion of our recorded goodwill balance was impaired. We determined, based on our estimates of forecasted discounted cash flows and
our market capitalization, that our goodwill was impaired at July 31, 2006. Further analysis indicated that goodwill impairment charges of $423.9 million were necessary in the third quarter of fiscal 2006. Other long-lived assets were assessed
for impairment prior to the performance of SFAS 142 analysis and were determined not to be impaired.

We evaluate the carrying value of our
long-lived assets, consisting primarily of purchased intangible assets, and property and equipment, in accordance with SFAS 144, Accounting for the Impairment or Disposal for Long-Lived Assets, whenever certain events or changes in
circumstances indicate that the carrying amount of these assets may not be recoverable, or at least annually. 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 make certain assessments with respect to the determination of all identifiable assets to be used in the business as well as research and development
activities as of an acquisition date. Each of these activities was evaluated by both interviews and data analysis to determine our state of development and related fair value. The purchased intangibles consist of purchased technology, customer
relations, trademarks, patents and non-compete agreements, and they typically have estimated useful lives of one to ten years.

Warranty
Accrual:

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

Deferred Taxes:

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



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Our net deferred tax asset balance as of July 31, 2006 was $0.4 million which relates to our foreign
subsidiaries that are currently generating taxable income. Our domestic tax assets reflect 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.

We are a United States.-based multinational company subject to tax in multiple United States and foreign tax
jurisdictions. Our effective tax rate is based on expected income, statutory rates and enacted tax rules, including transfer pricing. Significant judgment is required in determining our effective tax rate and in evaluating our tax positions on a
worldwide basis. We believe our tax positions, including intercompany transfer pricing policies are consistent with the tax laws in the jurisdictions in which we conduct our business. It is possible that these positions may be challenged which may
have an impact on our effective tax rate.

Restructuring Charges:

During previous years, we have recorded restructuring charges as we rationalized operations in light of customer demand declines and the economic
downturn. These measures, which included major changes in senior management, workforce reduction, facilities consolidation and changes to the strategic focus of a number of sites, were largely intended to align our capacity and infrastructure to
anticipate customer demand and to transition our operations to lower cost regions. The restructuring charges include employee severance and benefit costs, write-offs of property and equipment and costs related to leased facilities vacated and
subleased. Severance and benefit costs and other costs associated with restructuring activities were recorded in accordance with Statement of Financial Accounting Standard No. 146, Accounting for Costs Associated with Exit or Disposal
Activities, (SFAS 146). We also record severance and benefit costs in accordance with Statement of Financial Accounting Standard No. 112, Employers Accounting for Post Employment Benefits, (SFAS 112), as we conclude that
(a) we have a substantive post employment benefit obligation that is attributed to prior services rendered, (b) rights to those benefits have vested, and (c) payment is probable and the amount can be reasonably estimated. The current
accounting for restructuring costs requires us to record provisions and charges when we have a formal and committed restructuring plan.

Given the significance of, and the timing of the execution of such activities, this process is complex and involves periodic reassessments of original estimates. We continually evaluate the adequacy of the remaining liabilities under our
restructuring initiatives. 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.

Stock-Based Compensation:

In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123(R), Share Based Payment, (SFAS 123(R)). This statement requires that the cost resulting from all share-based
payment transactions be recognized in the unaudited condensed consolidated financial statements. In March 2005, the Securities and Exchange Commission (SEC) released SEC Staff Accounting Bulletin No. 107, Share-Based Payment
(SAB No. 107). SAB No. 107 provides the SECs staffs position regarding the application of SFAS No. 123(R) and certain SEC rules and regulations, and also provides the staffs views regarding the
valuation of share-based payment arrangements for public companies. We adopted SFAS 123(R), utilizing the modified prospective method, in the nine months ended July 31, 2006 and will continue to evaluate the impact of SFAS 123(R) on
our operating results and financial condition. Our assessment of the estimated compensation charges is affected by our stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impacts. These
variables include, but are not limited to, our stock price volatility and employee stock option exercise behaviors. See Note 7 Stock-Based Compensation of the Notes to the unaudited condensed consolidated financial statements for further
discussion.

We estimate the fair value of options granted using the Black-Scholes-Merton option valuation model and the assumptions
discussed in Note 7, Stock-Based Compensation, of the unaudited condensed consolidated financial statements. We estimate the expected term of options granted based on historical experience of similar awards, giving consideration to the
contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior. We estimate the volatility of our common stock at the date of grant based on a combination of historical and implied volatilities,
consistent with SFAS 123(R) and SEC SAB No. 107. Prior to the adoption of SFAS 123(R), we relied exclusively on the historical prices of our common stock in the calculation of expected volatility. We base the risk-free interest rate that we use
in the Black-Scholes-Merton option valuation model on the implied yield in effect at the time of option grant. We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future.
Consequently, we use an expected dividend yield of zero in the Black-Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are
expected to vest. For options granted before November 1, 2005, we estimated the fair value using the multiple option approach and we are amortizing the fair value on a graded vesting basis. For options granted on or after November 1, 2005,
we estimate the fair value using a



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single option approach and amortize the fair value on a straight-line basis. All options are amortized over the requisite
service periods of the awards, which are generally the vesting periods. We may elect to use different assumptions under the Black-Scholes-Merton option valuation model in the future if our current experience indicates that a different measure is
preferable, which could materially affect our net income or loss and net income or loss per share.

RESULTS OF OPERATIONS

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



|                                                                |  |                             |    |  |                            |    |  |        |    |  |       |   
|--------------------------------------------------------------- |  | --------------------------- | -- |  | -------------------------- | -- |  | ------ | -- |  | ----- | --
|                                                                |  | Three Months Ended July 31, |    |  | Nine Months Ended July 31, |   
|                                                                |  | 2006                        |    |  | 2005                       |    |  | 2006   |    |  | 2005  |   
|Net sales                                                       |  | 100.0                       | %  |  | 100.0                      | %  |  | 100.0  | %  |  | 100.0 | % 
|Cost of goods sold  on net sales                               |  | 56.2                        |    |  | 52.9                       |    |  | 55.1   |    |  | 57.4  |   
|Cost of goods sold  inventory write-downs                      |  | 22.1                        |    |  | 20.5                       |    |  | 10.2   |    |  | 9.5   |   
|                                                                |  |                             |    |  |                            |    |  |        |    |  |       |   
|Gross margin                                                    |  | 21.7                        |    |  | 26.6                       |    |  | 34.7   |    |  | 33.1  |   
|Operating expenses                                              |  |                             |    |  |                            |    |  |        |    |  |       |   
|Research and development                                        |  | 20.6                        |    |  | 21.3                       |    |  | 20.1   |    |  | 22.4  |   
|Selling, general and administrative                             |  | 26.4                        |    |  | 28.0                       |    |  | 24.0   |    |  | 30.8  |   
|Restructuring charges                                           |  | 1.6                         |    |  | 8.6                        |    |  | 0.9    |    |  | 3.7   |   
|Reduction of goodwill                                           |  | 386.8                       |    |  |                           |    |  | 120.2  |    |  |      |   
|Amortization of purchased intangibles and deferred compensation |  | 4.0                         |    |  | 5.1                        |    |  | 3.6    |    |  | 6.0   |   
|                                                                |  |                             |    |  |                            |    |  |        |    |  |       |   
|Total operating expenses                                        |  | 439.4                       |    |  | 63.0                       |    |  | 168.8  |    |  | 62.9  |   
|                                                                |  |                             |    |  |                            |    |  |        |    |  |       |   
|Operating loss                                                  |  | (417.7                      | )  |  | (36.4                      | )  |  | (134.1 | )  |  | (29.8 | ) 
|                                                                |  |                             |    |  |                            |    |  |        |    |  |       |   
|Net loss                                                        |  | (421.0                      | )% |  | (37.2                      | )% |  | (136.1 | )% |  | (31.7 | )%
|                                                                |  |                             |    |  |                            |    |  |        |    |  |       |   

Net sales consist of revenues from systems sales, upgrades, spare parts sales, maintenance
contracts and capital and operating lease sales. Net sales were $109.6 million for the third quarter of fiscal 2006 representing a decrease of 2% from net sales of $111.9 million during the third quarter of fiscal 2005. Net sales increased $44.7
million, or 15%, to $352.5 million for the nine months ended July 31, 2006 from $307.8 million for the nine months ended July 31, 2005. The decrease in net sales for the third quarter of fiscal 2006 as compared to fiscal 2005 was due to a
softening of the PC market and customer delays of product shipments. The increase in net sales for the nine months ended July 31, 2006 as compared to July 31, 2005 was due primarily to increased demand of our analog mixed signal and
wireless products. Furthermore, net sales increased as our products gained market acceptance. The increase in net sales was offset by a decrease of net sales of our memory products as a result of reduced capital spending in the memory products by
our major IDM customers.

Our net sales by product line for the three and nine months ended July 31, 2006 and 2005:



|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|----------------------------- |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                              |  | Three Months Ended July 31, |   |  | Nine Months Ended July 31, |  
|                              |  | 2006                        |   |  | 2005                       |   |  | 2006 |   |  | 2005 |  
|SoC                           |  | 30                          | % |  | 36                         | % |  | 33   | % |  | 37   | %
|Analog Mixed Signal           |  | 36                          |   |  | 21                         |   |  | 32   |   |  | 20   |  
|Memory                        |  | 3                           |   |  | 3                          |   |  | 2    |   |  | 3    |  
|Design Characterization Group |  | 5                           |   |  | 12                         |   |  | 8    |   |  | 12   |  
|Service                       |  | 26                          |   |  | 28                         |   |  | 25   |   |  | 28   |  
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  
|Total                         |  | 100                         | % |  | 100                        | % |  | 100  | % |  | 100  | %
|                              |  |                             |   |  |                            |   |  |      |   |  |      |  

For the three months ended July 31, 2006, net sales of our analog mixed signal product
increased 65% to $39.3 million from $23.8 million during the three months ended July 31, 2005. Our SoC, diagnostics and characterization and service and spare parts net sales for the three months ended July 31, 2006 decreased 20% to $67.5
million from $84.5 million during the three months ended July 31, 2005. Net sales from our memory products decreased 19% to $2.9 million during the three months ended July 31, 2006 from $3.6 million during the same period of fiscal 2005.

For the nine months ended July 31, 2006, net sales from our SoC, analog mixed signal and service and spare parts net sales increased
to $316.1 million representing an increase of 21% from $261.9 million from the same period of fiscal 2005. The increase in net sales was offset by a 25% decrease in net sales of our memory products from $9.3 million during the three



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months ended July 31, 2005 to $7.0 million during the same period of fiscal 2006. Furthermore, our net sales for
diagnostics and characterization products for the nine months ended July 31, 2006 decreased 20% to $29.4 million from $36.6 million during the nine months ended July 31, 2005.

We anticipate net sales will be flat in the fourth quarter of fiscal year 2006 compared to the third quarter of fiscal 2006. Net sales levels will be
affected by the economic climate as well as other risks and factors described under the section titled Risk Factors herein.



|                             |  |                             |   |  |                            |   |  |      |   |  |      |  
|---------------------------- |  | --------------------------- | - |  | -------------------------- | - |  | ---- | - |  | ---- | -
|                             |  | Three Months Ended July 31, |   |  | Nine Months Ended July 31, |  
|                             |  | 2006                        |   |  | 2005                       |   |  | 2006 |   |  | 2005 |  
|North America                |  | 26                          | % |  | 28                         | % |  | 31   | % |  | 34   | %
|Taiwan                       |  | 10                          |   |  | 11                         |   |  | 12   |   |  | 7    |  
|China                        |  | 4                           |   |  | 7                          |   |  | 5    |   |  | 6    |  
|Southeast Asia               |  | 35                          |   |  | 24                         |   |  | 26   |   |  | 18   |  
|Japan & Rest of Asia Pacific |  | 5                           |   |  | 9                          |   |  | 5    |   |  | 12   |  
|Europe & Middle East         |  | 20                          |   |  | 21                         |   |  | 21   |   |  | 23   |  
|                             |  |                             |   |  |                            |   |  |      |   |  |      |  
|Total net sales              |  | 100                         | % |  | 100                        | % |  | 100  | % |  | 100  | %
|                             |  |                             |   |  |                            |   |  |      |   |  |      |  

International net sales accounted for approximately 74% of total net sales in the third quarter of
fiscal 2006 compared to 72% in the third quarter of fiscal 2005. International net sales accounted for approximately 69% and 66% of total net sales for the nine months ended July 31, 2006 and July 31, 2005, respectively. Our net sales to
the Asia Pacific region accounted for approximately 54% and 50% of total net sales in the third quarter of fiscal 2006 and 2005, respectively, as well as 48% and 42% for the nine months ended July 31, 2006 and 2005, respectively. The demand for
automated test and engineering capital equipment in Asian markets historically has been highly volatile and in some Asian regions there has been geopolitical unrest, both of which have resulted in economic instabilities. These potential economic
instabilities could materially adversely affect demand for our products.

Gross Margin

Our gross margin as a percentage of net sales was 22% and 27% during the three months ended July 31, 2006 and 2005, respectively. The decrease of gross
margin during the three months ended July 31, 2006 as compared to the same period in 2005 was due primarily to increased in inventory write down charges of $0.7 million and the stock-based compensation expense of $0.3 million related to employee
stock options and employee stock purchases under SFAS 123(R) was charged to costs of good sold in the three months ended July 31, 2006. In addition, our gross margin benefited by approximately $0.5 million or 2.2% and $1.1 million or 3.7% from the
sale of fully reserved inventory during the three months ended July 31, 2006 and 2005, respectively. For three and nine months ended July 31, 2005, our gross margin benefited from the sale of fully reserved inventory by approximately $1.1 million or
3.7% and $4.0 million or 4.1%, respectively.

For nine months ended July 31, 2006 and 2005, our gross margin was 35% and 33%, respectively.
Gross margin for the nine months ended July 31, 2006 increased due to improved manufacturing efficiencies resulting from the consolidation of our manufacturing facilities offset by inventory write-downs charges of $36.1 million attributable to
decreased demand for our memory and other legacy products as compared to inventory write-downs charges of $29.1 million in the same period of fiscal 2005. In addition, the stock-based compensation expense of $0.5 million related to employee stock
options and employee stock purchases under SFAS 123(R) was charged to costs of good sold in the three months ended July 31, 2006. In addition, our gross margin benefited by approximately $1.0 million or 0.9% and $4.0 million or 4.1% from the sale of
fully reserved inventory during the nine months ended July 31, 2006, respectively. Our gross margin has been and will continue to be affected by a variety of factors, including manufacturing efficiencies, excess and obsolete inventory write downs,
sell through of previously written down inventory, pricing by competitors or suppliers, new product introductions, product sales mix, production volume, customization and reconfiguration of systems, international and domestic sales mix and field
service margins.

Research and Development

Research and Development, or R&D, expenses were $22.6 million during the three months ended July 31, 2006, representing a decrease of 5% from $23.8 million during the three months ended July 31, 2005. The decrease in expenses
during the three months ended July 31, 2006 resulted primarily from the reduction of engineering projects which caused project materials and outside services to decrease by approximately $0.5 million, decrease in maintenance contracts expense
$0.6 million, decrease in compensation expense of $0.6 million resulted from previous headcount reductions and decrease in travel expense of $0.2 million. The decrease in R&D expenses were offset in part by the stock-based compensation expense
of $0.6 million related to employee stock options and employee stock purchases under SFAS 123(R) was charged to R&D in the three months ended July 31, 2006.

R&D expenses were $70.8 million for the nine months ended July 31, 2006, compared to $68.9 million from the same period in the prior fiscal year, an increase of 3%. The increase in R&D expenses was
primarily attributable to accelerated



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new product development investment costs of approximately $1.8 million in the first nine months of fiscal 2006 offset in
part by a decrease in compensation expense of approximately $1.4 million due to previous headcount reductions and a decrease in travel expenses of $0.2 million. In addition, stock-based compensation expense of $1.5 million related to employee stock
options and employee stock purchases under SFAS 123(R) was charged to R&D in the nine months ended July 31, 2006. We will continue to invest significant resources in the development and completion of new products and product enhancements.
Accordingly, we anticipate that R&D expenses will remain flat or be slightly lower in the fourth quarter of fiscal year 2006 as compared to the third quarter.

Selling, General and Administrative

Selling, general, and administrative, or SG&A, expenses were $29.0 million in the
three months ended July 31, 2006, compared to $31.3 million for the same period in the prior fiscal year, a decrease of 7%. The decrease in SG&A expenses for the third quarter of fiscal 2006 as compared to the same period in fiscal 2005 is
primarily due to a decrease in audit and Sarbanes-Oxley compliance related costs of $2.7 million, integration expense in the third quarter fiscal 2005 of $1.7 million, with no comparable charges in the same period ended in fiscal year 2006, and a
decrease in depreciation and maintenance expenses of $0.2 million. The decrease in SG&A was offset by an increase in compensation expense of $1.8 million and an increase stock-based compensation expense of $0.8 million related to employee stock
options and employee stock purchases under SFAS 123(R) was charged to SG&A in the three months ended July 31, 2006.

SG&A
expenses were $84.4 million during the nine months ended July 31, 2006, compared to $94.6 million for the same period in the prior fiscal year, a decrease of 11%. SG&A expenses decreased during the nine months ended July 31, 2006 as
compared to the same period of fiscal 2005 due primarily to the decreases in audit and Sarbanes-Oxley compliance related costs of $2.7 million, integration expense for the nine months in fiscal 2005 of $9.7 million, with no comparable charges in the
same period ended in fiscal year 2006, and a decrease in depreciation and maintenance expenses of $0.6 million. The decrease in SG&A was offset by an increase in compensation expense of $2.0 million and stock-based compensation expense of $2.4
million related to employee stock options and employee stock purchases under SFAS 123(R) was charged to SG&A in the nine months ended July 31, 2006. We expect SG&A expenses will be flat or be slightly lower in the fourth quarter of
fiscal year 2006 as compared to the third quarter.

Amortization of Purchased Intangibles and Deferred Compensation

Amortization of purchased intangibles and deferred compensation expenses were $4.3 million for the three months ended July 31, 2006, compared to $5.7
million for the same period of the prior fiscal year, a decrease of 22%. Amortization of purchased intangibles and deferred compensation expenses were $12.7 million for the nine months ended July 31, 2006, compared to $18.7 million for the same
period in the prior fiscal year, a decrease of 32%. Upon the adoption of SFAS 123(R), we discontinued the amortization of our deferred stock compensation, which was approximately $1.0 million and $2.5 million in the three and nine months ended
July 31, 2005, respectively. Of the $5.7 million recorded in the three months ended July 31, 2005, amortization of purchased intangibles was $4.7 million. Of the $18.7 million recorded in the nine months ended July 31, 2005,
amortization of purchased intangibles was $16.2 million. The decrease in amortization of purchased intangible assets in the three and nine months ended July 31, 2006 from the comparable periods in fiscal 2005 was due primarily to certain
purchased intangible assets including trademark, purchase product backlog, patents and non-compete agreements that became fully amortized in the nine months ended July 31, 2006.

Reduction of Goodwill

Effective November 1, 2002, the Company adopted SFAS 142, which was
issued by the FASB in July 2001. Under this standard, the Company ceased amortizing goodwill effective November 1, 2002.

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

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



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The determination as to whether a write-down of goodwill is necessary involves significant judgment based
on short-term and long-term projections of our operations. The assumptions supporting the estimated future cash flows of the reporting unit, including profit margins, long-term forecasts of the amounts and timing of overall market growth and our
percentage of that market, discount rates and terminal growth rates, reflect our best estimates.

As mandated by SFAS 142, we completed our
annual goodwill impairment test as of July 31, 2005 during the fourth quarter of the fiscal year. We determined that, based on market capitalization and on the test which indicated that the sum of the expected future discounted cash flows from
the assets exceeded the carrying value of those assets, the goodwill was not impaired.

Based on a combination of factors identified during
the third quarter of fiscal 2006, particularly: (1) our changed current and projected operating results reflecting lower demand from major customers; and (2) our current market capitalization which was less than our book value for the
preceding 10 weeks, we concluded there were sufficient indicators to require us to assess whether any portion of our recorded goodwill balance was impaired. We concluded based on our estimates forecasted discounted cash flows as well as our market
capitalization that our goodwill was impaired at July 31, 2006. Further analysis indicated that goodwill impairment charges of $423.9 million were necessary in the third quarter of fiscal 2006. Other long-lived assets were assessed for
impairment prior to the performance of the SFAS 142 analysis and were determined not to be impaired.

We have performed the first step of
the interim SFAS No. 142 analysis, consisting of a comparison of the fair value of the reporting unit with our carrying amount, including the goodwill. The fair value of the reporting units was determined based on a combination of the Income
Approach, which estimates the fair value based on the future discounted cash flows, and Market Approach, which estimates the fair value based on market prices of comparable companies. Under the Income Approach, we assumed a forecasted cash flow
period of 5 years, long-term annual growth rates of 9% to 17%, a discount rate of 20% and terminal value growth rates of 5%. We also considered our total market capitalization as of July 31, 2006, and our average market capitalization for
the quarter in order to assess volatility of our market capitalization on that day. Based on the first step of the analysis, we determined that the carrying amount of the reporting unit was in excess of its fair value. As such, we were required to
perform the second step of the analysis on the reporting unit that has failed the first step test to determine the amount of the impairment loss. The second step of the analysis consisted of comparing the implied fair value of the goodwill with the
carrying amount of the goodwill, with an impairment charge resulting from any excess of the carrying value of the goodwill over the implied fair value of the goodwill based on a hypothetical allocation of the estimated fair value of the Company to
the Companys tangible and intangible assets (other than goodwill). Based on the second step of the analysis, we concluded that all of our recorded goodwill ($423.9 million) was impaired and as such recorded a noncash charge to continuing
operations during the third quarter of fiscal 2006.

Restructuring Charges

During the three months ended July 31, 2006 and 2005, we recorded restructuring charges of approximately $1.8 million and $9.7 million, respectively.
Restructuring charges were $3.2 million and $11.4 million during the nine months ended July 31, 2006 and 2005, respectively. The restructuring charges were for severance expenses related to headcount reduction, facilities, fixed assets
write-off and other liabilities related to the discontinuance of the memory product. We anticipate restructuring charges including severance and related charges ranging from $8.0 million to $10.0 million in the aggregate in the fourth quarter of
fiscal year 2006.

Interest Income

We
generated interest income of $1.0 million and $0.7 million in the third quarter of fiscal 2006 and 2005, respectively. For the nine months ended July 31, 2006 and 2005, interest income was $2.8 million and $2.0 million. The increase in the
three and nine months ended July 31, 2006, was primarily due to higher interest rates compared to the same period of prior year, partially offset by lower cash, cash equivalents and short-term investment balances.

Interest Expense

Interest expenses were $0.7 million
and $0.8 million for the third quarter of fiscal year 2006 and 2005, respectively. For the nine months ended July 31, 2006 and 2005, interest expenses were $2.1 million and $2.2 million, respectively. Interest expense primarily represents
interest on our convertible debt of $180.0 million.



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Other Income (Expense), Net

Other income (expense), net was $1.8 million of expense and $1.1 million of income for the third quarter of fiscal 2006 and 2005, respectively. For the nine months ended July 31, 2006 and 2005, other income
(expense), net was $2.7 million of expense and $3.0 million of income, respectively.

The change to net other expense in the three months
ended July 31, 2006 from net other income in the three months ended July 31, 2005 was primarily due to an unfavorable change in foreign currency valuation of approximately $0.8 million and the write off of impaired equity investment of
$0.9 million, offset in part by a gain of $0.4 million on fixed asset disposals in the three months ended July 31, 2006.

The change
to net other expense in the nine months ended July 31, 2006 from net other income in the nine months ended July 31, 2005 was primarily due to the mark up to fair value of an acquired liability of $1.2 million owed to the former parent of
NPTest , offset in part by a gain on the sale of an equity investment of $0.3 million in the nine months ended July 31, 2006. In addition, there was an unfavorable change in foreign currency valuation from the nine months ended July 31,
2005 to the nine months ended July 31, 2006 of approximately $2.0 million, the write off of impaired equity investment of $0.9 million and higher loss on the disposal of fixed assets of approximately $1.0 million during the nine month period
ended July 31, 2006 as compared to the same period in fiscal year 2005.

Income Taxes

We recorded an income tax provision of $2.1 million and $4.9 million for the three and nine months ended July 31, 2006, respectively, as compared to
$2.0 million and $8.6 million for the same periods of fiscal 2005, respectively. The income tax expense for the periods consists primarily of foreign tax expense on earnings 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.

Stock Options and Incentive Plan

We have a
stock-based compensation program that provides our board of directors broad discretion in creating employee equity incentives. This program includes incentive and non-statutory stock options granted under various plans, the majority of which are
stockholder approved. Stock options are generally time-based, vesting 25% on each annual anniversary of the hire date over four years and expire ten years from the grant date. Additionally, we have an Employee Stock Purchase Plan (ESPP) that allows
employees to purchase shares of common stock at 85% of the fair market value at the lower of either the date of enrollment or the date of purchase. Shares issued as a result of stock option exercises and our ESPP are generally from our new and
treasury shares. As of July 31, 2006, we had approximately 5.2 million shares of common stock reserved for future issuance under the stock option plans and ESPP.

On November 1, 2005, we adopted the provision of Statement of Financial Accounting Standard No. 123(R) (SFAS 123(R)), Share-Based
Payment, for our share-based compensation plans. Under SFAS 123(R), we are required to recognize stock-based compensation costs based on the estimated fair value at the grant date for our share-based awards. We previously accounted for our
employee stock option and employee ESPP under the intrinsic value recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related Interpretations, and
adopted the disclosure-only provisions of Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation, (SFAS 123), as amended by Statement of Financial Accounting Standard No. 148,
Accounting for Stock-Based Compensation  Transition and Disclosures, (SFAS 148).

We elected to use the modified
prospective transition method as permitted by SFAS 123(R), and therefore, have not restated our financial results for prior periods. In conjunction with the adoption of SFAS 123(R), we changed our method of attributing the value of stock-based
compensation to expense from the accelerated multiple-option approach to the straight-line single option method. Compensation expense for all share-based payment awards granted prior to November 1, 2005 will continue to be recognized using the
accelerated multiple-option approach while compensation expense for all share-based payment awards granted on or subsequent to November 1, 2005 is recognized using the straight-line single-option approach.

As a result of adopting SFAS 123(R), our losses before income taxes and net loss for the three and nine months ended July 31, 2006 were $1.2 million
and $2.6 million higher, respectively, than if we had continued to account for share-based compensation under APB 25. Basic and diluted net loss per share for the three and nine months ended July 31, 2006 would have been $0.01 and $0.04 lower,
respectively, if we had not adopted SFAS 123(R). There was no effect on the unaudited consolidated statements of cash flows from adopting SFAS 123(R).



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Prior to the adoption of SFAS 123(R), in August 2005, our board of directors approved the accelerated
vesting of certain unvested and out-of-the-money non-qualified stock options previously awarded to employees and officers with option exercise prices equal to or greater than $9.15. Options held by non-employee directors were excluded
from the vesting acceleration. In addition, in order to prevent executive officers from unintended personal benefits, our executive officers agreed to the imposition of restrictions on any shares received through the exercise of accelerated options.
Those restrictions prevent the sale of any shares received from the exercise of an accelerated option until the earlier of the original vesting date of the option or the executive officers termination of employment. The $9.15 price was
selected because it was higher than the closing price of our common stock of $8.84 on August 29, 2005, the date of this acceleration. The accelerated options represented approximately 15% or approximately 2.8 million shares of the total of
all outstanding options on August 29, 2005. The acceleration was intended to reduce the stock option expense we would be required to record after the adoption of SFAS 123(R). This acceleration reduced approximately $10.0 million of stock option
expenses under SFAS 123(R) which would have been recognized as an expense through December 2008.

At July 31, 2006, there was $10.0
million of unrecognized stock-based compensation expense related to non-vested options that is expected to be recognized over a weighted-average period of 3.0 years. At July 31, 2006, there was $1.0 million of unrecognized stock-based
compensation expense related to outstanding ESPP shares that is expected to be recognized over a six months period.

See Note 7
Stock-Based Compensation of the Notes to the unaudited condensed consolidated financial statements for further discussion.

LIQUIDITY AND
CAPITAL RESOURCES

In the nine months ended July 31, 2006, net cash used in operating activities was $11.3 million. The primary use
of this cash resulted from a net loss of $479.6 million, offset by reduction of goodwill of $423.9 million, depreciation and amortization of $39.7 million, non-cash charges related to the inventory write-downs, facility consolidation, and property
and equipment write-off of $37.5 million, stock-based compensation expense related to employee stock options and employee stock purchases under SFAS 123(R) of $4.5 million, allowance for doubtful accounts of $0.6 million and impairment of an equity
investment of $0.9 million. The net cash used in operating activities was offset in part by the increases in changes in operating assets and liabilities of $39.6 million.

Investing activities used net cash of $17.5 million for the nine months ended July 31, 2006, primarily attributable to net cash used of $28.6 million to purchase available-for-sale securities, $4.6 million used
to acquired Hypervision and $7.4 million to purchase property and equipment to support our business, partially offset by sales and maturities of available-for-sale securities of $20.8 million and proceeds from the sale of property and equipment of
$2.4 million which mainly reflected the sale of our Oregon land.

Financing activities used net cash of $1.1 million in the nine months
ended July 31, 2006, primarily attributed to payment of bank loan of $5 million, offset by cash provided from the issuance of common stock related to our employee equity plans.

As of July 31, 2006, we had working capital of $179.2 million, including cash and short-term investments of $129.3 million, and accounts receivable
and inventories totaling $163.6 million. We believe that because of the relatively long manufacturing cycles of many of our testers and the new products we presently offer and plan to introduce, investments in inventories will also continue to
represent a significant portion of our working capital. The semiconductor industry has historically been highly cyclical and has experienced downturns, which have had a material adverse effect on the semiconductor industrys demand for
automatic test equipment, including equipment manufactured and marketed by us. In addition, the automatic test equipment industry is highly competitive and subject to rapid technological change. Events related to these factors may occur in the near
term, which would cause a change to our estimate of the net realizable value of receivables, inventories or other assets, and the adequacy of accrued liabilities.

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.



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We lease some of our facilities and equipment under operating leases that expire through 2010. The
approximate future minimum lease payments at July 31, 2006 are as follows (in thousands):



|                         |  |                                |       |                                       |   |                                    |  |   |      
|------------------------ |  | ------------------------------ | ----- | ------------------------------------- | - | ---------------------------------- |  | - | -----
|                         |  | Committed Gross Lease Payments |       | Leases Written Off in
Special Charges |   | Net Estimated Future Lease Expense
|Remainder of fiscal 2006 |  | $                              | 997   |                                       | $ | 142                                |  | $ | 855  
|Fiscal 2007              |  |                                | 3,114 |                                       |   | 179                                |  |   | 2,935
|Fiscal 2008              |  |                                | 1,713 |                                       |   | 50                                 |  |   | 1,663
|Fiscal 2009              |  |                                | 1,269 |                                       |   |                                   |  |   | 1,269
|Fiscal 2010              |  |                                | 631   |                                       |   |                                   |  |   | 631  
|Thereafter               |  |                                | 1,228 |                                       |   |                                   |  |   | 1,228
|                         |  |                                |       |                                       |   |                                    |  |   |      
|                         |  | $                              | 8,952 |                                       | $ | 371                                |  | $ | 8,581
|                         |  |                                |       |                                       |   |                                    |  |   |      

The leases written off in special charges of $0.4 million are accounted for in our accrued
expenses and other liabilities balance on the condensed consolidated balance sheets at July 31, 2005.



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The following summarizes our minimum contractual cash obligations and other commitments at July 31,
2006, and the effect of such obligations in future periods (in thousands):



|                                                          |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      
|--------------------------------------------------------- |  | ----- | ------- | ------------------------ | - | ----------- |  | ----------- | ------ | ----------- | - | ----------- |  | ---------- | ----- |  | - | --- |  | - | -----
|                                                          |  | Total |         | Remainder of Fiscal 2006 |   | Fiscal 2007 |  | Fiscal 2008 |        | Fiscal 2009 |   | Fiscal 2010 |  | Thereafter
|Contractual Obligations:                                  |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      
|Facilities and equipment operating leases(1)              |  | $     | 8,952   |                          | $ | 997         |  | $           | 3,114  |             | $ | 1,713       |  | $          | 1,269 |  | $ | 631 |  | $ | 1,228
|Convertible subordinated notes(2)                         |  |       | 180,000 |                          |   |            |  |             |       |             |   | 180,000     |  |            |      |  |   |    |  |   |     
|Interest on convertible subordinated notes                |  |       | 4,838   |                          |   | 675         |  |             | 2,700  |             |   | 1,463       |  |            |      |  |   |    |  |   |     
|Minimum commitment under Technology Development Agreement |  |       | 940     |                          |   | 940         |  |             |       |             |   |            |  |            |      |  |   |    |  |   |     
|Open and non-cancelable purchase order commitments        |  |       | 57,791  |                          |   | 41,602      |  |             | 16,189 |             |   |            |  |            |      |  |   |    |  |   |     
|                                                          |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      
|Total contractual cash obligations                        |  |       | 252,521 |                          |   | 44,214      |  |             | 22,003 |             |   | 183,176     |  |            | 1,269 |  |   | 631 |  |   | 1,228
|                                                          |  |       |         |                          |   |             |  |             |        |             |   |             |  |            |       |  |   |     |  |   |      

---

|(1) | Approximately $0.4 million of this total has been accrued for as restructuring charges in the
condensed consolidated balance sheets as accrued expenses and other liabilities.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | This amount is recorded in the condensed consolidated balance sheets as convertible
subordinated notes.
|--- | -------------------------------------------------------------------------------------------------------

Some of the components that we purchase are unique to us and must be purchased in relatively high
minimum quantities with long (four and five month) lead times. These business circumstances can lead to us holding relatively high inventory levels and associated risks. In addition, purchase commitments for unique components are relatively
inflexible in terms of deferral or cancellation. At July 31, 2006, we had open and committed non-cancelable purchase orders totaling approximately $57.8 million. The contractual cash obligations and commitments table presented above contains
our minimum obligations at July 31, 2006 under these arrangements and others. Actual expenditures will vary based on the volume of transactions and length of contractual service provided. In addition to minimum spending commitments, certain of
these arrangements provide for potential cancellation charges.

As of July 31, 2006, our principal sources of liquidity consisted of
approximately $113.6 million of cash and cash equivalents and short-term investments of $15.7 million.

RECENT ACCOUNTING PRONOUNCEMENTS

In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position FAS 115-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments (FSP 115-1), which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on
measuring such impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as
other-than-temporary impairments. FSP115-1 is effective for reporting periods beginning after December 15, 2005. The adoption of FSP 115-1 on February 1, 2006 did not have a material impact on our financial statements.

In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, (FIN 47) which clarifies
that the term conditional asset retirement obligation as used in Statement of Financial Accounting Standard No. 143, Accounting for Asset Retirement Obligations (SFAS 143), refers to a legal obligation to perform an
asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. However, the obligation to perform the asset retirement activity is unconditional
even though uncertainty exists about the timing and/or method of settlement. FIN 47 requires that the uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation be factored into the measurement of the
liability when sufficient information exists. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years
ending after December 15, 2005. We do not believe the adoption of FIN 47 will have a material impact on our financial statements.



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In April 2006, the FASB issued FASB Staff Position No. FIN 46(R)-6 (FSP FIN 46(R)-6), which addresses how
a reporting enterprise should determine the variability to be considered in applying FASB Interpretation No. 46, Consolidation of Variable Interest Entities, as amended (FIN 46(R)). The variability that is considered in applying FIN
46(R) affects the determination of (a) whether the entity is a variable interest entity, (b) which interests are variable interests in the entity and (c) which party, if any, is the primary beneficiary of the variable interest entity.
That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP FIN 46(R)-6 provides additional guidance to consider for determining variability. FSP FIN 46(R)-6 is effective
beginning the first day of the first reporting period beginning after June 15, 2006. We are currently in the process of evaluating the impact that the adoption of FSP FIN 46(R)-6 will have on our financial position, results of operations and
cash flows.

In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes, (FIN 48), which
clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold
and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on de-recognition, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of adopting this interpretation.

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, United States Treasury notes and obligations of United States 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 October 31, 2005 |         |   | Future maturities of investments held at July 31, 2006
|                          |  | Balance July 31, 2006    |         |   | 2006                                                   |   |         | 2007 |  | 2008 |         | 2009 |  | Thereafter
|Cash and cash equivalents |  |                          |         |   |                                                        |   |         |      |  |      |         |      |  |            |  |   |  |   |  |  
|Amounts                   |  | $                        | 142,180 |   |                                                        | $ | 113,606 |      |  | $    | 113,606 |      |  |           |  |  |  |  |  | 
|Average rate              |  |                          | 2.29    | % |                                                        |   | 4.05    | %    |  |      | 4.05    | %    |  |           |  |  |  |  |  | 
|Short term investments    |  |                          |         |   |                                                        |   |         |      |  |      |         |      |  |            |  |   |  |   |  |  
|Amounts                   |  | $                        | 7,425   |   |                                                        | $ | 15,681  |      |  | $    | 15,681  |      |  |           |  |  |  |  |  | 
|Average rate              |  |                          | 3.84    | % |                                                        |   | 5.16    | %    |  |      | 5.16    | %    |  |           |  |  |  |  |  | 
|                          |  |                          |         |   |                                                        |   |         |      |  |      |         |      |  |            |  |   |  |   |  |  
|Total investment          |  | $                        | 149,605 |   |                                                        | $ | 129,287 |      |  | $    | 129,287 |      |  |           |  |  |  |  |  | 
|Average rate              |  |                          | 2.37    | % |                                                        |   | 4.18    | %    |  |      | 4.18    | %    |  |           |  |  |  |  |  | 
|Equity instruments        |  | $                        | 391     |   |                                                        |   |        |      |  |      |        |      |  |           |  |  |  |  |  | 

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

The sensitivity analysis model used by us for interest rate
exposure compares interest income on current investment interest rates versus current investment levels at current interest rates with a 10% increase. Based on this model, a 10% increase or decrease in interest rate would result in an increase or a
decrease in interest income of approximately $0.2 million. There can be no assurances that the above projected interest rate increase will materialize. Fluctuations of interest rates are beyond our control.

Foreign Exchange

We generate a
significant portion of our sales from customers located outside the United States, principally in Asia and, to a lesser extent, Europe. International sales are made mostly to foreign distributors and some foreign subsidiaries and are typically
denominated in United States dollars, but occasionally are denominated in the local currency for European and Japanese customers. The subsidiaries also incur most of their expenses in the local currency. Our SZ product line is developed and
manufactured in Germany and, thus, those expenses are Euro based. Accordingly, some of our foreign subsidiaries use the local currency as their functional currency. For the three months ended July 31, 2006 and 2005, foreign



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currency gains/losses were approximately $0.1 million loss and $0.9 million gain, respectively. Foreign currency
gains/losses were approximately $0.6 million loss and $1.2 million gain for the nine months ended July 31, 2006 and 2005, respectively. They are included in other income (expense), net on the condensed consolidated statements of operations. The
gain during the three and nine months ended July 31, 2005 was primarily due to the United States dollar becoming stronger.

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

Interest Rate Risk

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

ITEM 4.  CONTROLS AND PROCEDURES

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

Changes in Internal Control over Financial Reporting. There was no change in our internal control over financial reporting during the period
covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II.  OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

In March 2005, Roy Schmidt, a former employee, filed a complaint in the
Superior Court of Santa Clara County, California against us, alleging fraud and various other contractual and tort claims in connection with the termination of his employment by us. We settled this claim in early May 2006.

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 1A. RISK FACTORS.

Set forth below, elsewhere in this Quarterly Report on Form 10-Q, and in other
documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. The occurrence of any of the developments or
risks identified below may make the occurrence of one or more of the other risk factors below more likely to occur.

There have been no
material changes from the Risk Factors as previously disclosed in our Annual Report on Form 10-K for fiscal year ended October 31, 2005.

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



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LOGO

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



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



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



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



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



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



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



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



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



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



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



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



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



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| |  |  | 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, 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 systems sales have varied significantly and will continue to vary significantly based on a variety of factors including:



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



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



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



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



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



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



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



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



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



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



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



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

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

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

The semiconductor industry is cyclical.

The
semiconductor equipment industry is highly cyclical. 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 depends upon the current and anticipated market demand for semiconductors
and products incorporating semiconductors. The timing, length and severity of the up-and-down cycles in the semiconductor equipment industry are difficult to predict. This cyclical nature of the industry in which we operate affects



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our ability to accurately predict future revenue and, thus, future expense levels. When cyclical fluctuations result
in lower than expected revenue levels, operating results may be adversely affected and cost reduction measures may be necessary in order for us to remain competitive and financially sound. During a down cycle, we must be in a position to adjust
our cost and expense structure to prevailing market conditions and to continue to motivate and retain our key employees. In addition, during periods of rapid growth, we must be able to increase manufacturing capacity and personnel to meet customer
demand. We can provide no assurance that these objectives can be met in a timely manner in response to industry cycles. If we fail to respond to industry cycles, our business could be seriously harmed.

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

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

Over time, we have expanded our base of customers; however, a large portion of our revenues are generated from a small number of key customers. In
particular, two customers, Intel Corporation and Advanced Micro Devices, Inc., accounted for 14% and 20% of our net sales for the nine months ended July 31, 2006, respectively. Our top ten customers accounted for 65%, 66% and 55% of our net
sales for the nine months ended July 31, 2006 and fiscal years ended October 31, 2005 and 2004, respectively. We expect that our top ten customers in the aggregate will continue to account for a large portion of our net sales for the
foreseeable future, and the loss of one or more of these customers or collaborative partners or material reductions in capital spending by one or more of these customers or collaborative partners would harm our business and operating results. The
loss of a significant customer could also be perceived as a loss of momentum in our business and an adverse impact on our financial results, and this may cause the market price of our common stock to fall.

Implementation or changes to our enterprise resource planning system and other related systems may affect our business.

We may experience difficulties in implementing, making changes or enhancements to our enterprise resource planning or ERP system and other related systems
that could disrupt our ability to timely and accurately process and report key components of the results of our consolidated operations, our financial position and cash flows. Any disruptions or difficulties that may occur in connection with
implementing, making changes or enhancements to our ERP system or any future systems could also adversely affect our ability to complete the evaluation of our internal controls and attestation activities pursuant to Section 404 of the
Sarbanes-Oxley Act of 2002. System failure or malfunctioning may result in disruption of operations and the inability to process transactions and could adversely affect our financial results.

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

A change in accounting standards or practices can have a significant effect on our reported results and may even affect our reporting of transactions
completed before the change is effective. New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur in the future. Changes to existing standards or the questioning of current practices may
adversely affect our reported financial results or the way we conduct our business.

For example, since our inception, we have used stock
options and other long-term equity incentives as a fundamental component of our employee compensation packages. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder
value and, through the use of vesting, encourage employees to remain with Credence. The FASB issued changes to United States GAAP that requires us to record a charge to earnings for new and unvested employee stock option grants beginning on
November 1, 2005. This regulation has made it more expensive to grant stock options to employees and has negatively impacted our reported earnings by $1.2 million and $2.6 million for the three and nine months ended July 31, 2006,
respectively.



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We have a limited backlog and obtain most of our net sales from products that typically range in price from $200,000
to $5.0 million and generally ship products generating most of our net sales near the end of each quarter, which can result in fluctuations of quarterly results.

We obtain most of our net sales from the sale of a relatively few number of systems that typically range in selling price from $200,000 to $5.0 million. This has resulted and could continue to result in our net sales
and operating results for a particular period being significantly impacted by the timing of recognition of revenue from a single transaction. Our net sales and operating results for a particular period could also be materially adversely affected if
an anticipated order from just one customer is not received in time to permit shipment during that period. Backlog at the beginning of a quarter typically does not include all orders necessary to achieve our sales objectives for that quarter. Orders
in backlog are subject to cancellation, delay, deferral or rescheduling by customers with limited or no penalties. Throughout the recent fiscal years, we have experienced customer-requested shipment delays and order cancellations, and we believe it
is probable that orders will be canceled and delayed in the future. Consequently, our quarterly net sales and operating results have in the past, and will in the future, depend upon our obtaining orders for systems to be shipped in the same quarter
in which the order is received.

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

Furthermore, we generally ship
products generating most of our net sales near the end of each quarter. Accordingly, our failure to receive an anticipated order or a delay or rescheduling in a shipment near the end of a particular period or a delay in receiving customer acceptance
from a customer may cause net sales in a particular period to fall significantly below expectations, which could have a material adverse effect on our business, financial condition or results of operations. The relatively long manufacturing cycle of
many of our testers has caused and could continue to cause future shipments of testers to be delayed from one quarter to the next. Furthermore, as our competitors announce new products and technologies, and as we complete acquisitions of similar
technologies, 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 products.

We have in the past experienced significant delays in the development, introduction, volume production and sales of our new systems and related feature
enhancements. These delays related to our inability to successfully complete product hardware 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. 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. In the past, we have incurred and we may continue to incur substantial unanticipated costs to increase feature sets in
our systems. If our systems experience 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, delay 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 test system 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 and mixed signal testers are of critical importance to our future
financial results. As a result, our inability to correct any technical, reliability, parts shortages or other difficulties associated with our systems or to manufacture and ship the systems on a timely basis to meet customer requirements could
damage our relationships with current and prospective customers and would continue to materially adversely affect our business, financial condition and results of operations. In addition, the consolidation of our manufacturing operations in a single
site exposes us to the increased risk of manufacturing delays or disruption in the event of natural disasters or other calamities at the site. Any delays or disruptions could materially adversely affect our business, financial condition and results
of operations.

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

Our ability to compete in the Automatic Test Equipment, or ATE, market depends upon our ability to successfully develop and introduce new products and
enhancements 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 test systems with



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additional features, higher performance and other capabilities. Therefore, it is necessary for us to develop new systems
and/or enhance the performance and other capabilities of our existing systems to adequately address these requirements. Any success we may have in developing new and enhanced systems and new features to our existing systems will depend upon a
variety of factors, including:



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



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



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



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



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



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



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

Because we must make new
product development commitments well in advance of sales, new product decisions must anticipate both future demand and the availability of technology to satisfy that demand. We cannot be certain that we will be successful in selecting, developing,
manufacturing and marketing new hardware products or enhancements. Our inability to introduce new products that contribute significantly to net sales, gross margins and net income would have a material adverse effect on our business, financial
condition and results of operations. New product or technology introductions by our competitors could cause a decline in sales or loss of market acceptance of our existing products. If we introduce new products, existing customers may curtail
purchases of the older products resulting in inventory write-offs and they may delay new product purchases. In addition, capacity utilization at outsourced assembly and test houses, while improving, continues at low levels which is likely to depress
our non-integrated device manufacturers, or IDM business until such time that demand and supply conditions improve. Any decline in demand for our hardware products could have a materially 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, enhancement, production and commercialization of new products and technologies. During fiscal 2005, we introduced several enhancements as well as new products that are
evolutions or derivatives of existing products as well as products that were largely new. Under our revenue recognition policy adopted in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition, (SAB 104), we defer
revenue for transactions that involve newly introduced products or when customers specify acceptance criteria that cannot be demonstrated prior to the shipment. This results in a delay in the recognition of revenue as compared to the historic norm
of recognizing revenue upon shipment. Product introduction delays, if they occur in the future, will delay the recognition of revenue and gross profit and may result in delayed cash receipts by us that could materially adversely affect our business,
financial condition and results of operations. We invested and continue to invest significant resources in property, plant and equipment, purchased and leased facilities, inventory, personnel and other costs to begin or prepare to increase
production of these products. A significant portion of these investments will provide the marketing, administration and after-sales service and support required for these new 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.

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 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



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is difficult for competing vendors to achieve significant ATE sales to such customer for similar use. Our inability to
penetrate any particular large ATE customer or achieve significant sales to any ATE customer could have a material adverse effect on our business, financial condition or results of operations.

We face substantial competition from ATE manufacturers throughout the world. A substantial portion of our net sales is derived from sales of mixed-signal
testers. We face in some cases seven and in other cases nine 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. In addition,
three of our competitors recently completed initial public offerings. The success of these companies could make the competitive environment could become substantially more severe. 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 to satisfy specific
customer needs in a timely manner.

We must develop and deliver customized hardware 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 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 14%, 14% and 23% of our net sales in the nine months ended July 31, 2006 and fiscal years ended October 31, 2005 and 2004,
respectively. Our agreement with Spirox has no minimum purchase commitment and can be terminated for any reason on 180 days prior written notice. On May 31, 2005, we entered into an agreement with Spirox to combine our Taiwan operation with
Spiroxs T1 division into a corporation named Credence Spirox Integration Corporation, an operation owned 90% by Spirox and 10% by us. This new corporation is dedicated to supporting our products in the Taiwan region. Consequently, our
business, financial condition and results of operations could be materially adversely affected by the loss of or any reduction in orders by Spirox, any termination of the Spirox relationship, or the loss of any significant Spirox customer, including
the potential for reductions in orders by assembly and tester service companies due to technical, manufacturing or reliability problems with our products or continued slow-downs in the semiconductor industry or in other industries that manufacture
products utilizing semiconductors. Our ability to maintain or increase sales levels in Taiwan will depend upon:



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



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



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



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



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



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

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

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



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



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



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



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



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



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

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

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

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

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

We may repatriate cash
from our foreign subsidiaries, which could result in additional income taxes that could negatively impact our results of operations and financial position. In addition, if foreign countries currency policies limit our ability to repatriate the
needed funds, our business and results of operations could be adversely impacted.

One or more of our foreign subsidiaries hold a
portion of our cash and cash equivalents. If we need additional cash to acquire assets or technology, or to support our operations in the United States, and if the currency policies of these foreign countries allow us, we may repatriate some of our
cash from these foreign subsidiaries to the United States Depending on our financial results and the financial results of our subsidiaries at the time that the cash is repatriated, we may incur additional income taxes from the repatriation, which
could negatively affect our results of operations and financial position. In addition, if the currency policies of these foreign countries prohibit or limit our ability to repatriate the needed funds, our business and results of operations could be
adversely impacted.



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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.

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

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

Our international business exposes us to additional risks.

International sales accounted for approximately 69%, 69% and 72% of our total net sales in the nine months ended July 31, 2006 and fiscal years ended
October 31, 2005 and 2004, respectively. We anticipate that international sales will continue to account for a significant portion of our total net sales in the foreseeable future. These international sales will continue to be subject to
certain risks, including:



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



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



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



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



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



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



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



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



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| |  |  | greater difficulty in maintaining United States 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 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 51%, 47% and 52% of our total net sales the nine months ended July 31, 2006 and fiscal
years ended October 31, 2005 and 2004, respectively, and thus demand for our products is subject to the risk of economic instability in that region and health risks. 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.

No single Asian end-user customer accounted for more than 10% of our net sales during the nine months ended July 31,
2006 and fiscal years ended October 31, 2005 and 2004. No single European end-user customer accounted for more than 10% of our net sales during the nine months ended July 31, 2006 and fiscal year 2005. However, one end-user customer
headquartered in Europe, STMicroelectronics N.V., accounted for 15% of our net sales in fiscal 2004. Two customers headquartered in the United States, Intel Corporation and Advanced Micro Devices, accounted for 14% and 20% of our net sales in the
nine months ended July 31, 2006, respectively.

In addition, one of our major distributors, Spirox Corporation, which accounted for
14%, 14% and 23% of our net sales in the nine months ended July 31, 2006 and fiscal years ended October 31, 2005 and 2004, respectively, is a Taiwan-based company. This subjects a significant portion of our receivables and future revenues
to the risks associated with doing business in a foreign country, including political and economic instability, currency exchange rate fluctuations, fears related to health risks and regulatory changes. Disruption of business in Asia caused by the
previously mentioned factors could continue to have a material impact on our business, financial condition or results of operations.

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

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

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

We completed our annual goodwill impairment test as of July 31, 2005 during the three months ended
October 31, 2005. We determined that, based on market capitalization and on the test which indicated that the sum of the expected future discounted cash flows from the assets exceeded the carrying value of those assets, the goodwill was not
impaired.

Based on a combination of factors identified during the third quarter of fiscal 2006, particularly: (1) our changed current
and projected operating results reflecting lower demand from major customers; and (2) our current market capitalization which was significantly less than our book value for the preceding 10 weeks, we concluded there were sufficient indicators
to require us to assess whether any portion of our recorded goodwill balance was impaired. We determined, based on our estimates of forecasted discounted cash flows and our market capitalization, that our goodwill was impaired at July 31, 2006.
Further analysis indicated that goodwill impairment charges of $423.9 million were necessary in the third quarter of fiscal 2006. Other long-lived assets were assessed for impairment prior to the performance of the SFAS 142 analysis and were
determined not to be impaired.



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If economic conditions in our industry continue to deteriorate and adversely affect our business, we
could be required to record impairment charges related to our long-lived assets in accordance with SFAS 144, Accounting for Impairment or Disposal for Long-Lived Assets, which could have a material adverse effect on our results of
operations and financial condition.

Future acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value or divert
management attention.

Our growth depends upon market growth, our ability to enhance our existing products, and our ability to introduce
new products on a timely basis. We intend to continue to address the need to develop new products and enhance existing products through acquisitions of other companies, product lines, technologies, and personnel. Acquisitions involve numerous risks,
including the following:



| |  |  | Difficulties in integrating the operations, technologies, products, and personnel of the acquired companies;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | Diversion of managements attention from normal daily operations of the business;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Potential difficulties in completing projects associated with in-process research and development;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | Difficulties in entering markets in which we may have no or limited direct prior experience and where competitors in such markets may have stronger market positions;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Initial dependence on unfamiliar supply chains or relatively small supply partners;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | Insufficient revenue to offset increased expenses associated with acquisitions; and
| | - |  | -----------------------------------------------------------------------------------



| |  |  | The potential loss of key employees of the acquired companies.
| | - |  | --------------------------------------------------------------

Acquisitions may also cause us to:



| |  |  | Issue common stock that would dilute our current shareholders percentage ownership;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | Assume liabilities;
| | - |  | -------------------



| |  |  | Record goodwill and non-amortizable intangible assets that will be subject to impairment testing on a regular basis and potential periodic impairment charges;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Incur amortization expenses related to certain intangible assets;
| | - |  | -----------------------------------------------------------------



| |  |  | Incur large and immediate write-offs and restructuring and other related expenses; and
| | - |  | --------------------------------------------------------------------------------------



| |  |  | Become subject to intellectual property or other litigation.
| | - |  | ------------------------------------------------------------

Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results,
or financial condition. Failure to manage and successfully integrate acquisitions could materially harm our business and operating results. Prior acquisitions have resulted in a wide range of outcomes, from successful introduction of new products
and technologies to an inability to do so. Even when an acquired company has already developed and marketed products, there can be no assurance that product enhancements will be made in a timely fashion or that pre-acquisition due diligence will
have identified all possible issues that might arise with respect to such products.

From time-to-time, we have made acquisitions that
resulted in in-process research and development expenses being charged in a single quarter. These charges may occur in any quarter, contributing to variability in our quarterly earnings. Risks related to new product development also apply to
acquisitions.

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

Our future operating results depend substantially upon the continued service of our executive officers and key personnel. Our future operating results
also depend in significant part upon our ability to attract and retain qualified



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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.

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.

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

We may be
materially adversely affected by legal proceedings.

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

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

Recently enacted and proposed changes in the laws and regulations affecting public companies, including the
provisions of the Sarbanes-Oxley Act of 2002, have increased and will continue to increase our expenses as we evaluate the implications of new rules and devote resources to respond to the new requirements. Sarbanes-Oxley Act mandates, among other
things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards for audit committee members and imposes increased civil and
criminal penalties for companies, their chief executive officers and chief financial officers and directors for securities law violations. In particular, we incurred and expect to incur additional administrative expense as we implement
Section 404 of the Sarbanes-Oxley Act, which requires management to report on, and our Independent Registered Public Accounting Firm to attest to, our internal control over financial reporting. In addition, The Nasdaq National Market, on which
our common stock is listed, has also adopted comprehensive rules and regulations relating to corporate governance. These



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laws, rules and regulations have increased and will continue to increase the scope, complexity and cost of our corporate
governance, reporting and disclosure practices, which could harm our results of operations and divert managements attention from business operations. We also expect these developments to make it more difficult and more expensive for us to
obtain director and officer liability insurance in the future, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer and Chief Financial Officer
could face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficultly attracting and retaining qualified board members and executive officers, which would adversely affect our
business.

We are subject to the internal control evaluation and attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002.

Section 404 of the Sarbanes-Oxley Act of 2002 requires that we include in our annual report our assessment of the effectiveness of
our internal control over financial reporting and our audited financial statements as of the end of each fiscal year. Furthermore, our independent registered public accounting firm, or Firm, is required to attest to whether our assessment of the
effectiveness of our internal control over financial reporting is fairly stated in all material respects and separately report on whether it believes we maintained, in all material respects, effective internal control over financial reporting as of
the end of each fiscal year. We successfully completed our assessment and obtained our Firms attestation as to the effectiveness of our internal control over financial reporting as of October 31, 2005. In this and future years, if we fail
to timely complete this assessment, or if our Firm cannot timely attest to our assessment, we could be subject to regulatory sanctions and a loss of public confidence in our internal control. In addition, any failure to implement required new or
improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to timely meet our regulatory reporting obligations.

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 had a material adverse
effect on the economy.

Any similar future events may disrupt our operations or those of our customers and suppliers. Our markets currently
include Taiwan, Korea and Israel, which are experiencing political instability. In addition, these events have had and may continue to have an adverse impact on the United States 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 United States 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.

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

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

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE of PROCEEDS.

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None

ITEM 5. OTHER INFORMATION.

None



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##### Table of Contents

ITEM 6. EXHIBITS.

(a) See Exhibit Index



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SIGNATURES

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



|                        |  |                                                                                
|----------------------- |  | -------------------------------------------------------------------------------
|                        |  | CREDENCE SYSTEMS CORPORATION                                                   
|                        |  | (Registrant)                                                                   
|                        | 
|September 11, 2006 Date |  | /S/ JOHN BATTY                                                                 
|                        |  | John Batty Chief Financial Officer (Principal Financial and Accounting Officer)



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EXHIBIT INDEX



|               |  |                                                                                                                       
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  |                                                                                                                       
|3.1(1)         |  | Amended and Restated Certificate of Incorporation of Credence Systems Corporation, as currently in effect.            
|               | 
|3.2(2)         |  | Amended and Restated Bylaws of Credence Systems Corporation, as currently in effect.                                  
|               | 
|4.2(3)         |  | Indenture, dated as of June 2, 2003 between Credence Systems Corporation and The Bank of New York, as Trustee.        
|               | 
|4.3(3)         |  | Form of Global Note (included in Exhibit 4.3).                                                                        
|               | 
|10.4           |  | Lease and Sublease Termination Agreement between the Registrant and CARR NP Properties LLC.                           
|               | 
|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

---

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

|(2) | Incorporated by reference to Exhibit 3.2 to the Companys Quarterly Report on Form 10-Q for the quarterly period ended January 31, 2002.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-3 (File No. 333-108069) as filed with the Commission on August 19, 2003.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



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