Source: https://q10k.com/ESIO
Timestamp: 2019-04-22 22:07:25+00:00

Document:
The number of shares outstanding of the Registrant’s Common Stock as of January 25, 2019 was 34,422,361 shares.
These unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with United States generally accepted accounting principles (U.S. GAAP) have been condensed or omitted in these interim statements. Accordingly, these condensed consolidated financial statements should be read in conjunction with the financial statements and notes included in the Annual Report of Electro Scientific Industries, Inc. (the Company) on Form 10-K for its fiscal year ended March 31, 2018. These interim statements include all adjustments (consisting of only normal recurring adjustments and accruals) necessary for a fair presentation of results for the interim periods presented. The results for interim periods are not necessarily indicative of the results of operations for the entire year.
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of commitments and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results may differ from those estimates.
Management believes that the estimates used are reasonable. Estimates made by management include: revenue recognition; inventory valuation; valuation of investments; accrued restructuring costs; share-based compensation; income taxes, including the valuation of deferred tax assets; valuation of long-lived assets, including intangibles; valuation of goodwill and acquisition accounting.
The fiscal quarters ended December 29, 2018 and December 30, 2017 each consisted of 13-week periods. Similarly, the three fiscal quarters ended December 29, 2018 and the three fiscal quarters ended December 30, 2017 each consisted of 39-week periods.
On October 29, 2018, the Company signed a definitive agreement for MKS Instruments, Inc. (NASDAQ:MKSI) to acquire the Company. See Note 19: Merger Agreement for further details.
The only significant changes to the Company's significant accounting policies from those presented in Note 2: Summary of Significant Accounting Policies to the consolidated financial statements included in the Company's Annual Report on Form 10-K for its fiscal year ended March 31, 2018 were due to the adoption of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 606, "Revenue from Contracts with Customers". Changes to associated accounting policies are summarized below.
Trade receivables are stated at the amount the Company has an unconditional right to bill and generally do not bear interest, net of any estimated allowance for doubtful accounts. The Company establishes and monitors the collectability of amounts due from customers and sets appropriate credit limits based on an evaluation of the financial condition of customers and other relevant factors, including but not limited to obtaining credit ratings and customers' financial statements. With certain customers, letters of credit are obtained to mitigate credit risk. Subsequent to entering into a contract, if it is determined or expected that a customer will be unable to fully meet its financial obligation, such as in the case of a bankruptcy filing or other material events impacting its business, a specific allowance for bad debt is recorded to reduce the related receivable to the amount expected to be recovered. Bad debts are historically insignificant for the Company, and allowances for doubtful accounts are established based on actual experience.
Unbilled receivables arise when the Company has performed services and earned amounts related to a customer contract, but has not yet billed those amounts. Unbilled receivables were $1.2 million as of December 29, 2018 and $0.9 million as of March 31, 2018 and were included as a component of Trade receivables, net of allowances, on the Condensed Consolidated Balance Sheets.
Shipped systems pending acceptance represent deferred costs of sales related to systems shipped to the customer, but where revenue has been deferred pending the customer's final acceptance. These contracts also generally result in a deferred revenue contract liability. Once the criteria for revenue recognition have been met for these contracts, the deferred costs are recognized as a cost of sales together with the associated revenue.
Customer deposits are a contract liability representing amounts collected from customers prior to any performance of the contract on the part of the Company. Customer deposits are included as a component of Accrued liabilities on our balance sheet (see Note 6: Accrued Liabilities).
Deferred revenues (see Note 8: Deferred Revenue) are a contract liability representing the amount of billings for contracts where the Company has an unconditional right to consideration, in excess of revenues recognized and amounts billed. The value of customer deposits and deferred revenues will increase or decrease based on the timing of invoices and recognition of revenue.
The Company recognizes revenue according to the five steps required by ASC 606; (1) identifying the contract with a customer, (2) identifying the performance obligations in the contract, (3) determining the transaction price, (4) allocating the transaction price to performance obligations in the contract, and (5) recognizing revenue when (or as) the Company satisfies a performance obligation.
The Company's revenue streams primarily come from two sources, system sales and service sales.
Systems Revenues: The Company sells high-value capital equipment to customers and these system sales generally include the base system, supporting components (such as input devices and related tooling), and a standard warranty. The performance obligations related to system sales are generally satisfied at a point-in-time upon transfer of control. Transfer of control is determined with consideration of commercial and billing terms, physical movement, transfer of the risks and rewards of ownership, transfer of title, and customer acceptance or a track record of acceptance and any other relevant factors. If the Company has a demonstrable track record of acceptance for a system sold, the Company deems transfer of control to have occurred in accordance with commercial terms, even if customer acceptance has not been received, as the acceptance is a formality and is not considered substantive. Payment on system sales is generally due within 90 days of shipment or less. Standard warranties on systems are assurance-type warranties and are recorded as a liability at the time of shipment (see Note 7: Product Warranty).
Service Revenues: The Company offers additional services directly associated with the capital equipment it sells. These are generally in two major categories: (1) service contracts, which are generally recognized over time, and (2) point-in-time services. Service contracts recognized over time include extended service contracts (labor and materials), consumables and materials contracts, and labor-only contracts. Most service contracts recognized over time have a stated contract period and revenue is recognized over that period. Certain contracts may be consumption-based, in which case the revenue is recognized ratably in relation to the associated consumption. Service contracts are generally billed and are due in advance of the service period. Point-in-time services include spare parts sales, labor, trouble-shooting services, and similar items, and these are recognized at a point in time upon shipment or transfer of control, and are generally billed concurrent with recognition. Standard warranties on parts are assurance-type warranties and are recorded as a liability at the time of shipment (see Note 7: Product Warranty).
The Company must make various judgments and estimates that vary in level of significance and subjectivity when recognizing revenue. The primary judgments include an evaluation of any credit risk, as described in our policy on accounts receivable, the identification of variable consideration in the contract, the determination of performance obligations in a contract, the determination of standalone selling prices for performance obligations, and the determination of when performance obligations are fulfilled.
Generally, our revenue streams are subject to little variable consideration as we have minimal historical or expected future returns or other adjustments to selling price. Accordingly, standalone selling price is used to determine how to allocate the overall transaction price for a contract. Standalone selling price is based on historical transactions where available and relevant, and when not available, on a method that maximizes the use of observable inputs, which is generally a cost plus reasonable margin approach. Performance obligations are typically documented and evident from our contracts with customers and the associated triggers for transfer of control are generally objective as they are based on attributes such as shipment, customer acceptance, and other similar criteria. From time to time, however, the Company must exercise judgment to determine if transfer of control has occurred based on criteria such as whether a track record of acceptance has been established and acceptance terms are substantive, whether the risks and rewards of ownership have been transferred, or whether there are other facts and circumstances that could impact the timing and amount of revenue recognized. These judgmental determinations are made based on a weighting of all available evidence.
Revenues associated with sales to customers under local contracts in Japan are typically recognized upon title transfer, which generally occurs upon customer acceptance.
Revenues are recorded net of taxes collected from customers, which are subsequently submitted to governmental authorities.
For contracts with customers which have a duration of less than 12 months, the Company has elected the practical expedient to recognize commission costs when paid, as the amortization period would generally be one year or less. Commissions associated with contracts with a duration over 12 months are immaterial. Commission costs are recorded as a component of Selling, general and administrative expenses.
As the Company's contracts with customers generally have a duration of less than 12 months, and for certain contracts with a duration over 12 months, a right to payment exists as services are performed, the Company has elected to not disclose the remaining performance obligations for those contracts. For contracts where the Company has a right to consideration from a customer in an amount that corresponds directly to the services delivered to-date and for which the Company has a right to invoice, the Company recognizes revenue for the services rendered.
The Company's contracts are generally not paid more than 12 months in advance or more than 12 months after delivery and therefore do not typically have a significant financing element. Accordingly, the Company has elected to not assess whether a contract has a significant financing component in performing the revenue assessment.
For contracts where control transfers prior to delivery, the Company accounts for shipping and handling costs as a fulfillment cost and not as a performance obligation for revenue recognition purposes.
In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which made six targeted amendments to ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities. These amendments mostly affect the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. ASU 2018-03 became effective as of the Company's second quarter of fiscal 2019 ending September 29, 2018. Adopting ASU 2018-03 had no material effect on the Company's financial position, results of operations or cash flows.
In February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, in response the enactment of the Tax Cuts and Jobs Act (the Tax Act) and the subsequent questions and concerns of stakeholders regarding how to apply the changes to the income tax effects of deferred tax assets and liabilities sitting in accumulated other comprehensive income. The guidance eliminates the resulting stranded tax effects and improves the usefulness of the information reported to users of the financial statements. ASU 2018-02 was effective for the Company as of April 1, 2018, the beginning of fiscal 2019. Adopting ASU 2018-02 had no material effect on the Company's financial position, results of operations or cash flows.
In May 2017, the FASB issued ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting, which amends the scope of modification accounting surrounding share-based payment arrangements as issued in ASU 2016-09 by providing guidance on the various types of changes which would trigger modification accounting for share-based payment awards, specifically an entity would not apply modification accounting under ASC 718 if the fair value, vesting conditions, and classification of the awards are the same immediately before and after the modification. ASU 2017-09 was effective for the Company as of April 1, 2018, the beginning of fiscal 2019. The adoption of ASU 2017-09 had no material effect on the Company's financial position, results of operations or cash flows.
In March 2017, the FASB issued ASU 2017-07, Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which requires companies to disaggregate the current-service-cost component from other components of net benefit cost and provides specific guidance for presentation in the income statement. ASU 2017-07 was effective for the Company as of April 1, 2018, the beginning of fiscal 2019. The adoption of ASU 2017-07 had no material effect on the Company's financial position, results of operations or cash flows.
In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory, to improve and simplify the accounting for the income tax consequences of intra-entity transfers of assets other than inventory, requiring companies to recognize income tax consequences upon the transfer of the asset to a third party. ASU 2017-09 was effective for the Company as of April 1, 2018, the beginning of fiscal 2019. The adoption of ASU 2016-16 had no material effect on the Company's financial position, results of operations or cash flows.
The adoption of ASC 606 did not have a material impact on the Company's financial position, results of operations or cash flows as of and for the fiscal third quarter ended December 29, 2018 or the first three quarters of fiscal 2019 ended December 29, 2018. Additionally, we do not expect the adoption of the standard to have a material impact to our financial position on an ongoing basis.
In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement, to improve disclosures of the key provisions of ASC 820 by adding, modifying, and removing certain targeted disclosure requirements. ASU 2018-13 is effective for annual periods beginning after December 15, 2019, and interim periods within those annual periods, which would be the Company's fiscal year ending April 3, 2021. Early adoption is permitted, including adoption in any interim period, for public business entities for reporting periods for which financial statements have not yet been issued and early adoption is permitted for any removed or modified disclosure while delaying adoption of the remaining disclosures until their effective date. While the Company does not expect the adoption of ASU 2018-13 to have a material effect on its business, the Company is still evaluating any potential impact that adoption of ASU 2018-13 may have on its financial position, results of operations or cash flows.
In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, in order to (i) improve disclosures related to an entity's risk management activities through better transparency and understandability and (ii) simplify and reduce the complexity of hedge accounting by preparers. ASU 2017-12 is effective for annual periods beginning after December 15, 2018, and interim periods within those annual periods, which would be the Company's fiscal year ending March 28, 2020. Early adoption is permitted, including adoption in any interim period, for public business entities for reporting periods for which financial statements have not yet been issued. The FASB also issued ASU 2018-16 to modify and clarify portions of ASU 2017-12. While the Company does not expect the adoption of ASU 2017-12 to have a material effect on its business, the Company is still evaluating any potential impact that adoption of ASU 2017-12 may have on its financial position, results of operations or cash flows.
In February 2016, the FASB issued ASU 2016-02, Leases. ASU 2016-02 increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and requires disclosing key information about leasing arrangements. The FASB has issued ASU 2018-01, ASU 2018-11 and ASU 2018-20 to clarify and make targeted improvements to ASU 2016-02. ASU 2016-02 is effective for annual periods beginning after December 15, 2018 and interim periods within those annual periods, which would be the Company's fiscal year ending March 28, 2020. The Company is still evaluating any potential impact that adoption of ASU 2016-02 may have on its financial position, results of operations or cash flows. The Company is in the preliminary scoping phase of implementation and is currently identifying the impacted leases and preparing to perform initial quantification of the potential impacts. The Company has established a plan to develop and implement any associated business processes, as well as perform applicable accounting and reporting evaluations in advance of the effective date of the standard.
For Level 1 assets, the Company utilized quoted prices in active markets for identical assets.
For Level 2 assets, exclusive of forward contracts, the Company utilized quoted prices in active markets for similar assets. For forward contracts, spot prices at December 29, 2018 and March 31, 2018 were utilized to calculate fair values.
During the first three quarters of fiscal 2019 and fiscal 2018, there were no transfers between Level 1, 2 or 3 assets.
For purposes of determining gross realized gains and losses and reclassification out of accumulated other comprehensive income (loss), the cost of securities sold is based on specific identification. Net unrealized holding gains and losses on current available-for-sale securities included in accumulated other comprehensive income (loss) were insignificant as of December 29, 2018 and March 31, 2018.
Depreciation expense for demo and leased equipment in the first three quarters of fiscal 2019 totaled $0.6 million with no expense occurring in the third quarter of fiscal 2019. Depreciation expense for demo and leased equipment for the first three quarters of fiscal 2018 totaled $0.8 million with $0.6 million occurring in the third quarter of fiscal 2018. Of the total $7.5 million and $6.7 million of demo and leased equipment at December 29, 2018 and March 31, 2018, $1.3 million and $3.4 million were leased assets at customer sites expected to generate revenue.
Included in Other non-current assets are long-term investments held in a trust for the deferred compensation plan and other similar items.
Included in other current liabilities above are accrued amounts for value-added taxes, freight, restructuring activities and other similar items.
Net warranty charges incurred include labor charges and costs of replacement parts for repairs under warranty. These costs are recorded net of any estimated cost recoveries resulting from either successful repair of damaged parts or from warranties offered by the Company’s suppliers for defective components. The provision for warranty charges reflects the estimate of future anticipated net warranty costs to be incurred for all products under warranty at quarter end and is recorded to cost of sales. Of the total of $8.5 million and $9.0 million of product warranty accruals as of December 29, 2018 and December 30, 2017, $3.1 million and $4.5 million were non-current and were included in Other Liabilities on the Condensed Consolidated Balance Sheets.
Generally, revenue is recognized upon satisfaction of performance obligations, which includes fulfillment of acceptance criteria at the Company's factory and transfer of risk of loss and title. Revenue is deferred whenever title transfer is pending, risk of loss has not transferred, and/or acceptance criteria have not yet been fulfilled. Deferred revenue arises from, among other factors, sales to Japanese customers, shipments of substantially new products and shipments with custom specifications and other acceptance criteria where the Company cannot demonstrate a track record of acceptance. For sales involving multiple performance obligations, the stand-alone selling price of any undelivered performance obligation, is deferred until the performance obligations are delivered and acceptance criteria are met. Revenue related to maintenance and service contracts is deferred and recognized ratably over the duration of the contracts.
Of the total of $8.9 million and $12.4 million of deferred revenue at December 29, 2018 and December 30, 2017, $0.1 million and $0.4 million were non-current and were included in Other Liabilities on the Condensed Consolidated Balance Sheets. For the third quarter of fiscal 2019 and the first three quarters of fiscal 2019, revenue recognized that was included in the opening deferred revenue balance was $3.9 million and $8.4 million, respectively. For the third quarter of fiscal 2019 and the first three quarters of fiscal 2019, $0.6 million and $2.1 million of the beginning customer deposit balance was utilized in each of the periods, respectively. Customer deposits are included as a component of Accrued liabilities on our balance sheet (see Note 6: Accrued Liabilities). The amount of revenue recognized from performance obligations satisfied in prior periods was not material.
ESI Leasing, LLC (ESI Leasing), a wholly owned subsidiary of the Company, has a loan agreement (Loan Agreement) with First Technology Federal Credit Union (Lender) which provides for a term loan from the Lender to ESI Leasing in the principal amount of $14 million (Loan). The interest rate of the Loan is fixed at 4.75% per annum, except that it may be increased if certain covenants under the Loan Agreement are not satisfied and after and during the continuation of an “Event of Default” as defined in the Loan Agreement. The Loan amortizes over a period of approximately 20 years, with the outstanding principal maturing and becoming due on January 1, 2027. ESI Leasing pays monthly principal and interest payments on the Loan totaling $1.1 million annually through the maturity of the Loan. The Company unconditionally guarantees the Loan. The Company is required to maintain certain deposits with the Lender through March 31, 2019, at which point the restriction will be removed as long as it is in compliance with certain minimum covenants.
Deferred debt issuance costs related to the above long-term debt as of December 29, 2018 and March 31, 2018 were $277 thousand and $302 thousand, respectively.
See Note 20: Subsequent Events for events related to the Loan Agreement which occurred subsequent to the end of the third quarter of fiscal 2019.
The Company is party to a loan and security agreement (Credit Facility) with Silicon Valley Bank (SVB), which was initially entered into on March 20, 2015 and amended on July 12, 2016. The Credit Facility provides for a senior secured asset-based revolving facility with availability up to $30.0 million, including a $15.0 million sublimit for letters of credit. The Credit Facility expires March 20, 2019. At December 29, 2018, the Company had no amounts outstanding under the Credit Facility, was in compliance with all covenants, and was not in default under the Credit Facility. The commitment fee on the amount of unused credit was 0.3 percent. As amended, the Credit Facility allows for a greater level of EBITDA losses, but reduces the level of permitted acquisitions and purchases of capital equipment. If the Company fails to meet the covenants in its Credit Facility or its lenders fail to fund, access to the facility may be limited or the facility may become unavailable altogether.
See Note 20: Subsequent Events for events related to the Credit Facility which occurred subsequent to the end of the third quarter of fiscal 2019.
The Company mitigates credit risk by transacting with highly rated counterparties for foreign exchange contracts, letters of credit and other transactions where counterparty risk is a factor. The Company has evaluated the non-performance risks associated with the Company's lenders and other parties and believes them to be insignificant.
On or about November 29, 2018, the Company and members of the Board of Directors were named as defendants in a complaint filed in the U.S. District Court for the District of Oregon by alleged stockholders of the Company in connection with the proposed Merger. The complaint was dated November 29, 2018 and was captioned Brian Morris et. al. v. Electro Scientific Industries, Inc. et al. Five additional complaints were subsequently filed, two in the U.S. District Court for the District of Oregon and three in the Multnomah County Circuit Court in the State of Oregon. The cases filed in the U.S. District Court were dated December 6, 2018 and December 12, 2018 and captioned Melvyn Klein et. al. v. Electro Scientific Industries, Inc. et al. and Donald Mager et. al. v. Electro Scientific Industries, Inc. et al., respectively. The complaints filed in Multnomah County Circuit Court were dated December 5, 2018, December 5, 2018 and December 13, 2018 and captioned Michael Kent et. al v. Electro Scientific Industries, Inc. et al., Christopher Stanley et. al v. Electro Scientific Industries, Inc. et al. and Eduardo Colmenares et. al. v. Electro Scientific Industries, Inc. et al.
These lawsuits are purported class actions brought on behalf of Company stockholders, asserting various claims against members of the Board of Directors, MKS, and Merger Sub, including breach of fiduciary duty and aiding and abetting breach of fiduciary duty. The lawsuits allege that the Merger does not appropriately value the Company, and that the Company’s Merger related disclosures fail to disclose certain material information regarding the Merger. These complaints purport to seek unspecified damages and may seek injunctive relief preventing the consummation of the Merger.
The Company believes that the claims in these complaints are without merit and intends to vigorously defend this litigation. The Company provided supplemental Merger related disclosures to eliminate the burden and expense of litigation and to avoid any possible disruption to the Merger that could result from further litigation. An adverse judgment for monetary damages could have an adverse effect on the operations of the Company. A preliminary injunction could delay or jeopardize the completion of the Merger, and an adverse judgment granting permanent injunctive relief could indefinitely enjoin completion of the Merger.
The Company may also be party to various other litigations arising in the normal course of business. Currently, the Company is not party to any other litigation it believes would have a material adverse effect on the Company's financial position, results of operations or cash flows.
In December 2011, the Board of Directors authorized a share repurchase program totaling $20.0 million to acquire shares of the Company's outstanding common stock. The repurchases are to be made at management’s discretion in the open market or in privately negotiated transactions in compliance with applicable securities laws and other legal requirements and are subject to market conditions, acceptable share price and other factors. The Company did not repurchase any shares during fiscal 2018 or the first three quarters of fiscal 2019. There is no expiration date for the repurchase program and $18.3 million still remains for future repurchases.
The Company's share-based compensation consists of restricted stock unit awards with a service condition (time-based RSUs), restricted stock unit awards with a market performance condition (market-based RSUs), restricted stock unit awards with a performance condition other than market performance (performance-based RSUs), an employee stock purchase plan and stock-settled stock appreciation rights (SARs).
The fair value of time-based and performance-based restricted stock units (RSUs) are measured on the grant date based on the market value of the Company's common stock. The market-based RSUs must achieve the total shareholder return (TSR) measures in order for the awards to vest, and the grant date fair value of the awards is calculated using a Monte Carlo simulation model. The Company recognizes expense related to the fair value of the 1990 Employee Stock Purchase Plan (ESPP) and SARs using the Black-Scholes model to estimate the fair value of awards on the date of grant.
Except for performance-based RSUs, the Company recognizes compensation expense for all share-based compensation awards, net of estimated forfeitures, on a straight-line basis over the requisite service period of the award. Expense for performance-based RSUs is recognized based on the probability of achievement of the performance criteria. The compensation cost for market-based RSUs is recognized over the related service period, even if the market condition is never satisfied. The impact of adjustments related to awards where the requisite service period was not completed is reflected as an offset to current period shared-based compensation expense.
The Company granted a total of 277,915 time-based RSUs and 92,500 market-based RSUs during the first three quarters of fiscal 2019, but did not grant any SARs or performance-based RSUs. No time-based RSUs were granted during the third quarter of fiscal 2019.
The Company incurred $25 thousand of capitalizable share-based compensation costs during the first three quarters of fiscal 2019. The capitalizable cost was incurred for internal labor hours allocated to the enterprise resource planning software and related systems implementation, which will support the Company's operating and financial functions. No capitalized share-based compensation costs were incurred during fiscal 2018. As of December 29, 2018, the Company had $9.5 million of total unrecognized share-based compensation costs, net of estimated forfeitures, which are expected to be recognized over a weighted average period of 1.8 years.
Operating segments are defined as components of an enterprise about which separate financial information is available and evaluated regularly by the chief operating decision maker (CODM) in deciding how to allocate resources and in assessing performance. The Company's CODM is its Chief Executive Officer (CEO).
The Company and its consolidated subsidiaries operate in a single segment, defined as a manufacturer of high-technology microfabrication and related equipment. This segment sells products into a variety of end markets that are grouped into four major categories for the purpose of providing an understanding of the principal end markets for the products manufactured by the Company, specifically: (1) Printed Circuit Board (PCB), (2) Component Test, (3) Semiconductor, and (4) Industrial Machining. Service sales are interrelated with all major end markets of the Company and are separately presented.
In the fourth quarter of 2017, the Company initiated a restructuring plan to improve business effectiveness and streamline operations to achieve a stated target profit level for the Company as a whole. As a part of the restructuring plan, the management team was reorganized from a business unit to a functional structure; the Company closed facilities in Montreal, Canada; Napa, California; and Sunnyvale, California; the Company discontinued certain products; and the Company made select reductions in headcount across the Company. Actions under this plan were completed as of the end of the third quarter of fiscal 2018.
Total expenses related to the plan were $17.1 million in 2018, while no expenses have been incurred in the first three quarters of fiscal 2019. Included in the fiscal 2018 expenses are approximately $13.3 million of charges impacting gross margins, all incurred in the first and second quarters of fiscal 2018, primarily related to impairment of other assets and inventory stemming from the product portfolio program reviews which resulted in discontinuing certain products. Operating expense charges included $2.3 million of facilities and fixed assets charges related to streamlining facilities and discontinued products and $1.3 million of employee severance and related costs. Product portfolio reviews related to the restructuring plan were completed as of the end of the third quarter of fiscal 2018. The impacts of the decisions made in the portfolio reviews involve the use of certain estimates.
(1) Current asset impairments include inventory charges recorded in cost of sales.
The Company's previously disclosed other restructuring plans are largely complete. No net restructuring costs related to these plans were recorded in the first three quarters of fiscal 2019 while $0.4 million were recorded in fiscal 2018. The Company does not expect to incur additional expenses related to these plans.
As of December 29, 2018, and March 31, 2018, the amount of unpaid restructuring costs included in accrued liabilities on the Consolidated Balance Sheets were $0.1 million and $0.4 million, respectively. Included in the payable balance are amounts for severance and employee benefits, and net lease commitments.
The Tax Cuts and Jobs Act (the Tax Act) was enacted into law in the United States on December 22, 2017. The Tax Act includes various changes to the tax law, including a reduction in the U.S. corporate income tax rate from 35% to 21%.
The Tax Act added section 250 to the Internal Revenue Code, effectively creating a new preferential tax rate for income derived by domestic corporations from serving foreign markets. The new deduction is described as a deduction for foreign-derived intangible income. This lower tax rate provides a new benefit for owning intangible property and conducting business operations in the United States.
The Tax Act also includes a base erosion and anti-abuse tax (BEAT), applicable to corporations with annual gross receipts of at least $500 million for the prior 3-years, which requires U.S. multinationals making “excessive” deductible payments to their foreign affiliates to pay a 10 percent tax on their income without those deductions, after a one-year, 5 percent transition rate. The Company does not expect the BEAT provisions to apply until it meets the threshold. Further the Tax Act imposes a tax on global intangible low-taxed income (GILTI) on controlled foreign corporations’ aggregate net income over a 10% benchmark return on qualified business asset investment less interest expense. The Company continues to assess the impacts of these provisions on the Company’s financial position, results of operations or cash flows.
The Securities and Exchange Commission Staff Accounting Bulletin No. 118 (SAB 118) allows the use of provisional amounts in the Company’s financial statements during a measurement period if accounting for the income tax effects of the Tax Act has not been completed when the Company’s financial statements are issued. The Company has evaluated the new legislation and the additional technical guidance from the Department of Treasury, the FASB, and other relevant rule-making bodies issued to date and updated our financial position, results of operations, and cash flows based upon the available information. The SAB 118 impact relative to net income is an annual tax benefit of $1.8 million representing a 3.1% impact to the effective tax rate for the first three quarters and 31.5% impact to the third quarter. The accounting for the income tax effects of the Act are now complete.
RSUs and SARs representing an additional 0.1 million shares of stock for the third quarter of fiscal 2018 and 0.4 million shares of stock for the first three quarters of fiscal 2018 were not included in the calculation of diluted net earnings per share because their effect would have been antidilutive. Antidilutive shares were immaterial for the third quarter of fiscal 2019 and the first three quarters of fiscal 2019.
On October 29, 2018, the Company entered into an Agreement and Plan of Merger (the Merger Agreement) with MKS Instruments, Inc., a Massachusetts corporation (MKS) and EAS Equipment, Inc., a Delaware corporation and a wholly owned subsidiary of MKS (Merger Sub). The Merger Agreement provides for, subject to the terms and conditions of the Merger Agreement, the acquisition of the Company by MKS at a price of $30.00 per share in cash, without interest and subject to deduction for any required withholding tax, through the merger of Merger Sub into the Company (the Merger), with the Company surviving the Merger as a wholly owned subsidiary of MKS.
The Company incurred $4.3 million of merger and integration related costs during the third quarter of fiscal 2019.
See Note 20: Subsequent Events for events related to the Merger Agreement which occurred subsequent to the end of the third quarter of fiscal 2019.
On January 10, 2019, the Company held a special meeting of shareholders, and the Company's shareholders voted to approve the previously announced definitive merger agreement with MKS. All necessary regulatory and shareholder approvals are now complete, and subject to the satisfaction of certain remaining customary closing conditions, the transaction is expected to close in early February 2019. Upon the closing of the transaction, trading of the Company's shares on NASDAQ will cease.
On January 17, 2019 and in preparation for the merger with MKS, the Company terminated its Loan Agreement with the Lender, as referenced in Note 9: Long-term Debt, and extinguished the outstanding Loan by way of a $12.9 million cash payment. As part of the termination of the Loan Agreement, the deposit restrictions placed by the Lender on the Company are no longer required.
On January 17, 2019 and in preparation for the merger with MKS, the Company terminated its Credit Facility with SVB, as referenced in Note 10: Revolving Credit Facility, and extinguished any and all outstanding amounts under the Credit Facility.
The statements contained in this report that are not statements of historical fact, including without limitation statements containing the words “believes”, “expects”, “projects”, “anticipates,” “plan,” “continue,” “could,” “estimates,” “intends,” “should,” “will,” “may” and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties. Forward looking statements include any statements regarding anticipated sales, gross margins, our profitability in future periods, our proposed Merger with MKS, our expectations regarding customer processes and our products, our strategies and beliefs regarding the markets in which we compete or may compete and our product development plans to address these markets, the sufficiency of our financial resources to meet our working capital needs for at least the next 12 months, our expectations regarding taxes and tax adjustments, particularly with respect to the Tax Act, our expectations regarding various legal matters, our ability to rapidly increase our production capacity to accommodate demand, sources of our future revenue, the effect of new or recently adopted accounting standards on our business, financial results, results of operations or cash flows, future impairment of goodwill, future anticipated net warranty costs, our products’ ability to satisfy the needs of manufacturers, our relationships with suppliers and customers, trends that drive increases in applications for laser processing, the size and growth of our markets, increased use of our MLCC components, strong global demand for consumer electronics, automotive and other devices using radio frequency for communications, our expected inventory levels, our expected capital expenditures over the next 12 months, our growth of foreign operations, our customer concentrations, the adequacy of our liquidity and financing and our expectations regarding access to credit and our compliance with the covenants of our Credit Facility, our expectation that we will invest in new product development and enhancements, and our working capital requirements and resources. From time to time, we may make other forward-looking statements. Investors are cautioned that such forward-looking statements involve estimates, assumptions, risks, and uncertainties and are subject to an inherent risk that actual results may differ materially. Factors that may cause or contribute to differences include those discussed below in Item 1A Risk Factors.
Electro Scientific Industries, Inc., and its wholly-owned subsidiaries (ESI, we, our, or the Company), is a leading supplier of innovative laser-based microfabrication solutions for industries reliant on microtechnologies. ESI enables its customers to commercialize technology using precision laser processes. ESI's solutions produce the industry's highest quality and throughput, and we target the lowest total cost of ownership. Founded in 1944, ESI is headquartered in Portland, Oregon, with global operations and subsidiaries in Asia, Europe and North America.
Laser microfabrication comprises a set of precise micron-level processes, including drilling, scribing, dicing, singulation, cutting, ablating, trimming, and precision marking on multiple types of materials. These processes require application-specific laser systems that are able to meet our customers’ exacting performance and productivity requirements. Our laser-based systems are utilized in the production of flexible and rigid printed circuit board (PCB), semiconductor devices, advanced semiconductor packaging, consumer electronics, electronic sensors, touch-panel glass, flat panel liquid crystal displays (LCDs), organic light emitting diode (OLED) displays, applications within the automotive, aerospace, medical and display end markets as well as other high-value components and devices to enable functionality, increase performance and improve production yields.
Additionally, we produce high-capacity test and inspection equipment that is critical to the quality control process during the production of multilayer ceramic capacitors (MLCCs). Our equipment ensures that each component meets the electrical and physical tolerances required to perform properly.
The third quarter of fiscal 2019 ended December 29, 2018, the second quarter of fiscal 2019 ended September 29, 2018, and the third quarter of fiscal 2018 ended December 30, 2017 were all 13-week periods. Similarly, the three fiscal quarters ended December 29, 2018 and the three fiscal quarters ended December 30, 2017 each consisted of 39-week periods.
Merger Agreement with MKS Instruments, Inc.
On October 29, 2018, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with MKS Instruments, Inc., a Massachusetts corporation (MKS) and EAS Equipment, Inc., a Delaware corporation and a wholly owned subsidiary of MKS (Merger Sub). The Merger Agreement provides for, among other things, the acquisition by MKS of the Company. See Note 19: Merger Agreement of the Notes to Condensed Consolidated Financial Statements for additional information. Please also see Item 1A. Risk Factors. See Note 20: Subsequent Events for events related to certain closing conditions of the Merger and the Loan Agreement which occurred subsequent to the end of the third quarter of fiscal 2019.
Total net sales decreased from the second quarter of fiscal 2019 by 21% to $67.9 million in the third quarter of fiscal 2019 primarily driven by decreased sales in the PCB market due to a softening in demand for flex products as customers continue to absorb the significant level of shipments over the last two years. The declines in PCB market sales were partially offset by continued increases in sales to the Component Test market due to increased use of MLCC components, particularly in consumer electronics and automotive applications, which require our tools for processing.
Gross margin was 38.5% in the third quarter of fiscal 2019, down from 45.5% in the second quarter of fiscal 2019, primarily due to change in product mix and lower net sales.
Operating expenses were $22.3 million in the third quarter of fiscal 2019, and represent a $2.4 million increase compared to the second quarter of fiscal 2019. The increase was primarily driven by $4.3 million of merger related costs such as legal and professional fees.
Net income was $0.18 per diluted share, compared to $0.47 per share in the prior quarter, on lower sales and gross profit combined with higher operating expenses.
Net sales for the third quarter of fiscal 2019 was $67.9 million, a decrease of $42.9 million or 39% when compared to net sales for the third quarter of fiscal 2018.
Sales of products into the PCB market for the third quarter of fiscal 2019 decreased $67.5 million or 88% compared to the third quarter of fiscal 2018. During the third quarter of fiscal 2018, the flex market was in a period of very strong market demand driven by unit growth in consumer electronics and associated capacity additions plus new materials, technologies and applications that required increased levels of complex flexible circuits. Now that the market is absorbing the capacity added as a result of the strong demand environment, we're seeing significant declines, as evidenced by our third quarter of fiscal 2019 PCB sales.
Sales of products into the Component Test market for the third quarter of fiscal 2019 increased $25.4 million or 390% compared to the third quarter of fiscal 2018, primarily driven by equipment capacity shortages resulting from increased demand for MLCC components, particularly in consumer electronics and automotive applications, many of which require our tools for processing.
Sales of products into Semiconductor applications for the third quarter of fiscal 2019 increased $1.8 million or 17% compared to the third quarter of fiscal 2018. This increase was primarily driven by increased sales of our wafer mark systems.
Sales of products into Industrial Machining applications for the third quarter of fiscal 2019 decreased $3.4 million or 64% compared to the third quarter of fiscal 2018. This was primarily due to decreased sales of micromachining systems into PCB cutting applications.
Service revenues for the third quarter of fiscal 2019 increased $0.8 million or 7% compared to the third quarter of fiscal 2018. The increase was primarily driven by increased time and materials contracts resulting from products that we shipped in the last 18 months beginning to come off their warranty period.
Net sales to Asia decreased by $46.3 million or 45% primarily due to lower sales of flex tools to the PCB market on softening demand and overcapacity, partially offset by higher sales of our MLCC testing tools.
Gross profit was $26.1 million for the third quarter of fiscal 2019, a decrease of $27.0 million compared to $53.2 million in the third quarter of fiscal 2018. The gross profit decrease was primarily driven by lower net system sales and changes in mix to lower profit systems.
Selling, general and administration (SG&A) expenses primarily consist of labor and other employee-related expenses, including share-based compensation expense, travel expenses, professional fees, sales commissions and facilities costs. SG&A expenses for the third quarter of fiscal 2019 decreased $1.7 million compared to the third quarter of fiscal 2018. The decrease was primarily driven by lower variable expenses and restructuring actions taken in the prior year.
Research, development and engineering (RD&E) expenses primarily comprise labor and other employee-related expenses, including share-based compensation expense, professional fees, project materials costs, equipment costs and facilities costs. RD&E expenses for the third quarter of fiscal 2019 increased $0.4 million compared to the third quarter of fiscal 2018, primarily due to increased consulting and materials costs related to investment in new product development.
In the fourth quarter of fiscal 2017, we initiated a restructuring plan to improve business effectiveness, streamline operations and achieve a stated target cost level for the Company as a whole. Restructuring costs of $0.7 million in the third quarter of fiscal 2018 primarily related to severance payments made to a departed executive. There were no restructuring costs in the third quarter of fiscal 2019. See Note 16: Restructuring and Cost Management Plans for further discussion.
In the third quarter of fiscal 2019, the Company incurred $4.3 million of merger related costs such as legal and professional fees related to the Merger. See Note 19: Merger Agreement, and Note 20: Subsequent Events.
Non-operating income, net, consists of interest income and expense, market gains and losses on non-operating assets, realized and unrealized foreign exchange gains and losses, bank charges, investment management fees, gains related to the sale of the LAD business and other miscellaneous non-operating items, such as investment impairment. Net non-operating income was $2.0 million in the third quarter of fiscal 2019 compared to $0.8 million in the third quarter of fiscal 2018. The increased income in the third quarter of fiscal 2019 was primarily due to $1.6 million of gain related to the finalization of our laser ablation asset sale compared to $0.6 million of gain in the third quarter of fiscal 2018.
The income tax benefit for the third quarter of fiscal 2019 was $0.5 million on pretax income of $5.9 million for an effective tax rate of (8.2)%, compared to a $61 thousand tax provision on pretax income of $34.0 million for an effective tax rate of 0.2% in the third quarter of fiscal 2018. The 2019 effective tax rate is lower due to lower corporate tax rates, inclusion of foreign derived intangible income tax deduction and the completion of SAB 118 measurement period resulting in a current quarter benefit of 31.5% and release of additional valuation allowance.

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