Edgar Filing: ELECTRO SCIENTIFIC INDUSTRIES INC

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended February 25, 2006

¨	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: 0-12853

ELECTRO SCIENTIFIC INDUSTRIES, INC.


Oregon		93-0370304
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

13900 N.W. Science Park Drive, Portland, Oregon		97229
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number: (503) 641-4141

Registrant’s web address: www.esi.com

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file 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 shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x

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” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨

The number of shares outstanding of the Registrant’s Common Stock at March 21, 2006 was 28,995,039 shares.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

TABLE OF CONTENTS


		Page
PART I - FINANCIAL INFORMATION

Item 1.	Consolidated Condensed Financial Statements (unaudited)

	Consolidated Condensed Balance Sheets – February 25, 2006 and May 28, 2005	2

	Consolidated Condensed Statements of Operations – Three Months and Nine Months Ended February 25, 2006 and February 26, 2005	3

	Consolidated Condensed Statements of Cash Flows – Nine Months Ended February 25, 2006 and February 26, 2005	4

	Notes to Consolidated Condensed Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	30

Item 4.	Controls and Procedures	30

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	31

Item 6.	Exhibits	32

Signatures		33

PART I - FINANCIAL INFORMATION

Item 1.

Financial Statements

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands)

(Unaudited)


	February 25, 2006			May 28, 2005
Assets
Current assets:
Cash and cash equivalents	$	94,764		$	61,314
Marketable securities		129,779			137,753

Total cash and securities		224,543			199,067
Trade receivables, net of allowances of $671 and $833		47,382			36,163
Income tax refund receivable		1,227			9,227
Inventories		61,031			59,533
Shipped systems pending acceptance		4,700			4,014
Deferred income taxes		12,442			10,930
Prepaid and other current assets		4,367			3,169

Total current assets		355,692			322,103
Long-term marketable securities		960			19,834
Property, plant and equipment, net of accumulated depreciation of $49,902 and $45,598		42,273			32,959
Deferred income taxes, net		13,111			16,955
Other assets		17,420			11,706

Total assets	$	429,456		$	403,557

Liabilities and shareholders’ equity
Current liabilities:
Accounts payable	$	9,080		$	3,961
Accrued liabilities		24,234			29,455
Deferred revenue		15,637			12,986

Total current liabilities		48,951			46,402
Commitments and contingencies
Shareholders’ equity:
Preferred stock, without par value; 1,000 shares authorized; no shares issued		—			—
Common stock, without par value; 100,000 authorized; 28,993 and 28,615 shares issued and outstanding		165,248			156,367
Retained earnings		216,091			201,199
Accumulated other comprehensive loss		(834	)		(411	)

Total shareholders’ equity		380,505			357,155

Total liabilities and shareholders’ equity	$	429,456		$	403,557

The accompanying notes are an integral part of these statements.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)


	For the three months ended						For the nine months ended
	February 25, 2006			February 26, 2005			February 25, 2006			February 26, 2005
Net sales	$	55,937		$	49,084		$	149,088		$	187,708
Cost of sales		31,040			27,646			83,376			96,558

Gross profit		24,897			21,438			65,712			91,150
Operating expenses:
Selling, service and administration		11,287			12,290			33,729			42,494
Research, development and engineering		8,708			6,400			24,520			20,706

		19,995			18,690			58,249			63,200

Operating income		4,902			2,748			7,463			27,950
Interest income		2,087			1,867			5,963			5,190
Interest expense		(130	)		(1,784	)		(188	)		(5,356	)
Other expense, net		(158	)		(161	)		(465	)		(485	)

		1,799			(78	)		5,310			(651	)

Income before income taxes		6,701			2,670			12,773			27,299
Provision for (benefit from) income taxes		(3,656	)		672			(2,119	)		6,709

Net income	$	10,357		$	1,998		$	14,892		$	20,590

Net income per share - basic	$	0.36		$	0.07		$	0.52		$	0.73

Net income per share - fully diluted	$	0.35		$	0.07		$	0.51		$	0.72

Weighted average number of shares - basic		28,904			28,492			28,751			28,383

Weighted average number of shares - fully diluted		29,256			28,600			29,022			28,533

The accompanying notes are an integral part of these statements.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	For the nine months ended
	February 25, 2006			February 26, 2005
Cash flows from operating activities:
Net income	$	14,892		$	20,590
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization		6,886			7,176
Tax benefit of stock options exercised		1,525			637
Provision for doubtful accounts		(167	)		199
Loss on disposal of property and equipment		56			281
Deferred income taxes		2,347			6,271
Changes in operating accounts:
(Increase) decrease in trade receivables, net		(11,796	)		16,645
(Increase) decrease in income tax refund receivable		8,000			(1,642	)
Increase in inventories		(685	)		(11,781	)
(Increase) decrease in shipped systems pending acceptance		(686	)		3,059
Increase in prepaid and other current assets		(1,229	)		(1,346	)
Increase (decrease) in accounts payable and accrued liabilities		579			(18,407	)
Increase (decrease) in deferred revenue		2,651			(3,413	)

Net cash provided by operating activities		22,373			18,269
Cash flows from investing activities:
Purchase of property, plant and equipment		(15,211	)		(3,397	)
Proceeds from the sale of property and equipment		—			92
Proceeds from the sale of assets held for sale		—			2,361
Maturity of restricted securities		—			6,251
Purchase of securities		(487,296	)		(355,011	)
Proceeds from sales of securities and maturing securities		513,875			393,938
Increase in other assets		(6,633	)		(827	)

Net cash provided by investing activities		4,735			43,407
Cash flows from financing activities:
Proceeds from exercise of stock options and stock plans		6,342			5,690

Net cash provided by financing activities		6,342			5,690

Net change in cash and cash equivalents		33,450			67,366
Cash and cash equivalents:
Beginning of period		61,314			80,358

End of period	$	94,764		$	147,724

Supplemental cash flow information:
Cash paid for interest	$	(104	)	$	(6,163	)
Income tax refunds received		8,718			4
Cash paid for income taxes		(1,817	)		(3,376	)

The accompanying notes are an integral part of these statements.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

Note 1 - Basis of Presentation

These unaudited interim consolidated condensed 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 U.S. generally accepted accounting principles have been condensed or omitted in these interim statements. Accordingly, 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. These consolidated condensed financial statements are to be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K.

Results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.

Note 2 - Inventories

Inventories are principally valued at standard costs, which approximate the lower of cost (on a first-in, first-out basis) or market. Components of inventories were as follows (in thousands):


	February 25, 2006		May 28, 2005
Raw materials and purchased parts	$	39,617	$	37,367
Work-in-process		6,945		4,471
Finished goods		14,469		17,695

	$	61,031	$	59,533

Note 3 – Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):


	February 25, 2006		May 28, 2005
Payroll-related	$	7,925	$	8,275
Product warranty		3,443		3,625
Accrual for loss on purchase commitments		293		343
Income taxes payable		4,520		11,623
Other		8,053		5,589

	$	24,234	$	29,455

See Note 4 for a discussion of the accrual for product warranty.

Note 4 – Product Warranty

The Company evaluates obligations related to product warranties quarterly. A standard one-year warranty is provided on products. Warranty charges are comprised of costs to service the warranty, including labor to repair the system and replacement parts for defective items, as well as other costs incidental to the repairs. Inventory credits resulting from the return of repaired parts to inventory and any cost recoveries from warranties offered by our suppliers for defective components are recorded as a credit to the warranty accrual. Using historical data, the Company estimates average warranty cost per system or part type and records the provision for such charges as an element of cost of goods sold. Additionally, the overall warranty accrual balance is separately analyzed using the remaining warranty periods outstanding on systems and items under warranty, and any resulting changes in estimates are recorded as an adjustment to cost of sales. If circumstances change, or if a material change in warranty-related incidents occurs, the estimate of the warranty accrual could change significantly. Accrued product warranty is included on the balance sheet as a component of accrued liabilities.

Following is a reconciliation of the change in the aggregate accrual for product warranty for the nine months ended February 25, 2006 and February 26, 2005 (in thousands):


	February 25, 2006			February 26, 2005
Product warranty accrual, beginning	$	3,625		$	4,720
Warranty charges incurred		(6,951	)		(8,037	)
Inventory credits		3,157			3,362
Provision for warranty charges		3,612			3,975

Product warranty accrual, ending	$	3,443		$	4,020

Note 5 – Deferred Revenue

Revenue is deferred pending title transfer and fulfillment of acceptance criteria, which frequently occur at the time of delivery to a common carrier. Shipments for which title transfer has not occurred and/or acceptance criteria cannot be demonstrated at the Company’s factory include sales to Japanese end-user customers and shipments of substantially new products. In sales involving multiple element arrangements, the fair value of any undelivered elements, including installation services, is deferred until the elements 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.

The following is a reconciliation of the changes in deferred revenue for the nine months ended February 25, 2006 and February 26, 2005 (in thousands):


	February 25, 2006			February 26, 2005
Deferred revenue, beginning	$	12,986		$	11,985
Revenue deferred		17,757			16,847
Revenue recognized		(15,106	)		(20,259	)

Deferred revenue, ending	$	15,637		$	8,573

Note 6 - Earnings Per Share

Following is a reconciliation of weighted average shares outstanding and adjustments to net income used in the calculation of basic and diluted earnings per share (EPS) for the three months and nine months ended February 25, 2006 and February 26, 2005 (in thousands):


	Three months ended February 25, 2006			Three months ended February 26, 2005
	Income		Shares	Income		Shares
Net income available to common shareholders – basic	$	10,357	28,904	$	1,998	28,492
Effect of dilutive stock compensation		—	352		—	108

Net income available to common shareholders – fully diluted	$	10,357	29,256	$	1,998	28,600


	Nine months ended February 25, 2006			Nine months ended February 26, 2005
	Income		Shares	Income		Shares
Net income available to common shareholders – basic	$	14,892	28,751	$	20,590	28,383
Effect of dilutive stock compensation		—	271		—	150

Net income available to common common shareholders – fully diluted	$	14,892	29,022	$	20,590	28,533

The following common stock equivalents were excluded from the diluted EPS calculations because inclusion would have had an antidilutive effect (in thousands):


	Three months ended		Nine months ended
	February 25, 2006	February 26, 2005	February 25, 2006	February 26, 2005
Employee stock options	1,788	3,316	2,610	3,462
4¹/4% convertible subordinated notes	—	3,816	—	3,816

	1,788	7,132	2,610	7,278

Note 7 - Comprehensive Income

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


	Three months ended					Nine months ended
	February 25, 2006			February 26, 2005		February 25, 2006			February 26, 2005
Net income	$	10,357		$	1,998	$	14,892		$	20,590
Net unrealized gain (loss) on foreign exchange hedge contracts		(26	)		18		3			24
Foreign currency translation adjustment		433			128		(157	)		672
Net unrealized gain (loss) on securities classified as available for sale		(121	)		34		(269	)		563

	$	10,643		$	2,178	$	14,469		$	21,849

Note 8 – Stock Based Compensation Plans

The Company has elected to use the intrinsic value method under APB No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation, subsequently amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, to account for stock options, stock bonuses, restricted stock, time-based restricted stock units or performance-based restricted stock units issued to its employees under its stock compensation plans, and amortizes deferred compensation, if any, ratably over the vesting period of the awards.

Compensation expense resulting from the issuance of fixed term stock option awards is measured as the difference between the exercise price of the option and the fair market value of the underlying share of company stock subject to the option on the measurement date, which is typically the award’s grant date. Compensation expense, if any, is included in operating results over the vesting period of the underlying options using the straight-line method. Compensation expense resulting from the issuance of time-based restricted stock and restricted stock units is calculated based on the fair market value on the date of grant and is included in operating results over the related vesting period using the straight line method. Compensation expense resulting from the issuance of performance-based restricted stock units is recorded when performance is probable and can be reasonably estimated, and is calculated based upon current fair market values (adjusted each period) until such time as the number of units an employee is entitled to receive is fixed or determinable. During the first three quarters of fiscal 2006 and fiscal 2005, the Company recorded $1.0 million and $0.8 million, respectively, of compensation expense related to stock options and grants of restricted stock and restricted stock units on a pre-tax basis. No compensation cost has been recognized for employee stock purchase plan (ESPP) shares which are issued at a fifteen percent discount of the lower of the market price on either the first day of the applicable offering period or the purchase date.

Pro forma fair value disclosures required by SFAS No. 123 are presented below and reflect the impact on net income (loss) and net income (loss) per share as if the fair value of stock-based awards to employees had been applied (in thousands, except per share data):


	Three months ended						Nine months ended
	February 25, 2006			February 26, 2005			February 25, 2006			February 26, 2005
Net income, as reported	$	10,357		$	1,998		$	14,892		$	20,590
Add – Stock-based employee compensation expense included in reported net income, net of related tax effects		50			260			649			531
Deduct – total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(2,339	)		(5,590	)		(7,154	)		(19,586	)

Net income (loss), pro forma	$	8,068		$	(3,332	)	$	8,387		$	1,535

Net income per share – basic, as reported	$	0.36		$	0.07		$	0.52		$	0.73

Net income per share – fully diluted, as reported	$	0.35		$	0.07		$	0.51		$	0.72

Net income (loss) per share – basic, pro forma	$	0.28		$	(0.12	)	$	0.29		$	0.05

Net income (loss) per share – fully diluted, pro forma	$	0.27		$	(0.12	)	$	0.29		$	0.05

The Black-Scholes option pricing model is utilized to determine the fair value of stock options under SFAS No. 123. The following weighted average assumptions were made in calculating the value of all options granted during the periods presented:


	Three months ended				Nine months ended
	February 25, 2006		February 26, 2005		February 25, 2006		February 26, 2005
Risk-free interest rate	4.28	%	3.60	%	3.98	%	3.58	%
Expected dividend yield	0	%	0	%	0	%	0	%
Expected lives	4.9 years		5.7 years		5.0 years		5.6 years
Expected volatility	54.36	%	65.91	%	58.61	%	65.66	%

The following weighted average assumptions were made in calculating the value of all shares issued under the ESPP during the periods presented:


	Three months ended				Nine months ended
	February 25, 2006		February 26, 2005		February 25, 2006		February 26, 2005
Risk-free interest rate	4.33	%	2.33	%	4.09	%	2.30	%
Expected dividend yield	0	%	0	%	0	%	0	%
Expected lives	1.1 years		1.3 years		1.1 years		1.2 years
Expected volatility	34.88	%	54.39	%	41.31	%	54.40	%

Note 9 – Restructuring and Cost Management Plans

In December 2004, the Company announced a restructuring plan to streamline its infrastructure. This plan, which was effective in early January 2005, resulted in a decrease in workforce of 57 employees in the United States and impacted manufacturing, sales, marketing and administration and research, development and engineering. Charges incurred of approximately $1.2 million related to the plan were primarily comprised of severance and other employee-related charges. These amounts were paid during the third quarter of fiscal 2005 and are included in the consolidated condensed statements of operations for the three and nine months ended February 26, 2005 as follows (in thousands):


	Three and nine months ended February 26, 2005
Cost of sales	$	299
Selling, service and administrative		683
Research, developments and engineering		262

Total restructuring and cost management expenses	$	1,244

Note 10 – Income Taxes

The income tax benefit for the third quarter of fiscal 2006 was $3.7 million on pre-tax income of $6.7 million. The third quarter tax benefit resulted from a $5.3 million reduction in accrued income taxes due to the statutory closure of various tax years, offset by income tax expense of $1.6 million. The income tax provision for the third quarter of fiscal 2005 was $0.7 million on pre-tax income of $2.7 million.

The income tax benefit for the nine months ended February 25, 2006 was $2.1 million on pre-tax income of $12.8 million. The year-to-date tax benefit resulted from a $5.3 million reduction in accrued income taxes as discussed above, offset by income tax expense of $2.7 million and other discrete income tax expense items totaling $0.5 million. The income tax provision for the nine months ended February 26, 2005 was $6.7 million on pre-tax income of $27.3 million.

Note 11 – Legal Proceedings

On August 24, 2005, the Company executed a Provisional Attachment Order (the Attachment Order) issued by the Kaohsiung District Court of Taiwan (the Court) directed against All Ring Tech Co., Ltd. (All Ring) of Taiwan. In its petition requesting the Attachment Order, the Company alleged that All Ring’s Capacitor Tester Model RK-T6600 (the Capacitor Tester) infringes the Company’s Taiwan Patent No. 207469, entitled “Circuit Component Handler” (the 207469 patent). This patent corresponds to the Company’s U.S. Patent No. 5,842,579. The patented technology is used in the Company’s Model 3340 Multifunction MLCC Tester. All Ring has filed a bond with the Court to obtain relief from the attachment of its assets. The bond provides security to the Company with respect to its patent infringement claim against All Ring.

On September 19, 2005, the Court granted the Company’s petition for a Preliminary Injunction, and issued a Preliminary Injunction Order that prohibits All Ring from manufacturing, selling, offering for sale or using the Capacitor Tester, or importing the Capacitor Tester for any of these purposes, until final judgment is entered in the formal patent infringement action. Pursuant to the Court’s Order, the Company was required to post with the Court a Taiwan dollar security bond, which is included in Other Assets on the accompanying consolidated condensed balance sheet at February 25, 2006, and is valued at approximately US$7.0 million. The Court then executed the Preliminary Injunction Order in late October 2005. All Ring appealed the Preliminary Injunction Order on November 1, 2005, and the Company opposed the appeal. The High Court denied All Ring’s appeal on January 9, 2006. On November 10, 2005, All Ring filed a petition to post a counterbond to revoke the execution of the Preliminary Injunction Order, and the Company filed an opposition to the petition on December 2, 2005. The Court granted the counterbond petition on December 14, 2005. The Court’s order allows All Ring to obtain relief from the Preliminary Injunction Order if it posts a bond in the amount of approximately US$7.0 million. The Company appealed the counterbond order on December 30, 2005. The High Court has not yet decided the appeal. To date, All Ring has not posted a counterbond, and the Preliminary Injunction Order remains in effect.

On October 27, 2005, the Company filed a formal patent infringement action against All Ring in the Court. All Ring filed a defense brief responding to the complaint in late November 2005, and has filed subsequent supplemental defense briefs. The first hearing in the case was held on February 10, 2006.

On November 18, 2005, All Ring filed a cancellation action against the Company’s 207469 patent in the Taiwan Intellectual Property Office (the IPO). The Company’s defense brief was filed on March 17, 2006.

The Company intends to vigorously pursue its patent infringement claims against All Ring and defend against the cancellation action.

Note 12 – New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (Revised 2004), Share-Based Payments. (SFAS 123R). The scope of SFAS 123R includes a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. SFAS 123R replaces FASB Statement No. 123, Accounting for Stock-Based Compensation (SFAS 123), and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (Opinion 25). SFAS 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements and rescinds the ability of companies to elect the intrinsic value method prescribed under Opinion 25. That cost will be measured based on the fair value of the equity or liability instruments issued. The Company

will be required to implement SFAS 123R for the fiscal year beginning June 4, 2006. The Company has not completed its analysis of the impact of the adoption of SFAS 123R on its financial position or results of operations.

In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision with the American Jobs Creation Act of 2004. FSP No. 109-2 provides guidance under SFAS No. 109, Accounting for Income Taxes, with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act) on enterprises’ income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. Accordingly, the Company will continue to analyze and assess its options under this provision.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

The statements contained in this report that are not statements of historical fact, including without limitation statements containing the words “believes,” “expects” and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties. From time to time we may make other forward-looking statements. Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ as a result of many factors, including the risks described below under the heading “Factors That May Affect Future Results.”

Overview

Electro Scientific Industries, Inc. and its subsidiaries (ESI) provide high-technology manufacturing equipment to the global electronics market, including advanced laser systems that are used to microengineer electronic device features in high-volume production environments. Our customers are primarily manufacturers of semiconductors, passive components and electronic interconnect devices. Our equipment enables these manufacturers to achieve the yield and productivity gains in their manufacturing processes that can be critical to their profitability. The components and devices manufactured by our customers are used in a wide variety of end products in the computer, consumer electronics and communications industries.

We supply advanced laser microengineering systems that allow electronics manufacturers to physically alter select device features during high-volume production in order to heighten performance and boost production yields of semiconductor devices, passive components and circuitry, high-density interconnect (HDI) circuit boards and advanced semiconductor packaging. Laser microengineering comprises a set of precise fine-tuning processes (laser trimming, link processing and via drilling) that require application-specific laser systems able to meet semiconductor and microelectronics manufacturers’ exacting performance and productivity requirements.

Additionally, we produce high-speed test, inspection and termination equipment used in the high-volume production of multi-layer ceramic capacitors and other passive components, as well as original equipment manufacturer machine vision products.

The industry environment was generally favorable and indicative of steady growth during the third quarter of fiscal 2006, with orders of $53.0 million compared to average orders of $49.9 million per quarter over the first two quarters of fiscal 2006. Order volume was $34.8 million in the first quarter of fiscal 2006 and increased to $64.9 million in the second quarter. The large fluctuation between those two quarters was driven by the timing of several semiconductor group orders that were received shortly after the end of the first quarter. When compared to average quarterly orders for the first half of fiscal 2006, total third quarter orders were up due to increases in electronic interconnect and passive component group orders.

With respect to our semiconductor group, orders in the third quarter of fiscal 2006 decreased $16.3 million from the order level in the previous quarter, primarily due to the timing of certain large orders received early in the second quarter as noted above. Semiconductor group orders of $31.4 million in the current quarter are consistent with average orders of $31.3 million per quarter during the first and second quarters of fiscal 2006. During the third quarter of fiscal 2006, semiconductor group orders were primarily for our infrared (IR) based memory link processing systems as customers continue to add capacity for DRAM and NAND flash applications. Additionally, we received customer acceptance and recorded revenue for multiple Model 9835 systems shipped to a major customer during the third quarter of fiscal 2006. The Model 9835 is an ultraviolet (UV) based memory link processing system that delivers world class spot size with greater depth of focus for processing next generation integrated circuits. We

are making continued progress with qualification of the UV system at other customers and additional shipments of this system are expected in the fourth quarter of fiscal 2006. We anticipate continued strength in the memory link repair area as our customers ramp their 90nm production capability and see growth in demand for higher density memory devices which use DRAM and NAND flash technologies.

Passive component group orders increased $2.8 million and 29% sequentially in the third quarter of fiscal 2006. The increase in orders was primarily from customers in Taiwan, Korea and Japan for both test and termination equipment. Our customers are reporting high levels of factory utilization, with several exceeding 90% utilization. In addition, the smallest multi-layer ceramic capacitor (MLCC) product lines are seeing continued shortages and price increases. Despite forecasted growth in the end-markets, many manufacturers continue to be cautious before placing equipment orders.

Electronic interconnect group orders increased $1.6 million and 21% sequentially in the third quarter of fiscal 2006. Demand in this market continues to be driven primarily by single-head UV drill systems for flex-circuit manufacturers.

Shipments were $58.2 million in the third quarter of fiscal 2006, representing a 19% increase from shipments of $48.8 million in the second quarter of fiscal 2006. This increase was driven by a $12.3 million improvement in semiconductor group shipments, stemming from orders received in the second quarter of fiscal 2006. Net sales for the third quarter were $55.9 million, increasing 15% from $48.6 million for the second quarter of fiscal 2006, driven by the improved semiconductor group shipments in the current quarter. Deferred revenue increased $2.3 million to $15.6 million during the third quarter of fiscal 2006, with the increase driven primarily by electronic interconnect group system shipments pending customer acceptance of custom specifications.

Gross margin on third quarter sales of $55.9 million was 44.5%, representing an increase from the prior quarter margin of 43.5%, on sales of $48.6 million. The margin rate increase was primarily driven by favorable overhead absorption on increased production levels. Fourth quarter shipments and net sales are currently estimated to be in the range of $50 million to $60 million and related gross margins are expected to be slightly lower than the third quarter due to a change in product mix.

Operating expenses were $20.0 million for the third quarter compared to $19.3 million in the second quarter of fiscal 2006, with the increase primarily resulting from additional planned investment in research and development to develop next generation products and enable growth in existing and new markets. We anticipate operating expenses to increase in the fourth quarter of fiscal 2006 to between $20 million and $21 million, as we continue increasing our investment in research and development and incur expenses related to the launch of our new ERP system.

Net other income was $1.8 million in the third quarter of fiscal 2006, compared to $2.3 million in the second quarter of fiscal 2006. The decrease is primarily attributed to a $0.7 million interest payment received on an income tax refund in the second quarter of fiscal 2006, offset by increasing yields on our investment portfolio.

The income tax benefit for the third quarter of fiscal 2006 was $3.7 million on pre-tax income of $6.7 million, compared to an income tax provision of $0.9 million for the second quarter of fiscal 2006 on pretax income of $4.1 million. The effective tax rate in the third quarter of fiscal 2006 was a benefit of 55% compared to a provision of 22% in the second quarter of fiscal 2006. The third quarter tax benefit resulted from a $5.3 million reduction in accrued income taxes due to the statutory closure of various tax years, offset by income tax expense of $1.6 million. We expect the tax rate for the fourth quarter of fiscal 2006 to be approximately 21%.

Net income for the third quarter of fiscal 2006 was $10.4 million or $0.36 per share and $0.35 per share on a basic and fully diluted basis, respectively, compared to $3.2 million, or $0.11 per share on a basic and fully diluted basis for the second quarter of fiscal 2006.

Results of Operations

The following table sets forth results of operations data as a percentage of net sales.


	Three months ended				Nine months ended
	February 25, 2006		February 26, 2005		February 25, 2006		February 26, 2005
Net sales	100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales	55.5		56.3		55.9		51.4

Gross margin	44.5		43.7		44.1		48.6
Selling, service and administrative	20.2		25.1		22.6		22.7
Research, development and engineering	15.6		13.0		16.4		11.0

Operating income	8.8		5.6		5.0		14.9
Total other income (expense), net	3.2		(0.2	)	3.6		(0.3	)

Income before taxes	12.0		5.4		8.6		14.6
Income tax provision (benefit)	(6.5	)	1.3		(1.4	)	3.6

Net income	18.5	%	4.1	%	10.0	%	11.0	%

Net Sales

Certain information regarding our net sales by product group is as follows (net sales in thousands):


	Three months ended
	February 25, 2006				February 26, 2005
	Net Sales		% of Net Sales		Net Sales		% of Net Sales
Semiconductor Group (SG)	$	40,515	73	%	$	29,712	61	%
Passive Components Group (PCG)		9,179	16			12,479	25
Electronic Interconnect Group (EIG)		6,243	11			6,893	14

	$	55,937	100	%	$	49,084	100	%


	Nine months ended
	February 25, 2006				February 26, 2005
	Net Sales		% of Net Sales		Net Sales		% of Net Sales
Semiconductor Group (SG)	$	93,653	63	%	$	109,383	58	%
Passive Components Group (PCG)		32,261	22			51,061	27
Electronic Interconnect Group (EIG)		23,174	15			27,264	15

	$	149,088	100	%	$	187,708	100	%

Net sales were $55.9 million for the quarter ended February 25, 2006, an increase of $6.9 million or 14.0% compared to net sales of $49.1 million for the quarter ended February 26, 2005. Sales decreased 26% and 9% for PCG and EIG respectively, while sales for SG in the third quarter of fiscal 2006 increased 36% compared with the same period in the prior year.

The sales increase in SG of $10.8 million compared to the third quarter of the prior fiscal year is due primarily to an increase in system sales volumes for our IR-based memory link-processing tool and our new UV-based memory link-processing tool.

The $3.3 million decrease in third quarter fiscal 2006 PCG sales compared to the same quarter in the prior year is due to a decrease in the volume of test and termination system sales resulting from caution by component manufacturers, who are evaluating the sustainability of current high utilization rates before

placing additional equipment orders. In the first quarter of the prior fiscal year, PCG sales reached a four-quarter peak at approximately $21 million, driven by demand for passive components processed by our laser trim and passive test systems. Subsequently, PCG quarterly net sales decreased sequentially for the remainder of fiscal 2005, followed by an increase in the first half of fiscal 2006. PCG sales ranged between approximately $11 million and $12 million for the first two quarters of fiscal 2006, followed by third quarter sales of $9.2 million.

EIG sales levels decreased by $0.7 million compared to the same quarter in the prior year. Although third quarter shipments increased by $1.8 million compared to the same quarter in the prior year, revenue deferrals of system shipments due to custom specifications drove the reduction in net sales. EIG net sales have ranged from approximately $6 million to $7 million per quarter since the end of the third quarter of fiscal 2005, except for net sales in the second quarter of fiscal 2006. Net sales in that quarter were $11.4 million due to customer acceptances received on interconnect package drilling systems and upgrades included in deferred revenue at the beginning of the fiscal year.

Net sales were $149.1 million for the nine months ended February 25, 2006, a decrease of $38.6 million or 20.6% compared to net sales of $187.7 million for the nine months ended February 26, 2005. Of the decrease, $15.7 million resulted from decreased sales volumes in the SG product lines. Sales of SG systems reached a peak in the fourth quarter of fiscal 2004 as major DRAM manufacturers increased capacity during that market upturn. SG net sales then decreased sequentially during fiscal 2005 and fiscal 2006 until the rise in SG revenue in the current quarter. PCG sales for the nine months ended February 25, 2006 decreased $18.8 million as the trend of PCG demand peaked in the first half of fiscal 2005. The remaining decrease of $4.1 million was generated by EIG, which had higher revenue in the first nine months of the prior fiscal year due to recognition of previously deferred revenue for newly introduced systems in the integrated circuit package segment.

Net sales by geographic region were as follows (net sales in thousands):


	Three months ended
	February 25, 2006				February 26, 2005
	Net Sales		% of Net Sales		Net Sales		% of Net Sales
Asia	$	45,448	81	%	$	38,558	79	%
United States		5,952	11			8,357	17
Europe		4,537	8			2,169	4

	$	55,937	100	%	$	49,084	100	%


	Nine months ended
	February 25, 2006				February 26, 2005
	Net Sales		% of Net Sales		Net Sales		% of Net Sales
Asia	$	115,342	77	%	$	143,236	76	%
United States		22,752	15			29,090	16
Europe		10,994	8			15,382	8

	$	149,088	100	%	$	187,708	100	%

Compared to the third quarter in the prior year, the percentage of total net sales to Asia in the current quarter of fiscal 2006 increased modestly. The $6.9 million increase in sales to Asia is driven primarily by increases in Japan and resulted from the volume increase in net sales of SG products. Increased sales to Europe during the third quarter of fiscal 2006 of $2.4 million were offset by decreased sales to the United States of $2.4 million. This change in sales mix was due to fewer PCG and EIG sales in the United States and more SG sales to Europe in the current fiscal quarter compared to the third quarter of fiscal 2005. For the nine months ended February 25, 2006, the sales mix by region was relatively consistent compared to the nine months ended February 26, 2005.

Gross Profit

Gross profit was $24.9 million (44.5% of net sales) for the third quarter of fiscal 2006 compared to $21.4 million (43.7% of net sales) for the third quarter of fiscal 2005. Shipments in the third quarter of fiscal 2006 increased 20.4% compared to the same quarter in fiscal 2005 and allowed us to improve margin rates through volume-based manufacturing efficiencies and lower overhead costs per unit.

Gross profit for the nine month period ended February 25, 2006 was $65.7 million (44.1% of net sales) compared to $91.2 million (48.6% of net sales) for the same nine month period in the prior fiscal year. This represents a 4.5 percentage point reduction in gross margin rates, which resulted from lower overhead absorption per unit, a shift in mix, and an unfavorable margin impact from the sale of previous generation EIG product. Shipments of $151.6 million in the first nine months of fiscal 2006 declined by 17.8% compared to shipments of $184.3 million for the comparative period in fiscal 2005.

Operating Expenses

Selling, Service and Administrative Expenses


(in thousands)	Three months ended				Nine months ended
	February 25, 2006		February 26, 2005		February 25, 2006		February 26, 2005
Selling, service and administration	$	11,287	$	12,290	$	33,729	$	42,494

Included in totals above:
Patent litigation settlement and legal fees		—		—		—		2,240
Legal and professional fees – investigation and securities litigation		73		53		96		820
Restructuring and cost management plans		—		683		—		683

Impact of special charges	$	73	$	736	$	96	$	3,743

The primary items included in selling, service and administrative expenses are labor and other employee-related expenses, travel expenses, professional fees and facilities costs. Selling, service and administrative expenses were $11.3 million (20.2% of net sales) in the third quarter of fiscal 2006, a decrease of $1.0 million compared to $12.3 million (25.1% of net sales) in the third quarter of fiscal 2005. For the nine months ended February 25, 2006, selling, service and administrative expenses decreased $8.8 million to $33.7 million (22.6% of net sales) compared to $42.5 million (22.7% of net sales) for the nine months ended February 26, 2005.

Other special charges included in this category consist of charges relating to restructuring actions, patent litigation settlement and related legal fees and professional fees related to the 2003 audit committee investigation and securities litigation. The amounts and timing of these special charges are detailed above for comparative purposes. Exclusive of these special charges, selling, service and administrative expenses decreased $0.3 million in the third quarter of fiscal 2006 compared to the third quarter of fiscal 2005 and decreased $5.1 million for the first nine months of fiscal 2006 compared to the first nine months of fiscal 2005.

The decrease in selling, service and administrative expenses of $0.3 million, exclusive of the special charges detailed above, for the three months ended February 25, 2006 compared to the same period in the prior year is primarily due to a reduction in insurance expenses, which were elevated in fiscal 2005 as a result of legal actions related to the restatement of earnings in fiscal 2003.

The decrease in selling, service and administrative expenses of $5.1 million, exclusive of the special charges detailed above, for the nine months ended February 25, 2006 compared to the same period in the

prior year is primarily due to reductions in: compensation, commissions and other employee-related expenses, and to a lesser extent, reductions in bad debt expense, program management costs, property taxes and liability insurance as discussed above.

Research, Development and Engineering Expenses


(in thousands)	Three months ended				Nine months ended
	February 25, 2006		February 26, 2005		February 25, 2006		February 26, 2005
Research, development and engineering	$	8,708	$	6,400	$	24,520	$	20,706

Included in totals above:
Restructuring and cost management plans		—		262		—		262

Impact of special charges	$	—	$	262	$	—	$	262

Research, development and engineering expenses are primarily comprised of labor and other employee-related expenses, professional fees, project materials, equipment and facilities costs. Expenses associated with research, development and engineering totaled $8.7 million (15.6% of net sales) for the third quarter of fiscal 2006, representing a $2.3 million increase from expenses of $6.4 million (13.0% of net sales) for the third quarter of fiscal 2005. For the nine months ended February 25, 2006, research, development and engineering expenses increased $3.8 million to $24.5 million (16.4% of net sales) compared to $20.7 million (11.0% of net sales) for the nine months ended February 26, 2005.

Exclusive of special charges for previous restructuring and cost management plans detailed in the table above, research, development and engineering costs increased $2.6 million and $4.1 million, respectively, for the three and nine month periods ended February 25, 2006 compared to the same periods in the prior year. Beginning in early fiscal 2006, we initiated plans to increase our investment in research and development. The resulting increases in research and development costs, exclusive of special charges detailed above, are primarily due to an increase in compensation costs related to higher headcount and an increase in subcontracted and professional services and materials used in research and development activities. Additionally, for the nine months ended February 25, 2006, research and development costs increased due to increased legal fees related to patent registration and maintenance, an increase in subcontracted services and materials used in research and development activities and other cost increases related to our continued investment in development projects, new technical capabilities and initiatives.

Restructuring and Cost Management Plans

In December 2004, we initiated a restructuring plan designed to streamline our technology development efforts and enhance our customer-centric focus through several actions, including centralizing our research, development and engineering function, creating a technical marketing solutions group and creating a customer-centric manufacturing organization. In conjunction with the restructuring, 57 positions were eliminated in our U.S. operations, impacting all employee groups. The restructuring actions were completed in early January 2005 and we incurred and paid approximately $1.2 million in charges related to the fiscal 2005 restructuring plan during the third quarter of fiscal 2005, as detailed below (in thousands).


(in thousands)	Three and nine months ended February 26, 2005
	Cost of Sales		Selling, Service and Administration		Research, Development and Engineering		Total
Fiscal 2005 restructuring and cost management plan	$	299	$	683	$	262	$	1,244

Interest Income (Expense)

Interest income was $2.1 million in the third quarter of 2006, compared to $1.9 million in the same quarter of 2005, an increase of $0.2 million. Interest income was $6.0 million in the first nine months of 2006, compared to $5.2 million in the same nine months of 2005, an increase of $0.8 million. The increases are primarily due to the receipt of $0.7 million of interest relating to income tax refunds received during the second quarter of fiscal 2006 and increasing yields on invested assets, consistent with increases in market interest rates on cash equivalents and debt securities over the past year. These increases in interest income were partially offset by the lower amount of invested assets resulting from the redemption of our $145.0 million convertible subordinated notes in March 2005. Cash, cash equivalents and investments were $226 million at February 25, 2006 compared to $356 million at February 26, 2005.

Interest expense decreased by $1.7 million in the third quarter of 2006, compared to the same quarter of fiscal 2005, and decreased by $5.2 million in the first nine months of 2006, compared to the first nine months of fiscal 2005, due to the redemption of our convertible subordinated notes in March 2005.

Income Taxes

The income tax benefit for the third quarter of fiscal 2006 was $3.7 million on pre-tax income of $6.7 million, compared to the income tax provision in the third quarter of the prior fiscal year of $0.7 million on pretax income of $2.7 million. The effective tax rate in the third quarter of fiscal 2006 was a benefit of 55% compared to a provision of 25% in the third quarter of fiscal 2005. The third quarter tax benefit resulted from a $5.3 million reduction in accrued income taxes due to the statutory closure of various tax years, offset by income tax expense of $1.6 million.

The fiscal year-to-date benefit for income taxes at February 25, 2006 is $2.1 million on pretax income of $12.8 million compared to an income tax provision of $6.7 million on pretax income of $27.3 million in the nine months ended February 26, 2005. The year-to-date tax benefit resulted from a $5.3 million reduction in accrued income taxes as discussed above, offset by income tax expense of $2.7 million and other discrete income tax expense items totaling $0.5 million.

The effective tax rate for the fourth quarter of fiscal 2006 is expected to be approximately 21%. The effective tax rate is subject to fluctuation based upon the occurrence and timing of numerous discrete events, including, for example, changes in tax laws or their interpretations, extensions or expirations of research and

experimentation credits, closure of tax years subject to examination and finalization of income tax returns. Based on currently available information, we are not aware of any such discrete events which are likely to occur and which would have a materially adverse effect on our financial position, expected cash flows or results of operations.

Net Income

Net income for the three months ended February 25, 2006 was $10.4 million (18.5% of net sales) or $0.36 per share and $0.35 per share on a basic and fully diluted basis, respectively. For the nine months ended February 25, 2006, net income was $14.9 million (10.0% of net sales) or $0.52 per share and $0.51 per share on a basic and fully diluted basis, respectively. For the three months ended February 26, 2005, we recorded net income of $2.0 million (4.1% of net sales) or $0.07 per share on a basic and fully diluted basis. For the nine months ended February 26, 2005, we recorded a net income of $20.6 million (11.0% of net sales) or $0.73 and $0.72 per share on a basic and fully diluted basis, respectively.

Liquidity and Capital Resources

At February 25, 2006, our principal sources of liquidity consisted of existing cash, cash equivalents and marketable securities of $225.5 million and accounts receivable of $47.4 million. At February 25, 2006, we had a current ratio of 7.3 and no long-term debt. Working capital increased to $306.7 million at February 25, 2006 from $275.7 million at May 28, 2005. We believe that our existing cash, cash equivalents and marketable securities are adequate to fund our operations for at least the next twelve months.

Cash flows from operating activities for the nine months ended February 25, 2006 totaled $22.4 million. Cash totaling $25.5 million was provided by net income adjusted for non-cash items. Other significant factors impacting cash flows from operations included increases in accounts receivable and a decrease in income tax refund receivable.

Net trade receivables were $47.4 million at February 25, 2006 compared to $36.2 million at May 28, 2005, an increase of $11.2 million. The increase is primarily due to higher shipments late in the third quarter of fiscal 2006. Days sales outstanding increased to 77 days at the end of the third quarter of fiscal 2006, compared to 72 days at the end of fiscal 2005.

Income tax refunds receivable decreased by $8.0 million at February 25, 2006 to $1.2 million, compared to $9.2 million at May 28, 2005. During the second quarter of fiscal 2006 we received $7.2 million in federal tax refunds resulting from a completed examination of our tax years 1996 through 2003 plus interest of $0.7 million.

Cash flows from investing activities totaled $4.7 million for the nine months ended February 25, 2006. Capital expenditures totaled $15.2 million during this period and were principally comprised of costs related to the implementation of a new enterprise resource planning system and a major refurbishment of research and development clean rooms and laboratories. We also generated $26.6 million, net, in cash and cash equivalents through the maturity and sale of investments in our portfolio of marketable securities offset by certain reinvestments.

Cash flows from investing activities for the nine months ended February 25, 2006 also included a $7.0 million increase in other assets for a Taiwan dollar deposit security bond posted with the Kaohsiung Court in Taiwan related to our filing of a patent infringement suit against All Ring Tech Co., Ltd. in that jurisdiction. This deposit will be held by the court pending final resolution of the matter.

Cash flows from financing activities of $6.3 million were comprised of proceeds from the exercise of stock options and other employee stock plan purchases for the nine months ended February 25, 2006.

Critical Accounting Policies and Estimates

We reaffirm the critical accounting policies and our use of estimates as reported in our annual report on Form 10-K for our fiscal year ended May 28, 2005 as filed with the Securities and Exchange Commission on July 27, 2005.

Factors That May Affect Future Results

The statements contained in this report that are not statements of historical fact, including without limitation statements containing the words “believes,” “expects” and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties. From time to time we may make other forward-looking statements. Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ. The following information highlights some of the factors that could cause actual results to differ materially from the results expressed or implied by our forward-looking statements. Forward-looking statements should be considered in light of these factors. Factors that may result in such variances include, but are not limited to, the following:

The industries that comprise our primary markets are volatile and unpredictable.

Our business depends upon the capital expenditures of manufacturers of components and circuitry used in wireless communications, computers and other electronic products. In the past, the markets for electronic devices have experienced sharp downturns. During these downturns, electronics manufacturers, including our customers, have delayed or canceled capital expenditures, which has had a negative impact on our financial results. We cannot assure you when demand for our products will increase or that demand will not decrease. Even if demand for our products does increase, there may be significant fluctuations in our profitability and net sales.

During any downturn, it will be difficult for us to maintain our sales levels. As a consequence, to maintain profitability we will need to reduce our operating expenses. For example, in December 2004 we announced an operational restructuring and reduction in force to reduce our expenses in connection with the most recent downturn. Our ability to quickly reduce operating expenses is dependent upon the nature of the actions we take to reduce expense and our subsequent ability to implement those actions and realize expected cost savings. Additionally, we may be unable to defer capital expenditures and we will need to continue to invest in certain areas such as research and development. An economic downturn may also cause us to incur charges related to impairment of assets and inventory write-offs and we may also experience delays in payments from our customers, which would have a negative effect on our financial results.

Delays in manufacturing, shipment or customer acceptance of our products could substantially decrease our sales for a period.

We depend on manufacturing flexibility to meet the changing demands of our customers. Any significant delay or interruption in receiving raw materials or in our manufacturing operations as a result of software deficiencies, natural disasters, or other causes could result in reduced manufacturing capabilities or delayed product deliveries, any or all of which could materially and adversely affect our results of operations.

In addition, we derive a substantial portion of our revenue from the sale of a relatively small number of products. Consequently, shipment and/or customer acceptance delays, including acceptance delays related to new product introductions or customizations, could significantly impact recognition of revenue and could be further magnified by announcements from us or our competitors of new products and technologies, which announcements could cause our customers to defer purchases of our systems or purchase products from our competitors. Any of these delays could result in a material adverse change in our results of operations for any particular period.

Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business.

We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers for those materials. We generally do not have guaranteed supply arrangements with our suppliers. We seek to reduce the risk of production and service interruptions and shortages of key parts by selecting and qualifying alternative suppliers for key parts, monitoring the financial stability of key suppliers and maintaining appropriate inventories of key parts. Although we make reasonable efforts to ensure that parts are available from multiple suppliers, some key parts are available only from a single supplier or a limited group of suppliers in the short term. Operations at our suppliers’ facilities are subject to disruption for a variety of reasons, including changes in business relationships, competitive factors, work stoppages, and fire, earthquake, flooding or other natural disasters. Such disruption could interrupt our manufacturing. Our business may be harmed if we do not receive sufficient parts to meet our production requirements in a timely and cost-effective manner.

We depend on a few significant customers and we do not have long-term contracts with any of our customers.

Our top ten customers for fiscal 2005 accounted for approximately 51% of total net sales in fiscal 2005, with one customer, Samsung, accounting for approximately 13% of total net sales in fiscal 2005. No other customer in fiscal 2005 accounted for more than 10% of total net sales. In addition, none of our customers has any long-term obligation to continue to buy our products or services, and any customer could delay, reduce or cease ordering our products or services at any time.

Our markets are subject to rapid technological change, and to compete effectively we must continually introduce new products that achieve market acceptance.

The markets for our products are characterized by rapid technological change and innovation, frequent new product introductions, changes in customer requirements and evolving industry standards. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address technological changes as well as current and potential customer requirements. The introduction by us or by our competitors of new and enhanced products may cause our customers to defer or cancel orders for our existing products, which may harm our operating results. In the past we have also experienced delays in new product development. Similar delays may occur in the future. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or, where necessary, to license these technologies from others.

Product development delays may result from numerous factors, including:

•

Changing product specifications and customer requirements;

•

Difficulties in hiring and retaining necessary technical personnel;

•

Difficulties in reallocating engineering resources and overcoming resource limitations;

•

Difficulties with contract manufacturers;

•

Changing market or competitive product requirements; and

•

Unanticipated engineering complexities.

The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Any failure to respond to technological change that may render our current products or technologies obsolete could significantly harm our business.

Our ability to reduce costs is limited by our need to invest in research and development.

Our industry is characterized by the need for continued investment in research and development. Because of intense competition in the industries in which we compete, if we were to fail to invest sufficiently in research and development, our products could become less attractive to potential customers, and our business and financial condition could be materially and adversely affected. As a result of our need to maintain our spending levels in this area, our operating results could be materially harmed if our net sales fall below expectations. In addition, as a result of our emphasis on research and development and technological innovation, our operating costs may increase further in the future, and research and development expenses may increase as a percentage of total operating expenses and as a percentage of net sales.

We are exposed to the risks that others may violate our proprietary rights, and our intellectual property rights may not be well protected in foreign countries.

Our success is dependent upon the protection of our proprietary rights. In the high technology industry, intellectual property is an important asset that is always at risk of infringement. We incur substantial costs to obtain and maintain patents and defend our intellectual property. For example, we have initiated litigation alleging that certain parties have violated various patents of ours, such as the action we initiated in Taiwan against All Ring Tech Co., Ltd. in August 2005. We rely upon the laws of the United States and of foreign countries in which we develop, manufacture or sell our products to protect our proprietary rights. However, these proprietary rights may not provide the competitive advantages that we expect or other parties may challenge, invalidate or circumvent these rights.

Further, our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States. Many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries. If we fail to adequately protect our intellectual property in these countries, it could be easier for our competitors to sell competing products in foreign countries, which could result in reduced sales and gross margins.

We may be subject to claims of intellectual property infringement.

Several of our competitors hold patents covering a variety of technologies, applications and methods of use similar to some of those used in our products. From time to time, we and our customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents. Competitors or others have in the past and may in the future assert infringement claims against our customers or us with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others. If claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur.

If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, our financial condition and results of operations could be materially and adversely affected.

Our business is highly competitive, and if we fail to compete effectively, our business will be harmed.

The industries in which we operate are highly competitive. We face substantial competition from established competitors, some of which have greater financial, engineering, manufacturing and marketing resources than we do. If we are unable to compete effectively with these companies, our market share may decline and our business could be harmed. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products. New companies may enter the markets in which we compete, or industry consolidation may occur, further increasing competition in those markets. Furthermore, our technological advantages may be reduced or lost as a result of technological advances by our competitors.

Our competitors’ greater resources in the areas described above may enable them to:

•

Better withstand periodic downturns;

•

Compete more effectively on the basis of price and technology; and

•

More quickly develop enhancements to and new generations of products.

We believe that our ability to compete successfully depends on a number of factors, including:

•

Performance of our products;

•

Quality of our products;

•

Reliability of our products;

•

Cost of using our products;

•

The ability to upgrade our products;

•

Consistent availability of critical components;

•

Our ability to ship products on the schedule required;

•

Quality of the technical service we provide;

•

Timeliness of the services we provide;

•

Our success in developing new products and enhancements;

•

Existing market and economic conditions; and

•

Price of our products as compared to our competitors’ products.

We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins and loss of market share.

The loss of key personnel or our inability to attract, retain and assimilate sufficient numbers of managerial, financial, engineering and other technical personnel could have a material effect upon our results of operations.

Our continued success depends, in part, upon key managerial, financial, engineering and technical personnel as well as our ability to continue to attract, retain and assimilate additional personnel. The loss of key personnel could have a material adverse effect on our business or results of operations. We may not be able to retain our key managerial, financial, engineering and technical employees. For example, our Chief Financial Officer resigned effective December 7, 2005 and we are currently in the process of searching for a new Chief Financial Officer. Attracting qualified personnel may be difficult and our efforts to attract and retain these personnel may not be successful. In addition, we may not be able to assimilate qualified personnel, including any new members of senior management, which could disrupt our operations.

Our worldwide direct sales and service operations expose us to employer-related risks in foreign countries.

We have established direct sales and service organizations throughout the world. A worldwide direct sales and service model in foreign countries involves certain risks. We are subject to compliance with the labor laws and other laws governing employers in the countries where our operations are located and as a result we may incur additional costs to comply with these local regulations. Additionally, we may encounter labor shortages or disputes that could inhibit our ability to effectively sell, market and service our products. If we cannot effectively manage the risks related to employing persons in foreign countries, our operating results could be adversely affected.

We may make acquisitions in the future, and these acquisitions may subject us to risks associated with integrating these businesses into our current business.

Although we have no commitments or agreements for any acquisitions, in the future we may make acquisitions of, or significant investments in, businesses with complementary products, services or technologies.

Acquisitions involve numerous risks, many of which are unpredictable and beyond our control, including:

•

Difficulties and increased costs in connection with integration of the personnel, operations, technologies and products of acquired companies;

•

Diversion of management’s attention from other operational matters;

•

The potential loss of key employees of acquired companies;

•

Lack of synergy, or inability to realize expected synergies, resulting from the acquisition;

•

Acquired assets becoming impaired as a result of technological advancements or worse-than-expected performance by the acquired company; and

•

Difficulties establishing satisfactory internal controls at acquired companies.

Our inability to effectively manage these acquisition risks could materially and adversely affect our business, financial condition and results of operations. In addition, if we issue equity securities to pay for an acquisition the ownership percentage of our existing shareholders would be reduced and the value of the shares held by our existing shareholders could be diluted. If we use cash to pay for an acquisition the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes. In addition, the accounting for future acquisitions could result in significant charges resulting from amortization of intangible assets related to such acquisitions.

We are exposed to the risks of operating a global business, including risks associated with exchange rate fluctuations, legal and regulatory changes and the impact of regional and global economic disruptions.

International shipments accounted for 85% of net sales in fiscal 2005, with 77% of our net sales to customers in Asia. We expect that international shipments will continue to represent a significant percentage of net sales in the future. Our non-U.S. sales, purchases and operations are subject to risks inherent in conducting business abroad, many of which are outside our control, including the following:

•

Periodic local or geographic economic downturns and unstable political conditions;

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Price and currency exchange controls;

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Fluctuation in the relative values of currencies;

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Difficulties protecting intellectual property;

•

Local labor disputes;

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Shipping delays and disruptions;

•

Increases in shipping costs, caused by increased fuel costs or otherwise, which we may not be able to pass on to our customers;

•

Unexpected changes in trading policies, regulatory requirements, tariffs and other barriers; and

•

Difficulties in managing a global enterprise, including staffing, collecting accounts receivable, managing distributors and representatives and repatriation of earnings.

Our business and operating results are subject to uncertainties arising out of the possibility of regional or global economic disruptions (including those resulting from natural disasters and outbreaks of infectious disease), the economic consequences of military action or terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce. In particular, due to these uncertainties we are subject to:

•

The risk that future tightening of immigration controls may adversely affect the residence status of non-U.S. engineers and other key technical employees in our U.S. facilities or our ability to hire new non-U.S. employees in such facilities;

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The risk of more frequent instances of shipping delays; and

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The risk that demand for our products may not increase or may decrease.

Failure to maintain effective internal controls could have a material adverse effect on our business, operating results and stock price.

In connection with our fiscal 2005 audit, we documented and tested our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent registered public accounting firm addressing these assessments. If we fail to maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Our ability to maintain internal controls may be negatively impacted by our implementation of a new enterprise resource planning system in the fourth quarter of fiscal 2006. Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.

Enterprise resource planning (ERP) system implementation could have a material adverse effect on our business.

We are highly dependent on our systems infrastructure in order to process orders, track inventory, ship products in a timely manner, prepare invoices to our customers and otherwise carry on our business in the ordinary course. Key to the success of our strategy to drive greater productivity and cost savings is the implementation of a new worldwide ERP system in the fourth quarter of fiscal 2006. If we experience significant problems with the implementation of this system, the resulting disruption could adversely affect our business, sales, results of operations and financial condition. The transition to our new ERP system involves numerous risks, including:

•

difficulties in integrating the system with our current operations;

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potential delay in the processing of customer orders for shipment of products;

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diversion of management’s attention away from normal daily operations of our business;

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increased demand on our support operations;

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initial dependence on an unfamiliar system while training personnel in its use; and

•

increase in operating expenses surrounding the implementation date resulting from training, conversion and transition support activities.

Further, we may experience difficulties as we transition to the new software that could affect our internal control systems, processes, procedures and related documentation. The ERP implementation requires significant effort in a compressed timeframe, and will also result in our incurring costs to comply with Section 404 of the Sarbanes-Oxley Act by documenting all business processes that have been revised as a result of the implementation. This will result in compliance costs that will be in addition to the implementation costs of our new ERP system. There can be no assurances that the evaluation required by Section 404 of the Sarbanes-Oxley Act for fiscal 2006 will not result in the identification of significant control deficiencies or that our auditors will be able to attest to the effectiveness of our internal control over financial reporting subsequent to the implementation of the new ERP system.

Our reported results of operations will be materially and adversely affected by our adoption of SFAS 123R.

Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which will be effective in our first quarter of fiscal 2007, will result in recognition of substantial compensation expense relating to our stock incentive plan and employee stock purchase plan. We currently use the intrinsic value method to measure compensation expense for stock-based awards to our employees. Under this standard, we generally have not recognized any compensation expense related to stock option grants or the discounts we provide under our employee stock purchase plan. Under the new rules, we will be required to adopt a fair value-based method for measuring the compensation expense related to employee stock awards, which will lead to substantial additional compensation expense and will have a material adverse effect on our reported results of operations. Note 8 to Consolidated Financial Statements in this report provides our pro forma net income and earnings per share as if we had used a fair value-based method similar to the methods required under SFAS 123R to measure the compensation expense for employee stock awards during the periods presented.

The Company’s tax rates are subject to fluctuation, which could impact our financial position, and our estimates of tax liabilities may be subject to audit which could result in additional assessments.

Our effective tax rates are subject to fluctuation as the income tax rates for each year are a function of: (a) the effects of a mix of profits (losses) earned by ESI and our subsidiaries in numerous tax jurisdictions with a broad range of income tax rates, (b) our ability to utilize recorded deferred tax assets, (c) taxes, interest or penalties resulting from tax audits and (d) changes in tax laws or the interpretation of such tax laws. Changes in the mix of these items may cause our effective tax rates to fluctuate between periods, which could have a material adverse effect on our financial position.

We are subject to income taxes in both the United States and numerous foreign jurisdictions. During the ordinary course of business there are many transactions and calculations for which the ultimate tax determination is uncertain. Significant judgment is exercised in determining our world wide provisions for income taxes. Furthermore, we are regularly under audit by tax authorities. Although we believe our tax estimates are reasonable, the final outcome of tax audits and examinations could be materially different than what is reflected in historical income tax accruals. For example, in the third quarter of fiscal 2006, a significant tax benefit was recorded upon the reversal of accrued income taxes due to the statutory closure of returns for various open tax years. If additional taxes are assessed as a result of an examination, a material effect on our financial results, tax positions or cash flows could occur in the period or periods in which the determination is made.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in the market risk disclosure contained in our 2005 Annual Report on Form 10-K for our fiscal year ended on May 28, 2005.

Item 4.

Controls and Procedures

Attached to this quarterly report as exhibits 31.1 and 31.2 are the certifications of our President and Chief Executive Officer and our Interim Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302 Certifications). This portion of our quarterly report on Form 10-Q is our disclosure of the conclusions of our management, including our President and Chief Executive Officer and our Interim Chief Financial Officer, regarding the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report based on management’s evaluation of those disclosure controls and procedures. You should read this disclosure in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.

Disclosure Controls and Procedures

Our management has evaluated, under the supervision and with the participation of our President and Chief Executive Officer and Interim Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (Exchange Act). Based on that evaluation, our President and Chief Executive Officer and our Interim Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to our management, including our President and Chief Executive Officer and our Interim Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting that occurred during our fiscal quarter ended February 25, 2006 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

On August 24, 2005, ESI executed a Provisional Attachment Order (the Attachment Order) issued by the Kaohsiung District Court of Taiwan (the Court) directed against All Ring Tech Co., Ltd. (All Ring) of Taiwan. In its petition requesting the Attachment Order, ESI alleged that All Ring’s Capacitor Tester Model RK-T6600 (the Capacitor Tester) infringes our Taiwan Patent No. 207469, entitled “Circuit Component Handler” (the 207469 patent). This patent corresponds to our U.S. Patent No. 5,842,579. The patented technology is used in the Model 3340 Multifunction MLCC Tester. All Ring has filed a bond with the Court to obtain relief from the attachment of its assets. The bond provides security to ESI with respect to its patent infringement claim against All Ring.

On September 19, 2005, the Court granted our petition for a Preliminary Injunction, and issued a Preliminary Injunction Order that prohibits All Ring from manufacturing, selling, offering for sale or using the Capacitor Tester, or importing the Capacitor Tester for any of these purposes, until final judgment is entered in the formal patent infringement action. Pursuant to the Court’s Order, ESI was required to post with the Court a Taiwan dollar security bond, which is included in Other Assets on the accompanying consolidated condensed balance sheet at February 25, 2006, and is valued at approximately US$7.0 million. The Court then executed the Preliminary Injunction Order in late October 2005. All Ring appealed the Preliminary Injunction Order on November 1, 2005, and ESI opposed the appeal. The High Court denied All Ring’s appeal on January 9, 2006. On November 10, 2005, All Ring filed a petition to post a counterbond to revoke the execution of the Preliminary Injunction Order, and ESI filed an opposition to the petition on December 2, 2005. The Court granted the counterbond petition on December 14, 2005. The Court’s order allows All Ring to obtain relief from the Preliminary Injunction Order if it posts a bond in the amount of approximately US$7.0 million. ESI appealed the counterbond order on December 30, 2005. The High Court has not yet decided the appeal. To date, All Ring has not posted a counterbond, and the Preliminary Injunction Order remains in effect.

On October 27, 2005, ESI filed a formal patent infringement action against All Ring in the Court. All Ring filed a defense brief responding to the complaint in late November 2005, and has filed subsequent supplemental defense briefs. The first hearing in the case was held on February 10, 2006.

On November 18, 2005, All Ring filed a cancellation action against our 207469 patent in the Taiwan Intellectual Property Office (the IPO). ESI’s defense brief was filed on March 17, 2006.

We intend to vigorously pursue its patent infringement claims against All Ring and defend against the cancellation action.

Item 6.

Exhibits

This list is intended to constitute the exhibit index.


3.1		Restated Articles of Incorporation. Incorporated by reference to Exhibit 3-A of the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 1991.

3.2		Articles of Amendment of Third Restated Articles of Incorporation. Incorporated by reference to Exhibit 3-B of the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 1999.

3.3		Articles of Amendment of Third Restated Articles of Incorporation. Incorporated by reference to Exhibit 3 of the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended December 2, 2000.

3.4		2004 Restated Bylaws, as amended. Incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on October 21, 2004.

4.1		Amended and Restated Rights Agreement, dated as of March 1, 2001, between the Company and Mellon Investor Services, relating to rights issued to all holders of Company common stock. Incorporated by reference to Exhibit 4-A of the Company’s Annual Report on Form 10-K for the fiscal year ended June 2, 2001.

10.1		Offer Letter from the Company to Tom Wu. Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on January 19, 2006.

31.1		Certification of the Chief Executive Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Interim Chief Financial Officer pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Interim Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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


Dated: March 22, 2006	ELECTRO SCIENTIFIC INDUSTRIES, INC.

	By	/s/ Nicholas Konidaris
		Nicholas Konidaris
		President and Chief Executive Officer (Principal Executive Officer)

	By	/s/ Kerry Mustoe
		Kerry Mustoe
		Corporate Controller, Chief Accounting Officer and Interim Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

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