Edgar Filing: FSI INTERNATIONAL INC

e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended May 26, 2007


o		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:		0-17276

FSI INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)


MINNESOTA		41-1223238

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

3455 Lyman Boulevard, Chaska, Minnesota		55318

(Address of principal executive offices)		(Zip Code)

952-448-5440

(Registrant’s telephone number, including area code)

N/A

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

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.


þ YES		o NO

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.


Large Accelerated Filer o		Accelerated Filer þ		Non-Accelerated Filer o

Indicate by a checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).


o YES		þ NO

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

Common Stock, No Par Value — 30,438,000 shares outstanding as of June 27, 2007

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q


		PAGE NO.
PART I.	FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (unaudited): Condensed Consolidated Balance Sheets as of May 26, 2007 and August 26, 2006		3

	Condensed Consolidated Statements of Operations for the quarters ended May 26, 2007 and May 27, 2006		5

	Condensed Consolidated Statements of Operations for the nine months ended May 26, 2007 and May 27, 2006		6

	Condensed Consolidated Statements of Cash Flows for the nine months ended May 26, 2007 and May 27, 2006		7

	Notes to Condensed Consolidated Financial Statements		8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		17

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		27

Item 4.	Controls and Procedures		27

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings		27

Item 1A.	Risk Factors		28

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		29

Item 3.	Defaults upon Senior Securities		29

Item 4.	Submission of Matters to a Vote of Security Holders		29

Item 5.	Other Information		29

Item 6.	Exhibits		30

	SIGNATURE		31
Termination and Release Agreement
Stock Purchase Agreement
Certification Pursuant to Section 302
Certification Pursuant to Section 302
Certification Pursuant to Section 906

PART I. Item 1. FINANCIAL INFORMATION

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
MAY 26, 2007 AND AUGUST 26, 2006

ASSETS
(unaudited)
(in thousands)


	May 26,			August 26,
	2007			2006
Current assets:
Cash and cash equivalents	$	14,384		$	15,672
Restricted cash		149			144
Marketable securities		9,650			11,100
Trade accounts receivable, net of allowance for doubtful accounts of $200 and $520, respectively		17,908			23,173
Inventories, net		35,504			35,682
Prepaid expenses and other current assets		7,943			11,340


Total current assets		85,538			97,111


Property, plant and equipment, at cost		79,142			77,320
Less accumulated depreciation		(58,184	)		(56,925	)

		20,958			20,395
Restricted cash		516			—
Investment		460			7,632
Intangibles, net of accumulated amortization of $13,749 and $13,619, respectively		605			1,246
Other assets		1,160			1,160


Total assets	$	109,237		$	127,544

See accompanying notes to condensed consolidated financial statements.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
MAY 26, 2007 AND AUGUST 26, 2006
(continued)

LIABILITIES AND STOCKHOLDERS’ EQUITY
(unaudited)
(in thousands)


	May 26,			August 26,
	2007			2006
Current liabilities:
Trade accounts payable	$	4,208		$	8,803
Accrued expenses		11,217			15,212
Current portion of capital lease obligations		523			—
Customer deposits		2,471			5,408
Deferred profit		3,292			4,149


Total current liabilities		21,711			33,572

Capital lease obligations		786			—

Stockholders’ equity:
Preferred stock, no par value; 9,700 shares authorized; none issued and outstanding		—			—
Series A Junior Participating Preferred Stock, no par value; 300 shares authorized; none issued and outstanding		—			—
Common stock, no par value; 50,000 shares authorized; issued and outstanding, 30,438 and 30,309 shares, respectively		225,687			225,169
Accumulated deficit		(140,093	)		(132,052	)
Accumulated other comprehensive loss		(362	)		(218	)
Other stockholders’ equity		1,508			1,073


Total stockholders’ equity		86,740			93,972


Total liabilities and stockholders’ equity	$	109,237		$	127,544

See accompanying notes to condensed consolidated financial statements.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE QUARTERS ENDED MAY 26, 2007 AND MAY 27, 2006

(unaudited)

(in thousands, except per share data)


	May 26,			May 27,
	2007			2006
Sales (including sales to affiliate of $3,876 and $1,788, respectively)	$	25,227		$	31,957
Cost of sales		15,840			18,909

Gross margin		9,387			13,048

Selling, general and administrative expenses		8,571			9,303
Research and development expenses		6,119			6,305

Operating loss		(5,303	)		(2,560	)

Interest expense		(50	)		(14	)
Interest income		184			244
Impairment and loss on sale of investment		(489	)		—
Other income (expense), net		45			(39	)

Loss before income taxes		(5,613	)		(2,369	)

Income taxes		55			12


Loss before equity in earnings (loss) of affiliate		(5,668	)		(2,381	)

Equity in earnings (loss) of affiliate		25			(52	)


Net loss	$	(5,643	)	$	(2,433	)


Net loss per common share:
Basic	$	(0.19	)	$	(0.08	)
Diluted	$	(0.19	)	$	(0.08	)

Weighted average common shares		30,428			30,075
Weighted average common and potential common shares		30,428			30,075

See accompanying notes to condensed consolidated financial statements.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE NINE MONTHS ENDED MAY 26, 2007 AND MAY 27, 2006

(unaudited)

(in thousands, except per share data)


	May 26,			May 27,
	2007			2006
Sales (including sales to affiliate of $5,355 and $4,386, respectively)	$	96,284		$	72,867
Cost of sales		56,485			37,821

Gross margin		39,799			35,046

Selling, general and administrative expenses		26,177			27,307
Research and development expenses		18,247			18,379

Operating loss		(4,625	)		(10,640	)

Interest expense		(152	)		(28	)
Interest income		638			807
Impairment and loss on sale of investments		(4,088	)		(500	)
Other income, net		289			103

Loss before income taxes		(7,938	)		(10,258	)

Income taxes		130			37


Loss before equity in earnings (loss) of affiliate		(8,068	)		(10,295	)

Equity in earnings (loss) of affiliate		27			(155	)


Net loss	$	(8,041	)	$	(10,450	)


Net loss per common share:
Basic	$	(0.26	)	$	(0.35	)
Diluted	$	(0.26	)	$	(0.35	)

Weighted average common shares		30,383			29,979
Weighted average common and potential common shares		30,383			29,979

See accompanying notes to condensed consolidated financial statements.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED MAY 26, 2007 AND MAY 27, 2006

(unaudited)

(in thousands)


	May 26,			May 27,
	2007			2006
OPERATING ACTIVITIES:
Net loss	$	(8,041	)	$	(10,450	)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock compensation expense		427			807
Impairment and loss on sale of investments		4,088			500
Depreciation		2,723			2,620
Amortization		399			404
Gain on sale of fixed asset		(17	)		—
Equity in (earnings) loss of affiliate		(27	)		155
Changes in operating assets and liabilities:
Restricted cash		(5	)		139
Trade accounts receivable		5,265			1,880
Inventories		177			(6,806	)
Prepaid expenses and other current assets		3,396			(2,454	)
Trade accounts payable		(4,595	)		1,974
Accrued expenses		(3,998	)		(803	)
Customer deposits		(2,937	)		5,884
Deferred profit		(857	)		(213	)

Net cash used in operating activities		(4,002	)		(6,363	)


INVESTING ACTIVITIES:
Capital expenditures		(1,586	)		(1,996	)
Purchases of marketable securities		(66,650	)		(245,550	)
Sales of marketable securities		68,100			252,695
Dividend from affiliate		2,047			208
Proceeds from sale of investments		1,238			—
Proceeds from sale of fixed asset		17			—

Net cash provided by investing activities		3,166			5,357


FINANCING ACTIVITIES:
Net proceeds from issuance of common stock		518			744
Increase in restricted cash		(515	)		—
Principle payments on capital lease		(378	)		—

Net cash (used in) provided by financing activities		(375	)		744


Effect of exchange rate changes on cash and cash equivalents		(77	)		(145	)


Decrease in cash and cash equivalents		(1,288	)		(407	)

Cash and cash equivalents at beginning of period		15,672			11,352


Cash and cash equivalents at end of period	$	14,384		$	10,945

See accompanying notes to condensed consolidated financial statements.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(1) Description of Business and Summary of Significant Accounting Policies

Description of Business

FSI International, Inc. (the “Company”) is a global supplier of surface conditioning equipment (process equipment that is used to wet-etch and remove contaminates from the surfaces of microelectronic substrates and devices), and technology and support services for microelectronics manufacturing. The Company’s broad portfolio of batch and single-wafer cleaning products includes process technologies for immersion (a method used to clean substrates and devices by immersing them in multiple tanks filled with process chemicals), spray (sprays chemical mixtures, water and nitrogen in a variety of sequences on to the substrates and devices), vapor (utilizes gas phase chemistries to selectively remove sacrificial surface films) and CryoKinetic (a momentum transfer process used to remove non-chemically bonded particles from the surface of substrates and devices). The Company’s support services programs provide product and process enhancements to extend the life of installed FSI equipment.

The Company announced the winding down of its Microlithography business in March 2003 and transitioned the Microlithography (uses light to transfer a circuit pattern onto microelectronic substrates and devices) business to a POLARIS^® Systems and Services (“PSS”) organization to focus on supporting the more than 300 installed POLARIS^® Systems, including refurbishments, upgrades, training and spares.

The Company’s customers include microelectronics manufacturers located throughout North America, Europe, Japan and the Asia-Pacific region.

Condensed Consolidated Financial Statements

The accompanying condensed consolidated financial statements have been prepared by the Company without audit and reflect all adjustments (consisting only of normal and recurring adjustments, except as disclosed in the notes) which are, in the opinion of management, necessary to present a fair statement of the results for the interim periods presented. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission (“SEC”) but omit certain information and footnote disclosures necessary to present the statements in accordance with accounting principles generally accepted in the United States of America. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended August 26, 2006, previously filed with the SEC.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that could affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

New Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This interpretation is effective for the Company

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

beginning in fiscal year 2008. The Company is still evaluating the impact that the adoption of this pronouncement will have on its consolidated financial statements.

In June 2006, the FASB ratified the Emerging Issues Task Force (EITF) consensus on EITF Issue No. 06-3 “How Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF No. 06-3”). The scope of EITF No. 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer, and provides that a company may adopt a policy of presenting taxes either gross within revenue or on a net basis. For any such taxes that are reported on a gross basis, a company should disclose the amounts of those taxes for each period for which an income statement is presented if those amounts are significant. This statement is effective to financial reports for interim and annual reporting periods beginning after December 15, 2006. EITF No. 06-3 became effective for the Company as of February 25, 2007. The Company collects various sales and value-added taxes on certain product and service sales, which are accounted for on a net basis.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” to address diversity in practice in quantifying financial statement misstatements. SAB No. 108 requires that the Company quantify misstatements based on their impact on each of the Company’s financial statements and related disclosures. SAB No. 108 is effective as of the end of the Company’s fiscal year 2007, allowing a one-time transitional cumulative effect adjustment to retained earnings as of August 27, 2006, for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. The Company is still evaluating the impact SAB No. 108 will have on its consolidated financial statements and will adopt SAB No. 108 in the fourth quarter of fiscal 2007.

In September 2006, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 157, “Fair Value Measurements.” SFAS No. 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value and requires additional disclosures about fair-value measurements. This statement applies only to fair-value measurements that are already required or permitted by other accounting standards, except for measurements of share-based payments and measurements that are similar to, but not intended to be, fair value. This statement is expected to increase the consistency of fair value measurements, but imposes no requirements for additional fair-value measures in financial statements. The provisions under SFAS No. 157 are effective for the Company beginning in the first quarter of fiscal 2008. The Company is still evaluating the impact the adoption of this pronouncement will have on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 115” (SFAS No. 159). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of fiscal years that begin after November 15, 2007. The Company is still evaluating the impact the adoption of this pronouncement will have on its consolidated financial statements.

Reclassifications

Certain amounts have been reclassified to conform to the current year presentation.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(2) Inventories, net

Inventories, net are summarized as follows (in thousands):


	May 26,		August 26,
	2007		2006
Finished products	$	3,511	$	4,756
Work-in-process		13,995		17,435
Subassemblies		4,259		2,911
Raw materials and purchased parts		13,739		10,580

	$	35,504	$	35,682

(3) Accrued expenses

Accrued expenses are summarized as follows (in thousands):


	May 26,		August 26,
	2007		2006
Salaries and benefits	$	3,789	$	3,667
Product warranty		4,023		3,964
Professional fees		418		489
Income taxes		1,194		1,260
VAT taxes		192		4,257
Other		1,601		1,575

	$	11,217	$	15,212

(4) Supplementary cash flow information

The following summarizes supplementary cash flow items (in thousands):


	Nine Months Ended
	May 26,		May 27,
	2007		2006
Income taxes paid	$	93	$	32
Interest paid, net		153		—
Assets acquired by a capital lease	$	1,687	$	—

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(5) Comprehensive loss

Other comprehensive loss pertains to revenues, expenses, gains and losses that are not included in the net loss but rather are recorded directly in stockholders’ equity. For the quarters and nine months ended May 26, 2007 and May 27, 2006, other comprehensive loss consisted of the foreign currency translation adjustment. The components of comprehensive loss are summarized as follows (in thousands):


	Quarters Ended						Nine Months Ended
	May 26,			May 27,			May 26,			May 27,
	2007			2006			2007			2006
Net loss	$	(5,643	)	$	(2,433	)	$	(8,041	)	$	(10,450	)
Foreign currency translation		98			(53	)		(145	)		(600	)

Comprehensive loss	$	(5,545	)	$	(2,486	)	$	(8,186	)	$	(11,050	)

(6) Stock-Based Compensation

Stock-based compensation expense for stock options granted or vested under the Company’s stock incentive plan and Employees Stock Purchase Plan (“ESPP”) was reflected in the statements of operations for the third quarter and first nine months of each of fiscal 2007 and 2006 as follows (in thousands):


	Quarters Ended				Nine Months Ended
	May 26,		May 27,		May 26,		May 27,
	2007		2006		2007		2006
Cost of goods sold	$	6	$	11	$	22	$	32
Selling, general and administrative		112		193		316		550
Research and development		20		79		89		225

	$	138	$	283	$	427	$	807

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

The fair value of each option granted under the Company’s stock incentive plan and ESPP is estimated on the date of grant using the Black-Scholes option-pricing model. The Company uses historical data to estimate the expected price volatility, the expected option life and the expected forfeiture rate. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. The Company has not made any dividend payments nor does it expect to pay dividends in the foreseeable future. The following assumptions were used to estimate the fair value of options granted during the third quarter and first nine months of fiscal 2007 and 2006 using the Black-Scholes option-pricing model:


	Quarters Ended					Nine Months Ended
	May 26,		May 27,			May 26,			May 27,
	2007		2006			2007			2006
Stock options:
Volatility		*		68.0	%		69.0	%		68.5	%
Risk-free interest rates		*		4.9	%		4.7	%		4.5	%
Expected option life		*		5.5			5.5			5.6
Stock dividend yield		*		—			—			—

ESPP:
Volatility		*		*			69.0	%		68.3	%
Risk-free interest rates		*		*			5.1	%		4.3	%
Expected option life		*		*			0.5			0.5
Stock dividend yield		*		*			—			—


*		There were no stock options granted under the Company’s option plan in the third quarter of fiscal 2007 or under the ESPP in the third quarter of fiscal 2007 or the third quarter of fiscal 2006.

A summary of option activity for the first nine months of fiscal 2007 is as follows (in thousands, except price per share and contractual term):


						Weighted
				Weighted		-average
				-average		Remaining		Aggregate
	Number of			Exercise Price		Contractual		Intrinsic
	Shares			Per Share		Term		Value
Outstanding as of August 26, 2006		3,699		$	7.42
Options granted		173			5.20
Options forfeited		(5	)		3.73
Options expired		(179	)		11.26
Options exercised		(54	)		3.50


Outstanding as of May 26, 2007		3,634		$	7.19		5.4	$	778


Exercisable as of May 26, 2007		3,306		$	7.43		5.1	$	731

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

The weighted-average grant-date fair value based on the Black-Scholes option-pricing model for options granted in the first nine months of fiscal 2007 was $3.32 per share, for options granted in the third quarter of fiscal 2006 was $3.22 per share, and options granted in the first nine months of fiscal 2006 was $3.10 per share. The total intrinsic value of options exercised was $13,500 during the third quarter of fiscal 2007, $108,200 during the first nine months of fiscal 2007, $92,000 during the third quarter of fiscal 2006 and $203,700 during the first nine months of fiscal 2006.

A summary of the status of our unvested options as of May 26, 2007 is as follows (in thousands, except fair value amounts):


				Weighted-average
	Number of			Grant-Date Fair
	Shares			Value
Unvested at August 26, 2006		303		$	2.75
Options granted		173			3.32
Options forfeited		(5	)		2.30
Options vested		(143	)		2.80


Unvested at May 26, 2007		328		$	3.04

As of May 26, 2007, there was $852,000 of total unrecognized compensation cost related to unvested share-based compensation granted under our plans. That cost is expected to be recognized over a weighted-average period of 1.1 years. The total fair value of option shares vested during the third quarter of fiscal 2007 was $138,000, $427,000 during the first nine months of fiscal 2007, $283,000 during the third quarter of fiscal 2006, and $806,000 during the first nine months of fiscal 2006.

(7) Capital Lease

The Company entered into a capital lease to finance lab equipment during the first quarter of fiscal 2007. The future minimum lease payments as of May 26, 2007 are as follows (in thousands):


Last three months of fiscal 2007	$	162
Fiscal 2008		648
Fiscal 2009		647

		1,457
Less imputed interest		(148	)

Total capital lease obligation	$	1,309

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(8) m•FSI LTD Transaction

Prior to the transaction described below, the Company owned a 49 percent equity interest in m•FSI, LTD (“m•FSI”), a Japanese joint venture company formed in 1991 among the Company, Mitsui & Co., Ltd. (“Mitsui”) and Mitsui’s wholly owned subsidiary, Chlorine Engineers Corp., Ltd. (“CEC”). m•FSI is engaged in the manufacturing and distribution in the Japanese market of semiconductor equipment and products, including certain products of FSI. The Company, CEC, Mizuho Capital Co., Ltd, (“Mizuho”), The Yasuda Enterprise Development III, Limited Partnership (“Yasuda”) and certain m•FSI managers (“m•FSI Management Group”) entered into a Stock Purchase Agreement (the “Agreement”). The m•FSI Management Group does not include any officers or employees of the Company. Under the Agreement, m•FSI paid on May 15, 2007, (the “Closing Date”), a $4.2 million dividend to its shareholders prior to the sales contemplated in the Agreement, of which the Company received approximately $2.0 million. In addition, under the Agreement, CEC and MBK Project Holdings Ltd. (“MPH”), a wholly owned subsidiary of Mitsui, sold all of their combined 51 percent equity ownership in m•FSI and the Company sold 28.4 percent of its equity ownership in m•FSI, or a total of 79.4 percent, to Yasuda, Mizuho and the m•FSI Management Group for a total purchase price of $1.8 million. On the Closing Date, the Company received total proceeds of $3.2 million, net of applicable taxes. The Company maintains a 20.6 percent equity ownership in m•FSI after the completion of the transaction. As a result of the transaction, the Company’s ownership and business relationship with m•FSI changed such that the Company no longer had the ability to exercise significant influence over m•FSI. Therefore, beginning in the fourth quarter of fiscal 2007, the Company will begin to account for its investment in m•FSI under the cost method. Previously, the Company accounted for its investment in m•FSI under the equity method. On the Closing Date, the Company entered into a Termination and Release Agreement with Mitsui, CEC, MPH and m•FSI, for the termination of the following agreements and any amendments thereto:

	(i)		the m•FSI Distribution Agreement, dated September 17, 2004, providing the Company with the exclusive rights to distribute m•FSI surface conditioning products outside of Japan,

	(ii)		the FSI Distribution Agreement, dated June 5, 1991, providing m•FSI with exclusive rights to distribute the Company surface conditioning products in Japan,

	(iii)		the m•FSI License Agreement, dated September 17, 2004, pursuant to which m•FSI granted to the Company a license to certain m•FSI intellectual property and technology,

	(iv)		the FSI License Agreement, dated June 5, 1991, pursuant to which the Company granted to m•FSI a license to certain of the Company’s intellectual property and technology, and

	(v)		the Shareholders Agreement, dated June 5, 1991, among the Company, CEC and MPH related to the establishment of m•FSI.

Finally, the Company and m•FSI entered into a new distribution agreement, with an initial five-year term, providing m•FSI with the exclusive right to sell, lease or otherwise distribute FSI surface conditioning products in Japan. Also, the Company, Mizuho, Yasuda and the m•FSI Management Group entered into a new shareholders agreement providing for certain governance, transfer and other rights and restrictions related to their ownership of m•FSI.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(9) Impairment and loss on sale of Investments

In anticipation of completing the transaction described in Note 8, the Company recorded a $3.6 million impairment charge in the second quarter of fiscal 2007. With the completion of the transaction in the third quarter of fiscal 2007, the Company recorded an additional $0.5 million charge related to the transaction described in Note 8. During the first nine months of fiscal 2007, the Company recorded net charges of $4.1 million related to the transaction described in Note 8.

In the second quarter of fiscal 2006, the Company recorded a $0.5 million asset impairment charge associated with an investment it had in a Malaysian foundry that was accounted for under the cost method. On March 22, 2006, the majority shareholder of this Malaysian foundry announced that the foundry would merge with another foundry and form a new entity. Subsequent to the merger announcement, the Company was contacted by the majority shareholder and given the option of selling its shares at a nominal value to the majority shareholder or providing additional debt to the foundry as part of a pre-merger restructuring. Based on this information, the Company deemed its investment as being fully impaired as of February 25, 2006 and recorded a loss of $0.5 million in the second quarter of fiscal 2006. The Company sold its shares at a nominal value to the majority shareholder during the third quarter of fiscal 2006.

(10) Contingencies

The Company generates minor amounts of liquid and solid hazardous waste and uses licensed haulers and disposal facilities to ship and dispose of such waste. In the past, the Company has received notices from state or federal enforcement agencies that the Company is a potentially responsible party (“PRP”) in connection with the investigation of several hazardous waste disposal sites owned and operated by third parties. In each matter, the Company has elected to participate in settlement offers made to all de minimis parties with respect to such sites. The risk of being named a PRP is that if any of the other PRP’s are unable to contribute its proportionate share of the liability, if any, associated with the site, those PRP’s that are financially able could be held financially responsible for the shortfall. The Company currently does not have any of these claims outstanding.

In late calendar 2006, the Company determined that certain of its replacement valves, pumps and heaters could fall within the scope of United States export licensing regulations to products that could be used in connection with chemical weapons processes. The Company determined that these regulations require it to obtain licenses to ship some of its replacement spare parts, spare parts kits and assemblies to customers in certain controlled countries as defined in the export licensing regulations. During the second quarter of fiscal 2007, the Company was granted licenses to ship replacement spare parts, spare parts kits and assemblies to all customers in the controlled countries where the Company conducts business.

The applicable export licensing regulations frequently change. Moreover, the types and categories of products that are subject to export licensing are often described in the regulations in general terms and could be subject to differing interpretations.

In the second quarter of fiscal 2007, the Company made a voluntary disclosure to the United States Department of Commerce to clarify its licensing practices and to review its practices with respect to prior sales of certain replacement valves, pumps and heaters to customers in several controlled countries as defined in the licensing regulations.

The United States Department of Commerce could assess penalties for any past violation of export control regulations. The potential penalties are dependent upon the number of shipments in violation of the export control regulations. The penalties can range from zero to $50,000 per violation. Management believes that the resolution of this matter will not have a material adverse impact to the Company’s consolidated financial condition. The licenses that were granted during the second quarter of fiscal 2007 do not necessarily mitigate the Company’s risk with respect to past violations.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

(11) Cost Reductions

In the third quarter of fiscal 2007, the Company implemented cost reduction actions including an 11% reduction in headcount to approximately 500 employees and other operating cost initiatives. The cost reduction actions were related to industry conditions in the semiconductor device and thin film head (a device manufactured on a silicon wafer which is capable of reading and writing information onto a compact disc or other information storage device) segments that the Company serves, coupled with a delay in certain customer-specific equipment purchases. A total of 61 positions were eliminated in connection with this reduction of which 36 were manufacturing positions, 13 were sales, service and marketing positions and 12 were engineering positions. The terminations all occurred in the third quarter of fiscal 2007. Severance and outplacement costs recorded in the third quarter of fiscal 2007 were allocated as follows: $216,000 to selling, general and administrative expense, $216,000 to research and development expense and $142,000 to cost of goods sold.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The information in this report, except for the historical information, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and is subject to the safe harbor created by that statute. Typically, we identify forward-looking statements by use of an asterisk “*.” In some cases, you can identify forward-looking statements by terminology such as “expects,” “anticipates,” “intends,” “may,” “should,” “plans,” “believes,” “seeks,” “estimates,” “could,” “would,” or the negative of such terms or other comparable terminology. These forward-looking statements include, but are not limited to expected orders, revenues, gross margin, operating expense run rate, net loss and cash usage for the fourth quarter of fiscal 2007; and expected fourth quarter actions to lower our breakeven revenue level and to improve margins. These statements are subject to various risks and uncertainties, both known and unknown. Factors that could cause actual results to differ from these forward-looking statements include, but are not limited to the length and extent of industry slowdowns and recoveries; order delays or cancellations; general economic conditions; changes in customer capacity requirements and demand for microelectronics; the extent of demand for our products and our ability to meet demand; global trade policies; worldwide economic and political stability; our successful execution of internal performance plans; the cyclical nature of our business; volatility of the market for certain products; performance issues with key suppliers and subcontractors; the level of new orders; timely achievement of product acceptances; the timing and success of current and future product and process development programs; the success of our distributor in Japan; the success of our direct distribution organization; and the potential impairment of long-lived assets; as well as other factors listed from time to time in our SEC reports including, but not limited to, the Risk Factors set forth in the Form 10-K, as amended, for the fiscal year ended August 26, 2006. Readers also are cautioned not to place undue reliance on these forward-looking statements as actual results could differ materially. We undertake no duty to update any of the forward-looking statements after the date of this report.

This discussion and analysis should be read in conjunction with the Consolidated Condensed Financial Statements and footnotes thereto appearing elsewhere in this report.

Industry

In general, semiconductor and equipment industry analysts have become more cautious with respect to calendar 2007. Many analysts anticipate that demand for semiconductors will improve in the second half of calendar 2007 as compared to the first half.* On the other hand, some analysts are forecasting demand for equipment to weaken in the second half of calendar 2007 before recovering again in calendar 2008.*

Several semiconductor manufacturers have announced spin-offs and fab light initiatives. These changes are impacting how equipment suppliers conduct business. The recently announced combination of ST Microelectronics and Intel’s NOR (a type of flash memory chip with capabilities for applications in which programs run directly from memory) flash businesses and Texas Instruments’ announcement to partner with an Asian foundry are examples of such transactions. These initiatives, at least in the near term, can disrupt momentum on both revenue and development fronts, as the manufacturers involved delay or reduce spending until they implement their business model changes.*

In a softening industry environment, customers may take the opportunity to evaluate new products and process technologies. We continue to experience a steady flow of demonstration requests for our products and applications, particularly our ZETA^® ViPR™ technology.

It is often during periods of lower sales growth and reduced profit margins that customers request longer on-site product evaluations, sales concessions and delayed payment terms. In addition, in an effort to reduce costs and preserve cash, many customers let on-site support contracts expire. Due to lost revenue and profits, these actions put more financial burden on equipment suppliers.

Overview

During the third quarter of fiscal 2007, we completed the restructuring of m•FSI, our Japanese joint venture with Mitsui. m•FSI, established in 1991, is engaged in manufacturing and distributing semiconductor equipment and products in the Japanese market, including our surface conditioning products.

In the third quarter, we gained acceptance of another evaluation system at a key Asian customer. We also demonstrated the high volume throughput version of our MAGELLAN^® system in a customer’s production fab. As a result of leads during our Knowledge Service Seminars, we saw increased customer interest in our ViPR™ technology. In addition, we continued with customer process qualification for our new single wafer wet cleaning system.

With expected revenue in the $20 to 25 million range for the August and November 2007 quarters, we are conducting a comprehensive program and cost structure review and expect to take actions in the fourth quarter, focused on lowering our breakeven revenue level and improving our margins.* Our challenge, in the current industry environment, is to restructure our business without negatively impacting sales opportunities with new and existing customers of our flagship products while sustaining our key development initiatives and preserving our cash.

Application of Critical Accounting Policies and Estimates

In accordance with Securities and Exchange Commission guidance, those material accounting policies that we believe are the most critical to an investor’s understanding of our financial results and condition and require complex management judgment are discussed below.

Our critical accounting policies and estimates are as follows:

	•		revenue recognition;

	•		valuation of long-lived assets;

	•		estimation of valuation allowances and accrued liabilities, specifically product warranty, inventory reserves and allowance for doubtful accounts;

	•		stock-based compensation; and

	•		income taxes.

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectibility is reasonably assured. If our equipment sales involve sales to our existing customers who have previously accepted the same type(s) of equipment with the same type(s) of specifications, we account for the product sales as a multiple element arrangement. Revenue from multiple element arrangements is allocated among the separate accounting units based on the residual method. Under the residual method, the revenue is allocated to undelivered elements based on fair value of such undelivered elements and the residual amounts of revenue allocated to delivered elements. We recognize the equipment revenue upon shipment and transfer of title. The other multiple elements also include installation, service contracts and training. Equipment installation revenue is valued based on estimated service person hours to complete installation and published or quoted service labor rates and is recognized when the installation has been completed and the equipment has been accepted by the customer. Training revenue is valued based on published training class prices or quoted rates and is recognized when the customers complete the training classes or when a customer-specific training period has expired. The published or quoted service labor rates and training class prices are rates actually charged and billed to our customers.

All other product sales with customer-specific acceptance provisions are recognized upon customer acceptance. Future revenues may be negatively impacted if we are unable to meet customer-specific acceptance criteria. Revenue related to spare part sales is recognized upon shipment or delivery based on the title transfer terms. Revenues related to maintenance and service contracts are recognized ratably over the duration of such contracts.

The timing and amount of revenue recognized depends on whether revenue is recognized upon shipment versus acceptance. For revenue recognized upon acceptance, it is dependent upon when customer-specific criteria are met.

Valuation of Long-Lived Assets

We assess the impairment of identifiable long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

If we determine that the carrying value of long-lived assets may not be recoverable, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model or another valuation technique. Net intangible assets and long-lived assets amounted to $21.6 million as of May 26, 2007 and as of August 26, 2006.

Product Warranty Estimation

We record a liability for warranty claims at the time of sale. The amount of the liability is based on the trend in the historical ratio of claims to sales, releases of new products and other factors. The warranty periods for new equipment manufactured by us typically range from one to two years. Special warranty reserves are also accrued for major rework campaigns. Although management believes the likelihood to be relatively low, claims experience could be materially different from actual results because of the introduction of new, more complex products; competition or other external forces; manufacturing changes that could impact product quality; or as yet unrecognized defects in products sold.

Inventory Reserves Estimation

We record reserves for inventory shrinkage and for potentially excess, obsolete and slow moving inventory. These reserves are based upon historical loss trends, inventory levels, physical inventory and cycle count adjustments, expected product lives, forecasted sales demand and recoverability. Results could be materially different if demand for our products decreased because of economic or competitive conditions, length of the industry downturn, or if products become obsolete because of technical advancements in the industry or by us.

In the second quarter of fiscal 2003, we recorded POLARIS^® Systems and Services (“PSS”) product inventory reserves as a result of the wind-down of our Microlithography business. During the first nine months of fiscal 2007, we had sales of PSS product inventory that had previously been written down to zero with an original cost of approximately $887,000. During the third quarter and first nine months of fiscal 2006, we had sales of PSS product inventory that had previously been written down to zero with an original cost of $410,000 and $2.0 million, respectively. Also, in the first nine months of fiscal 2007, we recorded an additional $1.2 million reserve related to used tools and other raw materials purchased since March 2003 to be used for refurbished equipment. Since the write-down of the inventory in fiscal 2003, we have had cumulative sales of PSS product inventory that had previously been written down to zero and reductions in inventory buyback requirements of approximately $9.7 million and have disposed of approximately $6.5 million of PSS product inventory. The original cost of PSS product inventory available for sale or to be disposed of as of May 26, 2007 that has been written down to zero was approximately $8.7 million. Total inventory reserves were $14.7 million as of May 26, 2007 and $13.8 million as of August 26, 2006.

Allowance for Doubtful Accounts Estimation

Management must estimate the uncollectibility of our accounts receivable. The most significant risk is a sudden

unexpected deterioration in financial condition of a significant customer who is not considered in the allowance. Management specifically analyzes accounts receivable, historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Results could be materially impacted if the financial condition of a significant customer deteriorated, due to the cyclicality of our industry or for other reasons, and related accounts receivable are deemed uncollectible. Accounts receivable are charged off after management determines that they are uncollectible.

Stock-Based Compensation

We implemented the fair value recognition provisions of SFAS No. 123R effective August 28, 2005 using the modified prospective method. Under this method, we recognize compensation expense for all stock-based awards granted on or after August 28, 2005 and for previously granted awards not yet vested as of August 28, 2005.

We utilize the Black-Scholes option-pricing model to estimate fair value of each award on the date of grant. The Black-Scholes model requires the input of certain assumptions that involve management judgment. Key assumptions that affect the calculation of fair value include the expected life of stock-based awards and our stock price volatility. Additionally, we expense only those shares expected to vest. The assumptions used in calculating the fair value of stock-based awards and the forfeiture rate of such awards reflect management’s best estimates. However, circumstances may change and additional data may become available over time, which could result in changes to these assumptions that materially impact the fair value determination of future awards or their estimated rate of forfeiture. If factors change and we use different assumptions in the application of SFAS 123R in future periods, the compensation expense recorded under SFAS 123R may differ significantly from the expense recorded in the current period.

Income Taxes

Our effective income tax rate is based on income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. We have established valuation allowances against a portion of the U.S. and non-U.S. net operating losses to reflect the uncertainty of our ability to fully utilize these benefits given the limited carryforward periods permitted by the various jurisdictions. The evaluation of the realizability of our net operating losses requires the use of considerable management judgment to estimate the future taxable income for the various jurisdictions, for which the ultimate amounts and timing of such estimates may differ. The valuation allowance can also be impacted by changes in the tax regulations.

Significant judgment is required in determining our contingent tax liabilities. We have established contingent tax liabilities using management’s best judgment and adjust these liabilities as warranted by changing facts and circumstances. A change in our tax liabilities in any given period could have a significant impact on our results of operations and cash flows for that period.

THIRD QUARTER AND FIRST NINE MONTHS OF FISCAL 2007 COMPARED TO THIRD QUARTER AND FIRST NINE MONTHS OF FISCAL 2006

The Company

The following table sets forth on a consolidated basis, for the fiscal period indicated, certain income and expense items as a percent of total sales.


	Percent of Sales						Percent of Sales
	Quarter Ended						Nine Months Ended
	May 26,			May 27,			May 26,			May 27,
	2007			2006			2007			2006
Sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		62.8			59.2			58.7			51.9

Gross margin		37.2			40.8			41.3			48.1
Selling, general and administrative		34.0			29.1			27.2			37.5
Research and development		24.2			19.7			18.9			25.2

Operating loss		(21.0	)		(8.0	)		(4.8	)		(14.6	)
Other income, net		(1.2	)		0.6			(3.4	)		0.5

Loss before income taxes		(22.2	)		(7.4	)		(8.2	)		(14.1	)
Income taxes		0.2			—			0.1			—
Equity in (loss) earnings of affiliate		—			(0.2	)		—			(0.2	)

Net loss		(22.4	)%		(7.6	)%		(8.3	)%		(14.3	)%

Sales Revenue and Shipments

Sales revenue decreased by $6.7 million to $25.2 million for the third quarter of fiscal 2007 as compared to $32.0 million for the third quarter of fiscal 2006. The decrease in sales revenue related primarily to a decrease in shipments from $28.6 million in the third quarter of fiscal 2006 to $20.9 million in the third quarter of fiscal 2007. The decrease in shipments related to a decrease in customer orders as a result of slower industry conditions in the third quarter of fiscal 2007 than the third quarter of fiscal 2006. Sales revenue increased by $23.4 million to $96.3 million for the first nine months of fiscal 2007 as compared to $72.9 million for the first nine months of fiscal 2006. The increase in sales revenue related to an increase in shipments from $73.3 million in the first nine months of fiscal 2006 to $95.0 million in the first nine months of fiscal 2007. The increase in shipments primarily related to an increase in backlog from $19.3 million as of the beginning of the first nine months of fiscal 2006 to $39.8 million as of the beginning of the first nine months of fiscal 2007 associated with industry cycles.

Based upon our revenue recognition policy, certain shipments to customers are not recognized until customer acceptance. Therefore, depending on the timing of shipments and customer acceptances, there are time periods where shipments may exceed sales revenue or sales revenue may exceed shipments.

International sales were $18.9 million, representing 75% of total sales, during the third quarter of fiscal 2007 and $18.7 million, representing 59% of total sales, during the third quarter of fiscal 2006. The net increase in international sales related to increases in Europe and Japan, net of decreases in the Far East. International sales were $65.8 million, representing 68% of total sales, during the first nine months of fiscal 2007 and $42.4 million, representing 58% of total sales, during the first nine months of fiscal 2006. The increase in international sales related to increases in Europe and the Far East.

We expect fourth quarter of fiscal 2007 revenues to be between $20 and $24 million.* A portion of the expected revenue is subject to us obtaining timely acceptance from our customers and orders are subject to cancellation.

Gross Margin

Our gross profit margin fluctuates due to a number of factors, including the mix of products sold; the geographic mix of products sold, with international sales generally having lower gross profit than domestic sales; initial product placement discounts; utilization of manufacturing capacity; sales of PSS product inventory previously written down to zero; and the competitive pricing environment.

Gross margin as a percentage of sales for the third quarter of fiscal 2007 was 37.2% as compared to 40.8% for the third quarter of fiscal 2006. Gross margin as a percentage of sales for the first nine months of fiscal 2007 was 41.3% as compared to 48.1% for the first nine months of fiscal 2006. The decreases in margin in the fiscal 2007 periods were primarily due to an increase in the percentage of international sales as a percent of total sales and a product mix change. The change in gross margin in the third quarter of fiscal 2007 as compared to the third quarter of fiscal 2006 was also impacted by a reduction in our capacity utilization rate as shipments declined.

The fiscal 2007 margins were also impacted by the usage of PSS product inventory that had previously been written down to zero, offset by additional inventory reserves. During the third quarter of fiscal 2007, we had no significant sales of PSS product inventory that had previously been written down to zero. During the first nine months of fiscal 2007, we had sales of PSS product inventory with an original cost of $887,000 that had previously been written down to zero. The increase in gross margin was partially offset by $389,000 of additional inventory reserves recorded in the third quarter of fiscal 2007 and $1.2 million of additional inventory reserves recorded in the first nine months of fiscal 2007 related to excess inventory purchased since March 2003 to be used for refurbished equipment. In the third quarter of fiscal 2006, we had sales of PSS product inventory with an original cost of $410,000 that had previously been written down to zero. In the first nine months of fiscal 2006, we had sales of PSS product inventory with an original cost of $2.0 million that had previously been written down to zero.

We continue to try to sell the impaired inventory to our customers as spares, refurbished systems and upgrades to existing systems. If unsuccessful, some of the items will be disposed. Any significant sales of the impaired inventory will be disclosed. Gross margins will be higher if inventory carried at a reduced cost is sold.

Gross margins for the fourth quarter of fiscal 2007 are expected to be between 41% to 43% of revenues due to expected product and geographic sales mix, partially offset by a low factory utilization rate.* The gross margin expectations do not reflect any impact from the comprehensive program and cost structure review that we are conducting and expect to begin implementing in the fourth quarter of fiscal 2007.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased to $8.6 million for the third quarter of fiscal 2007 as compared to $9.3 million for the third quarter of fiscal 2006. Selling, general and administrative expenses were $26.2 million for the first nine months of fiscal 2007 as compared to $27.3 million for the same period in fiscal 2006. The decreases in selling, general and administrative expenses for 2007 primarily related to continued cost control efforts, including the reduction in headcount and travel restrictions imposed on our employees.

We expect selling, general and administrative expenses in the fourth quarter of fiscal 2007 to be in the range of $8.3 to $8.5 million as we experience the full quarterly impact of cost reductions implemented in March 2007.* The expense estimates do not reflect any impact from the comprehensive program and cost structure review that we are conducting and expect to begin implementing in the fourth quarter of fiscal 2007.

Research and Development Expenses

Research and development expenses were $6.1 million for the third quarter of fiscal 2007 as compared to $6.3 million for the third quarter in fiscal 2006. Research and development expenses were $18.2 million for the first nine months of fiscal 2007 as compared to $18.4 million for the same period in fiscal 2006. The majority of our research and development resources are focused on expanding the application capabilities of our products,

supporting initial product placements at customer locations and development and demonstration of our new single wafer cleaning system.

Research and development expenses for the fourth quarter of fiscal 2007 are expected to be in the range of $5.7 to $5.9 million as we continue to invest in new application and product development programs and provide support for product evaluations at customer locations along with laboratory demonstrations.* The expense estimates do not reflect any impact from the comprehensive program and cost structure review that we are conducting and expect to begin implementing in the fourth quarter of fiscal 2007.

Impairment and Loss on Sale of Investment

We recorded $0.5 million of impairment and loss on sale of investment for the third quarter of fiscal 2007, $4.1 million for the first nine months of fiscal 2007 and $0.5 million of impairment of investment for the first nine months of fiscal 2006. See further discussion related to these impairments in Note 9 of the Notes to Condensed Consolidated Financial Statements.

Income Taxes

We recorded tax expense of $55,000 in the third quarter of fiscal 2007, $12,000 in the third quarter of fiscal 2006, $130,000 in the first nine months of fiscal 2007 and $37,000 in the first nine months of fiscal 2006. The increases in income tax expense in the fiscal 2007 periods primarily related to foreign withholding taxes.

Our deferred tax assets on the balance sheet as of May 26, 2007 have been fully reserved with a valuation allowance. We do not expect to reverse our valuation allowance until we are consistently profitable on a quarterly basis.*

We have net operating loss carryforwards for federal income tax purposes of approximately $149.4 million, which will begin to expire in fiscal year 2011 through fiscal 2027 if not utilized. Of this amount, approximately $15.0 million is subject to Internal Revenue Code Section 382 limitations on utilization. This limitation is approximately $1.4 million per year.

Equity in Earnings (Loss) of Affiliate

The equity in earnings (loss) of affiliate was approximately $25,000 of income for the third quarter of fiscal 2007, compared to a loss of approximately $52,000 for the third quarter of fiscal 2006. The equity in earnings (loss) of affiliate was approximately $27,000 of income for the first nine months of fiscal 2007, compared to a loss of approximately $155,000 for the first nine months of fiscal 2006.

We will no longer be recording equity in earnings (loss) of affiliates due to the May 15, 2007 transaction with m•FSI LTD. See further discussion related to the transaction in Note 8 of the Notes to Condensed Consolidated Financial Statements.

Net Loss

Net loss was $5.6 million in the third quarter of fiscal 2007, as compared to a net loss of $2.4 million in the third quarter of fiscal 2006. Net loss was $8.0 million for the first nine months of fiscal 2007, as compared to a net loss of $10.5 million for the first nine months of fiscal 2006.

Assuming that we can achieve the projected revenue, gross margin, operating expense levels, interest income and affiliate earnings, we expect to report net loss of $3.5 to $4.5 million for the fourth quarter of fiscal 2007.* The net loss estimate does not reflect any impact from the comprehensive program and cost structure review that we are conducting and expect to begin implementing in the fourth quarter of fiscal 2007.

Liquidity and Capital Resources

Cash, restricted cash, cash equivalents and marketable securities were approximately $24.7 million as of May 26, 2007, a decrease of $2.2 million from the end of fiscal 2006. The net decrease in cash, restricted cash, cash equivalents and marketable securities was primarily due to $4.0 million of cash used in operating activities, $1.6 million in capital expenditures, $0.4 million of principle payments on the capital lease, and $0.1 million of negative currency impact. The decrease in these balances were offset by a $2.0 million dividend received from m•FSI LTD, $1.2 million proceeds related to the sale of a portion of our investment in m•FSI LTD and $0.5 million of proceeds from the issuance of common stock.

Accounts receivable decreased $5.3 million from the end of fiscal 2006 to $17.9 million as of May 26, 2007. The decrease in accounts receivable was primarily due to a decrease in shipments from $36.4 million in the fourth quarter of fiscal 2006 to $20.9 million in the third quarter of fiscal 2007. Accounts receivable will fluctuate from quarter to quarter, depending on individual customers’ timing of ship dates and payment terms. In certain situations, extended payment terms may be granted to customers.

Inventory decreased slightly to $35.5 million at May 26, 2007 as compared to $35.7 million at the end of fiscal 2006. The net decrease in inventory was due to decreases in finished goods and work-in-process inventory, partially offset by increases in subassemblies and raw materials inventory. Inventory reserves were $14.7 million at May 26, 2007 as compared to reserves of $13.8 million at the end of fiscal 2006. The increase in the inventory reserves is related to the slowdown in the industry.

Trade accounts payable decreased approximately $4.6 million to $4.2 million as of May 26, 2007 as compared to $8.8 million at the end of fiscal 2006. The decrease in trade accounts payable related primarily to a decrease in inventory purchases associated with a decrease in bookings.

Customer deposits decreased approximately $2.9 million to $2.5 million as of May 26, 2007 as compared to $5.4 million at the end of fiscal 2006. The decrease primarily relates to a decrease in legacy product bookings which generally require deposits.

Deferred profit decreased approximately $0.8 million to $3.3 million at May 26, 2007 as compared to $4.1 million at the end of fiscal 2006.

As of May 26, 2007, our current ratio of current assets to current liabilities was 3.9 to 1.0 and working capital was $63.8 million. We did not have any outstanding loans with our affiliate, or lines of credit for affiliate, as of May 26, 2007.

The following table provides aggregate information about our contractual payment obligations and the periods in which payments are due (in thousands):


	Payments due by period
Contractual Obligations:	Total		Less than 1 Year		1-3 years		3-5 years		More than 5 years
Operating lease obligations	$	1,874	$	909	$	870	$	95	$	—
Capital lease obligations		1,457		648		809
Purchase obligations		2,995		2,995		—		—		—
Royalty accruals		341		341		—		—		—
Other long-term obligations ⁽¹⁾		2,000		125		500		500	$	875


Total	$	8,667	$	5,018	$	2,179	$	595	$	$875


		⁽¹⁾ Other long-term obligations related to minimum royalty payments or discounts granted under a license agreement.

Capital expenditures were approximately $1.6 million in the first nine months of fiscal 2007 and $2.0 million in the first nine months of fiscal 2006. We expect total capital expenditures to be less than $300,000 in the fourth quarter of fiscal 2007.* Depreciation and amortization for the fourth quarter of fiscal 2007 is expected to be between approximately $1.1 million to $1.2 million.*

At the expected revenue and expense run rate, we anticipate using approximately $2.5 to $3.5 million in net cash for operations in the fourth quarter of fiscal 2007.* The cash usage estimate does not reflect any impact from the comprehensive program and cost structure review that we are conducting and expect to begin implementing in the fourth quarter of fiscal 2007. The comprehensive program and cost structure review initiative is focused on lowering our break even revenue level, improving our margins and preserving cash. We believe that with existing cash, cash receipts, cash equivalents, marketable securities and internally generated funds, there will be sufficient funds to meet our currently projected working capital requirements, and to meet other cash requirements through at least mid-fiscal 2008.* We believe that success in our industry requires substantial capital to maintain the flexibility to take advantage of opportunities as they arise. One of our strategic objectives is, as market and business conditions warrant, to consider divestitures, investments or acquisitions of businesses, products or technologies, particularly those that are complementary to our surface conditioning business. We may fund such activities with additional equity or debt financing. The sale of additional equity or debt securities, whether to maintain flexibility or to meet strategic objectives, could result in additional dilution to our shareholders.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

New Accounting Pronouncements

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109.” This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This interpretation is effective for us beginning in fiscal year 2008. We are still evaluating the impact that the adoption of this pronouncement will have on our consolidated financial statements.

includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer, and provides that a company may adopt a policy of presenting taxes either gross within revenue or on a net basis. For any such taxes that are reported on a gross basis, a company should disclose the amounts of those taxes for each period for which an income statement is presented if those amounts are significant. This statement is effective to financial reports for interim and annual reporting periods beginning after December 15, 2006. EITF No. 06-3 became effective for us as of February 25, 2007. We collect various sales and value-added taxes on certain product and service sales, which are accounted for on a net basis.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” to address diversity in practice in quantifying financial statement misstatements. SAB No. 108 requires that we quantify misstatements based on their impact on each of our financial statements and related disclosures. SAB No. 108 is effective as of the end of our fiscal year 2007, allowing a one-time transitional cumulative effect adjustment to retained earnings as of August 27, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. We are still evaluating the impact SAB No. 108 will have on our consolidated financial statements and will adopt SAB No. 108 in the fourth quarter of fiscal 2007.

In September 2006, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 157, “Fair Value Measurements.” SFAS No. 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value and requires additional disclosures about fair-value measurements. This statement applies only to fair-value measurements that are already required or permitted by other accounting standards, except for measurements of share-based payments and measurements that are similar to, but not intended to be, fair value. This statement is expected to increase the consistency of fair value measurements, but imposes no requirements for additional fair-value measures in financial statements. The provisions under SFAS No. 157 are effective for us beginning in the first quarter of fiscal 2008. We are still evaluating the impact the adoption of this pronouncement will have on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 115” (SFAS No. 159). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of fiscal years that begin after November 15, 2007. We are still evaluating the impact the adoption of this pronouncement will have on our consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our cash flows and earnings are subject to fluctuations in foreign exchange rates due to an investment in our foreign-based affiliate. As of May 26, 2007, our investment represents a 20.6% interest in m•FSI LTD, a distributor of our products that operates in Japan. We denominate the majority of our sales outside of the U.S. in U.S. dollars.

Because we assumed direct sales, service and applications support and logistics responsibilities for our products in Europe and the Asia Pacific region in March 2003, we have and will continue to incur labor, service and other expenses in foreign currencies. As a result, we may be exposed to fluctuations in foreign exchange rate risks.* As of May 26, 2007, we had not entered into any hedging activities and our foreign currency transaction gains and losses for the third quarter and first nine months of fiscal 2007 were insignificant. We are currently evaluating various hedging activities and other options to minimize these risks.

We do not have significant exposure to changing interest rates as we currently have no material long-term debt. As of May 26, 2007, amortized cost approximated market value for all outstanding marketable securities. We do not undertake any specific actions to cover our exposure to interest rate risk and we are not party to any interest rate risk management transactions. The impact on loss before income taxes of a 1% change in short-term interest rates would be approximately $247,000 based on our cash, restricted cash, cash equivalents and marketable securities balances as of May 26, 2007.

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on this evaluation, the principal executive officer and the principal financial officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There was no change in our internal control over financial reporting during our most recently completed fiscal quarter 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

We generate minor amounts of liquid and solid hazardous waste and use licensed haulers and disposal facilities to ship and dispose of such waste. In the past, we have received notices from state or federal enforcement agencies that we are a potentially responsible party (“PRP”) in connection with the investigation of several hazardous waste disposal sites owned and operated by third parties. In each matter, we have elected to participate in settlement offers made to all de minimis parties with respect to such sites. The risk of being named a PRP is that if any of the other PRP’s are unable to contribute its proportionate share of the liability, if any, associated with the site, those PRP’s that are financially able could be held financially responsible for the shortfall. We currently do not have any of these claims outstanding.

In late calendar 2006, we determined that certain of our replacement valves, pumps and heaters could fall within the scope of United States export licensing regulations to products that could be used in connection with chemical weapons processes. We determined that these regulations require us to obtain licenses to ship some of our replacement spare parts, spare parts kits and assemblies to customers in certain controlled countries as defined in the export licensing regulations. During the second quarter of fiscal 2007, we were granted licenses to ship replacement spare parts, spare parts kits and assemblies to all customers in the controlled countries where we currently conduct business.

In the second quarter of fiscal 2007, we made a voluntary disclosure to the United States Department of Commerce to clarify our licensing practices and to review our practices with respect to prior sales of certain replacement valves, pumps and heaters to customers in several controlled countries as defined in the licensing regulations.

The United States Department of Commerce could assess penalties for any past violation of export control regulations. The potential penalties are dependent upon the number of shipments in violation of the export control regulations. The penalties can range from zero to $50,000 per violation. We believe that the resolution of this matter will not have a material adverse impact on our consolidated financial condition. The licenses that were granted during the second quarter of fiscal 2007 do not necessarily mitigate our risk with respect to past violations.

ITEM 1.A. Risk Factors

There have not been any material changes from the risk factors previously disclosed in our Form 10-K for the fiscal year ended August 26, 2006, except as set forth below.

Because our business depends on the amount that manufacturers of microelectronics spend on capital equipment, downturns in the microelectronics industry may adversely affect our results.

The microelectronics industry experiences periodic downturns, which may have a negative effect on our sales and operating results. Our business depends on the amounts that manufacturers of microelectronics spend on capital equipment. The amounts they spend on capital equipment depend on the existing and expected demand for semiconductor devices and products that use semiconductor devices. When a downturn occurs, some semiconductor manufacturers experience lower demand and increased pricing pressure for their products. As a result, they are likely to purchase less semiconductor processing equipment and have sometimes delayed making decisions to purchase capital equipment. In some cases, semiconductor manufacturers have canceled or delayed orders for our products. Typically, the semiconductor equipment industry has experienced more pronounced decreases in net sales than the semiconductor industry as a whole.

We, along with others in the semiconductor equipment industry, have recently experienced a downturn in orders for new equipment as well as delays in existing orders, primarily from logic and flash memory manufacturers. We cannot predict the extent and length of the current downturn in orders and the overall softening in the industry in these segments. In addition:

•

the semiconductor equipment industry may experience other, possibly more severe and prolonged, downturns in the future;

•

any future recovery of the microelectronics industry may not result in an increased demand by semiconductor manufacturers for capital equipment or our products; and

•

the semiconductor equipment industry may not improve in the near future or at all.

Our licensing practices related to international spare parts sales may subject us to fines and could reduce our ability to be competitive in certain countries.

In addition to offering our customers microelectronics manufacturing equipment, we provide replacement spare parts, spare part kits and assemblies. In late calendar 2006, we determined that certain of our replacement valves, pumps and heaters could fall within the scope of United States export licensing regulations to products that could be used in connection with chemical weapons processes. We determined that these regulations require us to obtain

licenses to ship some of our replacement spare parts, spare part kits and assemblies to customers in certain controlled countries as defined in the export licensing regulations. During the second quarter of fiscal 2007, we were granted licenses to ship replacement spare parts, spare parts kits and assemblies to all customers in the controlled countries where we currently conduct business.

The United States Department of Commerce could assess penalties for any past violation of export control regulations. The licenses that were granted do not mitigate our risk with respect to past violations.

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

None

ITEM 3. Defaults upon Senior Securities

None

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

None

ITEM 5. Other Information

After consideration by the Company’s Board of Directors, the Company permitted its shareholder rights plan to expire on June 10, 2007. The Company’s shareholder rights plan was set forth in the Share Rights Agreement, dated as of May 22, 1997, between the Company and ComputerShare Investor Services, as Rights Agent (as amended, the “Rights Agreement”). The Rights Agreement and the related preferred share purchase rights expired in accordance with the terms on June 10, 2007.

ITEM 6 Exhibits and Reports on Form 8-K

(a) Exhibits


	2.1			Agreement and Plan of Reorganization, dated as of January 21, 1999 among FSI International, Inc., BMI International, Inc. and YieldUP International Corporation (4)
	2.2			Agreement and Plan of Reorganization by and Among FSI International, Inc., Spectre Acquisition Corp., and Semiconductor Systems, Inc. (1)
	2.3			Asset Purchase Agreement dated as of June 9, 1999 between FSI International, Inc. and The BOC Group, Inc. (5)
	3.1			Restated Articles of Incorporation of the Company. (2)
	3.2			Restated and amended By-Laws. (7)
	3.5			Articles of Amendment of Restated Articles of Incorporation (6)
	3.6			Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Shares. (3)
	10.1			Termination and Release Agreement dated as of May 15, 2007 with Mitsui & Co. Ltd., Chlorine Engineers Corp., Ltd., MBK Project Holdings Ltd. and m•FSI LTD.(filed herewith)
	10.2			Stock Purchase Agreement dated as of May 15, 2007 by and among FSI International, Inc., MBK Project Holdings Ltd., Chlorine Engineers Corp. Ltd., Yasuda Enterprise Development III Limited Partnership, Mizuho Capital Co., Ltd., Mr. Hideki Kawai, Mr. Takanori Yoshioka and Mr. Satoshi Shikami. (exhibits omitted) (filed herewith)
	31.1			Certification by Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(filed herewith)
	31.2			Certification by Principal Financial and Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(filed herewith)
	32.1			Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(filed herewith)


(1)		Filed as an Exhibit to the Company’s Registration Statement on Form S-4 (as amended) dated March 21, 1996, SEC File No. 333-1509 and incorporated by reference.

(2)		Filed as an Exhibit to the Company’s Report on Form 10-Q for the quarter ended February 24, 1990, SEC File No. 0-17276, and incorporated by reference.

(3)		Filed as an Exhibit to the Company’s Report on Form 8-A, filed by the Company on June 5, 1997, SEC File No. 0-17276, and incorporated by reference.

(4)		Filed as an Exhibit to the Company’s Report on Form 8-K, filed by the Company on January 27, 1999, SEC File No. 0-17276 and incorporated by reference.

(5)		Filed as an Exhibit to the Company’s Report on Form 8-K, filed by the Company on June 24, 1999, SEC File No. 0-17276 and incorporated by reference.

(6)		Filed as an Exhibit to the Company’s Report on Form 10-K for the fiscal year ended August 28, 1999, SEC File No. 0-17276, and incorporated by reference.

(7)		Filed as an Exhibit to the Company’s Report on Form 10-Q for the fiscal quarter ended February 23, 2002, SEC File No. 0-17276 and incorporated by reference.

FSI INTERNATIONAL, INC. AND SUBSIDIARIES

SIGNATURE

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.


	FSI INTERNATIONAL, INC. [Registrant]
	By:	/s/Patricia M. Hollister
		Patricia M. Hollister
		Chief Financial Officer on behalf of the Registrant and as Principal Financial and Accounting Officer

DATE: June 29, 2007

INDEX TO EXHIBITS


Exhibit	Description	Method of Filing
2.1	Agreement and Plan of Reorganization, dated as of January 21, 1999 among FSI International, Inc., BMI International, Inc. and YieldUP International Corporation (4)	Incorporated by reference.

2.2	Agreement and Plan of Reorganization by and Among FSI International, Inc., Spectre Acquisition Corp., and Semiconductor Systems, Inc. (1)	Incorporated by reference.

2.3	Asset Purchase Agreement dated as of June 9, 1999 between FSI International, Inc. and The BOC Group, Inc. (5)	Incorporated by reference.

3.1	Restated Articles of Incorporation of the Company. (2)	Incorporated by reference.

3.2	Restated and amended By-Laws. (7)	Incorporated by reference.

3.5	Articles of Amendment of Restated Articles of Incorporation (6)	Incorporated by reference.

3.6	Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Shares. (3)	Incorporated by reference.

10.1	Termination and Release Agreement dated as of May 15, 2007 with Mitsui & Co. Ltd., Chlorine Engineers Corp., Ltd., MBK Project Holdings Ltd. and m•FSI LTD.	Filed herewith.

10.2	Stock Purchase Agreement dated as of May 15, 2007 by and among FSI International, Inc., MBK Project Holdings Ltd., Chlorine Engineers Corp. Ltd., Yasuda Enterprise Development III Limited Partnership, Mizuho Capital Co., Ltd., Mr. Hideki Kawai, Mr. Takanori Yoshioka and Mr. Satoshi Shikami. (exhibits omitted)	Filed herewith

31.1	Certification by Principal Executive Officer Pursuant to section 302 of the Sarbanes-Oxley Act of 2002.	Filed herewith.

31.2	Certification by Principal Financial and Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.	Filed herewith.

32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.	Filed herewith.


(1)		Filed as an Exhibit to the Company’s Registration Statement on Form S-4 (as amended) dated March 21, 1996, SEC File No. 333-1509 and incorporated by reference.

(2)		Filed as an Exhibit to the Company’s Report on Form 10-Q for the quarter ended February 24, 1990, SEC File No. 0-17276, and incorporated by reference.

(3)		Filed as an Exhibit to the Company’s Report on Form 8-A, filed by the Company on June 5, 1997, SEC File No. 0-17276, and incorporated by reference.

(4)		Filed as an Exhibit to the Company’s Report on Form 8-K, filed by the Company on January 27, 1999, SEC File No. 0-17276 and incorporated by reference.

(5)		Filed as an Exhibit to the Company’s Report on Form 8-K, filed by the Company on June 24, 1999, SEC File No. 0-17276 and incorporated by reference.

(6)		Filed as an Exhibit to the Company’s Report on Form 10-K for the fiscal year ended August 28, 1999, SEC File No. 0-17276, and incorporated by reference.

(7)		Filed as an Exhibit to the Company’s Report on Form 10-Q for the fiscal quarter ended February 23, 2002, SEC File No. 0-17276 and incorporated by reference.

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