VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES INC - 10-Q Quarterly 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. Yes x No ¨

The accompanying notes to the unaudited consolidated financial statements are an integral part of these statements.

Varian Semiconductor designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits.

These unaudited interim consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These unaudited interim consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the annual report on Form 10-K filed by Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) with the Securities and Exchange Commission for the fiscal year ended September 27, 2002. In the opinion of Varian Semiconductor, the unaudited interim consolidated financial statements include all adjustments, consisting of only normal recurring adjustments, necessary to present fairly the information required to be set forth therein. The results of operations for the three months ended December 27, 2002 are not necessarily indicative of the results to be expected for a full year or for any other period.

Certain items in the prior year’s consolidated financial statements have been reclassified to conform to the current presentation of the financial statements.

Basic income per share is calculated based on net income and the weighted average number of shares outstanding during the reporting period. Diluted income per share includes additional dilution from stock issuable pursuant to the exercise of stock options outstanding. For purposes of the diluted income per share calculation, the additional shares issuable upon exercise of stock options were determined using the treasury stock method.

A reconciliation of the numerator and denominator used in the income per share calculations is presented as follows:

For the three month period ended December 27, 2002, options to purchase 2,497,343 common shares at a weighted average exercise price of $35.23 were excluded from the computation due to their exercise price exceeding the market value of the underlying common stock. For the three month period ended December 28, 2001, options to purchase 704,952 common shares at a weighted average exercise price of $50.92 were excluded from the computation due to their exercise price exceeding the market value of the underlying common stock.

As of December 27, 2002, Varian Semiconductor had outstanding options to purchase an aggregate of 5,615,605 shares of its common stock at a weighted average price of $23.54. Of these options, options to purchase an aggregate of 3,760,491 shares at a weighted average price of $19.49 were fully vested and exercisable.

Varian Semiconductor considers currency on hand, demand deposits, and all highly liquid investments with an original purchase maturity of three months or less to be cash and cash equivalents. The carrying amounts of cash and cash equivalents approximate estimated fair value because of the short maturities of those financial instruments. Cash equivalents at December 27, 2002 and September 27, 2002 were $307.0 million and $305.2 million, respectively. Short-term investments consist primarily of six-month certificates of deposits. All short-term investments have been classified as available-for-sale and are carried at fair market value, which approximate cost, due to the short period of time to maturity and the relative risk of the investments.

In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, to be effective for all fiscal years beginning after December 15, 2001. As part of the adoption of SFAS No. 142 on September 28, 2002, Varian Semiconductor will no longer amortize goodwill, eliminating annual goodwill amortization of approximately $1.6 million, and will test for impairment of goodwill at least on an annual basis and whenever events and changes in circumstances suggest that the carrying amount may not be recoverable. Varian Semiconductor completed its evaluation of the carrying amount of goodwill during the first quarter of fiscal year 2003 and concluded that no impairment existed as of that date. At September 27, 2002, Varian Semiconductor had unamortized goodwill of approximately $12.3 million (net of accumulated amortization of $7.0 million).

Had Varian Semiconductor adopted SFAS No. 142 as of September 29, 2001, net income and income per share would have been as follows:

As of December 27, 2002 and September 27, 2002, Varian Semiconductor’s subsidiary in Japan had two credit facilities available with two different financial institutions. Maximum available borrowings on each of the two loans were as follows: (Y)590,000,000 ($4.9 million at December 27, 2002) and (Y)1,000,000,000 ($8.3 million at December 27, 2002). The loans are unsecured and contain no restrictive covenants, although each loan is guaranteed by Varian Semiconductor. Interest rates for the (Y)590,000,000 credit facility are the Tokyo interbank offered rate + 1.75% (approximately 1.84% at December 27, 2002 and 1.84% at September 27, 2002). The interest rate for the other credit facility is based on the short-term prime rate + 0.25% (approximately 1.63% at December 27, 2002 and 1.38% at September 27, 2002). The loans mature every 30 to 90 days and are normally rolled over into new 30 to 90 day loans upon maturity. As of September 27, 2002, Varian Semiconductor had a third credit facility that was terminated during the first quarter of fiscal year 2003. Total outstanding borrowings at December 27, 2002 were (Y)590,000,000, or $4.9 million, and at September 27, 2002 were (Y)690,000,000, or $5.6 million.

Varian Semiconductor also has borrowing capacity in Europe, Korea and Taiwan. In June 2002, Varian Semiconductor’s European subsidiary renewed a credit facility which includes overdraft protection of Euro 2.5 million ($2.6 million at December 27, 2002). Interest accrues at the Euro base rate + 1.5% (approximately 5.0% at December 27, 2002). In April 2002, Varian Semiconductor’s subsidiary in Korea closed on a $3.0 million credit facility. Any outstanding borrowings accrue interest at the local base rate + 1.6% (approximately 6.5% at December 27, 2002) and are payable on demand. In July 2001, Varian Semiconductor’s subsidiary in Taiwan closed on a $1.0 million credit facility. Any outstanding borrowings accrue interest at the local base rate + 1.3% (approximately 4.0% at December 27, 2002) and are payable on demand. All three credit facilities are unsecured and contain no restrictive covenants, although each loan is guaranteed by Varian Semiconductor. There were no outstanding borrowings as of December 27, 2002 or September 27, 2002 on any of these three loans.

Varian Semiconductor provides for the estimated cost of product warranties, primarily from historical information, at the time product revenue is recognized. While Varian Semiconductor engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its component supplies, Varian Semiconductor’s warranty obligation is affected by product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should actual product failure rates, utilization levels, material usage, service delivery costs or supplier warranties on parts differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.

Product warranty activity for the first quarter of fiscal year 2003 was as follows:

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”). This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”(“EITF 94-3”). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. EITF 94-3 allowed for an exit cost liability to be recognized at the date of an entity’s commitment to an exit plan. SFAS No. 146 also requires that liabilities recorded in connection with exit plans be initially measured at fair value. SFAS No. 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. Varian Semiconductor will adopt SFAS No. 146 in the second quarter of fiscal year 2003.

In November 2002, the FASB issued FASB Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN No. 45 are applicable for financial statements of interim or annual periods ending after December 15, 2002. Varian Semiconductor adopted FIN No. 45 in the first quarter of fiscal year 2003 and has included the new disclosure requirements in the Notes to the Consolidated Financial Statements (see Note 9. Product Warranties).

In November 2002, the Emerging Issues Task Force Issue (“EITF”) issued No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. EITF No. 00-21 establishes three principles: revenue arrangements with multiple deliverables should be divided into separate units of accounting, arrangement consideration should be allocated among the separate units of accounting based on their relative fair values, and revenue recognition criteria should be considered separately for separate units of accounting. EITF No. 00-21 is effective for all revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” which amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation, and also amends the disclosure provision of SFAS No. 123 to require disclosure in the summary of significant accounting policies the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. The disclosure provision is required for all companies with stock-based employee compensation, regardless of whether the company utilizes the fair value method of accounting described in SFAS No. 123 or the intrinsic value method described in APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 148’s amendment of the transition and annual disclosure provisions of SFAS No. 123 are effective for fiscal years ending after December 15, 2002. The disclosure requirements for interim financial statements containing condensed consolidated financial statements are effective for interim periods beginning after December 15, 2002. Varian Semiconductor currently uses the intrinsic value method of accounting for stock-based employee compensation described by APB Opinion No. 25.

Varian Semiconductor does not expect the adoption of the above mentioned pronouncements to have a material impact on Varian Semiconductor’s consolidated financial statements.

Varian Semiconductor operates in one business segment: the manufacture, marketing and servicing of ion implantation systems. Since Varian Semiconductor operates in one segment, all financial segment information required by SFAS No. 131 can be found in the consolidated financial statements.

During the first quarter of fiscal year 2003, revenue from three customers accounted for 16%, 14% and 11% of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue for the foreseeable future. During the first quarter of fiscal year 2002, Lam accounted for 36% of total revenue and one other customer accounted for 15% of total revenue (See also Note 13. Settlement and License Agreement). Excluding the Lam royalty and license revenue, one customer accounted for 23% of total revenue during the first quarter of fiscal year 2002.

The following table summarizes revenue based on final destination and long-lived assets by geography:

Varian Semiconductor is currently a defendant in a number of legal actions and could incur an uninsured liability in one or more of them. In the opinion of management, the outcome of such litigation will not have a material adverse effect on the consolidated financial position, results of operations or cash flows of Varian Semiconductor.

Prior to the spin-off of Varian Semiconductor from Varian Associates, Inc. (“VAI”) on April 2, 1999, Varian Semiconductor’s business was operated as the Semiconductor Equipment Business (“SEB”) of VAI. On April 2, 1999, VAI contributed its Semiconductor Equipment Business (“SEB”) to Varian Semiconductor, its Instruments Business (“IB”) to Varian, Inc. (“VI”), and

changed its name to Varian Medical Systems, Inc. (“VMS”). These transactions were accomplished under the terms of a distribution agreement by and among Varian Semiconductor, VI and VMS (collectively, the “Distribution Related Agreements”). VAI has been named by the United States Environmental Protection Agency or third parties as a potentially responsible party under CERCLA, at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also involved in various stages of environmental investigation and/or remediation under the direction of, or in consultation with, foreign, federal, state and/or local agencies at certain current or former VAI facilities (including facilities disposed of in connection with VAI’s sale of its Electron Devices business during fiscal year 1995, and the sale of its Thin Film Systems (“TFS”) business during fiscal year 1997). The Distribution Agreement provides that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.

For certain of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate the future costs of such activities if undertaken. Varian Semiconductor has accrued $1.8 million in estimated environmental investigation and remediation costs for these sites and facilities as of December 27, 2002. As to other sites and facilities, sufficient knowledge has been gained to be able to reasonably estimate the scope and costs of future environmental activities. As such, Varian Semiconductor has accrued $5.0 million, which represents future costs discounted at 7%, net of inflation, to cover Varian Semiconductor’s portion of these costs. This reserve is in addition to the $1.8 million previously described.

As of December 27, 2002, Varian Semiconductor’s reserve for its portion of environmental liabilities, based upon future environmental related costs estimated by VMS as of that date and included in current and long-term accrued expenses, totaled $6.8 million, of which $1.2 million is classified as current.

The amounts set forth in the foregoing paragraph are only estimates of anticipated future environmental related costs, and the amounts actually spent in the years indicated may be greater or less than such estimates. The aggregate range of cost estimates reflects various uncertainties inherent in many environmental investigation and remediation activities and the large number of sites where VMS is undertaking such investigation and remediation activities. VMS believes that most of these cost ranges will narrow as investigation and remediation activities progress. Varian Semiconductor believes that its reserves are adequate, but as the scope of the obligations becomes more clearly defined, these reserves may be modified and related charges against income may be made.

Although any ultimate liability arising from environmental related matters described herein could result in significant expenditures that, if aggregated and assumed to occur within a single fiscal year, would be material to Varian Semiconductor’s financial statements, the likelihood of such occurrence is considered remote. Based on information currently available to management and its best assessment of the ultimate amount and timing of environmental related events, Varian Semiconductor’s management believes that the costs of these environmental related matters are not reasonably likely to have a material adverse effect on the consolidated financial statements of Varian Semiconductor.

Varian Semiconductor evaluates its liability for environmental related investigation and remediation in light of the liability and financial wherewithal of potentially responsible parties and insurance companies where Varian Semiconductor believes that it has rights to contribution, indemnity and/or reimbursement. Claims for recovery of environmental investigation and remediation costs already incurred, and to be incurred in the future, have been asserted against various insurance companies and other third parties. In 1992, VAI filed a lawsuit against 36 insurance companies with respect to most of the above-referenced sites and facilities. VAI received certain cash settlements with respect to these lawsuits in prior years. VMS has also reached an agreement with an insurance company under which the insurance company agreed to pay a portion of Varian Semiconductor’s past and future environmental related expenditures. Varian Semiconductor therefore has a receivable of $1.3 million in other assets at December 27, 2002, as its portion of the insurance recoveries. Although VMS intends to aggressively pursue additional insurance recoveries, Varian Semiconductor has not reduced any liability in anticipation of recovery with respect to claims made against third parties.

In September 2000, Varian Semiconductor and Applied Materials settled a patent infringement and antitrust litigation. After recording a payment to Applied Materials and legal expenses, Varian Semiconductor recorded a gain of $16.0 million ($10.8 million after taxes) relating to this litigation settlement. Varian Semiconductor maintains a provision to cover any residual indemnification obligations described above. Included in current liabilities and classified as an estimated loss contingency was $2.7 million as of December 27, 2002 and September 27, 2002.

Varian Semiconductor has agreed to indemnify VMS and VI for any costs, liabilities or expenses relating to Varian Semiconductor’s legal proceedings, including the Applied Materials matters. Under the Distribution Related Agreements, Varian Semiconductor has agreed to reimburse VMS for one-third of the costs, liabilities, and expenses, adjusted for any related tax benefits recognized or realized by VMS, with respect to certain legal proceedings relating to discontinued operations of VMS.

Varian Semiconductor’s operations are subject to various foreign, federal, state and/or local laws relating to the protection of the environment. These include laws regarding discharges into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. In addition, several countries are reviewing proposed regulations that would require manufacturers to dispose of their products at the end of a product’s useful life. These laws have the effect of increasing costs and potential liabilities associated with the conduct of certain operations.

On December 19, 2001, Varian Semiconductor and Lam Research Corporation (“Lam”) resolved the patent infringement litigation between the two parties, which was originally filed in October 1993, by Varian Semiconductor granting Lam a license under certain patents. Additionally, all claims and counterclaims have been dismissed in accordance with the agreement. The lawsuit involved Varian Semiconductor’s assertion that Lam infringed three Varian patents that relate to the use of low pressure gas to assist in the heating and cooling of semiconductor wafers during various manufacturing processes, and Lam’s denial that the patents are valid or infringed. Under the agreement, Varian Semiconductor has granted a license to Lam for the patents in return for the payment of $20.0 million, with $5.0 million paid immediately in exchange for prior use of the patents. The remaining $15.0 million is to be paid in 12 quarterly installments through December 2004 and is in exchange for future use of the patents. As further payment for past royalties, Lam issued to Varian Semiconductor a warrant to purchase 2,000,000 shares of Lam common stock for $21.30 per share, exercisable at any time prior to December 31, 2005. The fair value of the warrant was $22.8 million upon receipt on December 19, 2001, based on an independent third party valuation, and has been recognized as royalty and license revenue. In addition, the $5.0 million cash payment was recognized as royalty and license revenue during fiscal year 2002 and the remaining $15.0 million in cash payments to be received will be recognized as royalty and license revenue when due. Under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” the warrant was treated as a derivative and was measured at fair value at each balance sheet date. During fiscal year 2002, a gain was recorded in other income in the amount of $5.1 million to reflect the change in fair value of the warrant. On April 1, 2002, Varian Semiconductor completed the sale of the Lam warrant to an unrelated third party for $28.0 million in cash.

Varian Semiconductor’s business is cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. The semiconductor industry has historically experienced periodic downturns and in response, Varian Semiconductor has occasionally recorded restructuring charges in connection with cost reduction initiatives implemented in response to the industry downturns. Restructuring charges typically consist of severance, benefits and outplacement services offered to terminated employees and sometimes include charges for remaining lease payments on facilities that are closed. Prior to any restructuring announcements, the restructuring is approved by the appropriate level of management necessary to commit to the specific actions of the reduction in force.

During fiscal year 2002, Varian Semiconductor recognized $5.4 million in restructuring costs, of which $2.2 million was recognized in the first quarter and $3.2 million was recognized in the fourth quarter. The majority of the restructuring charges relate to termination costs for a total reduction in force of 296 employees in fiscal year 2002. There were also charges associated with closing an office and relocating another office. The majority of the restructuring reserve balance of $1.0 million as of December 27, 2002 is expected to be utilized by March 2003.

Below is a table summarizing the restructuring reserve activity in fiscal year 2002 and the first quarter of fiscal 2003:

The restructuring reserve of $1.0 million is included in accrued expenses on the balance sheet.

Varian Semiconductor has an agreement with two banks to sell specific receivables, subject to recourse provisions. There were no receivables sold under these arrangements during the first quarter of fiscal year 2003. During the first quarter of fiscal year 2002 approximately $4.7 million of receivables were sold under these arrangements. As of December 27, 2002 and September 27, 2002, approximately $0.1 million and $4.5 million, respectively, of receivables sold to the bank remained outstanding. Varian Semiconductor has not recorded any asset or liability in connection with these agreements. Varian Semiconductor does not believe it is materially at risk for any losses as a result of this agreement.

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

This Form 10-Q contains certain forward-looking statements. For purposes of the safe harbor provisions under The Private Securities Litigation Reform Act of 1995, any statements using the terms “believes”, “anticipates”, “expects”, “plans” or similar expressions, are forward-looking statements. The forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected. There are a number of important factors that could cause Varian Semiconductor’s actual results to differ materially from those indicated by forward-looking statements made in this report and presented by management from time to time. Some of the important risks and uncertainties that may cause Varian Semiconductor’s financial results to differ are under the heading “Risk Factors” in this report and in the annual report on Form 10-K for the fiscal year ended September 27, 2002, filed with the Securities and Exchange Commission on December 13, 2002.

The following information should be read in conjunction with the unaudited interim consolidated financial statements and notes thereto included in “Item 1.—Consolidated Financial Statements” of this quarterly report and the audited combined financial statements and notes thereto and the section titled “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Varian Semiconductor’s annual report on Form 10-K for the fiscal year ended September 27, 2002 filed with the Securities and Exchange Commission on December 13, 2002.

Critical Accounting Policies and Significant Judgments and Accounting Estimates

Varian Semiconductor’s discussion and analysis of its financial condition and results of operations are based upon Varian Semiconductor’s consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States. The preparation of these consolidated financial statements requires Varian Semiconductor to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a continual basis, Varian Semiconductor evaluates its estimates, including those related to inventories, accounts receivable, intangible assets, income taxes, warranty obligations, post-retirement benefits, contingencies, and functional currencies. Varian Semiconductor operates in a highly cyclical and competitive industry that is influenced by a variety of diverse factors including, but not limited to, technological advances, product life cycles, customer and supplier lead times, and macroeconomic and geographic economic trends. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor bases its estimates on historical experience, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. See also the factors discussed below under the section titled “Risk Factors.”

Varian Semiconductor believes that the following sets forth the critical accounting policies used by Varian Semiconductor in the preparation of its consolidated financial statements.

Varian Semiconductor recognizes revenue from product sales upon shipment provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectibility is reasonably assured through historical collection results and regular credit evaluations and there are no uncertainties regarding customer acceptance.

For established and new products, a portion of the total purchase price is typically not due until installation occurs and the customer accepts the product. For established products, the lesser of the amount allocated to the equipment or the contractual amount due upon delivery is recorded as product revenue upon delivery. The amount deferred is recognized as revenue upon customer acceptance. For new products, revenue allocated to the equipment is recognized upon customer acceptance. Revenue related to spare parts sales is recognized upon the later of delivery or when the title and risk of loss passes to the customer.

Products are classified as established products if post-delivery acceptance provisions and the installation process have been determined to be routine, commercially inconsequential and perfunctory (due to the fact that the acceptance provisions are generally a replication of pre-shipment procedures) and there is an established history of installations. The majority of products are designed and manufactured to meet contractual customer specifications. To ensure customer specifications are satisfied, the systems are tested at Varian Semiconductor’s manufacturing facility prior to shipment. To the extent that customers’ conditions can not be replicated in Varian Semiconductor’s facilities or if there is not a demonstrated history of meeting newer customer specifications, then the product is treated as new for revenue recognition purposes.

Service revenue includes revenue from maintenance and service contracts, paid service and installation services. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Revenue related to paid service is recorded when earned and revenue related to installation is recorded upon fulfillment of the service obligation. Royalty and license revenue is recognized when contractual obligations are met, evidence of an arrangement exists, fees are fixed or determinable and collection is reasonably assured.

When fees are not fixed or determinable, revenue is recorded when payments become due.

Varian Semiconductor’s transactions frequently include the sale of systems and services under multiple element arrangements. Revenue under these arrangements is allocated to all elements, except systems, based upon the fair market value of those elements. The amount allocated to installation is based upon hourly rates at the estimated time to complete the service. The fair value of all other elements is based upon the price charged when these amounts are sold separately and unaccompanied by other elements. The amount of revenue allocated to systems is done on a residual method basis. Under this method, the total value of the arrangement is allocated first to the undelivered elements based on their fair values, with the remainder being allocated to systems revenue. Installation is not essential to the functionality of the system, as these services do not alter the equipment’s capabilities.

Varian Semiconductor values its inventory at the lower of cost or market. The determination of lower of cost or market requires that Varian Semiconductor make significant assumptions about future demand for products and the transition to new product offerings from legacy products. Varian Semiconductor also reserves against those open purchase order commitments in which Varian Semiconductor’s estimated obligation to receive inventory under these commitments exceeds expected production demand. These assumptions include, but are not limited to, future manufacturing schedules, customer demand, supplier lead time and technological and market obsolescence. If market conditions are less favorable than those projected by management, additional inventory provisions may be required. If market conditions are more favorable than those projected by management and specific products previously reserved against are subsequently sold, gross profit would improve by the amount of the specific reserve in the quarter the product is sold.

Varian Semiconductor maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments for products and services. Accounts with known financial issues are first reviewed and specific estimates are recorded. The remaining accounts receivable balances are then grouped in categories by the amount of days the balance is past due and the estimated loss is calculated as a percentage of the total category based upon past history. If the financial condition of Varian Semiconductor’s customers were to deteriorate, resulting in their inability to make payments, additional allowances may be required. If accounts previously identified as a risk and reserved for subsequently stabilize and are deemed to no longer be at risk for collection or categories past due decrease, the allowance for doubtful accounts may be reduced. As a result, a reduction to bad debt expense would be recognized in the period the determination was made.

As required by Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes,” Varian Semiconductor evaluates the positive and negative evidence bearing upon the realizability of its deferred tax assets. Varian Semiconductor has considered taxable income that can be carried back, future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance and has concluded that no valuation allowance is required at this time. An adjustment to deferred tax assets would be charged to income in the period such determination was made, if Varian Semiconductor determined that it would not be able to realize all or part of its deferred tax assets in the future.

Liabilities are recorded when environmental assessments and/or remedial efforts are probable, and the costs can be reasonably

estimated. Generally, the timing of these accruals coincides with completion of a feasibility study or Varian Semiconductor’s commitment to a formal plan of action. In situations where the various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate then future costs, the lower limit of an estimated range is accrued on a non-discounted basis. All other liabilities, which are usually where Varian Semiconductor has generally sufficient knowledge to be able to better estimate the scope of costs and future activities, are accrued on a discounted basis. Should new information become available and/or different assumptions be applied in the estimation of environmental liabilities, revisions to the accrued environmental liability would be required.

As a multinational company, Varian Semiconductor faces exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as Varian Semiconductor’s business practices evolve and could have a material adverse impact on Varian Semiconductor’s financial results. Historically, Varian Semiconductor’s primary exposures have resulted from non-United States dollar denominated sales and purchases in Europe and Asia. Varian Semiconductor does not enter into forward exchange contracts for trading purposes. Varian Semiconductor’s forward exchange contracts generally range from one to six months in original maturity. No forward exchange contract has an original maturity greater than one year.

Varian Semiconductor’s business is highly cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. In the last two years, semiconductor equipment manufacturers experienced a significant contraction in the demand for products due to the slowdown in economies worldwide, specifically the slowdown in technology sectors which utilize integrated circuits.

Revenue. The following table sets forth revenue by category for the first quarter of fiscal years 2003 and 2002.

During the first quarter of fiscal year 2003, the increase in product revenue was the result of an increase in demand for ion implanters, particularly the VIISta 810HP, Varian Semiconductor’s latest medium current machine, that was introduced subsequent to the first quarter of fiscal year 2002. Demand for product parts and implanter upgrades also increased as a result of pockets of increased implanter utilization, customers spending their 2002 year-end budgets and desire for increased productivity.

Service revenue increased primarily due to increased machine installations resulting from higher machine shipments in previous quarters.

Pursuant to the terms of a Settlement and License Agreement between Varian Semiconductor and Lam Research Corporation (“Lam”), Varian Semiconductor received, during the first quarter of fiscal year 2002, a warrant to purchase 2,000,000 shares of Lam common stock at $21.30 per share and a $5.0 million cash payment in exchange for prior use of certain Varian Semiconductor patents. Total royalty and license revenue recognized from Lam during the first quarter of fiscal year 2002 includes the warrant, which was valued at $22.8 million, and the $5.0 million cash payment received. Lam continues to make quarterly cash payments of $1.25 million, which are included in the royalty revenue in the first quarter of fiscal year 2003. Lam is required to make quarterly cash payments of $1.25 million through December 2004 for future use of the patents. Quarterly cash payments are recognized as royalty and license revenue in the period they become due.

The following table reflects revenue by geography for the first quarter of fiscal years 2003 and 2002, including the Lam royalty and license revenue of $27.8 million recognized during the first quarter of fiscal year 2002.

The decrease in revenue in North America was primarily a result of the inclusion of $27.8 million of royalty and license revenue from Lam in the first quarter of fiscal year 2002. Product and service revenue in North America and Asia increased from the first quarter of fiscal year 2002 compared to the first quarter of fiscal year 2003, as a result of increased demand for new machines to be utilized in manufacturing advanced devices, particularly in 300mm fabs. The decrease in revenue in Europe was a result of a reduction in capital expenditures by semiconductor manufacturers in Europe.

Revenue for the second quarter of fiscal year 2003 is currently estimated to increase from $83.7 million in the first quarter of fiscal year 2003. However, at this time continued demand beyond the second quarter remains difficult to forecast, as visibility is limited by the cyclical nature of the industry. Three of our customers are expected to each represent over ten percent of our second quarter revenue in fiscal year 2003, with one customer representing significantly more than ten percent. Fluctuations in the timing and mix of product shipments, customer requirements for systems, and the completion of the installation of the product have a significant impact on revenue (see also Risk Factors and Critical Accounting Policies - Revenue Recognition).

Cost of Product and Service Revenue. Cost of product revenue was $37.5 million and gross margin was 39% for the first quarter of fiscal year 2003, as compared to the cost of product revenue of $29.5 million and gross margin of 14% for the first quarter of fiscal year 2002. Gross margin in the first quarter of fiscal year 2003 increased as a result of lowering inventory-related reserves by approximately $3.0 million, due to the sale of specific inventories previously reserved, improved supply chain management, and favorable factory operations. There was an unfavorable impact on gross margin in the first quarter of fiscal year 2002 as Varian Semiconductor experienced excess factory capacity and inventory levels that resulted in approximately $8.0 million of inventory-related charges. Varian Semiconductor has historically, and may in the future, sustain inventory-related charges resulting from changes in customers’ purchase commitments due to Varian Semiconductor’s manufacturing lead times. Cost of service revenue was $10.7 million and gross margin was 45% for the first quarter of fiscal year 2003, as compared to a cost of service revenue of $8.2 million and gross margin of 42% for the first quarter of fiscal year 2002. The improvement in gross margin of 3% for cost of service was primarily a result of improvements in the system installation process resulting in reduced field costs. Gross margin is expected to decrease in the second quarter of fiscal year 2003 as compared to the first quarter of fiscal year 2003. This decline in margin reflects increased pricing pressure in the industry as a result of low customer capital spending.

Research and Development. Research and development expenses were $13.6 million for the first quarter of fiscal year 2003 as compared to $12.9 million for the first quarter of fiscal year 2002. The increase was primarily a result of increased material spending associated with new products. These increases were partially offset by the elimination of the amortization of goodwill in the first quarter of fiscal year 2003, in accordance with SFAS No. 142. Varian Semiconductor continues to be committed to investment in product development, particularly the ongoing shift to 300mm implanters, factory automation, and the transition to advanced technology nodes. Expenses should be up moderately in the second quarter as Varian Semiconductor continues to increase our investment in research and development.

Marketing, General and Administrative. Marketing, general and administrative expenses were $18.9 million for the first quarter of fiscal year 2003 and 2002.

Restructuring Costs. During October 2001, Varian Semiconductor implemented a reduction in force, primarily in the U.S., in which its worldwide workforce was reduced by approximately 200 employees in the first quarter of fiscal year 2002. The reduction in force was in response to the downturn in the industry. As a result, Varian Semiconductor recognized $2.2 million in restructuring costs during the first quarter of fiscal year 2002. The restructuring costs were primarily severance related with $2.0 million and $0.2 million paid during the first and second quarter of fiscal year 2002, respectively.

Interest Income. During the first quarter of fiscal year 2003, Varian Semiconductor earned $1.2 million in interest income as compared with $1.6 million for the first quarter of fiscal year 2002. Despite increased cash balances, interest income decreased compared to the prior year’s first quarter due to lower short-term interest rates.

Other Income. During the first quarter of fiscal year 2003, Varian Semiconductor recorded $0.1 million in other income compared to $0.4 million in the first quarter of fiscal year 2002. Varian Semiconductor received a warrant to purchase shares of Lam common

stock on December 19, 2001 (See also Note 13. Settlement and License Agreement). The warrant was treated as a derivative and was measured at fair value. A $0.4 million gain was recorded in other income during the first quarter of fiscal year 2002 to reflect fair value accounting for the warrant.

Provision for Income Taxes. Varian Semiconductor’s effective income tax rate was 33% in the first quarter of fiscal year 2003 and 38% in the first quarter of fiscal year 2002. The decrease in rate primarily reflects the higher anticipated utilization of research and development credits in the current year. Future effective tax rates may vary from the historic rates depending on the worldwide allocation of earnings and the continuing availability of the extraterritorial income exclusion.

Net Income. As a result of the foregoing factors, in the first quarter of fiscal year 2003 Varian Semiconductor recorded net income of $2.8 million as compared to net income of $5.1 million for the first quarter of fiscal year 2002. The net income per diluted share was $0.08 for the first quarter of fiscal year 2003 as compared to net income per diluted share of $0.15 for the first quarter of fiscal year 2002.

Varian Semiconductor generated $18.9 million of cash from operations during the first quarter of fiscal year 2003 as compared to $10.4 million during the first quarter of fiscal year 2002. Cash provided by operations in the first quarter of fiscal year 2003 was derived primarily from the decreases in accounts receivable of $30.9 million and inventory of $4.9 million. These decreases were partially offset by a decreases in deferred revenue of $14.3 million, accrued expenses of $5.7 million and accounts payable of $4.7 million. In the first quarter of fiscal year 2002, cash provided by operations was primarily a result of decreases in accounts receivable of $31.0 million, inventory of $7.6 million and an increase in accrued expenses of $8.6 million. The increase to cash during the first quarter of fiscal year 2002 was partially offset by non-cash consideration of $22.8 million in royalty and license income, and decreases in deferred revenue of $13.9 million and product warranty of $5.3 million.

Varian Semiconductor used $14.0 million and $2.5 million of cash in investing activities, primarily for the purchase of short-term investments and property, plant and equipment, during the first quarter of fiscal year 2003 and 2002, respectively.

During the first quarter of fiscal year 2003, Varian Semiconductor generated $2.5 million of cash from financing activities, primarily due to the issuance of stock upon the exercise of stock options, offset by repayments on short-term borrowings. During the first quarter of fiscal year 2002, $1.0 million of cash was used by financing activities, primarily due to repayments of short-term borrowings of $1.7 million. This was partially offset by $0.6 million from the issuance of stock upon the exercise of stock options.

Under GAAP, certain obligations and commitments are not required to be included in the consolidated balance sheet and statement of operations. These obligations and commitments, while entered into in the normal course of business, may have a material impact on liquidity. The following commitments as of December 27, 2002 have not been included in the consolidated balance sheet and statement of operations included under Item 1. Consolidated Financial Statements, however, they have been disclosed in the following table in order to provide a more accurate picture of Varian Semiconductor’s financial position and liquidity. Varian Semiconductor does not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, Varian Semiconductor is not exposed to any financing, liquidity, market or credit risk that could arise if Varian Semiconductor had engaged in such relationships.

On November 27, 2002, Varian Semiconductor signed a purchase and sale agreement to purchase its sales and service facility located in Newburyport, Massachusetts. Under the agreement, Varian Semiconductor would make a lump sum upfront payment of approximately $3.4 million, assume a loan of approximately $5.2 million, and forfeit $0.5 million in prepaid rent. The transaction is expected to be completed during the second quarter of fiscal year 2003. Varian Semiconductor currently leases this facility from the seller. There are approximately $9.6 million in lease payments due through the termination of the lease in 2013.

($4.9 million at December 27, 2002) and (Y)1,000,000,000 ($8.3 million at December 27, 2002). The loans are unsecured and contain no restrictive covenants, although each loan is guaranteed by Varian Semiconductor. Interest rates for the (Y)590,000,000 credit facility are the Tokyo interbank offered rate + 1.75% (approximately 1.84% at December 27, 2002 and 1.84% at September 27, 2002). The interest rate for the other credit facility is based on the short-term prime rate + 0.25% (approximately 1.63% at December 27, 2002 and 1.38% at September 27, 2002). The loans mature every 30 to 90 days and are normally rolled over into new 30 to 90 day loans upon maturity. As of September 27, 2002, Varian Semiconductor had a third credit facility that was terminated during the first quarter of fiscal year 2003. Total outstanding borrowings at December 27, 2002 were (Y)590,000,000, or $4.9 million, and at September 27, 2002 were (Y)690,000,000, or $5.6 million.

Varian Semiconductor’s liquidity is affected by many factors, some based on the normal operations of the business and others related to the uncertainties of the industry and global economies. Varian Semiconductor believes that cash and short-term investments of $327.0 million at December 27, 2002 will be sufficient to satisfy working capital requirements, commitments for capital expenditures and other purchase commitments and cash requirements for the foreseeable future.

The unaudited interim consolidated financial statements of Varian Semiconductor reflect the financial position, results of operations and cash flows of Varian Semiconductor as of and for the three months ended December 27, 2002 and December 28, 2001.

Operations prior to April 2, 1999 had been part of the former Varian Associates, Inc. (“VAI”). (See also Note 12 in the Notes to the Consolidated Financial Statements.) On April 2, 1999, VAI contributed its Semiconductor Equipment Business (“SEB”) to Varian Semiconductor, then distributed to the holders of record of VAI common stock one share of common stock of Varian Semiconductor for each share of VAI common stock owned on March 24, 1999. At the same time, VAI contributed its Instruments Business (“IB”) to Varian, Inc. (“VI”) and distributed to the holders of record of VAI common stock one share of common stock of IB for each share of VAI common stock owned on March 24, 1999. VAI retained its Health Care Systems business and changed its name to Varian Medical Systems, Inc. (“VMS”) effective as of April 2, 1999. These transactions were accomplished under the terms of a Distribution Agreement by and among Varian Semiconductor, VAI, hereafter referred to as VMS for periods following the spin-off and VI (the “Distribution Agreement”). For purposes of providing an orderly transition and to define certain ongoing relationships between and among Varian Semiconductor, VMS and VI after the spin-off Varian Semiconductor, VMS and VI also entered into certain other agreements which include an Employee Benefits Allocation Agreement, an Intellectual Property Agreement, a Tax Sharing Agreement and a Transition Services Agreement (collectively, the “Distribution Related Agreements”).

The Distribution Related Agreements provide that, from and after the spin-off, VMS, VI, and Varian Semiconductor will indemnify each and their respective subsidiaries, directors, officers, employees and agents against all losses arising in connection with shared

liabilities (including certain environmental and legal liabilities). All shared liabilities will be managed and administered by VMS and expenses and losses, net of proceeds and other receivables, will be borne one-third each by VMS, VI, and Varian Semiconductor. The Distribution Related Agreements also provide that Varian Semiconductor shall assume all of its liabilities, other than shared liabilities (including accounts payable, accrued payroll, and pension liabilities) in accordance with their terms. During both the first quarter of fiscal year 2003 and 2002, Varian Semiconductor was charged $0.4 million by VMS in settlement of these obligations.

Varian Semiconductor does not expect the adoption of the above mentioned pronouncements to have a material impact on Varian Semiconductor’s consolidated financial statements.

The semiconductor industry is cyclical, and a slowdown in demand for Varian Semiconductor’s semiconductor manufacturing equipment has negatively affected financial results.

The semiconductor industry has been cyclical in nature and has historically experienced periodic downturns. The industry is currently experiencing extreme volatility in product pricing and a slowdown in product demand. Volatility and slowdowns have resulted in significant reductions and delays in the purchase of semiconductor manufacturing equipment and the construction of new fabrication facilities which has significantly harmed Varian Semiconductor’s financial results. Even though Varian Semiconductor’s revenues have declined, in order to remain competitive, Varian Semiconductor continues to invest in research and development and to maintain its worldwide customer service and support capability. These developments have adversely affected Varian Semiconductor’s financial results and could continue to adversely affect financial results. If the downturn in the semiconductor industry continues, the decrease in demand for Varian Semiconductor’s products will continue to adversely affect its financial results.

Varian Semiconductor faces intense competition in the semiconductor equipment industry.

Significant competitive factors in semiconductor equipment manufacturing include the strength of customer relationships, pricing, technological performance and timing, distribution capabilities and financial viability. Varian Semiconductor believes that in order to remain competitive in this industry, it will need to devote significant financial resources to product and process research and development, to offering and marketing a broad range of products, and to maintaining and enhancing customer service and support centers worldwide. The semiconductor equipment industry is becoming increasingly dominated by large manufacturers who have resources to support customers worldwide, and some of Varian Semiconductor’s competitors have substantially greater financial resources and more extensive engineering, manufacturing, marketing, service and support than does Varian Semiconductor. With fewer resources, Varian Semiconductor may not be able to match the product offerings or customer service and technical support offered by its competitors. In addition, some smaller equipment manufacturers provide innovative technology which may have performance advantages over Varian Semiconductor’s systems. If these manufacturers continue to improve their product performance and pricing, enter into strategic relationships or consolidate with large equipment manufacturers, sales of Varian Semiconductor’s products may suffer.

Varian Semiconductor derives a substantial portion of its revenues from a small number of customers, and its business may be harmed by the loss of any one significant customer.

Varian Semiconductor has historically sold at least half of its systems in any particular period to its ten largest customers, including AMD, IBM, Intel, Lam Research, Micron, Samsung, Texas Instruments and TSMC. Some of these customers have individually accounted for more than ten percent of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. Furthermore, Varian Semiconductor may have difficulty attracting additional large customers because its sales depend, in large part, upon the decision of a prospective customer to increase manufacturing capacity in an existing fabrication facility or to transfer a manufacturing process to a new fabrication facility, both of which typically involve a significant capital commitment. Once a semiconductor manufacturer has selected a particular supplier’s capital equipment, the manufacturer generally relies upon that equipment for the specific production line application and frequently will attempt to consolidate its other capital equipment requirements with the same supplier. Consequently, Varian Semiconductor may experience difficulty in selling to a prospective customer if that customer initially selects a competitor’s capital equipment.

Varian Semiconductor’s quarterly results of operations are likely to fluctuate, and as a result, Varian Semiconductor may fail to meet the expectations of its investors and securities analysts, which may cause the price of its common stock to decline.

Varian Semiconductor has experienced and expects to continue to experience significant fluctuations in its quarterly financial results. From time to time, customers may accelerate, postpone, or cancel shipments, or production difficulties could delay shipments. A cancellation, delay in shipment or delay in customer acceptance of the product upon installation in any quarter may cause revenue in such quarter to fall significantly below expectations, which could cause the market price of Varian Semiconductor’s common stock to decline. Varian Semiconductor’s financial results also fluctuate based on gross profit realized on sales. Gross profit as a percentage of revenue may vary based on a variety of factors, including the mix and average selling prices of products sold and costs to manufacture and customize systems. In addition, a number of other factors could impact Varian Semiconductor’s quarterly financial results, including, but not limited to the following:

Because Varian Semiconductor’s operating expenses are based on anticipated capacity levels, and a high percentage of Varian

Semiconductor’s expenses are relatively fixed, a variation in the timing of recognition of revenue and the level of gross profit from a single transaction could cause financial results to vary significantly from quarter to quarter.

It is difficult for Varian Semiconductor to predict the quarter in which it will be recognizing revenue from large product orders.

During a quarter, Varian Semiconductor customarily sells a relatively small number of ion implantation systems. Consequently, Varian Semiconductor’s revenue and financial results could be negatively impacted for a particular quarter if anticipated orders from even a few customers are not received in time to permit shipment and customer acceptance of the installation during that quarter. Varian Semiconductor recognizes all or a portion of the revenue from a product shipment at the time the product is installed and meets predetermined customer specifications. As a result, it is often difficult to determine both the timing of a product shipment and the completion of the installation of the product at the customer’s location. In addition, Varian Semiconductor’s product order backlog at the beginning of each quarter may not include all systems needed to achieve expected revenues for that quarter. Because Varian Semiconductor may build systems according to forecast, the absence of a significant backlog for an extended period of time could adversely affect financial results.

Varian Semiconductor’s future business depends, in part, on its ability to successfully introduce and manage the transition to new products, and Varian Semiconductor may not succeed in accomplishing these goals.

Varian Semiconductor believes that its future success will depend on its ability to develop, manufacture and successfully introduce new systems and product lines with improved capabilities and to continue enhancing existing products, in particular products that respond to the trend toward single wafer processing and 300mm wafer processing. Varian Semiconductor derives virtually all of its revenue from sales and servicing of ion implantation systems and related products and services. Varian Semiconductor must accurately forecast the demand for new products while managing the transition from older products, or it may otherwise mismanage inventory levels. In addition, Varian Semiconductor may be unable to complete the development or meet the technical specifications of new systems or enhancements or to manufacture and ship these systems or enhancements in volume and on time, which may harm its reputation and business. In the past, Varian Semiconductor has experienced some delays in manufacturing and shipping systems and enhancements as well as problems with the reliability and quality of such systems and enhancements. If any of Varian’s Semiconductor’s new products have reliability or quality problems, it may incur additional warranty and service expenses, experience a decline in product orders or incur higher manufacturing costs to correct such problems, all of which could adversely affect financial results.

Varian Semiconductor is subject to risks of operating internationally and it derives a substantial portion of its revenues from outside the United States.

International revenue has accounted for 61%, 71%, and 73% of Varian Semiconductor’s revenue in fiscal years 2002, 2001, and 2000, respectively, and specifically, revenue in Asia has accounted for a substantial portion of this revenue. Sales to Asia accounted for 44%, 50%, and 53% of revenue in fiscal years 2002, 2001, and 2000, respectively. Because Varian Semiconductor relies on sales to customers in Asia for a substantial portion of its revenue, its business is very likely to be adversely impacted by economic downturns and instability in that region. Varian Semiconductor’s business in Asia is affected by demand in each country. In addition, international sales are subject to risks, including, but not limited to:

If Varian Semiconductor is unable to protect its proprietary rights adequately, it may lose its ability to compete effectively in the semiconductor equipment industry.

Varian Semiconductor relies on obtaining and maintaining patent, copyright and trade secret protection for significant new technologies, products and processes and obtaining key licenses because of the length of time and expense associated with bringing new products through the development process to market. Varian Semiconductor intends to continue to file applications as appropriate

for patents covering new products and manufacturing processes. However, Varian Semiconductor cannot provide assurance of the following:

Varian Semiconductor also has agreements with third parties for licensing of patented or proprietary technology. These agreements include royalty bearing licenses and technology cross-licenses. Varian Semiconductor’s loss of licensing agreements with Applied Materials, Tokyo Electron Limited and Lam, could have a material adverse effect on its business.

In addition, Varian Semiconductor maintains and enforces its trademarks to increase customer recognition of its products. If its trademarks are used by unauthorized third parties, its business may be harmed. Varian Semiconductor also relies on contractual restrictions on disclosure, copying and transferring title, including confidentiality agreements with vendors, strategic partners, co-developers, employees, consultants and other third parties to protect its proprietary rights. If these contractual agreements are breached, Varian Semiconductor may not have adequate remedies for any such breaches. Varian Semiconductor also can not provide assurance that its trade secrets will not otherwise become known to or be independently developed by others.

Patent claims may be expensive to pursue, defend or settle and may substantially divert Varian Semiconductor’s resources and the attention of management.

Varian Semiconductor could incur substantial costs and diversion of management resources in defending patent suits brought against it or in asserting its patent rights against others. If the outcome of any such litigation is unfavorable to Varian Semiconductor, its business may be harmed. Varian Semiconductor may not be aware of pending or issued patents held by third parties that relate to its products or technologies. In the event that a claim is asserted against Varian Semiconductor, it may need to acquire a license to or contest the validity of a competitor’s patent. Varian Semiconductor cannot be certain that it could acquire such a license on commercially acceptable terms, if at all, or that it would prevail in such a proceeding. From time to time, Varian Semiconductor has received notices from and has issued notices to such third parties alleging infringement of patent and other intellectual property rights relating to its products. If Varian Semiconductor is subject to future claims of patent infringement, it may be required to make substantial settlement or damages payments and may have to devote substantial resources to reengineering its products.

Varian Semiconductor depends on limited groups of suppliers or single source suppliers, the loss of which could impair its ability to manufacture products and systems.

Varian Semiconductor obtains some of its components and subassemblies included in its products from a limited group of suppliers, or in some cases a single source supplier. The loss of any supplier, including any single source supplier, would require obtaining one or more replacement suppliers and may also require devoting significant resources to product development to incorporate new parts from other sources into its products. The need to change suppliers or to alternate between suppliers might cause delays in delivery or significantly increase Varian Semiconductor’s costs. Although Varian Semiconductor has nominal insurance to protect against loss due to business interruption from these and other sources, Varian Semiconductor cannot provide assurance that such coverage will be adequate or that it will remain available on commercially acceptable terms. Although Varian Semiconductor seeks to reduce its dependence on these limited source suppliers, disruption or loss of these sources could negatively impact its business and damage customer relationships.

Varian Semiconductor’s indemnification obligations under the Distribution Agreement could be substantial, and Varian Semiconductor may not be fully indemnified in accordance with this agreement for the expenses it incurs.

Under the terms of the Distribution Agreement, each of VMS, VI and Varian Semiconductor has agreed to indemnify the other parties (and certain related persons) from and after the spin-off with respect to certain indebtedness, liabilities and obligations which could be significant. The availability of such indemnities will depend upon the future financial strength of the companies. There is a risk that one or more of these companies will not be able to satisfy their indemnification obligations. In addition, the Distribution Agreement generally provides that if a court prohibits a company from satisfying its indemnification obligations, then such obligations will be shared equally by the other companies.

Failure to comply with present or future environmental regulations could subject Varian Semiconductor to penalties and environmental remediation costs.

Varian Semiconductor is subject to a variety of foreign, federal, state and local laws regulating the discharge of materials into the environment and the protection of the environment. These regulations include discharges into the soil, water and air and the generation, handling, storage and transportation and disposal of waste and hazardous substances. These laws increase the costs and potential liabilities associated with the conduct of Varian Semiconductor’s operations.

VAI has been named by the U.S. Environmental Protection Agency and third parties as a potentially responsible party under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended (“CERCLA”), at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also in various stages of environmental investigation and or remediation under the direction of, or in consultation with foreign, federal, state and local agencies at certain current or former VAI facilities (including facilities disposed of in connection with VAI’s sale of its Electron Devices business during fiscal year 1995, and the sale of its TFS business during fiscal year 1997). The Distribution Agreement provides that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.

For certain of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate the future costs of such activities if undertaken. Varian Semiconductor has accrued $1.8 million in estimated environmental investigation and remediation costs for these sites and facilities as of September 27, 2002. As to other sites and facilities, sufficient knowledge has been gained to be able to reasonably estimate the scope and costs of future environmental activities. As such, Varian Semiconductor has accrued $5.1 million, which represents future costs discounted at 7%, net of inflation, to cover Varian Semiconductor’s portion of these costs. This reserve is in addition to the $1.8 million previously described. Varian Semiconductor’s portion of total expenditures for environmental investigation and remediation amounted to $0.5 million in fiscal year 2002, $0.8 million in fiscal year 2001, and $1.2 million in fiscal year 2000.

These accrued amounts are only estimates of anticipated future environmental related costs, and the amounts actually spent may be greater than such estimates. Accordingly, Varian Semiconductor may need to make additional payments to cover its indemnification obligations that would exceed current estimates. In addition, Varian Semiconductor’s present and past facilities have been in operation for many years, and over that time in the course of those operations, such facilities have used substances which are or might be considered hazardous. Varian Semiconductor also may have generated and disposed of wastes which are or might be considered hazardous. Therefore, it is possible that additional environmental issues may arise in the future that Varian Semiconductor cannot now predict.

Varian Semiconductor’s ability to manage potential growth or decline; integration of potential acquisitions and potential disposition of product lines and technologies creates risks.

The cyclical nature of the semiconductor industry may cause Varian Semiconductor to experience rapid growth or decline in demand for products and services. As a result, Varian Semiconductor may face significant challenges in maintaining adequate financial and business controls, management processes, information systems and procedures on a timely basis and training, managing and appropriately sizing the work force. Current conditions in the semiconductor equipment industry challenge management to control spending on operating activities. There can be no assurance that Varian Semiconductor will be able to perform such actions successfully.

An important element of Varian Semiconductor’s management strategy is to review acquisition prospects that would complement existing products, augment market coverage and distribution ability, or enhance technological capabilities. In the future, Varian Semiconductor may make acquisitions of complementary companies, products or technologies, or may reduce or dispose of certain product lines or technologies, which no longer fit Varian Semiconductor’s long-term strategies. Managing an acquired business, disposing of product technologies or reducing personnel entail numerous operational and financial risks, including difficulties in assimilating acquired operations and new personnel or separating existing business or product groups, diversion of management’s attention to other business concerns, amortization of acquired intangible assets, the incurrence of debt and contingent liabilities and potential loss of key employees or customers of acquired or disposed operations, among others. Varian Semiconductor’s success will depend, to a significant extent, on the ability of its executive officers and other members of its senior management to identify and respond to these challenges effectively. In addition, any acquisitions could result in dilutive issuances of equity securities. There can be no assurance that Varian Semiconductor will be able to achieve and manage successfully any such growth, decline, integration of potential acquisitions, disposition of product lines or technologies, or reduction in personnel or that management, personnel or systems will be adequate to support continued operations. Any such inabilities or inadequacies would have a material adverse effect on Varian Semiconductor’s business, operating results, financial condition, cash flows and/or the price of Varian Semiconductor common stock.

Varian Semiconductor manufactures its products at one primary manufacturing facility and is thus subject to risk of disruption.

Varian Semiconductor has one primary manufacturing facility, located in Gloucester, Massachusetts and its operations are subject to disruption for a variety of reasons, including, but not limited to natural disasters, work stoppages, operational facility constraints and terrorism. Such disruption could cause delays in shipments of products to Varian Semiconductor’s customers and could result in cancellation of orders or loss of customers and could seriously harm Varian Semiconductor’s business.

If Varian Semiconductor loses key employees or is unable to attract and retain key employees, it may be unable to pursue business opportunities.

Varian Semiconductor’s future success depends to a significant extent on the continued service of key managerial, technical and engineering personnel. Competition for such personnel is intense, particularly in the labor markets around Varian Semiconductor’s facilities in Massachusetts. The available pool of qualified candidates is limited, and Varian Semiconductor may not be able to retain its key personnel or to attract, train, assimilate or retain other highly qualified engineers and technical and managerial personnel in the future. The loss of these persons or Varian Semiconductor’s inability to hire, train or retrain qualified personnel could harm Varian Semiconductor’s business and results of operations.

Varian Semiconductor has anti-takeover defenses that could delay or prevent an acquisition and could adversely affect the price of its common stock.

Provisions of Varian Semiconductor’s certificate of incorporation, and by-laws and of Delaware law could delay, defer or prevent an acquisition or change in control of Varian Semiconductor or otherwise adversely affect the price of its common stock. For example, Varian Semiconductor’s Board of Directors is classified into three classes, and stockholders do not have the right to call special meetings of stockholders. Varian Semiconductor’s certificate of incorporation also permits its board to issue shares of preferred stock without stockholder approval. In addition to delaying or preventing an acquisition, the issuance of a substantial number of preferred shares could adversely affect the price of the common stock. Varian Semiconductor has also adopted a stockholders rights plan which may significantly dilute the equity interests of a person seeking to acquire control of Varian Semiconductor without the approval of the Board of Directors.

Varian Semiconductor does not anticipate paying dividends on its common stock in the future.

Varian Semiconductor has not paid and does not anticipate paying dividends on its common stock. Varian Semiconductor’s Board of Directors will have discretion to make decisions to pay dividends to common stockholders in the future. The decision will depend on a number of factors, including results of operations, financial conditions and contractual restrictions, that the Board, in its opinion, deems relevant.

As a multinational company, Varian Semiconductor faces exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as Varian Semiconductor’s business practices evolve and could have a material adverse impact on Varian Semiconductor’s financial results. Historically, Varian Semiconductor’s primary exposures have resulted from non-U.S. dollar denominated sales and purchases in Europe and Asia. Varian Semiconductor does not enter into forward exchange contracts for trading purposes. Varian Semiconductor’s forward exchange contracts generally range from one to six months in original maturity. No forward exchange contract has an original maturity greater than one year.

Varian Semiconductor hedges currency exposures that are associated with certain of its assets and liabilities denominated in various non-U.S dollar denominated currencies. The aggregate exchange loss was immaterial for the first quarter of fiscal year 2003.

Forward exchange contracts outstanding as of December 27, 2002 are summarized as follows (amounts in thousands):

Varian Semiconductor also hedges currency exposures that are associated with certain of its product sales denominated in Japanese Yen. In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” these forward foreign exchange contracts are designated as hedges of anticipated product sales, and accordingly, the gains and losses resulting from the impact of currency rate movements on these contracts are not recognized in income until the underlying hedged transactions are recognized. Upon recognition, such gains and losses are recorded in revenue as an adjustment to the carrying amount of the underlying transactions in the period in which these transactions are recognized. Should the hedged anticipated product sales not occur within two months of the expiration of the forward foreign exchange contract, any unrealized gain or loss would be recorded in marketing, general and administrative expense. There were no forward foreign exchange contracts designated as hedges of anticipated product sales in Japanese Yen outstanding at December 27, 2002.

Although payments under certain of Varian Semiconductor’s overseas borrowing facilities are tied to market indices, Varian Semiconductor is not exposed to material interest rate risk from these borrowing facilities.

Varian Semiconductor has no material cash flow exposure due to rate changes for cash equivalents and short-term investments. Varian Semiconductor maintains cash investments primarily in U.S. Treasury, government agency securities, and investment quality municipal securities as well as short-term time deposits with investment-grade financial institutions. Cash equivalents at December 27, 2002 and September 27, 2002 were $307.0 million and $305.2 million, respectively. Varian Semiconductor’s short-term investments consist of six-month certificates of deposits. Short-term investments at December 27, 2002 were $11.5 million. There were no short-term investments at September 27, 2002.

During the first quarter of fiscal year 2003, revenue from three customers accounted for 16%, 14% and 11% of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. During the first quarter of fiscal year 2002, Lam accounted for 36% of total revenue and one other customer accounted for 15% of total revenue (See also Note 13. Settlement and License Agreement). Excluding the Lam royalty and license revenue, one customer accounted for 23% of total revenue during the first quarter of fiscal year 2002.

As of December 27, 2002 one customer accounted for 23% of the total accounts receivable balance. As of December 28, 2001, one customer accounted for 16% and another customer accounted for 14% of the total accounts receivable balance.

(a) Evaluation of disclosure controls and procedures. Based on their evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934) as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, the Company’s chief executive officer and chief financial officer have concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and are operating in an effective manner.

(b) Changes in internal controls. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluation.

Information required by this Item is provided in Note 12. Commitments and Contingencies to the Unaudited Interim Consolidated Financial Statements.

10.1 Purchase and Sale Agreement, made as of November 27, 2002, by and between Berkshire-Newburyport Limited Partnership and Varian Semiconductor Equipment Associates, Inc.

10.2 First Amendment to Purchase and Sale Agreement, dated as of January 6, 2003, by and between Berkshire-Newburyport Limited Partnership and Varian Semiconductor Equipment Associates, Inc.

10.3 Second Amendment to Purchase and Sale Agreement, dated as of January 28, 2003, by and between Berkshire-Newburyport Limited Partnership and Varian Semiconductor Equipment Associates, Inc.

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.

VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC. Registrant

By:		/s/ Robert J. Halliday
		Robert J. Halliday Vice President and Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)

35 Dory Road, Gloucester, Massachusetts		01930
(Address of principal executive offices)		(Zip code)

Item Number		Page Number

	PART I. FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements
	Consolidated Balance Sheets at December 27, 2002 and September 27, 2002	1
	Consolidated Statements of Operations for the three month periods ended December 27, 2002 and December 28, 2001	2
	Consolidated Statements of Cash Flows for the three month periods ended December 27, 2002 and December 28, 2001	3
	Notes to the Consolidated Financial Statements	4

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24

Item 4.	Controls and Procedures	25

	PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	26

Item 2.	Changes in Securities and Use of Proceeds	26

Item 3.	Defaults Upon Senior Securities	26

Item 4.	Submission of Matters to a Vote of Security Holders	26

Item 5.	Other Information	26

Item 6.	Exhibits and Reports on Form 8-K	26

	Signatures	27

	December 27, 2002		September 27, 2002
	(Amounts in thousands, except share data)
ASSETS
Current assets
Cash and cash equivalents	$	315,460	$	307,840
Short-term investments		11,500		—
Accounts receivable, net		55,747		85,793
Inventories		78,756		81,779
Deferred income taxes		42,576		42,311
Other current assets		9,545		9,530

Total current assets		513,584		527,253
Property, plant and equipment, net		43,498		46,718
Goodwill, net		12,280		12,280
Other assets		3,359		3,254

Total assets	$	572,721	$	589,505

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Notes payable and other short-term borrowings	$	5,005	$	5,779
Accounts payable		16,714		21,398
Accrued expenses		43,008		48,560
Product warranty		8,383		8,656
Deferred revenue		46,212		60,269

Total current liabilities		119,322		144,662
Long-term accrued expenses		5,653		5,674
Deferred income taxes		3,182		2,933

Total liabilities		128,157		153,269

Commitments and contingencies (Note 12)

Stockholders’ equity
Preferred stock, $0.01 par value; 5,000,000 shares authorized, none issued		—		—
Common stock, $0.01 par value; 150,000,000 shares authorized, 34,049,886 issued and outstanding at December 27, 2002, and 33,821,277 issued and outstanding at September 27, 2002		340		338
Capital in excess of par value		268,955		263,470
Retained earnings		175,269		172,428

Total stockholders’ equity		444,564		436,236

Total liabilities and stockholders’ equity	$	572,721	$	589,505

	Fiscal Three Months Ended
	December 27, 2002		December 28, 2001
	(Amounts in thousands, except per share data)
Revenue
Product	$	61,940	$	34,138
Service		19,320		14,032
Royalty		2,449		29,610

Total revenue		83,709		77,780


Cost of revenue
Product		37,544		29,520
Service		10,720		8,177

Total cost of revenue		48,264		37,697

Gross profit		35,445		40,083


Operating expenses
Research and development		13,569		12,850
Marketing, general and administrative		18,931		18,948
Restructuring		—		2,200

Total operating expenses		32,500		33,998

Operating income		2,945		6,085
Interest income, net		1,236		1,620
Other income, net		58		440

Income before income taxes		4,239		8,145
Provision for income taxes		1,398		3,095

Net income	$	2,841	$	5,050


Weighted average shares outstanding—basic		33,915		32,690
Weighted average shares outstanding—diluted		34,746		34,325
Net income per share—basic	$	0.08	$	0.15
Net income per share—diluted	$	0.08	$	0.15

	Fiscal Three Months Ended
	December 27, 2002			December 28, 2001
	(Amounts in thousands)
Cash flows from operating activities:
Net income	$	2,841		$	5,050
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,552			3,345
Non-cash consideration for royalty and license revenue		—			(22,800	)
Unrealized gain on investment		—			(440	)
Tax benefit from exercise of stock options		2,087			832
Deferred income taxes		(16	)		(2,117	)
Changes in assets and liabilities:
Accounts receivable		30,859			31,042
Inventories		4,884			7,616
Other current assets		(15	)		412
Accounts payable		(4,704	)		(2,137	)
Accrued expenses		(5,731	)		8,620
Product warranty		(355	)		(5,285	)
Deferred revenue		(14,302	)		(13,919	)
Other		(193	)		152

Net cash provided by operating activities		18,907			10,371

Cash flows from investing activities:
Purchase of property, plant and equipment		(2,456	)		(2,504	)
Purchase of available-for-sale securities		(11,500	)		—

Net cash used in investing activities		(13,956	)		(2,504	)

Cash flows from financing activities:
Proceeds from the issuance of common stock		3,400			606
Notes payable and short-term borrowing		(862	)		(1,650	)

Net cash provided by (used in) financing activities		2,538			(1,044	)

Effects of exchange rate changes on cash		131			(250	)

Net increase in cash and cash equivalents		7,620			6,573
Cash and cash equivalents at beginning of period		307,840			278,641

Cash and cash equivalents at end of period	$	315,460		$	285,214

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(Amounts in thousands except per share amounts)	Three Months Ended December 28, 2001
Net income as reported	$	5,050
Add back: Goodwill amortization expense, net of tax effect		270

Adjusted net income	$	5,320

Basic income per share, as reported	$	0.15
Add back: Goodwill amortization expense, net of tax effect		0.01

Adjusted basic income per share	$	0.16

Diluted income per share, as reported	$	0.15
Add back: Goodwill amortization expense, net of tax effect		0.01

Adjusted diluted income per share	$	0.16

(Amounts in thousands)	Amount of Liability
Balance as of September 27, 2002	$	(8,656	)
Accruals for warranties issued during the period		(2,787	)
Accruals related to pre-existing warranties		(141	)
Settlements made during the period		3,201

Balance as of December 27, 2002	$	(8,383	)

(Amounts in thousands)	North America		Europe		Japan		Taiwan		Korea		Other		Consolidated
Revenue – Three months ended:
December 27, 2002	$	40,657	$	11,672	$	7,670	$	9,102	$	11,549	$	3,059	$	83,709
December 28, 2001		53,027		14,017		3,378		3,474		3,187		697		77,780

Long-lived assets as of:
December 27, 2002	$	36,245	$	1,124	$	1,394	$	433	$	4,246	$	56	$	43,498
September 27, 2002		38,993		1,290		1,671		385		4,319		60		46,718

(Amounts in thousands)	Reduction in Work Force			Facility Closures			Other			Total
Balance as of September 28, 2001	$	—		$	—		$	—		$	—
New charges		4,594			602			209			5,405
Non-cash items		—			—			(114	)		(114	)
Cash payments		(2,427	)		—			—			(2,427	)

Balance as of September 27, 2002		2,167			602			95			2,864
Cash payments		(1,357	)		(401	)		(65	)		(1,823	)

Balance as of December 27, 2002	$	810		$	201		$	30		$	1,041

	Three Months Ended
(Amounts in thousands)	December 27, 2002		December 28, 2001		Change			Percent Change
Revenue
Product	$	61,940	$	34,138	$	27,802		81	%
Service		19,320		14,032		5,288		38	%
Royalty and license		2,449		29,610		(27,161	)	(92	%)

Revenue.	$	83,709	$	77,780	$	5,929		8	%

			Payments Due by Period
(Amounts in thousands)	Total		Less than 1 Year		1 – 3 Years		4 –5 Years		After 5 Years
Operating leases	$	13,327	$	3,364	$	4,452	$	2,083	$	3,428
Purchase order commitments		29,500		29,500		—		—		—
Letter of credit		1,900		1,900		—		—		—

Total commitments	$	44,727	$	34,764	$	4,452	$	2,083	$	3,428

	Notional Value		Contract Rate	Fair Value
Foreign currency purchase contracts:
Euro	$	1,259	1.01	$	1,307
Korean Won		1,237	1,213.00		1,245
Japanese Yen		2,410	124.50		2,494
New Taiwan Dollar		998	34.86		996
British Pound		261	0.64		269

Total foreign currency purchase contracts	$	6,165		$	6,311
Foreign currency sell contracts:
Japanese Yen	$	4,415	123.25	$	4,524
Korean Won		3,149	1,223.94		3,198
New Taiwan Dollar		287	34.81		286
Israeli Shekel		615	4.68		607

Total foreign currency sell contracts		8,466			8,615
Total contracts	$	14,631		$	14,926