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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

[ X ]   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended March 31, 2005

OR

[   ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from ______________ to ______________

Commission file number 0-25424

Semitool, Inc.
(Exact Name of Registrant as Specified in Its Charter)

655 West Reserve Drive
Kalispell, Montana 59901
(Address of principal executive offices, zip code)

Registrant’s telephone number, including area code:  (406) 752-2107

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES  X   NO __

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES  X   NO __

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practical date:

Semitool, Inc.
Form 10-Q
Table of Contents

PART I — FINANCIAL INFORMATION

Item 1.    Condensed Consolidated Financial Statements

SEMITOOL, INC.
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(Amounts in Thousands, Except Share Amounts)

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

SEMITOOL, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(Amounts in Thousands, Except Per Share Amounts)

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

SEMITOOL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Amounts in Thousands)

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

SEMITOOL, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(Amounts in Thousands)

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

SEMITOOL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.  Basis of Presentation

Semitool, Inc. (the Company) prepared the consolidated financial statements included herein, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted as permitted by such rules and regulations. These consolidated statements should be read in conjunction with the consolidated financial statements and the notes thereto for the year ended September 30, 2004 previously filed with the SEC on Form 10-K.

In the opinion of management, the accompanying unaudited consolidated financial statements contain all of the adjustments (normal and recurring in nature) necessary to present fairly the Company’s consolidated financial position as of March 31, 2005, the consolidated results of operations for the three and six month periods ended March 31, 2005 and 2004, and the consolidated cash flows for the six month periods ended March 31, 2005 and 2004. The results of operations for the periods presented may not be indicative of the results that may be expected for the entire fiscal year.

The discussion and analysis of the Company’s financial condition and results of operations is based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. Routinely, the Company evaluates its estimates, including those related to revenue recognition, bad debts, inventories, investments, intangible assets, income taxes, financing operations, warranty obligations, contingencies and litigation. The Company 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.

The Company’s consolidated financial statements include the accounts of Semitool, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Semitool has only one reportable segment.

New Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and SFAS No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations,” and non-marketable equity securities accounted for under the cost method. The EITF developed a basic three-step model to evaluate whether an investment is other-than-temporarily impaired. On September 30, 2004, the FASB approved the issuance of FASB Staff Position (FSP) EITF 03-1-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-1 to investments in securities that are impaired. The Company does not expect the adoption of EITF 03-1 to have a material effect on its results of operations or financial condition.

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”. This Statement revises FASB Statement No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123(R) focuses primarily on the accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) generally requires companies to recognize in the statement of income the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. In March 2005, the U.S. Securities and Exchange Commission (SEC) issued SAB 107 which expresses views of the SEC staff regarding the application of SFAS No. 123(R). Among other things, SAB 107 provides interpretive guidance related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations, as well as provides the SEC staff’s views regarding the valuation of share-based payment arrangements for public companies. On April 21, 2005, the SEC issued the final rule “Amendment to Rule 4-01(A) of Regulation S-X Regarding the Compliance Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment” which revised the effective date of SFAS No. 123(R) to the beginning of the Company’s next fiscal year that begins after June 15, 2005. Accordingly, the Company will adopt SFAS No. 123(R) in its first quarter of fiscal 2006. The Company is currently evaluating the provisions of SFAS No.123(R) including the assessment of allowable option valuation methodologies and methods of transition. Were the Company to continue to value options using the Black Scholes option pricing model, the impact of the adoption of this standard would result in approximately $300,000 of pretax stock compensation expense per quarter or $1.2 million per year.

In November 2004, the FASB issued SFAS Statement No. 151, “Inventory Costs — an Amendment of ARB No. 43, Chapter 4” (SFAS No. 151). SFAS No. 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Accordingly, the Company will adopt SFAS No. 151 in its first quarter of fiscal 2006. The Company does not expect the adoption of SFAS No. 151 to have a material effect on its results of operations or financial condition.

In December 2004, the FASB issued SFAS Statement No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions” (SFAS No. 153). SFAS No. 153 requires that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. Further, it expands the exception for nonmonetary exchanges of similar productive assets to nonmonetary assets that do not have commercial substance. The provisions of this Statement are effective for nonmonetary asset exchanges occurring in the first reporting period that begins after June 15, 2005. Accordingly, the Company will adopt SFAS No. 153 in its fourth quarter of fiscal 2005. The Company does not expect the adoption of SFAS No. 153 to have a material effect on its results of operations or financial condition.

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations an interpretation of FASB Statement No. 143,” (FIN 47) which clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated even though uncertainty exists about the timing and/or method of settlement and that the fair value of the liability should be recognized when incurred. The provisions of this Interpretation are effective no later than the end of fiscal years ending after December 15, 2005. Accordingly, the Company will adopt FIN 47 by the end of fiscal 2006. The Company does not expect the adoption of FIN 47 to have a material effect on its results of operations or financial condition.

Stock-Based Compensation

The Company accounts for stock-based employee compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25 (APB No. 25), “Accounting for Stock Issued to Employees” and has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123 (SFAS No. 123) “Accounting for Stock-Based Compensation” as amended by SFAS No. 148 (SFAS No. 148) “Accounting for Stock-Based Compensation Transition and Disclosure.” APB No. 25 provides that compensation expense relative to employee stock options is measured based on the intrinsic value of the stock options granted. Compensation expense is recognized in the statement of income in the case where the stock options are granted at exercise prices below fair market value on the date of grant. If the stock options are granted at market value, no compensation expense is recorded. SFAS No. 123 provides for a fair value based method of accounting for an employee stock option. For stock options, fair value is determined using an option pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, expected dividends, and the risk-free rate over the expected life of the option. SFAS No. 123 requires entities continuing to use an intrinsic value based method of accounting prescribed by APB No. 25 to provide pro forma disclosures of net income and earnings per share as if the fair value method of accounting had been used.

For options granted at market value, the Company does not recognize an expense. However, for options granted at exercise prices below fair market value on the date of grant, the Company recognizes compensation expense and amortizes deferred stock-based compensation on the accelerated vesting method described in FASB Interpretation Number 28 over the vesting periods of the applicable stock options (normally five years). The Company estimates the fair value of its stock-based awards to employees using a Black-Scholes option pricing model. Had compensation cost for the Option Plan been determined based on the fair value consistent with the provisions of SFAS No. 123, the Company’s net income and earnings per share would have been changed to the pro forma amounts shown below (in thousands, except for per share amounts):

Computation of Earnings Per Share

The computation of basic and diluted earnings per share is based on the following (in thousands):

Diluted earnings per share excludes the effects of antidilutive stock options of 207,250 and 38,650 for the three months ended March 31, 2005 and 2004, and 286,650 and 62,250 for the six months ended March 31, 2005 and 2004, respectively.

Note 2.  Inventories

The Company’s inventories are summarized as follows (in thousands):

For the three and six months ended March 31, 2005, $2.7 million and $3.5 million of inventory was transferred to property, plant and equipment for testing and laboratory use, respectively.

Note 3.  Warranty Obligations

Obligations for warranty are accrued concurrently with the revenue recognized on the related equipment. Provisions for warranty obligations are made based upon historical costs incurred for such obligations adjusted, as necessary, for current conditions and factors. Due to the significant uncertainties and judgments involved in estimating warranty obligations, including changing product designs and specifications, the ultimate amount incurred for warranty costs could change in the near term from the Company’s current estimate.

Changes in the Company’s accrued warranty liability were as follows (in thousands):

With the exception of product warranties the Company has not issued any guarantees or any indirect guarantee for the indebtedness of others.

Note 4.  Contingencies

The Company occasionally is involved in legal proceedings that arise in the ordinary course of its business. Although there can be no assurance as to the ultimate disposition of these matters, it is the opinion of management, based upon the information available at this time, that the currently expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on its business, financial condition, results of operations or cash flows.

Periodically, but not less than quarterly, the Company reviews the status of each significant matter and assesses its potential financial exposure. If the potential loss from any legal proceeding or claim is considered probable and the amount can be reasonably estimated, the Company accrues a liability for the estimated loss. Significant judgment is required in both the determination of probability and the determination as to whether an exposure is reasonably estimable. Due to the uncertainties related to these matters, accruals are based on the best information available at the time. As additional information becomes available, the Company reassesses the potential liability related to its pending litigation and claims and may revise its estimates. Although the Company has not made such revisions, any future revisions could have a material impact on its results of operations and financial condition.

Note 5.  Other Income (Expense), Net

Other income (expense), net for the first six months of fiscal 2005 includes a $2.9 million litigation settlement payment received from Novellus Systems, Inc.

Note 6.  Income Taxes

The Company’s estimated effective tax rate is 33% for fiscal 2005. The Company’s recorded tax rate for the first quarter of fiscal 2005 was approximately 30% due to the recognition of approximately $186,000 of Research and Experimentation Credit (Credit), which was generated in the fourth quarter of fiscal 2004. Legislation to extend the Credit was signed into law after September 30, 2004; therefore, the Company was unable to recognize the Credit in fiscal 2004. The effective tax rate for fiscal 2004 was 33%.

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

Introduction – Forward–Looking Statements

Statements contained in this Quarterly Report on Form 10-Q which are not purely historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on management’s estimates, projections and assumptions that underlie such statements at the time they are made. Forward-looking statements may contain words such as “may,” “will,” “should,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,” or the negative of these terms or other comparable terminology. Examples of forward-looking statements made in this Quarterly Report on Form 10-Q include statements regarding:

• key trends in the semiconductor industry that are driving growth;
• the industry trend toward stronger Asian markets;
• the sufficiency of funds and sources of liquidity;
• estimates of capital expenditures;
• estimates of tax rates for fiscal 2005;
• estimates of pretax stock compensation expense under SFAS No. 123(R);
• the level of research and development expenditures;
• the ability to finance activities;
• accounting policies and estimates; and
• effects of new accounting standards.

Management cautions that forward-looking statements are subject to risks and uncertainties that could cause our actual results to differ materially from those projected in such forward-looking statements. The risks, uncertainties and other important factors that may cause our results to differ materially from those projected in such forward-looking statements include the cyclicality in the semiconductor industry, rapid technological change, the introduction of competing products and technologies, market non-acceptance of Semitool’s new products and technologies, including our Raider tool, cancellations or rescheduling of orders, the potential loss of sales or incurrence of liabilities due to manufacturing defects, and litigation. Further, bookings, backlog and shipments are not necessarily an indication of revenue in any future period or future sales of any specific tool. Other risks and uncertainties are detailed under the heading “Factors That Might Affect Our Future Financial Results and Stock Price” and elsewhere in our Annual Report on Form 10-K for our fiscal year ended September 30, 2004. We undertake no obligation to update forward-looking statements to reflect subsequent events, changed circumstances, or the occurrence of unanticipated events.

Documents to Review in Connection with Management’s Discussion and Analysis of Financial Condition and Results Of Operations

This discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes presented in this Form 10-Q and the financial statements and notes in our last filed Annual Report on Form 10-K for a full understanding of our financial position and results of operations for the three and six month periods ended March 31, 2005.

Overview

We design, manufacture, install and service highly-engineered equipment for use in the fabrication of semiconductor devices. Our products are focused on the wet chemical process steps in integrated circuit, or IC, manufacturing and include systems for wafer surface preparation and electrochemical deposition, or ECD, applications. Our surface preparation systems are designed for wet cleaning, stripping and etching processes, including photoresist and polymer removal, and metal etching. Our ECD systems are used for copper and gold plating for the IC’s internal wiring, or interconnects; solder and gold bumps for wafer level packaging applications; and other metals for various semiconductor and related applications. Our products address critical applications within the semiconductor manufacturing process, and help enable our customers to manufacture more advanced semiconductor devices that feature higher levels of performance. The fabrication of semiconductor devices typically requires several hundred manufacturing steps, with the number of steps continuing to increase for advanced devices. Due to the breadth of our product portfolio and advanced technology capabilities, our solutions address over 100 of these manufacturing steps.

There are several key trends in the semiconductor manufacturing industry driving growth in demand for wafer surface preparation, ECD and other advanced semiconductor equipment:

• smaller device features for lower cost and higher performance;
• new materials to build more advanced semiconductor devices;
• increased use of 300mm wafers to reduce manufacturing costs;
• move to spray processing and single-wafer processing technologies for enhanced surface preparation; and
• wafer level and other advanced packaging enabling smaller portable products.

As the semiconductor manufacturing process increases in complexity and production parameters become more stringent, semiconductor manufacturers have increasingly relied upon providers of semiconductor equipment that features improved process control, smaller footprint and a lower cost of ownership of their manufacturing processes. We provide a broad suite of advanced, highly-engineered, innovative processing systems that include surface preparation and ECD equipment. Our batch and single-wafer processing systems for wet cleaning, stripping and etching feature our proprietary spray technology, as well as our unique process chamber designs. Our ECD equipment leverages our advanced computational techniques and Capsule technology for a variety of applications including copper interconnect, seed layer enhancement and gold and solder bumps for advanced packaging.

Key Performance Indicators

Our management focuses on revenues, gross margin, operating expenses, profitability and deferred revenue in managing our business. In addition to these financial measures found in our financial statements, we also use bookings, backlog and shipments as key performance indicators. Bookings are firm orders for which we have received written customer authorization in the fiscal period. Backlog is the balance of undelivered orders at the end of a fiscal period. In order to be included in bookings or backlog, an order must be scheduled to ship within the next 12 months. Backlog and forecasted orders drive our production schedule. Shipments measure how well we have met our production plan and are viewed as a primary measure of factory output.

A summary of key factors which impacted our financial performance during the second quarter includes:

• Net income was $2.5 million on revenues of $46.3 million during the second quarter of fiscal 2005 compared to net income of $4.1 million on revenues of $34.6 million in the second quarter of fiscal 2004. Second quarter fiscal 2004 net income includes a $7.5 million license initiation fee for our seed layer enhancement technology.
  
  
• Second quarter fiscal 2005 bookings were $46.0 million.
  
  
• Shipments in the second quarter of fiscal 2005 were $48.9 million.
  
  
• Deferred revenue at March 31, 2005 was $28.9 million.
  
  
• Our gross margin was 51.9% of net revenue, down from the 64.5% gross margin we reported in the second quarter of fiscal 2004. The fiscal 2004 margin was benefited by the $7.5 million license initiation fee.
  
  
• Cash, cash equivalents and marketable securities were $24.0 million at March 31, 2005, an increase of $4.7 million from $19.3 million at December 31, 2004 due primarily to cash flows from operations.

Results of Operations

The following table sets forth our consolidated results of operations for the periods indicated as a percentage of net revenue:

Second Quarter and First Half of Fiscal 2005 Compared with Second Quarter and First Half of Fiscal 2004

Net Revenue

Product and service revenue consists of revenues from sales of semiconductor equipment, spare parts and service. Our revenue recognition policy provides that revenue from sales of semiconductor equipment may be recognizable upon shipment if the product is an existing tool to a customer environment in which we have already successfully installed or gained acceptance of our products. Alternatively, revenue will be deferred and only recognized upon final customer acceptance for tools that are new products or where an existing tool is sold into a new customer environment. Revenue for elements other than equipment, such as installation revenue, is included in tool acceptance revenue. License fee revenue represents fees from licensing certain of our patents.

Net revenue increased $11.7 million for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004 and $31.9 million in the first six months of fiscal 2005 as compared to the first six months of fiscal 2004. In general, business activity levels have increased in fiscal 2005 as compared to fiscal 2004. Revenue from shipments increased 85% in the second quarter of fiscal 2005 while revenue from tool acceptances increased almost 200% over the comparable period in fiscal 2004. Shipment revenue increased 57% and acceptance revenue increased 224% in the first half of fiscal 2005. Revenue from both shipments and acceptances was weighted toward our Raider platform. Additionally, the second quarter of fiscal 2004 revenue included the $7.5 million license initiation fee received for our seed layer enhancement patents.

Geographically, our revenue mix changed to being weighted toward Asia, including Japan, from being weighted toward North America in fiscal 2004. We obtained acceptance for several tools at multiple customer sites in Asia and Japan during the first quarter of fiscal 2005. This corresponds to the overall industry trend toward stronger Asian markets.

Gross Profit

Gross profit increased $1.7 million in the second quarter of fiscal 2005 compared to the second quarter of fiscal 2004. In the first six months of fiscal 2005, gross profit increased $9.6 million as compared to the same period of fiscal 2004. As a percentage of net revenue, gross profit declined 12.6 percentage points to 51.9% in the second quarter of fiscal 2005 from 64.5% in fiscal 2004‘s second fiscal quarter. Year-to-date, gross margin declined 10.1 percentage points to 49.9% from 60.0% for the same period in fiscal 2004.

Gross profit increased in both comparative periods in absolute dollar terms because of higher sales volumes. Additionally, in fiscal 2004, both revenues and margins benefited from the receipt of a $7.5 million license initiation fee. Exclusive of the license initiation fee, margins were 54.7% and 54.6%, respectively, in the second quarter and first half of fiscal 2004. The gross profit percentage in both comparative periods in fiscal 2005 was impacted by:

• increased warranty expense that added an additional three percentage points to our cost of goods sold in the second quarter of fiscal 2005 as compared to the second quarter of fiscal 2004 and an additional one percentage point in the year-to-date comparison. In both fiscal 2004 periods, warranty expense was favorably impacted by expirations and changes in estimates of pre-existing warranties; and
  
  
• increased reserves for obsolete inventory that adversely impacted the gross profit percentage by an additional two percentage points in both comparative periods. In fiscal 2004, inventory reserves were minimal following the write-down of inventory at the end of fiscal 2003.

Second quarter fiscal 2005 gross margin was also favorably impacted by improved absorption of manufacturing costs.

Selling, General and Administrative

Selling, general and administrative (SG&A) expenses include employment costs for sales, marketing, customer support and administrative personnel as well as travel, communications, professional fees and expenses related to sales and service offices at our global locations. SG&A expenses increased $2.7 million in absolute dollars in the second quarter of fiscal 2005 as compared to the second quarter for fiscal 2004 but declined 3.3 percentage points to 32.5% of net revenue. SG&A expenses increased $6.9 million in the first six months of fiscal 2005 compared to the first six months of fiscal 2004 but declined 5.2 percentage points to 32% of net revenue demonstrating our ability to leverage our support costs.

Employment costs increased approximately 35% in the second quarter of fiscal 2005 as compared to the second quarter of fiscal 2004 and 32% in the year-to-date period of fiscal 2005 as compared with fiscal 2004 as we restored wages from previously imposed pay reductions, and increased staff to support expanded business activity. Travel and other expenses related to expanded business activity and customer support increased in both comparative periods. These increases were partially offset by decreased legal costs. Legal costs declined more than 90% in the second quarter of fiscal 2005 compared to fiscal 2004 and by 76% in the year-to-date comparison as a result of the settlement of the seed layer enhancement litigation.

Research and Development

Research and Development (R&D) expense consists of employment costs, project materials, laboratory costs, consulting fees and other costs associated with our product development efforts. R&D expense increased $1.4 million in absolute dollars in the second quarter of fiscal 2005 as compared with the second quarter of fiscal 2004 and remained flat as a percentage of net revenue. In the first six months of fiscal 2005, R&D expense increased $2.2 million as compared to the first six months of fiscal 2004 and declined to 9.7% of net revenue.

In the second quarter of fiscal 2005, prototype expense increased 554% when compared to the second quarter of fiscal 2004. Beginning in fiscal 2004, most of our research and development efforts have been focused on meeting new customer requirements for the Raider platform. Additionally, the ongoing development of our wafer thinning technology is reflected in increasing prototype costs in the second quarter of fiscal 2005. Employment costs increased 27% in the second quarter of fiscal 2005 compared with the same period in fiscal 2004 primarily related to increases in staffing levels and the lifting of a wage reduction that was in effect in the comparable period in fiscal 2004. Depreciation expense increased 62% in the second quarter of fiscal 2005 compared with the second quarter of fiscal 2004 related to additions of Raider platform tools to our demonstration laboratories.

Increasing employment costs were the primary driver in the $2.2 million increase in R&D expense in the first six months of fiscal 2005. Employment costs increased 28% over the comparable period as a result of the reversal of a wage reduction in effect in fiscal 2004 and staffing level increases. As discussed in the quarterly comparison above, both prototype and depreciation expense have increased in the first six months of fiscal 2005 as compared with the first six months of fiscal 2004.

Our research and development expense has fluctuated from quarter to quarter in the past. We expect such fluctuations to continue in the future, both in absolute dollars and as a percentage of net revenue, primarily due to the timing of expenditures and fluctuations in the level of net revenue in a given quarter. We expect to continue to fund research and development expenditures with a multi-year perspective and are committed to technology leadership in our sector of the semiconductor equipment industry.

Other Income (Expense), Net

Net other income (expense) decreased in the second quarter of fiscal 2005 as compared to the same period in fiscal 2004. A foreign exchange loss, primarily related to the increased weakness of the dollar compared with the Yen and the Euro, was partially offset by a gain on the sale of property.

Net other income (expense) increased in the first half of fiscal 2005 as compared to the same period in fiscal 2004. In October 2004, we received a litigation settlement payment of $2.9 million from Novellus Systems, Inc.

Income Taxes

Our estimated effective tax rate is 33% for fiscal 2005. Our recorded tax rate for the first quarter of fiscal 2005 was approximately 30% due to the recognition of approximately $186,000 of Research and Experimentation Credit (Credit), which was generated in the fourth quarter of fiscal 2004. Legislation to extend the Credit was signed into law after September 30, 2004; therefore, we were unable to recognize the Credit in fiscal 2004. The effective tax rate for fiscal 2004 was 33%.

Backlog and Deferred Revenue

Approximately 70% of our current backlog is for tools on the Raider platform. Deferred revenue increased almost $10 million at March 31, 2005 as compared with March 31, 2004 primarily because of increased shipments of Raiders that represent either new products into existing customer environments or shipments into new customer environments, in accordance with our revenue recognition policy. Current deferrals include all or a part of 15 Raiders at March 31, 2005 as compared with six Raiders at March 31, 2004.

We include in backlog those customer orders for which we have written customer authorization and for which shipment is scheduled within the next 12 months. Orders are generally subject to cancellation or rescheduling by customers with limited or no cancellation fees. As the result of systems ordered and shipped in the same quarter, possible changes in customer delivery dates, cancellations and shipment delays, the backlog at any particular date and the bookings for any particular period are not necessarily indicative of actual revenue for any succeeding period. In particular, during periods of downturns in the semiconductor industry we have experienced cancellations and significant shipment delays.

Deferred profit included in our current liabilities is derived from deferred revenue, which relates to equipment shipped to customers that has not been accepted by the customer, less the deferred cost of goods sold, including warranty and installation, and commission expenses. Deferred revenue is not included in orders backlog.

Liquidity and Capital Resources

In the first half of fiscal 2005, cash provided by operating activities was $3.8 million. We used cash as inventories grew $6.0 million, primarily in work-in-process inventory, as we prepare to meet customer delivery dates. In addition to the growth in inventories, we also reduced our accounts payable balance by $2.9 million. Deferred profit decreased by $10 million from year-end fiscal 2004 levels because acceptances of Raider and other high value tools have exceeded revenue, and associated cost, deferrals thus far in the fiscal 2005 period. The primary source of cash during the period was the collection of trade receivables in the normal course of business. Trade receivables declined by $10.7 million from September 30, 2004. We also received a $1.2 million income tax refund. Other sources of cash during the first half of fiscal 2005 included net income of almost $7.5 million and an increase in various accrued liabilities of $4.0 million. These liabilities relate to estimates of customer support obligations for tools on which we have recognized revenue during the fiscal year, as well as to increased employment-related costs.

Investing activities in the first half of fiscal 2005 included $2.2 million in purchases of factory equipment, primarily tools built in-house for our own laboratories, and net cash proceeds of $2.2 million from the sale of marketable securities.

Financing activities consisted primarily of cash received from stock option exercises of $211,000 offset by long-term debt repayments of $110,000 during the first half of fiscal 2005.

In the first half of fiscal 2004, the primary sources of cash from operating activities were the receipt of the $7.5 million license initiation fee included in income from operations and the receipt of over $15 million in income tax refunds. Inventory and accounts payable increased by $16.2 million and $5.9 million, respectively, as a result of our efforts to reduce manufacturing cycle times and provide faster deliveries to our customers by stocking components that will help shorten our lead times. Trade receivables increased $12 million due to the shipment of several Raiders in the latter half of the second quarter. The $4.6 million increase in deferred profit is the result of revenue and expenses deferred on our new Raider products pending final customer acceptance.

In the first six months of fiscal 2004, investing activities included $3.6 million in purchases of factory equipment and other property and net cash used for the purchase of marketable securities of $4.1 million. Financing activities consist primarily of stock option exercises of $701,000 offset by long-term debt repayments of $112,000 during the first half of fiscal 2004.

The following commitments as of March 31, 2005, incurred in the normal course of business, have been included in the consolidated financial statements with the exception of purchase order commitments and operating lease obligations, which are properly excluded under accounting principles generally accepted in the United States of America. They are disclosed in the following table in order to provide a consolidated picture of our financial position and liquidity. We do 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, we are not exposed to the types of financing, liquidity, market or credit risks that could arise if we had engaged in such relationships.

We have agreements with limited liability companies wholly-owned by Mr. Raymon F. Thompson, our Chairman and Chief Executive Officer, to lease aircraft and an aircraft hangar. The current rental rate is approximately $274,000 per month for both the aircraft and the hangar; the lease terms are month-to-month and therefore are not included in the above table.

As of March 31, 2005, our principal sources of liquidity consisted of approximately $20.2 million of cash and cash equivalents, $3.8 million in marketable securities, a $15.0 million line of credit with a commercial bank and incoming cash generated from operations. We believe that we have sufficient cash and cash equivalents, along with funds expected to be generated from operations to meet operating expenses and planned capital expenditures through fiscal 2005 and into the foreseeable future. We estimate capital expenditures will be between $10.0 million and $12.0 million during fiscal 2005. We currently have an effective shelf registration statement, which registers the offer and sale of up to an aggregate $75 million of our securities. If additional financial resources are required in the future, we expect either to issue securities from the shelf registration statement or to issue other financial instruments, whichever management deems advisable. Of course, there can be no assurance that in the future we will be able to issue additional common stock or other financial instruments on acceptable terms.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United Sates of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, inventories, warranty obligations, bad debts, investments, intangible assets, income taxes, financing operations, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

Revenue Recognition.  Revenue recognition is significant because revenue is a key component of our results of operations. We recognize revenue under the guidance for Staff Accounting Bulletin No. 104 (SAB 104), “Revenue Recognition.” Under this method, revenue is recognized only when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable and collectibility is reasonably assured. Our product sales generally contain substantive customer acceptance provisions. Sales of new products to new or existing customers are not recognized until customer acceptance. Likewise, sales of existing products to new customer environments are not recognized until customer acceptance. If multiple elements exist, sales of existing products into existing customer environments are treated as such in accordance with Emerging Issues Task Force Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” The amount of revenue recognized in multiple element arrangements is the lesser of the fair value of the equipment or the contracted amount that was due or payable upon title transfer. The revenue for elements other than equipment is recorded in deferred profit and is recognized when the remaining goods and/or services are delivered or performed. Revenue related to service is recognized upon completion of performance of the service or ratably over the life of the related service contract. Spare parts sales are recognized upon shipment when title and risk of loss pass to the customer. Unearned revenue from service contract agreements is included in Customer Advances in the current liability section of the balance sheet.

In addition, the timing of certain expenses, such as cost of goods sold, including installation and warranty, and commission expenses coincides with the recognition of the related revenues. We follow specific guidelines in measuring revenue; however, certain judgments such as the definition of a new customer environment and new acceptance criteria or if installation is perfunctory may be required in the application of our revenue policy.

Inventories.  Inventories are valued at the lower of cost or market on a first-in, first-out basis. Accordingly, we write down the carrying value of inventories for estimated obsolescence and future marketability. On a quarterly basis, we compare historical and projected sales and usage of raw materials and parts and our assumptions about future use of raw materials, parts and finished goods with our forecast, market demand and industry conditions to determine potential obsolescence or whether the inventory on hand represents excess quantities. As a result of our analysis, we record reserves impacting Cost of Goods Sold, if appropriate. If actual future use, demand or market conditions are less favorable than those projected by us, additional inventory valuation write-downs may be required.

Warranty Obligations.  We provide for the estimated cost of equipment warranties when the related revenue is recognized. We track individual warranties on a tool-by-tool basis and develop estimated rates by equipment class. The rates are used to estimate the warranty accrual for a given specific piece of equipment. These rates are revised periodically to reflect current cost trends due to the current life cycle of that product class. The warranty accrual is reduced by actual costs of providing the warranty or if a balance is remaining at the end of the warranty period, then that amount is also written off. Warranty accrual expense impacts primarily Cost of Goods Sold. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required.

Allowance for Doubtful Accounts.  We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We record expense as a component of selling, general and administrative within the Statements of Income. If the financial condition of our customers were to deteriorate, due to the cyclicality of the industries we serve or for other reasons, resulting in an impairment of their ability to make payments, additional allowances and expense may be required. Likewise, if we are successfully able to collect on an amount presumed to be uncollectible, the allowance for doubtful accounts and the related expense may be reduced. In general, it takes longer to collect payment in the capital equipment industry than in certain other industries. Days Sales Outstanding (DSO) of our peer companies, ranges between approximately 50 and 115 days in our industry.

Impairment of Investments in Marketable Securities.  We record an investment impairment charge when we believe an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future. Any investment impairment would be recorded in the financial statements as Other Expense.

Deferred Tax Assets.  We make estimates to determine the amount of our deferred tax assets that we believe is more likely than not to be realized. We consider future taxable income and ongoing prudent tax planning strategies in assessing the need for a valuation allowance; however, should we determine that we will not be able to realize all or part of our net deferred tax asset in the future, a decrease in the deferred tax asset would negatively impact our results of operations, particularly the income tax provision, in the period such determination was made.

New Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and SFAS No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations,” and non-marketable equity securities accounted for under the cost method. The EITF developed a basic three-step model to evaluate whether an investment is other-than-temporarily impaired. On September 30, 2004, the FASB approved the issuance of FASB Staff Position (FSP) EITF 03-1-1, which delays the effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-1 to investments in securities that are impaired. We do not expect the adoption of EITF 03-1 to have a material effect on our results of operations or financial condition.

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment”. This Statement revises FASB Statement No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123(R) focuses primarily on the accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) generally requires companies to recognize in the statement of income the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. In March 2005, the U.S. Securities and Exchange Commission (SEC) issued SAB 107 which expresses views of the SEC staff regarding the application of SFAS No. 123(R). Among other things, SAB 107 provides interpretive guidance related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations, as well as provides the SEC staff’s views regarding the valuation of share-based payment arrangements for public companies. On April 21, 2005, the SEC issued the final rule “Amendment to Rule 4-01(A) of Regulation S-X Regarding the Compliance Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment” which revised the effective date of SFAS No. 123(R) to the beginning of our next fiscal year that begins after June 15, 2005. Accordingly, we will adopt SFAS No. 123(R) in our first quarter of fiscal 2006. We are currently evaluating the provisions of SFAS No.123(R) including the assessment of allowable option valuation methodologies and methods of transition. Were we to continue to value options using the Black Scholes option pricing model, the impact of the adoption of this standard would result in approximately $300,000 of pretax stock compensation expense per quarter or $1.2 million per year.

In November 2004, the FASB issued SFAS Statement No. 151, “Inventory Costs — an Amendment of ARB No. 43, Chapter 4” (SFAS No. 151). SFAS No. 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Accordingly, we will adopt SFAS No. 151 in our first quarter of fiscal 2006. We do not expect the adoption of SFAS No. 151 to have a material effect on our results of operations or financial condition.

In December 2004, the FASB issued SFAS Statement No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions” (SFAS No. 153). SFAS No. 153 requires that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. Further, it expands the exception for nonmonetary exchanges of similar productive assets to nonmonetary assets that do not have commercial substance. The provisions of this Statement are effective for nonmonetary asset exchanges occurring in the first reporting period that begins after June 15, 2005. Accordingly, we will adopt SFAS No. 153 in our fourth quarter of fiscal 2005. We do not expect the adoption of SFAS No. 153 to have a material effect on our results of operations or financial condition.

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations an interpretation of FASB Statement No. 143,” (FIN 47) which clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated even though uncertainty exists about the timing and/or method of settlement and that the fair value of the liability should be recognized when incurred. The provisions of this Interpretation are effective no later than the end of fiscal years ending after December 15, 2005. Accordingly, the Company will adopt FIN 47 by the end of fiscal 2006. The Company does not expect the adoption of FIN 47 to have a material effect on its results of operations or financial condition.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

Market Risks

Market risks relating to our operations result primarily from changes in interest rate and changes in foreign currency exchange rates.

As of March 31, 2005, we had approximately $2.2 million in long-term debt and no short-term debt. Our long-term debt bears interest at a fixed rate. As a result, changes in the fixed rate interest market would change the estimated fair value of the fixed rate long-term debt. However, we believe that a 10% change in the long-term interest rate would not have a material effect on our business, financial condition, results of operations or cash flows.

All of our international operations are subject to inherent risks in conducting business abroad, including fluctuation in the relative value of currencies. We manage this risk and attempt to reduce such exposure through an economic hedge using short-term forward exchange contracts. At March 31, 2005, we held forward contracts to sell Japanese Yen with a total face value of $11.0 million, a total market value of $11.1 million and an unrealized loss of $100,000. The impact of movements in currency exchange rates on forward contracts is offset to the extent of receivables denominated in Japanese Yen. The effect of a 10% change in foreign exchange rates on hedged transactions involving Japanese Yen forward exchange contracts and the underlying transactions would not be material to our financial condition, results of operations or cash flows. We do not hold or issue derivative financial instruments for trading or speculative purposes.

Item 4.    Controls and Procedures

PART II — OTHER INFORMATION

Item 1.    Legal Proceedings

The Company occasionally is involved in legal proceedings that arise in the ordinary course of its business. Although there can be no assurance as to the ultimate disposition of these matters, it is the opinion of management, based upon the information available at this time, that the currently expected outcome of these matters, individually or in the aggregate, will not have a material adverse effect on its business, financial condition, results of operations or cash flows.

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

At the Company’s Annual Meeting of Shareholders held on February 16, 2005, the following proposals were adopted:

Item 6.    Exhibits

SIGNATURES

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