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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended November 29, 2003

or

For the transition period from                    to                    

Commission File Number: 0-17276

FSI INTERNATIONAL, INC.

952-448-5440

N/A

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.
          x YES   o NO

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

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

Common Stock, no par value – 29,667,000 shares outstanding as of December 30, 2003

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

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PART I.

ITEM 1. FINANCIAL INFORMATION

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
NOVEMBER 29, 2003 AND AUGUST 30, 2003
(unaudited)
(in thousands)

ASSETS

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
NOVEMBER 29, 2003 AND AUGUST 30, 2003
(continued)
(unaudited)
(in thousands)

LIABILITIES AND STOCKHOLDERS’ EQUITY

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
FOR THE QUARTERS ENDED NOVEMBER 29, 2003 AND NOVEMBER 30, 2002
(unaudited)
(in thousands, except per share amounts)

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
FOR THE QUARTERS ENDED NOVEMBER 29, 2003 AND NOVEMBER 30, 2002
(unaudited)
(in thousands)

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

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

     Description of Business

     FSI International, Inc. is a global supplier of surface conditioning equipment (process equipment used to etch and clean organic and inorganic materials from the surface of a silicon wafer), technology and support services for microelectronics manufacturing. The Company’s broad portfolio of batch and single-wafer cleaning products include process technologies for immersion (a method used to clean silicon wafers by immersing the wafer in multiple tanks filled with process chemicals), spray (sprays chemical mixtures, water and nitrogen in a variety of sequences on to the microelectronic substrate), vapor (utilizes gas phase chemistries to selectively remove sacrificial surface films) and CryoKinetic (a momentum transfer process used to remove non-chemically bonded particles from the surface of a microelectric device). The Company’s support services programs provide product and process enhancements to extend the life of installed FSI equipment, enabling worldwide customers to realize a higher return on their capital equipment.

     The Company has been winding down its Microlithography business since mid-March of fiscal 2003. The Company has transitioned the Microlithography business to a POLARIS^® Systems and Services (“PSS”) organization to focus on supporting the more than 400 installed POLARIS Systems.

     FSI International’s customers include microelectronics manufacturers located throughout North America, Europe, Japan and the Asia Pacific region.

     Consolidated Condensed Financial Statements

     The accompanying consolidated condensed financial statements have been prepared by the Company without audit and reflect all adjustments (consisting only of normal and recurring adjustments, except as disclosed in the notes) which are, in the opinion of management, necessary to present a fair statement of the results for the interim periods presented. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission but omit certain information and footnote disclosures necessary to present the statements in accordance with accounting principles generally accepted in the United States. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and footnotes to the financial statements included in the Company’s Annual 10-K Report for the fiscal year ended August 30, 2003 previously filed with the Securities and Exchange Commission.

     Revenue Recognition

     The Company recognizes revenue 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. If the Company’s equipment sales involve sales to its existing customers who have previously accepted the same type(s) of equipment with the same type(s) of specifications, the Company accounts for the product sales as a multiple element arrangement. The Company recognizes the equipment revenue upon shipment and transfer of title. The other multiple elements also include installation and training. Equipment installation revenue is valued based on estimated service person hours to complete installation and published or quoted service labor rates and is recognized when the labor has been completed. Training revenue is valued based on published training class prices and is recognized when the customers complete the training classes. The published or quoted service labor rates and training class prices are rates actually charged and billed to the Company’s customers.

     All other product sales with customer specific acceptance provisions are recognized upon customer acceptance. Future revenues may be negatively impacted if the Company is unable to meet customer-specific acceptance criteria. Revenue related to spare part sales is recognized upon shipment. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Timing and amount of revenue recognized is dependent on the mix of revenue recognized upon shipment versus acceptance and for revenue recognized upon acceptance, it is dependent upon when customer specific criteria are met.

     Other Comprehensive Income (Loss)

     Other comprehensive income (loss) pertains to revenues, expenses, gains, and losses that are not included in net loss, but rather are recorded directly in stockholders’ equity.

     Cash and Cash Equivalents

     All highly liquid investments purchased with an original effective maturity of three months or less are considered to be cash equivalents.

     Marketable Securities

     The Company classifies its marketable equity securities as available-for-sale and carries these securities at amounts that approximate fair market value.

     Trade Accounts Receivable

     Trade accounts receivable are recorded net of an allowance for doubtful accounts.

     Allowance for Doubtful Accounts

     The Company makes estimates of the uncollectibility of accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.

     Inventories

     Inventories are valued at the lower of cost, determined by the first in, first out method, or net realizable value.

     Inventory Reserves

     The Company records reserves for inventory shrinkage and for potentially excess, obsolete and slow moving inventory. The amounts of these reserves are based upon historical loss trends, inventory levels, physical inventory and cycle count adjustments, expected product lives, forecasted sales demand and recoverability.

     Property, Plant and Equipment

     Building and related costs are carried at cost and depreciated on a straight-line basis over a five to 30-year period. Leasehold improvements are carried at cost and amortized over a three- to five-year period or the term of the underlying lease, whichever is shorter. Equipment is carried at cost and depreciated on a straight-line method over its estimated economic life. Principal economic lives for equipment are one to seven years. Software developed for internal use is amortized over three to five years beginning when the system is placed in service. Maintenance and repairs are expensed as incurred; significant renewals and improvements are capitalized.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Valuation of Long-Lived and Intangible Assets

     The Company assesses the impairment of identifiable intangibles and long-lived assets at least annually, and whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

     If the Company determines that the carrying value of intangibles and long-lived assets may not be recoverable, the Company measures any impairment based on a projected discounted cash flow method using a discount rate determined by its management to be commensurate with the risk inherent in its current business model or another valuation technique. Net intangible assets and long-lived assets amounted to $46.6 million as of November 29, 2003.

     The Company amortizes intangible assets on a straight-line basis over their estimated economic lives which range from two to nine years. The estimated aggregate amortization of intangible assets for the next five years is $1,699,000 in the last nine months of fiscal 2004, $690,000 in fiscal 2005, $436,000 in fiscal 2006, $436,000 in fiscal 2007, $436,000 in fiscal 2008 and $109,000 in the first quarter of fiscal 2009.

     The Company has no intangible assets with indefinite useful lives. Intangible assets as of November 29, 2003 and August 30, 2003 consisted of the following (in thousands):

     Intangible assets were reviewed for impairment as of August 30, 2003, and were deemed not impaired. The Company will continue to review intangible assets for impairment on an annual basis or as it deems necessary.

     The Company’s investment in its affiliate, Metron Technology, was accounted for by the equity method of accounting until the beginning of the fourth quarter of fiscal 2003. While the Company determined at August 30, 2002 that its investment in Metron Technology was not other than temporarily impaired, its decision on October 8, 2002 to use Metron Technology shares with a value of $2.38 to settle the termination fee payment with Metron Technology triggered an impairment loss on that date for all of the shares it held. Accordingly, the difference between the $6.17 per share carrying value and the $2.38 per share value agreed upon for purposes of the Transition Agreement on the shares held was recorded as a non-cash impairment charge of $10.2 million in the quarter ended November 30, 2002. The $2.38 per share value reflected the average closing price of the common stock of Metron Technology for the five business days prior to the execution of the Transition Agreement.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Upon completion of the termination of the distribution agreement with Metron Technology, the Company’s ownership in Metron Technology was reduced from approximately 21% to 17%. As a result, the Company began to account for its investment in Metron Technology as a marketable equity security available-for-sale and carries the investment at fair market per the closing price of Metron Technology’s stock as reported on the Nasdaq National Market.

     During the first quarter of fiscal 2004, the company sold 627,000 shares of Metron Technology stock and its ownership in Metron Technology was approximately 12% as of November 29, 2003. The Company recorded a gain of approximately $2.0 million related to the sale of the 627,000 shares of Metron Technology stock. As of November 29, 2003, the fair market value of its investment in Metron was $6,766,000, including unrealized holding gains of $5,363,000. The fair value of Metron Technology is subject to stock market fluctuations. The stock price of Metron Technology ranged from $3.59 to $5.20 per share during the first quarter of fiscal 2004. Under the Company’s policy, the Company will continue to review its long-term investment in affiliates for other than temporary impairment as deemed necessary.

     The Company routinely considers whether indicators of impairment of its property and equipment assets are present. If such indicators are present, the Company determines whether the sum of the estimated undiscounted cash flows attributable to the asset in question is less than their carrying value. If less, an impairment loss is recognized based on the excess of the carrying amount of the asset over its fair value. Fair value is determined by discounted estimated future cash flows, appraisals or other methods deemed appropriate. If the asset determined to be impaired is to be held and used, the Company recognizes an impairment charge to the extent the present value of anticipated net cash flows attributable to the asset is less than the asset’s carrying value.

     Investment in Affiliate

     The Company’s investment in affiliated companies consists of a 49% interest in m•FSI Ltd. This investment is accounted for by the equity method utilizing a two-month lag due to the affiliate’s year end.

     The Company defers recognition of the profit on sales to affiliates which remain in the affiliates’ inventory based on the Company’s ownership percentage of the affiliate.

     The book value of the Company’s long-term investment in affiliate is reviewed for other than temporary impairment on an annual basis or as deemed necessary.

     Income Taxes

     Deferred income taxes are provided in amounts sufficient to give effect to temporary differences between financial and tax reporting. The Company accounts for tax credits as reductions of income tax expense in the year in which such credits are allowable for tax purposes.

     Product Warranty

     The Company, in general, warrants new equipment manufactured by the Company to the original purchaser to be free from defects in material and workmanship for one to two years, depending upon the product or customer agreement. Provision is made for the estimated cost of maintaining product warranties at the time the product is sold.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Warranty provisions and claims for the fiscal quarters ended November 29, 2003 and November 30, 2002 are as follows (in thousands):

     Foreign Currency Translation

     Assets and liabilities denominated in foreign currencies are translated into U.S. dollars at current exchange rates. Operating results for investees and foreign subsidiaries are translated into U.S. dollars using the average or actual rates of exchange prevailing during the period. The foreign currency translation adjustment is included in the accumulated other comprehensive loss account in stockholders’ equity.

     Net Loss Per Common Share

     Basic loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding during the period. Diluted loss per common share is computed using the treasury stock method to compute the weighted average number of common stock outstanding assuming the conversion of potential dilutive common shares. Net loss per share does not include the effect of common stock equivalents as their inclusion would be antidilutive. The number of shares excluded from the computation of net loss per share was 3,511,000 for the first quarter of fiscal 2004 and 3,344,000 for the first quarter of fiscal 2003.

     Derivative Instruments and Hedging Activities

     The Company does not use derivative financial instruments for trading or speculative purposes. The Company did not engage in any hedging activities during the first quarter of fiscal 2004 or the first quarter of fiscal 2003.

     Use of Estimates

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

     Employee Stock Plans

     In accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company elected to continue to apply the provisions of Accounting Principles Board’s Opinion No. 25 (APB No. 25), “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its employee stock option and stock purchase plans and therefore is not required to recognize compensation expense in connection with these plans as long as the quoted market price of the Company’s stock at the date of grant equals the amount the employee must pay to acquire the stock. Companies that continue to use APB No. 25 are required to present in the notes to the consolidated financial statements, on an annual basis, the pro forma effects on reported net income and earnings per share as if compensation expense had been recognized based on the fair value of options granted. With the adoption of SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” the Company began reporting this information on a quarterly basis in the third quarter of fiscal 2003.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     The Company has adopted the disclosure-only provisions of SFAS No. 123 but applies APB No. 25 and related interpretations in accounting for its plans. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock. The Company recognized no compensation expense in the first quarter of fiscal 2004 or the first quarter of fiscal 2003 under APB No. 25.

     If the Company had elected to recognize compensation cost for the stock option plan and employee stock purchase plan based on the fair value at the grant dates for awards under those plans, consistent with the method prescribed by SFAS No. 123, net loss and net loss per common share would have been changed to the pro forma amounts indicated below (in thousands, except per share amounts):

     The fair value of stock options used to compute pro forma net loss and net loss per common share disclosures is the estimated value at the grant date using the Black-Scholes option-pricing model with the following weighted average assumptions:

     There were no ESPP shares granted during the first quarter of fiscal 2004 or the first quarter of fiscal 2003. The weighted average grant date fair value, based on the Black-Scholes option pricing model, for options granted in the first quarter of fiscal 2004 was $3.31 per share and for options granted in the first quarter of fiscal 2003 was $1.77 per share.

     New Accounting Pronouncements

     In December 2002, the Emerging Issues Task Force issued EITF 00-21, “Revenue Arrangements with Multiple Deliverables.” This issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. In some arrangements, the different revenue-generating activities (deliverables) are sufficiently separable, and there exists sufficient evidence of their fair values to separately account for some or all of the deliverables (that is, there are separate units of accounting). In other arrangements, some or all of the deliverables are not independently functional, or there is not sufficient evidence of their fair values to account for them separately. This issue addresses when and, if so, how an arrangement involving multiple deliverables should be divided into separate units of accounting. This issue does not change otherwise applicable revenue recognition criteria. This issue is applicable to the Company for revenue arrangements entered into beginning in the first quarter of fiscal 2004. The adoption of EITF 00-21 did not have an effect on the Company’s consolidated financial statements.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Reclassifications

     Certain first quarter fiscal 2003 amounts have been reclassified to conform to the current year presentation.

(2)      Wind Down of Microlithography Business

     In March 2003, the Company announced that it was winding down the Microlithography business due to uncertain economic conditions and the weak semiconductor industry forecast. See Note 2 of the Notes to the Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the 2003 fiscal year for a discussion of the wind down of the Microlithography business.

     Prior to the wind down of the Microlithography business, approximately 292 of the Company’s 714 employees worked in this business. As of November 29, 2003, approximately 114 of the Company’s 476 employees worked in this business. The Company recorded $2.7 million in severance expenses in fiscal 2003. The severance expenses and payments are summarized as follows (in thousands):

     In the first quarter of fiscal 2004, the Company had sales of PSS inventory with an original cost of $1.245 million that had been written down to zero. This was primarily due to sales revenues generated from unanticipated PSS spare parts and upgrades sales.

     The PSS operations were not considered discontinued operations at November 29, 2003, as the Company is continuing to ship new systems that are currently in the backlog.

(3)      Transition Agreement with Metron Technology

     On October 9, 2002, the Company entered into a Transition Agreement with Metron Technology related to the early termination of the Company’s distribution agreements with Metron Technology for Europe and the Asia Pacific region, effective March 1, 2003. See Note 3 of the Notes to the Consolidated Financial Statement in the Company’s Annual Report on Form 10-K for the 2003 fiscal year for a discussion of the Transition Agreement with Metron Technology.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

(4)     Inventories

     Inventories are summarized as follows (in thousands):

(5)     Supplementary Cash Flow Information

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

(6)     Comprehensive Income (Loss)

     Other comprehensive income (loss) pertains to revenues, expenses, gains and losses that are not included in the net loss but rather are recorded directly in stockholders’ equity. For the quarter ended November 29, 2003, other comprehensive loss consisted of the foreign currency translation adjustment and unrealized holding gains in investments. For the quarter ended November 30, 2002, the only item of other comprehensive income was related to foreign currency translation. For the quarters ended November 29, 2003 and November 30, 2002, comprehensive income (loss) amounted to (in thousands):

(7)     Segment Information

     The Company has two segments, Surface Conditioning (“SC”) and POLARIS^® Systems and Services (“PSS”), formerly the Microlithography Division.

     The SC segment markets and supports equipment that uses wet, vapor, cryogenic and other chemistry techniques to clean, strip or etch the surfaces of silicon wafers. The PSS segment provides POLARIS^® customers with service, support, upgrade and refurbishment programs which enable customers to achieve a reasonable life for their POLARIS^® systems. General corporate expenses were allocated equally to the segments.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Segment information is as follows (in thousands):

     In the quarter ended November 30, 2002, the segment operating loss for each division included $1.4 million related to the early termination of the distribution agreements with Metron Technology.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

(8) Litigation

     In fall 1995, pursuant to the Employee Stock Purchase and Shareholder Agreement dated November 30, 1990 between Eric C. Hsu and Semiconductor Systems, Inc. (“SSI”) (the “Shareholder Agreement”) and in connection with Mr. Hsu’s termination of his employment with SSI in August 1995, the former shareholders of SSI purchased the shares of SSI common stock then held by Mr. Hsu. In April 1996, FSI acquired SSI, and SSI became a wholly owned subsidiary of FSI. In October 1996, Eric C. and Angie L. Hsu (the “plaintiffs”) filed a lawsuit in the Superior Court of California, County of Alameda, Southern Division, against SSI and the former shareholders of SSI. The plaintiffs alleged that such purchase breached the Shareholder Agreement and violated the California Corporations Code, breached the fiduciary duty owed plaintiffs by the individual defendants and constituted fraud.

     In September and October 2000, certain of Mr. Hsu’s claims were tried to a jury in Alameda County Superior Court in Oakland, California. At the conclusion of the trial, the jury found that SSI breached the Shareholder Agreement between it and Mr. Hsu and that the damages that resulted were approximately $2.4 million. In addition, each of the individual defendant shareholders was found liable for conversion and damages of $4.2 million were awarded. Certain individual defendants were also found to have intentionally interfered with Mr. Hsu’s prospective economic advantage and damages of $3.2 million were awarded. Finally, several individual defendants and SSI were found to have violated certain provisions of the California Corporation Code and damages of $2.4 million were awarded.

     In proceedings subsequent to the trial, the Court determined that plaintiffs are entitled to an award against SSI of prejudgment interest on the breach of contract damages (approximately $2.4 million) at 10 percent per annum from October 1996. In addition, the Court awarded plaintiffs approximately $127,000 in costs and approximately $1.8 million in attorneys’ fees against SSI and the individual defendants. On November 16, 2001, the court signed its final judgment reflecting the jury’s awards, interest, attorneys’ fees and costs assessed against each of the defendants.

     Following the entry of judgment, SSI and the other defendants filed post-trial motions seeking reduction in the jury’s damage awards and/or a new trial. The court denied these post-trial motions and there was no reduction in damages against SSI. Mr. Hsu was awarded an additional $431,000 for attorneys’ fees and expenses incurred since the judgment was rendered in November 2001. The total judgment against SSI together with post judgment interest and attorneys’ fees as of November 29, 2003 aggregated approximately $7.2 million.

     SSI and the individual defendants have filed an appeal on a variety of grounds, and the Company posted an appeal bond on behalf of SSI and defendants in the amount of $8.3 million. As part of the posting of the bond, the Company entered into a letter of credit in the amount of $2.5 million with a surety company. This letter of credit was collateralized with restricted cash of approximately the same amount. In November 2003, due to concerns related to the Company’s fiscal 2003 losses, the bonding company required the Company to increase the letter of credit to $5.0 million and to increase the collateral to a similar level.

     The Company, on behalf of SSI, has made a claim with respect to the lawsuit under the escrow created at the time of the Company’s acquisition of SSI. The escrow was established to secure certain indemnification obligations of the former shareholders of SSI. The escrow consists of an aggregate of 250,000 shares of FSI Common Stock paid to the former shareholders of SSI as consideration in the acquisition. The former shareholders have agreed to hold FSI and SSI harmless from any claim arising out of any securities transactions between SSI and the shareholders or former shareholders of SSI. The indemnification obligations of the individual SSI shareholders are capped at approximately $4.2 million in the aggregate. Any shares in the escrow returned to FSI to satisfy any indemnification obligations will be valued at $12.125 per share, the per-share price of FSI common stock at the time of the SSI acquisition.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Given the escrowed shares and the additional indemnification by the individual SSI shareholders, along with the Company’s litigation reserve, the Company believes it is adequately reserved for this potential liability. However, there is considerable uncertainty as to the ultimate resolution of this matter and the respective liability, if any, of SSI. The Company will continue with its appeal process and defense.

     In September 1995, CFM Technologies, Inc. and CFMT, Inc. (collectively “CFM”) filed a complaint in United States District Court for the District of Delaware against YieldUP. YieldUP was acquired by the Company in October 1999. YieldUP is now known as SCD Mountain View, Inc., a wholly owned subsidiary of the Company. The complaint alleged that the drying process incorporated in certain YieldUP products infringes a patent held by CFM. On October 14, 1997, the United States District Court held that CFM had failed to produce evidence on three separate elements of the patent claim. On June 30, 1998, the United States District Court of Delaware granted CFM’s petition for re-argument of the issue. In 2002, the case was transferred to a different judge and the prior grant of summary judgment was vacated. As a result, the litigation may proceed to trial. CFM is asking for monetary damages and an injunction against YieldUP’s use of the products at issue.

     CFM filed an additional complaint against YieldUP in United States District Court for the District of Delaware on December 30, 1998. The complaint alleged that the cleaning process incorporated in certain of YieldUP’s products infringes two patents held by CFM: U.S. Patent Nos. 4,917,123 and 4,778,532.

     On April 4, 2000, the United States District Court for the District of Delaware granted YieldUP’s motion for summary judgment that the ‘123 and ’532 patents were invalid. On July 29, 2000, the issue of whether CFM or its inventors engaged in inequitable conduct in prosecuting the ‘123 and ’532 patents was tried before the court. On June 6, 2001, the judge issued his opinion finding that the CFM inventors engaged in inequitable conduct during the prosecution of the patent application. On June 7, 2001, the judge ordered that judgment be entered in favor of YieldUP and against CFM on YieldUP’s defenses of lack of enablement and inequitable conduct. In November 2003, the United States Federal Appeals Court reversed both judgments and remanded the case to the United States District Court.

     Representatives from FSI and SCP Global Technologies, Inc., the current owner of the CFM patents allegedly being infringed by YieldUP products, are in settlement discussions. There can be no assurance that an ultimate settlement of all claims will be reached. The terms of any final settlement could have a material adverse impact on FSI, including the payment of licensing fees and other material settlement payments by FSI.

     If a settlement cannot be reached, the Company plans to vigorously defend its intellectual property rights against any and all claims. A loss, if any, resulting from an unfavorable adjudication, cannot presently be estimated. Any loss and associated costs resulting from an unfavorable adjudication could have a material adverse impact on FSI.

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

     The information in this report, except for the historical information contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and is subject to the safe harbor created by that statute. Typically, we identify forward-looking statements by use of an asterisk “*.” In some cases, you can identify forward-looking statements by terminology such as “expects,” “anticipates,” “intends,” “may,” “should,” “plans,” “believes,” “seeks,” “estimates,” “could,” “would,” or the negative of such terms or other comparable terminology. These statements are subject to various risks and uncertainties, both known and unknown. Factors that could cause actual results to differ include the increased industry demand for semiconductor equipment, expected orders, expected revenues, expected net losses and cash burn rate for the second quarter of fiscal 2004, the length and extent of the current industry recovery; order delays or cancellations; general economic conditions; changes in customer capacity requirements and demand for microelectronics; the extent of demand for our products and our ability to meet demand; global trade policies; worldwide economic and political stability; our successful execution of internal performance plans; the cyclical nature of our business; volatility of the market for certain products; performance issues with key suppliers and subcontractors; the transition to 300mm products; the level of new orders; the timing and success of current and future product and process development programs; the success of our affiliated distributor; the success of our direct distribution organization; legal proceedings; and the potential impairment of long-lived assets; as well as other factors listed from time to time in our SEC reports including, but not limited to, the Risk Factors included in this report. Readers also are cautioned not to place undue reliance on these forward-looking statements as actual results could differ materially. We undertake no duty to update any of the forward-looking statements after the date of this report.

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

Application of Critical Accounting Policies and Estimates:

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

     Our critical accounting policies and estimates are as follows:

	•		revenue recognition;
	•		valuation of long-lived and intangible assets and goodwill; and
	•		estimating valuation allowances and accrued liabilities; specifically product warranty, inventory obsolescence, allowance for doubtful accounts and assessment of the probability of the outcome of current litigation.

Revenue Recognition

     We recognize revenue 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. If our equipment sales involve sales to our existing customers who have previously accepted the same type(s) of equipment with the same type(s) of specifications, we account for the product sales as a multiple element arrangement. We recognize the equipment revenue upon shipment and transfer of title. The other multiple elements also include installation and training. Equipment installation revenue is valued based on estimated service person hours to complete installation and published or quoted service labor rates and is recognized when the labor has been completed. Training revenue is valued based on published training class prices and is recognized when the customers complete the training classes. The published or quoted service labor rates and training class prices are rates actually charged and billed to our customers.

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

     Timing and amount of revenue recognized is dependent on the mix of revenue recognized upon shipment versus acceptance and for revenue recognized upon acceptance, it is dependent upon when customer specific criteria are met.

Valuation of Long-Lived and Intangible Assets

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

     If we do determine that the carrying value of intangibles and long-lived assets may not be recoverable, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model or another valuation technique. Net intangible assets and long-lived assets amounted to $46.6 million as of November 29, 2003.

     Intangible assets were reviewed for impairment as of August 30, 2003, and were deemed not impaired. We will continue to review intangible assets for impairment on an annual basis or as we deem necessary. See Note 1 of the Notes to Consolidated Financial Statements in this quarterly report on Form 10-Q for a discussion of the impairment of our investment in our affiliate, Metron Technology.

Product Warranty Estimation

     We record a liability for warranty claims at the time of sale. The amount of the liability is based on the trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting warranty claim, anticipated releases of new products and other factors. The warranty periods range from 12 to 24 months. Although management believes the likelihood to be relatively low, claims experience could be materially different from actual results because of the introduction of new, more complex products; a change in our warranty policy in response to industry trends, competition or other external forces; manufacturing changes that could impact product quality; or as yet unrecognized defects in products sold.

Inventory Reserves Estimation

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

Allowance for Doubtful Accounts Estimation

     Management must make estimates of the uncollectibility of our accounts receivables. The most significant risk is the risk of sudden unexpected deterioration in financial condition of a significant customer which is not considered in the allowance. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Results could be materially impacted if the financial condition of a significant customer deteriorated and related receivables are deemed uncollectible.

Litigation Liability Estimation

     Management’s current estimated range of liability related to some of the pending litigation is based on claims for which our management can estimate the amount and range of loss. We have recorded the minimum estimated liability related to those claims, where there is a range of loss. Because of the uncertainties related to both the amount

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and range of loss on the pending litigation, management is not always able to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability related to our pending litigation and revise our estimates. Such revisions in our estimates of the potential liability could materially impact our results of operation and financial position.

FIRST QUARTER OF FISCAL 2004 COMPARED WITH FIRST QUARTER OF 2003

Industry:

     Industry conditions continue to improve in parallel with strengthening global economic conditions. In the fourth quarter of calendar 2003, worldwide unit demand for semiconductor devices exceeded the 2000 peak level. As a result, factory utilization rates for semiconductor manufacturers are now well above 90%.

     In calendar 2000, worldwide demand for semiconductor equipment was nearly $60 billion. By 2002, demand had decreased 51% to $30 billion. It is anticipated that when calendar 2003 statistics are reported later this quarter, the report will show that 2003 equipment demand has increased slightly to $31 billion.* Given the suppressed spending by customers of semiconductor equipment on new capacity the past few years, it is anticipated by industry analysts that demand for semiconductor equipment could increase by more than 30% in calendar 2004, as compared to calendar 2003.*

     As a result of the improving industry conditions, over the past several months we have experienced a significant increase in total order opportunities. Our order pipeline currently is well above the levels achieved since the industry downturn in 2001. Orders for our Surface Conditioning products increased over 80% to $16.2 million in the first quarter of fiscal 2004 as compared to $9.0 million in the fourth quarter of fiscal 2003. We expect total second quarter orders, primarily for our Surface Conditioning products, to be between $26 and $28 million, representing a 38% to 49% sequential increase.* This guidance includes $3.0 million of orders that were delayed from the first to the second quarter of fiscal 2004. This gives us confidence that the expected increase in Surface Conditioning revenues, starting in the third quarter of fiscal 2004, should more than offset the anticipated decline in POLARIS^® Systems and Services revenue as we continue to wind down the business and move toward a service, upgrade and refurbishment and spare part supply model. We expect to ship the final POLARIS^® System in the second fiscal quarter of 2004.*

The Company:

     The following table sets forth for the fiscal quarter indicated, certain income and expense items as a percent of our total sales.

Sales Revenues and Shipments:

     Sales revenues decreased 13 percent to $22.5 million for the first quarter of fiscal 2004, as compared to $25.9 million for the first quarter of fiscal 2003. Sales revenues for Surface Conditioning increased from $10.9 million in the first quarter of fiscal 2003 to $12.6 million in the first quarter of fiscal 2004. The increase in Surface Conditioning revenues was primarily due to a higher percentage of shipments of equipment to our existing customers

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who had previously accepted the same type(s) of equipment with the same type(s) of specifications in the first quarter of fiscal 2004 as compared to the first quarter of fiscal 2003. Sales revenues for POLARIS Systems and Services decreased from $15.0 million in the first quarter of fiscal 2003 to $9.9 million in the first quarter of fiscal 2004. The decrease in the PSS revenue was primarily due to our exit, beginning in March 2003, from the resist processing market.

     Shipments in the first quarter of fiscal 2004 decreased to $21 million from $27 million in the first quarter of fiscal 2003. Surface Conditioning shipments were approximately $13 million in both the first quarters of fiscal 2004 and 2003. PSS shipments decreased to $8 million in the first quarter of fiscal 2004 from $14 million in the first quarter of fiscal 2003. The decrease in PSS shipments was primarily due to our exit from the resist processing market.

     International sales were $8.1 million, representing 36% of total sales during the first quarter of fiscal 2004, and $5.8 million, representing 22% of total sales, during the first quarter of fiscal 2003. The increase in international sales occurred primarily in Europe. Because of its broader customer base, Surface Conditioning has higher amounts of international sales than PSS.

     Deferred revenue was approximately $8.7 million as of November 29, 2003. Deferred profit of $4.0 million as of November 29, 2003, as reported on the consolidated balance sheet, reflected deferred revenue less deferred cost of goods sold.

     Based upon our current backlog, deferred revenue, and initial second quarter orders, we have relatively good visibility with respect to the second quarter revenues. We expect second quarter revenues to be flat as compared to the first quarter level, or between $20 and $23 million.* Based upon current PSS backlog and deferred revenue, we expect that approximately 50% of our second quarter revenues will be for our PSS business systems and services.*

Gross Profit:

     Our gross profit margin fluctuates due to a number of factors, including the mix of products sold, as Surface Conditioning products generally have higher margins than the PSS products; the proportion of international sales, as international sales generally have lower margins due to pricing pressures and the level of manufacturing capacity.

     Gross profit as a percentage of sales was 46.7% for the first quarter of fiscal 2004 and was 26.3% for the first quarter of fiscal 2003. The increase in margins was primarily related to the product mix within PSS products as spares, service contracts and upgrades generally have higher margins than equipment.

     During the first quarter of fiscal 2004, we had sales of PSS inventory with an original cost of $1.245 million that had been written down to zero. This was primarily due to sales revenues generated from unanticipated PSS spare parts and upgrades sales. Our gross margin as a percentage of sales in the first quarter of fiscal 2004 would have been 41.1%if we include the original cost of the PSS inventory that had been written down to zero. Gross margin including the original cost of the PSS inventory that had been written down to zero is not calculated in accordance with generally accepted accounting principals (“GAAP”). Our management believes that the presentation of gross margin including the original cost of the PSS inventory that had been written down to zero provides a useful analysis of our ongoing operating trends and helps investors compare our operating performance period over period.

     The following is a reconciliation of our first quarter fiscal 2004 gross margin calculated in accordance with GAAP to our first quarter fiscal 2004 gross margin before the impact of the sales of PSS inventory that had previously been written down to zero (in thousands):

⁽¹⁾ Original cost of PSS inventory sold that had been written down to zero.

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

     Gross profit margins are expected to decrease to 39% to 42% of revenues for the second quarter of fiscal 2004, due to the mix of lower margin PSS business, the placement of initial products at new accounts and continued underutilization of our manufacturing capacities, partially offset by anticipated use of PSS inventory that was previously written down to zero.

Selling, General and Administrative Expenses:

     Selling, general and administrative expenses decreased 5% to $8.3 million in the first quarter of fiscal 2004, as compared to $8.8 million in the first quarter of fiscal 2003. The decrease was related to our cost reduction efforts related primarily to the corporate reorganization in the third quarter of fiscal 2003 and the wind down of the Microlithography business.

     Based upon our current operations, we expect the dollar amount of selling, general and administrative expenses in the second quarter of fiscal 2004 to be in the range of $8.3 to $8.6 million.*

Transition Agreement Termination Fee:

     In the first quarter of fiscal 2003, we recorded a non-cash charge of approximately $2.8 million associated with the early termination of the distribution agreements with Metron Technology. See Note 3 of the Notes to the Consolidated Financial Statement in the Company’s Annual Report on Form 10-K for the 2003 fiscal year for a discussion of the termination of our distribution agreements with Metron Technology.

Research and Development Expenses:

     Research and development expenses were $5.5 million for the first quarter of fiscal 2004 and $8.3 million for the first quarter of fiscal 2003. The decrease was primarily due to the reduction of engineering resources as a result of our decision to exit the resist processing market in March 2003. The majority of our research and development investment is focused on expanding the applications capabilities of our products and our product portfolio.

     Based upon current operations, research and development expenses for the second quarter of fiscal 2004 are expected to be in the range of $5.3 to $5.5 million.*

Other Income (Expense), Net:

     Other income (expense), net was approximately $2.1 million of income for the first quarter of fiscal 2004, as compared to $10.0 million of expense for the first quarter of fiscal 2003. In the first quarter of fiscal 2003, we recorded a $10.2 million impairment charge related to our investment in Metron Technology. In the first quarter of fiscal 2004, we recorded a $2.0 million gain on the sale of approximately 627,000 shares of Metron Technology common stock. As of January 13, 2004, we owned about 1.5 million shares of Metron Technology stock.

     Interest income for the second quarter of fiscal 2004 is expected to be between $75,000 to $100,000, given our current cash position and the anticipated interest rates.* This assumes no additional sales of Metron Technology stock.

Income Tax (Benefit) Expense:

     Our deferred tax assets on the balance sheet as of November 29, 2003 have been fully reserved for with a valuation allowance. We do not expect to significantly reduce our valuation allowance until we are consistently profitable on a quarterly basis.

     Overall, we have net operating loss carryforwards for federal purposes of approximately $125.7 million, which will begin to expire in fiscal 2011 through fiscal 2023 if not utilized. Of this amount, approximately $15.0 million is

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subject to Internal Revenue Code Section 382 limitations on utilization. This limitation is approximately $1.4 million per year.

Equity in Earnings (Losses) of Affiliates:

     The equity in earnings (losses) of affiliates was approximately $284,000 of income for the first quarter of fiscal 2004, compared to approximately $603,000 of losses for the first quarter of fiscal 2003. The first quarter fiscal 2003 loss was primarily related to losses from Metron Technology. The first quarter fiscal 2004 income was primarily due to profitable operations at m•FSI, our Japanese-based 49 percent owned affiliate.

     We expect to report equity in losses of affiliates between $50,000 to $100,000 in the second quarter of fiscal 2004 from m•FSI.*

Net Loss:

     Assuming that we can achieve the expected revenues, gross margin, operating expenses and affiliate loss levels, we expect to report a net loss of approximately $4.5 to $5.5 million in the second quarter of fiscal 2004.*

Liquidity and Capital Resources:

     Our cash, restricted cash and cash equivalents were approximately $36.9 million as of November 29, 2003, an increase of $1.3 million from the end of fiscal 2003. The net increase in cash, restricted cash, and cash equivalents was due primarily to proceeds from the sale of marketable securities of $2.6 million, net of $1.3 million of funds used for operations and $0.4 million of property, plant and equipment acquisitions.

     Marketable securities were approximately $6.8 million as of November 29, 2003, a decrease of $1.4 million from the end of fiscal 2003. The net decrease was due to the sale of $2.4 million of marketable securities net of a market increase of $1.0 million.

     Accounts receivable increased $0.2 million from the end of fiscal 2003. Trade accounts receivable from non-affiliates decreased $0.9 million from the end of fiscal 2003. Trade accounts receivable from affiliates increased $1.1 million from the end of fiscal 2003. The decrease in trade accounts receivable from non-affiliates related primarily to the timing of shipments to non-affiliates during the first quarter of fiscal 2004 as compared to during the fourth quarter of fiscal 2003. The increase in trade accounts receivable from affiliates related primarily to shipments to affiliates of $2.1 million in the first quarter of fiscal 2004 as compared to $1.8 million in the fourth quarter of fiscal 2003.

     Inventory decreased approximately $0.8 million to $18.7 million at November 29, 2003, as compared to $19.5 million at the end of fiscal 2003. The decrease in inventory was primarily in finished goods inventory related to the timing of tool shipments. Inventory reserves were $22.7 million at November 29, 2003, of which 17% of the reserves related to Surface Conditioning and 83% related to PSS. This compares to reserves of $24.7 million at the end of fiscal 2003, of which 15% related to Surface Conditioning and 85% related to PSS.

     As of November 29, 2003, our current ratio was 3.5 to 1.0, and working capital was $61.3 million.

     Our contractual cash obligations related to operating leases at November 29, 2003 are summarized as follows (in thousands):