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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 000-26911

(510) 668-2200

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

     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 þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K, or any amendment to this Form 10-K.     o

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).     Yes þ          No o

      The aggregate market value of the common equity held by non-affiliates of the registrant, based upon the closing price as of the last business day of the registrant’s most recently completed second fiscal quarter (September 28, 2003) as reported by the Nasdaq National Market, was approximately $122 million.

      As of June 1, 2004, the registrant had 35,652,190 shares of common stock outstanding.

      Portions of the Proxy Statement for the 2004 annual stockholders meeting are incorporated by reference into Part III.

THERMA-WAVE, INC.

Form 10-K

TABLE OF CONTENTS

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PART I

      This annual report on Form 10-K contains forward-looking statements, including, without limitation, statements concerning the conditions in the semiconductor and semiconductor capital equipment industries, our operations, economic performance and financial condition, including in particular statements relating to our business and growth strategy and product development efforts. The words “believe,” “expect,” “anticipate,” “intend” and other similar expressions generally identify forward-looking statements. Potential investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. These forward-looking statements are based largely on our current expectations and are subject to a number of risks and uncertainties, including, without limitation, those identified under Exhibit 99.1, “Risk Factors,” and elsewhere in this annual report and other risks and uncertainties indicated from time to time in our filings with the SEC. Actual results could differ materially from these forward-looking statements. In addition, important factors to consider in evaluating such forward-looking statements include changes in external market factors, changes in our business or growth strategy, an inability to raise additional funds if necessary, an inability to execute our strategy due to changes in our industry or the economy generally, the emergence of new or growing competitors, an inability to develop or introduce new products as planned, or the acceptance of those products by our customers and various other competitive factors. In light of these risks and uncertainties, there can be no assurance that the matters referred to in the forward-looking statements contained in this annual report will in fact occur.

Overview

      Therma-Wave develops, manufactures, markets and services process control metrology systems used in the manufacture of semiconductors and controls significant market share in the metrology industry. Process control metrology is used to monitor process parameters in order to enable semiconductor manufacturers to maintain high overall manufacturing yield, reduce the size of the circuit features imprinted on the semiconductor to improve the performance of the semiconductor device and increase their equipment productivity. Our current product families, Therma-Probe^®, Opti-Probe^®, Opti-Probe CD™ and RT/CD^®, Integra^® integrated metrology products, use proprietary and patented technology to provide precise, non-contact, non-destructive measurements for the basic building blocks, or process modules, in the manufacture of integrated circuits, or ICs:

	•	Ion Implantation — implanting ions, usually boron, phosphorus or arsenic, into selected areas of the silicon wafer to alter its electrical properties. Ion implantation may be performed typically ten to 24 times in the manufacture of ICs. For example, ion implantation creates the positively- and negatively-doped regions used to create each of the millions of transistors on each integrated circuit. It also is used to adjust the voltage (threshold voltage) at which the transistors will “turn on”. Our Therma-Probe product is used as a standard metrology tool for these ion implantation processes.
	•	Dielectric Film Deposition and Etching — depositing and selectively removing layers of dielectric films on the silicon wafer in order to provide electrical insulation for each layer of the semiconductor IC. Film deposition is typically done by Chemical Vapor Deposition, or CVD, and film removal is typically done by plasma etching. Our Opti-Probe is used as a standard, in-line metrology tool for film thickness in these processes. Our Opti-Probe CD and RT/CD, or Real-Time Critical Dimensions, and Integra integrated metrology products, are newly introduced products which provide rapid, non-destructive wafer-state information for control of the critical dimensions, or CDs, of the etch processes.
	•	Conductor Film Deposition and Etching — depositing and selectively removing layers of metal, polysilicon, and metal barrier films used to interconnect the transistors within a semiconductor device. Film deposition is typically done by Ppysical vapor deposition, or PVD, electrochemical deposition, or ECD, or by CVD. Film removal is typically done by plasma etching or chemical mechanical planarization. Our Opti-Probe is used as a standard metrology tool for the non-opaque conductor films.

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		Our Opti-Probe CD and RT/CD, and Integra integrated metrology products provide rapid, non-destructive wafer-state information for control of the CDs of the etch processes.
	•	Chemical Mechanical Planarization, or CMP — “leveling” the top surface of the wafer after each layer of device features is added. The leveling is done by mechanical polishing in a chemical solution, and is required to maintain flatness of the wafer throughout the sequence of hundreds of process steps. Our Opti-Probe is used as a standard, in-line metrology tool for film thickness in these processes.
	•	Wafer Patterning — using photolithographic techniques to create the fine (sub-micron) structures that define the integrated circuit. The wafer patterning is typically done by “stepper” exposure systems and the photoresist developing and removal is done by coater/developer “track” systems and “asher/strip” systems. Our Opti-Probe is used as a standard, in-line metrology tool for film thickness and reflectivity in these processes. Our Opti-Probe CD and RT/ CD, and Integra integrated metrology products provide rapid, non-destructive wafer-state information for control of the CDs of the wafer patterning process.

      Industry Background

      The demand for semiconductors has increased as the use of semiconductors has expanded beyond personal computers and computer systems to a wide array of additional applications, including telecommunication and data communication systems, automotive systems, consumer electronics, medical products and household appliances. Additionally, the Internet has stimulated the need for more high performance semiconductor devices. As a result, semiconductors have become more complex, requiring:

	•	successive decreases in feature line width, for example, from 150 nanometers, or nm to 130 nm, from 130 nm to 110 nm, and from 110 nm to 90 nm;
	•	as many as 500 process steps; and
	•	an increase in the number of metal or “interconnect” layers.

      Additionally, the life cycle for these semiconductor device processes has been compressed from four years in the early 1990s to approximately two years today. The increase in device complexity and reduction in product life cycles have led to a more costly and complex manufacturing process. At the same time, semiconductor manufacturers have continued to face significant price pressure due to competition in the industry. These factors have led semiconductor manufacturers to intensify efforts to improve fab productivity, including the increased use of process control metrology.

      Process control metrology is used to monitor process parameters in order to enable semiconductor manufacturers to reduce costs and improve device performance. Historically, semiconductor manufacturers have achieved annual reductions in cost per chip function through productivity improvements including reduced feature size, increased wafer size and increased equipment productivity. Although increasing wafer size and yield (percentage of “good” ICs per wafer) will continue to be sources of productivity gains by semiconductor manufacturers, increasingly, we believe, gains will come from reduced feature size and non-yield-derived manufacturing productivity enhancements. This important last category includes increased equipment uptime, reduced manufacturing space requirements, reduced use of wafers for testing purposes and lower tool maintenance costs.

Therma-Wave Metrology Solutions

      Our family of metrology products currently consists of the following product lines:

      The Therma-Probe product family was introduced in 1985 as our initial product line, and the Opti-Probe product family was introduced in 1992. Both product families feature proprietary and patented measurement technologies and offer robotic wafer handling, advanced vision processing, sophisticated but user-friendly

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      Opti-Probe CD and RT/ CD (Real-Time Critical Dimension): The Opti-Probe CD is a spectroscopic ellipsometer-based system that provides nondestructive Critical Dimension metrology for the smallest features of the next generations of ICs. This product employs our new RT/CD analysis software that provides real-time CD and profile results, and solutions based on a previously generated and stored library. During this fiscal year, we continued our expansion from being a hardware system supplier to a more complete CD system supplier (Opti-Probe CD plus RT/CD analysis software).

      Integra integrated metrology products: Integrated Metrology, or IM, is based on compact metrology “modules” which are installed and function inside an IC process system such as an etcher or coater/developer track system to provide metrology on each wafer before it exits the process tool. Originating as a means to further boost IC fab productivity, we believe IM is a growing trend in the semiconductor industry and that our Integra IM product offering is one of the most diverse in the semiconductor metrology industry.

      These products represent a substantial expansion of our fab productivity enhancement offerings to the semiconductor industry, and represent a growth in our addressed market by over 100%.

      For the years ended March 31, 2004, 2003 and 2002, revenues from the Opti-Probe product family accounted for approximately 44%, 41% and 62%, respectively, of our total net revenues. Revenues from the Therma-Probe product family accounted for approximately 8%, 11% and 13%, respectively, of our total net revenues in fiscal 2004, 2003 and 2002.

Therma-Probe Ion Implant Monitoring Products

      A key process step in the fabrication of semiconductor devices is the implantation of ions of boron, phosphorous, arsenic, antimony, and indium into selective areas of the silicon wafer to alter its electrical properties. Control of the accuracy and uniformity of the ion implant dose is critical to device performance and yield. Ion implantation is generally performed several (typically ten to 24) times during the early phases of the fabrication cycle. As a result, there is typically a time lag of several weeks between these implant steps and the first electrical measurements that indicate whether the ion implantation process was properly executed. Failure to identify improper ion implantation can be extremely costly to a semiconductor manufacturer if the wafer production is permitted to continue in error. To test on a more timely basis whether the ion implantation was properly executed, semiconductor manufacturers historically used a four-point probe, which required physical contact between the probe and the silicon wafer surface. Because the physical contact with the wafer surface produces silicon particles (defects), which can kill IC yield, the four-point probe method can only be used on monitor wafers (non-production blank wafers that have no IC devices on them). In contrast to that method, Therma-Probe’s ability to measure nondestructively on actual production IC wafers decreases manufacturing costs by reducing the need for test wafers. In addition, Therma-Probe systems detect implant processing problems that only affect the product wafers and which are not revealed by utilizing test wafer monitoring alone.

      As semiconductor devices decrease in size, demands for the formation of Ultra-Shallow-Junctions, or USJs, for source/drain formation are increasing. One of the main challenges in the scaling of complementary metal oxide semiconductor, or CMOS, devices is the formation, control and monitoring of these USJs. The Therma-Probe system performs nondestructive evaluation of USJs for junction depth and junction abruptness simultaneously. These measurements are enabled by our proprietary USJ software. This Therma-Probe capability allows engineers to monitor and contol the formation of USJs in CMOS device fabrication.

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      The Therma-Probe systems employ proprietary thermal wave technology that uses highly focused but low power laser beams to generate and detect thermal and plasma wave signals in the silicon wafer. Proprietary software correlates the signals to the ion implant dose. Unlike previous ion implant metrology systems, the Therma-Probe systems utilize a non-contact, non-damaging technology and thus can be used to monitor product wafers immediately after the ion implantation process. These features have been integrated into an easy-to-use and reliable package with automated wafer handling and statistical data processing.

      In 2003, we introduced the Therma-Probe XP Series for 200 and 300 mm ion implantation metrology applications. With the introduction of the XP-Series, the dose detectability and long term stability of the original Therma-Probe products have been further improved to provide more robust and repeatable measurement capability for the 90-nm technology node and beyond.

      We believe that our Therma-Probe systems offer the following technological advantages and benefits:

	•	Proprietary Technology. To provide non-contact, non-contaminating ion implant measurements on product wafers, Therma-Probe systems employ proprietary thermal wave technology, which uses highly focused but low power laser beams to generate and detect thermal wave signals in the silicon wafer that can be correlated to the ion implant dose. The thermal wave technology used to measure these signals is an extensively patented technology owned by our company.
	•	Ease of Use and Reliability. The Therma-Probe systems are configured specifically for use by semiconductor device manufacturers and feature automated wafer handling, automated data collection, statistical data processing and data management for 200 and 300 mm wafer applications.
	•	Continuous Improvement. We continue to develop, manufacture and market new and improved Therma-Probe systems to enhance system capability and to lower the cost of ownership to the customer. For example, the most recent generation TP-630XP Series possesses state-of-the-art ion implant measurement technology with enhanced dose detectability, long-term stability, and USJ capabilities for wafer sizes up to 300 millimeters.

      The following table summarizes the Therma-Probe product history:

Opti-Probe Thin-Film Metrology Systems

      The majority of the 200 to 500 process steps required to fabricate semiconductors on a silicon wafer involve the deposition and selective removal of a variety of insulating and conducting thin films. Thin-film metrology systems measure the thickness and material properties of these thin films and, because they are

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      Increasingly, traditional, single-technology film metrology systems have been unable to meet the process control metrology demands of the semiconductor industry. The continual demand for improved precision and repeatability requires the ability to measure thicknesses that range from extremely thin films, which generally measure below 20 angstroms, to films that are hundreds of thousands times thicker. Reflection spectrometers are most suitable for measuring thicker films, whereas ellipsometers are most suitable for measuring very thin films. Furthermore, the industry is now using film stacks composed of several layers of different films and the optical properties of many films are functions of the actual deposition conditions. Generally spectrometers or ellipsometers alone generate insufficient data to simultaneously determine the thicknesses and properties of these film stacks and new films with the precision and accuracy that semiconductor manufacturers require. Reflection spectrometer and most ellipsometer have limited capabilities for such simultaneous measurements of both thickness and optical parameters when used as independent standalone measurement technologies.

      Opti-Probe systems improve upon existing thin-film metrology systems with the integration of up to five distinct film measurement technologies, three of which are patented by our company. By combining the measured data from these multiple technologies, Opti-Probe systems provide increased measurement capability leading to higher yields, less misprocessing, less rework, faster production ramp-up and increased productivity on both test and product wafers.

      Several technological advantages and benefits of Opti-Probe systems including the following:

	•	Proprietary Measurement Technology. Opti-Probe systems combine up to five complementary measurement technologies: Beam Profile Reflectometry, or BPR®, Beam Profile Ellipsometry, or BPE®, Deep Ultra Violet Reflectometery, or DUV, Absolute Ellipsometery, or AE® and Rotating Compensator Spectroscopic Ellipsometery, or RCSE. Each technology addresses specific film measurement applications. The integration of these multiple technologies on a single tool allows for a wide range of capabilities on a single tool. Additionally, due to the amount of data that can be obtained by combining these optical technologies, it is possible to determine the thickness and optical parameters of multiple films simultaneously. We hold patents on the use of many of the combinations of these thin-film measurement technologies.
	•	Proprietary Software. The use of proprietary software algorithms in conjunction with the spectral information collected by the Opti-Probe measurement hardware enables the calculation of the film thickness and optical properties.
	•	Ease of Use and Reliability. Opti-Probe systems are configured specifically for semiconductor device manufacturers and feature automated wafer handling, advanced image processing, automated data collection, statistical data processing and data management.
	•	Continuous Improvement. We continue to develop, manufacture and market new and improved systems. We strive to provide the semiconductor industry with thin-film metrology systems that meet the precision, repeatability and matching requirements for each new technology node.

      In 1992, we introduced the first Opti-Probe system based on our patented BPR measurement technology to meet the film measurement needs for the 250-nm technology node. Over the years the Opti-Probe products

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      The following table summarizes the Opti-Probe product history:

Opti-Probe CD and RT/ CD Products

      In January 2002, we introduced Opti-Probe CD with Real Time CD processing, or RT/ CD, a product designed to measure the lateral Critical Dimensions and cross-sectional shape, or profile, of fine IC features. As semiconductor device manufacturers continue to shrink feature sizes to the 90 nm technology node and smaller, traditional CD metrology techniques such as critical dimension scanning electron microscopy, or CD-SEM, lack the resolution and stability required to provide accurate data about feature critical dimensions and profiles. A significant limitation is that these methods provide only a top-down view of features and provide little or no data about characteristics of the sides or bottom of a structure.

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      Semiconductor manufacturers are often confronted with problems involving variations in profile and sidewall angle. Detailed knowledge of profile shape is of high importance. In shallow trench isolation, or STI, or damascene integration schemes, etched trenches to be filled by downstream process steps may have problematic re-entrant angles, notching, t-topping or other artifacts. These feature artifacts can lead to yield-killing conditions such as voiding and cracking of deposited films in later deposition fill process steps.

      For the critical gate patterning process, tight control of the gate CD correlates to improved device performance and better bin sort yields (and revenues/chip). Furthermore, shape anomalies such as undercut, microtrenching or notching, can have a detrimental effect on device speed and reliability. In these and other applications, precise shape profiling is crucial.

      Our Opti-Probe RT/ CD is the first optical CD scatterometry system that combines high-information content SE, optical measurement with ultra-fast calculation (“real-time regression”) to analyze and display results without the use of off-line modeling and solution libraries. Complex CD profiles can be calculated in seconds with precision and repeatability with structural information not available with standard CD-SEM technologies.

      The Opti-Probe CD system leverages our established Opti-Probe thin-film metrology platform for optical data acquisition. The Opti-Probe’s patented RCSE provides rich spectral data, ensuring detail and accuracy in the results. This non-destructive CD measurement technology is beneficial for the current prevalent microelectronics technology node (130 nm), and is extendable to the 65 nm technology node and beyond for a wide range of process applications.

Integrated Metrology Products

      In 2000, we committed to a program of developing a broad family of IM, modules under the product family name Integra. We have at this time both spectrometer and spectroscopic ellipsometer based IM units available in the marketplace. These are compact metrology units that contain a single measurement technology matched to the specific metrology need of a particular semiconductor process tool (etch, coater/developer, CVD, CMP, stepper, etc.) Each IM unit is installed directly into a semiconductor process tool, and can measure each wafer immediately after processing. In this manner, processing variations can be detected at the earliest possible moment, as opposed to the conventional procedure in which a 25-wafer lot is typically completed before metrology is first done, thereby leaving the entire lot at risk of becoming scrap. With 300 mm wafers, this economic loss becomes increasingly large due to the additional product value of each processed wafer.

      IM is becoming increasingly accepted as a means to reach greater productivity. Advanced semiconductor manufacturing today is under great pressure to deliver greater levels of process performance, production availability and process repeatability in order to minimize risk of product loss, improve manufacturing efficiencies and improve device yields. The transition towards 300 mm wafers, continuing device shrinks and the mixed foundry manufacturing models are key contributors to these trends. To successfully meet these challenges, device manufacturers and process tool equipment manufacturers are actively engaged in developing technologies for advanced process control, or APC. We believe that APC implementation requires the integration of metrology capabilities directly onboard the process tool.

      Device manufacturers can derive a wide range of benefits by implementing integrated metrology and APC strategies in their fabs. By integrating the measurement directly onto the process tool, they can greatly increase the rate of sampling and decrease the delay between the process step and measurement. Increasing the measurement frequency to every single wafer allows for rapid fault detection and correction. This reduces

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      To strengthen our position as a leader in integrated metrology, we acquired Sensys Instruments Corporation in January 2002 and Sensys became a wholly owned subsidiary of our company focusing on integrated metrology applications and developing business with process tool equipment suppliers. Subsequent to the acquisition, all of the integrated metrology development and business operations have been consolidated into a single integrated metrology business focus team concentrating on providing optical CD, thin-film, and overlay integrated metrology solutions to semiconductor process equipment makers.

      All of our integrated metrology products, including the products originally developed by Sensys, are grouped into a family of products with the INTEGRA name. These include:

	•	INTEGRA CCD-i — a second-generation reflectometer unit for high throughput thin-film, CMP and OCD applications based on the CD-i product, and
	•	INTEGRA iX-SE — a spectroscopic ellipsometer unit for high performance thin-film and OCD applications.

      During fiscal 2004, multiple CCD-i units were installed at key development and pilot production fabs in Europe, North America, Taiwan and Japan by a major coater/developer equipment supplier to the semiconductor industry. Additional end-user installations for advanced technology development and production lines are planned during fiscal 2005.

      During fiscal 2004, iX-SE units were installed at key development and pilot production fabs in North America and Taiwan by a major etcher equipment supplier to the semiconductor industry. These units and technology are currently under development and evaluation as metrology systems to enable future Advanced Process Control (APC) in etch module applications.

      As of March 31, 2004, we employed 349 people, including 89 in engineering, research and development, 55 in manufacturing, 131 in customer support, 44 in sales and marketing and 30 in executive and administrative functions. Many of our employees are highly trained and hold advanced post-graduate degrees in science and engineering. None of our employees are represented by a labor union or covered by a collective bargaining agreement. We consider our employee relations to be good. We believe we have been able to attract and retain a highly talented group of managers, designers and engineers that enables us to continually improve our products and customer support. Due to reduction in force programs, we have terminated the employment of approximately 61 persons since March 31, 2003.

      We maintain sales offices and regional sales representatives throughout the world. In the United States, we maintain sales offices in California. We also utilize manufacturers’ sales representatives to cover those regions of the United States with too few customers to support a direct sales effort. In Asia, we maintain sales offices in Japan, China, Korea, Singapore and Taiwan. The Japan and Singapore offices work with manufacturers’ sales representatives to sell our products to customers in Japan, Singapore and Malaysia, while the China, Taiwan and Korea offices sell to customers directly. We also have sales representatives in the United Kingdom working with manufacturers’ sales representatives throughout the rest of Europe.

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      Sales to Taiwan Semiconductor Manufacturing Corporation, Intel Corporation, Tokyo Electon Limited, and Seki Technotron Corp. each accounted for more than 10% of net revenues in fiscal 2004. The following chart indicates the percentage of net revenues from each of these customers for fiscal years 2004, 2003 and 2002, respectively.

      International revenues in fiscal 2004, 2003 and 2002 accounted for approximately 72%, 72% and 62% of net revenues in each of these periods, respectively. We anticipate that international sales will continue to account for a significant portion of our net revenues in the foreseeable future. The following chart indicates the percentage of net revenues that we derived from our sales to Taiwan and Japan, our two largest overseas markets:

      In addition, we provide direct customer support in most parts of the world. In some locations, field service is still provided by the same manufacturers’ sales representative that handles the sales function, but applications support is provided by our employees in that territory. In the United States, we have field service and applications engineers located in Arizona, California, Florida, Idaho, Massachusetts, New Mexico, Oregon, Tennessee, Texas and Washington. Customers contract for dedicated site-specific field service and applications engineers. In Asia, we provide direct customer support in Japan, China, Taiwan, Korea and Singapore. In Europe and the Middle East, our service and applications personnel, located in France, the United Kingdom, Italy, Ireland and Israel provide direct customer support to customers in Europe and the Middle East and to our European manufacturers’ sales representatives. We provide our customers with comprehensive support before, during and after delivery of our products. Prior to shipment, our support personnel typically assist the customer in site preparation and inspection, and provide customers with training at our facilities and at the customer’s location. Our customer training programs include instructions in the maintenance of our systems and in system hardware and software tools for optimizing the performance of our systems. Our field support personnel work with the customers’ employees to install the equipment and demonstrate equipment readiness. In addition, we maintain a group of highly skilled applications scientists to respond to customers’ process needs worldwide when a higher level of technical expertise is required.

      We generally warrant our products for a period of up to 12 months from system acceptance, although this can, at times, be extended according to the terms of a particular contract. Installation and initial training are customarily included in the price of the system. After the expiration of the warranty period, customers may enter into support agreements covering both field service and field applications support. Our field service engineers may also provide customers with repair and maintenance services on a fee basis. Our applications engineers and scientists are also available to work with the customers on recipe development. Additionally, for a fee, we train customers to perform routine maintenance on their purchased tools. We also provide a 24-hour telephone help-line.

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      Our backlog consists of orders not yet shipped, deferred revenues for products that have been shipped and invoiced but have not yet been recognized as revenue in accordance with SAB 104, recurring fees payable under support contracts with our customers and orders for spare parts and billable services, such as non-recurring engineering services. Orders that are scheduled for shipment beyond the twelve-month window are not included in backlog until they fall within the twelve-month window. Orders are subject to rescheduling or cancellation by the customer, usually without penalty. Because of possible changes in product delivery schedules and cancellation of product orders and because our sales will sometimes reflect orders shipped in the same quarter that they are received, our backlog at any particular date is not necessarily indicative of actual sales for any succeeding period. At March 31, 2004, our backlog was $27.5 million, compared to $19.0 million at March 31, 2003.

      The process control metrology market is characterized by continuous technological development and product innovations. We believe that continued and timely development of new products and enhancements to existing products is necessary to maintain our competitive position. Accordingly, we devote a significant portion of our personnel and financial resources to engineering and research and development programs. As of March 31, 2004, our research, development and engineering staff comprised 89 people. We seek to maintain our close relationships with customers to make improvements in our products that respond to customers’ needs. For example, several of the improvements relating to the Opti-Probe and RT/ CD product families were developed in cooperation with some of our major customers to address their needs for more capable thin-film measurement systems.

      Software development accounts for a significant portion of our research and development efforts. We are currently transitioning all of our software applications from DOS to the Microsoft NT operating system in order to better serve our customers. NT is now the standard operating system used by our Opti-Probe customers for 300 millimeter wafer production.

      Our ongoing engineering and research and development efforts can be classified into three categories: new products; feature enhancements, such as features to improve precision, speed and automation; and customer-driven product enhancements, such as new measurement recipes or algorithms. We have research and development and engineering staffs working both on developing new products and features and on responding to the particular needs of customers. As a result of these efforts, we introduced a new Opti-Probe thin-film measurement family and a new Critical Dimension measurement product in fiscal year 2003.

      Engineering and research and development expenses were $18.7 million, $29.2 million and $29.1 million, in fiscal 2004, 2003 and 2002, respectively, or 29%, 59% and 36% of net revenues for those periods, respectively. We expect engineering and research and development expenditures will continue to represent a substantial percentage of our net revenues for the foreseeable future. The decrease in the percentage of research and development expenses to net revenues for fiscal year 2004 compared to 2003 reflects increased net revenues and decreased spending in 2004. We expect research and development expenditures to increase gradually but to decrease as a percentage of net revenues over time as industry conditions and our net revenues improve.

      Our manufacturing strategy is to produce technologically advanced and high quality metrology systems. We currently perform the majority of our system assembly activities in-house. In order to lower production costs in the future, we intend to perform in-house only those manufacturing activities that add significant value or that require unique technology or specialized knowledge. As a result, we expect to rely increasingly on subcontractors and turnkey suppliers to fabricate components, build assemblies and perform other activities in a cost effective manner.

      Our principal manufacturing activities include assembly and test work, both of which are conducted at our facility in Fremont, California. Assembly activities include inspection, subassembly and final assembly. Test activities include modular testing, system integration and final testing. Components and subassemblies,

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      We schedule production based upon firm customer commitments and anticipated orders. We have structured our production process and facility to be driven by both orders and forecasts and have adopted a modular system architecture to increase assembly efficiency and test flexibility. Cycle times for our products vary significantly. We believe these cycle times will improve as we continue to emphasize manufacturability in our new product designs.

      We conduct the assembly of some optical components and final testing of our systems in clean-room environments. This procedure is intended to reduce the amount of particulates and other contaminants in the final assembled system, and test our products against our customers’ acceptance criteria prior to shipment. Following the final test, the completed system is packaged within triple vacuum-sealed bags to maintain a high level of cleanliness during shipment and installation.

      The market for semiconductor capital equipment is highly competitive. We face substantial competition in each of the markets that we serve. Some of our competitors have greater financial, engineering, manufacturing and marketing resources and broader product offerings than we have. Significant competitive factors in the market for metrology systems include system performance, ease of use, reliability, cost of ownership to the customer, technical support and customer relationships. We believe we compete favorably on the basis of these factors in each of our served markets. We compete with both larger and smaller companies in the markets we serve.

      Our Therma-Probe systems compete primarily with other metrology systems designed to measure ion implant dose in some alternative fashion, such as contact and destructive four-point probe measurement systems, including those manufactured by KLA-Tencor Corporation, Applied Materials, Inc. and Kokusai Electric Ltd. Our Therma-Probe systems are non-contact, nondestructive ion implant metrology systems for product wafers and have a major share of the market. Several years ago, Jenoptik GmbH introduced a competitive product to our Therma-Probe systems, which utilized thermal wave technology. In November 1997, a jury found that Jenoptik’s product infringed on a number of our United States patents. As a result of the settlement of this litigation, Jenoptik has agreed not to sell any of its metrology products in the United States until the patents expire and to pay us a royalty fee for systems sold in Japan. To date, the sale of these products by Jenoptik (or TePla AG, who has purchased these rights from Jenoptik) has not had a material impact on our market position.

      On April 22, 2002, we filed a patent infringement suit against Boxer Cross Inc. We believe the Boxer Cross BX-10 product infringed certain patents held by us related to ion implant monitoring. More recently, Boxer Cross introduced a competitive product to our Therma-Probe systems that utilizes a similar technology. In July 2003, we settled this lawsuit and dismissed our claims.

      Our Opti-Probe film thickness metrology systems primarily compete with systems manufactured by KLA-Tencor Corporation, Rudolph Technologies, Inc., Nanometrics, Inc. and Dai Nippon Screen, Mfg. Co., Ltd. Our Opti-Probe CD and RT/ CD systems participate in a newly developing market of optical CD

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      Suppliers of integrated metrology with whom we compete include most of the companies listed above regarding the Opti-Probe, in addition to Nova Instruments.

      In recent years, there has been merger and acquisition activity among our competitors and potential competitors, as well as by us. Acquisitions by our competitors and potential competitors could allow them to expand their product offerings, which could afford such competitors and potential competitors an advantage in meeting customers’ demands. The greater resources, including financial, marketing and support resources, of competitors potentially engaged in these acquisitions could permit them to accelerate the development and commercialization of new products and the marketing of existing products to their larger installed bases. Accordingly, such business combinations and acquisitions could have a detrimental impact on both our market share and the pricing of our products, which could result in a material adverse effect on our business and results of operations.

Patents and Proprietary Rights

      We believe the success of our business depends as much on the technical competence, creativity and marketing abilities of our employees as on the protection derived from our patents and other proprietary rights. Nevertheless, our success will depend, at least in part, on our ability to obtain and maintain patents and proprietary rights to protect our technology.

      We have a policy of seeking patents where appropriate on inventions concerning new products and improvements as part of our ongoing engineering and research and development activities. We have acquired a number of patents relating to our two key product families, the Therma-Probe and the Opti-Probe systems. As of March 28, 2004, we owned 106 patents. Of these, we owned 88 U.S. patents with expiration dates ranging from 2004 to 2022 and we had filed applications for 100 additional U.S. patents. In addition, we owned 11 foreign patents with expiration dates ranging from 2004 to 2019 and had filed applications for 35 additional foreign patents.

      In May 2004, nine U.S. and six foreign patents expired. All these patents relate to our older Therma-Probe products and technologies that have since been upgraded or replaced with new technologies and more recent patents. The expiration of these patents is not expected to have a material impact on our operations.

      There can be no assurance that any of our pending patent applications will be approved, that we will develop additional proprietary technology that is patentable, that any patents owned by or issued to us will provide us with competitive advantages or that these patents will not be challenged by any third parties. Furthermore, there can be no assurance that third parties will not design around our patents. Any of the foregoing results could have a material adverse effect on our business, financial condition or results of operations.

      In addition to patent protection, we rely upon trade secret protection for our confidential and proprietary information and technology. We routinely enter into confidentiality agreements with our employees. However, there can be no assurance that these agreements will not be breached, that we will have adequate remedies for any breach or that our confidential and proprietary information and technology will not be independently developed by, or become otherwise known, to third parties.

      As of March 28, 2004, we owned 21 registered trademarks in the U.S. and two in Japan and had filed five trademark registration applications in the U.S.

SEC Reports

      Our annual reports on Form 10-K, quarterly reports on Form l0-Q, current reports on Form 8-K, and all amendments to these reports filed with the U.S. Securities and Exchange Commission, are available for review free of charge on the SEC’s website which you can access through our website at

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      Our executive and manufacturing, engineering, marketing, research and development operations are located in a 102,000 square foot building at 1250 Reliance Way in Fremont, California. The facility has approximately 800 square feet of Class 10 clean rooms for customer demonstrations and approximately 20,000 square feet of Class 1000 clean rooms for manufacturing. This facility is occupied under a lease expiring in 2006 at an aggregate annual rental expense of approximately $1.2 million. We have the option of extending this lease for another 15 years after 2006. We own substantially all of the equipment used in our facilities. We also lease a building of approximately 28,000 square feet on Kato Road in Fremont, California, and two buildings of approximately 24,574 square feet in Santa Clara, California. During March 2003, we moved all our employees out of the Kato Road and Santa Clara facilities and into our Reliance Way facility. We are attempting to sublet these buildings to reduce our costs. We have partially sublet one of the buildings in Santa Clara. We believe that our existing facilities, capital equipment and anticipated capital expenditures will be adequate to meet our requirements for at least the next two years and that suitable additional or substitute space will be readily available if needed.

      We also lease sales and customer support offices in Texas, Japan, China, Korea, Taiwan, Singapore, and the United Kingdom.

      On April 22, 2002, we filed a patent infringement suit against Boxer Cross Inc. in the United States District Court, Northern District of California. The suit alleged that Boxer Cross’ BX-10 product infringed certain patents held by Therma-Wave related to ion implant monitoring. On June 7, 2002, Boxer Cross filed its amended answer and counterclaims to our complaint and asserted various affirmative defenses to our claims of patent infringement. The pleading also contained various counterclaims including allegations that Therma-Wave’s Therma-Probe product infringed upon certain patents owned by Boxer Cross and also raised claims of misappropriation of trade secrets, tortious interference with contract, unfair competition and unfair business practices. We replied to Boxer Cross’s counterclaims, denying the material allegations and asserting declaratory judgment counterclaims. On April 29, 2003, Applied Materials announced that it had acquired all of the outstanding stock of Boxer Cross. We settled this lawsuit with Boxer Cross and Applied Materials on July 7, 2003. Pursuant to the settlement, Therma-Wave dismissed its pending patent infringement claims with prejudice. Boxer Cross dismissed its pending patent infringement claims without prejudice and dismissed its pending state law claims with prejudice.

      There are currently no other material legal proceedings pending against us. We may be required to initiate additional litigation in order to enforce any patents issued to or licensed to us or to determine the scope and/or validity of a third party’s patent or other proprietary rights. In addition, we may be subject to additional lawsuits by third parties seeking to enforce their own intellectual property rights. Any such litigation, regardless of outcome, could be expensive and time consuming and, as discussed above in the prior risk factor, could subject us to significant liabilities or require us to cease using proprietary third party technology and, consequently, could have a material adverse effect on our business, financial condition, results of operations or cash flows.

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      No matters were submitted to a vote of security holders during the quarter ended March 31, 2004.

PART II

      Our common stock is traded on The NASDAQ National Market. As of June 1, 2004, there were 183 holders of record of common stock. The following table sets forth, for the periods indicated, the high and low closing prices per share of our common stock as reported on The NASDAQ National Market.

      To date, we have not declared or paid cash dividends to our stockholders. We have no plans to declare or pay cash dividends in the near future. Any future determination to pay dividends will be at the discretion of the board of directors and will depend upon, among other factors, our results of operations, financial conditions, capital requirements and contractual restrictions.

Shares Authorized for Issuance Under Equity Compensation Plans

      The following table summarizes the total shares of our common stock that may be received by holders upon the exercise of currently outstanding options, the weighted average exercise price of those outstanding options and the number of shares of our common stock that are still available for future issuance under our equity compensation plans after considering the stock options currently outstanding as of March 31, 2004. All of the options described below have been or can be issued pursuant to our 1997 Stock Purchase and Option Plan, our 1997 Employee Stock Purchase and Option Plan, our 1997 Special Employee Stock Purchase and Option Plan, our 2000 Equity Incentive Plan and our 2000 Employee Stock Purchase Plan as of March 31, 2004. All of these plans have been approved by our stockholders.

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      The information in the table below takes into account our recent employee stock option exchange offer which expired on September 10, 2003. The voluntary program allowed Therma-Wave employees, excluding officers and directors, to return to us existing options issued before July 1, 2002 with an exercise price greater than $2.00 per share and exchange them for new options that were granted on September 10, 2003. The number of new options granted in the employee stock option exchange program was equal to 75% of the number of options canceled in the exchange. The new option grants have a different vesting schedule from the original option grants and have an exercise price equal to $2.38, the fair market value of our common stock on September 10, 2003. Of the 1,366,570 options eligible for exchange, 1,352,108 options, or 99%, were exchanged for 1,014,144 new options with an exercise price of $2.38. The replacement options vest 50% on June 11, 2004, and 50% on April 11, 2005 or according to the performance vesting schedules of specific option grants.

(1)	The number of securities to be issued upon the exercise of outstanding options and the weighted average exercise price of outstanding options under our Employee Stock Purchase Plan cannot be determined prior to the actual purchase dates under the plan.
(2)	The number of shares available for issuance under our 2000 Equity Incentive Plan increases each year by one percent of the total shares of our outstanding common stock pursuant to the terms of the plan.

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      The selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and accompanying notes thereto included elsewhere in this annual report on Form 10-K.

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(1)	Effective April 1, 2000, we changed our method of accounting for revenue recognition in accordance with Securities and Exchange Staff Accounting Bulletin Number 101 (SAB 101). In December 2003, the Securities Exchange Commission issued Staff Accounting Bulletin Number 104 (SAB 104), which supercedes SAB 101. We are in compliance with SAB 104.
(2)	On May 16, 1997, we effected the recapitalization. We issued $115.0 million in aggregate principal amount of 10 5/8% senior notes in connection with the recapitalization. In March 2000, we used approximately $130.5 million of net proceeds from our initial public offering of common stock to redeem or repurchase substantially all of the outstanding senior notes issued with our recapitalization in 1997. Approximately $18.4 million costs were associated with this early extinguishment of debt.
(3)	The consolidated financial statements for the years ended March 31, 2003 and 2002 were restated as a result of an investigation and revenue recognition review conducted by our Audit Committee with the assistance of outside legal counsel, independent forensic accountants, and our independent registered public accounting firm.
(4)	During fiscal year ended March 31, 2003, we conducted impairment reviews of goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” and Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. As a result of the reviews, we wrote off $65.9 million for goodwill, $0.6 million for developed technology, $0.2 million for a development contract and $0.8 million for trade name intangible assets.

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General

      We develop, manufacture, market and service process control metrology systems for use in the manufacture of semiconductors and control significant market share in the metrology industry. Process control metrology is used to monitor process parameters in order to enable semiconductor manufacturers to maintain high yields on the production lines, reduce feature size, increase wafer size, increase equipment productivity and improve device performance. Our metrology systems are used in all sections of the semiconductor fabrication plant, or “fab”, to control the wafer fabrication processes. Examples of wafer fab processes, in which our metrology systems supply key information, are photoresist processing to support lithography, deposition of insulator and conductor films, patterned removal, or “etching”, of insulator and conductor films, ion implantation and chemical mechanical planarization. We currently sell four product families of process control metrology systems: Therma-Probe systems, Opti-Probe systems, Opti-Probe CD systems, and Integra integrated metrology systems.

      Therma-Probe Product Family. Therma-Probe systems utilize our proprietary thermal wave technology and are non-destructive process control metrology systems used to measure the critical ion implantation process on product wafers in the fabrication of semiconductors. Therma-Probe systems have a major share of the market.

      Opti-Probe Product Family. Opti-Probe Film Metrology systems provide the industry’s most powerful capability to control and diagnose non-opaque films for semiconductor production. This unsurpassed metrology power is achieved by successfully integrating different measurement technologies, including optical technologies that are proprietary to our company, into each Opti-Probe system.

      Opti-Probe CD Product Family. Opti-Probe CD systems measure the critical dimensions, or CD, representing the device structures, using a revolutionary, nondestructive technique based on spectroscopic ellipsometry. These systems are capable of providing CD metrology for the smallest features of the next several generations of ICs.

      Integra Product Family. The Integra line of integrated metrology products is a broad-based family of compact metrology “modules” which are installed on and function in conjunction with an IC process system, such as an etching system or CVD deposition system, to provide metrology on each wafer before it exits the process tool.

Management Overview

      Our mission can be stated in simple terms — we want to help our customers achieve their goals, which will in turn help us achieve ours. Therma-Wave develops, manufactures, markets and services process control metrology systems for use in the manufacture of semiconductors. Our customers must have metrology equipment to improve their yields, an essential element to improving their profits. A significant number of our customers are now expanding their wafer production capacity while moving from 200 millimeter to new 300 millimeter technology. The industry is also advancing to smaller geometries for semiconductor device production, currently at the 130 nm technology node and advancing to 90 nm and in the future advancing to the 65 nm technology node. These technology advances will significantly increase the requirement to improve yields.

      Our core products include the latest generations of our Therma-Probe and Opti-Probe metrology systems. Our core markets, remain the thin film and ion implant measurement markets that we successfully addressed for nearly $200 million of revenue during the peak year of the last semiconductor industry cycle. Our new products include our optical RT/ CD product family and our integrated product line, Integra. All of our new and latest generation products, which taken together accounted for approximately 60% of our total systems

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      Therma-Wave introduced its Opti-Probe Real Time Critical Dimension system, Opti-Probe RT/CD, in 2002. This product combines a powerful computer and Therma-Wave proprietary software with our standard 7000 series Opti-Probe and has moved Therma-Wave into a market not previously served by the company. Opti-Probe RT/CD has positioned us to compete for business previously served by manufacturers of scanning electronic microscopes, known as CD SEM. CD SEM is becoming non-competitive in certain advanced technologies of 90 nm and smaller. We believe that our Opti-Probe RT/ CD product can address some CD requirements faster, better and at a substantially lower cost of ownership to the customer. Where CD SEM is an expensive low throughput technology, Opti-Probe RT/ CD can do the same thing faster and with more precision. We believe the superiority of Opti-Probe RT/ CD will become even greater as fabs move to 90 nm and then to 65 nm. We believe the total critical dimension market could be as much as $500 million to $700 million in calendar year 2005 based on Gartner/ Dataquest market information. Optical products may take an increasing share of this market as technology nodes decrease in size.

      Also in 2002, we introduced our first integrated critical dimension metrology product, Integra, which we sell primarily to an original equipment manufacturer of integrated circuit process systems. This product is a family of compact metrology modules that are installed on and function in conjunction with the IC process system. We are rated by Tokyo Electron as their Class 1 supplier for integrated CD metrology on their market leading photoresist track system.

      Therma-Wave has an installed base of more than 1,650 systems and has systems located at nearly every major semiconductor manufacturer in the world. Therma-Wave has never been a low price competitor. Our strength has been technology from the beginning of the company, when the Therma-Probe product dominated a market niche. We have protected our technology with 106 U.S. and foreign patents as of the end of fiscal 2004. We have a broad range of applications, with products that are reliable and have a low cost of ownership due to their capabilities, not necessarily due to their price.

      We also have a reputation for excellent customer support and we again last year ranked ahead of our top competitor in VLSI’s Customer Support Survey. We have a worldwide customer support organization of approximately 131 people located very close to all our major customers. We have subsidiaries in Japan, the UK and China and branch locations or offices in Taiwan, Hong Kong, Israel, and Ireland, as well as several locations in the U.S. We also have representatives or distributors in Germany, France, Italy, Singapore and Japan.

      To be competitive, our products must be extendable, provide low cost of ownership and help our customers to continuously meet the ever-advancing technology nodes challenge. Some of our customers are currently moving or planning to move from 130 nm to 90 nm and will begin moving to 65 nm as the next step. They will not purchase products from a supplier who they believe cannot continue to enable them to advance and meet those technology changes. Therma-Wave products have demonstrated the capability to be extendable and meet those challenges in the past and we believe our products are well positioned to meet those requirements for the future.

      Based on the Gartner/ Dataquest January 2004 industry survey information, it is estimated that the total process control market will grow to approximately $5.2 billion by calendar year 2005. Of that, approximately $2.3 billion is expected to be the metrology segment. Therma-Wave is targeting the transparent thin film, critical dimension and overlay segments of this market, which is estimated to be approximately $1.3 billion by 2005. Our goal is to capture a minimum of 15% of this market, plus a major share of the ion implant process measurement market, and plus normal upgrades and service and support. The ion implant market is actually included as a small part of the opaque film market by Gartner/ Dataquest, and we believe this market will be between $25 million and $30 million in calendar year 2005, most of which we expect to capture. If achieved,

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      As reported by the Gartner/ Dataquest industry survey, our Opti-Probe products in the standalone non-metal thin film metrology market increased market share from 15% in calendar 2002 to 19% in calendar 2003. Our Opti-Probe RT/ CD product also made strong market share gains, improving from 22% in 2002 to 50% in calendar 2003. This product was introduced in the second half of 2002. It is also noteworthy that the total market for optical critical dimension measurement equipment more than doubled, from $7.6 million in 2002 to $18 million in 2003. We believe this growth will continue and even accelerate further.

      The semiconductor industry has just gone through its longest and deepest downturn in its history. Therma-Wave was severely impacted. However, our orders and order activity increased during our fiscal third and fourth quarters of 2004. In our fiscal third quarter, we reported an 89% increase in orders from the previous quarter, which resulted in shipments increasing by over 28% in the fiscal fourth quarter. Our order rates for the last two quarters of our fiscal year 2004 were at the highest level they have reached since our fiscal year 2001. Although the industry orders picture is still somewhat unclear, we believe that business overall in the semiconductor industry is improving.

      In fiscal 2004, we also substantially increased our total number of customers worldwide to whom we sold systems to 39 customers worldwide, up from 29 the previous year. We sold products to eight of the top ten capital spending companies in the world in semiconductor manufacturing capital facilities and equipment, up from seven of the top ten in the previous year. We more than doubled our metrology systems orders to approximately $48 million in fiscal year 2004, up from approximately $21 million the previous year.

      In addition to the overall growth in orders, it is important to note that our new leading edge products grew as a percentage of our product mix. The advanced Therma-Probe systems grew from 3%, or $0.7 million, of total systems orders in fiscal 2003 to 16%, or $8.0 million, of total systems orders in fiscal 2004. The advanced Opti-Probe systems grew from 16%, or $3.5 million, to 31%, or $15.2 million, of total systems orders. Also, 60% of total systems booked during the year were for 300 millimeter business, which we feel is significant because it demonstrates that customers are accepting our more advanced products.

      Geographically, in our fiscal 2004, European business strengthened and we recaptured business in Korea. We opened a new subsidiary in Shanghai to service the new business in China. Overall for the fiscal year 2004, 56% of systems orders came from Asia excluding Japan, 19% came from Japan, 12% from Europe and 13% from the United States. This compared to 54% of systems orders from Asia excluding Japan, 12% from Japan, 4% from Europe and 29% from the United States for the fiscal year 2003. We believe the distribution of new orders in fiscal fourth quarter of 2004 is significant, indicating a broad market penetration, particularly the strong growth in Europe, Korea and Taiwan.

      During fiscal 2003, quarterly net revenues bottomed at between $10 and $11 million per quarter in the fiscal second and third quarters, then turned up to $13.1 million in the fiscal fourth quarter of 2003. We continued to make progress during fiscal year 2004, and net revenues for the fiscal fourth quarter of 2004 were $19.5 million. Sequentially, net revenues in the fiscal fourth quarter 2004 decreased by $0.4 million from the fiscal third quarter 2004, however fiscal third quarter included $15.2 million of our standard products and services and $4.7 million of revenue related to a development program that ended during the fiscal third quarter. Therefore, fiscal fourth quarter net revenues from standard products and services actually increased by $4.3 million or 28.5%. Net revenues for the fiscal year ended March 28, 2004 totaled $65.3 million compared to $49.2 million for fiscal year 2003, an increase of $16.1 million or 32.7%. This reflects the industry-wide upturn in purchases of semiconductor metrology capital equipment.

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      Gross margins improved steadily throughout fiscal year 2004 and continued this improvement in the fiscal fourth quarter, benefiting both from the higher volume and from cost reduction efforts. Our gross margins averaged 50.1% for our fiscal third quarter, including $3.7 million of margin from a development program that ended during the quarter and averaged 41.6% for our standard products and services in addition to $3.7 million from the conclusion of the development program mentioned above. Our third fiscal quarter gross margin from standard products and services benefited from the sale of $2.5 million, or 12% of revenues, of inventory that had previously been written off, and was reduced by new inventory charges of $0.6 million, or 3% of revenues. We improved gross margins for standard products and services to 43.4% in the fiscal fourth quarter of 2004, which includes the benefit of $2.5 million, or 13% of revenues, from the sale of previously written off inventory and the reduction of $2.2 million, or 11% of revenues, due to new charges to inventory in the fourth fiscal quarter.

      We ended fiscal year 2003 with average gross margins of negative 12%, including new inventory charges of $9.6 million, or 20% of net revenues, and the benefit from the sale of $1.0 million, or 2% of net revenues, of inventory that had previously been written off. We improved gross margins in fiscal year 2004 to over 41%, including the benefit from the sale of $10.6 million, or 16% of net revenues, of inventory previously written off and the reduction due to new inventory charges of $5.2 million, or 8% of net revenues. Net revenues from our 300 millimeter standalone tools increased to 57% of total net revenues for our fiscal fourth quarter, up 34% from the fiscal third quarter 2004. In addition, 60% of our new orders for the same period were for 300 millimeter products indicating that this trend should continue. The significance of this product mix to margins is that our 300 millimeter products are less mature and therefore margins on these systems are lower than on older, more mature 200 millimeter products. Cost reduction programs are under way to improve our 300 millimeter product margins.

      For the fiscal fourth quarter 2004, we fully absorbed our factory overhead for the first time in more than two years due to higher production volumes. This is important because it means that any additional volume growth begins to reduce the average overhead cost per tool produced, thereby reducing the average total cost per tool. However, our margins continued to be unfavorably impacted by lower than optimum production levels.

      During fiscal 2004, our efforts were directed toward managing our operating expenses to be in line with business conditions. Total operating expenses for the fiscal fourth quarter 2004 decreased by approximately $0.7 million from the fiscal third quarter. This decrease was due primarily to non-cash charges for variable accounting treatment for stock options of approximately $0.7 million that were incurred in the fiscal third quarter, compared to a credit of $0.1 million recorded for the variable accounting treatment for stock options in the fiscal fourth quarter. The credit occurred because our stock price decreased from quarter to quarter. Operating expenses for all costs other than the variable accounting treatment for stock options were up about $0.4 million from our fiscal third quarter, an increase of approximately 4%.

      For fiscal 2004, operating expenses were $44.8 million, down from $128.7 million in fiscal 2003. Fiscal 2003 included charges of $67.4 million for the impairment of goodwill and other intangible assets related to the Sensys acquisition. Excluding the $67.4 million impairment charges, fiscal 2003 expenses were $61.3 million. The reduction in operating expenses other than impairment charges in fiscal 2004 compared to fiscal 2003 reflects an 18% labor savings due to reductions in force, 54% lower direct material charges due to the timing of development activities, a 42% reduction in spending on outside services, and lower costs for marketing programs, travel, and facilities and information systems support. In fiscal 2005, we expect to manage operating expenses in line with revenues, increasing over time as the business grows, but declining as a percentage of revenues, thereby improving profitability.

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      Our net loss for the fiscal fourth quarter 2004 was $1.8 million or $0.05 per diluted share, including the sale of inventory with an original cost of $2.5 million, or $0.07 per share that had previously been written off, and was reduced by new inventory charges of $2.2 million, or $0.06 per share. This compared to a net loss for the fiscal third quarter of $1.0 million, or $0.03 per diluted share, that benefited from the sale of inventory with an original cost of $2.5 million that had previously been written off, and that was reduced by new inventory charges of $0.6 million, or $0.02 per share. However, our fiscal third quarter also benefited from approximately $3.7 million of net income, or approximately $0.10 per diluted share, recognized from the ending of a development program. The net loss from the sale of our standard products and services for the fiscal third quarter was $4.7 million or $0.13 per diluted share.

      Our net loss for the fiscal year 2004 was $18.1 million or $0.56 per diluted share compared to a loss of $133.6 million or $4.69 per diluted share for fiscal year 2003. However, our fiscal year 2004 benefited from approximately $3.7 million of net income, or approximately $0.10 per diluted share, recognized from the ending of the development program mentioned earlier. Our fiscal year 2004 also benefited from the sale of inventory that originally had cost $10.6 million, or $0.33 per share that had previously been written off, and was reduced by $5.2 million, or $0.16 per share, in new inventory charges. The fiscal year 2003 results included non-cash charges of $67.4 million, or $2.37 per share, for the impairment of goodwill and other intangible assets originating from the January 2002 acquisition of Sensys. The fiscal year 2003 net loss also benefited from the sale of inventory that originally cost $1.0 million, or $0.04 per share, that had previously been written off, and was reduced by $9.6 million, or $0.34 per share, in new inventory charges.

      Our balance sheet was strengthened significantly during our last two quarters of fiscal 2004. Cash and short-term investments totaled $23.9 million at March 28, 2004 an increase of $1.4 million from the $22.5 million reported as of December 28, 2004 and $22.6 million reported at September 28, 2003. This compares to cash and restricted cash as of the end of fiscal 2003 of $14.8 million. Cash improvements were due primarily to $11.7 million in net proceeds raised in a private offering completed on September 16, 2003, increased accounts receivable collections due to improved net revenues and reduced receivables days sales outstanding and sale of inventory, including the sale of inventory that had originally cost $10.6 million but that had later been written off prior to sale. Our receivables days sales outstanding, or DSO, ended the fiscal fourth quarter of 2003 at 106 days and was improved to 52 days for our fiscal fourth quarter of 2004. We have no long-term debt, and we have access to $15 million in credit facilities that are unused other than for supporting standby letters of credit.

      In previous communications to shareholders and the investment community, we identified inventory controls as a key component for the success of the company. In the fiscal fourth quarter inventory increased by approximately $0.2 million, the first increase in more than a year due primarily to increased purchasing of parts to accommodate the shift in product mix from 200 millimeter products to 300 millimeter products and also due to the increased manufacturing and sales volume. We also continued to sell previously written off 200 millimeter inventory.

      Our financial performance has significantly improved in the past year and we expect that improvement to continue. Our goal is that this improvement will bring us back to profitability during the current fiscal year. Our management team is lead by Boris Lipkin, who joined Therma-Wave as our CEO in February 2003. Mr. Lipkin has brought together a new team, most of which was assembled during fiscal year 2004. We have a new chairman, Papken Der Torossian, former chairman and CEO of Silicon Valley Group, who joined the board in March 2003. And in March of 2004 we added three new board members: Peter Handley, recently retired as President of Novellus, Larry Tomlinson, recently retired Treasurer of Hewlett Packard and Nam Pyo Suh, professor and Director of the Manufacturing Institute at MIT. Mr. Tomlinson is also now chairman of our audit committee.

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      By far our most important goal for fiscal year 2005 is to return the company to profitability. We undertook a course of action at the beginning of our fiscal year 2004 that started producing the expected results. During the year, our orders activity continued to improve, gross margins continued to improve and our losses were substantially reduced. In total our fiscal year 2004 was a substantial improvement over the previous year and confirms that our company is headed in the right direction. This does not mean that we are satisfied, but we are pleased with our fiscal year 2004 performance.

      The timing of orders and shipments continues to be difficult to predict, but we expect both orders and net revenues to steadily increase quarter by quarter during our fiscal year 2005. At least in the fiscal first quarter we expect gross margins to be influenced by the continued mix shift from 200 millimeter products to 300 millimeter products, and pricing pressures, though lessening to continue, slowing margin improvement, possibly offsetting potential margin improvements from higher volume. Operating expenses are expected to be higher due to higher research and development project costs, higher sales commissions that result from the increased new orders, and from expenses related to Sarbanes-Oxley Act compliance. We expect a net loss in the fiscal first quarter 2005. However, we continue to believe that our profitability will improve during fiscal year 2005, aided by expected further improvements in orders and shipments and a growing benefit from ongoing cost reduction efforts.

      As mentioned earlier, cash and short-term investments totaled $23.9 million at March 28, 2004 an increase of $1.4 million from the $22.5 million reported as of December 28, 2004. Our inventory increased in our fiscal fourth quarter 2004 for the first time in more than a year. We believe that growth in new orders and revenues and continued change in product mix, going toward more 300 millimeter products will increase inventories further and that trade receivables will also begin to increase in our fiscal first quarter of 2005. We expect this trend to continue at least through the first two quarters of our fiscal year 2005 and to require an investment in net working capital in our fiscal first quarter and possibly in the fiscal second quarter. We believe that we have adequate cash to fund this working capital growth. However, if required, we have access to $15 million in credit facilities available through our bank.

Critical Accounting Policies and Estimates

      Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The methods, estimates and judgments we use in applying our accounting policies has a significant impact on the results we report in our consolidated financial statements. On an on-going basis, management evaluates its estimates and judgments, including those related to revenue recognition, inventory, allowance for doubtful accounts receivable, valuation of long-lived assets and intangible assets, income taxes and warranty. Management bases its estimates and judgments on historical experience and on various other factors 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.

      An accounting policy is considered to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the financial statements. Management believes the following critical accounting policies affect its significant judgments and estimates used in the preparation of its consolidated financial statements. The following descriptions of critical accounting policies, judgments and estimates should be read in conjunction with our consolidated financial statements and other disclosures included in this report.

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      Effective April 1, 2000, we changed our method of accounting for revenue recognition in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, or SAB 101, “Revenue Recognition in Financial Statements.” In December 2003, the Securities Exchange Commission issued Staff Accounting Bulletin No. 104, or SAB 104, “Revenue Recognition,” which superceded SAB 101. SAB 104 is a codification of other revenue recognition pronouncements and in substance does not change SAB 101. Revenues are recognized when the contractual obligations have been performed, title and risk of ownership have passed to the customer, collectibility of the sales price has been reasonably assured and customer final acceptance has been obtained, if applicable. Freight terms of sales are FOB shipping point unless otherwise negotiated and agreed in written form between our customers and us. Shipments typically are made in compliance with shipment requirements specified in our customer’s purchase order.

   Systems Revenues. Equipment sales are accounted for as multiple-element arrangement sales that require the deferral of a significant portion of revenues in the amount of the greater of fair market value of installation and a percentage of payment subject to final acceptance. Systems revenues are allocated to each component of the multiple-element arrangement. Revenues on each element are recognized when the contractual obligations have been performed, title and risk of ownership have passed to the customer, collectibility of the sales price has been reasonably assured and customer final acceptance has been obtained, if applicable. Estimated contractual warranty obligations are recorded when related systems sales are shipped.

      Systems revenues on newly introduced products are deferred at shipment and recognized upon customer final acceptance. Systems revenues are also deferred when the customer has the right to return the product for credit. In such cases, systems revenues are not recognized until all of the following conditions have been evidenced after the customer’s purchase order has been fulfilled: the right of return has expired and any potential returns would require authorization by our company under warranty provisions; the price of the sales is fixed or determinable; the payment terms are fixed and enforceable and collectibility is reasonably assured.

      In accordance with SAB 104, we evaluate our systems sales to determine the appropriate timing for revenue recognition for each of the multiple elements involved in each sale. This sometimes results in deferrals of revenues from the period in which the tool is shipped to future periods.

   Services Revenues. We derive services revenues from three primary sources: sale of spare parts, service contracts and service labor. Revenues on the sale of spare parts are recognized when title and risk of ownership have transferred to the customer and collectibility of the sales price has been reasonably assured. Revenues on service contracts are deferred and recognized on a straight-line basis over the period of the contract. Revenues on time and material services performed are recognized when the services are completed, collectibility of the sales price has been reasonably assured and customer final acceptance has been obtained, if applicable.

      We value our inventory at the lower of cost (first-in, first-out method) or market. Due to changing market conditions, estimated future requirements, age of the inventories on hand and our production of new products, we regularly review inventory quantities on hand and record a provision to write down excess and obsolete inventory to its estimated net realizable value. A significant increase in the demand for our product could result in a short-term increase of inventory purchases while a significant decrease in demand could result in an increase in the charges for excess inventory quantities on hand. In addition, our industry is subject to technological change, new product development, and product technological obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Therefore, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and reported operating results. When we record additional reserves for excess and obsolete inventory, we create a new cost basis for the inventory. The reserve is only released if and when the reserved inventory is sold or scrapped, which is in accordance with SAB 100. The inventory charge in fiscal 2004 was $5.2 million, and was $9.6 million in fiscal 2003.

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      We utilize estimates in determining our allowance for doubtful accounts receivable and reserve for potential returns for credit. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience, any specific customer collection issues that we have identified, and the aging of the accounts receivable. While such credit losses have historically been within our expectations and the provisions established, there is no assurance that we will continue to experience the same credit loss rates that we have in the past. A significant change in the liquidity or financial position of our customers could have a material adverse impact on the collectibility of our accounts receivable and our future operating results.

      We have adopted Statement of Financial Accounting Standards No. 142, or SFAS No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We assess the impairment of identifiable intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review of such assets include the following:

	•	significant under-performance relative to expected historical or projected future operating results;
	•	significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and
	•	significant negative industry or economic trends.

      When we determine that the carrying value of intangibles and long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure the 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 business model. While we believe that our estimates of future cash flows are reasonable, different assumptions regarding such cash flows could materially affect our evaluations. In fiscal year 2003 we wrote off $67.4 million in regards to the impairment of goodwill and other intangibles associated with the Sensys acquisition.

      We account for income taxes using the asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income. A valuation allowance is established to reduce deferred tax assets to their estimated realizable value. We provide a valuation allowance to the extent we cannot conclude, based on available objective evidence, that it is more likely than not we will generate sufficient taxable income in future periods to realize the benefit of our deferred tax assets. Predicting future taxable income is difficult, and requires the use of significant judgment.

      We provide warranty coverage for a predetermined amount of time, on systems and parts for material and labor to repair and maintain the equipment. We record the estimated cost of systems and parts warranty upon shipment of tools, based on the average historical warranty expense for a specific tool. Should actual costs or material usage differ from our estimates, revisions to the estimated warranty liability may be required.

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Results of Operations

      The following table summarizes our historical results of operations as a percentage of net revenues for the periods indicated.

      Due to the 33% increase in net revenues in fiscal 2004 compared to fiscal 2003, cost of net revenues and operating expense as a percentage of net revenues declined, reducing the net loss as a percentage of revenues. Included in the changes from fiscal 2004 compared to fiscal 2003, among other changes, are (in millions):

      Due to a 40% decline in net revenues in fiscal 2003 compared to fiscal 2002, cost of net revenues increased as a percentage of net revenues, as did operating expenses, increasing the net loss as a percentage of net revenues in fiscal 2003 compared to fiscal 2002. Fiscal 2003 results included (in millions):

	•	a charge of $9.6 million, or 20% of net revenues, for the write down of inventory

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	•	a benefit from the sale of $1.0 million, or 2% of net revenues, of inventory previously written off
	•	a $67.4 million charge for the impairment of goodwill and other intangible assets related to the Sensys acquisition

      Net Revenues. Net revenues for the fiscal years ended March 31, 2004 and 2003 were $65.3 million and $49.2 million, respectively. Compared to fiscal 2003, net revenues in fiscal 2004 increased $16.1 million or 32.7% primarily as a result of capital spending increases in the semiconductor industry. We sold 40% more units of our Therma-Probe and Opti-Probe products in fiscal 2004 and the average selling price increased 55% in fiscal 2004 due to a shift in business towards newer, more expensive models. We experienced strong price competition during both fiscal 2004 and fiscal 2003.

      The following table summarizes our revenues in different categories as a percentage of total net revenues for the periods indicated.

      The fluctuations in these percentages are related primarily to the changes in the amount of metrology capital equipment being purchased by the semiconductor industry from one year to the next. Sales of service contracts and parts tend to reflect the installed base of systems previously sold rather than current system sales. As a result, the dollars of such sales do not fluctuate as widely as systems sales, and therefore represent a higher percentage of net revenues when product sales are lower.

      Net revenues attributable to international sales for the fiscal years ended March 31, 2004 and 2003 accounted for 72% of our total revenues for each of these two periods. We anticipate that international sales will continue to account for a significant portion of our revenues in the foreseeable future, because of the concentration of large customers in Asia. A substantial portion of our international sales is denominated in U.S. dollars. As a result, changes in the values of foreign currencies relative to the value of the U.S. dollar can render our products comparatively more expensive. Although we have not been negatively impacted in the past by foreign currency changes in Japan, Korea, China, Taiwan, Singapore, Israel and Europe, such conditions could negatively impact our international sales in future periods.

      Demand for semiconductors and semiconductor equipment increased during our fiscal year 2004. As a result, we increased the number of our customers and experienced higher order booking rates than in the previous fiscal year. The increased orders resulted in higher revenues for systems shipments and an increase in our ending backlog. The increased revenues materially improved our financial position and results of operations in fiscal 2004 compared to the previous year. We expect that the revenues for the first quarter of fiscal year 2005 will increase 8% to 12% from the fiscal fourth quarter of 2004 and that both orders and revenues will improve gradually by quarter in fiscal year 2005. However, due to the uncertainty of economic conditions, the market response to our newly introduced products and the timing of revenue recognition of our new products, we can give no assurance that we will be able to meet our revenue expectations.

      Gross Profit (Loss). Gross profit increased to $26.8 million in fiscal 2004 from a $5.8 million gross loss in fiscal 2003, a total change of $32.7 million. As a percentage of net revenues, gross profit increased from

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      Roughly one quarter of the improvement in gross profit reflects systems revenue increases in absolute dollars and as a percentage of total net revenues. Systems revenues, which contribute relatively higher gross margins, grew by 39% in fiscal 2004 compared to fiscal 2003, while service revenues, which contribute relatively lower gross margins, declined by 13% in fiscal 2004 compared to fiscal 2003. Increased demand for systems improved the margins in several others ways, specifically by enabling the sale of inventory that had been previously reserved ($10.6 million), facilitating sales of systems that had been used internally for demonstration and testing purposes, which generally have a lower cost basis than new systems ($2.5 million), and improving overhead absorption of fixed costs ($0.8 million).

      Overhead spending was reduced by over $6.1 million dollars, due to reductions in labor and discretionary spending in fiscal 2004 compared to fiscal 2003. These spending reductions contributed approximately 19% to the improvement in gross profit. Approximately 11% of the gross margin improvement is due to the termination of a development agreement in the third fiscal quarter of 2004, in which we recognized $4.7 million of previously deferred revenues and gross profit of $3.7 million. Approximately 4% of the improvement is due to the favorable resolution in the third fiscal quarter of 2004 of a potential tax exposure in Korea that we accrued in fiscal 2003.

      During fiscal 2004, as a result of favorable economic conditions and increasing demand for semiconductor products, our gross profits included $10.6 million for sales of previously reserved inventory and charges of $5.2 million in new inventory reserves. We also scrapped $3.1 million of previously reserved inventory. This compares to our gross loss in fiscal year 2003 in which we experienced a decline in sales and recorded an inventory charge of $9.6 million related to excess and obsolete inventories, partially offset by the sale of $1.0 million of inventory previously written off. Inventory charges recorded in fiscal 2003 have substantially lowered the net value of our 200 mm inventory on hand and will have a significant impact on our gross margin if we are able to continue to sell our excess 200 mm inventory in the future.

      We have implemented or are in the process of implementing a number of cost reduction measures to improve our overall gross margin financial performance. These cost reduction measures include, but are not limited to, sourcing and design initiatives to lower cost and improve product performance, tight controls on discretionary overhead spending, renegotiation of equipment maintenance contracts with vendors and so on. We expect these cost reduction measures will contribute to gross margin improvements in fiscal 2005.

      Research and Development, or R&D, Expenses. R&D expenses were $18.7 million and $29.2 million for fiscal years 2004 and 2003, respectively, a reduction of $10.5 million, or 36%. R&D expenses as a percentage of net revenues for fiscal 2004 decreased to 29% from 59% for fiscal 2003 due to both lower R&D spending and the increase of net revenues in fiscal 2004. During fiscal year 2004, in part due to reductions in force, labor and benefits costs were lower by $3.9 million, or 27%. We also reduced the use of outside services by $3.9 million, or 73%. Spending on project materials declined by $1.4 million, or 54%. Other discretionary spending and allocations for facilities and information systems support declined by $1.3 million, or 18%. We maintained the resources for our critical programs such as our real-time critical dimension product, or RT/ CD. We believe that technological leadership is essential to strengthen our market position in the next economic upturn and

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      Selling, General and Administrative, or SG&A, Expenses. SG&A expenses were $23.0 million and $26.1 million for fiscal years 2004 and 2003, respectively. Compared to fiscal 2003, SG&A expenses in fiscal 2003 decreased $3.1 million, or 12%. The decrease in fiscal 2004 SG&A expenses reflects lower headcount, partially due to reductions in force, resulting in savings of $1.3 million, or 9%. Spending on outside services declined by $1.9 million, or 22%. Commissions, however, increased by $0.5 million in 2004 compared to 2003 reflecting increased orders and revenues. Other discretionary spending, such as travel and entertainment and allocations for facilities and information systems support declined by $0.4 million, or 14%. SG&A expenses as a percentage of net revenues decreased to 35% in fiscal 2004 from 53% in fiscal 2003 primarily due to significantly higher net revenues in fiscal 2004. We expect SG&A expenses will increase in fiscal 2005 primarily due to the costs related to compliance with Section 404 of The Sarbanes-Oxley Act and to expansion of our selling, general and administrative activities as our business grows. However, SG&A expenditures as a percentage of net revenues may decrease gradually in fiscal 2005 as net revenues increase with improving industry conditions.

      Impairment of Goodwill and Other Intangible Assets. Due to operating losses, the absence of positive cash flows, significant declines in our common stock price and uncertainties resulting from the duration and severity of the industry downturn, we assessed the recoverability of the intangible assets related to the Sensys acquisition subject to amortization in accordance with SFAS No. 144 and tested goodwill related to the Sensys acquisition for impairment in accordance with SFAS No. 142 during the quarter ended September 30, 2002. In assessing the recoverability of the intangible assets related to the Sensys acquisition in accordance with SFAS No. 144 we projected significantly reduced future cash flows related to Sensys products and therefore we recognized an impairment expense of $0.6 million for developed technology, $0.2 million for a development contract and $0.4 million for trade name intangible assets in the quarter ended September 30, 2002. In addition, during the fourth quarter ended March 31, 2003, we recognized an additional impairment charge of $0.4 million related to trade name intangible assets.

      The impairment test under SFAS No. 142 was based on a two-step process involving comparing the estimated fair value of the related reporting unit to its net book value, and comparing the estimated implied fair value of goodwill to its carrying value. As a result of the test, we wrote down goodwill assets by $65.9 million in the quarter ended September 30, 2002.

      During the quarter ended December 31, 2003, due to the termination of a development agreement, we accelerated the amortization of $1.5 million of the related development contract intangible assets.

      Restructuring, Severance and Other. The following table summarizes the changes in restructuring, severance and other costs during the twelve months ended March 31, 2004 and 2003 (in thousands):