UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2004.

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

For the transition period from                     to                    .

Commission file number: 000-26966

ADVANCED ENERGY INDUSTRIES, INC.

Registrant’s telephone number, including area code: (970) 221-4670

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

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

As of November 1, 2004, there were 32,685,560 shares of the registrant’s Common Stock, par value $0.001 per share, outstanding.

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ADVANCED ENERGY INDUSTRIES, INC.
FORM 10-Q
TABLE OF CONTENTS

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PART I FINANCIAL INFORMATION

ITEM 1. UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ADVANCED ENERGY INDUSTRIES, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets (Unaudited)

The accompanying notes to condensed consolidated financial statements
are an integral part of these condensed consolidated balance sheets.

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ADVANCED ENERGY INDUSTRIES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (Unaudited)

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

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ADVANCED ENERGY INDUSTRIES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited)

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

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ADVANCED ENERGY INDUSTRIES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

(1) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     In the opinion of management, the accompanying unaudited condensed consolidated balance sheets, statements of operations and cash flows contain all adjustments, consisting of only normal, recurring adjustments necessary to present fairly the financial position of Advanced Energy Industries, Inc., a Delaware corporation, and its wholly owned subsidiaries (the “Company”) at September 30, 2004 and December 31, 2003, and the results of their operations for the three- and nine-month periods ended September 30, 2004 and 2003, and cash flows for the nine-month periods ended September 30, 2004 and 2003.

     The unaudited condensed consolidated financial statements presented herein have been prepared in accordance with the instructions to Form 10-Q and do not include all the information and note disclosures required by accounting principles generally accepted in the United States. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on February 24, 2004.

     The preparation of the Company’s condensed consolidated financial statements requires the Company’s management to make certain estimates and assumptions that affect the amounts reported and disclosed in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

     GOODWILL AND OTHER INTANGIBLE ASSETS — Goodwill and certain other intangible assets with indefinite lives, if present, are not amortized. Instead, goodwill and other indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. For the periods presented, the Company does not have any indefinite-lived intangible assets, other than goodwill. Impairment testing is performed in two steps: (i) the Company assesses goodwill for a potential impairment loss by comparing the fair value of its reporting unit with the carrying value, and (ii) if a potential impairment is indicated because the reporting unit’s fair value is less than its carrying amount, the Company measures the amount of impairment loss by comparing the implied fair value of goodwill with the carrying amount of that goodwill.

     In the fourth quarter of 2003, the Company performed its annual goodwill impairment test, and concluded that the estimated fair value of the Company’s reporting unit exceeded its carrying amount and no impairment of goodwill was indicated. As the Company is required to perform the test for impairment at least annually and economic and industry conditions remain uncertain, it is possible that a future test may indicate impairment, and the amount of the impairment may be material to the Company.

     Goodwill and other intangible assets consisted of the following as of December 31, 2003:

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     Goodwill and other intangible assets consisted of the following as of September 30, 2004:

     Aggregate amortization expense related to amortizable intangible assets for both three-month periods ended September 30, 2004 and 2003 was approximately $1.1 million and was approximately $3.4 million and $3.5 million for the nine-month periods ended September 30, 2004 and 2003, respectively. Estimated amortization expense related to the Company’s acquired intangible assets fluctuates with changes in foreign currency exchange rates between the U.S. dollar and the Japanese yen and the euro. Estimated amortization expense for each of the five years 2004 through 2008 is as follows:

     During the third quarter of 2003, the Company determined that one of its mass flow controller products would require a significant technological investment in order to conform to changing customer technologies which would enable it to be accepted by the semiconductor capital equipment industry. As a result, the Company performed an assessment of the carrying value of the related intangible asset. This assessment consisted of estimating the intangible asset’s fair value and comparing the estimated fair value to the carrying value of the asset. The Company estimated the intangible asset’s fair value using a cash flow model assuming the technological investment was made, discounted at rates consistent with the risk of the related cash flows, and applying a hypothetic royalty rate to the projected revenue stream. Based on this analysis the Company determined that the fair value of the intangible asset was minimal and recorded an impairment of the carrying value of approximately $1.2 million, which has been reported as an intangible asset impairment in the accompanying condensed consolidated financial statements.

     REVENUE RECOGNITION — The Company generally recognizes revenue upon shipment of its products and spare parts, at which time title passes to the customer, as the Company’s shipping terms are FOB shipping point, the price is fixed or determinable and collectability is reasonably assured. Generally, the Company does not have obligations to its customers after its products are shipped other than pursuant to warranty obligations. In limited instances the Company provides installation of its products. In such circumstances in accordance with Emerging Issues Task Force Issue 00-21 “Accounting for Revenue Arrangements With Multiple Deliverables,” the Company allocates revenue based on the fair value of the delivered item, generally the product, and the undelivered item, installation, based on their respective fair values. Revenue related to the undelivered item is deferred until the services have been completed. In certain limited instances, some of the Company’s customers have negotiated product acceptance provisions relative to specific orders. Under these circumstances the Company defers revenue recognition until the related acceptance provisions have been satisfied. Revenue deferrals are reported as customer deposits and deferred revenue in the accompanying condensed consolidated balance sheets.

     In certain instances, the Company requires its customers to pay for a portion or all of their purchases prior to the Company building or shipping these products. Cash payments received prior to shipment are

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recorded as customer deposits and deferred revenue in the accompanying condensed consolidated balance sheets, and then recognized as revenue upon shipment of the products. The Company does not offer price protections to its customers or generally allow returns, unless covered by its normal policy for repair of defective products.

     The Company may also deliver products to customers for evaluation purposes. In these arrangements, the customer retains the products for specified periods of time without commitment to purchase. On or before the expiration of the evaluation period, the customer either rejects the product and returns it to the Company, or accepts the product. Upon acceptance, title passes to the customer, the Company invoices the customer for the product, and revenue is recognized. Pending acceptance by the customer, such products are reported on the Company’s balance sheet at an estimated value based on the lower of cost or market, and are included in the amount for demonstration and customer service equipment, net of accumulated amortization.

     INCOME TAXES — The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires deferred tax assets and liabilities to be recognized for temporary differences between the tax basis and financial reporting basis of assets and liabilities, computed at current tax rates, as well as for the expected tax benefit of net operating loss and tax credit carryforwards. During the third quarter of 2003, the Company recorded valuation allowances against certain of its United States and foreign net deferred tax assets in jurisdictions where the Company has incurred significant losses. Given such experience, the Company’s management could not conclude that it was more likely than not that these net deferred tax assets would be realized. Accordingly, the Company’s management, in accordance with SFAS No. 109, in evaluating the recoverability of these net deferred tax assets, was required to place greater weight on the Company’s historical results as compared to projections regarding future taxable income. For the three-month period ended September 30, 2004, although the Company generated a consolidated loss before income taxes of $139,000, the Company had a $997,000 provision for income taxes due to income before income taxes earned in certain tax jurisdictions. For the three months ended September 30, 2004, the Company increased its valuation allowance by approximately $957,000 in the appropriate tax jurisdictions. For the nine-month period ended September 30, 2004, the Company generated income before taxes of $14.9 million, and reversed through the provision for income taxes approximately $754,000 of its valuation allowance in the appropriate tax jurisdictions. The Company will continue to evaluate its valuation allowance on a quarterly basis, and may in the future reverse some portion or all of its valuation allowance and recognize a reduction in income tax expense or increase its valuation allowance for previously unreserved assets and recognize an increase in income tax expense. A portion of the valuation allowance relates to the benefit from stock-based compensation. Any reversal of valuation allowance from this item will be reflected as an increase in additional paid in capital.

     When recording acquisitions, the Company has recorded valuation allowances due to the uncertainty related to the realization of certain deferred tax assets existing at the acquisition dates. For the three- and nine-month periods ended September 30, 2004, valuation allowances established in purchase accounting were reversed with a corresponding reduction in goodwill of approximately $545,000 and $3.1 million, respectively.

     STOCK-BASED COMPENSATION — At September 30, 2004, the Company had three active stock-based compensation plans, which are more fully described in Note 15 of the Company’s Form 10-K for the year ended December 31, 2003. During the second quarter of 2004, by resolution of the Company’s board of directors, the Company terminated its 2002 and 2001 Employee Stock Option Plans. Existing stock options outstanding under the 2002 and 2001 Employee Stock Option Plans remain outstanding according to their original terms. The Company accounts for employee stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. With the exception of certain options granted in 1999 and 2000 by a shareholder of Sekidenko prior to its acquisition by the Company (which was accounted for as a pooling of interests), all options granted under these plans have an exercise price equal to the market value of the underlying common stock on the date of grant, therefore no stock-based compensation cost is reflected in

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the Company’s net (loss) income. The stock options granted by a shareholder of Sekidenko resulted in deferred compensation that was being recognized as the options vested. The options fully vested during the first quarter of 2004.

     Had compensation cost for the Company’s plans been determined consistent with the fair value-based method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net (loss) income would have changed as indicated below:

     Compensation expense for the three-month and nine-month periods ended September 30, 2004 and 2003 are presented prior to income tax effects due to the Company recording valuation allowances against certain deferred tax assets in 2003 (see Income Taxes). Cumulative compensation cost recognized with respect to options that are forfeited prior to vesting is reflected as a reduction of compensation expense in the period of forfeiture. Compensation expense related to awards granted under the Company’s Employee Stock Purchase Plan (“ESPP”) is estimated until the period in which settlement occurs, as the number of shares of common stock awarded and purchase price are not known until settlement.

     For SFAS No. 123 purposes, the fair value of each option grant and purchase right granted under the ESPP are estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

     Based on the Black-Scholes option pricing model, the weighted-average estimated fair value of employee stock option grants was $6.01 and $10.35 for the three months ended September 30, 2004 and

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2003, respectively, and was $9.23 and $6.86 for the nine months ended September 30, 2004 and 2003, respectively. The weighted-average estimated fair value of purchase rights granted under the ESPP was $5.10 and $4.74 for the three months ended September 30, 2004 and 2003, respectively, and was $5.26 and $4.71 for the nine months ended September 30, 2004 and 2003, respectively.

     WARRANTY POLICY — The Company offers warranty coverage for its products for periods ranging from 12 to 60 months after shipment, with the majority of its products ranging from 18 to 24 months. The Company estimates the anticipated costs of repairing products under warranty based on the historical cost of the repairs and expected failure rates. The assumptions used to estimate warranty accruals are reevaluated periodically in light of actual experience and, when appropriate, the accruals are adjusted. The Company’s determination of the appropriate level of warranty accrual is subjective and based on estimates. The industries in which the Company operates are subject to rapid technological change and, as a result, the Company periodically introduces newer, more complex products, which tend to result in increased warranty costs. Estimated warranty costs are recorded at the time of sale of the related product, and are considered a cost of sales. The Company recorded warranty charges of $2.2 million and $2.1 million for the three months ended September 30, 2004 and 2003, respectively, and $7.7 million and $5.8 million for the nine months ended September 30, 2004 and 2003, respectively.

     The following table summarizes the activity in our warranty reserve during the three- and nine-month periods ended September 30, 2004 and 2003:

     RESTRUCTURING COSTS — Restructuring charges include the costs associated with actions taken by the Company in response to general economic and industry downturns and as a result of the ongoing execution of the Company’s strategy, primarily the continued expansion of the Company’s Shenzhen, China manufacturing facility. These charges consist of costs that are incurred to exit an activity or cancel an existing contractual obligation, including the closure of facilities and employee termination related charges.

     In the first and second quarters of 2004, the Company recorded restructuring charges of $220,000 and $187,000, respectively, which primarily consisted of the recognition of expense for involuntary employee termination benefits associated with the headcount reduction of approximately 34 and 12 employees, respectively, in the Company’s U.S. operations. All effected employees were terminated prior to the respective quarter ends. In the third quarter of 2004, the Company recorded restructuring charges of $88,000 consisting of the recognition of expense for involuntary employee termination benefits associated with headcount reduction of 4 employees in the U.S. operations and facility closure costs. Additionally, in the third quarter, the Company reversed $253,000 of previously recorded charges due to variances from the original estimates used to establish the Company’s reserve.

     At September 30, 2004, and December 31, 2003, outstanding restructuring liabilities were approximately $1.2 million and $3.2 million, respectively, and are included in other accrued expenses in the accompanying condensed consolidated balance sheets.

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     The following table summarizes the components of the restructuring charges, the payments and non-cash charges, and the remaining accrual as of September 30, 2004:

     FOREIGN CURRENCY TRANSLATION — The functional currency of the Company’s foreign subsidiaries is their local currency, with the exception of the Company’s manufacturing facility in Shenzhen, China where the United States dollar is the functional currency. Assets and liabilities of international subsidiaries are translated to United States dollars at period-end exchange rates, and statement of operations activity and cash flows are translated at average exchange rates during the period. Resulting translation adjustments are recorded as a separate component of stockholders’ equity.

     Transactions denominated in currencies other than the local currency are recorded based on exchange rates at the time such transactions arise. Subsequent changes in exchange rates result in foreign currency transaction gains and losses which are reflected in income as unrealized (based on period end translation) or realized (upon settlement of the transactions). Unrealized transaction gains and losses applicable to permanent investments by the Company in its foreign subsidiaries are included as cumulative translation adjustments, and unrealized translation gains or losses applicable to non-permanent intercompany receivables from or payables to the Company and its foreign subsidiaries are included in income.

     The Company recognized foreign currency gains of $354,000 and $290,000 for the three-month periods ended September 30, 2004 and 2003, respectively, and gains of $434,000 and $299,000 for the nine-month periods ended September 30, 2004 and 2003, respectively.

     EARNINGS PER SHARE — Basic Earnings Per Share (“EPS”) is computed by dividing income (loss) available to common stockholders by the weighted-average number of common shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS except that the numerator is increased to exclude certain charges which would not have been incurred, and the denominator is increased to include the number of additional common shares that would have been outstanding (using the if-converted and treasury stock methods), if securities containing potentially dilutive common shares (convertible notes payable and stock options) had been converted to such common shares, and if such assumed conversion is dilutive. For the three and nine months ended September 30, 2004 and 2003, certain stock options outstanding and the conversion of the Company’s convertible subordinated notes payable were not included in this calculation because to do so would be anti-dilutive. Due to the Company’s net loss for the three months ended September 30, 2004 and for the three and nine months ended September 30, 2003, basic and diluted EPS are the same, as the assumed conversion of all potentially dilutive securities would be anti-dilutive. Potential shares of common stock issuable under options and warrants for common stock at September 30, 2004 and 2003 were approximately 4.6 million and 4.1 million, respectively. Potential shares of common stock issuable upon conversion of the Company’s convertible subordinated notes payable were 5.4 million at September 30, 2004 and 2003.

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     The following is a reconciliation of the numerators and denominators used in the calculation of basic and diluted EPS for the three and nine months ended September 30, 2004 and 2003:

     RECLASSIFICATIONS — Certain prior period amounts have been reclassified to conform to the current period presentation.

(2) MARKETABLE SECURITIES

     Marketable securities consisted of the following:

     These marketable securities are classified as available-for-sale and are stated at period end market value. The commercial paper consists of high credit quality, short-term preferreds with maturities or reset dates of approximately 120 days.

(3) ACCOUNTS RECEIVABLE

     Accounts receivable consisted of the following:

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(4) INVENTORIES

     Inventories include costs of materials, direct labor and manufacturing overhead. Inventories are stated at the lower of cost or market, computed on a first-in, first-out basis and are presented net of reserves for obsolete and excess inventory. Inventory is written down or written off when it becomes obsolete, generally because of engineering changes to a product or discontinuance of a product line, or when it is deemed excess. These determinations involve the exercise of significant judgment by management, and as demonstrated in recent periods, demand for the Company’s products is volatile and changes in expectations regarding the level of future sales can result in substantial charges against earnings for obsolete and excess inventory. Inventories, net consisted of the following:

(5) STOCKHOLDERS’ EQUITY

     Stockholders’ equity consisted of the following:

(6) COMPREHENSIVE (LOSS) INCOME

     Comprehensive (loss) income for the Company consists of net (loss) income, foreign currency translation adjustments and net unrealized holding (loss) gains on available-for-sale marketable securities as presented below (in thousands):

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(7) CONVERTIBLE SUBORDINATED NOTES PAYABLE

     The Company has approximately $121.5 million of 5.0% convertible subordinated notes outstanding (“5.0% Notes”). These notes mature September 1, 2006, with interest payable on March 1st and September 1st of each year. At September 30, 2004, approximately $506,000 of interest expense related to the 5.0% Notes was accrued as a current liability.

     The Company has approximately $66.2 million of 5.25% convertible subordinated notes outstanding (“5.25% Notes”). These notes mature November 15, 2006, with interest payable on May 15th and November 15th each year. At September 30, 2004, approximately $1.3 million of interest expense related to the 5.25% Notes was accrued as a current liability.

(8) COMMITMENTS AND CONTINGENCIES

     The Company has committed to purchase approximately $12.8 million of parts, components and subassemblies from various suppliers, contingent upon the Company terminating business with such suppliers. These inventory purchase obligations consist of minimum purchase commitments to ensure the Company has an adequate supply of critical components to meet the demand of its customers.

DISPUTES AND LEGAL ACTIONS

     The Company is involved in disputes and legal actions arising in the normal course of its business. Currently and historically, the Company’s most significant legal actions have involved the application of patent law to complex technologies and intellectual property. The determination of whether such technologies infringe upon the Company’s or others’ patents is highly subjective. This high level of subjectivity introduces substantial additional risk with regard to the outcome of the Company’s disputes and legal actions related to intellectual property. While the Company currently believes that the amount of any ultimate potential loss for currently-known matters would not be material to the Company’s financial position, the outcome of these actions is inherently difficult to predict. In the event of an adverse outcome, the ultimate potential loss could have a material adverse effect on the Company’s financial position or reported results of operations in a particular period. An unfavorable decision, particularly in patent litigation, could require material changes in production processes and products or result in the Company’s inability to ship products or components found to have violated third-party patent rights. The Company accrues loss contingencies in connection with its litigation when it is probable that a loss will occur and the amount of the loss can be reasonably estimated.

     In April 2003, the Company filed a claim in the United States District Court for the District of Colorado seeking a declaratory ruling that its new plasma source products Xstream™ With Active Matching Network™ (“Xstream Products”) are not in violation of U.S. Patents held by MKS Instruments, Inc. (“MKS”). This case was transferred by the Colorado court to the United States District Court for the District of Delaware for consolidation with a patent infringement suit filed in that court by MKS in May 2003, alleging that the Company’s Xstream Products infringe five patents held by MKS. On July 23, 2004, a jury returned a verdict of infringement of three MKS patents, which did not stipulate damages. The court has not enjoined the Company from selling the Xstream Products. The Company has filed to have the verdict set aside based upon defects in the trial, along with additional grounds for post-trial relief from the verdict. The Company also intends to assert vigorously its remaining defenses against the MKS complaint that have not yet been heard by the court. Potential liability, if any, resulting from the jury verdict is indeterminable at this time, and therefore no amount has been accrued by the Company in the accompanying condensed consolidated financial statements.

     On June 2, 2004, MKS filed a petition in the District Court in Munich, Germany, alleging infringement by the Company’s Xstream Products of a counterpart German patent owned by MKS. On August 4, 2004, the German court dismissed MKS’s petition and assessed costs of the proceeding against MKS. MKS has refiled an infringement petition in the district court of Mannheim, which the Company will vigorously oppose.

     On July 12, 2004, the Company filed a complaint in the United States District Court for the District of Delaware against MKS alleging that MKS’s Astron reactive gas source products infringe Advanced

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Energy’s U.S. Patent No. 6,046,546. Trial has been tentatively scheduled for early 2006. Advanced Energy intends to enforce vigorously its intellectual property rights in this action.

     On September 17, 2001, Sierra Applied Sciences, Inc. (“Sierra”) filed for declaratory judgment asking the U.S. District Court for the District of Colorado to rule that its products did not infringe the Company’s U.S. patent no. 5,718,813 and that the patent was invalid. On March 24, 2003, the Court granted the Company’s motion to dismiss the case for lack of subject matter jurisdiction. The Court of Appeals for the Federal Circuit affirmed the dismissal on April 13, 2004 as to all of Sierra’s current activities, but remanded for findings related to past sales of older products. The case was settled and dismissed on September 2, 2004 under terms of a settlement agreement that provided for no monetary consideration to be paid by either party.

(9) FOREIGN OPERATIONS AND MAJOR CUSTOMERS

     The Company has operations in the U.S., Europe and Asia Pacific. The following is a summary of the Company’s operations by region:

     Intercompany sales among the Company’s geographic areas are recorded on the basis of intercompany prices established by the Company.

     Applied Materials, Inc. is the Company’s largest customer and accounted for 28% and 17% of the Company’s sales for the three months ended September 30, 2004 and 2003, respectively, and 29% and 19% of the Company’s sales for the nine months ended September 30, 2004 and 2003, respectively. Ulvac, Inc. accounted for 11% of the Company’s sales for the three months ended September 30, 2004 and less than 10% in previous quarters and for the nine months ended September 30, 2004. No other customer accounted for more than 10% of the Company’s sales during these periods.

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(10) SUPPLEMENTAL CASH FLOW DISCLOSURES

     In the first quarter of 2004, the Company made a strategic decision to further focus its marketing and product support resources on its core competencies and reorient its operating infrastructure towards sustained profitability. As a result, the Company sold its Noah chiller business to an unrelated third party for $797,000 in cash and a $1.9 million note receivable due March 31, 2009. The note bears interest at 5.0%, payable annually on March 31. The sale included property and equipment with a book value of approximately $300,000, inventory of approximately $1.0 million, goodwill and intangible assets net of accumulated amortization of approximately $900,000, demonstration and customer service equipment of approximately $140,000, and estimated warranty obligations of approximately $140,000. The Company recognized a gain on the sale of $404,000, which has been recorded as other income and expense in the accompanying condensed consolidated financial statements. In the third quarter of 2004, the Company purchased equipment of approximately $71,000 from the buyers of the Noah chiller assets in exchange for an equivalent reduction of the note receivable due March 31, 2009.

     In the second quarter of 2003, as part of the Company’s ongoing cost reduction measures, the Company committed to a plan to sell certain inventory and property and equipment assets to an unrelated third party at their respective net book values. These assets were primarily used in the manufacture of a component for the Company’s direct current and radio frequency products and were sold on June 30, 2003. In conjunction with the sale, the Company received approximately $1.6 million in cash and a short-term note receivable for approximately $1.5 million in exchange for inventory with a carrying value of approximately $2.1 million and property and equipment with a carrying value of approximately $1.0 million.

(11) SUBSEQUENT EVENT

     On October 21, 2004, the Company announced that its manufacturing facility in Fort Collins, Colorado will be realigned to focus on new product design and launch programs, integrated services, low volume legacy products, and advanced manufacturing processes. The volume product lines that are currently being manufactured in Fort Collins, Colorado will be transferred to the Shenzhen, China facility. The realignment of the Fort Collins facility is expected to be completed in the third quarter of 2005. Over the next year, we expect to incur severance costs of $2.5 million to $3.0 million associated with a headcount reduction of approximately 200 employees in Fort Collins. We also expect to consolidate facilities in Fort Collins, and incur facilities and related costs of approximately $1.5 million.

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

Special Note on Forward-Looking Statements

     The following discussion contains, in addition to historical information, forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Statements that are other than historical information are forward-looking statements. For example, statements relating to our beliefs, expectations and plans are forward-looking statements, as are statements that certain actions, conditions or circumstances will continue. Forward-looking statements involve risks and uncertainties, which are difficult to predict and many of which are beyond our control. These risks and uncertainties are described below and in other filings we make with the Securities and Exchange Commission, including our annual report on Form 10-K filed on February 24, 2004. As a result, our actual results may differ materially from the results discussed in the forward-looking statements. We assume no obligation to update any forward-looking statements or the reasons why our actual results might differ.

Risk and Uncertainties

     We have $187.7 million of convertible subordinated notes outstanding with maturity dates in the second half of 2006. Our current cash reserves are insufficient to repay this debt in full and there is no assurance that we will be able to internally generate sufficient cash from operations by the due dates. Refinancing of our debt obligations may require substantial dilution of our common shareholders equity.

     Our 5.0% convertible subordinated notes with a principal balance of $121.5 million are due September 1, 2006, and our 5.25% convertible subordinated notes with a principal balance of $66.2 million are due November 15, 2006. Our 5.0% notes are convertible into common stock at $29.83 per share. Our 5.25% notes are convertible into common stock at $49.53 per share. On November 1, 2004, the closing price of our common stock on the Nasdaq National Market was $10.01 per share.

     We will be required to repay the notes at maturity, unless we refinance the debt or our stock price rises sufficiently above the conversion levels. We might not be able to refinance the notes prior to their maturity on commercially favorable terms, or at all. Refinancing of our debt obligations may require substantial dilution of our common stockholders’ equity. Repayment of such notes at maturity, if we are required to do so, would have a significant impact on our cash available for operations. Our current cash reserves are insufficient to repay this debt in full and there is no assurance that we will be able to internally generate sufficient cash from operations by the due dates. If we are unable to generate sufficient additional cash from operations, through disposal of certain assets or from a capital offering prior to the maturity of the notes, we will be unable to repay the notes when they become due. If we are unable to repay the notes, the trustee of the notes will have the right to bring judicial proceedings against us to enforce the note

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holders’ rights, including the right to repayment prior and in preference to our common stockholders.

     The semiconductor and semiconductor capital equipment industries are highly cyclical, which impacts our operating results.

     The semiconductor and semiconductor capital equipment industries have historically been cyclical because of sudden changes in demand for semiconductors and manufacturing capacity. The rate of changes in demand, including end demand, is accelerating, and the effect of these changes is occurring sooner, exacerbating the volatility of these cycles. These changes affect the timing and amount of our customers’ equipment purchases and investments in new technology, as well as our costs and operations.

     During periods of declining demand for semiconductor equipment components, our customers typically reduce purchases, delay delivery of products and cancel orders. We might incur significant charges as we seek to align our cost structure with the reduction in sales. In addition, we might not be able to respond adequately or quickly enough to the declining demand. We may also be required to record significant reserves for excess and obsolete inventory as demand for our products changes. Our inability to reduce costs and the charges resulting from other actions taken in response to changes in demand for our products would adversely affect our operating results.

     During 2001, 2002 and much of 2003, the semiconductor capital equipment industry experienced the steepest cutback in capital equipment purchases in industry history. We experienced an increase in sales to semiconductor capital equipment manufacturers in the first half of 2004; however, this was followed by a decline in sales in the third quarter. We cannot be certain that this decline is not the beginning of a slowdown or prolonged downturn in the industry. A continued decline in the level of orders as a result of a slowdown or prolonged downturn in the semiconductor industry would harm our business, financial condition and results of operations.

     Our quarterly and annual operating results fluctuate significantly and are difficult to predict.

     Beginning in 2001 and through late 2003, demand for our products from the semiconductor capital equipment industry declined substantially from its peak in 2000, and we incurred significant losses each quarter from the second quarter of 2001 through the fourth quarter of 2003. We were able to generate net income of $11.4 million in the first six months of 2004 followed by a net loss of $1.1 million in the third quarter of 2004, due in part to the highly cyclical nature of the markets that we serve, particularly the semiconductor industry. Fluctuations in our operating results historically have resulted in corresponding changes in the market prices of our securities. Our operating results are affected by a variety of factors, many of which are beyond our control and difficult to predict. These factors include:

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•		Changes in economic conditions in the semiconductor and semiconductor capital equipment industries and other industries in which our customers operate;
•		The timing and nature of orders placed by our customers;
•		The seasonal variations in capital spending by our customers;
•		Changes in customers’ inventory management practices;
•		Customer cancellations of previously placed orders and shipment delays;
•		Pricing competition from our competitors;
•		Customer demands to reduce prices, enhance features, improve reliability, shorten delivery times and extend payment terms;
•		Component shortages or allocations or other factors that change our levels of inventory or substantially increase our spending on inventory or result in manufacturing delays;
•		The introduction of new products by us or our competitors;
•		Declines in macroeconomic conditions;
•		Potential litigation especially regarding intellectual property; and
•		Our exposure to currency exchange rate fluctuations between the several functional currencies in foreign locations in which we have operations.

     Our implementation of the requirements of Section 404 of the Sarbanes Oxley Act of 2002 has required us to commit significant financial resources and management time and attention. Nonetheless, we have determined that it is unlikely that we will be able to implement fully the requirements of Section 404 prior to the end of the current fiscal year.

     Section 404 of the Sarbanes Oxley Act of 2002 requires us to include in our Annual Report on Form 10-K for the year ending December 31, 2004, and subsequent annual reports, our management’s assessment as to the effectiveness of our internal controls over financial reporting. In addition, our independent auditors must report on management’s assessment and the adequacy of those controls. We are currently performing a comprehensive evaluation of our internal controls over financial reporting. We have identified areas that require remediation and have committed internal and external resources to those tasks. We have incurred, and continue to incur, significant expense to evaluate and remediate our internal controls over financial reporting. The evaluation and remediation process also has required, and continues to require, significant time and attention from our senior management. Despite these efforts, it is unlikely that the evaluation and remediation process will be completed in time for management and our independent auditors to perform sufficient testing to be able to satisfy the assessment and attestation requirements of Section 404 by December 31, 2004.

     If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, we may be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission or the Nasdaq National Market. Any such action could adversely affect our financial results and the market price of our common stock. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm the Company’s

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operating results, cause its failure to meet financial reporting obligations, limit the Company’s ability to raise capital through the public markets, lessen investor confidence and be ineffective in preventing fraud.

     We have invested significant human and financial resources to establish a manufacturing facility in Shenzhen, China and transition our supply base to Tier 1 Asian suppliers, but might not be able to achieve the intended benefits as quickly as anticipated, or at all.

     As part of our strategy to continually improve our operating cash flow, we are relying on lower labor and component costs associated with our China-based manufacturing facility, which was opened in April 2003, and our transition to Tier 1 Asian suppliers. By the end of 2004, we expect to have the operational capacity to produce approximately 70% of our Power and Flow Control manufacturing volume in Shenzhen, China based on current expected demand. Slower than expected customer acceptance; however, has resulted in our operating duplicate manufacturing facilities, which is negatively affecting our gross margin. This strategy involves significant risks, including:

•		Our customers may not accept products manufactured at our Chinese facility;
•		Certain major customers have strict “copy exact” requirements which may delay or prevent acceptance of lower-cost components from Tier 1 Asian suppliers;
•		We may not be able to attract and retain key personnel in our Chinese facility;
•		We may incur significant costs to test and repair products manufactured in our Shenzhen, China facility to mitigate the risk of shipping lower-quality products to our customers;
•		The Chinese government may allow the yuan to float against the U.S. dollar, which could significantly increase our operating costs; and
•		The transition may disrupt our United States employee base.

     In addition to these risks, we may not be able to comply successfully with China’s governmental regulations. The regulatory environment in China is evolving, and officials in the Chinese government often exercise discretion in deciding how to interpret and apply applicable regulations. Consequently, actions by Chinese governmental regulators may limit or adversely affect our ability to conduct business in China.

     Our inability to manage these risks among others could significantly impact our goal to improve our operating cash flow, as well as result in significant costs, expenditures, asset impairments and potentially damage our relationships with existing and prospective customers.

     Intellectual property rights are difficult to enforce in China.

     Commercial law in China is relatively undeveloped compared to the commercial law in the United States. Limited protection of intellectual property is available under

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Chinese law. Consequently, manufacturing our products in China may subject us to an increased risk that unauthorized parties may attempt to copy or otherwise obtain or use our intellectual property. We cannot assure you that we will be able to effectively protect our intellectual property rights or have adequate legal recourse in the event that we encounter difficulties with infringements of our intellectual property under Chinese law.

     We are highly dependent on our intellectual property and are exposed to various risks related to legal proceedings and claims.

     Our success depends significantly on our proprietary technology. We attempt to protect our intellectual property rights through patents and non-disclosure agreements; however, we might not be able to protect our technology, and competitors might be able to develop similar technology independently. In addition, the laws of some foreign countries might not afford our intellectual property the same protections as do the laws of the United States. Our intellectual property is not protected by patents in several countries in which we do business, and we have limited patent protection in other countries. If we are unable to successfully protect our intellectual property, our results of operations will be adversely affected.

     MKS Instruments, Inc. filed a patent infringement suit against us in the United States District Court in Wilmington, Delaware in May 2003, and a counterpart action in Germany in June 2004, alleging that our Xstream™ With Active Matching Network™ products infringe patents held by MKS. In July 2004, a jury returned a verdict of infringement of three MKS patents in the U.S. litigation, which did not stipulate damages. The court has not enjoined us from selling the Xstream Products. We have filed to have the verdict set aside based upon defects in the trial, along with additional grounds for post-trial relief from the verdict. We also intend to assert vigorously our remaining defenses against the MKS complaint that have not yet been heard by the court. On August 4, 2004 a German court dismissed an infringement action filed by MKS and assessed the costs of the proceeding against MKS; however, MKS has now refiled their claim in a different German court. In July 2004, we filed a patent infringement suit against MKS tentatively scheduled for trial in early 2006, and intend to enforce vigorously our own patent rights in this action. As a result of these claims and any other future litigation, we may incur litigation costs that are material to our financial condition and results of operations. Additionally, a final adverse determination in the MKS or any future litigation could cause us to lose proprietary rights, subject us to significant fines or liabilities to third parties, require us to seek licenses or alternative technologies from others or prevent us from manufacturing or selling our products and impact future revenue. Any of these events could adversely affect our business, financial condition and results of operations.

     A significant portion of our sales is concentrated among a few customers.

     Our ten largest customers accounted for 60% and 55% of our total sales during the three-month periods ended September 30, 2004 and 2003, respectively, and 60% and 53% for the nine-month periods ended September 30, 2004 and 2003, respectively. Our

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largest customer, Applied Materials, accounted for 28% and 17% of our total sales during the three-month periods ended September 30, 2004 and 2003, respectively, and 29% and 19% for the nine-month periods ended September 30, 2004 and 2003, respectively. Ulvac, Inc. accounted for 11% of our sales for the three months ended September 30, 2004 and less than 10% in all previous quarters. The loss of any of our significant customers or a material reduction in any of their purchase orders would significantly harm our business, financial condition and results of operations.

     Our customers continuously exert pressure on us to reduce our prices and extend payment terms. Given the nature of our customer base and the highly competitive markets in which we compete, we may be required to issue price concessions to our customers to remain competitive. A ten percent reduction in our historical selling prices could lead to a seven percent or greater decline in gross margin. We may not be able to reduce our other operating expenses in an amount sufficient to offset potential margin declines.

     Certain of our largest customers also exert pressure on us to restrict our product distribution including, limiting the sale of our products to certain original equipment manufacturers, based on shared technological development, and prohibiting sales to our end user customer base entirely. Given our size relative to certain of our largest customers, we may be required to agree to limitations of this nature to remain competitive. Such limitations of our customer base would significantly harm our business.

     The markets in which we operate are highly competitive.

     We face substantial competition, primarily from established companies, some of which have greater financial, marketing and technical resources than we do. Our primary competitors are Celerity Group, Inc.; Comdel; Daihen Corp.; Huettinger Elektronik GmbH; Kyosan Electric Manufacturing Co. Ltd.; MKS Instruments, Inc.; Mykrolis Corp.; Shindingen; and STEC, Inc., a Horiba Group Company. We expect that our competitors will continue to develop new products in direct competition with ours, improve the design and performance of their products and introduce new products with enhanced performance characteristics.

     To remain competitive, we must improve and expand our products and product offerings. In addition, we may need to maintain a high level of investment in research and development and expand our sales and marketing efforts, particularly outside of the United States. We might not be able to make the technological advances and investments necessary to remain competitive. Our inability to improve and expand our products and product offerings would have an adverse affect on our sales and results of operations.

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     We might not be able to compete successfully in international markets or meet the service and support needs of our international customers.

     For the three-month periods ended September 30, 2004 and 2003, our sales to customers outside the United States were approximately 47% and 57%, respectively, and for the nine-month periods ended September 30, 2004 and 2003, our sales to customers outside the United States were approximately 46% and 54%, respectively. Our success in competing in international markets is subject to our ability to manage various risks and difficulties, including, but not limited to:

•

Our ability to develop relationships with suppliers and other local businesses;

•

Compliance with product safety requirements and standards that are different from those of the United States;

•

Variations in enforcement of intellectual property and contract rights in different jurisdictions;

•

Trade restrictions, political instability, disruptions in financial markets and deterioration of economic conditions;

•

The ability to provide sufficient levels of technical support in different locations;

•

Collecting past due accounts receivable from foreign customers; and

•

Changes in tariffs, taxes and foreign currency exchange rates.

     Our ability to implement our business strategies and maintain market share will be compromised if we are unable to manage these and other international risks successfully.

     Component shortages exacerbated by our dependence on sole and limited source suppliers could affect our ability to manufacture products and systems and could delay our shipments.

     Our business depends on our ability to manufacture products that meet the rapidly changing demands of our customers. Our ability to manufacture depends in part on the timely delivery of parts, components and subassemblies from suppliers. We rely on sole and limited source suppliers for some of our parts, components and subassemblies that are critical to the manufacturing of our products. This reliance involves several risks, including the following:

•

The potential inability to obtain an adequate supply of required parts, components or subassemblies;

•

The potential for a sole source provider to cease operations;

•

Our potential need to fund the operating losses of a sole source provider;

•

Reduced control over pricing and timing of delivery of parts, components and subassemblies; and

•

The potential inability of our suppliers to develop technologically advanced products to support our growth and development of new products.

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     If we are unable to successfully qualify additional suppliers and manage relationships with our existing and future suppliers, we will experience shortages of parts, components or subassemblies, increased material costs and shipping delays for our products, which will adversely affect our results of operations and relationships with current and prospective customers.

     We must achieve design wins to retain our existing customers and to obtain new customers.

     The constantly changing nature of semiconductor fabrication technology causes equipment manufacturers to continually design new systems. We must work with these manufacturers early in their design cycles to modify our equipment or design new equipment to meet the requirements of their new systems. Manufacturers typically choose one or two vendors to provide the components for use with the early system shipments. Selection as one of these vendors is called a design win. It is critical that we achieve these design wins in order to retain existing customers and to obtain new customers.

     Once a manufacturer chooses a component for use in a particular product, it is likely to retain that component for the life of that product. Our sales and growth could experience material and prolonged adverse effects if we fail to achieve design wins. However, design wins do not always result in substantial sales or profits.

     We believe that equipment manufacturers often select their suppliers based on factors such as long-term relationships. Accordingly, we may have difficulty achieving design wins from equipment manufacturers who are not currently customers. In addition, we must compete for design wins for new systems and products of our existing customers, including those with whom we have had long-term relationships. If we are not successful in achieving design wins our sales and results of operations will be adversely impacted.

     Our success depends upon our ability to attract and retain key personnel.

     Our success depends in large part upon our ability to attract, retain and motivate key employees, including our senior management team and our technical, marketing and sales personnel. We do not have employment agreements with any of our executive officers or other key employees. These employees may voluntarily terminate their employment with us at any time. The process of hiring employees with the combination of skills and attributes required to carry out our strategy can be extremely competitive and time consuming. We may not be able to successfully retain existing personnel or identify, hire and integrate new personnel. If we lose the services of key personnel for any reason, including retirement, or are unable to attract additional qualified personnel, our business, financial condition and results of operations will be adversely affected. Additionally, we do not maintain key-person life insurance policies on our executive officers.

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     Warranty costs on certain products may be in excess of historical experience.

In recent years, we have experienced higher than expected levels of warranty costs on certain products. We have been required to repair, rework and, in some cases, replace these products. Our warranty costs generally increase when we introduce newer, more complex products. We recorded warranty expense of approximately $2.2 million and $2.1 million for the three-month periods ended September 30, 2004 and 2003, respectively, and $7.7 million and $5.8 million for the nine-month periods ended September 30, 2004 and 2003, respectively. These charges represented approximately 2.4% and 3.1% of sales for the three months ended September 30, 2004 and 2003, respectively, and 2.5% and 3.1% of sales for the nine months ended September 30, 2004 and 2003, respectively. If such levels of warranty costs persist or increase in the future, our financial condition and results of operations will be adversely affected.

     We are subject to numerous governmental regulations.

     We are subject to federal, state, local and foreign regulations, including environmental regulations and regulations relating to the design and operation of our products and control systems. We might incur significant costs as we seek to ensure that our products meet safety and emissions standards, many of which vary across the states and countries in which our products are used. In the past, we have invested significant resources to redesign our products to comply with these directives. We believe we are in compliance with current applicable regulations, directives and standards and have obtained all necessary permits, approvals and authorizations to conduct our business. However, compliance with future regulations, directives and standards could require us to modify or redesign some products, make capital expenditures or incur substantial costs. If we do not comply with current or future regulations, directives and standards:

•

We could be subject to fines;

•

Our production could be suspended; or

•

We could be prohibited from offering particular products in specified markets.

     Our inability to comply with current or future regulations, directives and standards will adversely affect our operating results.

     Our Chief Executive Officer owns a significant percentage of our outstanding common stock, which could enable him to control our business and affairs.

     Douglas S. Schatz, our Chief Executive Officer, owned approximately 33% of our common stock outstanding as of November 1, 2004. This stockholding gives Mr. Schatz significant voting power. Depending on the number of shares that abstain or otherwise are not voted on a particular matter, Mr. Schatz may be able to elect all of the members of our board of directors and to control our business affairs for the foreseeable future in a manner with which our stockholders may not agree.

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Critical Accounting Policies

     The following discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. In preparing our financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

     We believe that the following critical accounting policies, as discussed in our Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on February 24, 2004, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

•

Valuation of intangible assets and goodwill

•

Long-lived assets including intangible assets subject to amortization

•

Reserve for excess and obsolete inventory

•

Reserve for warranty

•

Commitments and contingencies

•

Revenue recognition

•

Stock-based compensation

•

Deferred income taxes

  OVERVIEW

     We design, manufacture and support a group of key components and subsystems primarily for vacuum process systems. Our primary products are complex power conversion and control systems used primarily in deposition or etch processes. Our products also control the flow of gases into the process chambers, provide thermal sensing within the chamber, deposit and clean the chamber. Our customers use our products in plasma-based thin-film processing equipment that is essential to the manufacture of, among other things:

•

Semiconductor devices for electronics applications;

•

Flat-panel displays for hand-held devices and computer and television screens;

•

Compact discs, DVDs and other digital storage media;

•

Optical coatings for architectural glass, eyeglasses and solar panels; and

•

Industrial laser and medical applications.

     We also sell spare parts and repair services worldwide through our customer service and technical support organization.

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     We provide solutions to a diversity of markets and geographic regions. However, we are focused on the semiconductor capital equipment industry, which accounted for approximately 61% and 56% of our sales in the three-month periods ended September 30, 2004 and 2003, respectively, and 64% and 58% in the nine-month periods ended September 30, 2004 and 2003, respectively. Future sales to the semiconductor capital equipment industry may represent approximately 55% to 70% of our total revenue, depending upon the strength or weakness of industry cycles.

     In mid 2003, the semiconductor capital equipment industry entered the early stages of a return to higher product demand, and in the first half of 2004, we generated net income of approximately $11.4 million on sales of $213.4 million. In the third quarter of 2004, we generated a net loss of $1.1 million on sales of $93.6 million. Our third quarter fall in sales was caused by a significant decline in demand in this industry, the extent and duration of which cannot be predicted.

     In effort to streamline operations, reduce manufacturing and repair costs and strengthen our long-term competitive position, in April 2003 we opened our 88,000 square-foot manufacturing facility in Shenzhen, China to be our high volume manufacturing location, which has been subsequently expanded to 100,200 square feet. By the end of 2004, we expect to have the operational capacity to produce 70% of our Power and Flow Control manufacturing volume in Shenzhen, China, based on current expected demand. On October 21, 2004, we announced that our manufacturing facility in Fort Collins, Colorado will be realigned to focus on new product design and launch programs, integrated services, low volume legacy products, and advanced manufacturing processes. The volume product lines that are currently being manufactured in Fort Collins, Colorado will be transferred to the Shenzhen, China facility. The realignment of the Fort Collins facility is expected to be completed in the third quarter of 2005. Over the next year, we expect to incur severance costs of $2.5 million to $3.0 million associated with a headcount reduction of approximately 200 employees in Fort Collins. We also expect to consolidate facilities in Fort Collins, and incur facilities and related costs of approximately $1.5 million. Once the transition has been completed, nearly all of our manufacturing volume will be produced in Shenzhen, China, which will reduce redundancies that have contributed to high labor and overhead expenses experienced during the past year.

     We plan to transition approximately 50% of our raw material purchasing to Tier 1 Asian suppliers by the end of 2004. Our biggest obstacle in our Tier 1 supplier initiative is complying with certain major customers’ stringent “copy exact” requirements. We are working closely with our largest original equipment manufacturers, or OEM’s, to ensure the transition proceeds on schedule. However, our transition goals may prove difficult to realize because of customer needs and product mix. This program ties in well with the ongoing transition to China manufacturing, as it is expected to increase the operating efficiencies in Shenzhen, China by synchronizing our product and supply base transfers to Asia.

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     Management is focused on improving gross and operating margins and believes that as the transition to China-based manufacturing and shift to Tier 1 suppliers progresses further our margins will improve. However, with continued competitive pricing pressures a return to historic gross and operating margin levels will be difficult to achieve.

Results of Operations

  SALES

     The following tables summarize our unaudited net sales and percentages of net sales by customer type for the three- and nine-month periods ended September 30, 2004 and 2003:

     The following tables summarize our unaudited net sales and percentages of net sales by geographic region for the three- and nine-month periods ended September 30, 2004 and 2003:

     Sales were $93.6 million in the third quarter of 2004 and $68.6 million in the third quarter of 2003, representing an increase of 36%. Sales were $306.9 million in the first nine months of 2004 and $187.7 million in the first nine months of 2003, representing an increase of 64%.

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     According to a leading industry research firm, sales of semiconductor capital equipment have grown at a compounded annual growth rate in excess of 11% over the past 30 years. However, the industry is highly cyclical and is impacted by changes in the macroeconomic environment, changes in semiconductor supply and demand and rapid technological advances in both semiconductor devices and wafer fabrication processes. Our sales to the semiconductor capital equipment industry increased by approximately 50% from the third quarter of 2003 to the third quarter of 2004, and 80% from the first nine months of 2003 to the first nine months of 2004, primarily driven by the recovery of the semiconductor and semiconductor capital equipment industries experienced primarily in the first half of 2004. Sales to our largest semiconductor capital equipment customers represented the majority of the increased sales volume.

     Applied Materials, Inc. is our largest customer and accounted for 28% and 17% of our sales for the three months ended September 30, 2004 and 2003, respectively, and 29% and 19% of our sales for the nine months ended September 30, 2004 and 2003, respectively. Ulvac, Inc. accounted for 11% of our sales for the three months ended September 30, 2004 and less than 10% in previous quarters and for the nine months ended September 30, 2004. No other customer accounted for more than 10% of our sales during these periods.

     Our sales to the flat panel display and advanced product applications markets increased by 89% and 22%, respectively, from the third quarter of 2003 to the third quarter of 2004, and increased by 94% and 29%, respectively, from the nine months ended September 30, 2003 to the nine months ended September 30, 2004, respectively. This growth is primarily attributed to order trends and the general expansion of end customer products including large flat panel displays, liquid crystal displays and applications dependent upon industrial coatings. Sales to the data storage market decreased 37% from the third quarter of 2003 to the third quarter of 2004, due to an earlier drop off in holiday season sales. Sales to this market increased by 14% from the nine months ended September 30, 2003 to the nine months ended September 30, 2004 attributable to the general expansion of the market.

     Looking forward to the remainder of 2004, there is no assurance that our revenue will remain consistent with, or increase from, the levels experienced during the three- and nine-month periods ended September 30, 2004. Changes in the macroeconomic environment, semiconductor supply and demand, and other changes that are beyond our control introduce significant uncertainty into our forecasts. Our average selling prices may also decline across all of our markets due to cost reduction initiatives by our major customers.

  GROSS MARGIN

     Our gross margin was 31.8% and 33.7% in the third quarters of 2004 and 2003, respectively. The decline from the 2003 period to the 2004 period is primarily due to product mix and duplicative costs associated with our China-based manufacturing

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facility. Our gross margin was 34.3% and 32.7% for the nine months ended September 30, 2004 and 2003, respectively. This increase in gross margin is primarily due to increased absorption of overhead due to the higher sales volumes offset by a relatively unfavorable product mix and the impact of the duplicative manufacturing facility costs. We have experienced higher demand for two specific product groups that currently have lower gross margin than our corporate average. These product lines are in transition to Shenzhen, China and other cost reduction initiatives are in place to mitigate their impact in the future. In addition to operating duplicative manufacturing facilities, the transition of a portion of our manufacturing capacity to Shenzhen, China has also required us to maintain redundant management and procurement teams, which during the 2004 periods negatively impacted our gross margin.

     While we expect the transition of the majority of our volume manufacturing to Shenzhen, China and our move to Tier 1 Asian suppliers will improve our gross margins in future periods, factors that could cause our margins to be negatively impacted include, but are not limited to the following:

•

Continued pricing pressure from our major customers;

•

Costs associated with transitioning a portion of our production to our Shenzhen, China facility, including costs incurred to operate duplicate manufacturing facilities;

•

Costs associated with refocusing the Fort Collins manufacturing facility on new product design and launch programs, integrated services, low volume legacy products, and advanced manufacturing processes

•

Unanticipated costs to comply with our customers’ “copy exact” requirements, especially related to our China transition and move to Tier 1 Asian suppliers;

•

Cost reduction programs initiated by semiconductor manufacturers and semiconductor capital equipment manufacturers that negatively impact our average selling price;

•

Warranty costs in excess of historical rates and our expectations;

•

Increased levels of excess and obsolete inventory, either due to market conditions, the introduction of new products by our competitors, or our decision to discontinue certain product lines;

•

Under absorption of overhead due to declining sales levels; and

•

Changes in foreign currency exchange rates that might affect our costs.

     Our warranty charges for the three months ended September 30, 2004 and 2003 were approximately $2.2 million and $2.1 million, respectively. Our warranty charges for the nine months ended September 30, 2004 and 2003 were $7.7 million and $5.8 million, respectively. These charges represented approximately 2.4% and 3.1% of sales for the three months ended September 30, 2004 and 2003, respectively, and 2.5% and 3.1% of sales for the nine months ended September 30, 2004 and 2003, respectively.

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  RESEARCH AND DEVELOPMENT EXPENSES

     The market for our subsystems for vacuum process systems and related accessories is characterized by ongoing technological changes. We believe that continued and timely development of new products and enhancements to existing products to support OEM requirements is necessary for us to maintain a competitive position in the markets we serve. Accordingly, we devote a significant portion of our personnel and financial resources to research and development projects and seek to maintain close relationships with our customers and other industry leaders in order to remain responsive to their product requirements. We believe that the continued investment in research and development and ongoing development of new products are essential to the expansion of our markets, and expect to continue to make significant investments in research and development activities. Since our inception, all of our research and development costs have been expensed as incurred.

     Our research and development expenses were $12.6 million and $13.0 million for the three months ended September 30, 2004 and 2003, respectively, and were $38.8 million and $38.9 million for the nine months ended September 30, 2004 and 2003, respectively. As a percentage of sales, research and development expenses decreased from 18.9% for the three months ended September 30, 2003 to 13.4% for the three months ended September 30, 2004, and from 20.7% for the nine months ended September 2003 to 12.6% for the nine months ended September 30, 2004, primarily due to the higher sales base. We expect our research and development expenses for the fourth quarter of 2004 to be in line with the first three quarters of 2004.

  SALES AND MARKETING EXPENSES

     We constantly monitor our sales and marketing levels to meet current industry conditions. Our sales and marketing expenses support domestic and international sales and marketing activities that include personnel, trade shows, advertising, and other selling and marketing activities.

     Sales and marketing expenses were $8.3 million and $7.3 million for the three months ended September 30, 2004 and 2003, respectively. For the nine months ended September 30, 2004 and 2003, sales and marketing expenses were $24.4 million and $23.9 million, respectively. As a percentage of sales, sales and marketing expenses decreased from 10.7% for the three months ended September 30, 2003 to 8.9% for the three months ended September 30, 2004, and from 12.7% for the nine months ended September 30, 2003 to 7.9% for the nine months ended September 30, 2004, due to the higher sales base. We expect our sales and marketing expenses for the fourth quarter to be in line with the first three quarters of 2004.

  GENERAL AND ADMINISTRATIVE EXPENSES

     Our general and administrative expenses support our worldwide corporate, legal, patent, tax, financial, corporate governance, administrative, information systems and

31

human resource functions in addition to our general management. General and administrative expenses were $7.1 million for the three months ended September 30, 2004, and $6.3 million for the three months ended September 30, 2003. General and administrative expenses were $21.3 million in the first nine months of 2004 and $17.5 million in the first nine months of 2003. The 12.6% and 21.7% increases in general and administrative expenses from the three- and nine-month periods in 2003 to the comparable periods in 2004, respectively, were primarily due to legal fees associated with our ongoing patent litigation, increased health insurance premiums, costs associated with the Company’s efforts to comply with the Section 404 internal control requirements of the Sarbanes-Oxley Act of 2002 and salary increases. As a percentage of sales, general and administrative expenses decreased from 9.2% for the three months ended September 30, 2003 to 7.6% for the three months ended September 30, 2004, and from 9.3% for the nine months ended September 30, 2003 to 6.9% for the nine months ended September 30, 2004 due to the higher sales base. We expect our general and administrative expenses to decrease slightly in the fourth quarter from the first three quarters of 2004 due to a reduction in the legal fees associated with our ongoing patent litigation offset in part by the Company’s continued efforts to comply with the Section 404 internal control requirements of the Sarbanes-Oxley Act of 2002.

  RESTRUCTURING CHARGES

     At the end of 2002, we announced major changes in our operations, including the establishment of a manufacturing location in Shenzhen, China, consolidating worldwide sales forces, a move to Tier 1 suppliers, primarily in Asia, and the intention to close or sell certain facilities. The Company recorded charges totaling approximately $1.5 million in the first quarter of 2003 primarily associated with manufacturing and administrative personnel headcount reductions in the Company’s Japanese operations. In accordance with Japanese labor regulations the Company offered voluntary termination benefits to all of its Japanese employees. The voluntary termination benefits were accepted by 36 employees prior to March 31, 2003, with termination dates in the second quarter of 2003. All termination benefits were paid in the second quarter of 2003.

     In the second quarter of 2003, the Company recognized charges that consisted primarily of the involuntary termination of 55 manufacturing and administrative personnel in the Company’s U.S. operations. Certain of the employees were terminated and paid prior to the end of the second quarter of 2003, which resulted in restructuring charges totaling approximately $768,000 for the three months ended June 30, 2003. In addition, certain employees were required to render service beyond a minimum retention period (generally 60 days). In accordance with SFAS No. 146, the Company measured the termination benefits at the communication date, but approximately $170,000 was recognized as expense during the third quarter of 2003, and approximately $170,000 was recognized as expense in the fourth quarter of 2003 as these employees completed their service requirement.

     The Company also recognized charges of approximately $1.0 million in the third quarter of 2003 that consisted primarily of the recognition of expense for involuntary

32

employee termination benefits associated with the Company’s second quarter headcount reduction, asset impairments incurred as a result of exiting its Longmont, Colorado manufacturing facilities, and the involuntary termination of 20 employees in the third quarter of 2003.

     In the first, second and third quarters of 2004, we recorded restructuring charges of approximately $220,000, $187,000 and $88,000, respectively, primarily consisting of the recognition of expense for involuntary employee termination benefits associated with the headcount reduction in our U.S. operations of 34, 12 and 4 employees, respectively. These employees were terminated prior to the respective quarter ends. Additionally, in the third quarter, the Company reversed $253,000 of previously recorded charges due to variances from the original estimates used to establish the Company’s reserve.

     On October 21, 2004, we announced that our manufacturing facility in Fort Collins, Colorado will be realigned to focus on new product design and launch programs, integrated services, low volume legacy products, and advanced manufacturing processes. The volume product lines that are currently being manufactured in Fort Collins, Colorado will be transferred to the Shenzhen, China facility. The realignment of the Fort Collins facility is expected to be completed in the third quarter of 2005. Over the next year, we expect to incur severance costs of $2.5 million to $3.0 million associated with a headcount reduction of approximately 200 employees in Fort Collins. We also expect to consolidate facilities in Fort Collins, and incur facilities and related costs of approximately $1.5 million. Once the transition has been completed, nearly all of our manufacturing volume will be produced in Shenzhen, which will reduce redundancies that have contributed to high labor and overhead expenses experienced during the past year.

  INTANGIBLE ASSET IMPAIRMENT

     During the third quarter of 2003, we determined that one of our mass flow controller products would require a significant technological investment in order to conform to changing customer technologies which would enable it to be accepted by the semiconductor capital equipment industry. As a result, we performed an assessment of the carrying value of the related intangible asset. This assessment consisted of estimating the intangible asset’s fair value and comparing the estimated fair value to the carrying value of the asset. We estimated the intangible asset’s fair value using a cash flow model assuming the technological investment was made, discounted at rates consistent with the risk of the related cash flow, and applying a hypothetic royalty rate to the projected revenue stream. Based on this analysis we determined that the fair value of the intangible asset was minimal and recorded an impairment of the carrying value of approximately $1.2 million, which has been reported as an intangible asset impairment in the accompanying condensed consolidated financial statements.

     During the fourth quarter of 2004, we will perform our annual goodwill impairment test in accordance with the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”

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     OTHER INCOME (EXPENSE)

     Other income (expense) consists primarily of interest income and expense, foreign exchange gains and losses and other miscellaneous gains, losses, income and expense items.

     Interest income was approximately $414,000 in the third quarter of 2004 and $358,000 in the third quarter of 2003. Interest income was approximately $1.2 million in the first nine months of 2004 and $1.3 million in the first nine months of 2003. Interest income is fairly comparable for these periods as our lower level of cash available for investment is being offset by increased interest rates.

     Interest expense consists principally of interest on our convertible subordinated notes, on borrowings under capital lease facilities and senior debt, and amortization of our deferred debt issuance costs, and therefore is not expected to fluctuate significantly. Interest expense was approximately $2.7 million and $2.8 million for the third quarter of 2004 and 2003, respectively, and $8.3 million and $8.4 million for the first nine months of 2004 and 2003, respectively.

     Our foreign subsidiaries’ sales are primarily denominated in currencies other than the U.S. dollar. We recorded net foreign currency gains of $354,000 and $290,000 in the third quarter of 2004 and 2003, respectively. We recorded net foreign currency gains of $434,000 and $299,000 for the first nine months of 2004 and 2003, respectively.

     Other income was $1.1 million for the first nine months of 2004, consisting primarily of the sale of a portion of a marketable equity security for a gain of $703,000 and the sale of our Noah chiller business for a gain of $404,000. Other expense was $529,000 for the first nine months of 2003.

     PROVISION FOR INCOME TAXES

     The income tax provision for the three- and nine-month periods ended September 30, 2004 was $997,000 and $4.6 million, respectively. Such provisions are generally attributed to taxable income generated in certain jurisdictions. The income tax provision for the three- and nine-month periods ended September 30, 2003 was $19.4 million and $11.0 million, respectively.

     During the third quarter of 2003, we recorded valuation allowances against certain of our United States and foreign net deferred tax assets in jurisdictions where we have incurred significant losses. Given such experience, management could not conclude that it was more likely than not that these net deferred tax assets would be realized. Accordingly, management, in accordance with SFAS No. 109, in evaluating the recoverability of these net deferred tax assets, was required to place greater weight on our historical results as compared to projections regarding future taxable income. For the three- and nine-month periods ended September 30, 2004, the Company generated (loss)/income before taxes of approximately ($139,000) and $14.9 million, respectively.

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For the three-month period ended September 30, 2004, due to losses before income taxes earned in certain tax jurisdictions, the company increased its valuation allowance by approximately $957,000 in the appropriate tax jurisdictions. For the nine-month period ended September 30, 2004, the company reversed through the provision for income taxes approximately $754,000 of its valuation allowance in the appropriate tax jurisdictions. We will continue to evaluate the valuation allowance on a quarterly basis, and may in the future reverse some portion or all of our valuation allowance and recognize a reduction in income tax expense or increase the valuation allowance for previously unreserved assets and recognize an increase in income tax expense. A portion of the valuation allowance relates to the benefit from stock-based compensation. Any reversal of valuation allowance from this item will be reflected as a component of stockholders’ equity.

     When recording acquisitions, we have recorded valuation allowances due to the uncertainty related to the realization of certain deferred tax assets existing at the acquisition dates. The amount of deferred tax assets considered realizable is subject to adjustment in future periods if estimates of future taxable income are changed. Reversals of valuation allowances recorded in purchase accounting are reflected as a reduction of goodwill in the period of reversal. For the three- and nine-month periods ended September 30, 2004, valuation allowances established in purchase accounting were reversed with a corresponding reduction in goodwill of approximately $545,000 and $3.1 million, respectively.

Liquidity and Capital Resources

     At September 30, 2004, our principal sources of liquidity consisted of cash, cash equivalents and marketable securities of $112.8 million, and a credit facility consisting of a $25 million revolving line of credit, none of which was outstanding at September 30, 2004. Advances under the revolving line of credit would bear interest at the prime rate (4.75% November 1, 2004) minus 1% and would be due and payable in May 2005. If we draw on this line of credit, we would be subject to covenants that provide certain restrictions related to working capital, net worth, acquisitions and payment and declaration of dividends. We were in compliance with all such covenants at September 30, 2004.

     During the first nine months of 2004, our cash, cash equivalents and marketable securities decreased $22.1 million from $134.9 million at December 31, 2003. At September 30, 2004, the total amount outstanding under our 5.0% Notes and our 5.25% Notes was $187.7 million. In 2006, when these convertible subordinated notes become due, it is possible we may need substantial funds in excess of our current cash reserves to repay such debt. Our 5.0% Notes with a principal balance of $121.5 million are due September 1, 2006, and our 5.25% Notes with a principal balance of $66.2 million are due November 15, 2006. Our 5.0% Notes are convertible into common stock at $29.83 per share, and our 5.25% Notes are convertible into common stock at $49.53 per share. On November 1, 2004, the closing price of our common stock was $10.01 per share. We may be unable to refinance the debt on favorable terms or at all.

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     We may raise capital during the next twelve months by issuing common stock, convertible or other debt securities, or a combination thereof. Such proceeds would be used to realign our capital structure and provide liquidity for future semiconductor capital equipment cycles. However, such sources of liquidity may not be available to us on acceptable terms, or at all.

     We have historically financed our operations and capital requirements through a combination of cash provided by operations, the issuance of long-term debt and common stock, bank loans, capital lease obligations and operating leases. However, we have not sustained positive cash flow from operations since 2001.

     The Company has committed to purchase approximately $12.8 million of parts, components and subassemblies from various suppliers, contingent upon the Company terminating business with such suppliers. These inventory purchase obligations consist of minimum purchase commitments to ensure the Company has an adequate supply of critical components to meet the demand of its customers.

     Operating activities used cash of $7.1 million in the first nine months of 2004, reflecting our net income of $10.3 million increased by non-cash items of $16.4 million and offset by net working capital changes of approximately $33.7 million. Non-cash items during this period primarily consisted of the following:

•		Depreciation and amortization of $14.0 million;
•		Amortization of deferred debt issuance costs of $825,000;
•		Provision for deferred income taxes of $2.0 million;
•		A loss on the disposal of property and equipment of $599,000;
•		A gain on the sale of our Noah chiller assets of $404,000; and
•		A gain on the sale of a marketable security investment of $703,000.

     Net working capital changes during the first nine months of 2004 used cash of $33.7 million and primarily consisted of the following:

•		An increase in accounts receivable of $13.1 million;
•		An increase in inventory of $26.7 million, due to the establishment of our China-based manufacturing facility and increased production volumes to meet customer contractual inventory levels and customer delivery requirements;
•		A $9.1 million increase in trade accounts payable, which was primarily incurred to finance our inventory purchases; and
•		A $7.1 million decrease in customer deposits and other accrued expenses.

     Operating activities used cash of $19.5 million in the first nine months of 2003, reflecting our net loss of $41.8 million partially offset by non-cash items of $31.0 million and increased by net working capital changes of approximately $8.7 million. Non-cash items during this period primarily consisted of the following:

•		Depreciation and amortization of $17.6 million;
•		Amortization of deferred debt issuance costs of $824,000;
•		A provision for deferred income taxes of $9.0 million;
•		A loss on the disposal of property and equipment of $1.9 million; and
•		An impairment of intangible assets of $1.2 million.

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     Net working capital changes during the first nine months of 2003 used cash of $8.7 million and primarily consisted of the following:

•		A $9.3 million increase in accounts receivable;
•		A $2.1 million increase in inventory;
•		A $2.9 million increase in demonstration and customer service equipment;
•		A $4.4 million increase in trade accounts payable; and
•		A $1.4 million decrease in customer deposits and other accrued expenses.

     Any future decline in the industries in which we operate could substantially affect our ability to generate new sales and collect payments from our customers. Additionally, cash will be used for severance payments associated with the reductions in force at the Fort Collins manufacturing facility and other costs associated with the transfer of operations to the high volume Shenzhen, China manufacturing facility. We are unable to provide any assurance regarding our future cash flow from operations.

     Investing activities generated cash of $8.7 million in the first nine months of 2004 and primarily consisted of the net sale of $19.2 million of marketable securities, proceeds from the sale of assets of $2.1 million partially offset by the purchase of property and equipment for $12.5 million. We expect to spend approximately $2.5 million for the purchase of property and equipment during the remainder of 2004. Our planned level of capital expenditures is subject to frequent revisions because our business experiences sudden changes as we move into industry upturns and downturns and expected sales levels change. In addition, changes in foreign currency exchange rates may significantly impact our capital expenditures and depreciation expense recognized in a particular period.

     Investing activities used cash of $13.9 million in the first nine months of 2003, and primarily consisted of the purchase of property and equipment for $15.6 million and the settlement of our escrow deposit liability related to our acquisition of Dressler in the first quarter of 2003 for $1.7 million, partially offset by proceeds from the sale of assets of $4.8 million.

     Investing cash flows experience significant fluctuations from period to period as we buy and sell marketable securities, which we convert to cash to fund strategic investments and our operating cash flow, and as we transfer cash into marketable securities when we attain levels of cash that are greater than needed for current operations. However, we do not expect to generate significant levels of cash that are greater than needed for our current operations in the near term.

     Financing activities used cash of $4.5 million in the first nine months of 2004, and consisted of payments on our senior borrowings and capital lease obligations of $7.3 million, offset by proceeds from borrowings of $1.6 million and proceeds from common stock transactions of $1.2 million.

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     Financing activities used cash of $4.9 million in the first nine months of 2003, and consisted of the repayment of notes payable and capital leases of $6.8 million, partially offset by proceeds from common stock transactions of $1.9 million.

     We expect our financing activities to continue to fluctuate in the future. If market conditions and our financial position are deemed appropriate, we may repurchase a portion of our convertible notes in the open market. Our payments under capital lease obligations and notes payable may also increase in the future if we enter into additional capital lease obligations or change the level of our bank financing.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

     Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt obligations. We generally place our investments with high credit quality issuers and by policy are averse to principal loss and seek to protect and preserve our invested funds by limiting default risk, market risk and reinvestment risk. As of September 30, 2004, our investments in marketable securities consisted primarily of commercial paper, municipal and state bonds and notes and institutional money markets. These securities are highly liquid. Earnings on our marketable securities are typically invested into similar securities. In the first nine months of 2004, the rates we earned on our marketable securities averaged approximately 1.9% on a before tax equivalent basis. The impact on interest income of a 10% decrease in the average interest rate would have resulted in approximately $120,000 less interest income in the first nine months of 2004.

     The interest rates on our subordinated debt are fixed, specifically, at 5.25% for the $66.2 million of our debt due November 15, 2006, and at 5.00% for the $121.5 million of our debt that is due September 1, 2006. Because these rates are fixed, we believe there is no risk of increased interest expense.

     The interest rates on our Aera Japan subsidiary’s credit lines are variable and currently range from 1.5% to 3.1%. We believe a 10% increase in the average interest rate on these instruments would not have a material effect on our financial position or results of operations.

Foreign Currency Exchange Rate Risk

     We transact business in various foreign countries. Our primary foreign currency cash flows are generated in countries in Asia and Europe. It is highly unpredictable how currency exchange rates will fluctuate in the future. We have entered into various forward foreign currency exchange contracts to mitigate currency fluctuations in the Japanese yen, euro, Taiwanese dollar and Chinese yuan. The notional amount of our foreign currency contracts at September 30, 2004 was $13.2 million. The potential fair value loss for a hypothetical 10% adverse change in foreign currency exchange rates at September 30, 2004, would be approximately $1.3 million, which would be essentially offset by corresponding gains related to the underlying assets. We will continue to evaluate various methods to minimize the effects of currency fluctuations when we translate the financial statements of our foreign subsidiaries into U.S. dollars. At September 30, 2004, we held foreign currency forward contracts, maturing through October 2004, to purchase U.S. dollars and sell various foreign currencies.

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     The following table summarizes our outstanding contracts at September 30, 2004: