COHERENT INC - 10-Q Quarterly Report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended July 3, 2004

or

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

For the transition period from to

Commission File Number: 0-5255

COHERENT, INC.

Delaware		94-1622541
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

5100 Patrick Henry Drive, Santa Clara, California 95054

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (408) 764-4000

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 ý No o

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

The number of shares outstanding of registrant’s common stock, par value $.01 per share, at August 4, 2004 was 30,322,096 shares.

COHERENT, INC.

INDEX

Part I.	Financial Information

Item I.	Financial Statements

	Condensed Consolidated Statements of Operations Three months and nine months ended July 3, 2004 and June 28, 2003

	Condensed Consolidated Balance Sheets July 3, 2004 and September 27, 2003

	Condensed Consolidated Statements of Cash Flows Nine months ended July 3, 2004 and June 28, 2003

	Notes to Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

Part II.	Other Information

Item 6.	Exhibits and Reports on Form 8-K

Signatures

PART I. FINANCIAL INFORMATION

Item I. Financial Statements

COHERENT, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited; in thousands, except per share data)

	Three Months Ended						Nine Months Ended
	July 3, 2004			June 28, 2003			July 3, 2004			June 28, 2003

Net sales	$	127,951		$	99,174		$	361,710		$	304,716
Cost of sales	72,964			62,225			213,716			186,333
Gross profit	54,987			36,949			147,994			118,383
Operating expenses:
Research and development	15,505			12,694			45,964			36,627
In-process research and development	—			4,430			—			4,430
Selling, general and administrative	28,626			25,437			83,716			75,024
Restructuring, impairment and other charges	18			289			255			23,111
Intangibles assets amortization	1,504			1,397			5,203			3,179
Total operating expenses	45,653			44,247			135,138			142,371
Income (loss) from operations	9,334			(7,298		)	12,856			(23,988		)
Other income (expense):
Interest and dividend income	574			995			1,912			4,318
Interest expense	(793		)	(912		)	(2,436		)	(3,017		)
Foreign exchange gain (loss)	(45		)	(1,136		)	772			(1,645		)
Write-down of Lumenis investment	—			—			—			(10,212		)
Other—net	614			1,383			694			5,912
Total other income (expense), net	350			330			942			(4,644		)
Income (loss) from continuing operations before income taxes and minority interest	9,684			(6,968		)	13,798			(28,632		)
Provision (benefit) for income taxes	4,261			(3,576		)	6,274			(6,893		)
Income (loss) from continuing operations before minority interest	5,423			(3,392		)	7,524			(21,739		)
Minority interest in subsidiaries’ (earnings) losses	(269		)	1,106			209			897
Income (loss) from continuing operations	5,154			(2,286		)	7,733			(20,842		)
Discontinued operations, net of income taxes of $145	—			—			218			—
Net income (loss)	$	5,154		$	(2,286	)	$	7,951		$	(20,842	)

Net income (loss) per basic share:
Income (loss) from continuing operations	$	0.17		$	(0.08	)	$	0.25		$	(0.71	)
Income from discontinued operations, net of income taxes	—			—			0.01			—
Net income (loss)	$	0.17		$	(0.08	)	$	0.26		$	(0.71	)

Net income (loss) per diluted share:
Income (loss) from continuing operations	$	0.17		$	(0.08	)	$	0.25		$	(0.71	)
Income from discontinued operations, net of income taxes	—			—			0.01			—
Net income (loss)	$	0.17		$	(0.08	)	$	0.26		$	(0.71	)

Shares used in computation
Basic	30,243			29,537			30,122			29,312
Diluted	30,620			29,537			30,502			29,312

See Accompanying Notes to Condensed Consolidated Financial Statements

COHERENT, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited; in thousands, except par value)

	July 3, 2004			September 27, 2003

ASSETS
Current assets:
Cash and cash equivalents	$	89,468		$	76,541
Restricted cash, cash equivalents and short-term investments	15,324			15,284
Short-term investments	64,520			58,407
Accounts receivable—net of allowances of $4,072 and $4,151, respectively	88,409			73,118
Inventories	107,045			100,147
Prepaid expenses and other assets	25,602			45,693
Deferred tax assets	41,214			29,792
Total current assets	431,582			398,982
Property and equipment, net	167,708			146,399
Restricted cash, cash equivalents and short-term investments	23,756			38,660
Goodwill	52,691			50,952
Intangible assets, net	37,500			40,327
Other assets	31,036			34,045
Total assets	$	744,273		$	709,365

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term obligations	$	14,039		$	14,140
Accounts payable	20,622			17,632
Income taxes payable	6,570			1,361
Other current liabilities	65,721			67,980
Total current liabilities	106,952			101,113
Long-term obligations	14,505			27,911
Other long-term liabilities	39,728			29,008
Minority interest in subsidiaries	7,015			7,475
Commitments and contingencies (Note 11)
Stockholder’s equity:
Common stock, par value $.01:
Authorized—500,000 shares Outstanding—30,317 shares and 29,939 shares, respectively	301			298
Additional paid-in capital	306,997			299,378
Notes receivable from stock sales	(758		)	(793		)
Accumulated other comprehensive income	35,016			18,409
Retained earnings	234,517			226,566
Total stockholders’ equity	576,073			543,858
Total liabilities and stockholders’ equity	$	744,273		$	709,365

See Accompanying Notes to Condensed Consolidated Financial Statements

COHERENT, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited; in thousands)

	Nine Months Ended
	July 3, 2004			June 28, 2003
Cash flows from continuing operating activities:
Income (loss) from continuing operations	$	7,733		$	(20,842	)
Adjustments to reconcile net income (loss) from continuing operations to net cash provided by continuing operating activities:
Purchases of short-term trading investments	—			(210,242		)
Proceeds from sales and maturities of short-term trading investments	—			178,241
Write-down of Lumenis investment	—			10,212
Write-down of notes receivable from Picometrix	—			3,723
Non-cash restructuring, impairment and other charges	—			19,540
In-process research and development	—			4,430
Gain on sale of Lumenis common stock	(94		)	(1,479		)
Depreciation and amortization	22,601			21,131
Intangible assets amortization	5,203			3,179
Deferred income taxes	2,432			13,994
Other	1,788			81
Changes in operating assets and liabilities	10,102			(10,822		)
Net cash provided by continuing operating activities	49,765			11,146
Cash flows from investing activities:
(Increase) decrease in restricted cash, cash equivalents and short-term investments	15,688			(55,167		)
Purchases of property and equipment	(41,310		)	(19,340		)
Proceeds from dispositions of property and equipment and assets held for sale	2,303			1,886
Acquisition of businesses and minority interests, net of cash acquired	(2,471		)	(44,131		)
Purchases of available-for-sale securities	(256,204		)	(75,703		)
Proceeds from sales and maturities of available-for-sale securities	250,300			146,798
Other – net	(2,804		)	38
Net cash used in investing activities	(34,498		)	(45,619		)
Cash flows from financing activities:
Long-term debt borrowings	—			360
Long-term debt payments	(14,254		)	(16,237		)
Short-term borrowings	—			710
Short-term repayments	—			(17,232		)
Cash overdrafts increase	3,045			1,597
Sales of shares under employee stock plans	6,923			10,825
Collection of notes receivable from stock sales	35			1,252
Net cash used in financing activities	(4,251		)	(18,725		)

Net cash provided by discontinued operations	218			—
Effect of exchange rate changes on cash and cash equivalents	1,693			6,809
Net increase (decrease) in cash and cash equivalents	12,927			(46,389		)
Cash and cash equivalents, beginning of period	76,541			131,018
Cash and cash equivalents, end of period	$	89,468		$	84,629

Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	3,198		$	4,065
Income taxes	$	7,002		$	10,258
Cash received during the period for:
Income taxes	$	27,842		$	8,132
Noncash investing and financing activities:
Tax benefit from stock option exercises	$	659		$	1,217
Portion of purchase price related to PLI acquisition included in other current liabilities	$	—		$	2,239

See Accompanying Notes to Condensed Consolidated Financial Statements

COHERENT, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to such rules and regulations. These interim condensed consolidated financial statements and notes should be read in conjunction with our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended September 27, 2003, as amended. All adjustments necessary for a fair presentation have been made and include all normal recurring adjustments. Interim results of operations are not necessarily indicative of results to be expected for the year.

Our fiscal year ends on the Saturday closest to September 30. Fiscal 2004 will include 53 weeks, whereas fiscal 2003 included 52 weeks. Accordingly, the nine months ended July 3, 2004 contained 40 weeks, whereas the nine months ended June 28, 2003 contained 39 weeks.

Certain prior period amounts have been reclassified to conform to the current period presentation. Such reclassifications had no impact on net income (loss) or stockholders’ equity for any period presented.

Stock-Based Compensation

As permitted under Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), we have elected to follow the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) to account for employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant.

SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an Amendment of FASB Statement No. 123” (SFAS 148) amends the disclosure requirements of SFAS 123 to require more prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS 123 requires the disclosure of pro forma net income (loss) and earnings (loss) per share had we adopted the fair value method. Under SFAS 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from our stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.

For purposes of estimating the effect of SFAS 123 on our net income (loss), the fair value of our options was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:

	Employee Stock Option Plans								Employee Stock Purchase Plans
	Three Months Ended				Nine Months Ended				Three Months Ended				Nine Months Ended
	July 3, 2004		June 28, 2003		July 3, 2004		June 28, 2003		July 3, 2004		June 28, 2003		July 3, 2004		June 28, 2003
Expected life in years	4.5		4.7		4.4		4.5		0.5		0.5		0.5		0.5
Expected volatility	73.0	%	74.5	%	73.6	%	76.2	%	42.7	%	48.5	%	44.1	%	51.7	%
Risk-free interest rate	3.7	%	2.7	%	3.2	%	2.7	%	1.5	%	1.2	%	1.4	%	1.3	%
Expected dividends	none		none		none		none		none		none		none		none

Our calculations for options under the Lambda Physik plan were made using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Employee Stock Option Plans
	Three Months Ended				Nine Months Ended
	July 3, 2004		June 28, 2003		July 3, 2004		June 28, 2003
Expected life in years	3.5		3.5		3.5		3.5
Expected volatility	75.0	%	75.0	%	75.0	%	75.0	%
Risk-free interest rate	4.7	%	4.7	%	4.7	%	4.7	%
Expected dividends	none		none		none		none

The resulting expense from options under the Lambda Physik plan is included in the pro forma net income (loss) amounts noted below. Our calculations are based on a single option valuation approach and forfeitures are recognized as they occur. The following table illustrates the effect on our net income (loss) and net income (loss) per share if we had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

	Three Months Ended					Nine Months Ended
	July 3, 2004		June 28, 2003			July 3, 2004		June 28, 2003
Net income (loss), as reported	$	5,154	$	(2,286	)	$	7,951	$	(20,842	)
Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of income taxes	4,852		2,793			5,518		10,580
Pro forma net income (loss)	$	302	$	(5,079	)	$	2,433	$	(31,422	)

Earnings (loss) per share:
Basic – as reported	$	0.17	$	(0.08	)	$	0.26	$	(0.71	)
Basic – pro forma	$	0.01	$	(0.17	)	$	0.08	$	(1.07	)

Diluted – as reported	$	0.17	$	(0.08	)	$	0.26	$	(0.71	)
Diluted – pro forma	$	0.01	$	(0.17	)	$	0.08	$	(1.07	)

2. ACQUISITIONS

On June 3, 2003, we initiated a tender offer to purchase the 5,250,000 (39.62%) outstanding shares of our Lambda Physik subsidiary owned by other shareholders (the minority interest) for approximately $10.50 per share. The offer period was originally set to expire on July 15, 2003, however, as a result of our decision to waive our requirement of owning a minimum of 95% of the total shares of Lambda Physik subsequent to the tender offer, the offer period was extended to July 30, 2003. As of September 27, 2003, we purchased a total of 4,489,823 outstanding shares of Lambda Physik for approximately $47.7 million, resulting in a total ownership percentage of 94.26% (inclusive of shares previously owned). We purchased an additional 98,677 outstanding shares of Lambda Physik for approximately $1.3 million during the nine month period ended July 3, 2004, resulting in a total ownership percentage of 95.01% (inclusive of shares previously owned). We have accounted for this transaction as a step acquisition using the purchase method.

During the nine months ended July 3, 2004, the difference between the purchase price of the minority interest of $1.7 million (including acquisition costs of $0.4 million) and the carrying value of the minority interest of $1.1 million was recorded as an adjustment of the carrying value of the assets of Lambda Physik (the step acquisition adjustment). The step acquisition adjustment was recorded based on the proportion of the minority interest acquired and was accounted for as follows (in thousands):

Reduction in carrying value of minority interest acquired	$	1,077
Tangible assets	45
In-process research and development	45
Adjustment to existing goodwill of Lambda Physik	(174		)
Goodwill	485
Intangible assets:
Existing technology	122
Trade name	59
Backlog	14
Customer base	5
Patents	2
Total	$	1,680

At July 3, 2004, we had $8.3 million held in an escrow account that is restricted for the sole purpose of acquiring the remaining outstanding shares of Lambda Physik and is included in non-current restricted cash, cash equivalents and short-term investments on our condensed consolidated balance sheets.

3. RESTRUCTURING, IMPAIRMENT AND OTHER CHARGES

Restructuring, impairment and other charges are as follows (in thousands):

	Three Months Ended					Nine Months Ended
	July 3, 2004		June 28, 2003			July 3, 2004		June 28, 2003
Termination of activities of the Coherent Telecom-Actives Group	$	—	$	339		$	—	$	14,122
Impairment of Lincoln land and building								3,150
Impairment of Picometrix note (Note 9)	—		—			—		3,723
Goodwill impairment	—					—		2,358
Other	18		(50		)	255		(242		)
Total	$	18	$	289		$	255	$	23,111

Coherent Telecom-Actives Group

Based on market information and insights and the status of our development projects of our Coherent Telecom-Actives Group (CTAG) obtained in the first quarter of fiscal 2003, we determined that our return on investment for at least the next several years would have been unsatisfactory and, therefore, additional investments were no longer justified. As a result, we decided to terminate the activities of CTAG, an operating segment that had been aggregated with our Photonics Group in our Electro-Optics reportable segment. During the nine months ended June 28, 2003, the charge related to the termination of these activities included a $6.5 million write-down of equipment and leasehold improvements to net realizable value; a $6.0 million accrual for the estimated contractual obligation for lease and other facility costs of the building, net of estimated sublease income, in San Jose, California, formerly occupied by CTAG; the $1.4 million write-off of our option to purchase Picometrix, Inc. (Picometrix); and $0.2 million of other restructuring costs.

Impairment of Long-lived Assets

In the fourth quarter of fiscal 2002, management decided that given our exit from the passive telecom market and the outsourcing of the production of printed circuit boards, our manufacturing facility located in Lincoln, California was not needed to support our operations. Accordingly, we committed to sell certain land, buildings and improvements and equipment with a total carrying value of $12.4 million. During the first quarter of fiscal 2003, the proposed sale of the facility met the necessary criteria to be classified as assets held for sale under SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” and the carrying values of the land, buildings and improvements and equipment were adjusted to their respective fair values less costs to sell of $9.1 million and $0.2 million, respectively. As a result, we recorded an impairment charge of $3.1 million during the second quarter of fiscal 2003. The determinations of fair values were based on quoted market prices and comparable sales of similar assets. In July 2003, we completed the sale of the land, buildings and improvements and equipment and received net proceeds of $9.2 million.

Goodwill Impairment

In the second quarter of fiscal 2003, our Lambda Physik reporting segment lowered its forecasted outlook in the lithography business and we determined the significant changes in the economic outlook for this business were an indicator that an impairment test was required under SFAS No. 142, “Goodwill and Other Intangible Assets.” As a result of our analysis, we determined that the goodwill associated with this business was impaired and we recorded a charge of $2.4 million in the second quarter of fiscal 2003.

Accrued Restructuring Charges

At July 3, 2004, we had $4.4 million accrued as a current liability on our condensed consolidated balance sheets for facilities related charges. The following table sets forth an analysis of additional provisions and payments made during the nine months ended July 3, 2004 (in thousands):

Balance, September 27, 2003	$	5,528
Provisions	237
Deductions	(1,343		)
Balance, July 3, 2004	$	4,422

The facilities related charges include an estimated $7.1 million of contractual obligations (net of estimated sublease income) for the lease and other facility related costs of our San Jose, California building, offset by $2.7 million of payments made through July 3, 2004. The remaining restructuring accrual balance at July 3, 2004 is expected to result in cash expenditures through fiscal 2007.

4. RECENT ACCOUNTING STANDARDS

The Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities” in January 2003, and a revised interpretation of FIN 46 (FIN 46R) in December 2003. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN 46 are effective immediately for all arrangements entered into after January 31, 2003. Since January 31, 2003, we have not invested in any entities that we believe are variable interest entities for which we are the primary beneficiary. For arrangements entered into prior to February 1, 2003, we were required to adopt the provisions of FIN 46R in the second quarter of fiscal 2004.

During the second quarter of fiscal 2004, we evaluated our loan agreement with Picometrix (see Note 9) and determined that Picometrix is a variable interest entity as defined by FIN 46. Furthermore, we concluded that we are the primary beneficiary as defined by FIN 46 and, as a result, we were required to consolidate Picometrix at April 3, 2004. The assets and liabilities of Picometrix were measured at their respective fair values as of April 3, 2004, resulting in the consolidation of $3.5 million of assets, $2.3 million of liabilities and $0.6 million of intangible assets (consisting of existing technology to be amortized over approximately 8 years), partially offset by minority interest of $1.1 million. In the third quarter of fiscal 2004, we were required to include the results of operations of Picometrix in our consolidated financial statements. As a result, we have included approximately $2.2 million of net sales and $0.4 million of income from continuing operations related to Picometrix. The entire amount of income from continuing operations has been allocated to the minority interest, accordingly, the consolidation of Picometrix had no impact on our net income. At July 3, 2004, Picometrix had approximately $0.4 million of cash and cash equivalents and $0.1 million of fixed assets that have been pledged as collateral on their outstanding obligations. No creditors of Picometrix have any recourse provisions to our general credit.

In March 2004 the Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 03-1, The Meaning of Other-than-Temporary Impairment and its application to Certain Investments. This issue provides guidance for evaluating whether an investment is other-than-temporarily impaired and should be applied in impairment evaluations made in reporting periods beginning after June 15, 2004. We have not yet determined the effect, if any, that the adoption of Issue No. 03-1 will have on our consolidated financial statements.

5. REVENUE RECOGNITION

We recognize revenue in accordance with Staff Accounting Bulletin No. 104, “Revenue Recognition” (SAB 104). Accordingly, revenue is recognized when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed or determinable and collection is probable. Delivery is generally considered to have occurred upon shipment. Our products typically include a one-year warranty and the estimated cost of product warranty claims is accrued at the time the sale is recognized, based on historical experience.

We generally recognize product revenue at the time of delivery and, for certain products for which we perform product installation services, the cost of installation is generally accrued at the time product revenue is recognized.

Our sales to distributors, resellers and end-user customers typically do not have customer acceptance provisions and only certain of our original equipment manufacturer (OEM) customer sales have customer acceptance provisions. Customer acceptance is generally limited to performance under our published product specifications. For the few product sales that have customer acceptance provisions because of higher than published specifications, (1) the products are tested and accepted by the customer at our site or by the customer’s acceptance of the results of our testing program prior to shipment to the customer, or (2) the revenue is deferred until customer acceptance occurs.

The vast majority of our sales are made to OEMs, distributors, resellers and end-users in the non-scientific market. Sales made to these customers do not require installation of the products by us and are not subject to other post-delivery obligations, except in occasional instances where, for example, we have agreed to perform installation or provide training. In those instances, we either defer revenue related to installation services until installation is completed or, if the installation services are inconsequential or perfunctory, we accrue installation costs at the time that product revenue is recognized. We defer revenue on training services until these services are provided.

our post-delivery installation obligations are essential to the functionality of our products, we defer revenue on the entire arrangement until completion of these services. For a limited number of products or arrangements where management considers installation to be significant in comparison to the value of the product sold, we defer revenue related to installation services until completion of these services.

For most products, training is not provided and thus no post-delivery training obligation exists. However, when training is provided to our customers, it is typically priced separately and is recognized as revenue as these services have been provided.

6. SHORT-TERM INVESTMENTS

Effective March 30, 2003, we transferred all securities formerly classified as trading securities to available-for-sale due to a change in our investment strategies. As required by SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115), the transfer of these securities between categories of investments was accounted for at fair value and the unrealized gains and losses previously recognized in earnings through the date of transfer from the trading category have not been reversed. All unrealized gains and losses subsequent to the date of transfer are included as a separate component of other comprehensive income (OCI).

All highly liquid investments with maturities of three months or less at the time of purchase are considered to be cash equivalents and are classified as available-for-sale securities. Marketable short-term investments in debt and equity securities are also classified and accounted for as available-for-sale securities and are valued based on quoted market prices. Investments classified as available-for-sale are reported at fair value with unrealized gains and losses, net of related tax, recorded as a separate component of OCI in stockholders’ equity until realized. Interest and amortization of premiums and discounts for debt securities are included in interest income. Gains and losses on securities sold are determined based on the specific identification method and are included in other income (expense).

Cash, cash equivalents and short-term investments consist of the following (in thousands):

	July 3, 2004
	Cost Basis		Unrealized Gains		Unrealized Losses			Fair Value
Cash and cash equivalents	$	123,549	$	—	$	—		$	123,549
Less: restricted cash and cash equivalents								(34,081		)
								$	89,468
Short-term investments:
Available-for-sale securities:
Commercial paper	$	995	$	—	$	—		$	995
Certificate of deposits	250		—		—			250
U.S. government and agency obligations	38,052		79		(7		)	38,124
State and municipal obligations	20,077		193		(50		)	20,220
Corporate notes and obligations	9,894		53		(17		)	9,930
Total short-term investments	$	69,268	$	325	$	(74	)	69,519
Less: restricted short term-investments								(4,999		)
								$	64,520

	September 27, 2003
	Cost Basis		Unrealized Gains		Unrealized Losses			Fair Value

Cash and cash equivalents	$	84,943	$	—	$	—		$	84,943
Less: restricted cash and cash equivalents								(8,402		)
								$	76,541
Short-term investments:
Available-for-sale securities:
Corporate equity securities	$	393	$	—	$	(116	)	$	277
Commercial paper	549		—		—			549
U.S. government and agency obligations	57,278		171		(29		)	57,420
State and municipal obligations	11,677		135		(1		)	11,811
Corporate notes and obligations	33,755		213		(76		)	33,892
Total short-term investments	$	103,652	$	519	$	(222	)	103,949
Less: restricted short term-investments								(45,542		)
								$	58,407

At July 3, 2004, $8.7 million of cash and cash equivalents were restricted for the purchase of the remaining outstanding shares of Lambda Physik (see Note 2), for security deposits and for disability insurance and $25.4 million were restricted pursuant to our Star notes agreement (see Note 10). In addition, $5.0 million of short-term investments were also restricted pursuant to our Star notes agreement. At September 27, 2003, $8.4 million of cash and cash equivalents were primarily restricted for the purchase of the remaining outstanding shares of Lambda Physik and for disability insurance and $45.6 million of short-term investments were restricted pursuant to our Star notes agreement.

The amortized cost and estimated fair value of available-for-sale investments in debt securities at July 3, 2004 and September 27, 2003, classified as short-term investments (including restricted amounts) on our condensed consolidated balance sheet were as follows (in thousands):

	July 3, 2004				September 27, 2003
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Due in less than 1 year	$	53,406	$	53,623	$	53,633	$	53,873
Due in 1 to 5 years	15,774		15,807		47,989		48,149
Due in 5 to 10 years	69		69		1,583		1,594
Due beyond 10 years	19		20		54		56
Total investments in available-for-sale debt securities	$	69,268	$	69,519	$	103,259	$	103,672

For the nine month period ended July 3, 2004, we received proceeds totaling $34.6 million from the sale of available-for-sale securities and realized gross gains and losses of $0.2 million and $0.1 million, respectively. There were no sales of available-for-sale securities prior to March 30, 2003. Realized gains from the sale of trading securities were $0.2 million for the nine month period ended June 28, 2003. There were no sales of trading securities during the nine month period ended July 3, 2004.

As part of the consideration received for the April 30, 2001 sale of our Medical segment assets, we received 5,432,099 shares of Lumenis, Ltd. common stock. The estimated fair value of the Lumenis common stock was $124.4 million at the time of the sale. In the third quarter of fiscal 2002, the market value of our investment in Lumenis common stock had declined from our initial valuation of $124.4 million to $20.2 million. This decline was deemed to be other-than-temporary and an impairment loss of $104.2 million ($79.2 million after income tax benefit of $25.0 million) was recognized in the third quarter of fiscal 2002. The $25.0 million in tax benefit related to the impairment loss recognized in the third quarter of fiscal 2002 was net of a $16.6 million valuation allowance recorded against this capital loss deferred tax asset. In the first quarter of fiscal 2003, the market value had further declined to $9.9 million. This decline was also deemed to be other-than-temporary and an additional impairment loss of $10.2 million was recognized. We recorded no net tax benefit related to the $10.2 million impairment loss as we recorded a $4.1 million valuation allowance against this capital loss deferred tax asset. In fiscal 2003, we sold 5,217,099 shares of Lumenis common stock for approximately $11.0 million while recognizing a gain of $1.5 million. During the first quarter of fiscal 2004, we sold our remaining 215,000 shares of Lumenis common stock for approximately $0.5 million while recognizing a gain of $0.1 million.

7. DERIVATIVES

In accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133) as amended, we record all derivatives, whether designated in hedging relationships or not, on our balance sheet at fair value. If the derivative is designated as a fair value hedge the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge the effective portions of the changes in the fair value of the derivative are recorded in OCI and are recognized in the income statement when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in other income (expense).

Our objective of holding derivatives is to minimize the risks of foreign currency fluctuation by using the most effective methods to eliminate or reduce the impact of these exposures. Principal currencies hedged include the Euro, Yen and British Pound. Forwards used to hedge a portion of forecasted foreign revenue for up to 15 months in the future are designated as cash flow hedging instruments.

For foreign currency forward contracts under SFAS 133, hedge effectiveness is measured by comparing the cumulative change in the hedged contract with the cumulative change in the hedged item, both of which are based on forward rates. For foreign currency option contracts under SFAS 133, hedge effectiveness is asserted when the critical elements representing the total changes in the option’s cash flows continue to match the related elements of the hedged forecasted transaction. Should

discrepancies arise, effectiveness is measured by comparing the change in option value and the change in value of a hypothetical derivative mirroring the critical elements of the forecasted transaction.

Forwards not designated as hedging instruments under SFAS 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies. Changes in fair value of these derivatives are recognized in other income (expense).

8. GOODWILL AND OTHER INTANGIBLE ASSETS

The carrying amount of goodwill attributable to each reporting segment is as follows (in thousands):

	July 3, 2004		September 27, 2003
Electro-Optics	$	35,279	$	34,991
Lambda Physik	17,412		15,961
Total	$	52,691	$	50,952

Components of our amortizable intangible assets are as follows (in thousands):

	July 3, 2004						September 27, 2003
	Gross Carrying Amount		Accumulated Amortization		Net		Gross Carrying Amount		Accumulated Amortization		Net
Existing technology	$	37,374	$	9,098	$	28,276	$	36,093	$	6,083	$	30,010
Patents	8,924		3,463		5,461		8,258		2,682		5,576
Licenses	4,261		3,941		320		4,261		3,621		640
Drawings	1,203		762		441		1,122		544		578
Order backlog	1,979		1,970		9		1,803		1,457		346
Customer lists	2,106		933		1,173		2,086		640		1,446
Trade name	1,610		382		1,228		1,360		176		1,184
Non-compete agreement	908		316		592		646		99		547
Total	$	58,365	$	20,865	$	37,500	$	55,629	$	15,302	$	40,327

Amortization expense for intangible assets during the three and nine months ended July 3, 2004 were $1.5 million and $5.2 million, respectively. At July 3, 2004, estimated amortization expense for the remainder of fiscal 2004, the next five succeeding fiscal years and all years thereafter are as follows (in thousands):

	Estimated Amortization Expense
2004 (remainder)	$	1,476
2005	5,800
2006	5,272
2007	4,827
2008	4,669
2009	4,339
Thereafter	11,117
Total	$	37,500

9. BALANCE SHEET DETAILS:

Inventories are as follows (in thousands):

	July 3, 2004		September 27, 2003
Purchased parts and assemblies	$	31,132	$	27,817
Work-in-process	47,016		44,721
Finished goods	28,897		27,609
Inventories	$	107,045	$	100,147

Prepaid expenses and other assets consist of the following (in thousands):

	July 3, 2004		September 27, 2003
Prepaid expenses and other	$	22,609	$	21,776
Prepaid and refundable income taxes	1,898		23,101
Assets held for sale	1,095		816
Total prepaid expenses and other assets	$	25,602	$	45,693

In August 2002, we entered into a loan agreement with Picometrix of Ann Arbor, Michigan. Picometrix develops and manufactures terahertz instruments; ultra high-speed photoreceivers and instrumentation for the telecommunication, data communication and test and measurement markets, focusing on epitaxial growth; photodetector design and microfabrication; high-speed microwave packaging; hybrid circuit assembly and high-speed testing. Under the loan agreement, we provided Picometrix with $6.0 million of debt financing in exchange for (1) a nine-month option to purchase 100% of the equity of Picometrix for $6.0 million plus a two-year earn-out of up to $25.0 million and (2) the repayment of the $6.0 million of loan principal at maturity and interest at the greater of prime (4.25% at September 30, 2002) minus 0.5% or 3.0% payable monthly over its term. We originally recorded the purchase option at its fair value of $1.4 million and the note at its fair value of $4.6 million and were amortizing the discount to interest income over the estimated 18-month term of the note. The maturity date of the note varied depending on whether we exercised the option to acquire Picometrix. On November 22, 2002, we terminated our option to purchase Picometrix and recorded a $1.4 million charge to write-off the value assigned to the purchase option. The termination of our purchase option also resulted in the note becoming due in full on May 26, 2003. In the first quarter of fiscal 2003, we evaluated the collectibility of our note receivable from Picometrix, including the ability of Picometrix to make the required interest and principal payments. We determined that the estimated net realizable value of the note at December 28, 2002 was $0.9 million, and accordingly recorded an impairment charge of $3.7 million ($2.3 million after-tax) during the first quarter of fiscal 2003 (see Note 3).

Assets held for sale at July 3, 2004 and September 27, 2003 includes $0.2 million and $0.8 million, respectively, of impaired equipment at our Auburn, California and Tampere, Finland facilities, all of which are recorded at estimated net realizable value. Assets held for sale at July 3, 2004 also includes $0.9 million for our former manufacturing facility in Sturbridge, Massachusetts, as this asset met the necessary requirements to be classified as such during the third quarter of fiscal 2004.

Other assets consist of the following (in thousands):

	July 3, 2004		September 27, 2003
Assets related to deferred compensation arrangements	$	19,724	$	17,466
Other assets	5,491		4,183
Deferred tax assets	5,821		11,433
Assets held for investment	—		963
Total other assets	$	31,036	$	34,045

Assets held for investment at September 27, 2003 included our former Sturbridge manufacturing facility.

Other current liabilities consist of the following (in thousands):

	July 3, 2004		September 27, 2003
Accrued payroll and benefits	$	22,590	$	22,006
Accrued expenses and other	18,700		18,729
Reserve for warranty	11,494		10,242
Accrued restructuring charges (Note 3)	4,422		5,528
Deferred income	4,628		3,756
Customer deposits	3,887		6,026
Lease termination cost	—		1,693
Total other current liabilities	$	65,721	$	67,980

We provide warranties on our product sales (generally one year) and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or replace the products under warranty. We currently establish warranty reserves based on historical

warranty costs for each product line. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of sales may be required in future periods.

Components of the reserve for warranty costs during the nine months ended July 3, 2004 and June 28, 2003 were as follows (in thousands):

	Nine Months Ended
	July 3, 2004			June 28, 2003
Beginning balance	$	10,242		$	8,495
Additions related to current period sales	16,445			9,912
Warranty costs incurred in the current period	(15,134		)	(8,018		)
Accruals resulting from acquisitions	—			253
Adjustments to accruals related to prior period sales	(59		)	73
Ending balance	$	11,494		$	10,715

Other long-term liabilities consist of the following (in thousands):

	July 3, 2004		September 27, 2003
Deferred compensation	$	19,724	$	17,466
Deferred tax liabilities	14,316		5,968
Deferred income	1,671		1,477
Environmental remediation costs	507		547
Other long-term liabilities	3,510		3,550
Total other long-term liabilities	$	39,728	$	29,008

10. CURRENT AND LONG-TERM OBLIGATIONS

At July 3, 2004 and September 27, 2003, our current and long-term obligations primarily consisted of our notes payable to finance our acquisition of Star Medical (Star notes). In September 2002, we amended our Star notes agreement. The amendment included modifications of certain covenants associated with the notes and allowed a prepayment of a portion of the principal balance. As a result, in October 2002 we prepaid $7.3 million of the principal balance with no prepayment penalty. The Star notes originally included financial covenants such as maintaining a minimum tangible net worth, minimum consolidated debt to capitalization ratio, fixed charge coverage ratio, as well as non-financial covenants such as providing quarterly statements to the note holders. In September 2003, we amended the agreement to relinquish all financial covenant requirements. In place of the covenants, the amendment requires that we place cash and short-term investment balances in an amount equal to 120% of the principal balance in a restricted collateral account. At July 3, 2004, $15.2 million and $15.2 million of current and non-current restricted cash, cash equivalents and short-term investments were related to the Star notes (see Note 6).

11. COMMITMENTS AND CONTINGENCIES

During the second quarter of fiscal 2002, we renewed the lease for our Santa Clara, California facility. The facility consists of 216,000 square feet of office, research and development and manufacturing space. Upon expiration of the lease, we had an option to purchase the facility for $24.6 million, renew the lease for an additional five years or arrange for the sale of the facility to a third party where we would retain an obligation to the owner for the difference between the sale price, if less than $24.6 million, and $21.3 million, subject to certain provisions of the lease. If we did not purchase the facility or arrange for its sale as discussed above, we would be obligated for an additional lease payment of $21.3 million. During the first quarter of fiscal 2004, we completed the purchase of the facility for $24.6 million.

Certain claims and lawsuits have been filed or are pending against us. In the opinion of management, all such matters have been adequately provided for, are without merit, or are of such kind that if disposed of unfavorably, would not have a material adverse effect on our consolidated financial position or results of operations.

We, along with several other companies, have been named as a party to a remedial action order issued by the California Department of Toxic Substance Control relating to soil and groundwater contamination at and in the vicinity of the Stanford Industrial Park in Palo Alto, California, where our former headquarters facility is located. The responding parties to the Regional Order (including Coherent) have completed Remedial Investigation and Feasibility Reports, which were approved by the State of

California. The responding parties have installed four remedial systems and have reached agreement with responding parties on final cost sharing.

We were was also named, along with other parties, to a remedial action order for the Porter Drive facility site itself in Stanford Industrial Park. The State of California has approved the Remedial Investigation Report, Feasibility Study Report, Remedial Action Plan Report and Final Remedial Action Report, prepared by us for this site. We have been operating remedial systems at the site to remove subsurface chemicals since April 1992. During fiscal 1997, we settled with the prior tenant and neighboring companies, on allocation of the cost of investigating and remediating the site at 3210 Porter Drive, Palo Alto and the bordering site at 3300 Hillview Avenue, Palo Alto.

Management believes that our probable, nondiscounted net liability at July 3, 2004 for remaining costs associated with the above environmental matters is $0.5 million, which has been previously accrued. This amount consists of total estimated probable costs of $0.6 million ($0.1 million included in other current liabilities and $0.5 million included in other long-term liabilities) reduced by minimum probable recoveries of $0.1 million included in other assets from other parties named to the order.

12. COMPREHENSIVE INCOME (LOSS)

The components of comprehensive income (loss), net of income taxes, are as follows (in thousands):

	Three Months Ended					Nine Months Ended
	July 3, 2004		June 28, 2003			July3, 2004		June 28, 2003
Net income (loss)	$	5,154	$	(2,286	)	$	7,951	$	(20,842	)
Translation adjustment	1,840		7,549			16,462		17,476
Net gain (loss) on derivative instruments	76		(1		)	64		91
Changes in unrealized gain (loss) on available-for-sale securities	10		1,819			81		(675		)
Total comprehensive income (loss)	$	7,080	$	7,081		$	24,558	$	(3,950	)

The following summarizes activity in accumulated other comprehensive income (loss) related to derivatives, net of income taxes, held by us (in thousands):

Balance, September 28, 2002	$	(238)
Changes in fair value of derivatives	44
Net losses reclassified from OCI	47
Balance, June 28, 2003	$	(147	)

Balance, September 27, 2003	$	(128	)
Changes in fair value of derivatives	60
Net losses reclassified from OCI	4
Balance, July 3, 2004	$	(64	)

Accumulated other comprehensive income (net of tax) at July 3, 2004 is comprised of accumulated translation adjustments of $35.2 million, net loss on derivative instruments of $0.1 million and unrealized loss on available-for-sale securities of $0.1 million. Accumulated other comprehensive income (net of tax) at September 27, 2003 is comprised of accumulated translation adjustments of $18.7 million, net loss on derivative instruments of $0.1 million and unrealized loss on available-for-sale securities of $0.2 million, respectively.

13. EARNINGS (LOSS) PER SHARE

Basic earnings (loss) per share is computed based on the weighted average number of shares outstanding during the period. Diluted earnings per share for the three and nine months ended July 3, 2004 is computed based on the weighted average number of shares outstanding during the period increased by the effect of dilutive stock options and stock purchase contracts using the treasury stock method and shares issuable under the Productivity Incentive Plan. Diluted loss per share for the three and nine months ended June 28, 2003 is computed based on the weighted average number of shares outstanding during the period and does not include the effect of stock options and stock purchase contracts using the treasury stock method or shares issuable under the Productivity Incentive Plan as these items are antidilutive as a result of the net losses for the three and nine months then ended.

The following table presents information necessary to calculate basic and diluted earnings (loss) per common share (in thousands, except per share data):

	Three Months Ended					Nine Months Ended
	July 3, 2004		June 28, 2003			July 3, 2004		June 28, 2003
Weighted average shares outstanding – basic	30,243		29,537			30,122		29,312
Common stock equivalents	354		—			356		—
Employee stock purchase plan equivalents	23		—			24		—
Weighted average shares and equivalents – diluted	30,620		29,537			30,502		29,312

Income (loss) from continuing operations for basic and diluted earnings per share computation	$	5,154	$	(2,286	)	$	7,733	$	(20,842	)

Income (loss) from continuing operations per share – basic	$	0.17	$	(0.08	)	$	0.25	$	(0.71	)
Income (loss) from continuing operations per share – diluted	$	0.17	$	(0.08	)	$	0.25	$	(0.71	)

A total of 2,975,000 and 3,487,000 anti-dilutive weighted shares have been excluded from the dilutive share equivalents calculation for the three months ended July 3, 2004 and June 28, 2003, respectively. A total of 3,294,000 and 3,598,000 anti-dilutive weighted shares have been excluded from the dilutive share equivalents calculation for the nine months ended July 3, 2004 and June 28, 2003, respectively.

14. SEGMENT INFORMATION

We are organized around two separately managed business units, Electro-Optics and Lambda Physik, which we have identified as reportable segments. Our Electro-Optics reportable segment focuses on markets such as semiconductor and related manufacturing, materials processing, OEM laser components and instrumentation, scientific research and government programs, and graphic arts and display. Our Lambda Physik reportable segment focuses on markets including lasers for the production of thin film transistors (TFT) used in flat panel displays, microlithography applications in the semiconductor industry, ink jet printers, automotive, environmental research, scientific research, medical OEMs, materials processing and micro-machining applications.

Our Chief Executive Officer and Chief Financial Officer have been identified as the chief operating decision makers (CODMs) for SFAS 131, “Disclosures about Segments of an Enterprise and Related Information” purposes as they assess the performance of the business units and decide how to allocate resources to the business units. Pretax income from continuing operations is the measure of profit and loss that our CODMs use to assess performance and make decisions. Pretax income from continuing operations represents the sales less the cost of sales and direct operating expenses incurred within the operating segments. In addition, our corporate expenses, except for depreciation of corporate assets and general legal expenses, are allocated to the operating segments and are included in the results below. Corporate expenses not allocated to the groups (depreciation of corporate assets and general legal expenses) are included in Corporate and Other in the reconciliation of operating results. Furthermore, the write-downs of our Lumenis investment, interest expense and interest income are included in Corporate and Other in the reconciliation of operating results.

	Three Months Ended						Nine Months Ended
	July 3, 2004			June 28, 2003			July 3, 2004			June 28, 2003
	(In thousands)
Net sales:
Electro-Optics	$	105,501		$	83,342		$	300,070		$	240,561
Lambda Physik	22,450			15,832			61,640			64,155
Total net sales	$	127,951		$	99,174		$	361,710		$	304,716

Intersegment net sales:
Electro-Optics	$	44		$	157		$	133		$	172
Lambda Physik	1,157			436			1,495			1,308
Total intersegment sales	$	1,201		$	593		$	1,628		$	1,480

Income (loss) from continuing operations before income taxes, including tax-effected minority interest:
Electro-Optics	$	12,268		$	(574	)	$	25,952		$	(12,330	)
Lambda Physik	(2,515		)	(5,660		)	(11,688		)	(6,107		)
Corporate and other	(338		)	372			(257		)	(9,298		)
Total income (loss) from continuing operations before income taxes, including tax-effected minority interest	$	9,415		$	(5,862	)	$	14,007		$	(27,735	)

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

COMPANY OVERVIEW

BUSINESS BACKGROUND

We are one of the world’s leading suppliers of photonics-based solutions in a broad range of commercial and scientific research applications. We design, manufacture and market lasers, laser-based systems, precision optics and related accessories for a diverse group of customers. Since inception in 1966, we have grown through internal expansion and through strategic acquisitions of complementary technologies, intellectual property, manufacturing processes and product offerings.

We have two reportable business segments: Electro-Optics and Lambda Physik, which work with customers to provide cost-effective photonics-based solutions. Our Electro-Optics segment focuses on markets such as semiconductor and related manufacturing, materials processing, original equipment manufacturer (OEM) laser components and instrumentation, scientific research and government programs and graphic arts and display. Lambda Physik AG (Lambda Physik), our 95.0% owned subsidiary with headquarters located in Göttingen, Germany, focuses on markets including lasers for the production of thin film transistors (TFT) used in flat panel displays, microlithography applications in the semiconductor industry, ink jet printers, automotive, environmental research, scientific research, medical OEMs, materials processing and micro-machining applications.

Our products address a broad range of applications. Both of our reportable business segments are focused on several areas of the photonics market including: microelectronics, graphic arts and display, materials processing, scientific research and government programs and OEM components and instrumentation.

FUTURE TRENDS

Microelectronics

With semiconductor fabrication utilization rates hovering at close to 100% capacity, the semiconductor industry continues to gain strength. The enhanced capabilities of consumer electronics products such as cell phones and personal digital assistants require an increase in laser-based tools for their production. New technologies that contributed to design wins over the past year are starting to be deployed and we are seeing the benefits of high volume requests for new, as well as legacy products. As these new technologies are increasingly laser based, we believe the expansion in the semiconductor industry bodes well for the growth of photonics applications as a result of its unique process and test capabilities.

Graphic arts and display

If the adoption of newer digital technologies in the graphic arts market continues to remain robust as it was in fiscal 2003, we anticipate that this will have the continued effect of driving purchases of new printing technology. A major trade show which occurs once every four years, took place in Dusseldorf, Germany in May 2004 where our technology was incorporated in a number of new products being introduced by our customers. In the display market, there is substantial interest in laser projection for both large venues (digital cinema) and consumer home theaters. While our OPS technology is still in an early stage for this application, we believe it has the potential to drive substantial development for low cost, mass producible display devices.

Materials processing

Anticipated drivers for expansion in the materials processing market include demands for reliability, longer tool lifetimes, lower cost of operation than conventional tools and expansion into new geographical areas. The market for materials processing in Asian countries grew substantially in early 2003, which was then curbed by the SARS epidemic. Growth has recently resumed at a rate similar to the rate experienced prior to the SARS epidemic. We have recently made inroads in the Computer Numerical Control (CNC) and thin metal processing applications. These applications have traditionally been served by machine tools. Broader penetration into these areas would increase our addressable base.

Scientific research and government programs

The scientific research market has historically grown at a rate similar to the growth rate of the general U.S. economy and we anticipate this trend to continue into fiscal 2004. We expect that new applications in ultrashort pulses and in bio-research, as well as additional product offerings will be the drivers of anticipated growth within the scientific research market.

OEM components and instrumentation

The instrumentation market has seen a migration from the use of mature laser technologies, mainly ion lasers, to new technologies primarily based on solid state and semiconductors. We continue to see strength in the bioinstrumentation market, where our Compass and Sapphire solid state lasers continue to take market share from older ion laser technology. Because of this migration, new markets are expected to surface in areas such as security, including the detection of bio-agents and the monitoring of people and goods. These markets are likely to require an increased number of lasers. The majority of these activities are still in the research and development stage and we expect only a moderate impact on the laser industry in fiscal 2004, with increases anticipated in future years.

OUR STRATEGY

We strive to develop innovative and proprietary products and solutions that meet the needs of our customers and that are based on our core expertise in lasers and optical technologies. In pursuit of our strategy, we intend to:

• Leverage our technology portfolio and application engineering to lead the proliferation of photonics into broader markets - We will continue to identify opportunities in which our technology portfolio and application engineering can be used to offer innovative solutions and gain access to new markets.

• Optimize our leadership position in existing markets – There are a number of markets where we have historically been at the forefront of technological development and product deployment and from which we have derived a substantial portion of our revenues. We plan to optimize our financial returns from these markets.

• Maintain and develop additional strong collaborative customer and industry relationships – We believe that the Coherent brand name and reputation for product quality, technical performance and customer satisfaction will help us to further develop our loyal customer base. We plan to maintain our current customer relationships and develop new ones with customers that are industry leaders. We plan to work together with these customers to design and develop innovative product systems and solutions as they develop new technologies.

• Develop and acquire new technologies – We will continue to enhance our market position through our existing technologies and we will develop new technologies through our internal research and development efforts as well as through the acquisition of additional complementary technologies, intellectual property, manufacturing processes and product offerings.

• Emphasize supply chain management – We will continue to focus on operational efficiency through an emphasis on supply chain management with the explicit intent of improving gross margins and increasing inventory turns.

• Focus on long-term improvement of return on invested capital — We will continue to focus on long-term improvement of return on invested capital.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of financial condition and our results of operations are based upon the methods, estimates and judgments we use in applying our accounting policies. Some of our accounting policies require management to make difficult and subjective judgments, often as a result of the need to make estimates and assumptions which are inherently uncertain. We have identified the following as the items that require the most significant judgment and often involve complex estimation: revenue recognition, accounting for long-lived assets (including goodwill and intangible assets), inventory valuation, warranty reserves, and accounting for income taxes.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104. Accordingly, revenue is recognized when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed or determinable and collection is probable. Delivery is generally considered to have occurred when shipped.

Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. Failure to obtain anticipated orders due to delays or cancellations of orders could have a material adverse effect on our revenue. In addition, pressures from customers to reduce our prices or to modify our existing sales terms may result in a material adverse effect on our revenue in future periods. Our products typically include a one-year warranty. The estimated cost of product warranty claims is accrued at the time the sale is recognized, based on historical experience.

Sales to end-users in the scientific market typically require installation and, thus, involve post-delivery obligations, however the majority of our post-delivery installation obligations are not essential to the functionality of our products. In cases where our post-delivery installation obligations are essential to the functionality of our products, we defer revenue on the entire arrangement until completion of these services. For a limited number of products or arrangements where management considers installation to be significant in comparison to the value of the product sold, we defer revenue related to installation services until completion of these services.

Long-lived Assets

We evaluate long-lived assets whenever events or changes in business circumstances or our planned use of assets indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Reviews are performed to determine whether the carrying values of assets are impaired based on comparison to either the discounted expected future cash flows (in the case of goodwill and intangible assets) or to the undiscounted expected future cash flows (for all other long-lived assets). If the comparison indicates that there is impairment, the impaired asset is written down to fair value. Significant management judgment is required in the forecast of future operating results that are used in the preparation of expected discounted and undiscounted cash flows.

At July 3, 2004, we had $90.2 million of goodwill and purchased intangible assets on our condensed consolidated balance sheet, the value of which we believe is reasonable based on the discounted estimated future cash flows of the associated products and technologies.

In fiscal 2003, we recorded total impairment charges of $19.2 million for the write-down of land, buildings, leasehold improvements and equipment to net realizable value as we determined their respective carrying values would not be fully recoverable. Also in fiscal 2003, we recorded a goodwill impairment charge of $2.4 million ($1.8 million, net of minority interest) related to Lambda Physik’s lithography business as a result of significant changes in the economic outlook for this business. At July 3, 2004, we had $167.7 million of property and equipment on our condensed consolidated balance sheet.

It is reasonably possible that the estimates of anticipated future net revenue, the remaining estimated economic life of the products and technologies, or both, could differ from those used to assess the recoverability of these assets. In that event, additional impairment charges or shortened useful lives of certain long-lived assets could be required.

Inventory Valuation

We record our inventory at the lower of cost (computed on a first-in, first-out basis) or market. We write-down our inventory to its estimated market value based on assumptions about future demand and market conditions. Inventory write-downs are generally recorded, within guidelines set by management, when the inventory for a device exceeds 12 months of demand for the device and when individual parts have been in inventory for greater than 12 months. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required which could materially affect our future results of

operations. We write-down our demo inventory by amortizing the cost of demo inventory over a two-year period from the fourth month it is placed in service. During the year ended September 27, 2003, we recorded $2.7 million ($1.2 million after-tax and net of minority interest) of additional inventory write-downs due to a decrease in anticipated future demand and significant changes in the economic outlook for Lambda Physik’s lithography business. Due to rapidly changing forecasts and orders, additional write-downs for excess or obsolete inventory, while not currently expected, could be required in the future. Differences between actual results and previous estimates of excess and obsolete inventory could result in material adverse effects on our future results of operations.

Warranty Reserves

We provide warranties on our product sales, and allowances for estimated warranty costs are recorded at the time of sale. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or replace the products under warranty. We currently establish warranty reserves based on historical warranty costs for each product line. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of sales may be required in future periods.

Income Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax provision (benefit) in each of the jurisdictions in which we operate. This process involves us estimating our current income tax provision (benefit) together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets.

We record a valuation allowance to reduce our deferred tax assets for the amount that is not more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

During fiscal 2003, our valuation allowance on deferred tax assets increased by $14.6 million, including a $7.8 million write down of deferred tax assets at Lambda Physik and increased allowances related to net capital loss carryforwards. In making the determination to record the valuation allowance, management considered the likelihood of future taxable income and feasible and prudent tax planning strategies to realize deferred tax assets. In the future, if we determine that we expect to realize more or less of the deferred tax assets, an adjustment to the valuation allowance will affect income in the period such determination is made.

Federal income taxes have not been provided for on a portion of the unremitted earnings of foreign subsidiaries either because such earnings are intended to be permanently reinvested or because foreign tax credits are available to offset any planned distributions of such earnings.

KEY PERFORMANCE INDICATORS

The following is a summary of some of the quantitative performance indicators (as defined below) that may be used to assess our results of operations and financial condition (dollars in thousands):

	Three Months Ended
	July 3, 2004			June 28, 2003			Change			% Change
Bookings – Electro-Optics	$	103,431		$	85,363		$	18,068		21.2	%
Bookings – Lambda Physik	$	21,513		$	18,158		$	3,355		18.5	%
Net sales – Electro-Optics	$	105,501		$	83,342		$	22,159		26.6	%
Net sales – Lambda Physik	$	22,450		$	15,832		$	6,618		41.8	%
Gross profit as a% of net sales – Electro-Optics	45.4		%	41.0		%	4.4		%	10.7	%
Gross profit as a% of net sales – Lambda Physik	31.6		%	17.5		%	14.1		%	80.6	%
Research and development as a% of net sales	12.1		%	12.8		%	(0.7		)%	(5.5	)%
Income (loss) from continuing operations before income taxes and minority interest	$	9,684		$	(6,968	)	$	16,652		239.0	%
Net cash provided by continuing operating activities	$	16,442		$	11,657		$	4,785		41.0	%
DSO in inventories	75.3			96.3			(21.0		)	(21.8	)%
DSO in receivables	62.2			67.4			(5.2		)	(7.7	)%
Capital spending as a% of net sales	6.1		%	6.8		%	(0.7		)%	(10.3	)%

	Nine Months Ended
	July 3, 2004			June 28, 2003			Change			% Change
Bookings – Electro-Optics	$	319,218		$	249,069		$	70,149		28.2	%
Bookings – Lambda Physik	$	69,916		$	51,749		$	18,167		35.1	%
Net sales – Electro-Optics	$	300,070		$	240,561		$	59,509		24.7	%
Net sales – Lambda Physik	$	61,640		$	64,155		$	(2,515	)	(3.9	)%
Gross profit as a% of net sales – Electro-Optics	43.6		%	41.8		%	1.8		%	4.3	%
Gross profit as a% of net sales – Lambda Physik	27.8		%	27.9		%	(0.1		)%	(0.3	)%
Research and development as a% of net sales	12.7		%	12.0		%	0.7		%	5.8	%
Income (loss) from continuing operations before income taxes and minority interest	$	13,798		$	(28,632	)	$	42,430		148.2	%
Net cash provided by continuing operating activities	$	49,765		$	11,146		$	38,619		346.5	%
Capital spending as a% of net sales	11.4		%	6.3		%	5.1		%	81.0	%

Definitions and analysis of these performance indicators is as follows:

Bookings

Bookings represent orders expected to be shipped within 12 months. Bookings are generally cancelable without substantial penalty and, historically, we generally have not experienced a significant rate of cancellation. Bookings for a period are calculated by adding current period net sales to the increase or decrease in ending backlog during the period.

In our Electro-Optics segment, third fiscal quarter bookings increased 21.2% from the same quarter one year ago and 28.2% from the same year-to-date period one year ago. Current quarter bookings, compared to the same quarter one year ago, increased in the microelectronics, graphic arts and display and OEM components and instrumentation markets, partially offset by decreases in the materials processing and scientific and government programs markets. Year-to-date bookings increased in the microelectronics, scientific and government programs, OEM components and instrumentation and materials processing markets, partially offset by decreases in the graphic arts and display market.

Bookings in the microelectronics market increased from the same prior year periods as a result of sustained demand for wafer and packaging applications. Demand in the wafer inspection, mask inspection and metrology applications remains strong as we benefited from legacy business as well as design wins achieved over the past 18 months. New orders for advanced packaging and interconnect in printed circuit board (PCB) applications were especially strong in Japan, signaling continuing penetration of photonics-based via drilling in PCB direct imaging applications. As growth in the PCB market is dependent upon higher throughput and support of new materials, we recently launched the new Avia^TM Thor^TM laser, which is an ideal tool for high-throughput via hole drilling in PC boards, as well as for drilling, cutting and trenching hard materials such as stainless steel, silicon, ceramics, diamond and sapphire. There are

encouraging signs for PCB direct imaging as adoption of laser-based tools is expanding. To address our key growth drivers of throughput, yield and cost per part, we recently released an 8W version of the Paladin, for which we expect the final tool will increase return on investments for PCB manufacturers. Although bookings in the scientific and government programs market decreased slightly in the current quarter, they increased significantly year-to-date from the same period one year ago. Geographically, the current quarter decrease was due to lower demand in Europe due to slower and potentially decreased funding for research and in Asia due to order delays. Incoming orders for our standard scientific producs in the current quarter were weak, however orders for our custom laser business, representing leading edge performance, were strong. Bookings in the OEM components and instrumentation market increased from the same periods one year ago, with strength in the bioinstrumentation market due to strong volume orders for our Compass and Sapphire lasers (primarily low-power). We have seen an increase in defense-related orders for use in countermeasures and remote detection as well as increased demand in the OEM medical market due to a pick-up in ophthalmic and dental applications. There are emerging applications in chip readers, DNA sequencing and microscopy that will leverage the higher power version of the Sapphire laser. Although bookings in the materials processing market decreased in the current quarter, they increased significantly year-to-date from the same period one year ago. The current quarter decrease resulted from large orders placed by customers in the prior quarter to lock-in deliveries; detailed reviews with our customers indicate the end-user demand remains strong for our photonics-based equipment. We have had no requests for delivery push-outs or order cancellations in this market and would not expect another large fluctuation in bookings in upcoming quarters. Graphic arts and display orders rebounded in the current quarter primarily due to thermal computer-to-plate (CTP) applications, which were the clear winners and the recent industry trade show, DRUPA, held in Düsseldorf, Germany during May. Updates to our legacy products as well as new product offerings to improve image quality, speed and cost have strengthened our position in thermal CTP. In addition, high-volume newspaper printing applications using our Paladin laser and applications for flexography and screen printing for textiles are exhibiting growth potential.

In our Lambda Physik segment, third fiscal quarter bookings increased 18.5% from the same quarter one year ago and 35.1% from the same year-to-date period one year ago. Bookings increases in the industrial and scientific and medical markets were partially offset by decreases in the lithography market.

Bookings in the industrial market increased from the same periods one year ago primarily due to a recovery in the microelectronics market, with improving demand for our TFT annealing products due to growth in flat panel display sales and increased activity in the ink-jet market, where Lambda excimer lasers are used to drill nozzles in the ink-jet heads. Bookings in the scientific and medical market increased primarily due to our Optex lasers in the medical market and strong U.S. scientific orders. Bookings in the lithography market decreased from the same periods one year ago primarily due to continued weakness in the lithography market, with current period orders related to service only. Subsequent to quarter-end, Lambda introduced the LithoTex^TM, its new high-power 193nm laser at Semicon West. The laser is based upon a unique architecture called MORRA^TM (Master Oscillator Regenerative Ring Amplifier). The design addresses two specific customer needs. First, it produces a longer, naturally occurring temporal pulse width that results in peak intensities approximately 50% lower than competitive products for any given power level. This serves to protect the expensive objective lens assembly from long-term intensity-driven degradation, resulting in lower cost of ownership for fab operators. The second advantage is the lowest specified levels of amplified stimulated emission (ASE), which is background light that can be projected through the optical delivery system and can compromise image contrast on the wafer. Minimizing ASE helps improve yields and lowers cost for chip manufacturers. The LithoTex^TM has also been designed with future needs in mind as it can accommodate increased output power and repetition rate as well as reduced linewidth.

Net Sales

Net sales include sales of lasers, laser-based systems, precision optics, related accessories and service contracts. Net sales for the third fiscal quarter increased 26.6% in our Electro-Optics segment and 41.8% in our Lambda Physik segment from the same quarter one year ago. Net sales for the first nine months of fiscal 2004 increased 24.7% in our Electro-Optics segment and decreased 3.9% in our Lambda Physik segment from the same period one year ago. For a more complete description of the reasons for changes in net sales, we refer you to the “Results of Operations” section of this Form 10-Q.

Gross Profit as a Percentage of Net Sales

Gross profit as a percentage of net sales (gross profit percentage) is calculated as gross profit for the period divided by net sales for the period. Gross profit percentage in the third fiscal quarter increased from 41.0% to 45.4% in our Electro-Optics segment and increased from 17.5% to 31.6% in our Lambda Physik segment from the same quarter one year ago. Gross profit percentage for the first nine months of fiscal 2004 increased from 41.8% to 43.6% in our Electro-Optics segment and decreased from 27.9% to 27.8% in our Lambda Physik segment from the same period one year ago. For a more complete description of the reasons for changes in gross profit percentage, we refer you to the “Results of Operations” section of this Form 10-Q.

Research and Development as a Percentage of Net Sales

Research and development as a percentage of net sales (R&D percentage) is calculated as research and development expense for the period divided by net sales for the period. R&D percentage decreased from 12.8% to 12.1% in the third fiscal quarter and increased from 12.0% to 12.7% for the nine months ended July 3, 2004 from the same quarter and year-to-date periods, respectively, one year ago. For a more complete description of the reasons for changes in R&D percentage, refer to the “Results of Operations” section of this Form 10-Q.

Income (Loss) From Continuing Operations before Income Taxes and Minority Interest

Our income (loss) from continuing operations before income taxes and minority interest in the third quarter of fiscal 2004 increased $16.7 million to income of $9.7 million from a loss of $7.0 million in the same quarter one year ago, primarily due to higher sales volumes and higher gross margins as a percentage of sales, partially offset by higher period expenses. Income (loss) from continuing operations before income taxes and minority interest for the first nine months of fiscal 2004 increased $42.4 million to income of $13.8 million from a loss of $28.6 million in the same period one year ago, primarily due to the prior year period’s larger restructuring, impairment and other charges, higher sales volumes and higher gross margins as a percentage of sales. For a more complete description of the reasons for changes in income (loss) from continuing operations before income taxes and minority interest, we refer you to the “Results of Operations” section of this Form 10-Q.

Net Cash Provided by Continuing Operating Activities

Net cash provided by continuing operating activities shown on our Condensed Consolidated Statements of Cash Flows represents the excess of cash collected from billings to our customers over cash paid to our vendors for expenses and inventory purchases to run our business. This amount represents what is available from current operations to pay for equipment, technology, and other investing activities, to repay debt, fund acquisitions and for other financing purposes. We believe this is an important performance indicator since cash generation over the long term is essential to maintaining a healthy business and providing funds to help fuel growth. We believe generating consistent cash from operations is an indication that our products are achieving a high level of customer satisfaction and we are appropriately monitoring our expenses and inventory levels. Cash flow from continuing operating activities in the third quarter of fiscal 2004 increased $4.8 million from the same quarter one year ago primarily due to increased net income. Cash flow from continuing operating activities in the first nine months of fiscal 2004 increased $38.6 million from the same period one year ago primarily due to the reclassification of our short-term investments from trading securities to available for sale securities and income tax refunds received in fiscal 2004, partially offset by increased trade receivables. For a more complete description of the components of cash flows from continuing operating activities, we refer you to the Condensed Consolidated Statements of Cash Flows in this Form 10-Q and the “Changes in Financial Condition” section of this Form 10-Q.

Daily Sales Outstanding in Inventories

We calculate daily sales outstanding (DSO) in inventories as net inventories at the end of the period divided by net sales of the period and then multiplied by the number of days in the period, using 90 days for quarters. This indicates how well we are managing our inventory levels, with lower DSO in inventories resulting in more working capital available. The more money we have tied up in inventory, the less money we have available for research and development, acquisitions, expansions, marketing and other activities to grow our business. Our DSO in inventories for the third quarter of fiscal 2004 decreased 21.0 days from the same quarter one year ago to 75.3 days. The improvement in DSO in inventories is primarily due to better management of inventory levels in relation to sales volumes.

Daily Sales Outstanding in Receivables

We calculate daily sales outstanding (DSO) in receivables as net receivables at the end of the period divided by net sales during the period and then multiplied by the number of days in the period, using 90 days for quarters. This indicates how well we are managing our collection of receivables, with lower DSO in receivables resulting in more working capital available. The more money we have tied up in receivables, the less money we have available for research and development, acquisitions, expansions, marketing and other activities to grow our business. Our DSO in receivables for the third quarter of fiscal 2004 decreased 5.2 days from the same quarter one year ago. The improvement in DSO in receivables is primarily due to improved cash collections at Lambda Physik.

Capital Spending as a Percentage of Net Sales

Capital spending as a percentage of net sales (capital spending percentage) is calculated as capital expenditures for the period divided by net sales for the period. This indicates the extent to which we are expanding or modernizing our operations, including investments

in technology. Our capital spending percentage decreased from 6.8% to 6.1% compared to the same quarter one year ago due to tighter controlled spending. Our capital spending percentage increased from 6.3% to 11.4% for the first nine months of fiscal 2004 compared to the same year-to-date period one year ago primarily due to our purchase of our previously-leased facility in Santa Clara, California in the first quarter of fiscal 2004. We anticipate that capital spending for the remainder of fiscal 2004 will be approximately 5% to 6% of net sales.

SIGNIFICANT EVENTS

On June 3, 2003, we initiated a tender offer to purchase the 5,250,000 (39.62%) outstanding shares of our Lambda Physik subsidiary owned by other shareholders for approximately $10.50 per share. The offer period was originally set to expire on July 15, 2003, however, as a result of our decision to waive our requirement of owning a minimum of 95% of the total shares of Lambda Physik subsequent to the tender offer, the offer period was extended to July 30, 2003. As of September 27, 2003, we purchased a total of 4,489,823 outstanding shares of Lambda Physik for approximately $47.7 million, resulting in a total ownership percentage of 94.26% (inclusive of shares previously owned). We purchased an additional 98,677 outstanding shares of Lambda Physik for approximately $1.3 million during the nine months ended July 3, 2004 resulting in a total ownership percentage of 95.01% (inclusive of shares previously owned). At July 3, 2004, we had $8.3 million held in an escrow account that is restricted for the sole purpose of acquiring the remaining outstanding shares of Lambda Physik and are included in non-current restricted cash, cash equivalents and short-term investments on our condensed consolidated balance sheets. In January 2004, we reached 95% ownership of Lambda Physik. On May 5, 2004, a resolution was passed at Lambda Physik’s shareholders meeting that permits us to acquire all remaining shares in accordance with the German Stock Corporation Act. Following the May 5, 2004 resolution, several of Lambda Physik’s minority shareholders exercised their rights to contest our efforts in acquiring all of the remaining outstanding shares and an initial judicial review of their claims is scheduled to take place in the future. Upon acquisition of the minority interest, we plan on converting Lambda Physik from a stock corporation to a limited liability company, which will result in the Lambda Physik shares being de-listed from the Frankfurt Stock Exchange.

In January 2004, Lambda Physik announced a restructuring program, in which it plans to merge production sites and reduce headcount. The remaining projected costs will result in an estimated cash outflow of approximately $0.2 million and will be recognized over the remainder of fiscal 2004, which we anticipate will be largely offset by savings achieved. We estimate the fiscal 2005 savings to be approximately $2.3 million, at current exchange rates.

Fiscal 2004 will include 53 weeks, whereas fiscal 2003 included 52 weeks. Accordingly, the nine months ended July 3, 2004 contained 40 weeks, whereas the nine months ended June 28, 2003 contained 39 weeks.

RESULTS OF OPERATIONS

CONSOLIDATED SUMMARY

The following table sets forth, for the periods indicated, the percentage of total net sales represented by the line items reflected in our condensed consolidated statements of operations:

	Three Months Ended				Nine Months Ended
	July 3, 2004		June 28, 2003		July 3, 2004		June 28, 2003
Net sales	100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales	57.0	%	62.7	%	59.1	%	61.1	%
Gross profit	43.0	%	37.3	%	40.9	%	38.9	%
Operating expenses:
Research and development	12.1	%	12.8	%	12.7	%	12.0	%
In-process research and development	—		4.5	%	—		1.5	%
Selling, general and administrative	22.4	%	25.6	%	23.1	%	24.6	%
Restructuring, impairment and other charges	0.0	%	0.3	%	0.1	%	7.6	%
Intangibles amortization	1.2	%	1.4	%	1.4	%	1.0	%
Total operating expenses	35.7	%	44.6	%	37.3	%	46.7	%
Income (loss) from operations	7.3	%	(7.3	)%	3.6	%	(7.9	)%
Other income (expense):
Interest and dividend income	0.4	%	1.0	%	0.5	%	1.4	%
Interest expense	(0.6	)%	(0.9	)%	(0.7	)%	(1.0	)%
Foreign exchange gain (loss)	0.0	%	(1.1	)%	0.2	%	(0.5	)%
Write-down of Lumenis investment	—		—		—		(3.4	)%
Other—net	0.5	%	1.4	%	0.2	%	1.9	%
Total other income (expense), net	0.3	%	0.3	%	0.2	%	(1.5	)%
Income (loss) from continuing operations before income taxes and minority interest	7.6	%	(7.0	)%	3.8	%	(9.4	)%
Provision (benefit) for income taxes	3.4	%	(3.6	)%	1.7	%	(2.3	)%
Income (loss) from continuing operations before minority interest	4.2	%	(3.4	)%	2.1	%	(7.1	)%
Minority interest in subsidiaries’ (earnings) losses	(0.2	)%	1.1	%	0.0	%	0.3	%
Income (loss) from continuing operations	4.0	%	(2.3	)%	2.1	%	(6.8	)%
Discontinued operations, net of tax	—		—		0.1	%	—
Net income (loss)	4.0	%	(2.3	)%	2.2	%	(6.8	)%

Income from continuing operations for the third quarter of fiscal 2004 was $5.2 million ($0.17 per diluted share) compared to loss from continuing operations of $2.3 million ($0.08 per diluted share) in the same quarter in the prior year. The current year quarter income included a $1.2 million gain related to the sale of certain technology. The prior year quarter loss included a $4.4 million write-off of purchased in-process research and development (IPR&D) related to the acquisition of Positive Light, Inc., partially offset by a gain of $1.5 million related to the sale of 5.2 million shares of Lumenis, Ltd. (Lumenis) and a $0.9 million tax benefit relating to a refund of prior year taxes. Income from continuing operations for the nine months ended July 3, 2004 was $7.7 million ($0.25 per diluted share), including a $1.2 million gain related to the sale of certain technology. For the same nine month period in the prior year, loss from continuing operations was $20.8 million ($0.71 per share), including restructuring, impairment and other charges of $20.8 million , write-off of IPR&D related to the acquisition of Positive Light, Inc. (PLI) of $4.4 million, goodwill impairment of $2.4 million related to Lambda Physik’s lithography business, and a $10.2 million impairment charge related to the write-down of our shares of Lumenis, partially offset by a settlement fee of $4.4 million received by Lambda Physik related to the cancellation of a customer contract, a gain of $1.5 million related to the sale of 5.2 million shares of Lumenis and a $0.9 million tax benefit related to a refund of prior year taxes. The restructuring, impairment and other charges in the prior year nine months included a $14.1 million charge related to the termination of activities of CTAG, a $3.7 million allowance against our note receivable from Picometrix, and a $3.2 million write-down of our Lincoln, California facility to estimated net realizable value at December 28, 2002.

NET SALES:

	Three Months Ended
	July 3, 2004				June 28, 2003
	Amount		Percentage of total net sales		Amount		Percentage of total net sales
	(Dollars in thousands)
Consolidated:
Domestic	$	48,013	37.5	%	$	39,480	39.8	%
Foreign	79,938		62.5	%	59,694		60.2	%
Total	$	127,951	100.0	%	$	99,174	100.0	%

Electro-Optics:
Domestic	$	44,847	35.0	%	$	37,090	37.4	%
Foreign	60,654		47.4	%	46,252		46.6	%
Total	$	105,501	82.4	%	$	83,342	84.0	%

Lambda Physik:
Domestic	$	3,166	2.5	%	$	2,390	2.4	%
Foreign	19,284		15.1	%	13,442		13.6	%
Total	$	22,450	17.6	%	$	15,832	16.0	%

	Nine Months Ended
	July 3, 2004				June 28, 2003
	Amount		Percentage of total net sales		Amount		Percentage of total net sales
	(Dollars in thousands)
Consolidated:
Domestic	$	139,304	38.5	%	$	112,891	37.0	%
Foreign	222,406		61.5	%	191,825		63.0	%
Total	$	361,710	100.0	%	$	304,716	100.0	%

Electro-Optics:
Domestic	$	130,796	36.2	%	$	101,627	33.4	%
Foreign	169,274		46.8	%	138,934		45.6	%
Total	$	300,070	83.0	%	$	240,561	79.0	%

Lambda Physik:
Domestic	$	8,508	2.3	%	$	11,264	3.6	%
Foreign	53,132		14.7	%	52,891		17.4	%
Total	$	61,640	17.0	%	$	64,155	21.0	%

Consolidated

Net sales for the third fiscal quarter and the nine months ended July 3, 2004 increased $28.8 million, or 29%, and $57.0 million, or 19%, respectively, from the same periods one year ago. The increase in the third fiscal quarter of 2004 was as a result of increased sales volumes in both segments and the year-to-date increase was due to increased sales volumes in the Electro-Optics segment, partially offset by decreased sales volumes in the Lambda Physik segment. During the third fiscal quarter, foreign sales increased by $20.2 million, or 34%, and domestic sales increased by $8.5 million, or 22%. During the nine months ended July 3, 2004, foreign sales increased $30.6 million, or 16%, and domestic sales increased $26.4 million, or 23%, from the same period one year ago. We anticipate that consolidated net sales in the fourth quarter of fiscal 2004 will increase approximately 3% to 6% from third quarter of fiscal 2004 net sales.

Electro-Optics

Electro-Optics net sales increased $22.2 million, or 27%, and $59.5 million, or 25%, for the third fiscal quarter and nine months ended July 3, 2004, respectively, compared to the corresponding prior year periods. Domestic sales increased $7.8 million, or

21%, and foreign sales increased $14.4 million, or 31%, during the third quarter of fiscal 2004 compared to the same quarter one year ago. Domestic sales increased $29.2 million, or 29%, and foreign sales increased $30.3 million, or 22%, for the first nine months of fiscal 2004 compared to the same period one year ago.

The third fiscal quarter increase is primarily due to increases in the markets for microelectronics, OEM components and instrumentation and materials processing applications, including the strengthening of the Euro and Yen against the U.S. dollar ($3.3 million). Microelectronics application sales increased $15.3 million, or 104%, compared to the third quarter of fiscal 2003, primarily due to improving fundamentals in the semiconductor equipment and consumer electronics markets. OEM components and instrumentation application sales increased $4.8 million, or 22%, primarily due to significantly increased bioinstrumentation volumes. Materials processing application sales increased $3.5 million, or 27%, primarily due to unusually strong orders in the prior quarter for marking, engraving and textile processing. The year-to-date increase is primarily due to increases in the markets for microelectronics, scientific research and government programs and OEM components and instrumentation applications, including the strengthening of the Euro and Yen against the U.S. dollar ($14.2 million). Microelectronics application sales increased $33.4 million, or 82%, compared to the same period in fiscal 2003, primarily due to improving fundamentals in the semiconductor equipment and consumer electronics markets. Net sales within the scientific research and government programs lines of business improved by $14.7 million, or 20%, compared to the nine months ended June 28, 2003, primarily as a result of the increase in sales from our acquisition of PLI and increased sales from new scientific products. OEM components and instrumentation application sales increased $8.4 million, or 12%, primarily due to significantly increased bioinstrumentation volumes. Although we experienced increases in orders received over the past several quarters and we continue to have a sizeable backlog of orders, current market conditions make it difficult to predict future orders.

Lambda Physik

Lambda Physik net sales increased $6.6 million, or 42%, for the third fiscal quarter and decreased $2.5 million, or 4%, for the nine months ended July 3, 2004, compared to the corresponding prior year periods. Domestic sales increased $0.8 million, or 32%, and foreign sales increased $5.8 million, or 43%, during the third quarter of fiscal 2004 compared to the same quarter one year ago. Domestic sales decreased $2.8 million, or 24%, and foreign sales increased $0.2 million, or less than 1%, for the first nine months of fiscal 2004 compared to the same period one year ago.

Net sales increased in the third quarter of fiscal 2004 primarily due to higher sales volumes of $8.5 million, or 151%, in the industrial market due to higher industrial TFT sales, higher ink jet system sales and higher service revenues and $1.8 million, or 54%, higher sales in the scientific and medical market due to stronger medical sales, partially offset by lower sales volumes of $3.6 million, or 53%, in the lithography market due to continued softness in the market. The third quarter of fiscal 2004 increases include the favorable impact of the strengthening of the Euro against the U.S. dollar ($1.2 million).

For the first nine months of fiscal 2004, net sales decreased primarily due to lower sales volumes of $12.6 million, or 51%, in the lithography market due to continued softness in the market, partially offset by higher industrial market sales of $7.3M, or 27%, due to increased industrial TFT and ink jet system sales as well as higher medical system sales. The year-to-date fiscal 2004 increases include the favorable impact of the strengthening of the Euro against the U.S. dollar ($5.5 million).

GROSS PROFIT

Consolidated

Our consolidated gross profit rate increased to 43.0% from 37.3% in the third fiscal quarter and increased to 40.9% from 38.9% for the nine months ended July 3, 2004, compared to the same periods one year ago. The third fiscal quarter increase in gross profit rate was primarily due to lower additional inventory provisions and lower losses on certain service contracts in the Lambda Physik segment, more favorable manufacturing overhead absorption in both segments and lower warranty expenses in the Lambda Physik segment, partially offset by increased lower margin industrial service business and lower shipments of higher margin lithography systems in the Lambda Physik segment. The increase for the first nine months of fiscal 2004 was primarily due to more effective leveraging of manufacturing overhead due to higher sales volumes and lower additional inventory provisions, lower losses on certain service contracts and lower warranty expenses in the Lambda Physik segment, partially offset by lower shipments of higher margin industrial and lithography systems in the Lambda Physik segment, higher inventory costs resulting from our step acquisition of Lambda Physik and higher warranty expenses in the Electro-Optics segment.

Our consolidated gross profit rates have been and will continue to be affected by a variety of factors including foreign and domestic sales mix, manufacturing efficiencies, excess and obsolete inventory write downs, warranty costs, pricing by competitors or suppliers, new product introductions, production volume, customization and reconfiguration of systems, foreign currency

fluctuations and field service margins. We anticipate that our gross profit rate will be in the range of 42% to 44% in the fourth quarter of fiscal 2004.

Electro-Optics

The gross profit rate increased to 45.4% from 41.0% in the third fiscal quarter and increased to 43.6% from 41.8% for the nine months ended July 3, 2004, compared to the same periods one year ago. The third fiscal quarter increase was primarily due to increased yields and productivity, improved absorption of manufacturing overhead and favorable product mix, with increased volumes of higher margin products. The increase for the first nine months of fiscal 2004 was primarily due to more effective leveraging of manufacturing overhead due to higher sales volumes and lower inventory provisions, partially offset by higher warranty expenses. We reached our goal of 45% margin one quarter ahead of schedule and anticipate a more modest improvement in our quarterly gross profit rate in the next quarter.

Lambda Physik

The gross profit rate increased to 31.6% from 17.5% in the third fiscal quarter, but decreased to 27.8% from 27.9% for the nine months ended July 3, 2004, compared to the same periods one year ago. The third fiscal quarter increase was primarily due to lower inventory provisions, lower losses on certain service contracts, lower manufacturing expenses and lower warranty expenses due to improved quality, partially offset by lower shipments of higher margin lithography systems. The slight decrease for the first nine months of fiscal 2004 was primarily due to lower shipments of higher margin industrial and lithography systems and higher inventory costs included in our cost of sales resulting from our step acquisition of Lambda Physik, partially offset by lower losses on certain service contracts, lower additional inventory provisions and lower warranty expenses due to improved quality.

OPERATING EXPENSES:

	Three Months Ended
	July 3, 2004				June 28, 2003
	Amount		Percentage of total net sales		Amount		Percentage of total net sales
	(Dollars in thousands)
Research and development	$	15,505	12.1	%	$	12,694	12.8	%
In-process research and development	—		—		4,430		4.5	%
Selling, general and administrative	28,626		22.4	%	25,437		25.6	%
Restructuring, impairment and other charges	18		0.0	%	289		0.3	%
Intangibles amortization	1,504		1.2	%	1,397		1.4	%
Total operating expenses	$	45,653	35.7	%	$	44,247	44.6	%

	Nine Months Ended
	July 3, 2004				June 28, 2003
	Amount		Percentage of total net sales		Amount		Percentage of total net sales
	(Dollars in thousands)
Research and development	$	45,964	12.7	%	$	36,627	12.0	%
In-process research and development	—		—		4,430		1.5	%
Selling, general and administrative	83,716		23.1	%	75,024		24.6	%
Restructuring, impairment and other charges	255		0.1	%	23,111		7.6	%
Intangibles amortization	5,203		1.4	%	3,179		1.0	%
Total operating expenses	$	135,138	37.3	%	$	142,371	46.7	%

Total operating expenses increased $1.4 million, or 3%, during the third fiscal quarter from one year ago and as a percentage of net sales, total operating expenses decreased to 35.7% from 44.6% one year ago. Total operating expenses decreased $7.2 million, or 5%, for the first nine months of fiscal 2004 compared to the same period one year ago and as a percentage of net sales, total operating expenses decreased to 37.3% from 46.7% compared to the same period one year ago. Total operating expenses include restructuring, impairment and other charges of $0.3 million during the quarter ended June 28, 2003 and $0.3 million and $23.1 million during the year-to-date periods ended July 3, 2004 and June 28, 2003, respectively.

Research and development (R&D) expenses increased $2.8 million, or 22%, and $9.3 million, or 25%, in the fiscal quarter and nine months ended July 3, 2004 compared to the comparable periods one year ago. As a percentage of net sales, R&D expense

decreased to 12.1% from 12.8% in the third fiscal quarter and increased to 12.7% from 12.0% in the nine months ended July 3, 2004.

The current quarter increase in spending was primarily due to increased spending to support new product development including the 193nm lithography program in our Lambda Physik segment, increased activities related to individually addressable semiconductor laser bar products in our Electro-Optics segment and the consolidation of Picometrix under FIN 46R. The current quarter decrease as a percentage of sales was due to significantly increased sales volumes. The year-to-date increase was due to increased spending to support new product development including the 193nm lithography program and increased spending to improve product reliability and expand specifications in our Lambda Physik segment, increased activities related to individually addressable semiconductor laser bar products in our Electro-Optics segment, the fiscal 2003 acquisitions of PLI and Molectron Detector, Inc. (Molectron) and the consolidation of Picometrix under FIN 46R, partially offset by the termination of our CTAG operations in the first quarter of fiscal 2003. We anticipate the R&D expenses to be in the range of 12.0% to 12.5% of net sales in the fourth quarter of fiscal 2004.

The in-process research and development charge of $4.4 million in the quarter and nine months ended June 28, 2003 resulted from our acquisition of PLI.

Selling, general and administrative (SG&A) expenses increased $3.2 million, or 13%, and $8.7 million, or 12%, in the fiscal quarter and nine months ended July 3, 2004 compared to the comparable periods one year ago. As a percentage of net sales, SG&A expenses decreased to 22.4% from 25.6% in the third fiscal quarter and to 23.1% from 24.6% in the nine months ended July 3, 2004. The current quarter dollar increase was primarily due to higher sales commissions, higher facilities expenses due to building remodeling, higher depreciation expense and consulting related to our investments in information technology systems and the consolidation of Picometrix under FIN 46R. The year-to-date increase was primarily due to the acquisitions of PLI and Molectron, higher depreciation expense and consulting related to our investments in information technology systems, higher facilities expenses due to building remodeling and higher headcount related expenses partially offset by cost containment efforts and lower bad debt provisions. We anticipate SG&A expenses to be in the range of 22.0% to 23.5% of net sales in the fourth quarter of fiscal 2004.

Our restructuring, impairment and other charges of $23.1 million during the nine months ended June 28, 2003 consisted of (1) a $14.1 million charge related to the termination of our CTAG operations for the write-down of equipment to net realizable value; an accrual for the estimated contractual obligation for lease and other facility costs of the building formerly occupied by CTAG, net of sublease income; and the write-down of our option to purchase Picometrix; (2) a $3.7 million impairment charge to write-down the value of our note receivable from Picometrix to net realizable value; (3) a charge of $3.2 million to write-down our Lincoln, California land, buildings and improvements and equipment to their estimated net realizable value; (4) goodwill impairment of $2.4 million related to Lambda Physik’s lithography business; and (5) recoveries of $0.3 million in excess of estimated net realizable value for assets previously impaired and classified as held for sale.

Amortization of intangible assets increased $0.1 million, or 8%, and $2.0 million, or 64%, in the fiscal quarter and nine months ended July 3, 2004 compared to the comparable periods one year ago. As a percentage of net sales, amortization expense decreased to 1.2% from 1.4% in the third fiscal quarter and increased to 1.4% from 1.0% in the nine months ended July 3, 2004. The dollar increases were due to amortization of intangibles related to our fiscal 2003 acquisitions of PLI and Molectron and the step acquisition of an additional 34.6% of the outstanding shares of our Lambda Physik subsidiary.

OTHER INCOME (EXPENSE)

Other income, net of other expense, was flat in the third quarter of fiscal 2004 from the comparable fiscal quarter one year ago. The current fiscal quarter included a gain of $1.2 million related to sale of certain technology while the comparable fiscal quarter one year ago included a gain of $1.5 million related to the sale of 5.2 million shares of Lumenis. For the first nine months of fiscal 2004, other income, net of other expense, changed to income of $0.9 million from an expense of $4.6 million one year ago primarily due to the prior year period’s $10.2 million charge for the write-down of our investment in Lumenis stock due to an other-than-temporary impairment, lower foreign exchange losses and lower interest expense, partially offset by the prior year period’s $4.4 million settlement fee received by Lambda Physik relating to the cancellation of a customer contract.

INCOME TAXES

The effective tax rate on income from continuing operations before minority interest for the third quarter of fiscal 2004 was 44.0% compared to a 51.3% effective tax rate on loss from continuing operations for the same quarter last year. The effective tax rate on income from continuing operations before minority interest for the nine months ended July 3, 2004 was 45.5% compared to a 24.1% effective tax rate on loss from continuing operations in the prior year period. The third quarter of fiscal 2004 effective tax

rate decreased compared to the prior year quarter primarily due to the nondeductibility of the prior year quarter’s goodwill impairment charge, partially offset by the current quarter’s valuation allowance against losses at Lambda Physik. For the first nine months of fiscal 2004, the effective tax rate increased compared to the prior year period primarily due the current year’s valuation allowance against losses at Lambda Physik, the prior year’s valuation allowances recorded on the write-down of Lumenis stock and impairment of the Lincoln, California facility due to capital loss limitations and the nondeductibility of the prior year period’s goodwill impairment charge.

Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates, changes in the valuation of our deferred tax assets or liabilities, higher than anticipated losses at Lambda Physik, or changes in tax laws or interpretations thereof. We are in the process of attempting to reorganize our German manufacturing entities and a delay in the legal reorganization could result in the inability for us to reduce our effective tax rate to historical levels during the remainder of fiscal 2004. In addition, we are subject to the examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

MINORITY INTEREST IN SUBSIDIARIES (EARNINGS) LOSSES

Minority interest in subsidiaries (earnings) losses decreased to expense of $0.3 million for the third quarter of fiscal 2004 from earnings of $1.1 million for the corresponding prior year quarter. Minority interest in subsidiaries (earnings) losses decreased to earnings of $0.2 million for the nine months ended July 3, 2004 from $0.9 million for the corresponding prior year period. The increase in expense during the third fiscal quarter was due to the consolidation of Picometrix’s earnings in accordance with FIN 46R, partially offset by our acquisition of additional shares of Lambda Physik during fiscal 2003 and the first nine months of fiscal 2004 and decreased losses of our Lambda Physik subsidiary. For the first nine months of fiscal 2004, the decrease in earnings is due to our acquisition of additional shares of Lambda Physik during fiscal 2003 and the first nine months of fiscal 2004 and the consolidation of Picometrix’s earnings in accordance with FIN 46R, partially offset by the decreased profitability of our Lambda Physik subsidiary. In the nine months ended July 3, 2004, our Lambda Physik subsidiary recorded a loss of approximately $11.8 million and we anticipate that additional losses will be incurred by Lambda Physik in the three months ended October 2, 2004.

We expect minority interest in subsidiaries’ (earnings) losses to decrease significantly in fiscal 2004 from fiscal 2003 due to our acquisition of additional shares of Lambda Physik during fiscal 2003 and 2004. As of July 3, 2004, minority shareholders owned 4.99% of the shares of Lambda Physik.

In January 2004, we reached 95% ownership of Lambda Physik. On May 5, 2004, a resolution was passed at Lambda Physik’s shareholders meeting that permits us to acquire all remaining shares in accordance with the German Stock Corporation Act. Following the May 5, 2004 resolution, several of Lambda Physik’s minority shareholders exercised their rights to contest our efforts in acquiring all of the remaining outstanding shares and an initial judicial review of their claims is scheduled to take place in the future.

FINANCIAL CONDITION

LIQUIDITY AND CAPITAL RESOURCES

Sources and Uses of Cash

Historically, our primary source of cash has been provided through operations. Other sources of cash include proceeds received from the sale of stock through public offerings and employee stock option and purchase plans, as well as through debt borrowings. Our historical uses of cash have primarily been for capital expenditures, acquisitions of businesses and payments of principal and interest on outstanding debt obligations. Supplemental information pertaining to our historical sources and uses of cash is presented as follows and should be read in conjunction with our condensed consolidated statements of cash flows and notes thereto:

	Nine Months Ended
	July 3, 2004			June 28, 2003
	(In thousands)
Net cash provided by operating activities	$	49,765		$	11,146
Sales of shares under employee stock plans	6,923			10,825
Capital expenditures	(41,310		)	(19,340		)
Acquisition of businesses, net of cash acquired	(2,471		)	(44,131		)
Net payments on debt borrowings	(14,254		)	(32,399		)

Net cash provided by operating activities increased by $38.6 million to $49.8 million for the nine months ended July 3, 2004 compared to net cash provided by operating activities of $11.1 million for the same period one year ago. The increase was primarily due to the reclassification of our short-term investments from trading securities to available-for-sale securities (resulting in a change in classification of net investments from the operating section to the investing section in the statement of cash flows) and income tax refunds received in fiscal 2004, partially offset by increased trade receivables. We believe that our cash flow provided by operating activities will be adequate to cover our current working capital needs, debt service requirements and planned capital expenditures for at least he next 12 months to the extent such items are known or are reasonably determinable based on current business and market conditions. However, we may elect to finance certain of our capital expenditure requirements through borrowings under our bank credit facilities. We continue to follow our strategy to further strengthen our financial position by primarily using available cash flow to fund operations and to reduce the amount of debt we have outstanding.

We intend to continue pursuing acquisition opportunities at prices we believe are reasonable based upon market conditions. However, we cannot accurately predict the timing, size and success of our acquisition efforts or our associated potential capital commitments. Furthermore, we cannot assure you that we will be able to acquire businesses on terms acceptable to us. We expect to fund future acquisitions through cash flows provided by current unrestricted cash balances, operations, additional borrowings or the issuance of securities. The extent to which we will be willing or able to use our securities to make acquisitions will depend on its market value from time to time and the willingness of potential sellers to accept it as full or partial payment.

Additional sources of cash available to us were a multi-currency line of credit and bank credit facilities totaling $48.9 million as of July 3, 2004, of which $48.6 million was unused and available. These credit facilities were used in Europe during the nine months ended July 3, 2004. Our domestic lines of credit include a $12.5 million unsecured revolving account from Union Bank of California, which expires January 31, 2005. No amounts have been drawn upon our domestic lines of credit as of July 3, 2004.

Our ratio of current assets to current liabilities was 4.0:1 at July 3, 2004 compared to 3.9:1 at September 27, 2003. The increase in our ratio from September 27, 2003 to July 3, 2004 is primarily due to increases in accounts receivable, cash and cash equivalents, inventories, current deferred tax assets and short-term investments partially offset by decreases in prepaid income taxes. Our cash position, working capital and debt obligations are as follows:

	July 3, 2004		September 27, 2003
	(In thousands)
Cash and cash equivalents	$	89,468	$	76,541
Working capital	324,630		297,869
Total debt obligations	28,544		42,051

Debt Obligations and Restricted Cash, Cash Equivalents and Short-term Investments

During fiscal 2002, we amended the notes used to finance our acquisition of Star Medical (Star notes). The amendment included modifications of certain covenants associated with the notes and allowed a prepayment of a portion of the principal balance. As a result, in October 2002 we prepaid $7.3 million of the principal balance with no prepayment penalty. The Star notes originally included financial covenants such as maintaining a minimum tangible net worth, minimum consolidated debt to capitalization ratio, fixed charge coverage ratio, as well as non-financial covenants such as providing quarterly statements to the note holders. In September 2003, we amended the agreement to relinquish all financial covenant requirements. In place of the covenants, the amendment requires that we place cash and short-term investment balances in an amount equal to 120% of the principal balance in a restricted collateral account. At July 3, 2004, $15.2 million and $15.2 million of current and non-current restricted cash, cash equivalents and short-term investments, respectively, were related to the Star notes (see Note 10 in our Notes to Condensed Consolidated Financial Statements).

Our $12.5 million unsecured revolving account from Union Bank of California agreement was subject to standard covenants related to financial ratios, profitability and dividend payments and required us to maintain $50 million of cash and certain short-term investments (as defined in the agreement) at all times in any bank in the United States. During the second quarter of fiscal 2004, we amended the agreement. The amendment relinquishes the cash requirements and modified the terms of certain financial covenants. As of July 3, 2004, we were in compliance with these covenants.

As part of our tender offer to purchase the remaining outstanding shares of our Lambda Physik subsidiary, we were required by local regulations to have funds available for the offer in an account located in Germany. As of July 3, 2004, we had $8.3 million restricted for the purchase of the remaining outstanding shares of Lambda Physik which are included in non-current restricted cash, cash equivalents and short-term investments on our condensed consolidated balance sheets.

Contractual Obligations and Off-Balance Sheet Arrangements

At July 3, 2004, we have committed $1.5 million to purchase equipment and software for our facilities and to improve our information technology infrastructure in our Electro-Optics segment.

Information regarding our long-term debt payments, operating lease payments, capital lease payments and long-term purchase commitments is provided in Item 7 “Management’s Discussion and Analysis of Results of Operations and Financial Condition” of our Annual Report on Form 10-K for the fiscal year ended September 27, 2003, as amended. There have been no material changes in contractual obligations since September 27, 2003, except for: (1) the purchase of the Santa Clara, California facility which resulted in the termination of the off-balance sheet arrangement and a decrease in our operating lease payment obligations of $0.8 million for each of fiscal years 2004 through 2006 and $21.3 million for fiscal 2007 and (2) in connection with our consolidation of Picometrix under FIN 46R, Picometrix’s monthly operating lease payment obligation of $59,000 for the lease of their facility which expires June 2010. Information regarding our other financial commitments at July 3, 2004 is provided in the Notes to the Condensed Consolidated Financial Statements in this filing. See “Notes to Condensed Consolidated Financial Statements, Note 11— Commitments and Contingencies.”

Changes in Financial Condition

Cash provided by operating activities during the nine months ended July 3, 2004 was $49.8 million, which included depreciation and amortization of $27.8 million, cash provided by operating assets and liabilities of $10.1 million, net income from continuing operations of $7.7 million, increases in net deferred tax assets of $2.4 million and other of $1.8 million.

Cash used for investing activities during the nine months ended July 3, 2004 of $34.5 million included $41.3 million used to acquire property and equipment primarily due to the purchase of the Santa Clara, California facility, manufacturing equipment and investments in information technology, $5.9 million, net, used to purchase available-for-sale securities, $2.5 million used primarily to purchase additional shares of Lambda Physik and to buy-out the minority shareholders of Microlas and Optomech, and other of $2.8 million, partially offset by a $15.7 million decrease in restricted cash due to a Star note payment and $2.3 million provided by proceeds from dispositions of property and equipment.

Cash used by financing activities during the nine months ended July 3, 2004 of $4.3 million included net debt repayments of $14.3 million, partially offset by $7.0 million generated from our employee stock purchase and stock option plans and an increase in cash overdraft of $3.0 million.

Changes in exchange rates during the nine months ended July 3, 2004 provided $1.7 million, primarily due to the strengthening of the Euro and Japanese Yen in relation to the U.S. dollar.

Discontinued operations during the nine months ended July 3, 2004 provided $0.3 million due to the collection of a receivable from a customer of our discontinued medical segment that had been fully reserved.

Accounts receivable, net, increased $15.3 million, or 21%, from September 27, 2003 to July 3, 2004 primarily due to increased sales volumes, the impact of the stronger Euro and Japanese Yen against the U.S. dollar and increases in receivables in Japan that have longer payment terms. Inventories increased $6.9 million, or 7%, primarily due to the impact of the stronger Euro and Japanese Yen against the U.S. dollar and increases to support higher sales volumes. Prepaid expenses and other assets decreased $20.1 million, or 44%, from September 27, 2003 to July 3, 2004 primarily due to tax refunds received. Restricted cash decreased $14.9 million, or 39%, primarily due to payments on the Star notes. Other assets decreased $3.0 million, or 9%, from September 27, 2003 to July 3, 2004 primarily due to lower deferred tax assets. Accounts payable increased $3.0 million, or 17%, from September 27, 2003 to July 3, 2004 primarily due to fees payable related to the Lambda Physik tender offer, increased inventories and timing of payments. Income taxes payable increased $5.2 million, or 383%, due to higher than forecasted income and timing of payments. Other current liabilities decreased $2.3 million, or 3%, from September 27, 2003 to July 3, 2004 primarily due to decreases in liabilities for deferred taxes, customer deposits and lease termination costs, partially offset by increased other taxes payable. Long-term obligations decreased $13.4 million, or 48%, due to payments made on Star notes. Other long-term liabilities increased $10.7 million, or 37%, from September 27, 2003 to July 3, 2004 primarily due to increased deferred tax liabilities.

RECENT ACCOUNTING STANDARDS

additional subordinated financial support from other parties. The provisions of FIN 46 are effective immediately for all arrangements entered into after January 31, 2003. Since January 31, 2003, we have not invested in any entities that we believe are variable interest entities for which we are the primary beneficiary. For arrangements entered into prior to February 1, 2003, we were required to adopt the provisions of FIN 46R in the second quarter of fiscal 2004.

FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY

This quarterly report on Form 10-Q contains forward-looking statements. These forward-looking statements include, without limitation, statements regarding:

• net sales;

• operating results;

• achievement of the expected results and benefits;

• gross profits and our gross profit rate;

• research and development projects and expenses;

• selling, general and administrative expenses;

• bookings;

• average selling price;

• amount of restructuring, impairment and other charges;

• capital expenditures;

• warranty reserves;

• legal proceedings;

• claims against third parties for infringement of our proprietary rights;

• liquidity and sufficiency of existing cash, cash equivalents and short-term investments for near-term requirements;

• development and acquisition of new technology and intellectual property;

• write-downs for excess or obsolete inventory;

• competitors and competitive pressures;

• growth of applications for our products and increase of market share;

• our ability to obtain components and materials in a timely manner;

• our ability to identify alternative sources of supply for components;

• our ability to achieve adequate manufacturing yields;

• impact of recent acquisitions, including Positive Light, Inc.;

• improvement of operating results in Lambda Physik;

• growth in the semiconductor industry;

• growth of the laser markets and applications for lasers;

• growth of existing and future markets for our products, including materials processing, scientific research and government programs and security;

• compliance with environmental regulations;

• leveraging of our technology portfolio and application engineering;

• our ability to optimize our leadership position in existing markets;

• collaborative customer and industry relationships;

• development and acquisition of new technologies and new companies;

• our emphasis on supply chain management;

• growth of direct digital imaging applications;

• use of financial market instruments;

• simplifications of our foreign legal structure and reduction of our presences in certain countries; and

• focus on long-term improvement of return on invested capital.

You can identify these and other forward-looking statements by use of the words such as “may,” “will,” “could,” “would,” “should,” “expects,” “plans,” “anticipates,” “relies,” “believes,” “estimates,” “predicts,” “intends,” “potential,” “continue,” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below in “Management’s Discussion and Analysis of Results of Operations and Financial Condition” and under the heading “Risk Factors.” All forward-looking statements included in this document are based on information available to us on the date hereof. We undertake no obligation to update these forward-looking statements as a result of events or circumstances or to reflect the occurrence of unanticipated events.

BUSINESS ENVIRONMENT AND INDUSTRY TRENDS

Risks Related to our Business

We may experience quarterly and annual fluctuations in our net sales and operating results in the future, which may result in volatility in our stock price.

Our net sales and operating results may vary significantly from quarter to quarter and from year to year in the future. A number of factors, many of which are outside of our control, may cause these variations, including:

• general economic uncertainties;

• fluctuations in demand for, and sales of, our products or prolonged downturns in the industries that we serve;

• ability of our suppliers to produce and deliver components and parts, including sole or limited source components, in a timely manner, in the quantity and quality desired and at the prices we have budgeted;

• timing or cancellation of customer orders and shipment scheduling;

• fluctuations in our product mix;

• foreign currency fluctuations;

• introductions of new products and product enhancements by our competitors, entry of new competitors into our markets, pricing pressures and other competitive factors;

• our ability to develop, introduce, manufacture and ship new and enhanced products in a timely manner without defects;

• rate of market acceptance of our new products;

• delays or reductions in customer purchases of our products in anticipation of the introduction of new and enhanced products by us or our competitors;

• our ability to control expenses;

• level of capital spending of our customers;

• potential obsolescence of our inventory; and

• costs related to acquisitions of technology or businesses.

In addition, we often recognize a substantial portion of our sales in the last month of the quarter. Our expenses for any given quarter are typically based on expected sales and if sales are below expectations in any given quarter, the adverse impact of the shortfall on our operating results may be magnified by our inability to adjust spending quickly to compensate for the shortfall. We also base our manufacturing on our forecasted product mix for the quarter. If the actual product mix varies significantly from our forecast, we may not be able to fill some orders during that quarter, which would result in delays in the shipment of our products. Accordingly, variations in timing of sales, particularly for our higher priced, higher margin products, can cause significant fluctuations in quarterly operating results.

Due to these and other factors, we believe that quarter-to-quarter and year-to-year comparisons of our past operating results may not be meaningful. You should not rely on our results for any quarter or year as an indication of our future performance. Our operating results in future quarters and years may be below public market analysts’ or investors’ expectations, which would likely cause the price of our common stock to fall. In addition, over the past several years, the stock market has experienced extreme price and volume fluctuations that have affected the stock prices of many technology companies. There has not always been a direct correlation between this volatility and the performance of particular companies subject to these stock price fluctuations. These factors, as well as general economic and political conditions or investors’ concerns regarding the credibility of corporate financial statements and the accounting profession, may have a material adverse affect on the market price of our stock in the future.

Lambda Physik may not achieve the expected results in the lithography business.

Our Lambda Physik subsidiary recorded a loss of 15.7 million Euros (approximately $17.0 million) in fiscal 2003 and a loss of 9.7 million Euros (approximately $11.8 million) in the nine months ended July 3, 2004. We anticipate that additional losses will be incurred by Lambda Physik for the remainder of fiscal 2004. To a large degree, Lambda Physik’s future success is dependent on its ability to become a significant supplier of 193nm excimer lasers for lithography applications. In the event that Lambda Physik does not make sufficient progress towards this goal by the end of calendar 2004, we may decide to exit lithography applications and deploy our resources in other more profitable areas. Should we decide to discontinue our lithography business or any components of our lithography business, there would be substantial charges that would have a material adverse effect on our consolidated financial performance.

We may not achieve the expected benefits of integration with Lambda Physik.

We are in the process of reviewing the operational efficiency of Lambda Physik’s operations and expect to achieve efficiencies by integrating some of Lambda Physik’s operations into other Coherent operations. However, integrating the operations of Lambda Physik into our operations is a complex, time consuming and expensive process. The complexity of the technologies and operations being integrated and the disparate corporate cultures being combined may increase the difficulty of integration. Management’s focus on the integration of operations may distract attention from our day-to-day business and may disrupt key research and development, marketing or sales efforts. In addition, it is common in the technology industry for aggressive competitors to attract customers and recruit key employees away from companies during the integration phase of an acquisition.

In accordance with German law, several minority shareholders of Lambda Physik have filed lawsuits objecting to the squeeze out resolution passed at the Annual General Meeting in May 2004. These lawsuits may delay integration activities and postpone some of the benefits arising from the acquisition of the minority shares by the Company.

Our future success depends on our ability to develop and successfully introduce new and enhanced products that meet the needs of our customers.

Our current products address a broad range of commercial and scientific research applications in the photonics markets. We cannot assure you that the market for these applications will continue to generate significant or consistent demand for our products. Demand for our products could be significantly diminished by new technologies or products that replace them or render them obsolete.

During the nine months ended July 3, 2004, our research and development expenses were 13% of net sales. Over the last three fiscal years, our research and development expenses have been in the range of 11% to 13% of net sales. Our future success depends on our ability to anticipate our customers’ needs and develop products that address those needs. Introduction of new products and product enhancements will require that we effectively transfer production processes from research and development to manufacturing and coordinate our efforts with those of our suppliers to achieve volume production rapidly. If we fail to effectively transfer production processes, develop product enhancements or introduce new products in sufficient quantities to meet the needs of our customers as scheduled, our net sales may be reduced and our business may be harmed.

The successful completion of the upgrade to our information systems is critical to our ability to effectively and efficiently operate our business in the future.

Our success in navigating the current market will depend heavily upon our ability to assemble the necessary information to make informed decisions and implement those decisions quickly and effectively. We have been working on a major upgrade to our technology infrastructure and information systems and have implemented the systems in the majority of our domestic manufacturing locations and our international sales and service sites. We are still in the process of implementing the systems in one of our major domestic manufacturing sites and several of our foreign manufacturing sites. This upgrade will result in a consolidation from multiple critical legacy systems to primarily one fully integrated enterprise system. While we are taking great care to properly plan this implementation and to test the solution fully prior to the conversion, there can be no guarantees given that the conversion will not disrupt our operations.

We depend on skilled personnel to operate our business effectively in a rapidly changing market, and if we are unable to retain existing or hire additional personnel when needed, our ability to develop and sell our products could be harmed.

Our future success depends upon the continued services of our executive officers and other key engineering, sales, marketing, manufacturing and support personnel. None of our key employees, except for employees associated with recent acquisitions in the United States, are bound by an employment agreement for any specific term and these personnel may terminate their employment at any time. In addition, we do not have “key person” life insurance policies covering any of our employees.

Although we believe our restructured operations and other cost reduction activities will improve our organizational effectiveness and competitiveness, they could lead, in the short term, to disruptions in our business, reduced employee morale and productivity, increased attrition and problems with retaining existing employees and recruiting future employees and increased financial costs.

Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. Recruiting and retaining highly skilled personnel in certain functions continues to be difficult. At certain locations where we operate, the cost of living is extremely high and it may be difficult to retain key employees and management at a reasonable cost. We may not be successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs. Our failure to attract additional employees and retain our existing employees could adversely affect our growth and our business.

We face risks associated with our foreign sales that could harm our financial condition and results of operations.

For the nine months ended July 3, 2004, 62% of our net sales were derived from customers outside of the United States. During fiscal years 2003, 2002 and 2001, net sales from customers outside of the United States were 61%, 60% and 55%, respectively. We anticipate that foreign sales will continue to account for a significant portion of our revenues in the foreseeable future. A portion of our foreign sales occurs through our foreign sales subsidiaries and the remainder of our foreign sales result from exports to foreign distributors, resellers and customers. Our foreign operations and sales are subject to a number of risks, including:

• longer accounts receivable collection periods;

• the impact of recessions in economies outside the United States;

• unexpected changes in regulatory requirements;

• certification requirements;

• environmental regulations, including Waste Electrical Equipment and Restriction of Hazardous Substance regulations;

• reduced protection for intellectual property rights in some countries;

• potentially adverse tax consequences;

• political and economic instability; and

• preference for locally produced products.

We are also subject to the risks of fluctuating foreign exchange rates, which could materially adversely affect the sales price of our products in foreign markets as well as the costs and expenses of our foreign subsidiaries. While we use forward exchange contracts and other risk management techniques to hedge our foreign currency exposure, we remain exposed to the economic risks of foreign currency fluctuations.

The markets in which we sell our products are intensely competitive and increased competition could cause reduced sales levels, reduced gross margins or the loss of market share.

Competition in the various photonics markets in which we provide products is very intense. We compete against a number of companies, including Newport Corporation’s Spectra-Physics Lasers business unit; JDS Uniphase Corp.; Cymer, Inc.; Gigaphoton, Inc.; Rofin-Sinar Technologies, Inc.; Lightwave Electronics Corp.; and Excel Technology, Inc. Some of our competitors are large companies that have significant financial, technical, marketing and other resources. These competitors may be able to devote greater resources than we can to the development, promotion, sale and support of their products. Several of our competitors that have larger market capitalizations or more cash reserves are much better positioned than we are to acquire other companies in order to gain new technologies or products that may displace our product lines. Any of these acquisitions could give our competitors a strategic advantage. Any business combinations or mergers among our competitors, forming larger competitors with greater resources, could result in increased competition, price reductions, reduced margins or loss of market share, any of which could materially and adversely affect our business, results of operations and financial condition.

Additional competitors may enter the market and we are likely to compete with new companies in the future. We may encounter potential customers that, due to existing relationships with our competitors, are committed to the products offered by these competitors. As a result of the foregoing factors, we expect that competitive pressures may result in price reductions, reduced margins and loss of market share.

Our future success depends on our ability to increase our sales volumes and decrease our costs to offset anticipated declines in the average selling prices of our products and, if we are unable to realize greater sales volumes and lower costs, our operating results may suffer.

Our future success depends on the continued growth of the markets for lasers, laser systems, precision optics and related accessories, as well as our ability to identify, in advance, emerging markets for laser-based systems. We cannot assure you that we will be able to successfully identify new high-growth markets on a timely basis in the future. Moreover, we cannot assure you that new markets will develop for our products or our customers’ products, or that our technology or pricing will enable such markets to develop. Future demand for our products is uncertain and will depend to a great degree on the continued technological development and the introduction of new or enhanced products. If this does not continue, sales of our products may decline and our business will be harmed.

We have historically been the industry’s high quality, high priced supplier of laser systems. We have, in the past, experienced decreases in the average selling prices of some of our products. We anticipate that as competing products become more widely available, the average selling price of our products may decrease. If we are unable to offset the anticipated decrease in our average selling prices by increasing our sales volumes, our net sales will decline. In addition, to maintain our gross margins, we must continue to reduce the cost

of our products. Furthermore, as average selling prices of our current products decline, we must develop and introduce new products and product enhancements with higher margins. If we cannot maintain our gross margins, our operating results could be seriously harmed, particularly if the average selling prices of our products decrease significantly.

We may not be able to protect our proprietary technology, which could adversely affect our competitive advantage.

We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We cannot assure you that our patent applications will be approved, that any patents that may be issued will protect our intellectual property or that any issued patents will not be challenged by third parties. Other parties may independently develop similar or competing technology or design around any patents that may be issued to us. We cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.

We could become subject to litigation regarding intellectual property rights, which could seriously harm our business.

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. In the future, we may be a party to litigation to protect our intellectual property or as a result of an alleged infringement of others’ intellectual property. These claims and any resulting lawsuit, if successful, could subject us to significant liability for damages or invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:

• stop manufacturing, selling or using our products that use the infringed intellectual property;

• obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, although such license may not be available on reasonable terms, or at all; or

• redesign the products that use the technology.

If we are forced to take any of these actions, our business may be seriously harmed. We do not have insurance to cover potential claims of this type.

We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights to protect these rights or to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could result in costly litigation and the diversion of our technical and management personnel.

Some of our laser systems are complex in design and may contain defects that are not detected until deployed by our customers, which could increase our costs and reduce our revenues.

Laser systems are inherently complex in design and require ongoing regular maintenance. The manufacture of our lasers, laser products and systems involves a highly complex and precise process. As a result of the technical complexity of our products, changes in our or our suppliers’ manufacturing processes or the inadvertent use of defective materials by us or our suppliers could result in a material adverse effect on our ability to achieve acceptable manufacturing yields and product reliability. To the extent that we do not achieve such yields or product reliability, our business, operating results, financial condition and customer relationships would be adversely affected. We provide warranties on our product sales, and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or replace the products under warranty. We currently establish warranty reserves based on historical warranty costs for each product line. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of sales may be required in future periods.

Our customers may discover defects in our products after the products have been fully deployed and operated under peak stress conditions. In addition, some of our products are combined with products from other vendors, which may contain defects. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to identify and fix defects or other problems, we could experience, among other things:

• loss of customers;

• increased costs of product returns and warranty expenses;

• damage to our brand reputation;

• failure to attract new customers or achieve market acceptance;

• diversion of development and engineering resources; and

• legal actions by our customers.

The occurrence of any one or more of the foregoing factors could seriously harm our business, financial condition and results of operations.

The long sales cycles for our products may cause us to incur significant expenses without offsetting revenues.

Customers often view the purchase of our products as a significant and strategic decision. As a result, customers typically expend significant effort in evaluating, testing and qualifying our products before making a decision to purchase them, resulting in a lengthy initial sales cycle. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses to customize our products to the customer’s needs. We may also expend significant management efforts, increase manufacturing capacity and order long-lead-time components or materials prior to receiving an order. Even after this evaluation process, a potential customer may not purchase our products. As a result, these long sales cycles may cause us to incur significant expenses without ever receiving revenue to offset those expenses.

If we fail to accurately forecast component and material requirements for our products, we could incur additional costs and incur significant delays in shipments, which could result in loss of customers.

We use rolling forecasts based on anticipated product orders and material requirements planning systems to determine our product requirements. It is very important that we accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials. We depend on our suppliers for most of our product components and materials. Lead times for components and materials that we order vary significantly and depend on factors including the specific supplier requirements, the size of the order, contract terms and current market demand for components. For substantial increases in our sales levels, some of our suppliers may need at least six months lead-time. If we overestimate our component and material requirements, we may have excess inventory, which would increase our costs. If we underestimate our component and material requirements, we may have inadequate inventory, which could interrupt and delay delivery of our products to our customers. Any of these occurrences would negatively impact our net sales, business and operating results.

We depend on sole source or limited source suppliers for some of the key components and materials, including exotic materials and crystals, in our products, which makes us susceptible to supply shortages or price fluctuations that could adversely affect our business.

We currently purchase several key components and materials used in the manufacture of our products from sole source or limited source suppliers. Some of these suppliers are relatively small private companies that may discontinue their operations at any time. We typically purchase our components and materials through purchase orders and we have no guaranteed supply arrangement with any of these suppliers. We may fail to obtain these supplies in a timely manner in the future. We may experience difficulty identifying alternative sources of supply for certain components used in our products. We would experience further delays while identifying, evaluating and testing the products of these potential alternative suppliers. Furthermore, financial or other difficulties faced by these suppliers or significant changes in demand for these components or materials could limit their availability. Any interruption or delay in the supply of any of these components or materials, or the inability to obtain these components and materials from alternate sources at acceptable prices and within a reasonable amount of time, would impair our ability to meet scheduled product deliveries to our customers and could cause customers to cancel orders.

We rely exclusively on our own production capability to manufacture certain strategic components, optics and optical systems, crystals, semiconductor lasers, lasers and laser-based systems. Because we manufacture, package and test these components, products and systems at our own facilities, and such components, products and systems are not readily available from other sources, any interruption in manufacturing would adversely affect our business. In addition, our failure to achieve adequate manufacturing yields of these items at our manufacturing facilities may materially and adversely affect our operating results and financial condition.

Our increased reliance on contract manufacturing may adversely impact our financial results and operations.

We have changed our manufacturing strategy to increase sourcing from contract manufacturers. In June 2003, we completed the transfer of our printed circuit board manufacturing activities in Auburn, California, to the global electronics contract manufacturer, Venture, which has factories in North America, Asia and Europe. Our ability to resume internal manufacturing operations for those products has been eliminated. The cost, quality, performance and availability of contract manufacturing operations are and will be essential to the successful production and sale of many of our products. The inability of any contract manufacturer to meet our cost, quality, performance and availability standards could adversely impact our financial condition or results of operations. We may not be able to provide contract manufacturers with product volumes that are high enough to achieve sufficient cost savings. If shipments fall below forecasted levels, we may incur increased costs or be required to take ownership of the inventory. Also, our ability to control the quality of products produced by contract manufacturers may be limited and quality issues may not be resolved in a timely manner, which could adversely impact our financial condition or results of operations.

Management of expenses is important to positive cash flow from operations and profitability.

We believe that the ability to properly manage expenses is an important element to maintaining positive cash flow from operations and achieving profitability in the future. Because it is difficult to forecast our business, it may be necessary to contain costs and reduce expenses in the future. If this occurred, a number of factors could preclude us from successfully bringing costs and expenses in line with our revenues. If we are unable to reduce expenses and contain costs in these circumstances, our operating results could be harmed.

If we fail to manage our growth effectively, our business could be disrupted, which could harm our operating results.

Our ability to successfully offer our products and implement our business plan in evolving markets requires an effective planning and management process. We continue to expand the scope of our operations domestically and internationally. The growth in employee headcount and in sales, combined with the challenges of managing geographically-dispersed operations, has placed, and our anticipated growth in future operations will continue to place, a significant strain on our management systems and resources. The failure to effectively manage our growth could disrupt our business and harm our operating results.

Any acquisitions we make could disrupt our business and harm our financial condition.

We have, in the past, made strategic acquisitions of other businesses and we continue to evaluate potential strategic acquisitions of complementary companies, products and technologies. In the event of any future acquisitions, we could:

• issue stock that would dilute our current stockholders’ percentage ownership;

• pay cash;

• incur debt;

• assume liabilities; or

• incur expenses related to in-process research and development, impairment of goodwill and amortization of intangible assets.

These purchases also involve numerous risks, including:

• problems combining the acquired operations, technologies or products;

• unanticipated costs or liabilities;

• diversion of management’s attention from our core businesses;

• adverse effects on existing business relationships with suppliers and customers; and

• potential loss of key employees, particularly those of the purchased organizations.

We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might acquire in the future, which may harm our business.

We use standard laboratory and manufacturing materials that could be considered hazardous and we could be liable for any damage or liability resulting from accidental environmental contamination or injury.

Although most of our products do not incorporate hazardous or toxic materials and chemicals, some of the gases used in our excimer lasers and some of the liquid dyes used in some of our scientific laser products are highly toxic. In addition, our operations involve the use of standard laboratory and manufacturing materials that could be considered hazardous. Also, if a facility fire were to occur at our Tampere, Finland site and spread to a reactor used to grow semiconductor wafers, it could release highly toxic emissions. We believe that our safety procedures for handling and disposing of such materials comply with all federal, state and offshore regulations and standards; however, the risk of accidental environmental contamination or injury from such materials cannot be entirely eliminated. In the event of such an accident involving such materials, we could be liable for damages and such liability could exceed the amount of our liability insurance coverage and the resources of our business.

If our facilities were to experience catastrophic loss, our operations would be seriously harmed.

Our facilities could be subject to a catastrophic loss from fire, flood, earthquake or terrorist activity. A substantial portion of our research and development activities, manufacturing, our corporate headquarters and other critical business operations are located near major earthquake faults in Santa Clara, California, an area with a history of seismic events. Any such loss at any of our facilities could disrupt our operations, delay production, shipments and revenue and result in large expenses to repair or replace the facility. While we have obtained insurance to cover most potential losses, after reviewing the costs and limitations associated with earthquake insurance, we have decided not to procure such insurance. We believe that this decision is consistent with decisions

reached by numerous other companies located nearby. We cannot assure you that our existing insurance coverage will be adequate against all other possible losses.

Provisions of our charter documents, Delaware law, our Common Shares Rights Plan and our Change-of-Control Severance Plan may have anti-takeover effects that could prevent or delay a change in control.

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition or make removal of incumbent directors or officers more difficult. These provisions may discourage takeover attempts and bids for our common stock at a premium over the market price. These provisions include:

• the ability of our board of directors to alter our bylaws without stockholder approval;

• limiting the ability of stockholders to call special meetings; and

• limiting the ability of our stockholders to act by written consent.

We are subject to Section 203 of the Delaware General Corporation Law, which prohibits a publicly held Delaware corporation from engaging in a merger, asset or stock sale or other transaction with an interested stockholder for a period of three years following the date such person became an interested stockholder, unless prior approval of our board of directors is obtained or as otherwise provided. These provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us without obtaining the prior approval of our board of directors, which may cause the market price of our common stock to decline. In addition, we have adopted a change of control severance plan, which provides for the payment of a cash severance benefit to each eligible employee based on the employee’s position and years of service to us. If a change of control occurs, our successor or acquirer will be required to assume and agree to perform all of our obligations under the change of control severance plan.

Our common shares rights agreement permits the holders of rights to purchase shares of our common stock to exercise the stock purchase rights following an acquisition of or merger by us with another corporation or entity, following a sale of 50% or more of our consolidated assets or earning power, or the acquisition by an individual or entity of 20% or more of our common stock. Our successor or acquirer is required to assume all of our obligations and duties under the common shares rights agreement, including in certain circumstances the issuance of shares of its capital stock upon exercise of the stock purchase rights. The existence of our common shares rights agreement may have the effect of delaying, deferring or preventing a change of control and, as a consequence, may discourage potential acquirers from making tender offers for our shares.

Risks related to our industry

Our market is unpredictable and characterized by rapid technological changes and evolving standards, and, if we fail to address changing market conditions, our business and operating results will be harmed.

The photonics industry is characterized by extensive research and development, rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. Because this market is subject to rapid change, it is difficult to predict its potential size or future growth rate. Our success in generating revenues in this market will depend on, among other things:

• maintaining and enhancing our relationships with our customers;

• the education of potential end-user customers about the benefits of lasers, laser systems and precision optics; and

• our ability to accurately predict and develop our products to meet industry standards.

For the nine months ended July 3, 2004, our research and development costs were $46.0 million, or 13% of net sales. For our fiscal years 2003, 2002 and 2001, our research and development costs were $50.8 million, or 12%, $52.6 million, or 13%, and $53.0 million, or 11%, of net sales, respectively. We cannot assure you that our expenditures for research and development will result in the introduction of new products or, if such products are introduced, that those products will achieve sufficient market acceptance. Our failure to address rapid technological changes in our markets could adversely affect our business and results of operations.

A downturn in the semiconductor manufacturing industry could adversely affect our business, financial condition and results of operations.

Our net sales depend in part on the demand for our products by semiconductor equipment companies. The semiconductor industry is highly cyclical and has historically experienced periodic and significant downturns, which have often severely affected the demand for semiconductor manufacturing equipment, including laser-based tools and systems. Although such a downturn could reduce our sales, we may not be able to reduce expenses commensurately, due in part to the need for continual spending in research and development

and the need to maintain extensive ongoing customer service and support capability. Accordingly, any sustained downturn in the semiconductor industry could have a material adverse effect on our financial condition and results of operations.

Terrorist activities and resulting military actions could adversely affect our business.

Terrorist attacks have disrupted worldwide commerce. The continued threat of terrorism within the United States, Europe and the Pacific Rim, and the military action and heightened security measures in response to such threat, may cause significant disruption to commerce throughout the world. To the extent that such disruptions result in delays or cancellations of customer orders, interruptions in or delays to our receipt of products from our suppliers, delays in collecting cash, a general decrease in corporate spending on information technology, or our inability to effectively market, manufacture or ship our products, our business and results of operations could be materially and adversely affected. We are unable to predict whether the threat of terrorism or the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have any long-term material adverse effect on our business, financial condition or results of operations.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk disclosures

We are exposed to market risk related to changes in interest rates, foreign currency exchange rates, and equity security price risk. We do not use derivative financial instruments for speculative or trading purposes.

Interest rate sensitivity

A portion of our investment portfolio is composed of income securities. These securities are subject to interest rate risk and will decrease in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels at July 3, 2004, the fair value of the portfolio, based on quoted market prices, would decline by an immaterial amount. We have the ability to generally hold our fixed income investments until maturity and therefore we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates on our securities portfolio. If necessary, we may sell short-term investments prior to maturity to meet our liquidity needs.

At July 3, 2004, the fair value of our available-for-sale debt securities was $69.5 million, of which $64.5 million was classified as short-term investments and $5.0 million was classified as restricted cash, cash equivalents and short-term investments on our condensed consolidated balance sheets at July 3, 2004.

At July 3, 2004, we had fixed rate long-term debt of approximately $27.2 million, and a hypothetical 10% increase in interest rates would not have a material impact on the fair market value of this debt, based on pricing models using current interest rates. We do not hedge any interest rate exposures.

Foreign currency exchange risk

We maintain operations in various countries outside of the United States and have foreign subsidiaries that manufacture and sell our products in various global markets. As a result, our earnings and cash flows are exposed to fluctuations in foreign currency exchange rates. We attempt to limit these exposures through operational strategies and financial market instruments. We utilize hedging instruments, primarily forward contracts with maturities of 12 months or less, to manage our exposure associated with anticipated cash flows and net asset and liability positions denominated in non-functional currencies. Gains and losses on the forward contracts are mitigated by gains and losses on the underlying exposures. We do not use derivative financial instruments for trading purposes.

Looking forward, we do not anticipate any material adverse effect on our consolidated financial position, results of operations or cash flows resulting from the use of these instruments. There can be no assurance that these strategies will be effective or that transaction losses can be minimized or forecasted accurately.

Excluding Lambda Physik (discussed separately below), a hypothetical 10% appreciation of the forward adjusted U.S. dollar to July 3, 2004 market rates would decrease the unrealized value of our forward contracts by $0.2 million. Conversely, a hypothetical 10% depreciation of the forward adjusted U.S. dollar to July 3, 2004 market rates would increase the unrealized value of our forward contracts by $0.3 million.

The following table provides information about our foreign exchange forward contracts at July 3, 2004. The table presents the value of the contracts in U.S. dollars at the contract exchange rate as of the contract maturity date, the weighted average contractual foreign currency exchange rates and fair value. The U.S. notional fair value represents the contracted amount valued at July 3, 2004 rates.

Forward contracts to sell (buy) foreign currencies for U.S. dollars (in thousands, except contract rates):

	Average Contract Rate	U.S. Notional Contract Value			U.S. Notional Fair Value
Fair Value Hedges:
Euro	1.1922	$	1,669		$	1,719
British Pound Sterling	1.7940	2,184			2,184
Japanese Yen	109.6654	(1,283		)	(1,326		)

At Lambda Physik, a hypothetical 10% appreciation of the Euro to July 3, 2004 market rates would decrease the unrealized value of our forward contracts by 1.4 million Euro. Conversely, a hypothetical 10% depreciation of the Euro to July 3, 2004 market rates would increase the unrealized value of our forward contracts by 1.7 million Euro.

The following table provides information about Lambda Physik’s foreign exchange forward contracts at July 3, 2004. The table presents the value of the contracts in Euro at the contract exchange rate as of the contract maturity date, the weighted average contractual foreign currency exchange rates and fair value. The Euro notional fair value represents the contracted amount valued at July 3, 2004 rates.

Forward contracts to sell foreign currencies for Euro (in thousands, except contract rates):

	Average Contract Rate	Euro Notional Contract Value	Euro Notional Fair Value
Fair value hedges:
Japanese Yen	130.9639	15,360	15,222
Cashflow hedges:
U.S. Dollar	1.1807	508	488

Item 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness and design of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms.

Changes in internal controls over financial reporting

There was no change in our internal controls over financial reporting that occurred during the third quarter of fiscal 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 6. Exhibits and Reports on Form 8-K

(a) Exhibits

2.1*		Agreement and Plan of Merger. (Previously filed as Exhibit 2.1 to Form 10-K for the fiscal year ended September 29, 1990).

3.1*		Restated and Amended Certificate of Incorporation. (Previously filed as Exhibit 3.1 to Form 10-K for the fiscal year ended September 29, 1990).

3.2*		Certificate of Amendment of Restated and Amended Certificate of Incorporation of Coherent, Inc. (Previously filed as Exhibit 3.2 to Form 10-K for the fiscal year ended September 28, 2002).

3.3*		Bylaws of Coherent, Inc, as amended (Previously filed as Exhibit 3.2 to Form 10-K for the fiscal year ended September 29, 1990).

4.1*		Amended and Restated Common Shares Rights Agreement dated June 24, 1998 between Coherent and the Bank of Boston. (Previously filed as Exhibit 1 to Form 8-A filed on July 1, 1998).

31.1		Certification of Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

* These exhibits were previously filed with the Commission as indicated and are incorporated herein by reference.

(b) Reports on Form 8-K

On April 27, 2004, we furnished a current report on Form 8-K under Item 12 (Results of Operations and Financial Condition) and Item 7 (Financial Statements and Exhibits) disclosing the issuance of a press release announcing our financial results for the quarter ended April 3, 2004.

On May 10, 2004, we filed a current report on Form 8-K under Item 4 (Changes in Registrant’s Certifying Accountant) and Item 7 (Financial Statements and Exhibits) disclosing the change of independent accountants for Lambda Physik AG, a majority owned subsidiary of Coherent, Inc., effective May 5, 2004.

COHERENT, INC.

SIGNATURES

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

	Coherent, Inc.
	(Registrant)


August 11, 2004	/s/:	JOHN R. AMBROSEO
		John R. Ambroseo
		President and Chief Executive Officer
		(Principal Executive Officer)


August 11, 2004	/s/:	HELENE SIMONET
		Helene Simonet
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

EXHIBIT INDEX

Exhibit No.
31.1		Certification of Chief Executive Officer pursuant to Merger Certification of Chief Executive Officer pursuant to Exchange Act Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.