ELECTRO SCIENTIFIC INDUSTRIES 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 August 28, 2004

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: 0-12853

ELECTRO SCIENTIFIC INDUSTRIES, INC.

Oregon		93-0370304
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

13900 N.W. Science Park Drive, Portland, Oregon		97229
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number: (503) 641-4141

Registrant’s web address: www.esi.com

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 Exchange Act). Yes ý No o

The number of shares outstanding of the Registrant’s Common Stock at September 29, 2004 was 28,424,411 shares.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

Item 1.	Consolidated Condensed Financial Statements (unaudited)

	Consolidated Condensed Balance Sheets – August 28, 2004 and May 29, 2004

	Consolidated Condensed Statements of Operations – Three Months Ended August 28, 2004 and August 30, 2003

	Consolidated Condensed Statements of Cash Flows – Three Months Ended August 28, 2004 and August 30, 2003

	Notes to Consolidated Condensed Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits

Signatures

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands)

(Unaudited)

	August 28, 2004			May 29, 2004

Assets
Current assets:
Cash and cash equivalents	$	88,729		$	80,358
Marketable securities	205,923			206,931
Restricted securities	3,194			6,251
Total cash and securities	297,846			293,540

Trade receivables, net of allowances of $1,000 and $901	61,224			51,696
Income tax refund receivable	7,411			7,466
Inventories, net	65,574			58,627
Shipped systems pending acceptance	7,169			4,391
Deferred income taxes	17,336			16,096
Assets held for sale	—			2,391
Other current assets	7,410			3,348
Total current assets	463,970			437,555

Long-term marketable securities	39,386			39,214
Property, plant and equipment, net of accumulated depreciation of $41,777 and $40,644	33,822			33,531
Deferred income taxes	12,095			17,630
Other assets	8,619			9,256
Total assets	$	557,892		$	537,186

Liabilities and shareholders’ equity
Current liabilities:
Accounts payable	$	14,620		$	13,248
Accrued liabilities	39,918			42,381
Deferred revenue	17,187			11,985
Total current liabilities	71,725			67,614
Convertible subordinated notes	142,976			142,759
Total liabilities	214,701			210,373

Shareholders’ equity:
Preferred stock, without par value; 1,000 shares authorized; no shares issued	—			—
Common stock, without par value; 100,000 authorized; 28,411 and 28,175 shares issued and outstanding	152,153			147,054
Retained earnings	192,008			181,362
Accumulated other comprehensive loss	(970		)	(1,603		)
Total shareholders’ equity	343,191			326,813
Total liabilities and shareholders’ equity	$	557,892		$	537,186

The accompanying notes are an integral part of these statements.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	For the three months ended
	August 28, 2004			August 30, 2003

Net sales	$	72,620		$	20,876
Cost of sales	35,734			16,036
Gross profit	36,886			4,840

Operating expenses:
Selling, service and administration	14,878			14,625
Research, development and engineering	6,560			5,748
	21,438			20,373
Operating income (loss)	15,448			(15,533		)

Interest income	1,550			2,002
Interest expense	(1,786		)	(1,927		)
Other income (expense)	(133		)	102
	(369		)	177
Income (loss) before income taxes	15,079			(15,356		)
Provision for (benefit from) income taxes	4,433			(5,989		)
Net income (loss)	$	10,646		$	(9,367	)

Net income (loss) per share - basic	$	0.38		$	(0.34	)
Net income (loss) per share - fully diluted	$	0.36		$	(0.34	)

Weighted average number of shares - basic	28,216			27,840
Weighted average number of shares - fully diluted	32,279			27,840

The accompanying notes are an integral part of these statements.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	For the three months ended
	August 28, 2004			August 30, 2003

Cash flows from operating activities:
Net income (loss)	$	10,646		$	(9,367	)
Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities:
Depreciation and amortization	2,255			2,664
Tax benefit of stock options exercised	503			78
Provision for doubtful accounts	99			—
Loss on disposal of property and equipment	54			—
Deferred income taxes	4,303			(1,155		)
Changes in operating accounts:
(Increase) decrease in trade receivables	(9,734		)	4,611
(Increase) decrease in income tax refund receivable	55			(5,583		)
Increase in inventories, net	(7,077		)	(951		)
Increase in shipped systems pending acceptance	(2,778		)	(5,163		)
Increase in other current assets	(1,855		)	(596		)
Decrease in other current liabilities	(1,041		)	(1,425		)
Increase in deferred revenue	5,202			8,462
Net cash provided by (used in) operating activities	632			(8,425		)

Cash flows from investing activities:
Purchase of property, plant and equipment	(882		)	(510		)
Proceeds from the sale of property and equipment	76			—
Proceeds from the sale of assets held for sale	2,361			—
Maturity of restricted securities	3,057			3,185
Purchase of securities	(79,311		)	(67,850		)
Proceeds from sales of securities and maturing securities	80,801			66,564
Increase in other assets	(582		)	(279		)
Net cash provided by investing activities	5,520			1,110

Cash flows from financing activities:
Proceeds from exercise of stock options and stock plans	2,219			133
Net cash provided by financing activities	2,219			133

Net change in cash and cash equivalents	8,371			(7,182		)

Cash and cash equivalents:
Beginning of period	80,358			31,017
End of period	$	88,729		$	23,835

Supplemental cash flow information:
Cash paid for interest	$	3,081		$	3,334
Income tax refunds received	3			808
Cash paid for income taxes	274			371

The accompanying notes are an integral part of these statements.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

Note 1 - Basis of Presentation

These unaudited interim consolidated condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted in these interim statements. Accordingly, these interim statements include all adjustments (consisting of only normal recurring adjustments and accruals) necessary for a fair presentation of results for the interim periods presented. These consolidated condensed financial statements are to be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K. Certain prior year amounts have been reclassified to conform to current year presentation. Additionally, subsequent to the issuance of the the Company’s earnings press release on September 23, 2004, the Company reclassified certain marketable securities from current to long-term on the balance sheet presentation as of August 28, 2004.

Results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.

Note 2 - Inventories

Inventories are principally valued at standard costs, which approximate the lower of cost (on a first-in, first-out basis) or market. Components of inventories were as follows (in thousands):

	August 28, 2004		May 29, 2004
Raw materials and purchased parts	$	34,542	$	34,710
Work-in-process	14,185		11,219
Finished goods	16,847		12,698
	$	65,574	$	58,627

Note 3 – Assets Held For Sale

Assets held for sale at May 29, 2004 consisted of an undeveloped parcel of land in Taiwan with a carrying value of $2.4 million. The Company sold this parcel of land in June 2004 and received net cash proceeds substantially equal to the carrying value.

Note 4 – Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

	August 28, 2004		May 29, 2004

Payroll-related	$	10,170	$	10,781
Product warranty	4,854		4,720
Interest payable	1,264		2,805
Accrual for loss on purchase commitments	536		536
Legal settlement accrual	3,800		3,800
Income taxes payable	11,823		12,212
Other	7,471		7,527
	$	39,918	$	42,381

See Note 5 for a discussion of the accrual for product warranty and Note 10 for a discussion of the accrual for legal settlement.

Note 5 – Product Warranty

The Company evaluates obligations related to product warranties quarterly. Products sold are inclusive of a standard one-year warranty. Warranty charges are comprised of costs to service the warranty including labor to repair the system and replacement parts for defective items, as well as other costs incidental to the repairs. Inventory credits resulting from the return of repaired parts to inventory and any cost recoveries from warranties offered by our suppliers for defective components are recorded as a credit to the warranty accrual. Using historical data, we estimate average warranty cost per system or part type and record the provision for such charges as an element of cost of goods sold. Additionally, the overall warranty accrual balance is separately analyzed using the remaining warranty periods outstanding on systems and items under warranty, and any resulting changes in estimates are recorded as an adjustment to cost of sales. If circumstances change, or if a material change in warranty-related incidents occurs, the estimate of the warranty accrual could change significantly. Accrued product warranty is included on the balance sheet as a component of accrued liabilities.

Following is a reconciliation of the change in the aggregate accrual for product warranty for the three months ended August 28, 2004 (in thousands):

Product warranty accrual, May 29, 2004	$	4,720
Warranty charges incurred	(2,766		)
Inventory credits	1,023
Provision for warranty charges	1,877
Product warranty accrual, August 28, 2004	$	4,854

Note 6 – Deferred Revenue

Revenue is deferred pending title transfer and fulfillment of acceptance criteria, which frequently occur at the time of delivery to a common carrier. Shipments for which title transfer has not occurred and/or acceptance criteria cannot be demonstrated at the Company’s factory include sales to Japanese end-user customers and shipments of substantially new products. In sales involving multiple element arrangements, the fair value of any undelivered elements, including installation services, is deferred until delivery. Revenue related to maintenance and service contracts is deferred and recognized ratably over the duration of the contracts.

The following is a reconciliation of the changes in deferred revenue for the three months ended August 28, 2004 (in thousands):

Deferred revenue, May 29, 2004	$	11,985
Revenue deferred	9,231
Revenue recognized	(4,029		)
Deferred revenue, August 28, 2004	$	17,187

Note 7 - Earnings Per Share

Following is a reconciliation of weighted average shares outstanding and adjustments to net income used in the calculation of basic and diluted earnings per share (EPS) for the three months ended August 28, 2004 (in thousands, except per share amounts):

	Income		Shares
Net income available to common shareholders - basic	$	10,646	28,216
Effect of dilutive stock options	—		247
Effect of 4 ¼% convertible subordinated notes	1,090		3,816
Net income available to common shareholders -fully diluted	$	11,736	32,279

In the diluted EPS calculation for the three months ending August 28, 2004, employee stock options equal to 3,744,000 common stock equivalent shares were excluded because inclusion would have had an antidilutive effect. Basic and diluted EPS were the same for the comparative three months ended August 30, 2003 because the Company was in a loss position for that period.

Note 8 - Comprehensive Income (Loss)

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

	Three months ended
	August 28, 2004			August 30, 2003

Net income (loss)	$	10,646		$	(9,367	)
Net unrealized gain (loss) on derivative instruments	28			(4		)
Foreign currency translation adjustment	(48		)	(73		)
Net unrealized gain (loss) on securities	653			(1,508		)
	$	11,279		$	(10,952	)

Note 9 – Stock Based Compensation Plans

The Company has elected to use the intrinsic value method under APB No. 25, “Accounting for Stock Issued to Employees”, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”, subsequently amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” to account for stock options and restricted stock issued to its employees under its stock compensation plans, and amortizes deferred compensation, if any, ratably over the vesting period of the awards. Compensation expense resulting from the issuance of fixed term stock option awards is measured as the difference between the exercise price of the option and fair market value of the underlying share of company stock subject to the option on the award’s grant date. The calculated total compensation expense, if any, is included in operating results over the vesting period of the underlying options using the straight-line method. However, no compensation cost has been recognized for employee share purchase plan (ESPP) shares which are issued at fifteen percent discount of the lower of the market price on either the first day of the applicable offering period or the purchase date.

Pro forma fair value disclosures required by SFAS No. 123 are presented below and reflect the impact on net income (loss) and net income (loss) per share as if the fair value of its stock-based awards to employees had been applied:

	Three months ended
	August 28, 2004			August 30, 2003

Net income (loss), as reported	$	10,646		$	(9,367	)
Deduct – Recapture of stock-based employee compensation expense related to cancellations included in reported net income (loss), net of related tax effect	—			(144		)
Add – Stock-based employee compensation expense included in reported net income (loss), net of related tax effects	126			40
Deduct – total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects	(12,400		)	(2,093		)
Net loss, pro forma	$	(1,628	)	$	(11,564	)

Net income (loss) per share – basic, as reported	$	0.38		$	(0.34	)
Net income (loss) per share – fully diluted, as reported	$	0.36		$	(0.34	)
Net loss per share – basic and fully diluted, pro forma	$	(0.06	)	$	(0.42	)

On June 28, 2004, the compensation committee of the Board of Directors approved an acceleration of the vesting of those employee stock options, excluding stock options granted to the Board of Directors and Chief Executive Officer, with an option price equal to or greater than the closing sale price of $23.38 per share on that date, as reported on the Nasdaq National Market. Approximately 1.2 million options with varying remaining vesting schedules were subject to the acceleration provision, and became immediately exercisable. The total pro forma stock-based employee compensation expense stated above of $12.4 million includes $9.9 million resulting from this acceleration provision, as calculated under SFAS no. 123.

The Black-Scholes option pricing model is utilized to measure compensation expense. The following weighted average assumptions were made in calculating the value of all options granted during the periods presented:

	Three months ended
	August 28, 2004		August 30, 2003
Risk-free interest rate	3.62	%	3.74	%
Expected dividend yield	0	%	0	%
Expected lives	5.6 years		5.6 years
Expected volatility	65.62	%	68.29	%

The following weighted average assumptions were made in calculating the value of all shares issued under the ESPP during the periods presented:

	Three months ended
	August 28, 2004		August 30, 2003
Risk-free interest rate	2.11	%	3.74	%
Expected dividend yield	0	%	0	%
Expected lives	1.2 years		1.0 years
Expected volatility	54.40	%	68.29	%

Note 10 – Legal Claims

As a result of the Company’s March 2003 announcement that it was reviewing certain accounting matters and would be restating some of its financial statements, between March 26, 2003 and May 20, 2003, three purported class action lawsuits were filed in the United States District Court for the District of Oregon against ESI and David F. Bolender (former director, CEO and Chairman of the Board), James T. Dooley (former President and CEO), and Joseph L. Reinhart (former Acting CFO). The complaints were filed on behalf of a purported class of persons who purchased ESI’s common stock between September 17, 2002 and at the latest April 15, 2003, and alleged violations of Section 10(b) of the Securities Exchange Act of 1934 (the Act) and Rule 10b-5 promulgated thereunder, as well as Section 20(a) of the Act. The complaints have been consolidated under the name In re Electro Scientific Industries, Inc. Securities Litigation, Case No. CV 03-404-HA. Lead plaintiffs and lead counsel for plaintiffs have been appointed. The plaintiffs’ consolidated class action complaint (the Consolidated Complaint) was filed on October 10, 2003, which shortened the purported class to purchasers between September 17, 2002 and March 20, 2003, and added Donald R. VanLuvanee (ESI’s President and CEO from 1992 until April 2002), John R. Kurdock (ESI’s former VP Operations), and James Lorenz (ESI’s former Corporate Controller) as additional defendants. The Consolidated Complaint alleges that defendants made false and misleading statements during the purported class period about ESI’s financial condition and performance, business prospects, and operations, artificially inflating ESI’s stock price and leading to the restatement first announced on March 20, 2003. In March 2003, the Company’s Audit Committee commenced an investigation into certain accounting matters. As a result of the investigation, which was completed on July 11, 2003, the Company restated its financial statements for the fiscal year ended June 1, 2002 and for the quarters ended August 31, 2002 and November 30, 2002.

behalf of ESI, alleges that all defendants breached fiduciary duties owed to ESI, abused their alleged control over ESI, wasted corporate assets, are liable for gross mismanagement, and were unjustly enriched by their conduct. The Complaint seeks an unspecified amount of monetary damages and seeks various equitable remedies, including a constructive trust on the proceeds received by the defendants from trading ESI common stock, and attorneys’ fees and costs. As filed, the Complaint is derivative in nature and does not seek monetary damages from ESI or the imposition of equitable remedies on ESI. A special litigation committee of the Company’s board of directors, with the assistance of independent legal counsel, was appointed to conduct an investigation relating to the allegations asserted in the Complaint.

On April 22, 2004, the Company announced an agreement in principle to settle both the class action and derivative actions. The settlement, which received preliminary court approval on September 3, 2004, calls for the payment of $9.3 million of which approximately $3.8 million in total will be paid by the Company and approximately $5.5 million will be paid by the Company’s insurance carrier. The Company paid approximately $3.7 million in September 2004 and the remaining $0.1 million payment will be paid subject to court approval.

On September 23, 2004, the Securities and Exchange Commission announced that it would not bring an enforcement action against the Company with respect to the matters resulting in the restatement of our financial statements.

On February 14, 2001, Cognex Corporation (Cognex) filed a lawsuit in the United States District Court for the District of Massachusetts (Cognex Corporation v. Electro Scientific Industries, Inc., No. 01-10287 WGY). The lawsuit alleges that the Company’s CorrectPlace product and some of its predecessors infringe United States Patent 5,371,690 (the ‘690 patent), which is owned by Cognex. The ‘690 patent concerns the inspection of surface mount devices that are attached to the surface of an electronic circuit board. Cognex seeks injunctive relief, damages, costs and attorneys’ fees. The Company filed several counterclaims, including one alleging that the ‘690 patent is unenforceable by reason of inequitable conduct and another alleging that Cognex falsely marked certain products with the ‘690 patent. The court denied the Company’s motion for summary judgment on the Cognex claim of infringement and denied the Cognex motions for summary judgment on the Company’s counterclaims of false marking and unenforceability. The lawsuit is scheduled to go to trial in December 2004. Additionally, certain customers have notified the Company that, in the event it is subsequently determined that their use of CorrectPlace infringes any patent, they may seek indemnification from the Company for damages or expenses resulting from this matter.

On August 18, 2003, GSI Lumonics Corporation (GSI) filed a lawsuit in the United States District Court for the Central District of California (GSI Lumonics Inc. v. Electro Scientific Industries, Inc., Case No. CV-03-5863 PA (SHx). The lawsuit alleges that ESI infringes three GSI patents: U.S. Patent No. 6,181,728, entitled “Controlling Laser Polarization” (the ‘728 patent); U.S. Patent No. 6,337,462, entitled “Laser Processing” (the ‘462 patent); and U.S. Patent No. 6,573,473, entitled “Method and System for Precisely Positioning a Waist of a Material-Processing Laser Beam to Process Microstructures Within a Laser Processing Site” (the ‘473 patent). These claims relate to the Company’s semiconductor yield improvement systems. GSI seeks injunctive relief, an unspecified amount of damages, costs, and attorneys’ fees. On September 2, 2003, GSI filed a First Amended Complaint which did not change the substantive allegations of patent infringement. By court order dated September 18, 2003, the case was transferred to the United States District Court for the Northern District of California. The case was re-assigned to a judge in the Northern District of California and has been renumbered CV-03-04302-MHP. On October 8, 2003, the Company filed its Answer to First Amended Complaint and Counterclaim for Declaratory Judgment of Invalidity and Noninfringement. On October 24, 2003, GSI filed a Reply to the Company’s counterclaim denying the allegations of invalidity and noninfringement. On May 11, 2004, pursuant to an agreement between the Company and GSI, the court entered a stipulated dismissal of two

of GSI’s asserted patents without prejudice: the ‘728 patent and the ‘462 patent. On August 26, 2004, pursuant to an agreement between the parties, the court entered a stipulated dismissal with prejudice of the remaining patent asserted by GSI: U.S. Patent No. 6,573,473. This dismissal resolves the entire controversy between the parties.

In addition to the legal matters described above, in the ordinary course of business the Company is involved in various other legal matters, either asserted or unasserted, and investigations. In the opinion of management, amounts accrued for awards or assessments in connection with these matters are management’s best estimate and ultimate resolution of these matters will not have a material effect on the Company’s consolidated financial position, results of operations or cash flow.

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

Forward Looking Statements

The statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words “believes,” “expects,” and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties. From time to time we may make other forward-looking statements. Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ as a result of many factors, including the risks described below under the heading “Factors That May Affect Future Results.”

Overview

Electro Scientific Industries, Inc. and its subsidiaries (ESI) provide high-technology manufacturing equipment to the global electronics market, including advanced laser systems that are used to microengineer electronic device features in high-volume production environments. Our customers are primarily manufacturers of semiconductors, passive components and electronic interconnect devices. Our equipment enables these manufacturers to achieve the yield and productivity gains in their manufacturing processes that can be critical to their profitability. The components and devices manufactured by our customers are used in a wide variety of end products in the computer, consumer electronics and communications industries.

We supply advanced laser microengineering systems that allow electronics manufacturers to physically alter select device features during high-volume production, in order to heighten performance and boost production yields of semiconductor devices, passive components and circuitry, high-density interconnect (HDI) circuit boards and advanced semiconductor packaging. Laser microengineering comprises a set of precise fine-tuning processes (laser trimming, link cutting and via drilling) that require application-specific laser systems able to meet semiconductor and microelectronics’ manufacturers exacting performance and productivity requirements.

Additionally, we produce high-speed test, inspection and termination equipment used in the high-volume production of multi-layer ceramic passives (MLCPs) and other passive components, as well as original equipment manufacturer (OEM) machine vision products.

In fiscal 2004 we experienced increased demand as the worldwide market for electronics and semiconductors and related manufacturing equipment experienced a recovery. In addition to the market recovery, we introduced multiple new products in the semiconductor, passive component and electronic interconnect business units. Orders increased from $133.0 million in fiscal 2003 to $273.5 million in fiscal 2004. Shipments and revenue increased 42.3% and 51.4% in fiscal 2004 compared to fiscal 2003, respectively. Consistent with the increase in shipments and revenue, gross margins improved steadily over the year. In early fiscal 2004 we continued to implement cost reduction plans to better align our infrastructure and operating costs with market demand, while continuing to invest in research and development and customer support. Our fiscal 2004 operating expenses were elevated due to costs related to the 2003 audit committee investigation, securities litigation and estimated charge to settle the class action and derivative lawsuits, totaling approximately $7.6 million. We finished the year with net income of $11.9 million or $0.42 per share.

Late in the first quarter of fiscal 2005, market demand lessened for our products. Our order volume declined 35.4% to $67.6 million in the first quarter of fiscal 2005 compared to the fourth quarter of fiscal 2004. Orders decreased sequentially across each of our three businesses, indicative of the broad-based cautiousness in the industry. Although a few customers have delayed orders, industry utilization rates remain high. Shipments were $77.9 million in the first quarter of fiscal 2005, up slightly over $77.1 million in the fourth quarter of fiscal 2004. Order volume may continue to decline in the second quarter to an estimated range of $50 million to $60 million. Consistent with this decrease, we estimate shipments and revenues to be in the range of $60 million to $70 million.

Results of Operations

The following table sets forth results of operations data as a percentage of net sales.

	Three months ended
	August 28, 2004		August 30, 2003

Net sales	100.0	%	100.0	%
Cost of sales	49.2		76.8
Gross margin	50.8		23.2
Selling, service and administrative	20.5		70.1
Research, development and engineering	9.0		27.5
Operating income (loss)	21.3		(74.4	)
Total other income (expense), net	(0.5	)	0.8
Income (loss) before taxes	20.8		(73.6	)
Income tax provision (benefit)	6.1		(28.7	)
Net income (loss)	14.7	%	(44.9	)%

Net Sales

Certain information regarding our net sales by product group is as follows (net sales in thousands):

	Three months ended
	August 28, 2004				August 30, 2003
	Net Sales		Percent of Total Net Sales		Net Sales		Percent of Total Net Sales
Semiconductor Group (SG)	$	44,013	60.6	%	$	5,736	27.5	%
Passive Components Group (PCG)	20,603		28.4		9,606		46.0
Electronic Interconnect Group (EIG)	8,004		11.0		5,534		26.5
	$	72,620	100.0	%	$	20,876	100.0	%

Net sales were $72.6 million for the quarter ended August 28, 2004, an increase of $51.7 million or 247.9% compared to $20.9 million for the quarter ended August 30, 2003. The increase in net sales was largely driven by sales increases in SG to major DRAM manufacturers to increase capacity and transition to newer technology. This trend began in the second quarter of fiscal 2004 and has continued through the first quarter of fiscal 2005. The increase in SG revenues was also driven by new products introduced in the 9800 model line that received acceptance by customers during fiscal 2004. The increase from sales of new SG products was complimented by stronger sales in our other markets; the PCG market saw end user demand improve in the latter half of fiscal 2004 for products that require the use of passive components processed by our laser trim and passive test systems, a trend which continued into the first quarter of fiscal 2005. EIG sales levels increased in the first quarter compared to the same period in the prior year, driven by shipments to manufacturers of flex circuits and IC packages that require the use of UV laser drills to produce highly precise manufacturing results.

Although shipment levels in the first quarter of fiscal 2005 were up slightly compared to the fourth quarter of fiscal 2004, net sales were down $9.2 million sequentially. This decrease primarily resulted from a net increase in deferred revenue of $5.2 million in the first quarter of fiscal 2005 compared a net decrease in deferred revenue in the fourth quarter of fiscal 2004 of $4.6 million, as shown in the table below.

Deferred revenue was $17.2 million at August 28, 2004 compared to $12.0 million at May 29, 2004, an increase of $5.2 million. Revenue is deferred pending title transfer and fulfillment of acceptance criteria, which frequently occur at the time of delivery to a common carrier. Shipments for which title transfer has not occurred and/or acceptance criteria cannot be demonstrated at our factory typically include sales to Japanese end-user customers and shipments of substantially new products. Due to these factors, as well as the timing of their occurrence in any given quarter, deferred revenue balances may fluctuate significantly from quarter to quarter. In sales involving multiple element arrangements, the fair value of any undelivered elements, including installation services, is deferred until delivery. Revenue related to maintenance and service contracts is deferred and recognized ratably over the duration of the contracts. Changes in deferred revenue were as follows:

Deferred revenue, February 28, 2004			$	16,620
Revenue deferred	8,200
Revenue recognized	(12,835	)
Net change in deferred revenue	(4,635	)
Deferred revenue, May 29, 2004			11,985
Revenue deferred	9,231
Revenue recognized	(4,029	)
Net change in deferred revenue	5,202
Deferred revenue, August 28, 2004			$	17,187

Net sales by geographic region were as follows (net sales in thousands):

	Three months ended
	August 28, 2004				August 30, 2003
	Net Sales		Percent of Total Net Sales		Net Sales		Percent of Total Net Sales
Asia	$	58,536	80.6		$	11,406	54.7
Americas	8,548		11.8		7,082		33.9
Europe	5,536		7.6		2,388		11.4
	$	72,620	100.0	%	$	20,876	100.0	%

The percentage of total net sales to Asia increased to 80.6% for the first quarter of fiscal 2005 compared to 54.7% for the first quarter of fiscal 2004. This percentage increase is a result of the dollar-volume increase in sales of SG products and PCG products, a substantial portion of which are shipped into the Asian markets.

Gross Profit

Gross profit was $36.9 million (50.8% of net sales) for the first quarter of fiscal 2005 compared to $4.8 million (23.2% of net sales) for the first quarter of fiscal 2004. Shipments in the first quarter of fiscal 2005 increased 163.2% compared to the same quarter in fiscal 2004. Increased shipment levels resulted in volume-based manufacturing efficiencies and lower costs per unit. In addition, higher production volumes increase our ability to negotiate lower material costs with some suppliers, contributing to overall gross margin improvements. Gross margins also benefited from a more favorable product sales mix compared to the first quarter of the prior fiscal year. Beginning in the first quarter of fiscal 2004, the semiconductor group introduced multiple new systems to the market from its 9800 product line. Revenue from these higher-margin products was initially deferred, but was included in net sales when the products gained acceptance with customers, beginning in the second quarter of fiscal 2004. Continued sales of these

established products in the first quarter of fiscal 2005, along with the cost efficiencies described above, contributed to gross margin improvements compared to the first quarter of fiscal 2004.

Operating Expenses

Selling, Service and Administrative Expenses

Selling, service and administrative expenses were $14.9 million (20.5% of net sales) in the first quarter of fiscal 2005, an increase of $0.3 million compared to $14.6 million (70.1% of net sales) in the first quarter of fiscal 2004. The primary items included in selling, service and administrative expenses are labor and other employee-related expenses, travel expenses, professional fees and facilities costs.

Included in selling, service and administrative expenses for the first quarter of fiscal 2004 were $0.8 million in charges related to our restructuring and cost management plans, discussed below. Also included in selling, service and administrative expenses are legal and professional fees related to the 2003 audit committee investigation and securities litigation. These charges totaled $0.4 million and $2.1 million in the first quarters of fiscal 2005 and fiscal 2004, respectively. Exclusive of the charges for restructuring and cost management plans and legal and professional fees related to the investigation and litigation, selling, service and administrative expenses increased $2.8 million in the first quarter of fiscal 2005 compared to the first quarter of fiscal 2004. The increase is primarily due to increased compensation costs, professional fees and sales commissions. These expense increases in the first quarter of fiscal 2005 compared to the first quarter of fiscal 2004 are consistent with the overall growth in business volume experienced sequentially throughout fiscal 2004.

Research, Development and Engineering Expenses

Research, development and engineering expenses are primarily comprised of labor and other employee-related expenses, professional fees, project materials, equipment and facilities costs. Expenses associated with research, development and engineering totaled $6.6 million (9.0% of net sales) for the first quarter of fiscal 2005, representing a $0.9 million increase from expenses of $5.7 million (27.5% of net sales) for the first quarter of fiscal 2004. Included in research and development expenses for the first quarter of fiscal 2004 is $0.2 million in severance and other employee-related expenses resulting from our fiscal 2004 cost management plan. Excluding these charges, the overall increase in research and development spending was $1.1 million and is primarily due to an increase in compensation costs as we continue to invest in development projects.

Restructuring and Cost Management Plans

In response to the economic climate and resulting decrease in demand for our products in prior fiscal years, we initiated restructuring and other cost management plans in early fiscal 2004, 2003 and 2002. The fiscal 2004 plan consisted of a headcount reduction to reduce expenditures. The fiscal 2003 actions primarily related to relocating the manufacturing of our electronic component product line from Escondido, California to our headquarters in Portland, Oregon. The fiscal 2002 actions included a headcount reduction, exiting the mechanical drill business and discontinuing the manufacture of certain other products and vacating related facilities. All expenses related to the fiscal 2004 and fiscal 2003 plans have been paid. As of August 28, 2004, we had a remaining amount accrued of approximately $0.5 million for future payments, net of estimated sublease rentals, for a property in Ann Arbor, Michigan that is leased and sublet through December 2006 and was vacated as a part of the 2002 restructuring plan. There were no expenses relating to restructuring and cost management plans recorded in the first quarter of fiscal 2005. A detail of expenses by business function for the prior year comparative three months ended August 30, 2003 is presented below (in thousands):

	Three months ended August 30, 2003
	Cost of Goods Sold		Selling, Service and Administration		Research, Development and Engineering		Total
Fiscal 2004 cost management plan	$	123	$	457	$	191	$	771
Fiscal 2003 cost management plan	5		276		—		281
Fiscal 2002 cost management plan	—		84		—		84
	$	128	$	817	$	191	$	1,136

Income Taxes

The income tax provision recorded for the first quarter of fiscal 2005 was $4.4 million on pretax income of $15.1 million, an effective rate of 29.4% compared to the income tax benefit of 39.0% recorded in the first quarter of fiscal 2004 on pretax loss of $15.4 million. The effective tax rate of 29% is lower than our statutory tax rate of 38%, primarily due to incentives for export sales and research credits

We currently have an outstanding examination by the Internal Revenue Service for our tax returns for the tax years ending in 1996 through 2003. Although the examination is substantially complete, the final outcome of the federal tax audit is uncertain. We believe the ultimate resolutions will not have a materially adverse effect on our results of operations or financial position.

Net Income (Loss)

Net income for the first quarter of fiscal year 2005 was $10.6 million (14.7% of net sales), or $0.36 per share on a fully diluted basis, compared to a net loss of $9.4 million (44.9% of net sales), or $0.34 per basic and fully diluted share, in the first quarter of fiscal year 2004.

Liquidity and Capital Resources

At August 28, 2004, our principal sources of liquidity consisted of existing cash, cash equivalents and marketable and restricted securities of $337.2 million and accounts receivable of $61.2 million. At August 28, 2004, we had a current ratio of 6.5:1 and long-term debt of $143.0 million. Working capital increased to $392.2 million at August 28, 2004 from $369.9 million at May 29, 2004. We believe that our existing cash, cash equivalents and marketable securities are adequate to fund our operations for at least the next twelve months.

Trade receivables increased $9.5 million to $61.2 million at August 28, 2004 from $51.7 million at May 29, 2004 primarily due to a higher percentage of the quarter’s shipments occurring later in the first quarter of fiscal 2005 than in the fourth quarter of fiscal 2004.

Inventory totaled $65.6 million at August 28, 2004 compared to $58.6 million at May 29, 2004. The increase of $7.0 million is comprised of additions to both finished goods and work-in-process inventory. The overall increase was due to delayed timing of shipments previously anticipated in the first quarter of fiscal 2005.

Assets held for sale of $2.4 million at May 29, 2004 consisted of an undeveloped parcel of land in Taiwan. This land was sold and cash proceeds were received during the first quarter of fiscal 2005.

Deferred revenue was $17.2 million at August 28, 2004 compared to $12.0 million at May 29, 2004. The increase in deferred revenue is primarily due to shipments for which title transfer has not occurred and/or acceptance criteria cannot be demonstrated at our factory, including sales to Japanese end-user customers and shipments of substantially new products.

In fiscal 2004 we recorded a charge of $3.8 million for the settlement of the class action and derivative lawsuits arising from the restatement of earnings announced in fiscal 2003. The settlement, which received preliminary court approval on September 3, 2004, calls for the payment of $9.3 million of which approximately $3.8 million in total will be paid by ESI and approximately $5.5 million will be paid by our insurance carrier. We paid approximately $3.7 million on September 20, 2004 and the remaining $0.1 million payment will be paid subject to court approval.

At August 28, 2004 we had $143.0 million recorded on our balance sheet related to our 4 ¼% convertible subordinated notes due December 21, 2006. The difference between the $145.0 million face value and the $143.0 million balance at August 28, 2004 relates to underwriting discounts, which originally totaled $4.5 million. These discounts are being amortized as additional interest expense over the life of the subordinated notes at a rate of $0.9 million per year, resulting in a corresponding accretion to the recorded amount of the notes. During the first quarter of fiscal 2005, we made a semi-annual interest payment of $3.1 million which was fully funded by a $3.1 million liquidation of restricted securities.

Proceeds from stock option exercises and employee stock plans totaled $2.2 million during the first quarter of fiscal 2005. Additionally, $2.2 million in proceeds from the exercise of stock options at the end of the quarter were received upon settlement early in the second quarter of fiscal 2005.

Critical Accounting Policies and Estimates

We reaffirm the critical accounting policies and our use of estimates as reported in our annual report on Form 10-K for our fiscal year ended May 29, 2004 as filed with the Securities and Exchange Commission on July 29, 2004.

Factors That May Affect Future Results

Described below are some of the factors that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. See “Forward Looking Statements” at the beginning of this Item 2.

The industries that comprise our primary markets are volatile and unpredictable.

Our business depends upon the capital expenditures of manufacturers of components and circuitry used in wireless communications, computers and other electronic products. In the past, the markets for electronic devices have experienced sharp downturns. During these downturns, electronics manufacturers, including our customers, have delayed or canceled capital expenditures, which has had a negative impact on our financial results.

During any downturn it will be difficult for us to maintain our sales levels. As a consequence, to maintain profitability we will need to reduce our operating expenses. However, because there is a lag between actions we take to reduce expense and the actual reductions of the costs, our ability to quickly reduce these fixed operating expenses is limited. Moreover, we may be unable to defer capital expenditures, and we will need to continue to invest in certain areas such as research and development. An economic downturn may also cause us to incur charges related to impairment of assets and inventory write-offs and we may also experience delays in payments from our customers, which would have a negative effect on our financial results.

After experiencing a significant increase in orders in fiscal 2004, we experienced reduced demand in the first quarter of fiscal 2005. We cannot assure you that demand for our products will increase. Even if

demand for our products does increase, there may be significant fluctuations in our profitability and net sales.

We face risks relating to governmental inquiries and the results of our internal investigation of accounting matters.

On March 20, 2003, we contacted the SEC in connection with our issuance of a press release announcing the need to restate our financial results for the quarters ended August 31, 2002 and November 30, 2002. In March 2003, the audit committee of our board of directors, with the assistance of outside legal counsel and independent forensic accountants, commenced an internal investigation of certain accounting matters. The investigation involved the review of (1) the circumstances surrounding the reversal of an accrual for employee benefits, (2) unsupported accounting adjustments and clerical errors primarily relating to inventory and cost of goods sold, and (3) certain other areas where potential accounting errors could have occurred, including revenue recognition and restructuring reserves. As a result of the investigation, we determined that our unaudited consolidated condensed financial statements for the three months ended August 31, 2002 and November 30, 2002, and our audited consolidated financial statements for the year ended June 1, 2002 (and the quarters contained therein) required restatement. We have cooperated with all government investigations into the matters addressed by the internal investigation, and the SEC has announced that because of our swift and extensive cooperation in the SEC’s investigation the SEC will not bring any enforcement action against us. Depending on the scope, timing and result of any other governmental investigation, management’s attention and our resources could be diverted from operations, which could adversely affect our operating results and contribute to future stock price volatility.

We have entered into indemnification agreements in the ordinary course of business with our current and former officers and directors, some of whom may be the subject of any governmental investigation or party to proceedings brought as a result of any investigation. In addition, our bylaws contain indemnification provisions with respect to our directors, officers, and employees. We may be obligated throughout any investigation or proceeding to advance payment of legal fees and costs incurred by any current and former directors, officers, employees and agents pursuant to the indemnification agreements, our bylaws and applicable Oregon law. We may also be obligated to indemnify any former and/or current directors, officers, employees and agents for judgments, fines and amounts paid in settlement if the person acted in good faith and in a manner reasonably believed to be in or not opposed to our best interests. Payments made by us under these obligations, to the extent not reimbursed by insurance carriers, could have a material adverse impact on our financial condition.

Our ability to reduce costs is limited by our need to invest in research and development.

Our industry is characterized by the need for continued investment in research and development. Because of intense competition in the industries in which we compete, if we were to fail to invest sufficiently in research and development, our products could become less attractive to potential customers, and our business and financial condition could be materially and adversely affected. As a result of our need to maintain our spending levels in this area, our operating results could be materially harmed if our net sales fall below expectations. In addition, as a result of our emphasis on research and development and technological innovation, our operating costs may increase further in the future, and research and development expenses may increase as a percentage of total operating expenses and as a percentage of net sales.

We depend on a few significant customers and we do not have long-term contracts with any of our customers.

Our top ten customers for fiscal 2004 accounted for approximately 61% of total net sales in fiscal 2004, with one customer accounting for approximately 26% of total net sales in fiscal 2004. No other customer in fiscal 2004 accounted for more than 10% of total net sales. In addition, none of our customers have any long-term obligation to continue to buy our products or services, and any customer could delay, reduce or cease ordering our products or services at any time.

Delays in manufacturing, shipment or customer acceptance of our products could substantially decrease our sales for a period.

We derive a substantial portion of our revenues from the sale of a relatively small number of products with high average selling prices, some with prices in excess of $1 million per unit.

We depend on manufacturing flexibility to meet the changing demands of our customers. Any significant delay or interruption in receiving raw materials or in our manufacturing operations as a result of software deficiencies, natural disasters, or other causes could result in reduced manufacturing capabilities or delayed product deliveries, any or all of which could materially and adversely affect our results of operations.

Shipment and/or customer acceptance delays could significantly impact our recognition of revenue and could be further magnified by announcements from us or our competitors of new products and technologies, which announcements could cause our customers to defer purchases of our existing systems or purchase products from our competitors. Any of these delays could result in a material adverse change in our results of operations for any particular period.

Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business.

We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers for those materials. We generally do not have guaranteed supply arrangements with our suppliers. We seek to reduce the risk of production and service interruptions and shortages of key parts by selecting and qualifying alternative suppliers for key parts, monitoring the financial stability of key suppliers and maintaining appropriate inventories of key parts. Although we make reasonable efforts to ensure that parts are available from multiple suppliers, key parts are available only from a single supplier or a limited group of suppliers in the short term. Operations at our suppliers’ facilities are subject to disruption for a variety of reasons, including changes in business relationships, competitive factors, work stoppages, fire, earthquake, flooding or other natural disasters. Such disruption could interrupt our manufacturing. Our business may be harmed if we do not receive sufficient parts to meet our production requirements in a timely and cost-effective manner.

We may make additional acquisitions in the future, and these acquisitions may subject us to risks associated with integrating these businesses into our current business.

Although we have no commitments or agreements for any acquisitions, in the future we may make acquisitions of, or significant investments in, businesses with complementary products, services or technologies.

Acquisitions involve numerous risks, many of which are unpredictable and beyond our control, including:

• Difficulties and increased costs in connection with integration of the personnel, operations, technologies and products of acquired companies;

• Diversion of management’s attention from other operational matters;

• The potential loss of key employees of acquired companies;

• Lack of synergy, or inability to realize expected synergies, resulting from the acquisition;

• The risk that the issuance of our common stock in a transaction could be dilutive to our shareholders if anticipated synergies are not realized; and

• Acquired assets becoming impaired as a result of technological advancements or worse-than-expected performance by the acquired company.

Our inability to effectively manage these acquisition risks could materially and adversely affect our business, financial condition and results of operations. In addition, if we issue equity securities to pay for an acquisition the ownership percentage of our existing shareholders would be reduced and the value of the shares held by our existing shareholders could be diluted. If we use cash to pay for an acquisition the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes. In addition, the accounting for future acquisitions could result in significant charges resulting from amortization of intangible assets related to such acquisitions.

Our markets are subject to rapid technological change, and to compete effectively we must continually introduce new products that achieve market acceptance.

The markets for our products are characterized by rapid technological change and innovation, frequent new product introductions, changes in customer requirements and evolving industry standards. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address technological changes as well as current and potential customer requirements. The introduction by us or by our competitors of new and enhanced products may cause our customers to defer or cancel orders for our existing products, which may harm our operating results. We have in the past experienced a slowdown in demand for our existing products and delays in new product development, and similar delays may occur in the future. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or, where necessary, to license these technologies from others. Product development delays may result from numerous factors, including:

• Changing product specifications and customer requirements;

• Difficulties in hiring and retaining necessary technical personnel;

• Difficulties in reallocating engineering resources and overcoming resource limitations;

• Difficulties with contract manufacturers;

• Changing market or competitive product requirements; and

• Unanticipated engineering complexities.

The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Any failure to respond to technological change that may render our current products or technologies obsolete could significantly harm our business.

We are exposed to the risks that others may violate our proprietary rights, and our intellectual property rights may not be well protected in foreign countries.

Our success is dependent upon the protection of our proprietary rights. In the high technology industry, intellectual property is an important asset that is always at risk of infringement. We incur substantial costs to obtain and maintain patents and defend our intellectual property. For example, we have initiated litigation alleging that certain parties have violated various patents of ours. We rely upon the laws of the United States and of foreign countries in which we develop, manufacture or sell our products to protect our proprietary rights. However, these proprietary rights may not provide the competitive advantages that we expect or other parties may challenge, invalidate or circumvent these rights.

Further, our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States. Many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries. If we fail to adequately protect our intellectual property in these countries, it could be easier for our competitors to sell competing products in foreign countries.

We may be subject to claims of intellectual property infringement.

Several of our competitors hold patents covering a variety of technologies, applications and methods of use similar to some of those used in our products. From time to time, we and our customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents. For example, in February 2001 and August 2003, Cognex Corporation and GSI Lumonics, respectively, filed lawsuits against us claiming we infringed patents owned by each of them. See Part II, Item 1. Legal Proceedings. Competitors or others may assert infringement claims against our customers or us in the future with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others. If claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur.

If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, our financial condition and results of operations could be materially and adversely affected.

We are exposed to the risks of operating a global business, including risks associated with exchange rate fluctuations, legal and regulatory changes and the impact of regional and global economic disruptions.

International shipments accounted for 88.2% of net sales for the first quarter of fiscal 2005, with 80.6% of our net sales to customers in Asia. We expect that international shipments will continue to represent a significant percentage of net sales in the future. Our non-U.S. sales and operations are subject to risks inherent in conducting business abroad, many of which are outside our control, including the following:

• Periodic local or geographic economic downturns and unstable political conditions;

• Price and currency exchange controls;

• Fluctuation in the relative values of currencies;

• Difficulties protecting intellectual property;

• Unexpected changes in trading policies, regulatory requirements, tariffs and other barriers; and

• Difficulties in managing a global enterprise, including staffing, collecting accounts receivable, managing distributors and representatives and repatriation of earnings.

Our business and operating results are subject to uncertainties arising out of the possibility of regional or global economic disruptions, the economic consequences of military action or terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce. In particular, due to these uncertainties we are subject to:

• The risk that future tightening of immigration controls may adversely affect the residence status of non-U.S. engineers and other key technical employees in our U.S. facilities or our ability to hire new non-U.S. employees in such facilities;

• The risk of more frequent instances of shipping delays; and

• The risk that demand for our products may not increase or may decrease.

The loss of key management or our inability to attract, retain and assimilate sufficient numbers of managerial, financial, engineering and other technical personnel could have a material effect upon our results of operations.

Our continued success depends, in part, upon key managerial, financial, engineering and technical personnel as well as our ability to continue to attract, retain and assimilate additional personnel. The loss of key personnel could have a material adverse effect on our business or results of operations. We may not be able to retain our key managerial, financial, engineering and technical employees. Attracting qualified personnel is difficult, and our efforts to attract and retain these personnel may not be successful. In addition, we may not be able to assimilate qualified personnel, including any new members of senior management, which could disrupt our operations.

Our worldwide direct sales and service operations expose us to employer-related risks in foreign countries.

We have established direct sales and service organizations throughout the world. A worldwide direct sales and service model in foreign countries involves certain risks. We are subject to compliance with the labor laws and other laws governing employers in the countries where our operations are located and as a result we may incur additional costs to comply with these local regulations. Additionally, we may encounter labor shortages or disputes that could inhibit our ability to effectively sell, market and service our products. If we cannot effectively manage the risks related to employing persons in foreign countries, our operating results could be adversely affected.

Our business is highly competitive, and if we fail to compete effectively, our business will be harmed.

The industries in which we operate are highly competitive. We face substantial competition from established competitors, some of which have greater financial, engineering, manufacturing and marketing resources than we do. If we are unable to compete effectively with these companies, our market share may decline and our business could be harmed. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products. New companies may enter the markets in which we compete, or industry consolidation may occur, further increasing competition in those markets. Furthermore, our technological advantages may be reduced or lost as a result of technological advances by our competitors.

Their greater resources in these areas may enable them to:

• Better withstand periodic downturns;

• Compete more effectively on the basis of price and technology; and

• More quickly develop enhancements to and new generations of products.

We believe that our ability to compete successfully depends on a number of factors, including:

• Performance of our products;

• Quality of our products;

• Reliability of our products;

• Cost of using our products;

• Consistent availability of critical components;

• Our ability to ship products on the schedule required;

• Quality of the technical service we provide;

• Timeliness of the services we provide;

• Our success in developing new products and enhancements;

• Existing market and economic conditions; and

• Price of our products as compared to our competitors’ products.

We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins and loss of market share.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in our reported market risks since we filed our 2004 Annual Report on Form 10-K, with the Securities and Exchange Commission on July 29, 2004.

Item 4. Controls and Procedures

Attached to this annual report as exhibits 31.1 and 31.2 are the certifications of our President and Chief Executive Officer and our Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302 Certifications). This portion of our quarterly report on Form 10-Q is our disclosure of the conclusions of our management, including our President and Chief Executive Officer and our Chief Financial Officer, regarding the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report based on management’s evaluation of those disclosure controls and procedures. You should read this disclosure in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.

Disclosure Controls and Procedures

Our management has evaluated, under the supervision and with the participation of our President and Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (Exchange Act). Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to our management, including our President and Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting that occurred during our fiscal quarter ended August 28, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

As a result of our March 2003 announcement that we were reviewing certain accounting matters and would be restating some of our financial statements, between March 26, 2003 and May 20, 2003, three purported class action lawsuits were filed in the United States District Court for the District of Oregon against ESI and David F. Bolender (former director, CEO and Chairman of the Board), James T. Dooley (former President and CEO), and Joseph L. Reinhart (former Acting CFO). The complaints were filed on behalf of a purported class of persons who purchased our common stock between September 17, 2002 and at the latest April 15, 2003, and alleged violations of Section 10(b) of the Securities Exchange Act of 1934 (the Act) and Rule 10b-5 promulgated thereunder, as well as Section 20(a) of the Act. The complaints have been consolidated under the name In re Electro Scientific Industries, Inc. Securities Litigation, Case No. CV 03-404-HA. Lead plaintiffs and lead counsel for plaintiffs have been appointed. The plaintiffs’ consolidated class action complaint (the Consolidated Complaint) was filed on October 10, 2003, which shortened the purported class to purchasers between September 17, 2002 and March 20, 2003, and added Donald R. VanLuvanee (ESI’s President and CEO from 1992 until April 2002), John R. Kurdock (ESI’s former VP Operations), and James Lorenz (ESI’s former Corporate Controller) as additional defendants. The Consolidated Complaint alleges that defendants made false and misleading statements during the purported class period about our financial condition and performance, business prospects, and operations, artificially inflating our stock price and leading to the restatement first announced on March 20, 2003. In March 2003, our Audit Committee commenced an investigation into certain accounting matters. As a result of the investigation, which was completed on July 11, 2003, we restated our financial statements for the fiscal year ended June 1, 2002 and for the quarters ended August 31, 2002 and November 30, 2002.

On March 31, 2003 and April 28, 2003, two separate purported shareholder derivative complaints were filed in the Circuit Court of Oregon in Washington County. The complaints were consolidated under the name In re Electro Scientific Industries, Inc. Derivative Litigation, Lead Case No. C 031067 CV. A consolidated complaint (Complaint) was filed on September 24, 2003, and names as defendants James Dooley (former President and CEO), David Bolender (former director, CEO and Chairman), Joseph Reinhart (former Acting CFO), Barry Harmon (director and former President and CEO), and current or former directors W. Arthur Porter, Gerald Taylor, Larry Hansen, Vernon Ryles, Keith Thomson and Jon Tompkins. We are named as a “nominal defendant.” The Complaint, which purports to be brought on behalf of ESI, alleges that all defendants breached fiduciary duties owed to ESI, abused their alleged control over ESI, wasted corporate assets, are liable for gross mismanagement, and were unjustly enriched by their conduct. The Complaint seeks an unspecified amount of monetary damages and seeks various equitable remedies, including a constructive trust on the proceeds received by the defendants from trading ESI common stock, and attorneys’ fees and costs. As filed, the Complaint is derivative in nature and does not seek monetary damages from ESI or the imposition of equitable remedies on ESI. A special litigation committee of our board of directors, with the assistance of independent legal counsel, was appointed to conduct an investigation relating to the allegations asserted in the Complaint.

On April 22, 2004, we announced an agreement in principle to settle both the class action and derivative actions. The settlement, which received preliminary court approval on September 3, 2004, calls for the payment of $9.3 million of which approximately $3.8 million in total will be paid by ESI and approximately $5.5 million will be paid by our insurance carrier. We paid approximately $3.7 million in September 2004 and the remaining $0.1 million payment will be paid subject to court approval.

On February 14, 2001, Cognex Corporation (Cognex) filed a lawsuit in the United States District Court for the District of Massachusetts (Cognex Corporation v. Electro Scientific Industries, Inc., No. 01-10287 WGY). The lawsuit alleges that our CorrectPlace product and some of its predecessors infringe United States Patent 5,371,690 (the ‘690 patent), which is owned by Cognex. The ‘690 patent concerns the inspection of surface mount devices that are attached to the surface of an electronic circuit board. Cognex seeks injunctive relief, damages, costs and attorneys’ fees. We filed several counterclaims, including one alleging that the ‘690 patent is unenforceable by reason of inequitable conduct and another alleging that Cognex falsely marked certain products with the ‘690 patent. The Court denied our motion for summary judgment on the Cognex claim of infringement and denied the Cognex motions for summary judgment on our counterclaims of false marking and unenforceability. The lawsuit is scheduled to go to trial in December 2004. Additionally, certain of our customers have notified us that, in the event it is subsequently determined that their use of CorrectPlace infringes any patent, they may seek indemnification from us for damages or expenses resulting from this matter.

On August 18, 2003, GSI Lumonics Corporation (GSI) filed a lawsuit in the United States District Court for the Central District of California (GSI Lumonics Inc. v. Electro Scientific Industries, Inc., Case No. CV-03-5863 PA (SHx). The lawsuit alleges that we infringe three GSI patents: U.S. Patent No. 6,181,728, entitled “Controlling Laser Polarization” (the ‘728 patent); U.S. Patent No. 6,337,462, entitled “Laser Processing” (the ‘462 patent); and U.S. Patent No. 6,573,473, entitled “Method and System for Precisely Positioning a Waist of a Material-Processing Laser Beam to Process Microstructures Within a Laser Processing Site” (the ‘473 patent). These claims relate to our semiconductor yield improvement systems. GSI seeks injunctive relief, an unspecified amount of damages, costs, and attorneys’ fees. On September 2, 2003, GSI filed a First Amended Complaint which did not change the substantive allegations of patent infringement. By court order dated September 18, 2003, the case was transferred to the United States District Court for the Northern District of California. The case was re-assigned to a judge in the Northern District of California and has been renumbered CV-03-04302-MHP. On October 8, 2003, we filed our Answer to First Amended Complaint and Counterclaim for Declaratory Judgment of Invalidity and Noninfringement. On October 24, 2003, GSI filed a Reply to our counterclaim denying the allegations of invalidity and noninfringement. On May 11, 2004, pursuant to an agreement between GSI and us, the court entered a stipulated dismissal of two of GSI’s asserted patents without prejudice: the ‘728 patent and the ‘462 patent. On August 26, 2004, pursuant to an agreement between the parties, the court entered a stipulated dismissal with prejudice of the remaining patent asserted by GSI: U.S. Patent No. 6,573,473. This dismissal resolves the entire controversy between the parties.

In addition to the legal matters described above, in the ordinary course of business we are involved in various other legal matters, either asserted or unasserted, and investigations. In the opinion of management, amounts accrued for awards or assessments in connection with these matters are management’s best estimate, and ultimate resolution of these matters will not have a material effect on our consolidated financial position, results of operations or cash flows.

Item 6. Exhibits

This list is intended to constitute the exhibit index.

3.1 Restated Articles of Incorporation. Incorporated by reference to Exhibit 3-A of the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 1991.

3.2 Articles of Amendment of Third Restated Articles of Incorporation. Incorporated by reference to Exhibit 3-B of the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 1999.

3.3 Articles of Amendment of Third Restated Articles of Incorporation. Incorporated by reference to Exhibit 3 of the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended December 2, 2000.

3.4 2001 Restated Bylaws. Incorporated by reference to Exhibit 3 of the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 3, 2001.

4.1 Amended and Restated Rights Agreement, dated as of March 1, 2001, between the Company and Mellon Investor Services, relating to rights issued to all holders of Company common stock. Incorporated by reference to Exhibit 4-A of the Company’s Annual Report on Form 10-K for the fiscal year ended June 2, 2001.

10.1 Notice of Grant of Stock Options and Option Agreement to John A. Corr and related Option Terms and Conditions

31.1 Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of the Chief Financial Officer 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.

SIGNATURES

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

Dated:	October 1, 2004	ELECTRO SCIENTIFIC INDUSTRIES, INC.


		By	/s/ Nicholas Konidaris
		Nicholas Konidaris
		President, Chief Executive Officer and Director
		(Principal Executive Officer)

		By	/s/ J. Michael Dodson
		J. Michael Dodson
		Senior Vice President of Administration, Chief Financial Officer and Secretary
		(Principal Financial Officer)

		By	/s/ Kerry Mustoe
		Kerry Mustoe
		Corporate Controller and Chief Accounting Officer
		(Principal Accounting Officer)