UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended August 31, 2002

Commission File Number: 0-12853

ELECTRO SCIENTIFIC INDUSTRIES, INC.

(an Oregon corporation)

93-0370304
(I.R.S. Employer Identification No.)

13900 N.W. Science Park Drive, Portland, Oregon 97229

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 |X| No |_|

The number of shares outstanding of the Registrant’s Common Stock at August 31, 2002 was 27,712,357 shares.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

* Audited

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

Part I. Financial Information

Item 1. Consolidated Financial Statements

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands except per share data)

The accompanying notes are an integral part of these statements.

*Audited

2

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands except per share data)

The accompanying notes are an integral part of these statements.

* Audited

3

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share data)
(unaudited)

The accompanying notes are an integral part of these statements.

4

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

Cash payments for interest were $3,330 and $10 for the three months ended August 31, 2002 and September 1, 2001, respectively. Cash refunds for income taxes were $5,863 for the three months ended August 31, 2002. Cash payments for income taxes were $2,330 for the three months ended September 1, 2001.

The accompanying notes are an integral part of these statements.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands except per share data unless otherwise noted)
(unaudited)

Note 1 - Basis of Presentation

We have prepared the condensed consolidated financial statements included herein without audit, 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. We believe that the interim statements include all adjustments (consisting of only normal recurring accruals) necessary for a fair presentation of results for the interim periods. These condensed consolidated financial statements are to be read in conjunction with the financial statements and notes thereto included in the Company’s 2002 Annual Report on Form 10-K. Certain prior year amounts have been reclassified to conform to current year presentation.

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

Note 2 - Accounts Receivable, Net

We entered into an agreement that allows us to sell accounts receivable from selected customers at a discount to a financial institution. Receivables sold under these provisions have terms and credit risk characteristics similar to our overall receivables portfolio. Receivable sales have the effect of increasing cash and reducing accounts receivable and days sales outstanding. Accounts receivable sales under these agreements were $7.1 million for the period ended August 31, 2002 and $9.0 million for the twelve-month period ended June 1, 2002. Discounting fees were recorded as interest expense and were not material for the three months ended August 31, 2002 and September 1, 2001. At August 31, 2002, $7.8 million of receivables sold under these agreements remained outstanding, compared to $9.0 million outstanding at June 1, 2002.

Note 3 - Inventories

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

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands except per share data unless otherwise noted)
(unaudited)

Note 4 - Earnings Per Share

We compute net income per share in accordance with Statement of Financial Accounting Standards 128, “Earnings Per Share” (SFAS 128). All earnings per share amounts in the following table are presented to conform to the SFAS 128 requirements.

For purposes of computing diluted earnings per share, weighted average common share equivalents do not include the following stock options or shares issuable upon conversion of our 4¼% convertible subordinated notes due 2006 because inclusion would have an anti-dilutive effect on the earnings per share calculation.

Note 5 - Comprehensive Income (Loss)

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

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands except per share data unless otherwise noted)
(unaudited)

Note 6 - Income Taxes

The effective income tax rate for the interim period is based on estimates of annual amounts of taxable income, tax credits and other factors. The income tax rate for the three months ended August 31, 2002 and September 1, 2001 was 32% and 33%, respectively. The lower tax rate as compared to the statutory federal tax rate is largely a result of the tax benefit related to the extraterritorial income exclusion.

Note 7 - Recent Accounting Pronouncements

In August 2002, the FASB issued SFAS 146 “Accounting for costs associated with exit or disposal activities.” SFAS 146 nullifies EITF Issue 94-3, “Liability recognition for certain Employee termination benefits and other costs to exit an activity.” Under SFAS 146, liabilities for exit or disposal activities are recognized and measured initially at fair value only when the liability is incurred. This statement is effective for exit costs initiated after December 31, 2002, and will be applied on prospective transactions only.

In June 2001, the Financial Accounting Standards Board issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (SFAS 143), which is effective for fiscal years beginning after June 15, 2002. SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, and normal operation of a long-lived asset, except for certain lease obligations. We are evaluating the impact of SFAS 143, but do not expect the adoption of SFAS 143 to have a significant impact on our financial position or the results of our operations.

On June 1, 2002, we adopted Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144). SFAS 144 provides a single accounting model for long-lived assets to be disposed of and significantly changes the criteria for classifying an asset as held-for-sale. Classification as held-for-sale is an important distinction since such assets are not depreciated and are stated at the lower of fair value or carrying amount. SFAS 144 also requires expected future operating losses from discontinued operations to be displayed in the period in which the losses are incurred, rather than as of the measurement date as presently required. The adoption of SFAS 144 did not have a material impact on our financial position or the results of our operations.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands except per share data unless otherwise noted)
(unaudited)

Note 8 - Q1 Fiscal 2002 Non-Recurring Operating Items

In order to better align our operating expenses with anticipated revenues, we implemented a restructuring plan during June of 2001. Pursuant to this plan, we reduced our work force by 419 employees in June and August of 2001. This reduction impacted all employee groups. In connection with this plan, we recorded a charge of $2.4 million in employee severance and $0.2 million in other employee expenses for the three months ended September 1, 2001.

The restructuring plan also included vacating buildings located in California, Massachusetts, Michigan, Minnesota and Texas. As a result, we recorded a charge of approximately $1.5 million for the three months ended September 1, 2001, which consisted of $1.1 million for lease termination fees and $0.4 million for the write-off of certain leasehold improvements. We also recorded a $3.5 million inventory write-down related to discontinuing the manufacturing of certain products for the three months ended September 1, 2001. This inventory write-down was reflected in costs of sales.

The following table displays the amounts included as a non-recurring charge for the three months ended September 1, 2001.

Note 9 - Restructuring Accruals

At August 31, 2002, we had $1.0 million remaining in accrued liability, compared to $0.7 million at June 1, 2002. The majority of the remaining accrued liability was related to lease termination fees and other facility consolidation costs expected to be incurred through 2006.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands except per share data unless otherwise noted)
(unaudited)

The following table displays rollforwards of the accruals established related to the restructuring from June 1, 2002 to August 31, 2002.

Note 10 - Subsequent Event

On October 2, 2002, we announced a plan to relocate the manufacturing of our Electronic Component Systems product line from Escondido, California to our headquarters facility in Portland, Oregon. We plan on completing this move by December 31, 2002. Approximately 45 employees at our Escondido facility have been offered relocation to our headquarters. The remaining employees have been offered a severance package following a sixty-day notice period. As a result of the closure of the California facility and other cost reduction steps, we expect that total employment will be reduced by approximately 100 people by the end of December 2002, from the current level of approximately 800 people. Beginning in the third fiscal quarter, which starts on December 1, 2002, we expect to save at least $8.0 million annually as a result of facilities consolidation, employment reductions and other cost reduction steps as related to this restructuring plan. In the second quarter, we expect to record a one-time charge of approximately $9.0 million for severance and other costs related to the plant closure. Additional relocation costs of approximately $2.0 million will be charged in future quarters as they occur, and are expected to be offset by a gain on the sale of the building and land.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS

Overview

Electro Scientific Industries, Inc. and its subsidiaries (“ESI”) provide high technology manufacturing equipment to the global electronics market. Our customers are primarily manufacturers of semiconductors, passive electronic components and electronic interconnect devices. Our equipment enables these manufacturers to reduce production costs, increase yields and improve the quality of their products. The components and devices manufactured by our customers are used in a wide variety of end-use products in the computer, communications and automotive industries.

We believe we are the leading supplier of advanced laser systems used to improve the production yield of semiconductor devices; high-speed test and termination equipment used in the high-volume production of multi-layer ceramic capacitors (MLCCs) and other passive electronic components; and advanced laser systems used to fine tune electronic components and circuitry. Additionally, we produce a family of laser drilling systems for production of high-density interconnect (HDI) circuit boards and advanced electronic packaging, as well as inspection systems and original equipment manufacturer (OEM) machine vision products.

Results of Operations

Net sales of $43.0 million for the quarter ended August 31, 2002 were $6.5 million or 13.2% lower than the first quarter of fiscal 2002, and were $1.9 million or 4.7% higher than the quarter ended June 1, 2002. Advanced electronic packaging systems, circuit fine tuning systems, and vision inspection systems experienced higher sales volume compared to the three months ended September 1, 2001, while sales of semiconductor yield improvement systems and electronic component manufacturing systems decreased over the same quarter of the prior year. Sales of semiconductor yield improvement systems, advanced electronic packaging systems and circuit fine tuning systems increased in comparison to the quarter ended June 1, 2002, while sales of electronic component manufacturing systems decreased and vision inspection systems remained relatively flat compared to the prior quarter. Semiconductor yield improvement systems comprised the largest percentage of sales for the quarter at 39.8% of total sales versus 46.5% in the first quarter of the prior year and 37.2% for the quarter ended June 1, 2002.

The following data represents sales by product line for the periods indicated (in thousands):

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

Gross margin, excluding restructuring costs, for the three months ended August 31, 2002 decreased to 46.5% from 50.4% for the same period in the prior fiscal year and 47.7% for the quarter ended June 1, 2001. Included in costs of good sold for the three months ended August 31, 2002 was severance expense of $0.1 million. Lower margins were due to a change in product mix and lower utilization of factory capacity. We also continue to see normal pricing pressure in all of our markets due to the continued softness in overall electronics demand and pressure on our customers’ earnings.

Selling, service and administrative expenses for the three months ended August 31, 2002 were $13.2 million, 30.7% or $5.8 million lower than for the first quarter of fiscal 2002 and 9.6% or $1.4 million lower compared to the prior quarter. Selling, service and administrative expenses as a percentage of sales for the three months ended August 31, 2002 decreased from 38.4% to 30.7% compared to the first quarter of fiscal year 2002 and decreased from 35.5% to 30.7% over the prior quarter. Included in selling, service and administrative expenses for the three months ended August 31, 2002 was severance expense of $0.2 million offset by a one-time credit of $1.0 million related to a change in employee benefits for our Asian subsidiaries. In addition, lower sales volume and a reduction of force resulted in decreased commission and payroll expense compared to prior quarter and prior year levels.

Future operating results are highly dependent on our ability to maintain a competitive advantage in the products and services we provide. To protect this advantage we continue to make investments in our research and development efforts. Expenses associated with research, development and engineering for the three months ended August 31, 2002 were $7.7 million, 37.0% or $4.5 million lower than for the same period in the prior fiscal year and 6.9% or $0.5 million higher compared to the prior quarter. Research, development and engineering expenses as a percentage of sales for the three months ended August 31, 2002 decreased from 24.6% to 17.8% compared to the first quarter of fiscal year 2002 and increased from 17.5% to 17.8% over the prior quarter. The decrease in comparison to the first quarter of fiscal 2002 was primarily due to decreases in research, development, and engineering headcount and lower project costs. The increase in comparison to the prior quarter was primarily due to severance expense of $0.2 million in the three months ended August 31, 2002. We continue to invest in a significant number of development and engineering projects that we see as important to our future.

In order to better align our operating expenses with anticipated revenues, we implemented a restructuring plan in the first quarter of fiscal year 2002. The restructuring plan consisted of reducing our work force and vacating several buildings. This reorganization resulted in restructuring charges to operating expenses of $4.4 million in the first quarter of fiscal year 2002. We also recorded a $3.5 million inventory write-down related to discontinuing the manufacturing of certain products in the three months ended September 1, 2001. This inventory write-down was reflected in costs of sales.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

Interest income for the three months ended August 31, 2002 was $3.5 million, $1.6 million higher than for the three months ended September 1, 2001. This increase is mainly due to an increase in investment balances generated from our sale of $150 million aggregate principal amount of 4¼% convertible subordinated notes due 2006. Interest income increased $0.3 million compared to last quarter, due to interest income incurred on tax refunds.

The income tax rate for the three months ended August 31, 2002 was 32.0% versus 33.0% and 36.8% for the three months ended September 1, 2001 and June 1, 2002, respectively. The lower tax rate as compared to the statutory federal tax rate is largely a result of the tax benefit related to the extraterritorial income exclusion.

Net income for the quarter ended August 31, 2002 was $0.2 million or $0.01 per diluted share. This represents an increase of $8.2 million or 102.0% over the first quarter in the prior year, when we had a net loss of $8.0 million or $0.30 per diluted share. Net loss for the three months ended June 1, 2002 was $8.2 million or $0.30 per diluted share. This represents an increase of $8.4 million or 101.9% over fourth quarter in the prior year.

Ending backlog on August 31, 2002 was $15.5 million compared to $27.2 million on June 1, 2002 and $34.4 million at the end of the first quarter of the prior fiscal year.

Liquidity and Capital Resources

Our principal sources of liquidity consist of existing cash, cash equivalents and marketable securities of $288.9 million and accounts receivable of $58.9 million. At August 31, 2002, we had a current ratio of 18.6:1 and long-term debt of $146.1 million. Working capital increased to $358.9 million at August 31, 2002 compared to $341.9 million at June 1, 2002. Due to increased sales, accounts receivable increased $1.4 million from June 1, 2002 to August 31, 2002. Inventory decreased by $0.8 million from June 1, 2002 to August 31, 2002. Other current assets increased $0.5 million primarily due to prepaid expenses. Property, plant and equipment increased $1.9 million from June 1, 2002 to August 31, 2002. The increase in property, plant and equipment is due to the continued construction of a new corporate headquarters in Portland, Oregon. We have capital commitments of approximately $4.4 million for construction of a 62,000 square foot corporate headquarters building located on the Portland, Oregon campus. We expect that the facility will be completed in the second quarter of fiscal 2003. Current liabilities decreased $2.5 million from June 1, 2002 primarily due to the decrease in accrued interest expense generated from our 4¼% convertible subordinated notes due 2006.

Critical Accounting Policies and Estimates

We reaffirm the critical accounting policies and our use of estimates as reported in our Form 10-K for the year-ended June 1, 2002.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

Factors That May Affect Future Results

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 issue other forward-looking statements. Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ. The following information highlights some of the factors that could cause actual results to differ materially from the results expressed or implied by our forward-looking statements. Forward-looking statements should be considered in light of these factors. Factors that may result in such variances include, but are not limited to the following:

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, automotive electronics 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.

The current economic downturn has resulted in a reduction in demand for our products and significant fluctuations in our profitability and net sales. We had net income of $0.2 million during the three months ended August 31, 2002 on net sales of $43.0 million. This reflects a significant change from net loss of $8.0 million for the three months ended September 1, 2001 on net sales of $49.5 million. We cannot assure you that demand for our products will continue to increase.

During any downturn, including the current downturn, it will be difficult for us to maintain our sales levels. As a consequence, in order to maintain profitability we will need to reduce our operating expenses. However, much of our operating expenses are fixed and our ability to reduce such expenses is limited. Moreover, we may be unable to defer capital expenditures, and we will need to continue investment in certain areas such as research and development. We may incur charges related to impairment of assets and inventory write-offs. We also may experience delays in payments from our customers. The combined effect of these will have a negative effect on our financial results.

If the markets for our products improve, we must attract, hire and train a sufficient number of employees, including technical personnel, to meet increased customer demand. Our inability to achieve these objectives in a timely and cost-effective manner could have a negative impact on our business.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

Our recent capacity expansion may not be utilized successfully or effectively, which could negatively affect our business.

We have completed a 53,000 square-foot manufacturing facility on a 31-acre parcel in Klamath Falls, Oregon. In June 2001 we began construction of a 62,000 square foot corporate headquarters building in Portland, Oregon. Both projects have been funded with existing capital resources and internally generated funds. Our capacity expansion involves risks. For example, the electronics industry has historically been cyclical and subject to significant economic downturns characterized by over-capacity and diminished demand for products of the type manufactured by us. In fiscal 2002 we adopted a restructuring plan that involved the closure of several of our manufacturing facilities in response to the current economic downturn. Unfavorable economic conditions affecting the electronics industry in general, or any of our major customers, may affect our ability to successfully utilize our additional manufacturing capacity in an effective manner, which could adversely affect our operating results.

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 these or any of our other customers.

Twelve large, multinational electronics companies constituted 49.4% of our fiscal 2002 net sales, and the loss of any of these customers could significantly harm our business. 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.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

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

We will continue to 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 as high as $2.0 million per unit. We generally recognize revenue upon shipment of our products. As a result, the timing of revenue recognition from a small number of orders could have a significant impact on our net sales and operating results for a reporting period. Shipment 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.

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

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 to supply 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 may be available only from a single supplier or a limited group of suppliers. Operations at our suppliers’ facilities are subject to disruption for a variety of reasons, including 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.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

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, we have made, and plan in the future to 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:

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 Financial Accounting Standards Board has disallowed the pooling-of-interests method of acquisition accounting. This could result is significant charges resulting from amortization of intangible assets recorded in connection with future 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:

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

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 would 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 of our patents. 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. These proprietary rights may not provide the competitive advantages that we expect, however, 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.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

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, Cognex Corporation filed a lawsuit against us claiming we infringed a patent owned by it. 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 and legal and regulatory changes.

International shipments accounted for 73.6% of net sales for fiscal 2002, with 57.5% 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:

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

In addition, as a result of our significant reliance on international sales, we may also be adversely affected by challenges to U.S. tax laws that benefit companies with certain foreign sales. In February 2000, the World Trade Organization (WTO) ruled that foreign sales corporations (FSCs), which provide an overall reduction in effective tax rates for companies with FSCs, violate U.S. obligations under the General Agreement on Tariffs and Trade (GATT). Responding to the WTO’s decision that FSCs constitute an illegal export subsidy, the U.S. government repealed the FSC rules effective October 1, 2000, subject to certain transition rules, and created a new income tax benefit that permanently excludes “foreign extraterritorial income” from taxable income. The extraterritorial income (ETI) regime, which applies to transactions after September 30, 2000, provides a similar tax benefit for export sales as the FSC regime did. Following a European Union (EU) complaint, the WTO concluded in August 2001 that the ETI provisions are also not WTO-compliant because provisions violate the GATT agreements. The United States appealed the decision, but in January 2002, an appellate body denied the appeal. On August 30, 2002, a WTO arbitration panel issued a report approving the retaliatory tariffs requested by the EU. The EU now has the authority to begin imposing trade sanctions on U.S. exports up to the level approved by the arbitrators and the authority for such sanctions will continue until the United States rectifies the WTO violation. The U.S. government will likely choose to rectify the violation to avoid retaliatory trade sanctions and is considering several options to do so. It is possible that the U.S. government will repeal the ETI regime and if the government does not replace it with an equivalent form of tax relief for foreign income, our future results of operations may be adversely affected.

Our establishment of direct sales in Asia exposes us to the risks related to having employees in foreign countries.

We have established direct sales and service organizations in China, Taiwan, Korea and Singapore. Previously, we sold our products through a network of commission-based sales representatives in these countries. Our shift to a direct sales model in these regions involves risks. For example, we may encounter labor shortages or disputes that could inhibit our ability to effectively sell and market our products. We also are subject to compliance with the labor laws and other laws governing employers in these countries and we will incur additional costs to comply with these regulatory schemes. Additionally we will incur new fixed operating expenses associated with the direct sales organizations, particularly payroll related costs and lease expenses. If amounts saved on commission payments formerly paid to our sales representatives do not offset these expenses, our operating results may be adversely affected.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

Our business is highly competitive, and if we fail to compete 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. Furthermore, our technological advantages may be reduced or lost as a result of technological advances by our competitors. Their greater capabilities in these areas may enable them to:

In addition, new companies may in the future enter the markets in which we compete, further increasing competition in those markets.

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

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.

Recent terrorist attacks have increased uncertainties for our business.

Like other U.S. companies, our business and operating results are subject to uncertainties arising out of the recent terrorist attacks on the United States, including the potential worsening or extension of the current global economic slowdown, the economic consequences of military action or additional 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:

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES
MANAGEMENT’S DISCUSSION AND ANALYSIS (continued)

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

Our continued success depends, in part, upon key managerial, engineering and technical personnel as well as our ability to continue to attract and retain 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, engineering and technical employees. Our growth may be affected by our ability to hire a new chief executive officer, new highly skilled and qualified technical personnel, and personnel that can implement and monitor our financial and managerial controls and reporting systems. Attracting qualified personnel is difficult, and our recruiting efforts to attract and retain these personnel may not be successful.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

Item 3. Market Risk Disclosure

Interest Rate Risk

As of August 31, 2002, our investment portfolio includes marketable debt securities of $250.6 million. These securities are subject to interest rate risk, and will decline in value if interest rates increase. These securities are classified as Securities Available for Sale; therefore, the impact of interest rate changes is reflected as a separate component of shareholder’s equity. Due to the short duration of our investment portfolio, generally less than one year, an immediate 10% increase in interest rates would not have a material effect on our financial condition or the results of our operations. Our $150 million aggregate principal amount of 4¼% convertible subordinated notes due 2006 is at a fixed interest rate. Therefore, there is no associated volatility.

Foreign Currency Exchange Rate Risk

We have limited involvement with derivative financial instruments and do not use them for trading purposes. Hedging derivatives are used to manage well-defined foreign currency risks. We enter into forward exchange contracts to hedge the value of accounts receivable denominated in Japanese yen. The impact of exchange rates on the forward contracts will be substantially offset by the impact of such changes on the underlying transactions. The effect of an immediate 10% change in exchange rates on the forward exchange contracts and the underlying hedged positions, denominated in Japanese yen, would not be material to our financial position or results of operations.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

Within the 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Acting President and Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934. Based on their review of our disclosure controls and procedures, the Acting President and Chief Executive Officer and the Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us that is required to be included in our periodic SEC filings.

Internal Controls and Procedures

There were no significant changes in internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

Part II. Other Information

Item 1. Legal Proceedings

We initiated litigation against Dynamic Details, Inc. and GSI Lumonics, Inc. for patent infringement in March 2000 in the U.S. District Court for the Central District of California (Electro Scientific Industries v. Dynamic Details, Inc. and GSI Lumonics, Inc., No. SACV00-272 AHS (ANX)). We believe that Dynamic Details and GSI Lumonics are violating our U.S. patent 5,847,960 entitled “Multi-tool Positioning System”. The complaint alleges that Dynamic Details infringes our patent 5,847,960 and that GSI Lumonics has actively induced infringement of, and contributorily infringed, our patent 5,847,960. The complaint seeks injunctive relief and monetary damages. Dynamic Details, Inc. and GSI Lumonics, Inc. have filed a counterclaim for a declaratory judgment of non-infringement and invalidity of our patent 5,847,960. In August 2001, the District Court issued an order granting Dynamic Details and GSI Lumonics’ motion for summary judgment of non-infringement. We appealed the District Court’s order to the U.S. Court of Appeals for the Federal Circuit. On October 7, 2002 the Court of Appeals vacated the District Court’s judgment of non-infringement on the basis that the District Court erred in its claim construction of our patent 5,847,960. The Court of Appeals has remanded the case to the District Court for a determination of infringement based on a complete claim construction.

Item 2. Changes in Securities and Use of Proceeds

We amended the Amended and Restated Rights Agreement, dated as of March 1, 2002, between us and Mellon Investor Services LLC effective as of August 26, 2002 to permit EQSF Advisors, Inc. to beneficially own up to, but not including, an aggregate of 19.99% of the outstanding shares of our common stock.

Item 6. Exhibits and Reports on Form 8-K

A report on Form 8-K was filed on August 27, 2002, reporting that the Amended and Restated Rights Agreement, dated as of March 1, 2002, between us and Mellon Investor Services, LLC to permit EQSF Advisors Advisors, Inc. to beneficially own up to, but not including, an aggregate of 19.99% of the outstanding shares of our common stock.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

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.

ELECTRO SCIENTIFIC INDUSTRIES, INC.

25

SARBANES-OXLEY ACT SECTION 302(a) CERTIFICATION

I, David F. Bolender, certify that:

26

Date: October 14, 2002

/s/ DAVID F. BOLENDER
—————————————————
David F. Bolender
Chairman of the Board of Directors and
Acting President and Chief Executive Officer

27

SARBANES-OXLEY ACT SECTION 302(a) CERTIFICATION

I, James T. Dooley, certify that:

28

Date: October 14, 2002

/s/ JAMES T. DOOLEY
—————————————————
James T. Dooley
Senior Vice President, Chief Financial Officer and
Acting Chief Operating Officer

29

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with this quarterly report on Form 10Q of Electro Scientific Industries, Inc. (the “Company”) for the period ended August 31, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, David F. Bolender, Chairman of the Board of Directors and Acting President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ DAVID F. BOLENDER
—————————————————
David F. Bolender
Chairman of the Board of Directors and
Acting President and Chief Executive Officer
October 14, 2002

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with this quarterly report on Form 10Q of Electro Scientific Industries, Inc. (the “Company”) for the period ended August 31, 2002 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, James T. Dooley, Senior Vice President, Chief Financial Officer and Acting Chief Operating Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ JAMES T. DOOLEY
—————————————————
James T. Dooley
Senior Vice President, Chief Financial Officer and
Acting Chief Operating Officer
October 14, 2002