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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE

ACT OF 1934

For the quarterly period ended April 2, 2004

OR

¨ 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: 0-25395

VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

(Exact name of Registrant as Specified in its Charter)

(978) 282-2000

(Registrant’s telephone number, including area code)

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

Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

Shares of common stock outstanding at May 9, 2004: 36,301,416.

An index of exhibits filed with this Form 10-Q is located on page 26.

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

INDEX

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ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

UNAUDITED CONSOLIDATED BALANCE SHEETS

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

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

UNAUDITED CONSOLIDATED STATEMENTS OF INCOME

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

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Description of Business and Basis of Presentation

Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits to customers located both in the U.S. and in international markets. Varian Semiconductor faces risk factors similar to all companies in the semiconductor manufacturing equipment market including, but not limited to, competition, market downturn, technological change, international operations and related foreign currency risks and ability to recruit and retain key employees.

These unaudited interim consolidated 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 financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These unaudited interim consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the annual report on Form 10-K filed by Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) with the Securities and Exchange Commission for the fiscal year ended October 3, 2003. In the opinion of Varian Semiconductor, the unaudited interim consolidated financial statements include all adjustments, consisting of only normal recurring adjustments, necessary to present fairly the information required to be set forth therein. The results of operations for the three and six-month periods ended April 2, 2004 are not necessarily indicative of the results to be expected for a full year or for any other period.

Reclassifications

Certain items in the prior year’s consolidated financial statements have been reclassified to conform to the current presentation of the financial statements.

Note 2. Accounting for Stock-Based Compensation

Varian Semiconductor accounts for stock compensation plans in accordance with APB Opinion No. 25. Accordingly, no compensation expense has been recognized in the financial statements for stock compensation plans. If Varian Semiconductor had elected to recognize compensation cost based on the fair value of all stock awards at grant date as prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 123, the net income and net income per basic and diluted share for the three- and six-month periods ended April 2, 2004 and March 28, 2003 would have been reduced to the pro forma amounts shown below:

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 3. Computation of Net Income Per Share

Basic net income per share is calculated based on net income and the weighted average number of common stock outstanding during the reporting period. Diluted net income per share includes additional dilution from stock issuable pursuant to the exercise of stock options outstanding. For purposes of the diluted net income per share calculation, the additional shares issuable upon exercise of stock options are determined using the treasury stock method.

A reconciliation of the numerator and denominator used in the net income per share calculations is presented as follows:

For the three- and six-month periods ended April 2, 2004, options to purchase 653,986 and 652,433 common shares at a weighted average exercise price of $50.94 and $51.01, respectively (an exercise price that exceeded the market value of the underlying common stock), were excluded from the computation of diluted earnings per share as inclusion would be anti-dilutive. For the three- and six-month periods ended March 28, 2003, options to purchase 2,554,133 and 2,510,143 common shares at a weighted average exercise price of $34.72 and $35.04, respectively (an exercise price that exceeded the market value of the underlying common stock), were excluded from the computation of diluted earnings per share.

As of April 2, 2004, Varian Semiconductor had outstanding options to purchase an aggregate of 3,685,795 shares of its common stock at a weighted average price of $28.06. Of these options, options to purchase an aggregate of 2,909,366 shares of its common stock at a weighted average price of $26.70 were exercisable.

Note 4. Cash, Cash Equivalents and Short-term Investments

Varian Semiconductor considers currency on hand, demand deposits, and all highly liquid investments with an original purchase maturity of three months or less to be cash and cash equivalents. The carrying amounts of cash and cash equivalents approximate estimated fair value because of the short-term maturities of those financial instruments. Cash equivalents at April 2, 2004 and October 3, 2003 were $270.9 million and $304.3 million, respectively. Short-term investments consist primarily of U.S. Treasury and government agency securities, certificates of deposit and corporate bonds with ratings AA or better. All of Varian Semiconductor’s short-term investments are classified as available-for-sale at the respective balance sheet dates. Varian Semiconductor manages its cash equivalents and short-term investments as a single portfolio of highly marketable securities that is intended to be available to meet Varian Semiconductor’s current cash requirements. As of April 2, 2004, an accumulated net unrealized gain on short-term investments of $46,000 had been recorded as accumulated other comprehensive income.

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Short-term investments by security type at April 2, 2004 were as follows:

Short-term investment maturities are as follows:

Note 5. Accounts Receivable

Accounts receivable consist of the following:

Note 6. Inventories

The components of inventories are as follows:

Note 7. Accrued Expenses

The components of accrued expenses are as follows:

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 8. Product Warranties

Varian Semiconductor warrants that its products will be free from defects in materials and workmanship and will conform to standard published specifications in effect at the time of delivery, for a period of three to twelve months from the date the customer accepts the products. Additionally, Varian Semiconductor warrants that maintenance services will be performed in a workmanlike manner consistent with generally accepted industry standards for a period of ninety days from the completion of any agreed-upon services. Varian Semiconductor provides for the estimated cost of product warranties, primarily from historical information, at the time product revenue is recognized. Varian Semiconductor’s warranty obligation is affected by a number of factors, including product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should these factors or other factors affecting warranty costs differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.

Product warranty activity for the first half of fiscal year 2004 was as follows:

Note 9. Long-Term Accrued Expenses

Long-term accrued expenses are comprised of accruals for environmental costs not expected to be expended within the next year. The current portion is recorded within accrued expenses.

Note 10. Operating Segments, Significant Customers and Geographic Information

Varian Semiconductor operates in one business segment: the manufacturing, marketing and servicing of ion implantation systems. Since Varian Semiconductor operates in one segment, all financial segment information required by SFAS No. 131, “Segment Reporting,” can be found in the consolidated financial statements.

During the second quarter of fiscal year 2004, revenue from two customers each accounted for 16% of Varian Semiconductor’s total revenue. During the second quarter of fiscal year 2003, revenue from three customers accounted for 26%, 16% and 14% of Varian Semiconductor’s total revenue. During the first six months of fiscal year 2004, revenue from one customer accounted for 18% of Varian Semiconductor’s total revenue. During the first six months of fiscal year 2003, revenue from two customers accounted for 20% and 13% of Varian Semiconductor’s total revenue.

As of April 2, 2004, two customers, each representing 10% or greater of the total accounts receivable balance, accounted for 25% of the total accounts receivable balance. As of October 3, 2003, one customer accounted for 12% of the total accounts receivable balance.

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following table summarizes revenue based on final geographic destination and long-lived assets by geography:

Note 11. Commitments, Contingencies and Guarantees

Varian Semiconductor is currently a defendant in a number of legal actions and could incur an uninsured liability in one or more of them. In the opinion of management, the outcome of such litigation will not have a material adverse effect on the consolidated financial position, results of operations or cash flows of Varian Semiconductor.

As permitted under Delaware law, Varian Semiconductor has agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was, serving in such capacity at the request of Varian Semiconductor. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments Varian Semiconductor could be required to make under these indemnification agreements is unlimited; however, Varian Semiconductor has a Director and Officer insurance policy that limits its exposure and enables Varian Semiconductor to recover a portion of any future amounts paid. As a result of Varian Semiconductor’s insurance policy coverage, management believes the estimated fair value of these indemnification agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of April 2, 2004.

Varian Semiconductor enters into indemnification agreements in the normal course of business. Pursuant to these agreements, Varian Semiconductor indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our customers, in connection with any patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments Varian Semiconductor could be required to make under these indemnification agreements is unlimited. Management believes the estimated fair value of these agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of April 2, 2004.

Varian Semiconductor also indemnifies certain customers with respect to damages, losses and liabilities they may suffer or incur relating to personal injury, personal property damage, product liability, and environmental claims relating to the use of Varian Semiconductor’s products and services or resulting from the acts or omissions of Varian Semiconductor, its employees, officers, authorized agents or subcontractors. Varian Semiconductor has general and umbrella insurance policies that limit its exposure under these indemnification obligations and guarantees. As a result of our insurance policy coverage, Varian Semiconductor believes the estimated fair value of these indemnification agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of April 2, 2004.

Environmental Remediation

Prior to the spin-off of Varian Semiconductor from Varian Associates, Inc. (“VAI”) on April 2, 1999, Varian Semiconductor’s business was operated as the Semiconductor Equipment Business (“SEB”) of VAI. On April 2, 1999, VAI contributed its SEB to Varian Semiconductor, its Instruments Business (“IB”) to Varian, Inc. (“VI”), and changed its name to Varian Medical Systems, Inc. (“VMS”). These transactions were accomplished under the terms of several agreements by and among Varian Semiconductor, VI and VMS (collectively, the “Distribution Related Agreements”). VAI has been named by the United States

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Environmental Protection Agency or third parties as a potentially responsible party under CERCLA, at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also involved in various stages of environmental investigation and/or remediation under the direction of, or in consultation with, foreign, federal, state and/or local agencies at certain current or former VAI facilities (including facilities disposed of in connection with VAI’s sale of its Electron Devices business during fiscal year 1995, and the sale of its Thin Film Systems (“TFS”) business during fiscal year 1997). The Distribution Related Agreements provide that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.

For certain of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate the future costs of such activities if undertaken. Varian Semiconductor has accrued $1.7 million in estimated environmental investigation and remediation costs for these sites and facilities as of April 2, 2004. As to other sites and facilities, sufficient knowledge has been gained to be able to reasonably estimate the scope and costs of future environmental activities. As such, Varian Semiconductor has accrued $4.5 million, which represents future costs discounted at 7%, net of inflation, to cover Varian Semiconductor’s portion of these costs. This reserve is in addition to the $1.7 million previously described.

As of April 2, 2004, Varian Semiconductor’s environmental liability, based upon future environmental-related costs estimated by VMS as of that date and included in current and long-term accrued expenses, totaled $6.2 million, of which $1.3 million is classified as current.

The amounts set forth in the foregoing paragraph are only estimates of anticipated future environmental-related costs, and the amounts actually spent in the years indicated may be greater or less than such estimates. The aggregate range of cost estimates reflects various uncertainties inherent in many environmental investigation and remediation activities and the large number of sites where VMS is undertaking such investigation and remediation activities. VMS believes that most of these cost ranges will narrow as investigation and remediation activities progress. Varian Semiconductor believes that its reserves are adequate, but as the scope of the obligations becomes more clearly defined, these reserves may be modified and related charges against income may be made.

Although any ultimate liability arising from environmental-related matters described herein could result in significant expenditures that, if aggregated and assumed to occur within a single fiscal year, would be material to Varian Semiconductor’s financial statements, the likelihood of such occurrence is considered remote. Based on information currently available to management and its best assessment of the ultimate amount and timing of environmental-related events, Varian Semiconductor’s management believes that the costs of these environmental-related matters are not reasonably likely to have a material adverse effect on the consolidated financial statements of Varian Semiconductor.

Varian Semiconductor evaluates its liability for environmental-related investigation and remediation in light of the liability and financial wherewithal of potentially responsible parties and insurance companies where Varian Semiconductor believes that it has rights to contribution, indemnity and/or reimbursement. Claims for recovery of environmental investigation and remediation costs already incurred, and to be incurred in the future, have been asserted against various insurance companies and other third parties. In 1992, VAI filed a lawsuit against 36 insurance companies with respect to most of the above-referenced sites and facilities. VAI received certain cash settlements with respect to these lawsuits in prior years. VMS has also reached an agreement with an insurance company under which the insurance company agreed to pay a portion of Varian Semiconductor’s past and future environmental-related expenditures. Varian Semiconductor therefore has a receivable of $1.3 million in other assets at April 2, 2004, as its portion of the insurance recoveries. Although VMS intends to aggressively pursue additional insurance recoveries, Varian Semiconductor has not reduced any liability in anticipation of recovery with respect to claims made against third parties.

As part of the purchase of Varian Semiconductor’s facility located in Newburyport, Massachusetts, the Company has indemnified the lender for any violation of any local, state and federal laws pertaining to environmental regulations, contamination or clean-up. Varian Semiconductor believes the estimated fair value of this indemnification is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for this agreement as of April 2, 2004.

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Legal Proceedings

In September 2000, Varian Semiconductor and Applied Materials settled patent infringement and antitrust litigation. After recording a payment to Applied Materials and legal expenses, Varian Semiconductor recorded a gain of $16.0 million ($10.8 million after taxes) relating to this litigation settlement. Varian Semiconductor maintains a reserve to cover any residual indemnification obligations. Included in current liabilities and classified as an estimated loss contingency was $2.7 million as of April 2, 2004 and October 3, 2003. It is reasonably possible that the amount in this loss contingency could be reduced in the near future, as obligations have been minimal.

Varian Semiconductor has agreed to indemnify VMS and VI for any costs, liabilities or expenses relating to Varian Semiconductor’s legal proceedings, including the Applied Materials matter. Under the Distribution Related Agreements, Varian Semiconductor has agreed to reimburse VMS for one-third of the costs, liabilities, and expenses, adjusted for any related tax benefits recognized or realized by VMS, with respect to certain legal proceedings relating to discontinued operations of VMS. Varian Semiconductor believes the estimated fair value of the indemnification agreements is minimal, except as already recorded on the financial statements.

Varian Semiconductor’s operations are subject to various foreign, federal, state and/or local laws relating to the protection of the environment. These include laws regarding discharges into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. In addition, several countries are reviewing proposed regulations that would require manufacturers to dispose of their products at the end of a product’s useful life. These laws have the effect of increasing costs and potential liabilities associated with the conduct of certain operations.

Varian Semiconductor is currently the plaintiff in several legal disputes related to breach of contract, and the infringement of certain of Varian Semiconductor’s patents by third parties. The outcome of these claims, the timing and amount, if any, is uncertain.

Note 12. Restructuring Costs

Varian Semiconductor’s business is cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. The semiconductor industry has historically experienced periodic downturns, and in response Varian Semiconductor has occasionally recorded restructuring charges in connection with cost reduction initiatives implemented in response to the industry downturns. Restructuring charges typically consist of severance, benefits and outplacement services offered to terminated employees, and charges for remaining lease payments on facilities that are closed.

During fiscal year 2003, Varian Semiconductor recognized approximately $1.4 million in restructuring costs. The restructuring costs related to a reduction in headcount of approximately 55 employees and were severance-related. All of the remaining restructuring reserve balance of $0.1 million as of April 2, 2004 is expected to be paid by the end of fiscal year 2006.

Below is a table summarizing the restructuring reserve activity in the first six months of fiscal 2004:

The restructuring reserve of $0.1 million is included in accrued expenses on the balance sheet.

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VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 13. Comprehensive Income

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

This Form 10-Q contains certain forward-looking statements. For purposes of the safe harbor provisions under The Private Securities Litigation Reform Act of 1995, any statements using the terms “believes,” “anticipates,” “expects,” “plans” or similar expressions are forward-looking statements. The forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected. There are a number of important factors that could cause Varian Semiconductor’s actual results to differ materially from those indicated by forward-looking statements made in this report and presented by management from time to time. Some of the important risks and uncertainties that may cause Varian Semiconductor’s financial results to differ are under the heading “Risk Factors” in this report and in the annual report on Form 10-K for the fiscal year ended October 3, 2003, filed with the Securities and Exchange Commission on December 12, 2003.

The following information should be read in conjunction with the unaudited interim consolidated financial statements and notes thereto included in “Item 1. Consolidated Financial Statements” of this quarterly report and the audited consolidated financial statements and notes thereto and the section titled “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Varian Semiconductor’s annual report on Form 10-K for the fiscal year ended October 3, 2003 filed with the Securities and Exchange Commission on December 12, 2003.

Critical Accounting Policies and Significant Judgments and Accounting Estimates

Varian Semiconductor’s discussion and analysis of its financial condition and results of operations are based upon Varian Semiconductor’s consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States. The preparation of these consolidated financial statements requires Varian Semiconductor to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a continual basis, Varian Semiconductor evaluates its estimates, including those related to inventories, accounts receivable, intangible assets, income taxes, warranty obligations, post-retirement benefits, contingencies, and functional currencies. Varian Semiconductor operates in a highly cyclical and competitive industry that is influenced by a variety of diverse factors including, but not limited to, technological advances, product life cycles, customer and supplier lead times, and macroeconomic and geographic economic trends. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. See also the factors discussed below under the section titled “Risk Factors.”

Varian Semiconductor believes that the following sets forth the critical accounting policies used by Varian Semiconductor in the preparation of its consolidated financial statements.

Revenue Recognition

Product revenue includes established products, new products and spare parts.

Varian Semiconductor recognizes revenue from product sales upon shipment, provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectibility is reasonably assured through historical collection results and regular credit evaluations, and there are no uncertainties regarding customer acceptance.

For established and new products, a portion of the total purchase price is typically not due until installation occurs and the customer accepts the product. For established products, the lesser of the amount allocated to the equipment or the contractual amount due upon delivery is recorded as product revenue upon delivery. The amount deferred is recognized as revenue upon customer acceptance of all material terms of the customer acceptance criteria. For new products, revenue allocated to the equipment is recognized upon customer acceptance. Revenue related to spare parts and upgrade sales is recognized upon the later of delivery or when the title and risk of loss passes to the customer.

Products are classified as established products if post-delivery acceptance provisions and the installation process have been determined to be routine (due to the fact that the acceptance provisions are generally a replication of pre-shipment procedures) and there is a demonstrated history of achieving predetermined installation cost targets. The majority of products are designed and manufactured to meet contractual customer specifications. To ensure customer specifications are satisfied, the systems are

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tested at Varian Semiconductor’s manufacturing facility prior to shipment. To the extent that customers’ conditions cannot be replicated in Varian Semiconductor’s facilities or if there is not a demonstrated history of meeting newer customer specifications, then the product is treated as new for revenue recognition purposes. Varian Semiconductor has predetermined criteria for changing the classification of a new product to an established product. A new product must achieve a set number of acceptances and a set target for installation cost. Once the criteria have been achieved for a new product, the product is considered established.

Service revenue includes revenue from maintenance and service contracts, paid service and installation services. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Revenue related to paid service is recorded when earned and revenue related to installation is recorded upon fulfillment of the service obligation. Royalty and license revenue is recognized when contractual obligations are met, evidence of an arrangement exists, fees are fixed or determinable and collection is reasonably assured.

When fees are not fixed or determinable, revenue is recorded when payments become due.

Varian Semiconductor’s transactions frequently include the sale of systems and services under multiple element arrangements. Revenue under these arrangements is allocated to all elements, except systems, based upon the fair market value of those elements. The amount allocated to installation is based upon hourly rates at the estimated time to complete the service. The fair value of all other elements is based upon the price charged when these amounts are sold separately and unaccompanied by other elements. The amount of revenue allocated to systems is done on a residual method basis. Under this method, the total value of the arrangement is allocated first to the undelivered elements based on their fair values, with the remainder being allocated to systems revenue.

Inventory and Purchase Order Commitments

Varian Semiconductor values its inventory at the lower of cost or market. The determination of lower of cost or market requires that Varian Semiconductor make significant assumptions about future demand for products and the transition to new product offerings from legacy products. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor also provides for losses on those open purchase order commitments in which Varian Semiconductor’s estimated obligation to receive inventory under these commitments exceeds expected production demand. These assumptions include, but are not limited to, future manufacturing schedules, customer demand, supplier lead time and technological and market obsolescence. Once inventory is written down and a new cost basis has been established, it is not written back up if demand increases. If market conditions are less favorable than those projected by management, additional inventory provisions may be required. If market conditions are more favorable than those projected by management, and specific products previously reserved against are subsequently sold, gross profit would improve by the amount of the specific reserve reversed in the quarter the product is sold. In the case of purchase order commitments, more favorable market conditions or successful negotiations with suppliers will result in a reduction of provisions in the quarter the excess purchase order commitments are reduced.

Allowance for Doubtful Accounts

Varian Semiconductor maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments for products and services. Accounts with known financial issues are first reviewed and specific estimates are recorded. The remaining accounts receivable balances are then grouped in categories by the amount of days the balance is past due and the estimated loss is calculated as a percentage of the total category based upon past history. If the financial conditions of Varian Semiconductor’s customers were to deteriorate resulting in their inability to make payments, additional allowances may be required. If accounts previously identified as a risk and reserved for subsequently stabilize and are deemed to no longer be at risk for collection or categories past due decrease, the allowance for doubtful accounts may be reduced. As a result, a reduction to bad debt expense would be recognized in the period the determination was made.

Income Tax Provision

Varian Semiconductor’s effective tax rate is affected by the relative levels of taxable income in domestic and foreign tax jurisdictions, U.S. tax credits generated and utilized for research and development expenditures, the U.S. extraterritorial income exclusion and other tax incentives specific to domestic and foreign operations. From time to time, Varian Semiconductor is subject to various domestic and foreign tax audits pertaining to income tax filings for prior periods. Accordingly, foreign and domestic income tax payments could differ from previously recorded income tax provisions depending on the outcome of those audits.

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Valuation Allowance on Deferred Tax Assets

Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. On a quarterly basis, Varian Semiconductor evaluates both the positive and negative evidence bearing upon the realizability of its deferred tax assets. Varian Semiconductor considers future taxable income, ongoing prudent and feasible tax planning strategies, and the ability to utilize tax losses and credits in assessing the need for a valuation allowance. Management has concluded that no valuation allowance is required at this time. Should Varian Semiconductor determine that it is not able to realize all or part of its deferred tax assets in the future, a valuation allowance would be required resulting in an expense recorded within the provision for income taxes line in the Statement of Income in the period in which such determination was made. It is reasonably possible that the amount of the deferred tax asset considered realizable could be reduced in the near term if future taxable income is reduced. Varian Semiconductor’s effective tax rate is affected by levels of taxable income in domestic and foreign tax jurisdictions, U.S. tax credits generated and utilized for research and development expenditures, U.S. foreign income exclusion, investment tax credits and other tax incentives specific to domestic and foreign operations. Varian Semiconductor, from time to time, is subject to various domestic and foreign tax audits pertaining to income tax filings for prior periods. Accordingly, foreign and domestic income tax payments could differ from previously recorded income tax provisions depending on the outcome of those audits.

Product Warranties

Varian Semiconductor provides for the estimated cost of product warranties, the amount of which is based primarily upon historical information, at the time product revenue is recognized. While Varian Semiconductor engages in extensive product quality programs and processes including actively monitoring and evaluating the quality of its component supplies, Varian Semiconductor’s warranty obligation is affected by product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should actual product failure rates, utilization levels, material usage, service delivery costs or supplier warranties on parts differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.

Environmental Liabilities

Liabilities are recorded when environmental assessments and/or remedial efforts are probable and the costs can be reasonably estimated. Generally, the timing of these accruals coincides with completion of a feasibility study or Varian Semiconductor’s commitment to a formal plan of action. In situations where the various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate then future costs, the lower limit of an estimated range is accrued on a non-discounted basis. All other liabilities, which are usually where Varian Semiconductor has generally sufficient knowledge to be able to better estimate the scope of costs and future activities, are accrued on a discounted basis. Should new information become available and/or different assumptions be applied in the estimation of environmental liabilities, revisions to the accrued environmental liability would be required.

Derivative Financial Instruments and Forward Exchange Contracts

As a multinational company, Varian Semiconductor faces exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as Varian Semiconductor’s business practices evolve and could have a material adverse impact on Varian Semiconductor’s financial results. Historically, Varian Semiconductor’s primary exposures have resulted from non-U.S. dollar-denominated sales and purchases in Europe and Asia. Varian Semiconductor does not enter into forward exchange contracts for trading purposes. Varian Semiconductor’s forward exchange contracts generally range from one to six months in original maturity.

Results of Operations

Industry

Varian Semiconductor designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits. The Company’s business is highly cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. Other factors that affect customers’ demand for tools include device size and performance and wafer size.

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Revenue

The following table sets forth revenue by category for the three- and six-month periods ended April 2, 2004 and March 28, 2003:

Product

During the second quarter and first six months of fiscal year 2004, product revenue was $109.4 million and $195.8 million, respectively, compared to $94.1 million and $156.1 million for the same periods a year ago. The increases in product revenue during the second quarter and first six months of fiscal year 2004 were due to an increased demand for ion implanters as well as increased demand for upgrades for our installation base of existing customer machines due to customer requirements to increase wafer production capacity. In addition, the industry is increasing 300mm wafer capacity, thereby increasing demand for 300mm ion implanters.

Service

Service revenue during the second quarter of fiscal year 2004 was $16.3 million, compared to $15.1 million for the same period a year ago, and for the first six months of fiscal year 2004 was $29.6 million, compared to $34.4 million for the same period of fiscal year 2003. The respective increase and decrease in service revenue for the second quarter and first six months of fiscal 2004 was primarily due to the timing of installation revenue. Installation revenue is influenced by shipment volume of ion implanters, product mix and customer mix, and timing of customer acceptance.

Royalty

Pursuant to the terms of a Settlement and License Agreement between Varian Semiconductor and Lam Research Corporation (“Lam”), Lam continues to make quarterly cash payments of $1.25 million, which are included in the royalty revenue in the first and second quarters of fiscal year 2004. Lam is required to make quarterly cash payments of $1.25 million through December 2004 for future use of certain of Varian Semiconductor’s patents. Quarterly cash payments are recognized as royalty and license revenue in the period they become due and are dependent upon shipment volume of products from which royalty payments are generated. Fluctuations in royalty revenue are dependent upon shipment volume of products related to several licensed patents and can fluctuate in any one period.

During the second quarter of fiscal year 2004, revenue from two customers each accounted for 16% of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. During the second quarter of fiscal year 2003, revenue from three customers accounted for 26%, 16% and 14% of Varian Semiconductor’s total revenue.

During the first six months of fiscal year 2004, revenue from one customer accounted for 18% of Varian Semiconductor’s total revenue. During the first six months of fiscal year 2003, revenue from two customers accounted for 20% and 13% of Varian Semiconductor’s total revenue.

As of April 2, 2004, two customers, each representing 10% or greater of the total accounts receivable balance, accounted for 25% of the total accounts receivable balance. As of October 3, 2003, one customer accounted for 12% of the total accounts receivable balance.

Fluctuations in the timing and mix of product shipments, customer requirements for machines, and the completion of the installation of the product will continue to have a significant impact on the timing and amount of revenue in any given period (see also “Risk Factors” and “Critical Accounting Policies—Revenue Recognition”).

Cost of Product and Service Revenue. Cost of product revenue was $60.1 million and gross margin was 45.1% for the second quarter of fiscal year 2004, compared to the cost of product revenue of $60.2 million and gross margin of 36.1% for the second quarter of fiscal year 2003. For the first six months of fiscal year 2004, cost of product revenue was $110.5 million and gross margin was 43.6%, compared to cost of product revenue of $97.7 million and gross margin of 37.4% for the same period of fiscal year 2003.

Increased production in the second quarter and first six months of fiscal year 2004, relating to increased customer demand in both the second and third quarters of fiscal year 2004, resulted in more efficient factory (primarily overhead absorption) and supply chain operations than the same period a year ago. The product gross margin also improved due to lower warranty costs,

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as engineering and design enhancements have reduced warranty experience. In addition, the gross margin and pre-tax income in the second quarter and first six months of fiscal year 2003 were favorably impacted by $1.3 million and $4.2 million, respectively, from the sale of certain inventory for which the carrying value had been reduced in previous periods and from the reduction of adverse inventory purchase commitments. Varian Semiconductor has historically, and may in the future, sustain inventory-related charges resulting from numerous factors, including changes in customers’ purchase commitments, changes in commitments to Varian Semiconductor vendors, technology changes and Varian Semiconductor’s manufacturing lead times.

Cost of service revenue was $9.6 million and gross margin was 41.1% for the second quarter of fiscal year 2004, compared to a cost of service revenue of $9.3 million and gross margin of 38.0% for the second quarter of fiscal year 2003. For the first half of fiscal year 2004, cost of service revenue was $18.6 million and gross margin was 37.1%, compared to cost of service revenue of $20.1 million and gross margin of 41.7% for the first six months of fiscal year 2003. The increase in gross margin for cost of service revenue for the three-month period ended April 2, 2004 was primarily a result of the product mix of service contracts and paid service. The decrease in gross margin for cost of service revenue for the first six months of fiscal 2004 was primarily a result of the product mix of service contracts and installations completed.

Research and Development. Research and development expenses were $17.0 million for the second quarter of fiscal year 2004, compared to $14.4 million for the second quarter of fiscal year 2003. Research and development expenses for the first six months of fiscal 2004 were $33.2 million, compared to $28.0 million for the first six months of fiscal 2003. The increases were a result of increased labor and material spending associated with the development of new products, particularly high current implanters.

Marketing, General and Administrative. Marketing, general and administrative expenses were $21.0 million for the second quarter of fiscal year 2004, compared to $19.8 million in the same period in 2003. For the first half of fiscal year 2004, marketing, general and administrative expenses were $40.8 million, compared to $38.7 million for the first half of fiscal year 2003. The increases in expenses were the result of supporting increased revenue volume compared to the same period a year ago.

Interest Income and Interest Expense. During the second quarter of fiscal year 2004, Varian Semiconductor earned $0.9 million in net interest income, compared to $1.0 million for the second quarter of fiscal year 2003. Net interest income for the first half of fiscal year 2004 was $1.8 million, compared to $2.2 million for the first half of fiscal year 2003. Despite increased investment balances, net interest income decreased from the same periods in 2003 due to the interest expense related to the debt assumed as part of the purchase of the facility in Newburyport, Massachusetts in February 2003 and slightly lower interest rates.

Other Expense, Net. Other expense, net, was $0.1 million and $0.2 million for the three-month periods ended April 2, 2004 and March 28, 2003, respectively, and $0.1 million for each of the six-month periods ended April 2, 2004 and March 28, 2003.

Provision for Income Taxes. Varian Semiconductor’s effective income tax rate was 31.7% in the second quarter of fiscal year 2004 and 33% in the second quarter of fiscal year 2003. Varian Semiconductor’s effective income tax rate was 32% in the six-month period ended April 2, 2004, as compared with 33% in the first six months of fiscal year 2003.The effective tax rate differs from the statutory U.S. federal rate of 35%, primarily due to the extraterritorial income exclusion and tax credits. Future tax rates may vary from the historic rates depending on the worldwide composition of earnings and the continuing availability of income tax credits, the extra territorial income exclusion, as well as the potential resolution of tax contingencies.

Net Income. As a result of the foregoing factors, in the second quarter of fiscal year 2004 Varian Semiconductor recorded net income of $14.0 million, compared to net income of $5.5 million for the second quarter of fiscal year 2003. The net income per diluted share was $0.38 for the second quarter of fiscal year 2004, compared to net income per diluted share of $0.16 for the second quarter of fiscal year 2003. For the six-month period ended April 2, 2004, Varian Semiconductor recorded net income of $18.8 million and $0.51 per diluted share, as compared with net income of $8.3 million and $0.24 per diluted share in the same period of fiscal year 2003.

Liquidity and Capital Resources

Varian Semiconductor generated $2.8 million of cash from operations during the first six months of fiscal year 2004, compared to $37.5 million of cash generated from operations during the first six months of fiscal year 2003. Cash used in operations in the first six months of fiscal year 2004 was primarily due to increases in accounts receivable of $41.3 million and inventories of $22.6 million. Accounts receivable increased due to a substantial increase in shipments toward the end of the quarter. Inventories increased as a result of increased customer deliveries in the third and fourth quarters. These increases were partially offset by increases in accounts payable of $6.8 million and deferred revenue of $24.7 million, in addition to net income of $18.8 million and a tax benefit of $13.2 million from stock option exercises. In the first six months of fiscal year

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2003, cash provided by operations was primarily a result of a decrease in accounts receivable of $25.7 million and inventory of $23.0 million. These decreases were partially offset by decreases in deferred revenue of $27.7 million.

Varian Semiconductor used $59.3 million and $21.5 million of cash and cash equivalents for the purchase of short-term investments during the first six months of fiscal year 2004 and 2003, respectively, and $8.0 million and $6.9 million of cash and cash equivalents for the purchase of property, plant and equipment during the first six months of fiscal year 2004 and 2003, respectively. These were partially offset by proceeds from sales and maturities of short-term investments of $7.1 million during the first six months of fiscal year 2004.

During the six-month period ended April 2, 2004, Varian Semiconductor generated $22.1 million of cash from financing activities, primarily due to $22.2 million from the issuance of common stock upon the exercise of stock options and under the Employee Stock Purchase Plan, partially offset by repayments on long-term borrowings. During the first six months of fiscal year 2003, $4.5 million of cash was generated by financing activities, primarily due to $5.3 million from the issuance of common stock upon the exercise of stock options and under the Employee Stock Purchase Plan, partially offset by repayments on short-term borrowings.

Varian Semiconductor’s liquidity is affected by many factors, some based on the normal operations of the business and others related to the uncertainties of the industry and global economies. Varian Semiconductor believes that cash, cash equivalents and short-term investments of $367.1 million at April 2, 2004 will be sufficient to satisfy working capital requirements, commitments for capital expenditures and other purchase commitments, environmental contingencies and cash requirements for the foreseeable future.

Off-Balance Sheet Arrangements

Varian Semiconductor does not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. As such, Varian Semiconductor is not exposed to any financing, liquidity, market or credit risk that could arise if Varian Semiconductor had engaged in such relationships.

Contractual Obligations

Under GAAP, certain obligations and commitments are not required to be included in the consolidated balance sheets and statements of income. These obligations and commitments, while entered into in the normal course of business, may have a material impact on liquidity. The following commitments as of April 2, 2004 have not been included in the consolidated balance sheets and statements of income included under Item 1. Consolidated Financial Statements; however, they have been disclosed in the following table in order to provide a more accurate picture of Varian Semiconductor’s financial position and liquidity.