UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended March 31, 2006

or

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

Commission File No. 000-25705

GSI Group Inc.

(Exact name of registrant as specified in its charter)

New Brunswick, Canada	98-0110412
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
39 Manning Road Billerica, MA	01821
(Address of principal executive offices)	(Zip Code)

(978) 439-5511

(Registrant’s telephone number, including area code)

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 such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨            Accelerated filer  x            Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

As of May 1, 2006 there were approximately 42,194,867 of the Registrant’s common shares, no par value, issued and outstanding.

GSI GROUP INC.

TABLE OF CONTENTS

Item No.			Page No.
PART I — FINANCIAL INFORMATION			2
	ITEM 1.	FINANCIAL STATEMENTS	2
		CONSOLIDATED BALANCE SHEETS (unaudited)	2
		CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)	3
		CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)	4
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)	5
	ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	17
	ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	23
	ITEM 4.	CONTROLS AND PROCEDURES	23
PART II — OTHER INFORMATION			23
	ITEM 1.	LEGAL PROCEEDINGS	23
	ITEM 1A.	RISK FACTORS	24
	ITEM 6.	EXHIBITS	30
SIGNATURES			31

1

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

GSI GROUP INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(U.S. GAAP and in thousands of U.S. dollars, except share amounts)

	March 31, 2006			December 31, 2005
ASSETS
Current
Cash and cash equivalents (note 7)	$	86,385		$	69,286
Short-term investments (note 7)		22,463			26,757
Accounts receivable, less allowance of $1,487 (December 31, 2005 — $1,592) (note 6, 10)		65,177			55,348
Income taxes receivable (note 11)		2,387			2,517
Inventories (note 2)		62,763			63,475
Deferred tax assets (note 11)		10,980			10,630
Other current assets (note 2)		14,499			20,357
Total current assets		264,654			248,370
Property, plant and equipment, net of accumulated depreciation of $22,412 (December 31, 2005 — $20,608)		32,389			32,220
Deferred tax assets (note 11)		20,877			20,124
Other assets (note 2)		844			699
Long-term investments (note 7)		616			613
Intangible assets, net of amortization of $4,567 (December 31, 2005 — $4,035) (note 2)		16,325			16,834
Patents and acquired technology, net of amortization of $31,512 (December 31, 2005 — $30,359) (note 2)		27,043			28,163
Goodwill (note 2)		26,421			26,421
	$	389,169		$	373,444
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current
Accounts payable	$	18,858		$	14,998
Income taxes payable (note 11)		5,547			2,475
Accrued compensation and benefits		9,659			9,212
Other accrued expenses (note 2)		13,689			14,625
Total current liabilities		47,753			41,310
Deferred compensation		2,622			2,576
Deferred tax liabilities (note 11)		11,785			13,252
Accrued minimum pension liability (note 12)		9,787			9,750
Total liabilities		71,947			66,888
Commitments and contingencies (note 10)
Stockholders’ equity (note 5)
Common shares, no par value; Authorized shares: unlimited; Issued and outstanding: 42,194,867 (December 31, 2005 — 41,628,171)		313,787			309,545
Additional paid-in capital		4,340			3,339
Retained earnings		12,792			7,688
Accumulated other comprehensive loss		(13,697	)		(14,016	)
Total stockholders’ equity		317,222			306,556
	$	389,169		$	373,444

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

2

GSI GROUP INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(U.S. GAAP and in thousands of U.S. dollars, except share amounts)

	Three Months Ended
	March 31, 2006			April 1, 2005
Sales	$	76,123		$	64,841
Cost of goods sold		44,470			41,893
Gross profit		31,653			22,948
Operating expenses:
Research and development		7,454			6,460
Selling, general and administrative		15,004			15,380
Amortization of purchased intangibles		1,827			1,752
Other (note 9)		(96	)		197
Total operating expenses		24,189			23,789
Income (loss) from operations		7,464			(841	)
Other income (expense)		31			—
Interest income		887			392
Interest expense		(144	)		4
Foreign exchange transaction gains (losses)		(709	)		618
Income before income taxes		7,529			173
Income tax provision (note 11)		2,425			63
Net income	$	5,104		$	110
Net income per common share:
Basic	$	0.12		$	0.00
Diluted	$	0.12		$	0.00
Weighted average common shares outstanding (000’s)		41,868			41,464
Weighted average common shares outstanding for diluted net income per common share (000’s)		42,524			41,825

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

3

GSI GROUP INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(U.S. GAAP and in thousands of U.S. dollars)

	Three Months Ended
	March 31, 2006			April 1, 2005
Cash flows from operating activities:
Net income	$	5,104		$	110
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
(Gain) loss on long lived assets		(6	)		197
Depreciation and amortization		3,549			3,578
Unrealized loss on derivatives		—			56
Stock-based compensation		—			(62	)
Deferred income taxes		(2,324	)		(398	)
Changes in current assets and liabilities:
Accounts receivable		(9,875	)		6,264
Inventories		744			(3,063	)
Other current assets		(284	)		2,027
Accounts payable, accruals, taxes (receivable) payable and other liabilities		6,352			(9,896	)
Cash provided by (used in) operating activities		3,260			(1,187	)
Cash flows from investing activities:
Sale of assets		6,113			—
Additions to property, plant and equipment		(1,808	)		(898	)
Proceeds from the sale and maturities of investments		26,800			3,000
Purchases of investments		(22,514	)		(7,976	)
(Increase) decrease in other assets		(148	)		102
Cash provided by (used in) investing activities		8,443			(5,772	)
Cash flows from financing activities:
Proceeds from the exercise of stock options and warrants		4,244			191
Tax benefit of stock options		1,001			—
Cash provided by financing activities		5,245			191
Effect of exchange rates on cash and cash equivalents		151			(1,206	)
Increase (decrease) in cash and cash equivalents		17,099			(7,974	)
Cash and cash equivalents, beginning of period		69,286			82,334
Cash and cash equivalents, end of period	$	86,385		$	74,360

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

4

GSI GROUP INC.

NOTES TO CONSOLIDATED STATEMENT OF OPERATIONS (Unaudited)

(U.S. GAAP and in thousands of U.S. dollars, except share amounts)

1. Basis of Presentation

These unaudited interim consolidated financial statements have been prepared by GSI Group Inc. in United States (U.S.) dollars and in accordance with generally accepted accounting principles in the U.S. for interim financial statements and the rules and regulations promulgated by the U.S. Securities and Exchange Commission, including the instructions to Form 10-Q and the provisions of Regulation S-X pertaining to interim financial statements. Accordingly, these interim consolidated financial statements do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. The consolidated financial statements reflect all adjustments and accruals, consisting only of adjustments and accruals of a normal recurring nature, which management considers necessary for a fair presentation of financial position and results of operations for the periods presented. The consolidated financial statements include the accounts of GSI Group Inc. and its wholly-owned subsidiaries (the “Company”). Intercompany transactions and balances have been eliminated. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. The results for interim periods are not necessarily indicative of results to be expected for the year or for any future periods. The amounts are stated in thousands of U.S. dollars, unless otherwise indicated.

Comparative Amounts

Certain prior year amounts have been reclassified to conform to the current year presentation in the financial statements and notes as of and for the three months ended March 31, 2006. These reclassifications had no effect on the previously reported results of operations or financial condition.

2. Supplementary Balance Sheet Information

The following tables provide details of selected balance sheet accounts.

Inventories

	March 31, 2006		December 31, 2005
Raw materials	$	27,286	$	27,155
Work-in-process		12,847		10,299
Finished goods		16,495		19,323
Demo inventory		6,135		6,698
Total inventories	$	62,763	$	63,475

Other Assets

	March 31, 2006		December 31, 2005
Short term other assets:
Prepaid VAT and VAT receivable	$	6,703	$	6,648
Other prepaid expenses		4,119		4,119
Other current assets		3,677		9,590
Total	$	14,499	$	20,357
Long term other assets:
Deposits and other	$	844	$	699
Total	$	844	$	699

5

Intangible Assets

	March 31, 2006						December 31, 2005
	Cost			Accumulated Amortization			Cost			Accumulated Amortization
Patents and acquired technology	$	58,555		$	(31,512	)	$	58,522		$	(30,359	)
Accumulated amortization		(31,512	)					(30,359	)
Net Patents and acquired technology	$	27,043					$	28,163

	March 31, 2006						December 31, 2005
	Cost			Accumulated Amortization			Cost			Accumulated Amortization
Customer relationships	$	14,548		$	(3,212	)	$	14,528		$	(2,791	)
Trademarks, trade names and other		6,344			(1,355	)		6,341			(1,244	)
Total cost		20,892		$	(4,567	)		20,869		$	(4,035	)
Accumulated amortization		(4,567	)					(4,035	)
Net intangible assets	$	16,325					$	16,834

At both March 31, 2006 and December 31, 2005 intangible assets of $0.4 million included in trademarks, trade names and other, related to the Company’s Japan pension plan. This pension intangible is not amortized. Instead, the asset is increased or decreased in relation to the increase or decrease in the accumulated benefit obligation as compared to the fair value of the pension plan’s assets.

Goodwill

The Company accounts for goodwill pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires that goodwill no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. During the second quarter of 2005, the Company completed its annual testing of goodwill. There were no indications of impairment; therefore, no write-down of goodwill was necessary. The goodwill of $26.4 million is assigned to a reporting unit within our Precision Motion Group.

Other Accrued Expenses

	March 31, 2006		December 31, 2005
Accrued warranty	$	4,578	$	4,445
Deferred revenue		2,733		2,963
Accrued audit		611		1,100
VAT payable		83		498
Accrued restructuring (note 8)		1,334		1,392
Accrual for recourse receivable		1,087		730
Other		3,263		3,497
Total	$	13,689	$	14,625

Accrued Warranty

	For the Three Months Ended March 31, 2006			For the Three Months Ended April 1, 2005
Balance at the beginning of the period	$	4,445		$	5,880
Charged to costs of goods sold		1,363			1,720
Use of provision		(1,239	)		(2,021	)
Foreign currency exchange rate changes		9			(47	)
Balance at the end of the period	$	4,578		$	5,532

The Company generally warrants its products for a period of up to 12 months for material and labor to repair and service the system. A provision for the estimated cost related to warranty is recorded at the time revenue is recognized. The estimate of costs to service the warranty obligations is based on historical experience and expectation of future conditions. To the extent the Company experiences increased warranty claims or increased costs associated with servicing those claims, revisions to the estimated warranty liability would be made.

6

3. New Accounting Pronouncements

Inventory Cost

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”) to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). It requires that abnormal expenditures be recognized as expenses in the current period. SFAS 151 also requires that the amount of fixed production overhead allocated to inventory be based on the normal capacity of the production facilities. The standard is effective for fiscal years beginning after June 15, 2005, and is required to be adopted by the Company effective January 1, 2006. The Company’s adoption of SFAS 151 on January 1, 2006 did not have a material impact on the consolidated results of operations and financial condition.

Share-Based Payment

The Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) on January 1, 2006. SFAS 123R replaced SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) which superseded APB 25. SFAS 123R requires the determination of the fair value of all share-based payments to employees, including grants of employee stock options, and the recognition of the related expense over the period in which the service is received. The pro forma disclosures previously permitted under SFAS 123, are no longer an alternative to financial statement recognition. Under SFAS 123R, the Company determines the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used upon adoption. SFAS 123R allows the use of both closed form models (e.g., Black-Scholes Model) and open form models (e.g., lattice models) to measure the fair value of the share-based payment as long as that model is capable of incorporating all of the substantive characteristics unique to share-based awards. The transition methods include modified prospective and modified retrospective adoption options. The Company has elected to apply the modified prospective method of adoption of SFAS 123R. Under the modified prospective method, awards that are granted, modified, or settled after the date of adoption should be measured and accounted for in accordance with SFAS 123R. Additionally, SFAS 123R requires that tax benefits received in excess of compensation cost be reclassified from operating cash flows to financing cash flows in the Consolidated Statement of Cash Flows. On December 16, 2005, prior to the adoption of FAS 123R, the Company accelerated all outstanding unvested stock options. The decision to accelerate the vesting of these options was made primarily to reduce future compensation expense under SFAS 123R. As a result of the acceleration, options to purchase 558,446 of GSI Group Inc.’s common shares, which would otherwise have vested over the four following years, became fully vested. In the three months ended March 31, 2006, there were no new share based awards granted. As a result, the Company does not have any unvested options at March 31, 2006. Going forward the Company anticipates granting awards with both performance and service based awards rather than traditional stock options with service only conditions. The Company currently does not have an equity compensation plan that will allow for the granting of such instruments. The proposed 2006 Equity Incentive Plan will allow for performance based options and awards and has been presented to our shareholders for vote at the Annual Meeting of Shareholders on May 15, 2006. The Company’s board is currently evaluating the various equity instruments and is reviewing the Company’s policy on granting equity instruments, but it is expected that the granting pattern will change going forward. At this time, the Company is unable to quantify the effect SFAS 123R will have going forward on its consolidated results and earnings per share, nor has the Company determined whether it will use the Black-Scholes model or an open form model (lattice model) to measure the fair value of share-based payments. Additionally, the Company has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123, included in note 5 to the financial statements.

Accounting for Conditional Asset Retirement Obligations

In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”). FIN 47 clarifies that a conditional asset retirement obligation, as used in SFAS 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of the settlement are conditional on a future event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. FIN 47 is effective January 1, 2006, with early adoption allowed. The Company adopted FIN 47 on January 1, 2006. The adoption of FIN 47 did not have a material impact on the Company’s consolidated results of operations or financial condition.

4. Bank Indebtedness

At both March 31, 2006 and December 31, 2005, the Company had no lines of credit but had two bank guarantees in British Pounds Sterling and Euros with National Westminster Bank, (“NatWest”), and Deutsche Bank respectively, for a total amount of available credit of $0.1 million at both March 31, 2006 and December 31, 2005. The NatWest bank guarantee for letters of credit, which are used for VAT and duty purposes in the United Kingdom, is valued at $45 thousand for both March 31, 2006 and December 31, 2005. The Deutsche Bank guarantee of $102 thousand and $101 thousand for March 31, 2006 and December 31, 2005, respectively, is for our Munich, Germany office lease. At December 31, 2005, pursuant to a security agreement between the Company and Bank of America, marketable securities included in short-term investments totaling $5.0 million were pledged as collateral for the Bank of America pledge agreement. This pledge is no longer required at March 31, 2006.

7

5. Stockholders’ Equity

Capital Stock

The authorized capital of the Company consists of an unlimited number of common shares without nominal or par value. During the three months ended March 31, 2006 and April 1, 2005, 564,002 and 39,837, respectively, common shares were issued pursuant to exercised stock options for proceeds of approximately $4.2 million and $0.2 million, respectively. During the three months ended March 31, 2006 certain warrant holders exercised warrants to purchase 2,694 of the Company’s common shares for an aggregate of $26 thousand.

Stock option and warrant activity for the three months ended March 31, 2006 is presented below:

	Number of Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term in Years	Aggregate Intrinsic Value
Outstanding at December 31, 2005	3,565		$	8.21
Granted	—			—
Exercised	(567	)		7.54
Forfeited and expired	(114	)		17.45
Outstanding at March 31, 2006	2,884		$	11.02	2.44	$	4,407
Exercisable at March 31, 2006	2,884		$	11.02	2.44	$	4,407

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying options and warrants and the quoted price of our common stock for the 2.1 million options and warrants that were in the money at March 31, 2006. The intrinsic value of exercised options and warrants at March 31, 2006 was $3.0 million. At April 1, 2005, the aggregate intrinsic value of exercised options was $0.2 million.

The Company has a number of share based programs for its directors, officers and employees. Options to purchase the Company’s common stock are granted with exercise prices equal to the market value at the date of grant. Options granted have a ten year life and typically vest 25% each year for four years. Compensation expense is recognized on a straight line basis over the vesting period. The Company has granted both incentive stock options and non-qualified stock options. It is the Company’s policy to issue new shares upon the exercise of options and warrants. The Company, in accordance with Canadian law, is not permitted to hold its own stock, (e.g., treasury stock). As a result all option and warrant exercises will result in the issuance of new shares.

Accumulated Other Comprehensive Income (Loss)

The following table provides the details of accumulated other comprehensive loss at:

	March 31, 2006			December 31, 2005
Unrealized gain on investments, net of tax of nil	$	2		$	9
Accumulated foreign currency translations		(3,912	)		(4,275	)
Accrued minimum pension liability, net of tax of nil		(9,787	)		(9,750	)
Total accumulated other comprehensive loss	$	(13,697	)	$	(14,016	)

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

	Three Months Ended
	March 31, 2006			April 1, 2005
Net income	$	5,104		$	110
Change in unrealized gain on investments, net of tax of nil		(7	)		2
Change in accrued minimum pension liability, net of tax of nil		(37	)		21
Foreign currency translation adjustments		363			(2,636	)
Comprehensive income (loss)	$	5,423		$	(2,503	)

8

Net income per common share

Basic net income per common share was computed by dividing net income by the weighted-average number of common shares outstanding during the period. For diluted net income per common share, the denominator also included dilutive outstanding stock options and warrants determined using the treasury stock method.

Common shares and common share equivalent disclosures are:

	Three Months Ended
	March 31, 2006	April 1, 2005
	(In thousands)
Weighted average common shares outstanding	41,868	41,464
Dilutive potential common shares	656	361
Diluted common shares	42,524	41,825
Excluded from calculation - stock options and warrants that would have been anti-dilutive	760	1,837

At March 31, 2006, the Company had options and warrants outstanding entitling holders to acquire up to 2,835,361 and 48,492 common shares, respectively. At April 1, 2005, the Company had options and warrants outstanding entitling holders to acquire up to 3,519,811 and 51,186 common shares, respectively. At March 31, 2006 and April 1, 2005, the Company had both incentive stock options and non-qualified stock options outstanding.

Shareholders Rights Plan

At the May 26, 2005 Annual and Special Meeting of Shareholders, the shareholders of the Company approved a resolution to implement a Shareholder Rights Plan (the “Plan”) for a term of three years. This Plan was substantially similar to the Shareholder Rights Plan that was approved by the shareholders on May 9, 2002 and expired on April 12, 2005.

Under the Plan, one Right was issued in respect of each common share outstanding as of May 26, 2005 and one Right has been or will be issued in respect of each common share issued thereafter. Under the Plan, each Right, when exercisable, entitles the holder to purchase from the Company one common share at the exercise price of Cdn$200, subject to adjustment and certain anti-dilution provisions (the “Exercise Price”).

The Rights cannot be transferred separately from the common shares until the eighth business day (subject to extension by the Board of Directors) after the earlier of (a) the first date of public announcement that a person or group of affiliated or associated persons (excluding certain persons and groups) has acquired beneficial ownership of 20% or more of the outstanding common shares of the Company, or (b) the date of commencement of, or first public announcement of the intent of any person or group of affiliated or associated persons to commence, a take-over bid. At such time as any person or group of affiliated or associated persons becomes an “Acquiring Person”, meaning they hold 20% or more of the outstanding shares of the Company (a “Flip-In Event”), each Right shall constitute the right to purchase from the Company that number of common shares having an aggregate market price on the date of the Flip-In Event equal to twice the Exercise Price, for the Exercise Price (such Right being subject to anti-dilution adjustments).

So long as the Rights are not transferable separately from the common shares, the Company will issue one Right with each new common share issued. The Rights could have certain anti-takeover effects, in that they would cause substantial dilution to a person or group that attempts to acquire the Company on terms not approved by the Board of Directors.

2006 Equity Incentive Plan

On March 7, 2006, the Compensation Committee submitted, and the Board of Directors approved, the adoption of the 2006 Equity Incentive Plan, subject to shareholder approval at the Annual Meeting of Shareholders in May 2006. The 2006 Equity Incentive Plan is intended to correct structural deficiencies in the Second Restatement of the 1995 Equity Incentive Plan, and would, if adopted, control the award of equity incentive awards by the Company going forward. The 2006 Equity Incentive Plan generally provides for the sale or grant of various awards of, or the value of, shares of the Company’s common stock including stock options, restricted stock, stock appreciation rights, restricted stock and performance shares and units, performance-based awards, and stock grants, to officers, directors, employees and certain consultants to the Company and its affiliates. The 2006 Equity Incentive Plan and a detailed summary description of its terms have been included in the Company’s 2006 Proxy Statement. The maximum number of the Company’s common shares which may be issued pursuant to the 2006 Equity Incentive Plan is 6,906,000 common shares, subject to adjustment in the event of certain corporate events and reduced by the number of shares already issued pursuant to awards under the Company’s 1992 and 1995 Equity Incentive Plans. As of March 31, 2006, there remain 1,868,721 shares available to issue to eligible participants going forward pursuant to the 2006 Equity Incentive Plan. That number is subject to increase by the number of outstanding options that expire without exercise. The Company reserves the right to seek approval to issue additional shares to fund

9

equity incentive awards in the event that it determines a future need. If adopted by the Shareholders, the Compensation Committee will administer the 2006 Equity Incentive Plan, determine the terms of all awards and otherwise decide all questions arising under the 2006 Equity Incentive Plan. Under the 2006 Equity Incentive Plan, outstanding options, stock appreciation rights, and restricted stock and restricted stock units not based on performance goals will continue to vest after a change of control, and will accelerate in full upon any termination of the participant’s employment within one year following the change of control. Restricted stock and restricted stock units based on performance goals will be deemed to have been satisfied upon a change of control pro rata from the date of grant to the change of control event. The 2006 Equity Incentive Plan will, if adopted, have a ten-year term.

2005 Incentive Awards

On October 25, 2005, the Company established a 2005 Incentive Award program which, if the Company reaches certain profit targets, will require the Company to make cash payments based upon the sum of the trading price of the Company’s common shares as of the date the Board of Directors approves the annual audited financial statements multiplied by the number of shares earned under the 2005 Incentive Awards, if any. The 2005 Incentive Award program has a four-year term from 2005 through 2008, with awards triggered upon achieving certain operating income goals. It is the intention of the Board to convert the cash awards into performance-based restricted stock awards upon approval of the 2006 Equity Incentive Plan. In the event that the 2006 Equity Incentive Plan is not approved by the shareholders, future awards, if any, would continue to be made in cash. As of March 31, 2006 the minimum operating income threshold required to be met to make payments under this Plan was not achieved. Therefore, no payments were made to participants and as it is not probable that any of the financial targets will be achieved, no compensation expense was accrued in the financial statements. The Company will continue to monitor the circumstances of these awards and make appropriate updates to the accounting as required.

Stock Based Compensation

On January 1, 2006, the Company adopted FAS123R on a modified prospective basis. Prior to this, the Company used the intrinsic value method as proscribed in APB 25. On December 16, 2005, prior to the adoption of FAS 123R, the Company accelerated all outstanding unvested stock options and in the three months ended March 31, 2006, there were no new share based awards granted. The effect of FAS 123R on the Company’s consolidated results of operations and cash flows is zero for the three months ended March 31, 2006 as there were no instruments by which to apply FAS 123R. Going forward, the Company anticipates granting awards with both performance and service conditions rather than traditional stock options with service only conditions. The cost of those awards will be determined by the fair market value of the shares at grant date and will be expensed ratably over the period the restrictions lapse. The Company currently does not have an equity compensation plan that will allow for the granting of such instruments. The proposed 2006 Equity Incentive Plan which has been presented to our shareholders for vote in our 2006 Proxy Statement will allow for performance based options and awards. This plan is described above. At this time, the Company is unable to quantify the effect SFAS 123R will have going forward on its consolidated results and earnings per share. Nor has the Company determined whether it will use the Black-Scholes model or an open form model (lattice model) to measure the fair value of share-based payments. Additionally, the Company has not determined whether the adoption will result in amounts that are similar to the prior quarter’s pro forma disclosures under SFAS 123 below.

Pro Forma Stock Based Compensation

Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic value method as proscribed under APB 25. Had compensation cost for the Company’s stock option plans been determined consistent with SFAS No. 123 prior to 2006, the Company’s net income and net income per share would have been decreased to the pro forma amounts below.

	Three months ended April 1, 2005
Net income:
As reported	$	110
Stock based compensation included in results of operations, net of related tax effects		(62	)
Stock based compensation if fair value based method was applied, net of related tax effects		(652	)
Pro forma income (loss)	$	(604	)
Basic net income (loss) per share:
As reported	$	—
Pro forma	$	(0.01	)
Diluted income (loss) per share:
As reported	$	—
Pro forma	$	(0.01	)

10

The fair value of options was estimated at the date of grant using a Black-Scholes option-pricing model with the following assumptions:

	April 1, 2005
Risk-free interest rate		3.88	%
Expected dividend yield		—
Expected life from date of grant		5.0 years
Expected volatility		60	%
Weighted average fair value per share	$	5.28

6. Related Party Transactions

Richard B. Black, Chairman of the Company, is also the President and Chief Executive Officer of ECRM, Inc. ECRM, Inc. purchased $95 thousand of equipment from GSI Group Corporation and GSI Group Ltd in the three months ended March 31, 2006 and $46 thousand in the three months ended April 1, 2005 at amounts and terms approximately equivalent to those found in arms length third-party transactions. Receivables from ECRM, Inc. of $93 thousand and $51 thousand at March 31, 2006 and December 31, 2005, respectively, are included in accounts receivable on the balance sheet.

The Company recorded sales revenue from Sumitomo Heavy Industries Ltd., a significant shareholder of the Company, of $0.9 million in the three months ended March 31, 2006 and $1.5 million in the three months ended April 1, 2005 at amounts and terms approximately equivalent to those found in arms length third-party transactions. Receivables from Sumitomo Heavy Industries Ltd. of $0.5 million and $0.4 million at March 31, 2006 and December 31, 2005, respectively, are included in accounts receivable on the balance sheet. The Company purchases raw materials from Sumitomo at amounts and terms approximately equivalent to third-party transactions. The Company purchased $12 thousand and $40 thousand from Sumitomo in the three months ended March 31, 2006 and April 1, 2005, respectively. Payables due to Sumitomo Heavy Industries Ltd. of $33 thousand and $9 thousand as at March 31, 2006 and December 31, 2005, respectively, are included in accounts payable on the balance sheet.

The Company has an agreement with V2Air LLC relating to the use of V2Air LLC’s aircraft for Company purposes. V2Air LLC is owned by the Company’s President and Chief Executive Officer, Charles D. Winston. Pursuant to the terms of the agreement, the Company is required to reimburse V2Air LLC for gas and related travel expenses (airport and landing fees, local hanger fees, ground transportation and other direct expenses) associated with the use of the aircraft for Company business travel. The Company sets the hourly rental rate based on market surveys for comparable aircraft, conducted twice per year. During the three months ended March 31, 2006 and April 1, 2005, the Company reimbursed V2Air LLC $55 thousand and $14 thousand, respectively, under the terms of the agreement.

7. Financial Instruments

Cash Equivalents, Short-term and Long-term Investments

At March 31, 2006, the Company had $70.3 million invested in cash equivalents predominately denominated in United States dollars and British Pounds Sterling with maturity dates between April 3, 2006 and May 25, 2006. At December 31, 2005, the Company had $43.7 million invested in cash equivalents predominately denominated in United States dollars and British Pounds Sterling with maturity dates between January 3, 2006 and February 1, 2006. At both March 31, 2006 and December 31, 2005, cost approximates fair value.

At March 31, 2006, the Company had $22.5 million in short-term investments with maturity dates between April 13, 2006 and April 20, 2006. At December 31, 2005, the Company had $26.8 million in short-term investments with maturity dates between January 3, 2006 and February 16, 2006. These are recorded at fair value based upon market quotes. At both March 31, 2006 and December 31, 2005, the unrealized gain (loss) on the short-term and long-term investments was not material. As discussed in Note 4 to the financial statements at December 31, 2005, $5.0 million of short-term investments was pledged as collateral for the Bank of America pledge agreement which is no longer outstanding at March 31, 2006. Long-term investments at March 31, 2006 and December 31, 2005 represents a 20% equity investment in a private United Kingdom company, Laser Quantum, valued at GBP 0.4 million (approximately $0.6 million at both March 31, 2006 and December 31, 2005). This is recorded at cost. The Company does not have the ability to exercise significant control over this investment. It is not practicable to determine the fair value of this investment and there has been no indication of impairment.

11

Derivative Financial Instruments

The Company uses derivatives to manage exposures to changes in foreign currency exchange rates associated with forecasted sales transactions. Currency forwards and swaps are used to fix the cash flow variable of local currency costs or selling prices denominated in currencies other than the functional currency. For hedged forecasted transactions, hedge accounting is discontinued if the forecasted transaction is no longer intended or expected to occur and any previously unrealized hedging gains or losses recorded in other comprehensive income are immediately recorded to earnings. Earnings impacts for all designated hedges are recorded in the consolidated statement of operations generally on the same line item as the gain or loss on the item being hedged. The Company records all derivatives at fair value as assets or liabilities in the consolidated balance sheet, with classification as current or long-term depending on the duration of the instrument. Although the Company marks-to-market short-term hedge contracts to the statement of operations, the Company does not intend to enter into hedging contracts for speculative purposes.

At March 31, 2006, the Company had no open hedge contracts. At December 31, 2005, the Company had one short term currency swap that matured in December of 2005 and was settled in January 2006. The currency swap was an exchange for Yen valued at $8.7 million United States dollars with an aggregate fair value loss of $0.1 million after-tax recorded in the Statement of Operations for the period ending March 31, 2006.

8. Restructuring

Restructuring Charges

Several significant markets for our products had been in severe decline from 2000 through early 2003. In response to the business environment, the Company restructured operations in an effort to bring costs in line with our expectations for sales of systems for the semiconductor and telecommunications markets. Our emphasis was predominantly on consolidating operations at various locations and reducing overhead. The Company incurred restructuring charges in each of the years from 2000 to 2003 as it continued to reduce and consolidate operations around the world. Each year, the Company evaluates accruals that it has made as part of prior restructuring actions. In 2004 and 2005, it was determined that additional charges of $0.6 million and $0.5 million, respectively, were needed for the excess space in the Munich facility due to continued softness in the Munich commercial market. The Company estimated the restructuring charges for the Munich, Germany facility based on contractual payments required on the lease for the unused space, less the amount expected to be received for subleasing the facility. Future sublease market conditions may require the Company to make further adjustments to this restructuring reserve. The Company has taken restructuring charges on this Munich facility in each of the years from 2000 through 2005. As of December 31, 2005, the Company had $1.4 million remaining in the accruals related to all restructuring actions. The majority of the accruals related to provisions for lease costs at our facility in Munich, Germany for future contractual obligations under operating leases, net of expected sublease income, which the Company cannot terminate, because this is a long-term lease that extends until 2013. The Company will amortize the amount accrued over the life of the lease. In addition, a negligible amount of the accrual related to an amount for a leased facility in Nepean, Ontario originally recorded in 2001 for future contractual obligations under an operating lease, net of expected sublease income on such lease that the Company cannot terminate. This lease expired in January 2006. In the first quarter of 2006, the only restructuring and remaining accrual activity related to payments under the Munich leases noted above.

The following table summarizes changes in the facilities restructuring provision included in other accrued expenses on the balance sheet.

	Total
	(In millions)
Provision at December 31, 2005	$	1.4
Charges during the three months of ended March 31, 2006		—
Cash payments during the three months ended March 31, 2006		(0.1	)
Provision at March 31, 2006	$	1.3

On March 17, 2006, GSI Lumonics GmbH, a wholly owned subsidiary of the Company, entered into a leasing arrangement to sublet 1,700 square meters of the Munich, Germany facility (out of a total 2,745 sqm) for 60 months commencing July 1, 2006. The subtenant has the right to extend the sublease until the end of the Company’s lease term (January 2013).

9. Other

Other

The Company recorded rental income of $0.1 million on its excess facilities during the three months ended March 31, 2006. The Company sold the Maple Grove facility on January 5, 2006 for $6.3 million. The Company recorded a write-down of $0.2 million for the estimated loss on the expected sale in the fourth quarter of 2005.

12

10. Commitments and Contingencies

Operating leases

The Company leases certain equipment and facilities under operating lease agreements. Most of these lease agreements expire between 2006 and 2013. In the United Kingdom where longer leases are more common, the Company has land leases that extend through 2078. The facility leases require the Company to pay real estate taxes and other operating costs. The rent on certain leases is subject to escalation clauses in future years.

Legal Proceedings and Disputes

The Company’s French subsidiary is subject to a claim by a customer that a Laserdyne 890 system, which was delivered in 1999, had unresolved technical problems that resulted in the customer’s loss of revenue and profit, plus the costs to repair the machine. In May 2001, the Le Creusot commercial court determined that the Company had breached its obligations to the customer and that it should be liable for damages. An expert appointed by the Le Creusot commercial court had filed an initial report, which estimated the cost to repair the machine at approximately French Franc 0.8 million (or approximately US$0.2 million). In the third quarter of 2003, the Company was notified that the customer is seeking cost of repairs, damages and lost profits of Euro 1.9 million (approximately US$2.6 million). In July 2004, a court appointed expert estimated the actual damages at Euro 0.9 million (or approximately $1.2 million). The customer has not paid Euro 0.3 million (or approximately $0.4 million) of the purchase price for the system, which the Company believes it may offset against any damages. The Company has fully reserved this receivable.

During the second quarter of 2005, the Company’s French subsidiary filed for bankruptcy protection, which was granted by the French courts on July 7, 2005. On January 25, 2006, the commercial court of Le Creusot held a hearing on the amount the customer could properly claim under French bankruptcy law. The customer proposed Euro 1,572,531 (approximately US$1.87 million), and the Company argued that the amount should be Euro 598,079 (approximately US$712,203).

On April 18, 2006, the commercial court in Le Creusot rendered its final decision and ruled that the customer’s claim was Euro 598,079 (approximately US$712,203), plus court costs and expert fees for a total claim of Euro 684,024 (approximately US$862,358). As a result of the bankruptcy petition, any claim in excess of available assets in the bankruptcy estate would have to be brought against the French subsidiary’s parent in its home jurisdiction, which is the United Kingdom. At this time, the Company does not believe it will be required to make a payment regarding this action as the costs to pursue a foreign action in the United Kingdom would be substantial relative to the amount in dispute. Accordingly, nothing has been accrued in the financial statements.

The Company has made claims for indemnification and breaches of warranty under the asset purchase agreement against Lumenis Ltd. and Spectron Cosmetics Ltd. (formerly known as Spectron Laser Systems Limited) (collectively “Spectron”). The Company filed its claim in the English courts on July 29, 2005 as a result of defects in the line of laser products purchased under the asset agreement, and related claims. The Company has also put Spectron on notice of the Company’s intent to file a second action against Spectron for fraud in connection with representations made to the Company by Spectron pre-sale concerning the viability of Spectron’s DPSS product line. As part of the asset purchase agreement, US$1.3 million was deposited into escrow, which amount remains in the hands of the escrow agent. The Company filed a claim for the entire escrow balance, as well as additional amounts in excess of the escrow account. The Company has recorded in other current assets a receivable of £0.4 million (approximately US$0.7 million) for certain indemnification claims, and for a purchase price adjustment as part of the Company’s initial purchase accounting. One customer, Hapa, thereafter raised a warranty claim associated with lasers sold by Spectron prior to the acquisition. Hapa has made the same demand to Spectron, and the Company has sent a formal demand to Spectron for indemnification from the Hapa claim. No lawsuit has been filed by Hapa. In addition, a second customer, Hankwang Opto Corp., a Korean company, has raised a warranty claim for DPSS product and requested a refund on up to six DPSS lasers. The Company has notified Spectron of the demand and has requested to be indemnified of and from any damages associated with the Hankwang claim. To date, no customer claims are the subject of any legal proceeding.

It is not possible to determine the amount of recovery, if any, which the Company may ultimately receive from the Spectron litigation, but the Company anticipates that at least the amount recorded as a receivable will be recovered. Additionally, it is not possible to determine any amounts that we may have to pay to satisfy Spectron customer warranty claims, although it is expected that any such amounts would be included in any future settlement with Spectron.

The Company is also subject to various legal proceedings and claims that arise in the ordinary course of business. The Company does not believe that the outcome of these claims will have a material adverse effect upon the Company’s financial conditions or results of operations but there can be no assurance that any such claims, or any similar claims, would not have a material adverse effect upon the Company’s financial condition or results of operations.

13

Recourse Receivables

In Japan, where it is customary to do so, the Company discounts certain customer notes receivable at a bank with recourse. The Company’s maximum exposure was $1.1 million at March 31, 2006 and $0.7 million at December 31, 2005. The book value of the recourse receivables approximates fair value. Recourse receivables are included in accounts receivable and the related liability is included in accrued expenses.

Guarantees

In the normal course of our operations, we execute agreements that provide for indemnification and guarantees to counterparties in transactions such as business dispositions, the sale of assets, sale of products and operating leases. Additionally, the by-laws of the Company require it to indemnify certain current or former directors, officers, and employees of the Company against expenses incurred by them in connection with each proceeding in which he or she is involved as a result of serving or having served in certain capacities. Indemnification is not available with respect to a proceeding as to which it has been adjudicated that the person did not act in good faith in the reasonable belief that the action was in the best interests of the Company. These indemnities and guarantees are routine and customary in the industry.

These indemnification undertakings and guarantees may require us to compensate the counterparties for costs and losses incurred as a result of various events including breaches of representations and warranties, intellectual property right infringement, loss of or damages to property, environmental liabilities, changes in the interpretation of laws and regulations (including tax legislation) or as a result of litigation that may be suffered by the counterparties. Also, in the context of the sale of all or a part of a business, this includes the resolution of contingent liabilities of the disposed businesses or the reassessment of prior tax filings of the corporations carrying on the business.

Certain indemnification undertakings can extend for an unlimited period and generally do not provide for any limit on the maximum potential amount. The nature of substantially all of the indemnification undertakings prevents us from making a reasonable estimate of the maximum potential amount we could be required to pay counterparties as some agreements do not specify a maximum amount, although our standard terms and conditions limits exposure to the sales price of our products. Additionally, the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time.

Historically, we have not made any significant payments under such indemnifications. At March 31, 2006 and December 31, 2005, nothing has been accrued in the consolidated balance sheet with respect to these indemnification undertakings.

Risks and uncertainties

The Company uses financial instruments that potentially subject it to concentrations of credit risk. Such instruments include cash equivalents, securities available-for-sale, trade receivables and financial instruments used in hedging activities. The Company does not believe it is exposed to any significant credit risk on these instruments.

Due to the short term nature of the Company’s investments, the Company does not believe it is exposed to any significant interest rate risk.

Certain of the components and materials included in the Company’s laser systems and optical products are currently obtained from single source suppliers. There can be no assurance that a disruption of this outside supply would not create substantial manufacturing delays and additional cost to the Company.

There is no concentration of credit risk related to the Company’s position in trade accounts receivable. Credit risk, with respect to trade receivables, is minimized because of the diversification of the Company’s operations, as well as its large customer base and its geographical dispersion.

The Company’s operations involve a number of other risks and uncertainties including, but not limited to, the cyclicality of the semiconductor and electronics markets, the effects of general economic conditions, rapidly changing technology, and international operations.

11. Income Taxes

At the end of each interim reporting period, the Company determines its estimated annual effective tax rate, which is revised, as required, at the end of each successive interim period based on facts known at that time. The estimated annual effective tax rate is applied to the year-to-date pre-tax income at the end of each interim period. The tax effect of significant unusual items is reflected in the period in which they occur. The Company’s reported effective tax rate of 32.2% for the three months ended March 31, 2006, differed from the expected Canadian federal statutory rate, primarily due to certain tax credits, valuation allowances and discrete items in certain jurisdictions that affected the tax rate.

14

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

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

Income taxes have not been provided for unremitted earnings of foreign subsidiaries because such earnings are intended to be permanently reinvested by the Company.

12. Defined Benefit Pension Plan

The Company’s subsidiary in the United Kingdom maintains a pension plan, known as the GSI Lumonics Ltd. United Kingdom Pension Scheme Retirement Savings Plan. The plan has two components: the Final Salary Plan, which is a defined benefit plan, and the Retirement Savings Plan, which is a defined contribution plan. Effective April 1997, membership to the Final Salary Plan was closed. Benefits under this plan were based on the employees’ years of service and compensation. In December 2002, the Company notified plan participants that it no longer wanted to sponsor the Final Salary Plan. After a consultation period, the curtailment of the plan was effective June 1, 2003, after which no additional benefits accrue to the participants.

The Company continues to follow its policy to fund pensions and other benefits based on widely used actuarial methods as permitted by regulatory authorities. The funded amounts reflect actuarial assumptions regarding compensation, interest and other projections. The assets of this plan consist primarily of equity and fixed income securities of U.K. and foreign issuers.

Pension and other benefit costs reflected in the consolidated statements of operations are based on the projected benefit method of valuation. Within the consolidated balance sheet, pension plan benefit liabilities are included in accrued compensation and benefits.

The table below sets forth the estimated net periodic cost of the Final Salary Plan of GSI Lumonics Ltd. United Kingdom Pension Scheme Retirement Savings Plan.

	Three Months Ended March 31, 2006			Three Months Ended April 1, 2005
Components of the net periodic pension cost:
Service cost	$	—		$	—
Interest cost		345			418
Expected return on plan assets		(258	)		(267	)
Amortization of unrecognized gain (loss)		104			99
Net periodic pension cost	$	191		$	250

The Company’s subsidiary in Japan maintains a tax qualified pension plan. The plan, a quasi-defined benefit pension plan, covers substantially all regular employees, under which the company deposits funds under various fiduciary-type arrangements and/or purchases annuities under group contracts. Benefits are based on years of service and the employee’s compensation at retirement. For employees with less than twenty years of service to the Company, the benefit is paid out in a lump sum based on years of service and the employee’s compensation at retirement. For employees with twenty or more years of service to the Company, the benefit is guaranteed for a certain number of years and is based on years of service and the employee’s compensation at retirement. Participants may under certain circumstances, receive a benefit upon termination of employment.

The assumptions that are used to value the costs and obligations of the plan reflect the Japanese economic environment. The Company continues to fund the plan sufficiently to meet current benefits as well as to fund a certain portion of future benefits as permitted in accordance with regulatory authorities.

15

The table below sets forth the estimated net periodic cost of the tax qualified pension plan.

	Three Months Ended March 31, 2006			Three Months Ended April 1, 2005
Components of the net periodic pension cost:
Service cost	$	47		$	53
Interest cost		7			7
Expected return on plan assets		(1	)		(1	)
Amortization of unrecognized gain (loss)		16			18
Net periodic pension cost	$	69		$	77

13. Segment Information

There have been no significant changes to the Company’s reportable operating segments since December 31, 2005. The Company’s operating segments are the same as those described in the Annual Report on Form 10-K.

Segments

Information on reportable segments is as follows:

	Three months ended
	March 31, 2006			April 1, 2005
Sales:
Precision Motion Group	$	38,572		$	33,985
Laser Group		8,406			10,261
Laser Systems Group		31,329			22,004
Intersegment sales elimination		(2,184	)		(1,409	)
Total	$	76,123		$	64,841
Segment income (loss) from operations:
Precision Motion Group	$	5,751		$	3,297
Laser Group		(186	)		(711	)
Laser Systems Group		5,736			1,623
Total by segment		11,301			4,209
Unallocated amounts:
Corporate expenses		3,817			4,827
Amortization of purchased intangibles not allocated to a segment		26			26
Other		(6	)		197
Income (loss) from operations	$	7,464		$	(841	)

The Company’s chief operating decision maker does not review asset information on a segmented basis and the Company does not maintain assets on a segmented basis, therefore a breakdown of assets by segments is not included.

16

Geographic Segment Information

The Company attributes revenues to geographic areas on the basis of the bill-to customer location. Not infrequently, equipment is sold to large international companies, which may be headquartered in Asia-Pacific for example, but the sales of our systems are billed and shipped to locations in the United States. In this example, these sales are reflected in North America totals in the table below. Long-lived assets, which include property, plant and equipment, intangibles and goodwill, but exclude other assets, long-term investments and deferred tax assets, are attributed to geographic areas in which the Company assets reside.

	Three months ended
	March 31, 2006				April 1, 2005
	Sales (in millions)		% of Total		Sales (in millions)		% of Total
North America	$	21.1	28	%	$	25.0	39	%
Latin and South America		0.3	—			0.4	—
Europe (EMEA)		12.0	16			11.1	17
Japan		10.7	14			13.7	21
Asia-Pacific, other		32.0	42			14.6	23
Total	$	76.1	100	%	$	64.8	100	%

	March 31, 2006		December 31, 2005
Long-lived assets and goodwill:
USA	$	66,657	$	67,055
Canada		—		—
Europe		32,211		33,434
Japan		1,043		946
Asia-Pacific, other		2,267		2,203
Total	$	102,178	$	103,638

14. Subsequent Event

In April 2006, the Company began repurchasing its stock as part of the previously announced stock repurchase program. Purchases were made on the open market at prevailing prices using the Company’s available cash. The Company announced in December 2005 that its board of directors authorized a stock repurchase program, providing for the repurchase of up to $15 million of the Company’s common stock.

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the Consolidated Financial Statements and Notes included in Item 1 of this Report. MD&A contains certain forward-looking statements within the meaning of the United States Private Securities Litigation Reform Act of 1995, Section 27A of the United States Securities Act of 1933, as amended, and Section 21E of the United States Securities Exchange Act of 1934, as amended. These forward-looking statements relate to anticipated financial performance; drivers of revenue growth; management’s plans and objectives for future operations and expenditures; business prospects; industry trends; market conditions; changes in accounting principles and changes in actual or assumed tax liabilities; our expectations regarding tax exposure; our anticipated capital requirements and working capital needs; our anticipated reinvestment of future earnings; our anticipated expenditures in regard to our benefit plans; and our anticipated use of currency hedges. These forward-looking statements are neither promises nor guarantees, but involve risks and uncertainties that may cause actual results to differ materially from those in the forward-looking statements. Factors that may cause such differences include, but are not limited to, our ability to maintain or accurately forecast revenue growth or to anticipate and accurately forecast a decline in revenue from any of our products or services; our ability to compete in an intensely competitive market; our ability to develop and introduce new products or enhancements on schedule and that respond to customer requirements and rapid technological change; new product introductions and enhancements by competitors; our ability to select and implement appropriate business models; plans and strategies and to execute on them; our ability to identify, hire, train, motivate, and retain highly qualified management/other key personnel and our ability to manage changes and transitions in management/other key personnel, including the planned transition to a new Chief Executive Officer in 2006, the impact of global economic conditions on our business; unauthorized use or misappropriation of our intellectual property; as well as the risk factors discussed previously and in other periodic reports filed with the SEC. Readers should not place undue reliance on any such forward-looking statements, which speak only as of the date they are made. We disclaim any obligation to publicly update or revise any such statement to reflect any change in our expectations or in events, conditions, or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those contained in the forward-looking statements.

17

Overview

The Company develops and delivers the enabling technology solutions that bring our customers’ advanced manufacturing applications to life. Our leading brands include precision motion products, lasers, and laser systems, and are used to boost efficiency and productivity in the semiconductor, electronics, industrial and global medical markets.

Our Laser Group produces high quality repeatable cuts, welds, holes and specialist marks on customer’s products. These include hermetically sealing (by laser) heart defibrillators and rechargeable batteries.

Our Precision Motion Group contains diversified product lines ranging from ultra high speed spindles to super precise measuring devices. Applications include formatting hard drives and drilling holes in printed circuit boards. Our products allow manufacturers to perform tasks such as drilling thousands of holes per minute with accuracy at a micron level.

Our Laser Systems Group supplies leading edge equipment to the semiconductor industry. These include systems to scribe and test silicon wafers and repair semiconductor memory wafers.

Highlights for the Three Months Ended March 31, 2006

• Sales for the quarter were $76.1 million, compared to $64.8 million in the first quarter of 2005.

• Net income for the quarter was $5.1 million, or $0.12 per diluted share, compared to net income of $0.1 million, or $0.00 per diluted share, in the first quarter of last year.

• Bookings of orders were $71.0 million in the first quarter of 2006 compared to $62.4 million in the first quarter of 2005. Ending backlog was $79.3 million at March 31, 2006 as compared with $58.9 million at the end of the first quarter of 2005.

• Cash, cash equivalents, short-term investments and short-term marketable securities were $108.8 million at March 31, 2006.

Results of Operations

The following table sets forth items in the unaudited consolidated quarterly statement of operations as a percentage of sales for the periods indicated:

	Three Months Ended
	March 31, 2006		April 1, 2005
Sales	100.0	%	100.0	%
Cost of goods sold	58.4		64.6
Gross profit	41.6		35.4
Operating expenses:
Research and development	9.8		10.0
Selling, general and administrative	19.7		23.7
Amortization of purchased intangibles	2.4		2.7
Other	(0.1	)	0.3
Total operating expenses	31.8		36.7
Income (loss) from operations	9.8		(1.3	)
Interest income	1.2		0.6
Interest expense	(0.2	)	—
Foreign exchange transaction gains (losses)	(0.9	)	1.0
Income before income taxes	9.9		0.3
Income tax provision	3.2		0.1
Net income	6.7	%	0.2	%

18

Three Months Ended March 31, 2006 Compared to Three Months Ended April 1, 2005

Sales by Segment. The following table sets forth sales in thousands of dollars by our business segments for the first quarter of 2006 and 2005.

	Three Months Ended
	March 31, 2006			April 1, 2005			Increase (Decrease)
Sales:
Precision Motion Group	$	38,572		$	33,985		$	4,587
Laser Group		8,406			10,261			(1,855	)
Laser Systems		31,329			22,004			9,325
Intersegment sales elimination and other		(2,184	)		(1,409	)		(775	)
Total	$	76,123		$	64,841		$	11,282

Sales. Sales for the three months ended March 31, 2006 at $76.1 million, increased by $11.3 million or 17%, compared to the three months ended April 1, 2005.

Sales in the Precision Motion Group segment were $38.6 million in the first quarter of 2006 compared to $34.0 million in the same period in 2005, an increase of $4.6 million or 14%. The increase was primarily attributed to the increased sales of PCB spindles, MicroE products and components which were partially offset by decreases in specialty air bearings and GMAX. Smaller changes in sales of other product lines accounted for the remaining increase in Precision Motion segment sales.

Laser Group segment sales decreased $1.9 million, or 18% in the first three months of 2006 as compared to the same period in 2005, largely the result of lower volume of shipments.

Sales in the Laser Systems segment increased $9.3 million or 42% to $31.3 million in the three months ended March 31, 2006 as compared to $22.0 million in the same period in 2005. Sales increases in Memory Repair and Wafer Trim product lines together were partially offset by decreases in other product lines, mainly our Semiconductor Marker products.

Sales in our Corporate segment represent the elimination of sales between our segments and are shown in the table above as intersegment sales elimination and other. There was a $0.8 million increase in sales between segments for the three months ended March 31, 2006 as compared to the same period last year. The increase was a result of increases in sales from our Precision Motion and Laser segments to our Laser Systems segment, which was due to the increased volume in the Laser Systems business.

Sales by Region. We distribute our systems and services via our global sales and service network and through third-party distributors and agents. Our sales territories are divided into the following regions: North America consisting of the United States and Canada; Latin and South America; Europe, consisting of Europe, the Middle East and Africa; Japan; and Asia-Pacific, consisting of ASEAN countries, the People’s Republic of China (“PRC”) and other Asia-Pacific countries. Sales are attributed to these geographic areas on the basis of the bill-to customer location. Not infrequently, equipment is sold to large international companies, which may be headquartered in Asia-Pacific for example, but the sales of our systems are billed and shipped to locations in the United States, although the equipment may eventually be installed in Asia-Pacific, for instance. In this example, these sales are therefore reflected in North America totals in the table below. The following table shows sales in millions of dollars to each geographic region for the first quarter of 2006 and 2005, respectively.

	Three Months Ended
	March 31, 2006				April 1, 2005
	Sales		% of Total		Sales		% of Total
	(In millions)				(In millions)
North America	$	21.1	28	%	$	25.0	39	%
Latin and South America		0.3	—			0.4	—
Europe (EMEA)		12.0	16			11.1	17
Japan		10.7	14			13.7	21
Asia-Pacific, other		32.0	42			14.6	23
Total	$	76.1	100	%	$	64.8	100	%

Asia-Pacific and Japan continue to be areas of focus for growth for all of the Company’s segments. The increase in Asia-Pacific sales reflects the results of this focus, particularly in the Laser Systems Wafer Repair and Wafer Trim product lines.

19

Backlog. We define backlog as unconditional purchase orders or other contractual agreements for products for which customers have requested delivery within the next twelve months. Order backlog at March 31, 2006 was $79.3 million compared to $58.9 million at April 1, 2005. Backlog is up primarily due to a strengthening in the semiconductor and electronics markets, which are cyclical industries as compared to a year ago.

Gross Profit.

Gross Profit by Segment. The following table sets forth gross profit in thousands of dollars by our business segments for the first quarter of 2006 and 2005, respectively.

	Three Months Ended
	March 31, 2006			April 1, 2005
Gross profit:
Precision Motion Group	$	15,727		$	12,549
Laser Group		2,858			2,602
Laser Systems		12,970			7,786
Intersegment sales elimination and other		98			11
Total	$	31,653		$	22,948
Gross profit %:
Precision Motion Group		40.8	%		36.9	%
Laser Group		34.0			25.4
Laser Systems		41.4			35.4
Intersegment sales elimination and other		(4.5	)		(0.8	)
Total		41.6	%		35.4	%

Gross profit was 41.6% in the three months ended March 31, 2006 compared to 35.4% in the three months ended April 1, 2005. Gross profit percentage can be influenced by a number of factors including product mix, pricing, volume, third-party costs for raw materials and outsourced manufacturing, warranty costs and charges related to excess and obsolete inventory, and the reversal thereof, at any particular time.

Precision Motion Group segment gross profit improved by $3.2 million or 3.9 percentage points in the first quarter of 2006 as compared to the same period in 2005. Most of the gross profit improvement came from increased sales volume and to a lesser extent improvements in profitability and product mix. In the first quarter of 2005, $0.3 million was incurred for workforce reductions for which there were no similar charges in the current period.

The Laser Group segment experienced a $0.3 million improvement or 8.6 percentage points in gross profit from $2.6 million for the first quarter of 2005 to $2.9 million for the first quarter of 2006 on a $1.9 million decrease in sales for the same period to period comparison. In the first quarter of 2005, Laser Group incurred a $0.4 million UK customs charge and a $0.2 million severance accrual.

Gross profit for the Laser Systems segment improved by $5.2 million, or 6.0 percentage points in the first quarter of 2006 as compared to the same period in 2005 primarily as a result of increased sales volume and improved product mix.

The gross profit for the intersegment sales elimination and other was insignificant for the first quarters of 2006 and 2005.

Research and Development Expenses. Research and development expenses for the three months ended March 31, 2006 were $7.5 million or 9.8% of sales as compared to $6.5 million or 10.0% of sales for the three months ended April 1, 2005, an increase of $1.0 million largely in the Precision Motion segment as a result of increased development efforts.

Selling, General and Administrative Expenses. Selling, general and administrative expenses for the three months ended March 31, 2006 were $15.0 million or 19.7% of sales as compared to $15.4 million or 23.7% of sales for the three months ended April 1, 2005, a decrease of $0.4 million, primarily the result of decreased spending on personnel.

Amortization of Purchased Intangibles. Amortization of purchased intangibles remained constant at $1.8 million for the first quarter of 2006 as compared to the same period in 2005.

Other. During the first three months of 2006, the Company recorded rental income of approximately $0.1 million on its sublet facilities. This compares to a loss of $0.2 million in the same period last year from the expected sale of the Company’s building located in Nepean, Ontario. The building was sold in the second quarter of 2005.

20

Income (Loss) from Operations. The following table sets forth income (loss) from operations in millions of dollars by our business segments for the first quarter of 2006 and 2005.

	Three Months Ended
	March 31, 2006			April 1, 2005
Segment income (loss) from operations:
Precision Motion	$	5,751		$	3,297
Laser Group		(186	)		(711	)
Laser Systems		5,736			1,623
Total by segment		11,301			4,209
Unallocated amounts:
Corporate expenses		3,817			4,827
Amortization of purchased intangibles not allocated to a segment		26			26
Other		(6	)		197
Income (loss) from operations	$	7,464		$	(841	)

Other Income (Expense). During the three months ended March 31, 2006 the Company recorded $31 thousand compared to nil in 2005.

Interest Income. Interest income was $0.9 million in the first quarter of 2006 compared to $0.4 million in the first quarter of 2005. The increase in interest income in the first quarter of 2006 compared to the same period last year is due to higher invested balances coupled with higher yields on investments.

Interest Expense. Interest expense was $0.1 million in the first quarter of 2006 compared to a credit of $4 thousand in the three months ended April 1, 2005. During 2006 and 2005, the Company had no bank debt. Interest expense is primarily from interest on deferred compensation, tax liabilities and from discounting receivables.

Foreign Exchange Transaction Gain (Losses). Foreign exchange transaction losses were approximately $0.7 million in the three months ended March 31, 2006, compared to a gain of $0.6 million for the three months ended April 1, 2005. These amounts arise primarily from transactions denominated in currencies other than functional currency and unrealized gains (losses) on derivative contracts. In the three months ended March 31, 2006, the Company had no open hedge contracts. The loss in the first quarter of 2006 is due primarily to the settlement of a long-term hedge contract.

Income Taxes. The annualized effective tax rate at March 31, 2006 was 32.2% of income before taxes, compared to an effective tax rate of 36.4% of income before taxes for the three months ended April 1, 2005. Our effective tax rate in 2006 reflects a normalized statutory tax rate as the Company operates in jurisdictions that reflect this rate. Fluctuations in the tax rate period over period reflect the application of tax credits, valuation allowances and discrete items in certain jurisdictions.

Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” (“SFAS No. 109”) requires a valuation allowance be established when it is “more likely than not” that all or a portion of deferred tax assets will not be realized. When making this determination, a review of all available positive and negative evidence needs to be considered, including a company’s performance, the market environment in which the company operates, length of carry-back and carry-forward periods, existing sales backlog, future taxable income projections and tax planning strategies. We have previously provided valuation allowances against losses in the parent company and subsidiaries with an inconsistent history of taxable income and loss due to the uncertainty of their realization. In addition, the Company has provided a valuation allowance on tax credits and net operating losses, due to the uncertainty of generating earned income to claim the tax credits or use the net operating losses. In the event that actual results differ from our estimates of future taxable income, or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could have a material impact on our financial position and results of operations.

Net Income. As a result of the foregoing factors, net income for the first quarter of 2006 was $5.1 million, compared to $0.1 million in the same period in 2005.

Critical Accounting Policies and Estimates

Our consolidated financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. There is no change in our critical accounting policies included in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of the Company’s Form 10-K, as amended, for the year ended December 31, 2005, except as noted below.

21

Share-Based Payment

The Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) on January 1, 2006. Prior to this, the Company used the intrinsic value method as proscribed in APB 25. The Company has elected to apply the modified prospective method of adoption of SFAS 123R. Under the modified prospective method, awards that are granted, modified, or settled after the date of adoption should be measured and accounted for in accordance with SFAS 123R. Additionally, SFAS 123R requires that tax benefits received in excess of compensation cost be reclassified from operating cash flows to financing cash flows in the Consolidated Statement of Cash Flows. On December 16, 2005, prior to the adoption of FAS 123R, the Company accelerated all outstanding unvested stock options. The decision to accelerate the vesting of these options was made primarily to reduce future compensation expense under SFAS 123R. As a result of the acceleration, options to purchase 558,446 of GSI Group Inc.’s common shares, which would otherwise have vested over the four following years, became fully vested. In the three months ended March 31, 2006, there were no new share based awards granted. As a result, the Company does not have any unvested options at March 31, 2006. The effect of FAS 123R on the Company’s consolidated results of operations and cash flows is zero for the three months ended March 31, 2006 as there were no instruments by which to apply FAS 123R. Going forward the Company anticipates granting awards with both performance and service based awards rather than traditional stock options with service only conditions. The Company currently does not have an equity compensation plan that will allow for the granting of such instruments. The proposed 2006 Equity Incentive Plan will allow for performance based options and awards and was presented to our shareholders for vote at the Annual Meeting of Shareholders on May 15, 2006. The Company’s board is currently evaluating the various equity instruments and is reviewing the Company’s policy on granting equity instruments, but it is expected that the granting pattern will change going forward. At this time, the Company is unable to quantify the effect SFAS 123R will have going forward on its consolidated results and earnings per share, nor has the Company determined whether it will use the Black-Scholes model or an open form model (lattice model) to measure the fair value of share-based payments. Additionally, the Company has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123, included in note 5 to the financial statements.

Liquidity and Capital Resources

Cash Flows for Three Months Ended March 31, 2006 and April 1, 2005

Cash and cash equivalents totaled $86.4 million at March 31, 2006 compared to $69.3 million at December 31, 2005. In addition the Company had $22.5 million in marketable short-term investments at March 31, 2006 compared to $26.8 million in marketable short-term investments at December 31, 2005. Long-term investments, at both March 31, 2006 and December 31, 2005 consist of a minority equity investment in a private United Kingdom company valued at $0.6 million.

Cash flows provided by operating activities for the three months ended March 31, 2006 were $3.3 million, compared to a use of cash of $1.2 million during the three months ended April 1, 2005. Net income after adjusting for the gain on sale of long lived asset, depreciation and amortization and deferred income taxes provided cash of $6.3 million in the first quarter of 2006. Decreases in inventories and increases in current liabilities provided $7.1 million. Increases in accounts receivable and other current assets used $10.1 million in cash. Net income after adjusting for loss on long lived asset, depreciation and amortization, unrealized loss on derivatives, stock-based compensation and deferred income taxes provided cash of $3.5 million in the first quarter of 2005. Decreases in accounts receivable and other current assets provided $8.3 million. The decrease in receivables is primarily the result of a decrease in sales in the quarter. Increases in inventories and decreases in current liabilities used $13.0 million in cash.

Cash flows provided by investing activities were $8.4 million during the three months ended March 31, 2006, primarily from the sale of assets of $6.1 million and proceeds from the sale and maturity of short-term investments, net of purchases of $4.3 million offset by additions to property plant and equipment of $1.8 million. The Company sold its Maple Grove building in January 2006. Cash flows used in investing activities were $5.8 million during the same period in 2005, primarily from the purchase of short and long-term investments, net of sales and maturities of $5.0 million.

Cash flows provided by financing activities during the three months ended March 31, 2006 were $5.2 million from the issue of share capital from the exercise of stock options and warrants as well as the tax benefit of stock options, compared to $0.2 million for the same period in 2005.

Other Liquidity Matters

There have been no significant changes in the Company’s lines of credit, pensions, contractual obligations, acquisitions or off-balance sheet arrangements since December 31, 2005.

Our future liquidity and cash requirements will depend on numerous factors, including, but not limited to, the level of sales we will be able to achieve in the future, the amount of expenses incurred, the introduction of new products and potential acquisitions of related businesses or technology. We believe that existing cash and investment balances, together with cash generated from operations, will be sufficient to satisfy anticipated cash needs to fund working capital and investments.

22

Special Note Regarding Forward-Looking Statements

Certain statements contained in this report on Form 10-Q constitute forward-looking statements within the meaning of the United States Private Securities Litigation Reform Act of 1995, Section 27A of the United States Securities Act of 1933, as amended, and Section 21E of the United States Securities Exchange Act of 1934, as amended. These forward-looking statements relate to anticipated financial performance, management’s plans and objectives for future operations, business prospects, customer behavior, outcome of regulatory proceedings, market conditions, tax issues and other matters. All statements contained in this report on Form 10-Q that do not relate to matters of historical fact should be considered forward-looking statements, and are generally identified by words such as “anticipate,”, “believe,” “estimate,” “expect,” “intend,” “plan” and “objective” and other similar expressions. Readers should not place undue reliance on the forward-looking statements contained in this document. Such statements are based on management’s beliefs and assumptions and on information currently available to management and are subject to risks, uncertainties and changes in condition, significance, value and effect, including risks discussed in reports and documents filed by the Company with the United States Securities and Exchange Commission and with securities regulatory authorities in Canada. Such risks, uncertainties and changes in condition, significance, value and effect, many of which are beyond our control, could cause our actual results and other future events to differ materially from those anticipated. We do not assume any obligation to update these forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting such forward-looking statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk. Our exposure to market risk associated with changes in interest rates relates primarily to our cash equivalents, short-term investments, long-term investments and debt obligations. As described in note 7 to the consolidated financial statements, at March 31, 2006, the Company had $70.3 million invested in cash equivalents and $22.5 million in short-term marketable investments. At December 31, 2005, the Company had $43.7 million invested in cash equivalents and $26.8 million in short-term marketable investments. Due to the average maturities and the nature of the investment portfolio at March 31, 2006, a one percent change in interest rates could have approximately a $0.9 million impact on our interest income on an annual basis. We do not use derivative financial instruments in our investment portfolio. We do not actively trade derivative financial instruments but may use them to manage interest rate positions associated with our debt instruments. We currently do not hold interest rate derivative contracts.

Foreign Currency Risk. We have substantial sales and expenses and working capital in currencies other than U.S. dollars. As a result, we have exposure to foreign exchange fluctuations, which may be material. To reduce the Company’s exposure to exchange gains and losses, we generally transact sales and costs and related assets and liabilities in the functional currencies of the operations. Additionally, we may utilize currency forwards, currency swaps and currency options to hedge exposure to foreign currencies. These financial instruments are used to fix the cash flow variable of local currency costs or selling prices denominated in currencies other than the functional currency. We do not currently use currency forwards or currency options for trading purposes. The Company does not designate short-term contracts as hedges. Accordingly, such contracts are recorded at fair value with changes in fair value recognized in income, instead of included in accumulated other comprehensive income. Although the Company marks-to-market short-term hedge contracts to the statement of operations, the Company does not intend to enter into hedging contracts for speculative purposes. At March 31, 2006, the Company did not have any forward exchange contracts outstanding. At April 1, 2005, we had six United States dollars to British Pounds Sterling forward exchange contracts to purchase $4.5 million United States dollars with a combined aggregate fair value loss of $0.1 million included in foreign exchange transaction gains (losses).

Item 4. Controls and Procedures

The Company’s management, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, has conducted an evaluation of effectiveness of disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the United States Securities Exchange Act of 1934, as amended. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures of the Company are effective as of the end of the period covered by this report. There have been no changes in the Company’s internal control over financial reporting that occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

See the description of legal proceedings in note 10 to the Consolidated Financial Statements.

23

Item 1A. Risk Factors

The risks presented below may not be all of the risks that we may face. These are the factors that we believe could cause actual results to be different from expected and historical results. Other sections of this report include additional factors that could have an effect on our business and financial performance. The markets in which we compete are very competitive and change rapidly. Sometimes new risks emerge and management may not be able to predict all of them, or be able to predict how they may cause actual results to be different from those contained in any forward-looking statements. You should not rely upon forward-looking statements as a prediction of future results.

A halt in economic growth or a slowdown will put pressure on our ability to meet anticipated revenue levels. A large portion of our sales is dependent on the need for increased capacity or replacement of inefficient manufacturing processes, because of the capital-intensive nature of our customers’ businesses. These also tend to lag behind in an economic recovery longer than other businesses. If a down turn lasts longer than expected, if a recovery does not begin or if a general economic slowdown commences, we may not be able to meet anticipated revenue levels on a quarterly or annual basis.

We have a history of operating losses and may not be able to sustain or grow the current level of profitability. Beginning in the second half of 2003, we have generated profits from operations. However, we have incurred operating losses on an annual basis from 1998 through 2003. For the years ended December 31, 2005 and December 31, 2004, we generated net income of $9.7 million and $41.5 million, respectively. No assurances can be given that we will sustain or increase the level of profitability in the future and the market price of our common shares may decline as a result.

Our inability to remain profitable may result in the loss of significant deferred tax assets. In determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets requires subjective judgment and analysis. While we recovered a portion of our current deferred tax assets based on profitability in Q1 2006 and planned profits for the remainder of 2006, 2007 and beyond, we are consistently evaluating our deferred tax assets based on current year performance. Our ability to maintain our deferred tax assets at March 31, 2006 depends upon our ability to continue to generate future profits in the United States, Canada, Japan, and United Kingdom tax jurisdictions. If actual results differ from our plans or we do not achieve profitability, we may be required to increase the valuation allowance on our tax assets by taking a charge to the Statement of Operations, which may have a material negative result on our operations.

Our business depends significantly upon capital expenditures, including those by manufacturers in the semiconductor, electronics, machine tool and automotive industries, each of which are subject to cyclical fluctuations. The semiconductor and electronics, machine tool and automotive industries are cyclical and have historically experienced periods of oversupply, resulting in significantly reduced demand for capital equipment, including the products that we manufacture and market. The timing, length and severity of these cycles, and their impact on our business, are difficult to predict. For the foreseeable future, our operations will continue to depend upon capital expenditures in these industries, which, in turn, depend upon the market demand for their products.

The cyclical variations in these industries have the most pronounced effect on our Laser Systems Group, due in large measure to that segment’s historical focus on the semiconductor and electronics industries and our need to support and maintain a comparatively larger global infrastructure (and, therefore, lesser ability to reduce fixed costs) in that segment than in our other segments. There is no assurance that we will not continue to be impacted from the slowdown as we were in 2005, that we will benefit in the future to the same extent as we did in 2004, or that we will not be materially adversely affected by future downturns or slowdowns in the semiconductor and electronics, and other industries that we serve.

The success of our business is dependent upon our ability to respond to fluctuations in demand for our products. During a period of declining demand, we must be able to quickly and effectively reduce expenses while continuing to motivate and retain key employees. Our ability to reduce expenses in response to any downturn is limited by our need for continued investment in engineering and research and development and extensive ongoing customer service and support requirements. In addition, the long lead-time for production and delivery of some of our products creates a risk that we may incur expenditures or purchase inventories for products which we cannot sell. We attempt to manage this risk by employing inventory management practices such as outsourcing portions of the development and manufacturing processes, limiting our purchase commitments and focusing on production to order rather than to stock, but no assurances can be given that our efforts in this regard will be successful in mitigating this risk or that our financial condition or results of operations will not be materially adversely affected thereby.

During a period of increasing demand and rapid growth, we must be able to increase manufacturing capacity quickly to meet customer demand and hire and assimilate a sufficient number of qualified personnel. Our inability to ramp up in times of increased demand could harm our reputation and cause some of our existing or potential customers to place orders with our competitors rather than with us.

Fluctuations in our customers’ businesses, timing and recognition of revenues from customer orders and other factors beyond our control may cause our results of operations quarter over quarter to fluctuate, perhaps substantially. Our revenues and net income, if any, in any particular period may be lower than revenues and net income, if any, in a preceding or comparable period. Factors contributing to these fluctuations, some of which are beyond our control, include:

• fluctuations in our customers’ businesses;

24

• timing and recognition of revenues from customer orders;

• timing and market acceptance of new products or enhancements introduced by us or our competitors;

• availability of components from our suppliers and the manufacturing capacity of our subcontractors;

• timing and level of expenditures for sales, marketing and product development;

• changes in the prices of our products or of our competitors’ products; and

• fluctuations in exchange rates for foreign currency.

We derive a substantial portion of our sales from products that have a high average selling price and significant lead times between the initial order and delivery of the product, which, on average, can range from five to eleven weeks, although it will vary by product. We may receive one or more large orders in one quarter from a customer and then receive no orders from that customer in the next quarter. As a result, the timing and recognition of sales from customer orders can cause significant fluctuations in our operating results from quarter to quarter. If our quarterly revenue or operating results fall below the expectations of investors or public market analysts, our common share price may decline as a result.

Gross profits realized on product sales vary depending upon a variety of factors, including production volumes, the mix of products sold during a particular period, negotiated selling prices, the timing of new product introductions and enhancements, inventory provisions, warranty costs, foreign exchange rates and manufacturing costs.

A delay in a shipment, or failure to meet our revenue recognition criteria, near the end of a fiscal quarter or year, due, for example, to rescheduling or cancellations by customers or to unexpected difficulties experienced by us, may cause sales in a particular period to fall significantly below our expectations and may materially adversely affect our operations for that period. Our inability to adjust spending quickly enough to compensate for any sales shortfall would magnify the adverse impact of that sales shortfall on gross profits and on our results of operations.

As a result of these factors, our results of operations for any quarter are not necessarily indicative of results to be expected in future periods. We believe that fluctuations in quarterly results may cause the market prices of our common shares on The NASDAQ Stock Market to fluctuate, perhaps substantially.

Our reliance upon third party distribution channels subjects us to credit, inventory, business concentration and business failure risks beyond our control. We sell products through resellers (which include original equipment manufacturers, “OEMs”, systems integrators and distributors). Reliance upon third party distribution sources subjects us to risks of business failure by these individual resellers, distributors and OEMs, and credit, inventory and business concentration risks. In addition, our net sales depend in part upon the ability of our OEM customers to develop and sell systems that incorporate our products. Adverse economic conditions, large inventory positions, limited marketing resources and other factors influencing these OEM customers could have a substantial impact upon our financial results. No assurances can be given that our OEM customers will not experience financial or other difficulties that could adversely affect their operations and, in turn, our financial condition or results of operations.

The steps we take to protect our intellectual property may not be adequate to prevent misappropriation or the development of competitive technologies or products by others that could harm our competitive position and materially adversely affect our results of operations. Our future success depends in part upon our intellectual property rights, including trade secrets, know-how and continuing technological innovation. There can be no assurance that the steps we take to protect our intellectual property rights will be adequate to prevent misappropriation, or that others will not develop competitive technologies or products. As of April 2006, we held 185 United States and 111 foreign patents; in addition, applications were pending for 77 United States and 112 foreign patents. There can be no assurance that other companies are not investigating or developing other technologies that are similar to ours, that any patents will issue from any application filed by us or that, if patents do issue, the claims allowed will be sufficiently broad to deter or prohibit others from marketing similar products. In addition, there can be no assurance that any patents issued to us will not be challenged, invalidated or circumvented, or that the rights thereunder will provide a competitive advantage to us.

Our success depends upon our ability to protect our intellectual property and to successfully defend against claims of infringement by third parties. From time to time we receive notices from third parties alleging that our products infringe such parties’ patent or other proprietary rights. While these notices are common in the laser industry and we have in the past been able to develop non-infringing technology or license necessary patents or technology on commercially reasonable terms, there can be no assurance that we would in the future prevail in any litigation seeking damages or expenses from us or seeking to enjoin us from selling our products on the basis of such alleged infringement, or that we would be able to develop any non-infringing technology or license any valid and infringed patents on commercially reasonable terms. In the event any third party makes a valid claim against us or our

25

customers for which a license was not available to us on commercially reasonable terms, we would be adversely affected. Our failure to avoid litigation for infringement or misappropriation of propriety rights of third parties or to protect our propriety technology could result in a loss of revenues and profits or force us to settle with these other parties.

The industries in which we operate are highly competitive and competition in our markets could intensify, or our technological advantages may be reduced or lost, as a result of technological advances by our competitors. 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. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products. There can be no assurance that we will successfully differentiate our current and proposed products from the products of our competitors, or that the market place will consider our products to be superior to competing products. To maintain our competitive position, we believe that we will be required to continue a high level of investment in engineering, research and development, marketing and customer service and support. There can be no assurance that we will have sufficient resources to continue to make these investments, that we will be able to make the technological advances necessary to maintain our competitive position, or that our products will receive market acceptance. We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins, loss of market share and an inability to generate cash flows that are sufficient to maintain or expand our development of new products.

Our operations in foreign countries subject us to risks not faced by companies operating exclusively in the United States. In addition to operating in the United States, Canada, the United Kingdom and the People’s Republic of China (“PRC”), we currently have sales and service offices in Germany, Switzerland, Japan, Korea, Singapore, Taiwan and the PRC. We may in the future expand into other international regions. During the three months ended March 31, 2006, approximately 72% of our revenue was derived from operations outside North America. International operations are an expanding part of our business both from a sales focus and an operating base.

Because of the scope of our international operations, we are subject to risks, which could materially impact our results of operations, including:

• foreign exchange rate fluctuations;

• longer payment cycles;

• greater difficulty in collecting accounts receivable;

• use of different systems and equipment;

• difficulties in staffing and managing foreign operations and diverse cultures;

• protective tariffs;

• trade barriers and export/import controls;

• transportation delays and interruptions;

• reduced protection for intellectual property rights in some countries; and

• the impact of recessionary foreign economies.

We cannot predict whether the United States or any other country will impose new quotas, tariffs, taxes or other trade barriers upon the importation of our products or supplies or gauge the effect that new barriers would have on our financial position or results of operations.

We do not believe that travel advisories or health concerns have had a material effect on our business to date. However, no assurances can be given that future travel advisories or health concerns will not have an impact on our business.

We may not be able to find suitable targets or consummate acquisitions in the future, and there can be no assurance that the acquisitions we have made and do in the future make will provide expected benefits. In 2003 and 2004, we consummated four strategic acquisitions and may in the future continue to pursue other strategic acquisitions of businesses, technologies and products complementary to our own. Our identification of suitable acquisition candidates involves risks inherent in assessing the values, strengths, weaknesses, risks, synergy and profitability of acquisition candidates, including the effects of the possible acquisition on our business, diversion of management’s attention from our core businesses and risks associated with unanticipated problems or liabilities. No assurances can be given that management’s efforts in this regard will be sufficient, or that identified acquisition candidates will be receptive to our advances or, consistent with our acquisition strategy, be accretive to earnings.

Should we acquire another business, the process of integrating acquired operations into our existing operations may result in unforeseen operating difficulties or additional expenses and may require the allocation of significant financial or other resources such as personnel and management that would otherwise be available for the ongoing development or expansion of our existing business. We attempt to mitigate these risks by focusing our attention on the acquisition of businesses, technologies and products that have

26

current relevancy to our existing lines of business and that are complementary to our existing product lines. Other difficulties we may encounter, and which we may or may not be successful in addressing, include those risks associated with the potential entrance into markets in which we have limited or no prior experience and the potential loss of key employees, particularly those of the acquired business.

Our operations could be negatively affected if we lose key executives or employees or are unable to attract and retain skilled executives and employees as needed. Our business and future operating results depend in part upon our ability to attract, groom and retain qualified management, technical, sales and support personnel for our operations on a worldwide basis. The loss of key personnel could negatively impact our operations. Competition for qualified personnel is intense and we cannot guarantee that we will be able to continue to attract, train and retain qualified personnel. In addition, the Company plans to transition to a new CEO in 2006. There is no assurance that the transition will not have an adverse impact in the Company’s operations or financial performance.

Decreased effectiveness of equity compensation could adversely affect our ability to attract and retain employees. We have historically used stock options and other forms of equity-related compensation as key components of our total rewards employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention, and provide competitive compensation packages. In recent periods, many of our employee stock options have had exercise prices in excess of our stock price, which reduces their value to employees and could affect our ability to retain or attract present and prospective employees.

Changes in accounting for equity compensation could adversely affect earnings. The Financial Accounting Standards Board has issued changes to U.S. generally accepted accounting principles requiring us and other companies to record a charge to earnings for employee stock option grants and other equity incentives. Moreover, applicable stock exchange listing standards relating to obtaining shareholder approval of equity compensation plans could make it more difficult or expensive for us to grant options to employees in the future. As a result, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, any of which could materially adversely affect our business.

Integrating acquisitions into our enterprise resource planning (ERP) system could have a material adverse effect on our business. We are highly dependent on our systems infrastructure in order to process orders, track inventory, ship products in a timely manner, prepare invoices to our customers and otherwise carry on our business in the ordinary course. Key to the success of our strategy to drive greater productivity and cost savings is our drive to standardize recent acquisitions on our ERP and reporting systems. If we experience problems with integration, the resulting disruption could adversely affect our business, sales, results of operations and financial condition. The transition involves numerous risks, including:

• difficulties in integrating systems with our current operations;

• initial dependence on an unfamiliar system while training personnel in its use;

• increased demand on our support operations; and

• potential delay in the processing of customer orders for shipment of products.

Further, we may experience difficulties in the transition to the new software that could affect our internal control systems, processes, procedures and related documentation. There can be no assurances that the evaluation required by Section 404 of the Sarbanes-Oxley Act will not result in the identification of significant control deficiencies or that our auditors will be able to attest to the effectiveness of our internal control over financial reporting subsequent to the transition to our ERP system.

Failure to achieve and maintain effective internal controls could have a material adverse effect on our business, operating results and stock price. We document and test our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. If we fail to achieve and maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information.

We may not develop, introduce or manage the transition to new products as successfully as our competitors. The markets for our products experience rapidly changing technologies, evolving industry standards, frequent new product introductions, changes in customer requirements and short product life cycles. To compete effectively we must continually introduce new products that achieve market acceptance. 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. Developing new technology is a complex and uncertain process requiring us to be innovative and to accurately anticipate technological and market trends. We may have to manage the transition from older products to minimize disruption in customer ordering patterns, avoid excess inventory and ensure adequate supplies of new products. 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. Failed market acceptance of new products or problems associated with new product transitions could harm our business.

27

Delays or deficiencies in research, development, manufacturing, delivery of or demand for new products or of higher cost targets could have a negative impact on our business, operating results or financial condition. We are active in the research and development of new products and technologies. Our research and development efforts may not lead to the successful introduction of new or improved products. The development by others of new or improved products, processes or technologies may make our current or proposed products obsolete or less competitive. Our ability to control costs is limited by our need to invest 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.

In addition, we may encounter delays or problems in connection with our research and development efforts. Product development delays may result from numerous factors, including:

• changing product specifications and customer requirements;

• difficulties in hiring and retaining necessary technical personnel;

• difficulties in reallocating engineering resources and overcoming resource limitations;

• changing market or competitive product requirements; and

• unanticipated engineering complexities.

New products often take longer to develop, have fewer features than originally considered desirable and achieve higher cost targets than initially estimated. There may be delays in starting volume production of new products and new products may not be commercially successful. Products under development are often announced before introduction and these announcements may cause customers to delay purchases of existing products until the new or improved versions of those products are available.

Defects in our products or problems arising from the use of our products together with other vendors’ products may seriously harm our business and reputation. Products as complex as ours may contain known and undetected errors or performance problems. Defects can be found in any period immediately following introduction and initial implementation of new products or enhancements to existing products. Although we attempt to resolve all errors that we believe would be considered serious by our customers before implementation, our products are not error-free. These errors or performance problems could result in lost revenues or customer relationships or require us to incur additional costs to correct product problems and could be detrimental to our business and reputation generally. In addition, our customers generally use our products together with their own products and products from other vendors. As a result, when problems occur in a combined environment, it may be difficult to identify the source of the problem. These problems may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. To date, defects in our products or those of other vendors’ products with which ours are used by our customers have not had a material negative effect on our business. However, we cannot be certain that a material negative impact will not occur in the future.

We depend on limited source suppliers that could cause substantial manufacturing delays and additional cost if a disruption in supply occurs. While we attempt to mitigate risks associated with our reliance on single suppliers by actively managing our supply chain, we do obtain some components used in our business segments from a single source. We also rely on a limited number of independent contractors to manufacture subassemblies for some of our products, particularly in our Laser Systems Group. Despite our and their best efforts, there can be no assurance that our current or alternative sources will be able to continue to meet all of our demands on a timely basis. If suppliers or subcontractors experience difficulties that result in a reduction or interruption in supply to us, or fail to meet any of our manufacturing requirements, our business would be harmed until we are able to secure alternative sources, if any, on commercially reasonable terms.

Each of our suppliers can be replaced, either by contracting with another supplier or through internal production of the part or parts previously purchased in the market, but no assurances can be given that we would be able to do so quickly enough to avoid an interruption or delay in delivery of our products to our customers and any associated harm to our reputation and customer relationships. Unavailability of necessary parts or components, or suppliers of the same, could require us to reengineer our products to accommodate available substitutions. Any such actions would likely increase our costs and could have a material adverse effect on manufacturing schedules, product performance and market acceptance, each or all of which could be expected to have a material adverse effect on our financial condition or results of operations.

28

Economic, political or trade problems with foreign countries could negatively impact our business. We are increasingly outsourcing the manufacture of sub assemblies to suppliers based in the PRC and elsewhere overseas. Economic, political or trade problems with foreign countries could substantially impact our ability to obtain critical parts needed in the manufacture of our products.

Production difficulties and product delivery delays could materially adversely affect our business, operating results or financial condition. We assemble our products at our facilities in the United States, the United Kingdom and the PRC. If use of any of our manufacturing facilities was interrupted by natural disaster or otherwise, our operations could be negatively impacted until we could establish alternative production and service operations. In addition, we may experience production difficulties and product delivery delays in the future as a result of:

• changing process technologies;

• ramping production;

• installing new equipment at our manufacturing facilities; and

• shortage of key components.

If the political conditions globally do not improve or if the economic turnaround is not sustained, we may experience material adverse impacts on our business, operating results and financial condition. Our business is subject to the effects of general economic and political conditions globally. While there have been improvements in the general economy since late 2003, our revenues and operating results are subject to fluctuations from unfavorable economic conditions as well as uncertainties arising out of the threatened terrorist attacks on the United States and throughout the world, including the economic consequences of protracted 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:

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

• the risk of more frequent instances of shipping delays.

Increased governmental regulation of our business could materially adversely affect our business, operating results and financial condition. We are subject to many governmental regulations, including but not limited to the laser radiation safety regulations of the Radiation Control for Health and Safety Act administered by the National Center for Devices and Radiological Health, a branch of the United States Food and Drug Administration. Among other things, these regulations require a laser manufacturer to file new product and annual reports, to maintain quality control and sales records, to perform product testing, to distribute appropriate operating manuals, to incorporate design and operating features in lasers sold to end-users and to certify and label each laser sold to end-users as one of four classes (based on the level of radiation from the laser that is accessible to users). Various warning labels must be affixed and certain protective devices installed depending on the class of product. The National Center for Devices and Radiological Health is empowered to seek fines and other remedies for violations of the regulatory requirements. We are subject to similar regulatory oversight, including comparable enforcement remedies, in the European markets we serve.

Changes in governmental regulations may reduce demand for our products or increase our expenses. We compete in many markets in which we and our customers must comply with federal, state, local and international regulations, such as environmental, health and safety and food and drug regulations. We develop, configure and market our products to meet customer needs created by those regulations. Any significant change in regulations could reduce demand for our products, which in turn could materially adversely affect our business, operating results and financial condition.

29

Item 6. Exhibits

a) List of Exhibits

Exhibit Number	Description
10.1	Incentive Compensation Agreement between Registrant and Charles D. Winston dated March 7, 2006
31.1	Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Chief Executive Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Chief Financial Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

30

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, GSI Group Inc., has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

GSI Group Inc. (Registrant)

Name	Title	Date
/s/ CHARLES D. WINSTON	President and Chief Executive Officer (Principal Executive Officer)	May 8, 2006
Charles D. Winston
/s/ ROBERT L. BOWEN	Vice President and Chief Financial Officer (Principal Financial Officer)	May 8, 2006
Robert L. Bowen

31

EXHIBIT INDEX

Exhibit Number	Description
10.1	Incentive Compensation Agreement between Registrant and Charles D. Winston dated March 7, 2006
31.1	Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Chief Executive Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Chief Financial Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.