10-Q 1 a4451391.txt ELECTRO SCIENTIFIC INDUSTRIES, INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 1, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to _____ Commission File Number: 0-12853 ELECTRO SCIENTIFIC INDUSTRIES, INC. (an Oregon corporation) 93-0370304 (I.R.S. Employer Identification No.) 13900 N.W. Science Park Drive, Portland, Oregon 97229 Registrant's telephone number: (503) 641-4141 Registrant's web address: www.esi.com Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No --- --- The number of shares outstanding of the Registrant's Common Stock at August 1, 2003 was 27,837,914 shares. ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Page Item 1. Consolidated Condensed Financial Statements (Unaudited) Consolidated Condensed Balance Sheets - March 1, 2003 and June 1, 2002 (restated) 2 Consolidated Condensed Statements of Operations - Three and Nine Months Ended March 1, 2003 and March 2, 2002 (restated) 3 Consolidated Condensed Statements of Cash Flows - Nine Months Ended March 1, 2003 and March 2, 2002 (restated) 4 Notes to Consolidated Condensed Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk 27 Item 4. Controls and Procedures 28 PART II - OTHER INFORMATION Item 1. Legal Proceedings 31 Item 5. Other Information 32 Item 6. Exhibits and Reports on Form 8-K 33 Signatures 34 1
PART I - FINANCIAL INFORMATION Item 1. Financial Statements ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED BALANCE SHEETS (In thousands) (Unaudited) March 1, June 1, 2003 2002 ------------------- ------------------- Assets (Restated) Current Assets: Cash and cash equivalents $ 14,241 $ 29,435 Marketable securities 228,791 181,019 Restricted securities 6,293 6,353 ------------------- ------------------- Total cash and securities 249,325 216,807 Trade receivables, net of allowances of $1,462 at March 1 and $1,437 at June 1 50,397 55,810 Income tax refund receivable 27,018 14,402 Inventories, net 42,321 63,916 Shipped systems pending acceptance 7,192 2,007 Deferred income taxes 8,243 8,243 Assets held for sale 6,576 - Other current assets 5,298 4,960 ------------------- ------------------- Total Current Assets 396,370 366,145 Long-term marketable securities 42,499 73,445 Long-term restricted securities 6,053 12,047 Property, plant and equipment, at cost 85,803 95,656 Less - accumulated depreciation (35,872) (37,610) ------------------- ------------------- Net property, plant and equipment 49,931 58,046 Other assets 12,104 16,589 ------------------- ------------------- ------------------- ------------------- Total Assets $ 506,957 $ 526,272 =================== =================== Liabilities and Shareholders' Equity Current Liabilities: Accounts payable $ 3,964 $ 3,246 Accrued liabilities 18,074 16,062 Deferred revenue 12,600 5,308 ------------------- ------------------- Total Current Liabilities 34,638 24,616 Convertible subordinated notes 141,675 145,897 ------------------- ------------------- Total Liabilities 176,313 170,513 Shareholders' Equity: Preferred stock, without par value; 1,000 shares authorized; no shares issued - - Common stock, without par value; 100,000 authorized; 27,825 and 27,619 shares issued and outstanding at March 1, 2003 and June 1, 2002, respectively 139,741 136,370 Retained earnings 190,270 219,561 Accumulated other comprehensive income 633 (172) ------------------- ------------------- Total Shareholders' Equity 330,644 355,759 ------------------- ------------------- Total Liabilities and Shareholders' Equity $ 506,957 $ 526,272 =================== =================== The accompanying notes are an integral part of these statements
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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (In thousands, except per share data) (Unaudited) For the Three Months Ended For the Nine Months Ended -------------------------------------------------------------------------------- March 1, 2003 March 2, 2002 March 1, 2003 March 2, 2002 ---------------- ---------------- ---------------- ---------------- (Restated) (Restated) Net sales $ 31,631 $ 36,244 $ 114,407 $ 122,470 Cost of sales 32,175 19,529 96,134 66,276 ---------------- ---------------- ---------------- ---------------- Gross margin (544) 16,715 18,273 56,194 Operating expenses: Selling, service and administration 16,140 14,467 47,261 51,660 Research, development and engineering 5,706 7,774 20,618 29,300 ---------------- ---------------- ---------------- ---------------- 21,846 22,241 67,879 80,960 ---------------- ---------------- ---------------- ---------------- Operating loss (22,390) (5,526) (49,606) (24,766) Interest income 2,729 2,122 8,481 5,679 Interest expense (1,810) (1,571) (5,591) (1,649) Other income (expense), net (224) (83) 41 (105) ---------------- ---------------- ---------------- ---------------- ---------------- ---------------- ---------------- ---------------- 695 468 2,931 3,925 ---------------- ---------------- ---------------- ---------------- Income (loss) before income taxes (21,695) (5,058) (46,675) (20,841) Provision (benefit) for income taxes (8,706) (6,300) (17,384) (11,574) ---------------- ---------------- ---------------- ---------------- Net income (loss) $ (12,989) $ 1,242 $ (29,291) $ (9,267) ================ ================ ================ ================ Net income (loss) per share - basic $ (0.47) $ 0.05 $ (1.06) $ (0.34) ================ ================ ================ ================ Net income (loss) per share - diluted $ (0.47) $ 0.04 $ (1.06) $ (0.34) ================ ================ ================ ================ Weighted average number of shares - basic 27,782 27,392 27,715 27,263 ================ ================ ================ ================ Weighted average number of shares - diluted 27,782 28,087 27,715 27,263 ================ ================ ================ ================ The accompanying notes are an integral part of these statements
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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) For the Nine Months Ended -------------------------------------------------- March 1, 2003 March 2, 2002 -------------------- -------------------- (Restated) Cash flows from operating activities: Net loss $ (29,291) $ (9,267) Adjustments to reconcile net loss to cash provided by (used in) operating activities: Depreciation and amortization 7,752 8,436 Tax benefit of stock options exercised 108 1,088 Provision for doubtful accounts 275 319 (Gain) loss on disposal and impairment of property and equipment (269) 1,135 Gain on debt extinguishment (218) - Deferred income taxes 322 4,902 Changes in operating accounts: Decrease in trade receivables, net 7,463 21,725 (Increase) decrease in inventories, net 19,005 (3,424) Increase in income taxes receivable (12,616) (18,521) Increase in other current assets (223) (5,057) Increase in deferred revenue 7,292 1,627 (Increase) decrease in current liabilities 252 (17,929) -------------------- -------------------- Net cash used in operating activities (148) (14,966) Cash flows from investing activities: Purchase of property, plant and equipment (8,040) (12,076) Proceeds from the sale of property, plant and equipment 1,074 633 Maturity (purchase) of restricted securities 6,054 (18,179) Purchase of securities (196,396) (522,835) Proceeds from sales of securities and maturing securities 180,237 357,480 Decrease in other assets 3,438 544 -------------------- -------------------- Net cash used in investing activities (13,633) (194,433) Cash flows from financing activities: Proceeds from the sale of convertible notes - 145,500 Repurchase of ESI-issued convertible notes (4,676) - Proceeds from exercise of stock options and stock plans 3,263 6,742 -------------------- -------------------- Net cash provided by financing activities (1,413) 152,242 Net change in cash and cash equivalents (15,194) (57,157) Cash and cash equivalents: Beginning of period 29,435 68,522 -------------------- -------------------- End of period $ 14,241 $ 11,365 ==================== ==================== Supplemental cash flow information: Cash paid for interest $ 6,410 $ 121 Income tax refunds received 5,604 - Cash paid for income taxes 1,245 2,540 The accompanying notes are an integral part of these statements
4 ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (unaudited) Note 1 - Basis of Presentation General We have prepared the consolidated condensed financial statements included herein without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in these interim statements. We believe that the interim statements include all adjustments (consisting of only normal recurring accruals) necessary for a fair presentation of results for the interim periods. These consolidated condensed financial statements are to be read in conjunction with the financial statements and notes thereto included in our 2002 Annual Report on Form 10-K/A. Certain prior year amounts have been reclassified to conform to current year presentation. Results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Investigation and Restatements of Financial Statements In March 2003, our Audit Committee commenced an internal investigation of the circumstances surrounding the reversal of an employee benefits accrual that occurred in the first quarter of 2003. The investigation also identified and addressed: (1) unsupported accounting adjustments and clerical errors primarily relating to inventory and cost of goods sold, and (2) certain other areas where potential accounting errors could have occurred, including revenue recognition. Restatement of 2002 Financial Statements We have restated our financial statements for the fiscal year ended June 1, 2002 (and the quarters contained therein) principally related to the deferral of revenue for certain transactions where customer specified acceptance criteria existed but were not properly considered in determining whether our criteria for revenue recognition had been met as of year-end. We also corrected our financial statements for other matters we identified, including: the failure to write-off fixed assets that were sold prior to year-end, but had not been removed from our books, the write-off of inventory due to a change in our accounting for defective parts being returned by customers, an unauthorized change in depreciation methods and the correction of a bank error related to amortization of bond premiums/discounts. Restatement of Fiscal 2003 First and Second Quarters We have also restated the financial statements for the quarters ended August 31, 2002 and November 30, 2002 related to the deferral of revenue, an unauthorized change in depreciation method and the amortization of bond premiums/discounts as described above. 5 For the first quarter of fiscal 2003, the financial statements have also been restated to reflect the reinstatement of an inappropriately reversed accrual for employee benefits. Other matters corrected for that quarter primarily include the following: the write-down of inventory that was double counted, the write-down of inventory due to an error in the computation of overhead, an increase in operating expenses due to improper capitalization of a period expense and an increase in warranty expense due to an unauthorized change in accounting method. For the second quarter of fiscal 2003, the financial statements have also been restated for other matters primarily including: the write-down of inventory due to an unauthorized change in our accounting for parts inventory at customer locations, the write-down of inventory that was double counted, an increase in accrued liabilities related to purchase commitments for excess and obsolete inventory and an increase in warranty expense due to an unsupported accounting entry. These restated financial statements are included in our amended quarterly reports on Form 10-Q/A for the fiscal quarters ended August 31, 2002 and November 30, 2002 and our amended annual report on Form 10-K/A for the fiscal year ended June 1, 2002, each of which was filed on August 11, 2003. Note 2 - Accounts Receivable, Net We entered into an agreement that allows us to sell accounts receivable from selected customers at a discount to a financial institution. Receivables sold under these provisions have terms and credit risk characteristics similar to our overall receivables portfolio. Receivable sales have the effect of increasing cash and reducing accounts receivable and days sales outstanding. Accounts receivable sales under these agreements were $12.0 million for the nine months ended March 1, 2003. There were no accounts receivable sales for the nine months ended March 2, 2002. Discounting fees were recorded as interest expense and were not material for the nine months ended March 1, 2003 and March 2, 2002. At March 1, 2003, none of the receivables sold under these agreements remained outstanding. Note 3 - Inventory Inventory is principally valued at standard cost, which approximates the lower of cost (first-in, first-out) or market. Components of inventory were as follows (in thousands): March 1, 2003 June 1, 2002 ---------------------- ---------------- (restated) Raw materials and purchased parts $25,121 $ 41,013 Work-in-process 1,184 1,942 Finished goods 16,016 20,961 ---------------------- ---------------- Total inventories $42,321 $ 63,916 ====================== ================ 6 Note 4 - Assets Held for Sale In order to better align operating expenses with anticipated revenues, we implemented a restructuring plan during June 2001. This restructuring plan included vacating several buildings. During the third quarter of fiscal 2003, we sold our 29,000 square foot building on 3 acres of land near Minneapolis, Minnesota for $1.0 million, which resulted in a gain of $0.6 million that is included as a component of selling, service and administration expense on our consolidated condensed statements of operations for the three and nine month periods ended March 1, 2003. On October 2, 2002, we announced a plan to relocate the manufacturing of our Electronic Component Systems product line from Escondido, California to our headquarters in Portland, Oregon. The consolidation of the facilities was completed on December 31, 2002. We own a 60,000 square foot plant on 10 acres of land near Escondido, California. We have contracted with a real estate agent to find a buyer and anticipate that we will sell the assets within one year. We account for long-lived assets to be disposed of in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which we adopted effective June 1, 2002. SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Based on current market information provided by our real estate agent on the California property, we determined that the market values of the property, less selling costs, exceeds our book value for the property. Accordingly, we have reflected the property on our consolidated condensed balance sheet as assets held for sale at book value and have ceased depreciation. Components of net assets held for sale were as follows (in thousands): March 1, 2003 ---------------------- Land $2,626 Buildings 3,931 Automobiles 19 ---------------------- $6,576 ====================== Note 5 - Earnings Per Share Following is a reconciliation of basic earnings (loss) per share ("EPS") and diluted EPS (in thousands, except per share amounts):
Three Months Ended March 1, 2003 Three Months Ended March 2, 2002 (restated) ------------------------------------ ------------------------------------ Per Share Per Share Basic EPS Loss Shares Amount Income Shares Amount --------- ------------------------------------ ------------------------------------ Net income (loss) available to common shareholders $ (12,989) 27,782 $ (0.47) $ 1,242 27,392 $ 0.05 =========== ============= Diluted EPS Effect of dilutive stock options - - - 695 ------------------------ ---------------------- Net income (loss) available to common shareholders $ (12,989) 27,782 $ (0.47) $ 1,242 28,087 $ 0.04 =========== =============
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Nine Months Ended March 1, 2003 Nine Months Ended March 2, 2002 (restated) ------------------------------------ ------------------------------------ Per Share Per Share Basic EPS Loss Shares Amount Loss Shares Amount --------- ------------------------------------ ------------------------------------ Net loss available to common shareholders $ (29,291) 27,715 $ (1.06) $ (9,267) 27,263 $ (0.34) =========== ============= Diluted EPS Effect of dilutive stock options - - - - ------------------------ ---------------------- Net loss available to common shareholders $ (29,291) 27,715 $ (1.06) $ (9,267) 27,263 $ (0.34) =========== =============
The following common stock equivalents were excluded from the diluted EPS calculations because inclusion would have had an antidilutive effect (in thousands): Three and Nine Months Ended ---------------------------------- March 1, 2003 March 2, 2002 --------------- --------------- Employee stock options 4,465 3,766 4 1/4% convertible subordinated notes 3,816 3,947 --------------- --------------- 8,281 7,713 =============== =============== Note 6 - Comprehensive Income (Loss) The components of comprehensive income (loss), net of tax, are as follows (in thousands):
Three Months Ended Nine Months Ended ------------------------------------- ------------------------------------- March 1, 2003 March 2, 2002 March 1, 2003 March 2, 2002 ------------------- ---------------- ---------------- ------------------- (restated) (restated) Net income (loss) $ (12,989) $ 1,242 $ (29,291) $ (9,267) Net unrealized gain (loss) on derivative instruments (1) (1) 12 - Foreign currency translation adjustment 21 (152) 126 (169) Net unrealized gain (loss) on securities 163 (334) 667 33 ------------------- ---------------- ---------------- ------------------- Total comprehensive income (loss) $ (12,806) $ 755 $ (28,486) $ (9,403) =================== ================ ================ ===================
Note 7 - Income Taxes The effective income tax rate for the interim period is based on estimates of annual amounts of taxable income, tax credits and other factors. The income tax rate for the three months ended March 1, 2003 and March 2, 2002 was 40.1% and 124.6%, respectively. The tax rate for the three months ended March 2, 2002 included a benefit for the effect of the research and development tax credit recognized during this quarter totaling 87.4%. Note 8 - Recent Accounting Pronouncements In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 addresses certain accounting issues related to hedging activity and derivative instruments embedded in other contracts. In general, the amendments require contracts with comparable characteristics to be accounted for similarly. In addition, SFAS No. 149 provides guidance as to when a financing component of a derivative must be given special reporting treatment in the statement of cash flows. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003. We are currently evaluating the effects of SFAS No. 149, but do not expect that the adoption of SFAS No. 149 will have a material effect on our financial position or results of operations. 8 In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities, An Interpretation of ARB No. 51." FIN 46 provides guidance on: 1) the identification of entities for which control is achieved through means other than through voting rights, known as "variable interest entities" (VIEs); and 2) which business enterprise is the primary beneficiary and when it should consolidate the VIE. This new model for consolidation applies to entities: 1) where the equity investors (if any) do not have a controlling financial interest; or 2) whose equity investment at risk is insufficient to finance that entity's activities without receiving additional subordinated financial support from other parties. In addition, FIN 46 requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. FIN 46 is effective for all new VIEs created or acquired after January 31, 2003. For VIEs created or acquired prior to February 1, 2003, the provision of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. Certain disclosures are effective immediately. We are in the process of assessing the effects of FIN 46, but do not expect its implementation to have a material effect on our financial position or results of operations. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation" to provide two additional alternative transition methods if a company voluntarily decides to change its method of accounting for stock-based employee compensation to the fair-value method. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 by requiring that companies make quarterly disclosures regarding pro forma effects of using the fair-value method of accounting for stock-based compensation, effective for interim periods beginning after December 15, 2002. We will adopt the disclosure provisions of SFAS No. 148 during the fourth quarter of fiscal 2003. In December 2002, the EITF published the Consensus on Issue 00-21, "Revenue Arrangements with Multiple Deliverables." The Consensus provides guidance on when and how to allocate revenue from bundled sales transactions. The Consensus is applicable for fiscal years beginning after June 15, 2003. We are currently evaluating the impact of the Consensus on Issue 00-21. On December 31 2002, we adopted FASB Interpretation No. 45 (FIN 45), "Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45 requires a liability to be recognized at the time a company issues a guarantee for the fair value of the obligations assumed under certain guarantee agreements. Additional disclosures about guarantee agreements are also required in the interim and annual financial statements. The adoption of FIN 45 did not have a material effect on our financial position or the results of our operations. 9 In August 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated With Exit or Disposal Activities." SFAS No. 146 nullifies EITF Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity." Under SFAS No. 146, liabilities for exit or disposal activities are recognized and measured initially at fair value only when the liability is incurred. This statement is effective for exit costs initiated after December 31, 2002, and will be applied on prospective transactions only. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations," which is effective for fiscal years beginning after June 15, 2002. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, and normal operation of a long-lived asset, except for certain lease obligations. We are evaluating the impact of SFAS No. 143, but do not expect the adoption of SFAS No. 143 to have a significant effect on our financial position or the results of our operations. On June 1, 2002, we adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 provides a single accounting model for long-lived assets to be disposed of and significantly changes the criteria for classifying an asset as held-for-sale. Classification as held-for-sale is an important distinction since such assets are not depreciated and are stated at the lower of fair value or carrying amount. SFAS No. 144 also requires expected future operating losses from discontinued operations to be displayed in the period in which the losses are incurred, rather than as of the measurement date as presently required. The adoption of SFAS No. 144 did not have a material effect on our financial position or the results of our operations. Note 9 - Restructuring and Special Charges In order to better align our operating expenses with anticipated revenues, we implemented a restructuring plan during June 2001. Pursuant to this plan, we reduced our work force by a total of 419 employees in June and August 2001. An additional 97 employees were terminated in October 2001. This reduction impacted all employee groups. The restructuring plan also included vacating buildings located in California, Massachusetts, Michigan, Minnesota, and Texas. We also recorded a $3.5 million inventory write-down related to discontinuing the manufacturing of certain products, which is reflected in costs of sales. The following table displays the amounts included as restructuring and/or special charges for the three and nine month periods ended March 2, 2002 (in thousands).
Three Months Ended Nine Months Ended March 2, 2002 March 2, 2002 ---------------------------- ------------------------- Employee severance and other employee expenses $ 391 $4,404 Facility consolidation and lease termination costs 56 1,660 Gain on disposal of equipment - (308) Other expenses 208 870 ---------------------------- ------------------------- 655 6,626 Inventory write-downs (reflected in cost of sales) (388) 3,109 ---------------------------- ------------------------- Total restructuring and special charges $ 267 $9,735 ============================ =========================
10 On October 2, 2002, we announced a plan to relocate the manufacturing of our Electronic Component Systems product line from Escondido, California to our headquarters in Portland, Oregon. The consolidation of these facilities was completed on December 31, 2002. 37 employees from our Escondido facility accepted relocation offers to our headquarters. The remaining employees were offered a severance package following a sixty-day required notice period. As a result of the closure of the California facility, the discontinuance of certain electronic component manufacturing product lines and other cost reduction steps, headcount declined to approximately 700 employees at the end of the third quarter of fiscal 2003. Included in cost of sales and operating expenses for the three and nine months ended March 1, 2003 is $4.9 million and $22.6 million, respectively, of restructuring and special charges related to these activities and inventory write-downs related to the discontinuance of certain electronic component manufacturing product lines. In both the current and prior year, all restructuring costs have been included in the line items to which they functionally relate. Note 10 - Restructuring Accrual At March 1, 2003, we had $0.7 million remaining in accrued liabilities relating to our restructuring plans implemented in fiscal 2002 and 2003, compared to $1.0 million at June 1, 2002. The following table displays rollforwards of the accruals from June 1, 2002 to March 1, 2003 (in thousands):
Accruals at Accruals at June 1, Charges to Amounts March 1, 2002 Accruals Used 2003 -------------- ---------------- ---------------- ----------------- Lease termination fees and other facility consolidation costs $ 664 $ 396 $ (440) $ 620 Purchase order obligations $ 334 $ - $ (334) $ - Employee severance $ - $ 1,538 $ (1,438) $ 100
Accrued lease termination fees and other facility consolidation costs will be paid through fiscal 2006 and accrued employee severance will be paid through the first quarter of fiscal 2004. Note 11 - Repurchase of Convertible Subordinated Notes In December 2001 and January 2002, we sold $150 million aggregate principal amount of 4 1/4% convertible subordinated notes due 2006 in a private offering. In January 2003, our Board of Directors approved the repurchase of up to $50.0 million aggregate principal amount of these notes during calendar 2003. In February 2003, we repurchased $5.0 million principal amount of our outstanding convertible subordinated notes. For the three and nine month periods ended March 1, 2003, we recorded a gain of $0.2 million related to this repurchase, which is reflected as other income on our consolidated condensed statements of operations. 11 Note 12 - Legal Matters Between March 26, 2003 and May 20, 2003, three putative class action lawsuits were filed in the United States District Court for the District of Oregon against ESI and David F. Bolender, James T. Dooley, and Joseph L. Reinhart, who are current and/or former officers and directors of ESI. Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs' consolidated class action complaint is due to be filed 45 days following the filing of our restated financial statements referred to below. In March 2003, our Audit Committee commenced an investigation into certain accounting matters. As a result of the investigation, which was completed on July 11, 2003, we have restated our financial statements for the fiscal year ended June 1, 2002 and for the quarters ended August 31, 2002 and November 30, 2002. The restated financial statements are set forth in our annual report on Form 10-K/A and quarterly reports on Form 10-Q/A for the corresponding periods, filed August 11, 2003. The consolidated class action complaint had not been filed and discovery had not yet commenced when this report was filed, and we were in the early stages of our assessment of the possible outcomes of this litigation. We expect, however, that the litigation will be costly and will to some degree divert management's attention from daily operations. On March 31, 2003 and April 28, 2003, two separate purported shareholder derivative complaints were filed in the Circuit Court of Oregon in Washington County. The named defendants include certain current and/or former officers and directors of ESI. ESI is named as a "nominal defendant." Lead plaintiffs and lead counsel for plaintiffs have been appointed. The parties have stipulated that the plaintiffs will file a consolidated complaint within 45 days of the filing of our restated financial statements referred to above. The existing complaints allege that certain defendants breached fiduciary duties to ESI and were unjustly enriched. The complaint seeks an unspecified amount of monetary damages and seeks various equitable remedies, including a constructive trust on the proceeds received by the defendants from trading ESI common stock. As filed, the complaints are derivative in nature and do not seek monetary damages from, or the imposition of equitable remedies on, ESI. We have entered into indemnification agreements in the ordinary course of business with our officers and directors and may be obligated throughout this action to advance payment of legal fees and costs incurred by the defendant current and former officers and directors pursuant to the indemnification agreements and applicable Oregon law. The special litigation committee of our board of directors, with the assistance of independent legal counsel, is conducting an investigation relating to the allegations asserted in the complaints. On February 14, 2001, Cognex Corporation (Cognex) filed a lawsuit in the United States District Court for the District of Massachusetts (Cognex Corporation v. Electro Scientific Industries, Inc., No. 01-10287 RCL). The lawsuit alleges that our CorrectPlace ver. 5.0 product infringes United States Patent 5,371,690, which is owned by Cognex. The patent concerns the inspection of surface mount devices that are attached to the surface of an electronic circuit board. Cognex seeks injunctive relief, damages, costs and attorneys' fees. We filed a motion for summary judgment of non-infringement on October 8, 2002, which remains pending. Cognex filed motions for summary judgment on the issues of unenforceability and mismarking on October 8, 2002. The court denied Cognex's motion on the issue of unenforceability on April 25, 2003. 12 The motion on the issue of mismarking remains pending. We believe we have meritorious defenses to the action and intend to pursue them vigorously. Fact discovery is completed in the lawsuit. Additionally, certain of our customers have notified us that, in the event it is subsequently determined that their use of CorrectPlace ver. 5.0 infringes any patent, they may seek indemnification from us for damages or expenses resulting from this matter. In addition to the legal matters previously discussed, in the ordinary course of business, we are involved in various other legal matters and investigations. Total amounts included in accrued expenses related to all of our legal activities, which represent estimated awards and assessments as well as unpaid legal services incurred through March 1, 2003, was approximately $1.2 million. In the opinion of management, amounts accrued for awards or assessments in connection with these matters, which specifically excludes the class action lawsuits and related derivative complaints noted above, are management's best estimate and ultimate resolution of these matters will not have a material effect on our consolidated financial position, results of operations or cash flow. We can not reliably estimate the costs related to the class action lawsuits and related derivative complaints at this time. Note 13 - Subsequent Event - Legal Matters See Note 12 for a discussion of changes to our legal matters subsequent to March 1, 2003. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview Electro Scientific Industries, Inc. and its subsidiaries (ESI) provide high technology manufacturing equipment to the global electronics market. Our customers are primarily manufacturers of semiconductors, passive electronic components and electronic interconnect devices. Our equipment enables these manufacturers to reduce production costs, increase yields and improve the quality of their products. The components and devices manufactured by our customers are used in a wide variety of end-use products in the computer, communications and automotive industries. We believe we are the leading supplier of advanced laser systems used to improve the production yield of semiconductor devices, high-speed test and termination equipment used in the high-volume production of multi-layer ceramic capacitors (MLCCs) and other passive electronic components, and advanced laser systems used to fine tune electronic components and circuitry. Additionally, we produce a family of laser drilling systems for production of high-density interconnect (HDI) circuit boards and advanced electronic packaging, as well as inspection systems and original equipment manufacturer (OEM) machine vision products. 13 Fiscal 2003 Results For certain information about our results of operations for the three months and fiscal year ended May 31, 2003 and our financial condition at that date, please see our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 11, 2003. Results of Operations Net sales decreased $4.6 million to $31.6 million for the quarter ended March 1, 2003 (the third quarter of fiscal 2003) from $36.2 million for the quarter ended March 2, 2002 (the third quarter of fiscal 2002). Net sales decreased $8.1 million to $114.4 million for the nine months ended March 1, 2003 from $122.5 million for the nine months ended March 2, 2002. The decrease in the third quarter of fiscal 2003 compared to the third quarter of fiscal 2002 is a result of decreases in sales in all of our product lines with the exception of the Advanced Electronic Packaging Systems product group. While this market continues to be very competitive, we were successful in winning sales at key customers. The largest sales decrease was in our Electronic Component Systems product group. This market remains over-sold with significant unused capacity. Semiconductor yield improvement systems comprised the largest percentage of sales for the quarter at 37.9% of total sales versus 37.5% in the third quarter of the prior year. In addition to the above factors, the decrease in the nine months ended March 1, 2003 compared to the nine months ended March 2, 2002 is due to continued pricing pressure in all of our markets, which resulted from continued softness in overall electronics demand and pressure on our customers' earnings. Certain information regarding our net sales by product line is as follows (net sales in thousands):
Three Months Ended Three Months Ended March 1, 2003 March 2, 2002 -------------------------------- ------------------------------- (restated) Percent of Percent of Net Sales Total Net Sales Net Sales Total Net Sales --------- --------------- --------- --------------- Semiconductor Yield Improvement Systems $ 11,989 37.9% $ 13,584 37.5% Electronic Component Manufacturing Systems 6,544 20.7 10,569 29.1 Advanced Electronic Packaging Systems 6,293 19.9 2,999 8.3 Vision and Inspection Systems 3,229 10.2 3,705 10.2 Circuit Fine Tuning Systems 3,576 11.3 5,387 14.9 -------- ------ -------- ------ $ 31,631 100.0% $ 36,244 100.0% -------- ------ ======== ======
14
Nine Months Ended Nine Months Ended March 1, 2003 March 2, 2002 -------------------------------- ------------------------------- (restated) Percent of Percent of Net Sales Total Net Sales Net Sales Total Net Sales --------- --------------- --------- --------------- Semiconductor Yield Improvement Systems $ 47,015 41.1% $50,974 41.6% Electronic Component Manufacturing Systems 22,255 19.5 32,653 26.7 Advanced Electronic Packaging Systems 19,267 16.8 11,626 9.5 Vision and Inspection Systems 9,378 8.2 8,780 7.2 Circuit Fine Tuning Systems 16,492 14.4 18,437 15.0 --------- ------ -------- ------ $ 114,407 100.0% $122,470 100.0% --------- ------ ======== ======
On October 2, 2002, we announced a plan to relocate the manufacturing of our Electronic Component Systems product line from Escondido, California to our headquarters in Portland, Oregon. The consolidation of these facilities was completed on December 31, 2002. Thirty-seven employees from our Escondido facility accepted relocation offers to our headquarters. The remaining employees were offered a severance package following a sixty-day required notice period. As a result of the closure of the California facility, the discontinuance of certain electronic component manufacturing product lines and other cost reduction steps, headcount declined to approximately 700 employees at the end of the third quarter of fiscal 2003. Included in cost of sales and operating expenses for the three and nine months ended March 1, 2003 is $4.9 million and $22.6 million, respectively, of restructuring and special charges related to these activities and inventory write-downs related to the discontinuance of certain electronic component manufacturing product lines. The amount of restructuring and special charges included in costs of sales for the three and nine months ended March 1, 2003 was $2.0 million and $15.9 million, respectively. For the nine month period, these charges included $6.8 million in inventory write-downs for excess and obsolete inventory, $2.5 million of write-offs related to open purchase order commitments, $4.1 million in inventory write-downs related to the discontinuance of certain electronic component manufacturing product lines, $1.8 million in inventory write-downs and long term asset impairments related to the discontinuance of certain other product lines, $0.6 million in employee severance and other employee related expenses and $0.3 million in other facilities consolidation costs, offset by a $0.2 million gain on the disposal of equipment. Gross margin decreased $17.3 million to $(0.5) million for the third quarter of fiscal 2003 from $16.7 million (46.1% of net sales) for the third quarter of fiscal 2002. Gross margin decreased $37.9 million to $18.3 million (16.0% of net sales) for the nine month period ended March 1, 2003 from $56.2 million (45.9% of net sales) for the comparable period of the prior fiscal year. As discussed above, included in costs of sales for the three and nine month periods ended March 1, 2003 were restructuring and special charges totaling $2.0 million and $15.9 million, respectively. In comparison, the gross margin for three and nine month periods ended March 2, 2002 included a gain of $0.4 million and a charge of $3.1 million, respectively, for such charges, net. In addition to these charges, the primary reasons for the decreases in our gross margins are low utilization of our factory capacity, changes in our product mix and downward pricing pressures. 15 Selling, service and administrative expenses were $16.1 million (51.0% of net sales) and $47.3 million (41.3% of net sales), respectively, for the three and nine month periods ended March 1, 2003 compared to $14.5 million (39.9% of net sales) and $51.7 million (42.2% of net sales), respectively, for the comparable periods of fiscal 2002. As a result of the Escondido consolidation and other restructuring steps discussed above, included in selling, service and administrative expenses for the three and nine month periods ended March 1, 2003 were $2.6 million and $5.6 million, respectively, of restructuring and/or special charges. As a result of the restructuring plan we implemented in June 2001 as discussed in Note 9, included in selling, service and administrative expenses for the three and nine month periods ended March 2, 2002, were restructuring and special charges totaling $0.5 million and $5.3 million, respectively. Increases in selling, service and administrative expenses in the fiscal 2003 periods due to these charges were offset in part by a reduction in force and other cost reduction efforts compared to prior year levels. Selling, service and administrative expense is expected to increase significantly in the fourth quarter of fiscal 2003 as a result of professional fees incurred in connection with the internal investigation of certain accounting matters, defending the shareholder and derivative suits described in Part II, Item 1, "Legal Proceedings," and complying with the Sarbanes-Oxley Act of 2002. We expect to continue to incur additional expenses in fiscal 2004 in connection with defending the shareholder and derivative suits and complying with the Sarbanes-Oxley Act. We also expect to pay increased premiums for our directors' and officers' liability insurance in fiscal 2004. Future operating results are highly dependent on our ability to maintain a competitive advantage in the products and services we provide. To protect this advantage we continue to make investments in our research and development efforts. Research, development and engineering expenses were $5.7 million (18.0% of net sales) and $20.6 million (18.0% of net sales), respectively, for the three and nine month periods ended March 1, 2003 compared to $7.8 million (21.4% of net sales) and $29.3 million (23.9% of net sales) for the comparable periods in the prior fiscal year. As a result of the Escondido consolidation and other restructuring steps discussed above, included in research, development and engineering expenses for the three and nine month periods ended March 1, 2003 were restructuring and special charges totaling $0.3 million and $1.2 million, respectively. As a result of the restructuring plan we implemented in June 2001 as discussed in Note 9, included in research, development and engineering expenses for the three and nine month periods ended March 2, 2002, were restructuring and special charges totaling $0.1 million and $1.3 million, respectively. Increases in research, development and engineering expenses due to these charges were more than offset by reductions due to the relocation of our Electronic Component Systems group to our headquarters in Portland, Oregon from Escondido, California. Research and development spending often fluctuates from quarter to quarter as engineering projects move through their life cycles. We continue to invest in a significant number of development and engineering projects that we see as important to our future. Interest income was $2.7 million and $8.5 million, respectively, for the three and nine month periods ended March 2, 2003 compared to $2.1 million and $5.7 million, respectively, for the comparable periods of fiscal 2002. The increases in the fiscal 2003 periods compared to the fiscal 2002 periods are due to an increase in our investment balances as a result of our sale of $150 million aggregate principal amount of 4 1/4% convertible subordinated notes due 2006 (the "Convertible Notes") in December 2001 and January 2002. 16 Interest expense was $1.8 million and $5.6 million, respectively, for the three and nine month periods ended March 1, 2003 compared to $1.6 million for both of the comparable periods of the prior fiscal year. These increases are primarily due to the sale in December 2001 and January 2002 of $150 million aggregate principal amount of Convertible Notes. Quarterly interest related to the Convertible Notes, after the $5.0 million principal amount repurchase in the third quarter of fiscal 2003, totals $1.5 million plus $0.2 million for the accretion of underwriting discounts. Net other loss of $0.2 million in the three months ended March 1, 2003 includes a $0.4 million loss on securities, offset in part by a $0.2 million gain related to the repurchase of $5.0 million principal amount of Convertible Notes described above. The $41,000 of other income in the nine month period ended March 1, 2003 includes a gain of $0.6 million related to legal settlements and a $0.2 million gain related to the repurchase of $5.0 million principal amount of Convertible Notes, offset by a net $0.5 million loss on the sale of securities and $0.2 million of bank charges. The income tax rate for the nine months ended March 1, 2003 was 37.2% compared to 55.5% for the comparable period of fiscal 2002. The rate in fiscal 2002 includes the effects of a $4.6 million tax credit due to a re-evaluation of our application of the research and development tax credit for the years 1996 through 2001. Net loss was $13.0 million, or $0.47 per diluted share, and $29.3 million, or $1.06 per diluted share, respectively, for the three and nine month periods ended March 1, 2003 compared to net income of $1.2 million, or $0.04 per diluted share, and a net loss of $9.3 million, or $0.34 per diluted share, in the comparable periods of fiscal 2002. Liquidity and Capital Resources At March 1, 2003, our principal sources of liquidity consisted of existing cash, cash equivalents and marketable securities of $285.5 million and accounts receivable of $50.4 million. At March 1, 2003, we had a current ratio of 11.4:1 and with a long-term debt carrying value of $141.7 million. Working capital increased to $361.7 million at March 1, 2003 compared to $341.5 million at June 1, 2002. Trade receivables decreased $5.4 million to $50.4 million at March 1, 2003 from $55.8 million at June 1, 2002 due lower sales and fewer sales with extended terms. Income tax refunds receivable increased $12.6 million to $27.0 million at March 1, 2003 from $14.4 million at June 1, 2002 due to the availability of tax benefits related to the carry-back of our fiscal 2003 net losses. Inventory decreased $21.6 million to $42.3 million at March 1, 2003 from $63.9 million at June 1, 2002. Inventories were written down by a total of $11.9 million in the nine months ended March 1, 2003 for excess, obsolescence and discontinued product lines. In addition, we transferred $5.2 million of inventory to shipped systems pending acceptance during the nine months ended March 1, 2003. 17 Purchases of property, plant and equipment of $8.0 million in the first nine months of fiscal 2003 were primarily for the continued construction and completion of our new corporate headquarters in Portland, Oregon. At March 1, 2003 we had $141.7 million recorded on our balance sheet related to the Convertible Notes. During the third quarter of fiscal 2003, we repurchased $5.0 million principal amount of the Convertible Notes. The difference between the remaining $145.0 million face value and the $141.7 million balance at March 1, 2003 relates to underwriting discounts, which originally totaled $4.5 million and are being amortized as additional interest expense over the life of the Convertible Notes at a rate of $0.2 million per quarter. Critical Accounting Policies and Estimates We reaffirm the critical accounting policies and our use of estimates as reported in our annual report on Form 10-K/A for the year-ended June 1, 2002, as filed with the Securities and Exchange Commission on August 11, 2003. Factors That May Affect Future Results The statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words "believes," "expects," and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties. From time to time we may issue other forward-looking statements. Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ. The following information highlights some of the factors that could cause actual results to differ materially from the results expressed or implied by our forward-looking statements. Forward-looking statements should be considered in light of these factors. Factors that may result in such variances include, but are not limited to the following: The industries that comprise our primary markets are volatile and unpredictable. Our business depends upon the capital expenditures of manufacturers of components and circuitry used in wireless communications, computers, automotive electronics and other electronic products. In the past, the markets for electronic devices have experienced sharp downturns. During these downturns, electronics manufacturers, including our customers, have delayed or canceled capital expenditures, which has had a negative impact on our financial results. The current economic downturn has resulted in a reduction in demand for our products and significant reductions in our profitability and net sales. We had a net loss of $29.3 million during the nine months ended March 1, 2003 on net sales of $114.4 million and a net loss of $17.8 million for the year ended June 1, 2002. We cannot assure you that demand for our products will increase. If demand for our product does increase, there may be significant fluctuations in our profitability and net sales. 18 During any downturn, including the current downturn, it will be difficult for us to maintain our sales levels. As a consequence, in order to maintain profitability we will need to reduce our operating expenses. However, much of our operating expenses are fixed and our ability to reduce such expenses is limited. Moreover, we may be unable to defer capital expenditures, and we will need to continue investment in certain areas such as research and development. We may incur charges related to impairment of assets and inventory write-offs. We also may experience delays in payments from our customers. The combined effect of these will have a negative effect on our financial results. If the markets for our products improve, we must attract, hire and train a sufficient number of employees, including technical personnel, to meet increased customer demand. Our inability to achieve these objectives in a timely and cost-effective manner could have a negative impact on our business. Pending or future litigation could have a material adverse impact on our operating results and financial condition. In addition to intellectual property litigation, we have been, from time to time, subject to legal proceedings and claims, including a putative securities class action lawsuit and other securities-related litigation. See Part II, Item 1, "Legal Proceedings." Where we can make a reasonable estimate of the liability relating to pending litigation, we record a liability. As additional information becomes available, we assess the potential liability and revise estimates as appropriate. Because of uncertainties relating to litigation, however, the amount of our estimates could be wrong. Moreover, plaintiffs may not specify an amount of damages sought. In addition to the direct costs of litigation and the use of cash, pending or future litigation could divert management's attention and resources from the operation of our business. Accordingly, our operating results and financial condition could suffer. We face risks relating to a pending SEC inquiry and the results of our internal investigation of accounting matters. On March 20, 2003, we contacted the SEC in connection with our issuance of a press release announcing the need to restate our financial results for the quarters ended August 31, 2002 and November 30, 2002. In March 2003, the audit committee of our board of directors, with the assistance of outside legal counsel and independent forensic accountants, commenced an internal investigation of certain accounting matters. The investigation involved the review of (1) the circumstances surrounding the reversal of an accrual for employee benefits, (2) unsupported accounting adjustments and clerical errors primarily relating to inventory and cost of goods sold, and (3) certain other areas where potential accounting errors could have occurred, including revenue recognition. As a result of the investigation, we determined that our unaudited consolidated condensed financial statements for the three months ended August 31, 2002 and November 30, 2002, and our audited consolidated financial statements for the year ended June 1, 2002 required restatement. We will continue to cooperate with any government investigation into the matters addressed by the internal investigation. Depending on the scope, timing and result of any governmental investigation, management's attention and our resources could be diverted from operations, which could adversely affect our operating results and contribute to future stock price volatility. Governmental investigations also could lead to further restatement of our prior period financial statements or require that we take other actions not currently contemplated. 19 Our management is implementing what it believes to be improvements in our internal and disclosure controls and procedures. See Item 4. Controls and Procedures. Nonetheless, future accounting restatements could occur because these controls and procedures prove to be ineffective or for other reasons. During the pendency of its internal investigation, our audit committee was in contact with attorneys in the SEC's Enforcement Division and kept them informed of the progress of the investigation. Our audit committee completed its investigation and delivered a final report to the SEC on August 1, 2003. After its review of the final report, the SEC could commence a formal investigation into the accounting matters. Such an investigation would result in a diversion of management's attention and resources which could negatively impact our operating results and may contribute to current and future stock price volatility. Moreover, an SEC investigation could lead to further restatement of our prior period financial statements or require that we take other actions not currently contemplated. Our management is implementing a more effective system of internal controls, however, there can be no assurance that these efforts will be adequate to prevent future restatements. In addition to a potential SEC investigation, the restatement of our previously issued financial statements may lead to new litigation, may expand the claims and the class periods in pending litigation, and may increase the cost of defending or resolving current litigation. Our operating results could suffer as we have recently experienced significant changes in our senior management and plan to add new members to our management team. Several members of our senior management have only joined ESI as employees in the last few months and we intend to continue to add new members to our senior management team. Changes in management may be disruptive to our business and negatively impact our operating results and may result in the departure of existing employees or customers. Further, it could take an extended period of time to locate, retain and integrate qualified management personnel. Our recent capacity expansion may not be utilized successfully or effectively, which could negatively affect our business. In November 2002, we completed construction of a 62,000 square foot corporate headquarters building in Portland, Oregon. The project was funded with existing capital resources and internally generated funds. Our capacity expansion involves risks. For example, the electronics industry has historically been cyclical and subject to significant economic downturns characterized by over-capacity and diminished demand for products of the type manufactured by us. In fiscal 2002 and 2003 we adopted restructuring plans that involved the closure of several of our manufacturing facilities in response to the current economic downturn. Unfavorable economic conditions affecting the electronics industry in general, or any of our major customers, may affect our ability to successfully utilize our additional manufacturing capacity in an effective manner, which could adversely affect our operating results. 20 Our ability to reduce costs is limited by our need to invest in research and development. Our industry is characterized by the need for continued investment in research and development. Because of intense competition in the industries in which we compete, if we were to fail to invest sufficiently in research and development, our products could become less attractive to potential customers, and our business and financial condition could be materially and adversely affected. As a result of our need to maintain our spending levels in this area, our operating results could be materially harmed if our net sales fall below expectations. In addition, as a result of our emphasis on research and development and technological innovation, our operating costs may increase further in the future, and research and development expenses may increase as a percentage of total operating expenses and as a percentage of net sales. We depend on a few significant customers and we do not have long-term contracts with any of our customers. Twelve large, multinational electronics companies represented 50.0% of our fiscal 2002 net sales, and the loss of any of these customers could significantly harm our business. In addition, none of our customers have any long-term obligation to continue to buy our products or services, and any customer could delay, reduce or cease ordering our products or services at any time. Delays in shipment or manufacturing of our products could substantially decrease our sales for a period. We will continue to derive a substantial portion of our revenues from the sale of a relatively small number of products with high average selling prices, some with prices as high as $2.0 million per unit. We generally recognize revenue upon shipment of our products. As a result, the timing of revenue recognition from a small number of orders could have a significant impact on our net sales and operating results for a reporting period. Shipment delays could significantly impact our recognition of revenue and could be further magnified by announcements from us or our competitors of new products and technologies, which announcements could cause our customers to defer purchases of our existing systems or purchase products from our competitors. Any of these delays could result in a material adverse change in our results of operations for any particular period. We depend on manufacturing flexibility to meet the changing demands of our customers. Any significant delay or interruption of manufacturing operations as a result of software deficiencies, natural disasters, or other causes could result in ineffective manufacturing capabilities or delayed product deliveries, any or all of which could materially and adversely affect our results of operations. 21 Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business. We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply materials. We generally do not have guaranteed supply arrangements with our suppliers. We seek to reduce the risk of production and service interruptions and shortages of key parts by selecting and qualifying alternative suppliers for key parts, monitoring the financial stability of key suppliers and maintaining appropriate inventories of key parts. Although we make reasonable efforts to ensure that parts are available from multiple suppliers, key parts may be available only from a single supplier or a limited group of suppliers. Operations at our suppliers' facilities are subject to disruption for a variety of reasons, including work stoppages, fire, earthquake, flooding or other natural disasters. Such disruption could interrupt our manufacturing. Our business may be harmed if we do not receive sufficient parts to meet our production requirements in a timely and cost-effective manner. We may make additional acquisitions in the future, and these acquisitions may subject us to risks associated with integrating these businesses into our current business. Although we have no commitments or agreements for any acquisitions, we have made, and plan in the future to make, acquisitions of, or significant investments in, businesses with complementary products, services or technologies. Acquisitions involve numerous risks, many of which are unpredictable and beyond our control, including: -- Difficulties and increased costs in connection with integration of the personnel, operations, technologies and products of acquired companies; -- Diversion of management's attention from other operational matters; -- The potential loss of key employees of acquired companies; -- Lack of synergy, or inability to realize expected synergies, resulting from the acquisition; -- The risk that the issuance of our common stock in a transaction could be dilutive to our shareholders if anticipated synergies are not realized; and -- Acquired assets becoming impaired as a result of technological advancements or worse-than-expected performance by the acquired company. Our inability to effectively manage these acquisition risks could materially and adversely affect our business, financial condition and results of operations. In addition, if we issue equity securities to pay for an acquisition the ownership percentage of our existing shareholders would be reduced and the value of the shares held by our existing shareholders could be diluted. If we use cash to pay for an acquisition the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes. In addition, the Financial Accounting Standards Board has disallowed the pooling-of-interests method of acquisition accounting. This could result is significant charges resulting from amortization of intangible assets recorded in connection with future acquisitions. 22 Our markets are subject to rapid technological change, and to compete effectively we must continually introduce new products that achieve market acceptance. The markets for our products are characterized by rapid technological change and innovation, frequent new product introductions, changes in customer requirements and evolving industry standards. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address technological changes as well as current and potential customer requirements. The introduction by us or by our competitors of new and enhanced products may cause our customers to defer or cancel orders for our existing products, which may harm our operating results. We have in the past experienced a slowdown in demand for our existing products and delays in new product development, and similar delays may occur in the future. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or, where necessary, to license these technologies from others. Product development delays may result from numerous factors, including: -- Changing product specifications and customer requirements; -- Difficulties in hiring and retaining necessary technical personnel; -- Difficulties in reallocating engineering resources and overcoming resource limitations; -- Difficulties with contract manufacturers; -- Changing market or competitive product requirements; and -- Unanticipated engineering complexities. The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Any failure to respond to technological change would significantly harm our business. We are exposed to the risks that others may violate our proprietary rights, and our intellectual property rights may not be well protected in foreign countries. Our success is dependent upon the protection of our proprietary rights. In the high technology industry, intellectual property is an important asset that is always at risk of infringement. We incur substantial costs to obtain and maintain patents and defend our intellectual property. For example, we have initiated litigation alleging that certain parties have violated various of our patents. We rely upon the laws of the United States and of foreign countries in which we develop, manufacture or sell our products to protect our proprietary rights. These proprietary rights may not provide the competitive advantages that we expect, however, or other parties may challenge, invalidate or circumvent these rights. 23 Further, our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States. Many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries. If we fail to adequately protect our intellectual property in these countries, it could be easier for our competitors to sell competing products in foreign countries. We may be subject to claims of intellectual property infringement. Several of our competitors hold patents covering a variety of technologies, applications and methods of use similar to some of those used in our products. From time to time, we and our customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents. For example, in February 2001, Cognex Corporation filed a lawsuit against us claiming we infringed a patent owned by it. Competitors or others may assert infringement claims against our customers or us in the future with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others. If claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur. Total amounts included in accrued expenses related to all of our legal activities, which represent estimated awards and assessments as well as unpaid legal services incurred through March 1, 2003, was approximately $1.2 million. If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, our financial condition and results of operations could be materially and adversely affected. We are exposed to the risks of operating a global business, including risks associated with exchange rate fluctuations and legal and regulatory changes. International shipments accounted for 74.8% of net sales for fiscal 2002, with 46.8% of our net sales to customers in Asia. We expect that international shipments will continue to represent a significant percentage of net sales in the future. Our non-U.S. sales and operations are subject to risks inherent in conducting business abroad, many of which are outside our control, including the following: -- Periodic local or geographic economic downturns and unstable political conditions; -- Price and currency exchange controls; -- Fluctuation in the relative values of currencies; -- Difficulties protecting intellectual property; -- Unexpected changes in trading policies, regulatory requirements, tariffs and other barriers; and -- Difficulties in managing a global enterprise, including staffing, collecting accounts receivable, managing distributors and representatives and repatriation of earnings. 24 In addition, our ability to address normal business transaction issues internationally is at risk due to outbreaks of serious contagious diseases. For example, in response to the recent Severe Acute Respiratory Syndrome outbreak in Asia, management limited travel to Asia in accordance with the World Health Organization's recommendations. In addition, as a result of our significant reliance on international sales, we may also be adversely affected by challenges to U.S. tax laws that benefit companies with certain foreign sales. In February 2000, the World Trade Organization (WTO) ruled that foreign sales corporations (FSCs), which provide an overall reduction in effective tax rates for companies with FSCs, violate U.S. obligations under the General Agreement on Tariffs and Trade (GATT). Responding to the WTO's decision that FSCs constitute an illegal export subsidy, the U.S. government repealed the FSC rules effective October 1, 2000, subject to certain transition rules, and created a new income tax benefit that permanently excludes "foreign extraterritorial income" from taxable income. The extraterritorial income (ETI) regime, which applies to transactions after September 30, 2000, provides a similar tax benefit for export sales as the FSC regime did. Following a European Union (EU) complaint, the WTO concluded in August 2001 that the ETI provisions are also not WTO-compliant because provisions violate the GATT agreements. The United States appealed the decision, but in January 2002, an appellate body denied the appeal. On August 30, 2002, a WTO arbitration panel issued a report approving the retaliatory tariffs requested by the EU. The EU now has the authority to begin imposing trade sanctions on U.S. exports up to the level approved by the arbitrators and the authority for such sanctions will continue until the United States rectifies the WTO violation. We believe the U.S. government will choose to rectify the violation to avoid retaliatory trade sanctions and it is considering several options to do so. The U.S. government may repeal the ETI regime and if the government does not replace it with an equivalent form of tax relief for foreign income, our future results of operations may be adversely affected. Our establishment of direct sales in Asia exposes us to the risks related to having employees in foreign countries. We have established direct sales and service organizations in China, Taiwan, Korea and Singapore. Previously, we sold our products through a network of commission-based sales representatives in these countries. Our shift to a direct sales model in these regions involves risks. For example, we may encounter labor shortages or disputes that could inhibit our ability to effectively sell and market our products. We also are subject to compliance with the labor laws and other laws governing employers in these countries and we will incur additional costs to comply with these regulatory schemes. Additionally we will incur new fixed operating expenses associated with the direct sales organizations, particularly payroll related costs and lease expenses. If amounts saved on commission payments formerly paid to our sales representatives do not offset these expenses, our operating results may be adversely affected. 25 Our business is highly competitive, and if we fail to compete our business will be harmed. The industries in which we operate are highly competitive. We face substantial competition from established competitors, some of which have greater financial, engineering, manufacturing and marketing resources than we do. If we are unable to compete effectively with these companies, our market share may decline and our business could be harmed. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products. Furthermore, our technological advantages may be reduced or lost as a result of technological advances by our competitors. Their greater resources in these areas may enable them to: -- Better withstand periodic downturns; -- Compete more effectively on the basis of price and technology; -- More quickly develop enhancements to and new generations of products; and -- More effectively retain existing customers and obtain new customers. In addition, new companies may in the future enter the markets in which we compete, further increasing competition in those markets. We believe that our ability to compete successfully depends on a number of factors, including: -- Performance of our products; -- Quality of our products; -- Reliability of our products; -- Cost of using our products; -- Our ability to ship products on the schedule required; -- Quality of the technical service we provide; -- Timeliness of the services we provide; -- Our success in developing new products and enhancements; -- Existing market and economic conditions; and -- Price of our products as compared to our competitors' products. We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins, and loss of market share. Possibilities of terrorist attacks have increased uncertainties for our business. Like other U.S. companies, our business and operating results are subject to uncertainties arising out of the possibility of terrorist attacks on the United States, including the potential worsening or extension of the current global economic slowdown, the economic consequences of military action or additional terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce. 26 In particular, due to these uncertainties we are subject to: -- The risk that future tightening of immigration controls may adversely affect the residence status of non-U.S. engineers and other key technical employees in our U.S. facilities or our ability to hire new non-U.S. employees in such facilities; -- The risk of more frequent instances of shipping delays. -- The risk that demand for our products may not increase or may decrease. Our inability to attract and retain sufficient numbers of managerial, financial, engineering and other technical personnel could have a material adverse effect upon our results of operations. Our continued success depends, in part, upon key managerial, financial, engineering and technical personnel as well as our ability to continue to attract and retain additional personnel. The loss of key personnel could have a material adverse effect on our business or results of operations. In April 2003, Barry L. Harmon became President and Chief Executive Officer of ESI with the understanding that he will serve in that capacity until a permanent successor is hired. Recently, The Board of Directors decided to commence a search in the fall for a new Chief Executive Officer to succeed Mr. Harmon. In addition, there are several key positions open in our finance department. We are in the process of recruiting highly skilled accounting and financial reporting personnel to fill these finance positions. It could take longer than anticipated, however, to hire and train the appropriately qualified professionals. Moreover, we cannot be certain that the employees hired to fulfill these duties will perform at the level necessary to ensure that our internal controls are not compromised. It may also take longer than anticipated to hire a new Chief Executive Officer. In addition, we may not be able to retain our key managerial, financial, engineering and technical employees. Our growth may be affected by our ability to hire new managerial personnel, highly skilled and qualified technical personnel, and personnel that can implement and monitor our financial controls and reporting systems. Attracting and retaining qualified personnel is difficult, and our recruiting efforts to attract and retain these personnel may not be successful. Item 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk As of March 1, 2003, our investment portfolio included marketable debt securities of $271.3 million. These securities are subject to interest rate risk, and will decline in value if interest rates increase. These securities are classified as Securities Available for Sale; therefore, the impact of interest rate changes is reflected as a separate component of shareholders' equity. Due to the short duration of our investment portfolio, generally less than one year, an immediate 10% increase in interest rates would not have a material effect on our financial condition or the results of our operations. Our $145 million aggregate principal amount of 4 1/4% convertible subordinated notes due 2006 is at a fixed interest rate. Therefore, there is no associated volatility. 27 Foreign Currency Exchange Rate Risk We have limited involvement with derivative financial instruments and do not use them for trading purposes. Hedging derivatives are used to manage well-defined foreign currency risks. We enter into forward exchange contracts to hedge the value of accounts receivable denominated in Japanese yen. The impact of exchange rates on the forward contracts will be substantially offset by the impact of such changes on the underlying transactions. The effect of an immediate 10% change in exchange rates on the forward exchange contracts and the underlying hedged positions, denominated in Japanese yen, would not be material to our financial position or results of operations. Item. 4. Controls and Procedures Immediately following the signature page of this quarterly report are certifications of our President and Chief Executive Officer and our Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002 (the "Section 302 Certification"). This portion of our quarterly report on Form 10-Q is our disclosure of the results of our controls evaluation conducted under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, and within 90 days prior to the filing of this quarterly report referred to in paragraphs (4), (5) and (6) of the Section 302 Certification and should be read in conjunction with the Section 302 Certification for a more complete understanding of the topics presented. In March 2003 the Audit Committee of our Board of Directors, with the assistance of outside legal counsel and forensic accountants, commenced an internal investigation of certain accounting matters. The investigation involved the review of (1) the circumstances surrounding the reversal of an accrual for employee benefits, (2) unsupported accounting adjustments and clerical errors primarily relating to inventory and cost of goods sold, and (3) certain other areas where potential accounting errors could have occurred, including revenue recognition. On July 15, 2003, we announced that the Audit Committee had completed its review of these matters. As a result of the review, we determined that the unaudited consolidated condensed financial statements for the three months ended August 31, 2002 and November 30, 2002 and the audited consolidated financial statements for the year ended June 1, 2002 required restatement. 28 Management has advised the Audit Committee that upon reviewing the restatement adjustments and performing an evaluation of our controls and disclosure procedures, management noted deficiencies in internal controls relating to: 1. Lack of complete sales documentation, particularly as it relates to customer specified acceptance criteria; 2. Lack of adequate job transition/cross training and poorly documented "desk" processes and procedures in the finance/accounting area; 3. Changes to accounting methodologies without notification to, or proper authorization by, accounting oversight parties (i.e., the audit committee and independent auditors); and 4. Lack of adequate tracking and monitoring of finished goods inventory that was transferred out of the inventory management information system. The independent auditors advised the Audit Committee that these internal control deficiencies constitute reportable conditions and, collectively, a material weakness as defined in Statement of Auditing Standards No. 60. Certain of these internal control weaknesses may also constitute deficiencies in our disclosure controls. While we, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, are in the process of implementing a more effective system of disclosure controls and procedures, we have instituted controls, procedures and other changes to ensure that information required to be disclosed in this quarterly report on Form 10-Q has been recorded, processed, summarized and reported. The steps that we have taken to ensure that all material information about our company is accurately disclosed in this report include: 1. The appointment of an independent director to be Chairman of the Board in April 2003, who was previously the Chief Executive Officer and Chairman of the Board of KLA-Tencor Corporation; 2. The appointment of a previously independent director to be President and Chief Executive Officer in April 2003, who was previously Chief Financial Officer of Apex, Inc. and was the former Senior Vice President and Chief Financial Officer of ESI for seven years until 1998; 3. The appointment of a new Chief Financial Officer in May 2003, who was previously Chief Financial Officer of SpeedFam-IPEC, Inc. and Vice President and Corporate Controller of Novellus Systems, Inc.; 4. The engagement of outside professionals specializing in accounting and finance to assist our management in the collection, substantiation and analysis of the information contained in this report; and 5. The performance of additional procedures by us designed to ensure that these internal control deficiencies did not lead to material misstatements in our consolidated financial statements. 29 We have also increased by two the number of independent directors on our board by electing Richard J. Faubert, who previously served as President and Chief Executive Officer of SpeedFam-IPEC, Inc. and held senior management positions at Tektronix, Inc. and Genrad, Inc., and Frederick A. Ball, who previously served as Senior Vice President and Chief Financial Officer of Borland Software Corporation and as Vice President of Finance of KLA-Tencor Corporation. Based in part on the steps listed above, our President and Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, in order to address further the deficiencies described above and to improve our internal disclosure and control procedures for future periods, we will: 1. Review and revise our processes and procedures for applying revenue recognition policies, including more formalized training of finance, sales, order management and other staffs; 2. Enhance accounting/finance training programs and desk processes and procedures documentation as well as retain additional full-time experienced accounting/finance personnel; 3. Provide additional management oversight and perform detailed reviews of disclosures and reporting with the assistance of outside legal counsel; 4. Account for all completed systems in the inventory management information system; and 5. Use outside resources, as necessary, to supplement our employees in the preparation of the consolidated financial statements and other reports filed or submitted under the Securities Exchange Act of 1934. These steps will constitute significant changes in internal controls. We will continue to evaluate the effectiveness of our disclosure controls and internal controls and procedures on an ongoing basis, and will take further action as appropriate. 30 PART II - OTHER INFORMATION Item 1. Legal Proceedings Between March 26, 2003 and May 20, 2003, three putative class action lawsuits were filed in the United States District Court for the District of Oregon against the Company and David F. Bolender, James T. Dooley, and Joseph L. Reinhart, who are current and/or former officers and directors of ESI. The complaints were filed on behalf of a purported class of persons who purchased ESI's common stock between September 17, 2002 and at the latest April 15, 2003. The complaints assert causes of action (and seek unspecified damages) for alleged violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, as well as Section 20(a) of the Act. In particular, the complaints allege that the defendants were involved in making false and misleading statements during the putative class period about ESI's business, prospects, and operations, all of which resulted in artificially inflating ESI's stock price. The complaints have been consolidated under the name In re Electro Scientific Industries, Inc. Securities Litigation, Case No. CV 03-404-HA. Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs' consolidated class action complaint is due to be filed 45 days following the filing of our restated financial statements referred to below. In March 2003, our Audit Committee commenced an investigation into certain accounting matters. As a result of the investigation, which was completed on July 11, 2003, we have restated our financial statements for the fiscal year ended June 1, 2002 and for the quarters ended August 31, 2002 and November 30, 2002. The restated financial statements are set forth in our annual report on Form 10-K/A and quarterly reports on Form 10-Q/A for the corresponding periods, filed August 11, 2003. The consolidated class action complaint had not been filed and discovery had not yet commenced when this report was filed, and we were in the early stages of our assessment of the possible outcomes of this litigation. We expect, however, that the litigation will be costly and will to some degree divert management's attention from daily operations. On March 31, 2003 and April 28, 2003, two separate purported shareholder derivative complaints were filed in the Circuit Court of Oregon in Washington County. The named defendants include certain current and/or former officers and directors of ESI. ESI is named as a "nominal defendant." The complaints have been consolidated under the name In Re Electro Scientific Industries, Inc. Derivative Litigation, Lead Case No. C 031067 CV. Lead plaintiffs and lead counsel for plaintiffs have been appointed. The parties have stipulated that the plaintiffs will file a consolidated complaint within 45 days of the filing of our restated financial statements referred to above. The existing complaints allege that certain defendants breached fiduciary duties to ESI and were unjustly enriched. The complaint seeks an unspecified amount of monetary damages and seeks various equitable remedies, including a constructive trust on the proceeds received by the defendants from trading ESI common stock. As filed, the complaints are derivative in nature and do not seek monetary damages from, or the imposition of equitable remedies on, ESI. We have entered into indemnification agreements in the ordinary course of business with our officers and directors and may be obligated throughout this action to advance payment of legal fees and costs incurred by the defendant current and former officers and directors pursuant to the indemnification agreements and applicable Oregon law. The special litigation committee of our board of directors, with the assistance of independent legal counsel, is conducting an investigation relating to the allegations asserted in the complaints. 31 On February 14, 2001, Cognex Corporation (Cognex) filed a lawsuit in the United States District Court for the District of Massachusetts (Cognex Corporation v. Electro Scientific Industries, Inc., No. 01-10287 RCL). The lawsuit alleges that our CorrectPlace ver. 5.0 product infringes United States Patent 5,371,690, which is owned by Cognex. The patent concerns the inspection of surface mount devices that are attached to the surface of an electronic circuit board. Cognex seeks injunctive relief, damages, costs and attorneys' fees. We filed a motion for summary judgment of non-infringement on October 8, 2002, which remains pending. Cognex filed motions for summary judgment on the issues of unenforceability and mismarking on October 8, 2002. The court denied Cognex's motion on the issue of unenforceability on April 25, 2003. The motion on the issue of mismarking remains pending. We believe we have meritorious defenses to the action and intend to pursue them vigorously. Fact discovery is completed in the lawsuit. Additionally, certain of our customers have notified us that, in the event it is subsequently determined that their use of CorrectPlace ver. 5.0 infringes any patent, they may seek indemnification from us for damages or expenses resulting from this matter. Item 5. Other Information Changes in Management and Board of Directors On April 15, 2003, James T. Dooley, our President and Chief Executive Officer, was placed on administrative leave of absence pending the results of a review of our financial statements for the first two quarters of fiscal 2003. Mr. Dooley remained on our Board of Directors at this time. During Mr. Dooley's leave of absence, Mr. Barry L. Harmon, who was, at the time of Mr. Dooley's being placed on leave, a member of our Board of Directors and our Audit Committee, served as our President and Chief Executive Officer. On June 9, 2003, Mr. Dooley was terminated and resigned from our board of directors. Mr. Harmon continues to serve as our Chief Executive Officer. In addition, also on April 15, 2003, Mr. Larry L. Hansen, a member of our Board of Directors and our Compensation and Governance and Nominating Committees, became a member of our Audit Committee and Mr. Jon D. Tompkins was named Chairman of the Board of Directors, succeeding Mr. David F. Bolender, who remains a director of ESI. On May 5, 2003, we hired J. Michael Dodson to be our Vice President of Administration and Chief Financial Officer. Mr. Dodson replaced Richard Okumoto who resigned. Mr. Okumoto was hired by ESI in February 2003. Mr. Richard J. Faubert and Mr. Frederick Ball were elected to our Board of Directors on June 3, 2003 and July 17, 2003, respectively. Restatements In March 2003 our Audit Committee commenced an internal investigation of certain accounting matters. The investigation involved the review of (1) the circumstances surrounding the reversal of an accrual for employee benefits, (2) unsupported accounting adjustments and clerical errors primarily relating to inventory and cost of goods sold, and (3) certain other areas where potential accounting errors could have occurred, including revenue recognition. As a result of the investigation, we determined that the unaudited consolidated condensed financial statements for the three months ended August 31, 2002 and November 30, 2002, and the audited consolidated financial statements for the year ended June 1, 2002 (and the quarters contained therein) required restatement. 32 These restated financial statements are included in our amended quarterly reports on Form 10-Q/A for the fiscal quarters ended August 31, 2002 and November 30, 2002 and our amended annual report on Form 10-K/A for the fiscal year ended June 1, 2002, each of which was filed on August 11, 2003. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits This list is intended to constitute the exhibit index. 10.1 Agreement and Release of All Claims by and between Electro Scientific Industries, Inc. and Mr. Robert E. Belter dated September 19, 2001. 10.2 Separation Agreement by and between Electro Scientific Industries, Inc. and Mr. Kevin Longe dated September 12, 2002. 10.3 Separation Agreement by and between Electro Scientific Industries, Inc. and Mr. Brad Cooley dated February 24, 2003. 10.4 Separation Agreement by and between Electro Scientific Industries, Inc. and Mr. Gary Kapral dated June 11, 2003. 10.5 Change in Control Agreement by and between Electro Scientific Industries, Inc. and Mr. Bob Chamberlain dated January 16, 2003. 10.6 Change in Control Agreement by and between Electro Scientific Industries, Inc. and Mr. Jack Isselmann dated January 16, 2003. 10.7 Change in Control Agreement by and between Electro Scientific Industries, Inc. and Mr. Joe Reinhart dated January 16, 2003. 10.8 Change in Control Agreement by and between Electro Scientific Industries, Inc. and Mr. Ed Swenson dated January 16, 2003. 10.9 Change in Control Agreement by and between Electro Scientific Industries, Inc. and Mr. Keith Taft dated January 16, 2003. 10.10 Employment Agreement by and between Electro Scientific Industries, Inc. and Mr. Mike Dodson dated May 5, 2003. 99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K The following reports on Form 8-K were filed during the quarter ended March 1, 2003: -- Dated and filed December 16, 2002 pursuant to Item 5., "Other Events," regarding the appointment of James T. Dooley as President and Chief Executive Officer of the Company; -- Dated January 16, 2003 and filed January 22, 2003 pursuant to Item 5., "Other Events," regarding the approval by the Board of Directors for the Company to repurchase up to $50.0 million aggregate principal amount of the Company's 4 1/4% Convertible Subordinated Notes during 2003; -- Dated and filed February 18, 2003 pursuant to Item 5., "Other Events," regarding the Company's revenue expectations for its third fiscal quarter ending March 1, 2003; and -- Dated and filed February 18, 2003 pursuant to Item 5., "Other Events," regarding the appointment of Richard Okumoto as Vice President of Administration and Chief Financial Officer of the Company. 33 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed by the undersigned thereunto duly authorized. Dated: August 11, 2003 ELECTRO SCIENTIFIC INDUSTRIES, INC. By /s/ Barry L. Harmon Barry L. Harmon President and Chief Executive Officer (Principal Executive Officer) By /s/ J. Michael Dodson J. Michael Dodson Vice President of Administration and Chief Financial Officer (Principal Financial and Accounting Officer) 34 CERTIFICATION PURSUANT TO SECTION 302(a) OF THE SARBANES-OXLEY ACT OF 2002 I, Barry L. Harmon, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Electro Scientific Industries, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report fairly present, in all material respects, the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: August 11, 2003 /s/ Barry L. Harmon ----------------------- Barry L. Harmon President and Chief Executive Officer 35 CERTIFICATION PURSUANT TO SECTION 302(a) OF THE SARBANES-OXLEY ACT OF 2002 I, J. Michael Dodson, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Electro Scientific Industries, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements and other financial information included in this quarterly report fairly present, in all material respects, the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this amended quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: August 11, 2003 /s/ J. Michael Dodson --------------------------- J. Michael Dodson Vice President of Administration and Chief Financial Officer 36