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ELECTRO SCIENTIFIC INDUSTRIES INC
10-Q, 2000-10-16
MISCELLANEOUS ELECTRICAL MACHINERY, EQUIPMENT & SUPPLIES

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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FORM 10-Q

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

For the quarterly period ended September 2, 2000

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

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ELECTRO SCIENTIFIC INDUSTRIES, INC.

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

(503) 641-4141

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    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 / /

    As of September 2, 2000 there were 26,924,787 shares of Common Stock of Electro Scientific Industries, Inc. outstanding.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

EXHIBIT INDEX

				Page No.
Part I.		Financial Information
Item 1.		Consolidated Financial Statements (Unaudited)
		Consolidated Balance Sheets September 2, 2000 and June 3, 2000*		3-4
		Consolidated Statements of Income Three Months ended September 2, 2000 and August 31, 1999		5
		Consolidated Statements of Cash Flows Three Months ended September 2, 2000 and August 31, 1999		6
		Notes to Consolidated Financial Statements		7-9
Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations		10-13
Part II.		Other Information
Item 1.		Legal Proceedings		14
Item 6.		Exhibits and Reports on Form 8-K		14
		Signature		15

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*

Audited

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands except per share data)

					September 2, 2000*			June 3, 2000
ASSETS
CURRENT ASSETS:
	Cash and cash equivalents				$	48,093		$	34,876
	Securities available for sale					77,422			63,522
	Trade receivables, net					77,055			73,346
	Inventory					64,663			56,334
	Deferred income taxes					8,171			8,171
	Other current assets					2,200			3,625
			Total current assets			277,604			239,874
PROPERTY AND EQUIPMENT, AT COST						78,942			79,161
	Less—Accumulated depreciation					(41,364	)		(43,144	)
			Net property and equipment			37,578			36,017
OTHER ASSETS						14,299			15,750
Total Assets					$	329,481		$	291,641

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*

Unaudited

The accompanying notes are an integral part of these statements.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands except per share data)

					September 2, 2000*			June 3, 2000
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
	Accounts payable				$	16,945		$	13,061
	Accrued liabilities:
		Payroll related				13,279			13,820
		Commissions				4,130			3,214
		Warranty				2,960			2,513
		Income Taxes Payable				8,233			—
		Other				2,487			1,798
			Total accrued liabilities			31,089			21,345
	Deferred revenue					2,294			668
Total current liabilities						50,328			35,074
Deferred income taxes						426			426
TOTAL LIABILITIES:					$	50,754		$	35,500
SHAREHOLDERS' EQUITY:
	Preferred stock, without par value; 1,000 shares authorized; no shares issued					—			—
	Common stock, without par value; Authorized: 40,000 shares; Outstanding: 26,925, and 26,855 respectively					120,570			120,140
	Retained earnings					160,700			137,405
	Accumulated other comprehensive loss					(2,543	)		(1,404	)
			Total shareholders' equity			278,727			256,141
	Total liabilities and shareholders' equity				$	329,481		$	291,641

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*

Unaudited

The accompanying notes are an integral part of these statements.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(in thousands except per share data)

				Three Months Ended* September 2, 2000			Three Months Ended* August 31, 1999
Net sales				$	128,532		$	58,974
Cost of sales					53,700			28,353
	Gross margin				74,832			30,621
Operating expenses:
	Selling, service and administrative				29,124			16,319
	Research, development and engineering				11,750			7,482
		Total operating expenses			40,874			23,801
Operating income					33,958			6,820
Interest income					1,803			257
Other income (expense), net					76			(40	)
Income before income taxes					35,837			7,037
Provision for income taxes					12,542			2,252
Net income				$	23,295		$	4,785
Net income per share:
	Basic			$	0.87		$	0.18
	Diluted			$	0.83		$	0.18
Weighted average number of shares:
	Basic				26,870			26,118
	Diluted				27,971			26,770

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*

Unaudited

The accompanying notes are an integral part of these statements.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands except per share data)

				Three Months Ended
				September 2, 2000*			August 31, 1999*
Cash Flows From Operating Activities:
Net income				$	23,295		$	4,785
Adjustments to reconcile net income to cash provided by (used in) operating activities:
	Depreciation and amortization				2,325			2,141
	Deferred Income Taxes				—			(1,200	)
Changes in operating accounts:
	(Increase) decrease in trade receivables				(5,034	)		2,773
	Increase in inventories				(8,903	)		(226	)
	Decrease in other current assets				1,425			2,786
	Increase in current liabilities				15,422			226
Net cash provided by operating activities:					28,530			11,285
Cash Flows From Investing Activities:
Purchases of property and equipment					(3,567	)		(1,362	)
Purchase of securities					(16,774	)		(5,552	)
Proceeds from sales of securities and maturing securities					2,944			7,057
(Increase) decrease in other assets					1,654			(369	)
Net cash used in investing activities:					(15,743	)		(226	)
Cash Flows From Financing Activities:
Proceeds from exercise of stock options and stock plans					430			1,272
Net cash, provided by financing activities:					430			1,272
Net Change in Cash and Cash Equivalents					13,217			12,331
Cash and Cash Equivalents at Beginning of Period					34,876			7,793
Cash and Cash Equivalents at End of Period				$	48,093		$	20,124

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*

Unaudited

    Cash payments for interest were not significant for the three months ended September 2, 2000 and August 31, 1999. Cash payments for income taxes were $1,726 and $562 for the three months ended September 2, 2000 and August 31, 1999, respectively.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands except per share data)

(Unaudited)

Note 1—Basis of Presentation

    The condensed consolidated financial statements included herein have been prepared by the Company, 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 generally accepted accounting principles have been condensed or omitted in these interim statements. Management believes that the interim statements include all adjustments (consisting of only normal recurring accruals) necessary for a fair presentation of results for the interim periods. It is suggested that these condensed consolidated financial statements be read in conjunction with the financial statements and notes thereto included in the Company's 2000 Annual Report filed on Form 10-K.

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

Note 2—Inventories

    Inventories consist of the following:

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*

Audited

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Note 3—Net Income Per Share

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

    For purposes of computing diluted earnings per share, weighted average common share equivalents do not include the following stock options because inclusion would have an anti-dilutive effect on the earnings per share calculation.

Note 4—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.

Note 5—New Accounting Pronouncements

Revenue Recognition

    The Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial Statements," in December 1999. SAB 101 provides guidance for applying Generally Accepted Accounting Principles (GAAP) to revenue recognition in financial statements filed with the SEC. Specifically, SAB 101 addresses recognizing revenue upon installation and acceptance versus shipment. The Company generally recognizes revenue upon shipment. The Company will be required to adopt SAB 101 in the fourth fiscal quarter of 2001. Management has not yet determined the potential effect of the implementation of SAB 101 on the Company's financial

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condition or results of operations. Since the implementation of SAB 101 could result in changes to the timing of the Company's revenue recognition, its effect could be material and adverse to the Company's financial condition and results of operations in the period of implementation.

Hedging Activities

    The Financial Accounting Standards Board issued "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133), in June 1998. SFAS 133 requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. The change in the derivative's fair value related to the ineffective portion of a hedge, if any, will be immediately recognized in earnings. The Company expects to adopt this Standard as of the beginning of its fiscal year 2002. The effect of adopting this standard is currently being evaluated, but is not expected to have a material effect on the Company's financial position or its results of operations.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

MANAGEMENT DISCUSSION AND ANALYSIS

Results of Operations

    Revenue of $128.5 million for the quarter ended September 2, 2000, was $69.6 million or 118.0% higher than in the first quarter of fiscal 2000, and $19.6 million or 18.0% higher than in the quarter ended June 3, 2000. All product lines experienced higher sales volume in comparison to the same quarter of the prior year. Electronic component manufacturing systems made up the largest percentage of sales for the quarter at 46.6% of total revenues versus 29.5% in the same quarter of the prior year. Sales of semiconductor yield improvement systems, electronic component manufacturing systems, circuit fine tuning systems, and vision inspection systems increased in comparison to the quarter ended June 3, 2000, and were partially offset by a decrease in advanced electronic packaging equipment. Electronic component manufacturing systems sales showed the greatest increase with $59.9 million in revenue for the current quarter and $47.5 million for the quarter ended June 3, 2000.

    Gross margin for the three months ended September 2, 2000 increased, to 58.2% from 51.9% for the first quarter of the prior fiscal year. Higher margins were the result of favorable absorption of manufacturing costs associated with higher volume, cost reduction efforts on certain product lines, and favorable product mix. Gross margin for the current period increased from 55.8% for the quarter ended June 3, 2000, due to the same factors.

    Selling, service and administrative expenses for the three months ended September 2, 2000 were $12.8 million higher than for the first quarter of fiscal 2000, but decreased as a percentage of sales from 27.7% to 22.7%. A higher sales volume in the current quarter resulted in increased bonus accrual and commission expense. Expenses for sales, services and administration were up from the prior quarter as increased sales volume resulted in higher commissions, and as the result of a payroll expense increase associated with annual salary reviews.

    Expenses associated with research, development and engineering for the three months ended September 2, 2000, increased from both the first quarter of fiscal 2000 and the fourth quarter of fiscal 2000. The $4.3 million increase over the first quarter, prior year, is attributable to higher spending on project material and increased payroll and bonus expense. R&D expenses increased $1.1 million over the prior quarter, due to higher levels of spending on material and labor for engineering projects. R&D spending typically fluctuates from quarter to quarter as engineering projects move through their life cycles.

    Interest income for the quarter was up substantially over the same quarter in the prior year due mainly to an increase in cash invested related to both an increase in sales and a decrease in the time between shipping product and collecting cash from our customers.

    The income tax rate increased from 32% to 35% for the three months ended August 31, 1999 and September 2, 2000, respectively. This increase is due mainly to anticipated reduction of benefits related to the FSC.

    Net income for the quarter ended September 2, 2000 was $23.3 million or $0.87 per basic share. This represents an increase of 386.8% over the first quarter of fiscal 2000, when earnings were $4.8 million or $0.18 per basic share.

    As market conditions continued to improve, ending backlog as of September 2, 2000 increased to $196.9 million as compared to $168.7 million as of June 3, 2000, and $39.0 million as of August 31, 1999.

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Financial Condition, Liquidity, and Capital Resources

    The Company's principal sources of liquidity are existing cash and cash equivalents and marketable debt securities of $125.5 million, accounts receivable of $77.1 million, and a $7.0 million line of credit, none of which was outstanding at September 2, 2000. Accounts receivable at September 2, 2000 was slightly higher than at June 3, 2000, due to higher revenues. ESI has a current ratio of 5.5:1 and no long-term debt. Working capital increased to $227.3 million at September 2, 2000 vs. $204.8 million at June 3, 2000. Inventory increased by $8.3 million as compared to the June 3, 2000 level. A decrease in finished goods was partially offset by increases in raw materials and work in process inventory, in support of higher manufacturing volumes.

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 involve a number of risks and uncertainties. From time to time the Company 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. Factors that may result in such variances include, but are not limited to, the following:

Industry Volatility

    The Company's business depends in large part upon the capital expenditures of manufacturers of electronic devices, including miniature capacitors, semiconductor memory devices and circuits used in wireless communications equipment, including pagers and wireless phones, automotive electronics and computers. The markets for products manufactured by the Company's customers are cyclical and have historically experienced periodic downturns, which have had a negative effect on the demand for capital equipment such as that sold by the Company.

Customer Concentration

    Ten large multinational electronics companies constituted 39.7% of the Company's fiscal 2000 sales and are expected to comprise a similar ratio in fiscal 2001. The loss of any of these customers would be significant.

Technological Change and Competition

    The market for the Company's products is characterized by rapidly changing technology and evolving industry standards. The Company believes that its future success will depend on its ability to develop and manufacture new products and product enhancements, and to introduce them successfully into the market. Failure to do so in a timely fashion could harm the Company's competitive position. The announcements or introductions of new products by the Company or its competitors may adversely affect the Company's operating results, since these announcements may cause customers to defer ordering products from the Company's existing product lines.

International Trade and Economic Conditions

    International shipments have accounted for 76% of year-to-date sales for fiscal 2001 as compared to 72% for the fiscal year 2000. The Company expects that international shipments will continue to represent a significant percentage of net sales in the future. Because of our significant dependence on

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international revenues, a continued or additional decline in the economies of any of the countries in which we do business would negatively affect our operating results. Other risks involved with international trade include changes in demand resulting from fluctuations in interest and currency exchange rates, as well as factors such as government financed competition, changes in trade policies, availability and cost of transporation, tariff regulations, difficulties in obtaining United States export licenses and the difficulties of staffing and managing foreign operations.

    Most of the Company's sales are transacted in dollars and the Company's products are made in the United States. Many Japanese customers pay in yen; therefore, ESI hedges these sales transactions to mitigate currency risk. The European and Asian sales subsidiaries' operating expenses are denominated in their respective local currencies. These transactions represent approximately 9.0% of consolidated operating expenses and are split 38% and 62%, respectively, between Europe and Asia. Changes in the value of the local currency, as measured in US dollars, will commensurately increase or decrease operating expenses.

Euro Conversion

    The Company's information technology systems will allow for transactions to take place in both local currencies and the Euro, with the eventual elimination of the local currency. The Company will continue to evaluate the impact over time of the introduction of the Euro. However, the Company does not believe that the introduction of the Euro has or will have a material adverse affect on our results of operations.

Foreign Sales Corporation Benefit

    In February 2000, the World Trade Organization (WTO) ruled that Foreign Sales Corporations (FSC) provisions violated U.S. obligations under the General Agreement on Tariffs and Trade (GATT). As a result, the Company is required to discontinue use of its FSC by October 1, 2000. The Company is currently studying the effects of this ruling on its financial statements. Legislation for an alternative to the FSC may be forthcoming. Without any alternative, the Company believes that the WTO ruling will increase its effective tax rate and have a material effect on its financial statements.

Acquisitions

    The Company has made, and may in the future make, acquisitions of, or significant investments in, businesses with complementary products, services and/or technologies. Acquisitions involve numerous risks, including management assimilation and costs in connection with integration of the operations, technologies, and products of the acquired companies, possible impairment of acquired intangible assets, and the potential loss of key employees of the acquired companies. In addition, the Financial Accounting Standards Board has indicated that they plan to disallow 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, and may alter the Company's acquisition strategy. The inability to manage these risks effectively could materially affect the Company's financial condition and results of operations.

Key Suppliers

    The Company uses numerous vendors to supply materials used in production. Although the Company makes 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. If the Company does not

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receive parts for production in a timely and cost effective manner, there can be no assurance that the Company's results of operations will not be materially and adversely affected.

Manufacturing Delays or Interruptions

    The Company depends on manufacturing flexibility to meet the changing demands of its customers. Any significant delay or interruption of manufacturing operations as a result of software deficiencies, natural disasters, and other causes, could result in ineffective manufacturing capabilities or delayed product deliveries. Any or all of which could materially and adversely affect the Company's results of operations and financial condition.

Patent Infringement

    Our business is characterized by continual technological change, with frequent introductions of new products and technologies. As a result, companies often design and develop similar products to those introduced by others, increasing the risk that their products and processes may give rise to claims that they infringe on the intellectual property rights of others. This inherent risk of infringement could cause the Company to incur significant litigation costs or other expenses.

Stock Market Volatility

    ESI believes that it has product offerings and resources needed for continued success. Future revenue and margin trends cannot be reliably predicted and may cause the Company to adjust its operations. Factors external to the Company can result in volatility of the Company's common stock price. Because of these factors, recent trends should not be considered reliable indicators of future stock prices or financial results.

Item 3. Market Risk Disclosure

Interest Rate Risk

    As of September 2, 2000, the Company's investment portfolio includes marketable debt securities of $77.4 million. These securities are subject to interest rate risk, and will decline in value if interest rates increase. These securities are classified as Securities Available for Sale; therefore, the impact of interest rate changes is reflected as a separate component of shareholder's equity. Due to the short duration of the Company's investment portfolio, an immediate 10% increase in interest rates would not have a material effect on the Company's financial condition.

Foreign Currency Exchange Rate Risk

    The Company has limited involvement with derivative financial instruments and does not use them for trading purposes. Derivatives are used to manage well-defined foreign currency risks. The Company enters 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 the Company's financial position or the results of its operations.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

Part II Other Information

Item 1. Legal Proceedings

    ESI initiated litigation against Dynamic Details, Inc. and GSI Lumonics, Inc. for patent infringement in March 2000 in the U.S. District Court for the Central District of California (Electro Scientific Industries v. Dynamic Details, Inc. and GSI Lumonics, Inc., No. SACV00-272 AHS (ANX)). The complaint alleges that Dynamic Details and GSI Lumonics are violating ESI's U.S. patent 5,847,960 entitled "Multi-tool Positioning System". The complaint alleges that Dynamic Details infringes ESI's patent 5,847,960 and that GSI Lumonics has actively induced infringement of, and contributorily infringed, ESI's patent 5,847,960. The complaint seeks injunctive relief and monetary damages. Dynamic Details, Inc. and GSI Lumonics, Inc. have filed a counterclaim for a declaratory judgment of non-infringement and invalidity of ESI's patent 5,847,960.

    ESI initiated litigation against General Scanning Inc. for patent infringement in December 1996 in the U.S District Court for the Northern District of California (Electro Scientific Industries, Inc. v. General Scanning, Inc. No. C-96-4268 SBA). On April 2, 1999, a federal court jury issued a verdict upholding the validity of ESI's link blowing patent, U.S. patent 5,265,114 entitled "System and Method for Selectively Laser Processing a Target Structure of One or More Materials of a Multimaterial, Multilayer Device". The jury found ESI's U.S. patent 5,473,624 entitled "Laser System and Method for Selectively Severing Links" invalid for reasons of obviousness. On April 8, 1999, the same federal court jury awarded ESI $13.1 million in damages, and also concluded that General Scanning's infringement was willful. On July 8, 1999 the court issued orders denying General Scanning's motions for a new trial and to set aside the jury verdict. The court also entered a permanent injunction prohibiting General Scanning from making, using, selling, or offering for sale in the United States memory repair systems and upgrade kits equipped with 1.3 micron lasers. General Scanning has filed an appeal of the U.S. District Court judgment with the U.S. Court of Appeals for the Federal Circuit. ESI has not reflected the $13.1 million award in its financial results. Separately, the U.S. Patent and Trademark Office has issued an order granting a request by General Scanning to re-examine ESI's patent 5,265,114. On July 27, 2000 the Patent Office issued a non-final first office action in its re-examination of ESI's patent 5,265,114. The action by the Patent Office states that some of the claims of the 5,265,114 patent are unpatentable. ESI has responded to the action under Patent Office procedures and its response asserts the basis for the patentability of the claims. ESI continues to record legal expenses related to this litigation and the Patent Office action as these expenses are incurred.

    Numerous users of the Company's products have received notice of patent infringement from the Lemelson Medical, Educational & Research Foundation Limited Partnership ("Partnership") alleging that their use of the Company's products infringes certain patents transferred to the Partnership by the late Jerome H. Lemelson. Certain of these users have notified the Company that, in the event it is subsequently determined that their use of the Company's products infringes any of the Partnership's patents, they may seek indemnification from the Company for damages or expenses resulting from this matter.

Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits

3.

Articles of Amendment of the Third Restated Articles of Incorporation of the Company.

27.

Financial Data Schedule

(b)

Report on Form 8-K.

No reports on Form 8-K were filed by the Company during the quarter ended September 2, 2000.

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SIGNATURES

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

		ELECTRO SCIENTIFIC INDUSTRIES, INC.
Dated: October 16, 2000		By:		/s/ JAMES T. DOOLEY    James T. Dooley, Vice President and Chief Financial Officer

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