UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended November 26, 2005

OR

For the transition period from         to        

Commission File Number:  0-12853

ELECTRO SCIENTIFIC INDUSTRIES, INC.

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 ý  No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes ý  No  o

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

The number of shares outstanding of the Registrant’s Common Stock at December 20, 2005 was 28,839,891 shares.

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

(In thousands)

(Unaudited)

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)

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)

The accompanying notes are an integral part of these statements.

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ELECTRO SCIENTIFIC INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

Note 1 - Basis of Presentation

These unaudited interim consolidated condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted in these interim statements.  Accordingly, these interim statements include all adjustments (consisting of only normal recurring adjustments and accruals) necessary for a fair presentation of results for the interim periods presented.  These consolidated condensed financial statements are to be read in conjunction with the financial statements and notes included in the Company’s Annual Report 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 are principally valued at standard costs, which approximate the lower of cost (on a first-in, first-out basis) or market.  Components of inventories were as follows (in thousands):

Note 3 — Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

See Note 4 for a discussion of the accrual for product warranty.

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Note 4 — Product Warranty

The Company evaluates obligations related to product warranties quarterly. A standard one-year warranty is provided on products. Warranty charges are comprised of costs to service the warranty, including labor to repair the system and replacement parts for defective items, as well as other costs incidental to the repairs.  Inventory credits resulting from the return of repaired parts to inventory and any cost recoveries from warranties offered by suppliers for defective components are recorded as a credit to the warranty accrual.  Using historical data, the Company estimates average warranty cost per system or part type and records the provision for such charges as an element of cost of goods sold.  Additionally, the overall warranty accrual balance is separately analyzed using the remaining warranty periods outstanding on systems and items under warranty, and any resulting changes in estimates are recorded as an adjustment to cost of sales.  If circumstances change, or if a material change in warranty-related incidents occurs, the estimate of the warranty accrual could change significantly.  Accrued product warranty is included on the balance sheet as a component of accrued liabilities.

Following is a reconciliation of the change in the aggregate accrual for product warranty for the six months ended November 26, 2005 and November 27, 2004 (in thousands):

Note 5 — Deferred Revenue

Revenue is deferred pending title transfer and fulfillment of acceptance criteria, which frequently occur at the time of delivery to a common carrier.  Shipments for which title transfer has not occurred and/or acceptance criteria cannot be demonstrated at the Company’s factory include sales to Japanese end-user customers and shipments of substantially new products.  In sales involving multiple element arrangements, the fair value of any undelivered elements, including installation services, is deferred until the elements are delivered and acceptance criteria are met.  Revenue related to maintenance and service contracts is deferred and recognized ratably over the duration of the contracts.

The following is a reconciliation of the changes in deferred revenue for the six months ended November 26, 2005 and November 27, 2004 (in thousands):

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Note 6 - Earnings Per Share

Following is a reconciliation of weighted average shares outstanding and adjustments to net income used in the calculation of basic and diluted earnings per share (EPS) for the three months and six months ended November 26, 2005 and November 27, 2004 (in thousands):

The following common stock equivalents were excluded from the diluted EPS calculations because inclusion would have had an antidilutive effect (in thousands):

Note 7 - Comprehensive Income

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

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Note 8 — Stock Based Compensation Plans

The Company has elected to use the intrinsic value method under APB No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation, subsequently amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, to account for stock options, stock bonuses, restricted stock, time-based restricted stock units or performance-based restricted stock units issued to its employees under its stock compensation plans, and amortizes deferred compensation, if any, ratably over the vesting period of the awards.

Compensation expense resulting from the issuance of fixed term stock option awards is measured as the difference between the exercise price of the option and the fair market value of the underlying share of company stock subject to the option on the measurement date, which is typically the award’s grant date.  Compensation expense, if any, is included in operating results over the vesting period of the underlying options using the straight-line method.  Compensation expense resulting from the issuance of time-based restricted stock and restricted stock units is calculated based on the fair market value on the date of grant and is included in operating results over the related vesting period using the straight line method.  Compensation expense resulting from the issuance of performance-based restricted stock units is recorded when performance is probable and can be reasonably estimated, and is calculated based upon current fair market values (adjusted each period) until such time as the number of units an employee is entitled to receive is fixed or determinable.  During the first half of fiscal 2006 and fiscal 2005, the Company recorded $0.9 million and $0.4 million, respectively, of compensation expense related to grants of restricted stock and restricted stock units on a pre-tax basis.  No compensation cost has been recognized for employee stock purchase plan (ESPP) shares which are issued at a fifteen percent discount of the lower of the market price on either the first day of the applicable offering period or the purchase date.

Pro forma fair value disclosures required by SFAS No. 123 are presented below and reflect the impact on net income and net income per share as if the fair value of stock-based awards to employees had been applied (in thousands, except per share data):

The Black-Scholes option pricing model is utilized to determine the fair value of stock options under SFAS No. 123. The following weighted average assumptions were made in calculating the value of all options granted during the periods presented:

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The following weighted average assumptions were made in calculating the value of all shares issued under the ESPP during the periods presented:

Note 9 — Legal Proceedings

On August 24, 2005, the Company executed a Provisional Attachment Order (the Attachment Order) issued by the Kaohsiung District Court of Taiwan (the Court) directed against All Ring Tech Co., Ltd. (All Ring) of Taiwan.  In its petition requesting the Attachment Order, the Company alleged that All Ring’s Capacitor Tester Model RK-T6600 (the Capacitor Tester) infringes the Company’s Taiwan Patent No. 207469, entitled “Circuit Component Handler” (the 207469 patent).  This patent corresponds to the Company’s U.S. Patent No. 5,842,579.  The patented technology is used in the Company’s Model 3340 Multifunction MLCC Tester. All Ring has filed a bond with the Court to obtain relief from the attachment of its assets.  The bond provides security to the Company with respect to its patent infringement claim against All Ring.

On September 19, 2005, the Court granted the Company’s petition for a Preliminary Injunction, and issued a Preliminary Injunction Order that prohibits All Ring from manufacturing, selling, offering for sale or using the Capacitor Tester, or importing the Capacitor Tester for any of these purposes, until final judgment is entered in the formal patent infringement action.  Pursuant to the Court’s Order, the Company was required to post with the Court a Taiwan dollar security bond of approximately US$6.8 million, which is included in Other Assets on the accompanying consolidated balance sheet at November 26, 2005.  The Court then executed the Preliminary Injunction Order in late October 2005.  All Ring appealed the Preliminary Injunction Order on November 1, 2005.  The Company intends to file an opposition to the appeal.  On November 10, 2005, All Ring filed a petition to post a counterbond to revoke the execution of the Preliminary Injunction Order. The Court granted the counterbond petition on December 14, 2005.  The Court’s order allows All Ring to obtain relief from the Preliminary Injunction Order if it posts a bond in the amount of approximately US$6.8million.

On October 27, 2005, the Company filed a formal patent infringement action against All Ring in the Court.  All Ring filed a defense brief responding to the complaint in late November 2005.

On November 18, 2005, All Ring filed a cancellation action against the Company’s 207469 patent in the Taiwan Intellectual Property Office (the IPO). The IPO has not yet served the Company with All Ring’s brief.

The Company intends to vigorously pursue its patent infringement claims against All Ring and defend against the cancellation action.

Note 10 - New Accounting Pronouncements

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In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (Revised 2004), Share-Based Payments. (SFAS 123R).  The scope of SFAS 123R includes a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans.  SFAS 123R replaces FASB Statement No. 123, Accounting for Stock-Based Compensation (SFAS 123), and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (Opinion 25). SFAS 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements and rescinds the ability of companies to elect the intrinsic value method prescribed under Opinion 25. That cost will be measured based on the fair value of the equity or liability instruments issued.  The Company will be required to implement SFAS 123R for the fiscal year beginning June 4, 2006. The Company has not completed its analysis of the impact of the adoption of SFAS 123R on its financial position or results of operations.

In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision with the American Jobs Creation Act of 2004.  FSP No. 109-2 provides guidance under SFAS No. 109, Accounting for Income Taxes, with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act) on enterprises’ income tax expense and deferred tax liability.  The Jobs Act was enacted on October 22, 2004.  FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. Accordingly, the Company will continue to analyze and assess its options under this provision.

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

Forward Looking Statements

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 make other forward-looking statements.  Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ as a result of many factors, including the risks described below under the heading “Factors That May Affect Future Results.”

Overview

Electro Scientific Industries, Inc. and its subsidiaries (ESI) provide high-technology manufacturing equipment to the global electronics market, including advanced laser systems that are used to microengineer electronic device features in high-volume production environments.  Our customers are primarily manufacturers of semiconductors, passive components and electronic interconnect devices.  Our equipment enables these manufacturers to achieve the yield and productivity gains in their manufacturing processes that can be critical to their profitability.  The components and devices manufactured by our customers are used in a wide variety of end products in the computer, consumer electronics and communications industries.

We supply advanced laser microengineering systems that allow electronics manufacturers to physically alter select device features during high-volume production in order to heighten performance and boost production yields of semiconductor devices, passive components and circuitry, high-density interconnect (HDI) circuit boards and advanced semiconductor packaging.  Laser microengineering comprises a set of precise fine-tuning processes (laser trimming, link cutting and via drilling) that require application-specific laser systems able to meet semiconductor and microelectronics manufacturers’ exacting performance and productivity requirements.

 Additionally, we produce high-speed test, inspection and termination equipment used in the high-volume production of multi-layer ceramic capacitors and other passive components, as well as original equipment manufacturer machine vision products.

During the first half of fiscal 2006 we experienced market demand for our products at slightly improved levels compared to the latter half of fiscal 2005.  Orders for the second half of fiscal 2005 were $91.8 million.  Order volume was $34.8 million in the first quarter of fiscal 2006 and increased to $64.9 million in the second quarter of fiscal 2006 for a total of $99.7 million.  The increase in the second quarter of fiscal 2005 was driven by a significant rise in semiconductor group orders and an increase in passive component group orders discussed below, offset by a decrease in electronic interconnect group orders.

With respect to our semiconductor group, orders in the second quarter of fiscal 2006 tripled from the order level in the previous quarter, partially due to the timing of certain large orders received early in the second quarter.  We experienced an increase in semiconductor group orders for our IR-based memory link-processing tools from multiple customers.  The first large volume order for our new UV-based tool was also received in the second quarter.  We anticipate continued strength in the memory repair area as our customers ramp their 90nm production capability and enjoy growth in higher density memory devices.

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The increase in orders also reflected a slight increase in passive component group orders, with customers reporting high levels of factory utilization, some of whom are exceeding 90% utilization.  Many manufacturers continue to be cautious before placing equipment orders During the quarter, we also received orders from Japanese customers for our electrical test and visual test solutions.  We hope to build on these successes to achieve greater market penetration in Japan.

Shipments were $48.8 million in the second quarter of fiscal 2006, representing a 9.5% increase from shipments of $44.6 million in the first quarter of fiscal 2006.  Deferred revenue remained essentially unchanged at the end of the first and second quarters of fiscal 2006 at approximately $13 million. Accordingly, net sales for the second quarter were $48.6 million, increasing 9.3% from $44.5 million for the first quarter of fiscal 2006.

Gross margin on second quarter sales of $48.6 million was 43.5%, representing a slight decrease from the prior quarter margin of 44.1%, on sales of $44.5 million.  The margin impact from the sale of previous generation EIG product was partially offset by favorable overhead absorption on increased production levels. Third quarter shipments and net sales are currently estimated to be in the range of $50 million to $60 million and related gross margins are expected to be in the mid-40s.

Operating expenses were $19.3 million for the second quarter compared to $18.9 million in the first quarter of fiscal 2006.  We anticipate operating expenses to increase in the third quarter of fiscal 2006 by approximately $1 million as we increase our investment in research and development.

Net other income was $2.3 million in the second quarter of fiscal 2006, compared to net other income of $1.2 million in the first quarter of fiscal 2006.  The increase is attributed to a $0.7 million interest payment received on an income tax refund and increasing yields on our investment portfolio.

The income tax provision recorded for the second quarter of fiscal 2006 was $0.9 million on pretax income of $4.1 million, compared to $0.6 million on pretax income of $2.0 million for the first quarter of 2006. The effective tax rate in the second quarter of fiscal 2006 was 22% compared to 32% in the first quarter of fiscal 2006.  Included in the rate this quarter is a benefit for state tax refunds resulting from the settlement of our IRS examinations as well as a benefit from an adjustment to our accrued taxes on foreign earnings.  These benefits were offset by an increase in the valuation allowance on state tax operating loss carryforwards resulting from a change in state tax laws during the quarter.  The effective tax rate for the third quarter of fiscal 2006 is expected to be approximately 20%.

Net income for the second quarter of fiscal 2006 was $3.2 million or $0.11 per share on a basic and fully diluted basis, compared to $1.3 million, or $0.05 per share on a basic and fully diluted basis for the first quarter of fiscal 2006.

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Results of Operations

The following table sets forth results of operations data as a percentage of net sales.

Net Sales

Certain information regarding our net sales by product group is as follows (net sales in thousands):

Net sales were $48.6 million for the quarter ended November 26, 2005, a decrease of $17.4 million or 26.3% compared to $66.0 million for the quarter ended November 27, 2004.  Sales decreased $10.4 million or 29.2% for SG, $6.0 million or 33.1% for PCG and $1.0 million or 8.0% for EIG, compared to the same period in the prior year.

The sales decreases in SG are attributed primarily to a decrease in system sales volumes.   Net sales in the second quarter of the prior year included higher volumes of memory repair product sales driven by DRAM manufacturer capacity requirements. SG net sales in the fourth quarter of 2004 were $54.1 million followed by sequential volume decreases continuing throughout fiscal 2005 and fiscal 2006 to date. This decreasing capital investment trend is consistent with the trend in the overall semiconductor market compared to the prior year.  SG net sales amounts have ranged between $25 and $30 million over the four most recent quarters.

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The decrease in second quarter fiscal 2006 PCG sales compared to the same quarter in the prior year is due to continuing caution by component manufacturers, who are evaluating the sustainability of utilization rates before placing equipment orders. In the first quarter of the prior year, PCG sales reached a four-quarter peak, driven by demand for passive components processed by our laser trim and passive test systems.   PCG net sales have ranged between approximately $10 million and $12 million for the four most recent quarters.

EIG sales levels decreased compared to the same quarter in the prior year as a result of industry softness.  Sales in the second quarter of fiscal 2006 increased over the first quarter of fiscal 2006 due to customer acceptances received on interconnect package drilling systems and upgrades that were included in deferred revenue at the beginning of the fiscal year, as well as higher volume shipments of other drilling systems.  EIG net sales have ranged from approximately $6 million to $7 million for the three most recent fiscal quarters and are approximately $11 million in the current quarter.

Net sales were $93.2 million for the six months ended November 26, 2005, a decrease of $45.4 million or 32.8% compared to $138.6 million for the six months ended November 27, 2004.  Of the decrease, $26.5 million resulted from decreased sales in the SG product lines, $15.5 million resulted from decreased PCG sales and $3.4 million resulted from decreased EIG sales.  The fiscal year-to-date net sales decreases compared to the same period in fiscal 2005 are the result of peak sales cycles experienced in early fiscal 2005.

Net sales by geographic region were as follows (net sales in thousands):

Total net sales in the second quarter of fiscal 2006 to Asia, the United States and Europe decreased $7.2 million, $4.9 million and $5.2 million, respectively, compared to the same quarter in the prior fiscal year consistent with the market trends described above.  Asian sales as a percentage of total net sales increased in the second quarter of fiscal 2006 compared to the same period in the prior year due to product acceptances received from EIG customers in Taiwan and PCG customers in Japan.  For the six months ended November 26, 2005, compared to the six months ended November 27, 2004, sales by region were consistently weighted to Asia.

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Gross Profit

Gross profit was $21.2 million (43.5% of net sales) for the second quarter of fiscal 2006 compared to $32.8 million (49.7% of net sales) for the second quarter of fiscal 2005.  Shipments in the second quarter of fiscal 2006 decreased 16.0% compared to the same quarter in fiscal 2005.  Decreased shipment levels resulted in lower volume-based manufacturing efficiencies and reduced overhead absorption resulting in higher costs per unit.  Additionally, the second quarter of fiscal 2006 reflects an unfavorable margin impact from the sale of previous generation EIG product.

Gross profit for the six month period ended November 26, 2005 was $40.8 million (or 43.8% of net sales) compared to $69.7 million (or 50.3% of net sales) for the same six month period in the prior fiscal year.  This represents a 6.5% decline in gross margin rates, which can be attributed to the same factors described in the quarterly comparisons above.  In particular, shipments of $93.4 million in the first six months of fiscal 2006 were approximately 31.3% lower than shipments of $136.0 for the same six months in fiscal 2005.

Operating Expenses

Selling, Service and Administrative Expenses

The primary items included in selling, service and administrative expenses are employee compensation and other related expenses, travel expenses, professional fees and facilities costs. Selling, service and administrative expenses were $11.4 million (23.4% of net sales) in the second quarter of fiscal 2006, a decrease of $3.9 million compared to $15.3 million (23.2% of net sales) in the second quarter of fiscal 2005.

The second quarter of fiscal 2005 includes $0.4 million in special charges for professional fees related to the 2003 audit committee investigation and securities litigation and $2.2 million related to a patent litigation settlement.  Exclusive of these special charges, selling, service and administrative expenses decreased $1.4 million in the second quarter of fiscal 2006 compared to the second quarter of fiscal 2005 and decreased $4.8 million in the six months ended November 26, 2005 compared to the same period in the prior year.  The decrease is primarily due to a reduction in payroll and related costs resulting from restructuring and other cost containment initiatives implemented in the third quarter of fiscal 2005.  Additionally, commission expenses decreased due to the reduction in revenue compared to the second quarter of fiscal 2005.  These savings were partially offset by increases in spending related to the enterprise resource planning system implementation project.

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Research, Development and Engineering Expenses