Overview of Business

Electro Scientific Industries, Inc. and its subsidiaries (ESI) provide high-technology manufacturing equipment to the global semiconductor and micro-electronics markets, including advanced laser systems that are used to micro-engineer electronic device features in high-volume production environments. Our customers are primarily manufacturers of semiconductors, passive components, electronic interconnect devices, and other components used in a wide variety of end products in the computer, consumer electronics, communications and other industries. Our equipment enables these manufacturers to achieve yield and productivity gains in their manufacturing processes that can be critical to their profitability. ESI was founded in 1944 and is headquartered in Portland, Oregon.

Our advanced laser microengineering and testing systems allow semiconductor and micro-electronics manufacturers to physically alter select device features during high-volume production in order to heighten performance and boost production yields. Laser micro-engineering comprises a set of precise fine-tuning processes, including micro-machining, wafer scribing and dicing, semiconductor memory-link cutting, device trimming and via drilling, that requires application-specific laser systems able to meet our customers' exacting performance and productivity requirements. Our laser-based systems improve production yields or enable improved performance during the manufacturing process for semiconductor devices, high-density interconnect (HDI) circuits, including flexible interconnect material and advanced semiconductor packaging, high-brightness light emitting diodes (LED), flat panel liquid crystal displays (LCD) and general micro-machining applications.

Additionally, we produce high-capacity test and optical inspection equipment that is critical to the quality control process during the production of multi-layer ceramic capacitors (MLCCs). Our equipment ensures that each MLCC meets both the electrical and physical tolerances required to perform properly.

Change in Fiscal Reporting Periods

During fiscal 2008, the Board of Directors approved a change in our reporting periods that results in a fiscal year end on the Saturday nearest March 31. Accordingly, year-to-date information for the period ended March 29, 2008 (fiscal 2008) consists of the ten months beginning June 3, 2007 and ending March 29, 2008. The current fiscal year financial statements are presented for the twelve months ended March 28, 2009, which represents fiscal 2009.

In addition, as discussed in Note 4 "Comparative Consolidated Statements of Operations (Unaudited)", the Company provided pro forma results for the twelve months ended March 29, 2008 for comparative purposes. All references to years or quarters relate to fiscal years or fiscal quarters unless otherwise noted.

Acquisition of New Wave Research, Incorporated

On July 20, 2007, we acquired New Wave Research, Incorporated (NWR), a privately-held company headquartered in Fremont, California. NWR is a global leader in the development of high-end lasers and laser-based systems and its products are used in a variety of applications including sapphire wafer scribing, flat-panel display repair and semiconductor failure analysis, among other applications. The acquisition was an investment aimed at leveraging our combined core competencies into adjacent markets and driving revenue growth and shareholder value.

We acquired 100% of NWR's outstanding common stock for approximately $36.2 million, comprised of $34.9 million in cash and $1.3 million of merger-related transaction costs. The contractual purchase price of $36.0 million was reduced by $1.1 million related to certain net working capital adjustments and indemnity payments agreed upon prior to closing. The results for fiscal 2008 include the results of our NWR division from the date of acquisition forward.

Purchase accounting expenses recorded during the fiscal year ended March 28, 2009 and ten-month fiscal year ended March 29, 2008 were as follows:

          (In thousands)                                    2009      2008
          Cost of sales                                    $ 1,157   $ 1,946
          Selling, service and administration                1,175     1,445
          Write-off of in-process research & development        -      2,800

                                                           $ 2,332   $ 6,191

Purchase accounting expenses recorded in cost of sales were primarily related to the fair value adjustments to acquired inventory and amortization of acquired intangibles. Purchase accounting expenses included in operating expenses for 2009 reflect amortization of acquired intangibles, and for 2008 also reflect adjustments to the depreciable value of property, plant & equipment and the write-off of $2.8 million of in-process research & development. See further discussion of in-process research & development below.

Overview of Financial Results

Due to the change in our fiscal reporting periods discussed above, within the following analyses, we have presented supplemental comparisons of the twelve months ended March 28, 2009 to a pro forma twelve-month period ended March 29, 2008. Necessary estimates were made for certain items in order to create the pro forma twelve-month statement of operations for 2008. See Note 4 "Comparative Consolidated Statements of Operations (Unaudited)" of the Notes to the Consolidated Financial Statements in Item 8 Financial Statements and Supplementary Data for further discussion.

The financial results of fiscal 2009 reflected the extremely difficult global economic environment. The global downturn depressed our customers' product output and thus their need for new production equipment. In addition to the impact of weak memory prices and the financial crisis, consumer demand softened throughout the year. The weak consumer product market further reduced the capacity requirements of our customers, constraining their profitability and their capital spending. As a result, our total order volume of $129.2 million in fiscal 2009 decreased 42% compared to orders of $224.4 million in fiscal 2008.

Orders for our Semiconductor Group (SG) products during 2009 decreased by approximately 69% and 74% compared to fiscal 2008 and the pro forma twelve months ended March 29, 2008, respectively. The primary driver of this decrease was weak demand by our memory customers.

Orders for our Passive Components Group (PCG) products during 2009 decreased by approximately 69% and 74% compared to fiscal 2008 and the pro forma twelve months ended March 29, 2008, respectively. These decreases reflect depressed demand for our electrical and optical test systems due to the economic recession which significantly impacted capacity utilization of our customers.

In contrast, orders for our Interconnect/Micro-machining Group (IMG) products during 2009 increased by approximately 31% and 5% compared to fiscal 2008 and the pro forma twelve months ended March 29, 2008, respectively. The strong growth in orders was due to penetration of new applications for our micro-machining products and solid demand for our via drilling and laser ablation products.

Fiscal 2009 shipments were $156.0 million compared to $306.3 million for the pro forma twelve months ended March 29, 2008. SG and PCG shipments decreased approximately 71% and 65%, respectively, while IMG shipments increased 16%, again compared to the pro forma twelve months ended March 29, 2008. Backlog was $16.8 million as of March 28, 2009 compared to $42.1 million as of March 29, 2008, representing a decrease of 60%. These trends reflect the economic and operational factors discussed above.

Gross margins were 37.1% on net sales of $157.3 million in 2009 compared to 45.4% on net sales of $247.2 million in fiscal 2008. The decrease in gross margin percentage primarily reflects the impact of lower sales volume.

Net operating expenses of $112.7 million in 2009 increased $20.6 million from $92.1 million in fiscal 2008. Compared to the pro forma twelve-month fiscal 2008, operating expenses in 2009 increased $4.9 million from $107.8 million. This increase in 2009 was primarily due to $17.4 million of goodwill impairment charges, a $4.1 million write-off of materials from an RD&E program due to a change in our product development strategy, $1.9 million of merger transaction costs, and $3.0 million higher restructuring costs than in 2008. Excluding these expenses, fiscal 2009 operating expenses declined $5.8 million compared to fiscal 2008 and $21.5 million compared to the pro forma twelve months ended March 29, 2008, reflecting restructuring actions and cost containment efforts taken during 2009.

Operating loss was $54.3 million in fiscal 2009 compared to operating income of $20.0 million in fiscal 2008, a reduction of $74.3 million. On a pro forma basis, operating income decreased approximately $87.8 million from $33.6 million for the pro forma twelve months ended March 29, 2008. These results reflect the impact of greatly reduced revenue levels driven by the overall economic environment along with the significant goodwill impairment charge in fiscal 2009 and other increased expense items discussed above. Non-operating expense for 2009 of $10.4 million was driven by $13.6 million of other-than-temporary impairment charges related to our auction rate investments. Additionally, interest and other income of $3.2 million in 2009 decreased by $3.3 million compared to fiscal 2008, primarily reflecting market-driven decreases in investment yields. Net loss was $51.0 million in 2009 compared to net income of $16.6 million in fiscal 2008, a decrease of $67.6 million. On a pro forma basis, the decrease was $76.9 million. These decreases reflect the impact of the items discussed above.

Looking forward, we expect to see continued weakness in the overall semiconductor memory capital equipment market and cautious spending in our other markets related to the global economic recession. The timing of a recovery in our markets is uncertain.

Results of Operations

The following table sets forth results of operations data as a percentage of net sales for the fiscal year ended March 28, 2009, the ten-month fiscal year ended March 29, 2008 and the fiscal year ended June 2, 2007:

                                                        2009          2008         2007
Net sales                                               100.0 %       100.0 %      100.0 %
Cost of sales                                            62.9          54.6         56.6

Gross margin                                             37.1          45.4         43.4
Selling, service and administration                      32.6          21.2         19.6
Research, development and engineering                    24.3          14.6         15.0
Goodwill impairment                                      11.1            -            -
Restructuring costs                                       2.5           0.4           -
Merger transaction costs                                  1.2            -            -
Write-off of in-process research & development             -            1.1           -
Insurance recoveries                                       -             -          (0.9 )

Operating (loss) income                                 (34.6 )         8.1          9.7
Other-than-temporary impairment of auction rate
investments                                              (8.6 )          -            -
Interest and other income, net                            2.0           2.6          4.1

(Loss) income before income taxes                       (41.2 )        10.7         13.8
(Benefit from) provision for income taxes                (8.7 )         4.0          4.4

Net (loss) income                                       (32.5 )%        6.7 %        9.4 %

Twelve Months Ended March 28, 2009 Compared to Ten Months and Pro Forma Twelve
Months Ended March 29, 2008

Net Sales

The following table presents net sales for the fiscal year ended March 28, 2009,
the ten-month fiscal year ended March 29, 2008, and the pro forma twelve months
ended March 29, 2008:



                                                                                    Ten months ended                 Pro forma twelve months ended
                                                 Fiscal 2009                         March 29, 2008                    March 29, 2008 (Unaudited)
                                                         Percent of                           Percent of                               Percent of
(In thousands, except percentages)      Net Sales      Total Net Sales       Net Sales      Total Net Sales        Net Sales         Total Net Sales
Semiconductor (SG)                      $   44,855                28.5 %     $  109,156                44.2 %     $    156,831                    50.0 %
Passive Components (PCG)                    29,243                18.6           75,112                30.4             85,840                    27.4
Interconnect/Micro-machining (IMG)          83,215                52.9           62,887                25.4             70,875                    22.6

                                        $  157,313               100.0 %     $  247,155               100.0 %     $    313,546                   100.0 %

Net sales for the twelve months ended March 28, 2009 decreased $89.8 million or 36.4% over net sales for the ten months ended March 29, 2008. A significant decrease in SG and PCG net sales was partially offset by a significant increase in IMG net sales, including the impact of a full year of NWR sales.

Net sales for the twelve months ended March 28, 2009 decreased $156.2 million or 49.8% compared to net sales of $313.5 million for the pro forma twelve months ended March 29, 2008. The downward trend was driven by sharp decreases in SG and PCG net sales, partially offset by an increase in IMG net sales, including an $8.0 million increase in NWR's IMG sales.

SG sales for the twelve months ended March 28, 2009 decreased $64.3 million or 58.9% compared to the ten months ended March 29, 2008. SG sales for the twelve months ended March 28, 2009 decreased $112.0 million or 71.4% compared to the pro forma twelve months ended March 29, 2008. The reductions in SG revenues were attributable to weakened memory markets. For each comparison, there was a partial increase in sales resulting from the acquisition of NWR.

PCG sales for the twelve months ended March 28, 2009 were down $45.9 million or 61.1% compared to the ten months ended March 29, 2008 and down $56.6 million or 65.9% compared to the pro forma twelve months ended March 29, 2008. These decreases in revenues were due to the impact of the slowing global economy on consumption of consumer electronics, which led to excess capacity for our customers in this market.

IMG sales for the twelve months ended March 28, 2009 increased $20.3 million or 32.3% over IMG sales for the ten months ended March 29, 2008 and increased $12.3 million or 17.4% compared to the pro forma twelve months ended March 29, 2008. The increase was driven primarily by demand for our micro-machining products, partially offset by softening demand in the flex-circuit and integrated circuit packaging segments of the market. The increase in fiscal 2009 reflected $8.0 million in additional sales for Laser Ablation tools and Laser Components as a result of the acquisition of NWR.

Net sales by geographic region for the fiscal year ended March 28, 2009, the ten-month fiscal year ended March 29, 2008, and the pro forma twelve months ended March 29, 2008 were as follows:

                                                                             Ten months ended                 Pro forma twelve months ended
                                          Fiscal 2009                         March 29, 2008                    March 29, 2008 (Unaudited)
(In thousands, except                             Percent of                           Percent of                               Percent of
percentages)                     Net Sales      Total Net Sales       Net Sales      Total Net Sales        Net Sales         Total Net Sales
Asia                             $  110,114                70.0 %     $  183,783                74.4 %     $    236,389                    75.4 %
Americas                             30,637                19.5           43,870                17.7             51,040                    16.3
Europe                               16,562                10.5           19,502                 7.9             26,117                     8.3

                                 $  157,313               100.0 %     $  247,155               100.0 %     $    313,546                   100.0 %

Net sales to Asia for the twelve months ended March 28, 2009 decreased $73.7 million or 40.1%, compared to the ten months ended March 29, 2008, and declined $126.3 million or 53.4% compared to the pro forma twelve months ended March 29, 2008. The reduction in net sales reflects the overall downward trend in revenue due to the continued decline in the memory market and reduced demand for consumer electronics which impacted SG and PCG sales. NWR sales in the region for the twelve months ended March 28, 2009 increased $2.5 million over both comparison periods.

Net sales to the Americas for the twelve months ended March 28, 2009 declined $13.2 million or 30.2% compared to the ten months ended March 29, 2008 and declined $20.4 million or 40.0% compared to the pro forma twelve months ended March 29, 2008. These decreases were due to the overall decline in market conditions for capital equipment, specifically in sales of SG systems. NWR sales in the region for the twelve months ended March 28, 2009 increased $5.0 million over both comparison periods ended March 29, 2008, partially offsetting the overall decreases.

Net sales to Europe for the twelve months ended March 28, 2009 declined $2.9 million or 15.1% compared to the ten months ended March 29, 2008, and declined $9.6 million or 36.6% compared to the pro forma twelve months ended March 29, 2008. This decrease was primarily due to a drop in SG sales from the softening of global memory markets, which was somewhat offset by an increase in NWR sales in the region of $1.7 million over both comparison periods.

Gross Profit

Gross profit for the fiscal year ended March 28, 2009, the ten-month fiscal year
ended March 29, 2008, and the pro forma twelve months ended March 29, 2008 was
as follows:



                                                                        Ten months ended                 Pro forma twelve months ended
                                       Fiscal 2009                       March 29, 2008                    March 29, 2008 (Unaudited)
(In thousands, except           Gross         Percent of            Gross         Percent of             Gross             Percent of
percentages)                    Profit      Total Net Sales        Profit       Total Net Sales          Profit          Total Net Sales
Gross Profit                   $ 58,418                37.1 %     $ 112,141                45.4 %     $    141,301                    45.1 %

Gross profit was $58.4 million for the twelve months ended March 28, 2009, a decrease of $53.7 million and $82.9 million compared to the ten months ended March 29, 2008 and pro forma twelve months ended March 29, 2008, respectively. The net dollar decreases were primarily caused by decreased revenue levels along with an associated reduction in capacity utilization, and to a lesser extent, higher excess and obsolete charges. As a response to the decline in business, management implemented cost reduction efforts throughout fiscal 2009, including reductions in manufacturing labor and overhead, which partially mitigated the impact of lower production volumes.

Gross profit as a percentage of net sales was 37.1% for the fiscal year ended March 28, 2009 compared to 45.4% and 45.1% for the ten months ended March 29, 2008 and the pro forma twelve months ended March 29, 2008, respectively. The same factors discussed above caused the decrease in margin rate over these periods.

Operating Expenses

Operating expenses for the fiscal year ended March 28, 2009, the ten-month
fiscal year ended March 29, 2008, and the pro forma twelve months ended
March 29, 2008 were as follows:



                                                                           Ten months ended                  Pro forma twelve months ended
                                         Fiscal 2009                        March 29, 2008                     March 29, 2008 (Unaudited)
(In thousands, except                           Percent of                           Percent of                                Percent of
percentages)                    Expenses      Total Net Sales        Expenses      Total Net Sales          Expenses         Total Net Sales
Selling, Service and
Administration                  $  51,260                32.6 %      $  52,262                21.2 %      $     61,495                    19.6 %
Research, Development &
Engineering                        38,179                24.3           36,104                14.6              42,479                    13.6
Goodwill Impairment                17,396                11.1               -                   -                   -                       -
Restructuring costs                 4,011                 2.5              972                 0.4                 972                     0.3
Merger transaction costs            1,850                 1.2               -                   -                   -                       -
Write-off of In-process R&D            -                   -             2,800                 1.1               2,800                     0.9

                                $ 112,696                71.7 %      $  92,138                37.3 %      $    107,746                    34.4 %

Selling, Service and Administration Expenses

The primary items included in selling, service and administration (SS&A) expenses are labor and other employee-related expenses, travel expenses, professional fees, sales commissions and facilities costs. SS&A expenses for the twelve months ended March 28, 2009 were $1.0 million lower than during the ten months ended March 29, 2008. This $1.0 million decrease reflects cost savings realized from restructuring actions and cost management activities partially offset by the two-month differential in reporting periods, and increases of $0.4 million due to equity compensation and $0.3 million attributable to assuming NWR operations. In addition, purchase accounting expenses relating to the NWR acquisition decreased $0.3 million.

SS&A expenses for the twelve months ended March 28, 2009 decreased $10.2 million compared to the pro forma twelve months ended March 29, 2008. This decrease reflects cost savings realized from restructuring actions and cost management activities.

Research, Development and Engineering Expenses

Research, development and engineering (RD&E) expenses are primarily comprised of labor and other employee-related expenses, professional fees, project materials, equipment costs and facilities costs. RD&E expenses for the twelve months ended March 28, 2009 were $2.1 million higher than the ten months ended March 29, 2008. This increase is primarily due to the two month differential in reporting periods, increases in equity compensation, and the addition of NWR for a full year. Additionally, fiscal 2009 included a $4.1 million charge incurred during the fourth quarter to write-off material from an RD&E program due to a change in our product development strategy. Excluding these impacts, RD&E expense was lower in fiscal 2009 than fiscal 2008, which was the result of cost savings realized from restructuring and cost management efforts.

RD&E expenses for the twelve months ended March 28, 2009 decreased $4.3 million from the pro forma twelve months ended March 29, 2008. Apart from the $4.1 million charge to write-off materials, expenses decreased $8.4 million, primarily due to cost management and restructuring actions.

Goodwill Impairment

The Company's stock price and market capitalization declined substantially during the third quarter of 2009. As a result, we reviewed the recoverability of goodwill under SFAS 142 as of December 27, 2008 and recognized

an impairment charge of $17.4 million. This charge is reflected in "Goodwill impairment" in the accompanying Consolidated Statement of Operations for the year ended March 28, 2009. This charge is not deductible for income tax purposes and has no effect on the Company's cash flows or liquidity.

Restructuring Costs

Restructuring expenses incurred during the twelve months ended March 28, 2009 totaled $4.0 million, compared to $1.0 million during the ten months ended March 29, 2008 and pro forma twelve months ended March 29, 2008. The 2008 expenses were incurred in the fourth quarter as the result of actions taken in response to weakness in the memory market and reductions in capital spending. These trends worsened during 2009 amid the global economic recession, and as a result, we took additional actions, resulting in $4.0 million of restructuring expenses for the twelve months ended March 28, 2009. See Note 25 "Restructuring and Cost Management Plans" of the Notes to the Consolidated Financial Statements in Item 8 Financial Statements and Supplementary Data for additional information.

Merger Transaction Costs

Merger transaction costs of $1.9 million included in operating expenses for the twelve months ended March 28, 2009 represent expenses incurred in connection with the terminated merger with Zygo Corporation (Zygo). The acquisition was originally announced on October 16, 2008. On January 20, 2009, Zygo announced that its Board of Directors had withdrawn its recommendation in favor of the merger agreement, and during the fourth quarter of 2009, we elected to pursue termination of the agreement. As a result, we recognized $1.9 million of merger-related expenses as operating expenses during the fourth quarter of 2009. On April 2, 2009, we announced that the termination of the acquisition was formalized by a Settlement Agreement and Mutual Release (Settlement Agreement) with Zygo. Under the terms of the Settlement Agreement, Zygo paid ESI $5.4 million in the first quarter of fiscal 2010. An additional $1.2 million will become payable to ESI if Zygo announces within six months that its Board of Directors has accepted a proposal for a sale of the company. See Note 6 "Termination of Zygo Merger Agreement" of the Notes to the Consolidated Financial Statements in Item 8 Financial Statements and Supplementary Data for additional information. We expect to incur approximately $0.9 million of incremental costs relating to the merger termination in the first quarter of fiscal 2010.

Write-off of In-process Research & Development

. . .