All dollar amounts are in thousands unless specified otherwise. Share and per share amounts give effect to the 1-for-12 reverse stock split effected on July 25, 2006

Company Overview

Tegal Corporation, a Delaware corporation ("Tegal" or the "Company"), designs, manufactures, markets and services plasma etch and deposition systems that enable the production of micro-electrical mechanical systems ("MEMS"), power integrated circuits ("ICs") and optoelectronic devices found in products like smart phones, networking gear, solid-state lighting, and digital imaging. The Company's plasma etch and deposition tools enable sophisticated manufacturing techniques, such as 3-D interconnect structures formed by intricate silicon etch, also known as Deep Reactive Ion Etching ("DRIE"). Etching and deposition constitute two of the principal device production process steps and each must be performed numerous times in the production of such devices.

Our business objective is to utilize the technologies that we have developed internally or acquired externally in order to increase our market share in process equipment for MEMS and power device fabrication, advanced 3-D packaging, and certain areas of semiconductor manufacturing, including compound semiconductors and light emitting diodes ("LEDs"). In the recent past, we focused on competing with more established competitors by being "designed-in" to the advanced device fabrication plans of our customers. We have done so primarily by engaging in research and development activities on behalf of our customers that our more established competitors were unwilling or unable to perform, including several applications of our technology in certain types of new, non-volatile memory devices intended as replacements for flash memory, such as MRAM, RRAM and FeRAM. Many of these advanced new memory devices promised substantial returns as consumer demand for certain functions grew and new markets were created. However, the timing of the emergence of such demand was highly uncertain and, as of today, these markets as of today have not developed as expected.

In September 2008 we took the step of acquiring the products lines of AMMS and the related intellectual property of Alcatel, in order to pursue more fully the smaller, but higher-growth markets of MEMS and 3-D packaging. Our acquisition of these products served two purposes: 1) to increase revenues, as demand for our etch and deposition systems in more traditional semiconductor markets fell dramatically with the collapse of semiconductor capital spending; and 2) to enable us to focus our various technologies on specific applications that served the common markets of MEMS and 3-D device manufacturing and packaging.

At the present time, we are continuing our transition of the Company's involvement in specialized aspects of traditional semiconductor markets to the faster-growth but smaller markets for MEMS, power devices and specialized compound semiconductors. However, given the severe economic downturn generally, and in the semiconductor capital equipment industry in particular, achieving wins with customers in these markets has been extremely challenging for us. We expect that orders for our systems will continue to fluctuate from quarter to quarter, and we expect demand to continue to be low and our ability to forecast demand will be limited as the global financial crisis and the resulting recession continues. Although we have over the past several years streamlined our cost structure by headcount reductions, salary and benefit reductions and limits on discretionary spending of all types, our costs for maintaining our research and development efforts and our service and manufacturing infrastructure have remained constant or in some cases increased. We intend to continue our cost-containment measures, including outsourcing certain activities, such as engineering and software development, and maintaining or further reducing our headcount as we strive to improve operational efficiency within this challenging economic environment. However, since we are unable to predict the timing of a stable reemergence of demand for our products and services, we believe that the realization of assets and discharge of liabilities are each subject to significant uncertainty and a substantial doubt exists as to whether we will be able to continue as a going concern. In consideration of these circumstances, we have engaged Cowen & Co., LLC to assist us in evaluating strategic alternatives for the Company, which may include a merger with or into another company, a sale of all or substantially all of our assets and the liquidation or dissolution of the company, including through a bankruptcy proceeding. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The audited consolidated financial statements have been prepared using the going concern basis, which assumes that we will be able to realize our assets and discharge our liabilities in the normal course of business for the foreseeable future. However, it is not possible to predict when our business and results of operations will improve in light of the current economic downturn that continues to dramatically affect our industry. Therefore, the realization of assets and discharge of liabilities are each subject to significant uncertainty. Accordingly, substantial doubt exists as to whether we will be able to continue as a going concern. If the going concern basis is not appropriate in future filings, adjustments will be necessary to the carrying amounts and/or classification of assets and liabilities in our consolidated financial statements included in such filings.

The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, sales returns allowance, inventory, intangible and long lived assets, warranty obligations, restructure expenses, deferred taxes and freight charged to customers. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies are the most significant to the presentation of our consolidated financial statements:

Revenue Recognition

Each sale of our equipment is evaluated on an individual basis in regard to revenue recognition. We have integrated in our evaluation the related interpretative guidance included in Topic 13 of the codification of staff accounting bulletins, and recognize the role of the consensus on Emerging Issues Task Force Issue No. 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables ("EITF Issue 00-21"). We first refer to EITF Issue 00-21 in order to determine if there is more than one unit of accounting and then we refer to Staff Accounting Bulletin ("SAB") 104 for revenue recognition topics for the unit of accounting. We recognize revenue when persuasive evidence of an arrangement exists, the seller's price is fixed or determinable and collectability is reasonably assured.

For products produced according to our published specifications, where no installation is required or installation is deemed perfunctory and no substantive customer acceptance provisions exist, revenue is recognized when title passes to the customer, generally upon shipment. Installation is not deemed to be essential to the functionality of the equipment since installation does not involve significant changes to the features or capabilities of the equipment or building complex interfaces and connections. In addition, the equipment could be installed by the customer or other vendors and generally the cost of installation approximates only 1% of the sales value of the related equipment

For products produced according to a particular customer's specifications, revenue is recognized when the product has been tested and it has been demonstrated that it meets the customer's specifications and title passes to the customer. The amount of revenue recorded is reduced by the amount (generally 10%), which is not payable by the customer until installation is completed and final customer acceptance is achieved.

For new products, new applications of existing products, or for products with substantive customer acceptance provisions where performance cannot be fully assessed prior to meeting customer specifications at the customer site, 100% of revenue is recognized upon completion of installation and receipt of final customer acceptance. Since title to goods generally passes to the customer upon shipment and 90% of the contract amount becomes payable at that time, inventory is relieved and accounts receivable is recorded for the entire contract amount. The revenue on these transactions is deferred and recorded as deferred revenue. We reserve for warranty costs at the time the related revenue is recognized. As of March 31, 2009 and 2008 deferred revenue as related to systems was $103 and $252.

Revenue related to sales of spare parts is recognized upon shipment. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Unearned maintenance and service revenue is included in deferred revenue. As of March 31, 2009 and 2008, $11 and $0 of deferred revenue was related to service contracts.

The Company's return policy is for spare parts and components only. A right of return does not exist for systems. Customers are allowed to return spare parts if they are defective upon receipt. The potential returns are offset against gross revenue on a monthly basis. Management reviews outstanding requests for returns on a quarterly basis to determine that the reserves are adequate.

Accounts Receivable - Allowance for Sales Returns and Doubtful Accounts

The Company maintains an allowance for doubtful accounts receivable for estimated losses resulting from the inability of the Company's customers to make required payments. If the financial condition of the Company's customers were to deteriorate, or even a single customer was otherwise unable to make payments, additional allowances may be required. As of March 31, 2009 five customers accounted for approximately 75% of the accounts receivable balance. As of March 31, 2008 three customers accounted for approximately 56% of the accounts receivable balance.

Inventories

Inventories are stated at the lower of cost or market, reduced by provisions for excess and obsolescence. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis and includes material, labor and manufacturing overhead costs. We estimate the effects of excess and obsolescence on the carrying values of our inventories based upon estimates of future demand and market conditions. We establish provisions for related inventories in excess of production demand. Should actual production demand differ from our estimates, additional inventory write-downs may be required. Any excess and obsolete provision is released only if and when the related inventories is sold or scrapped.

The Company periodically analyzes any systems that are in finished goods inventory to determine if they are suitable for current customer requirements. At the present time, the company's policy is that, if after approximately 18 months, it determines that a sale will not take place within the next 12 months and the system would be useable for customer demonstrations or training, it is transferred to fixed assets. Otherwise, it is expensed.

The carrying value of systems used for demonstrations or training is determined by assessing the cost of the components that are suitable for sale. Any parts that may be rendered unsellable as a result of such use are removed from the system and are not included in finished goods inventory. The remaining saleable parts are valued at the lower of cost or market, representing the system's net realizable value. The depreciation period for systems that are transferred to fixed assets is determined based on the age of the system and its remaining useful life (typically five to eight years).

Impairment of Long-Lived Assets

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If undiscounted expected future cash flows are less than the carrying value of the assets, an impairment loss is recognized based on the excess of the carrying amount over the fair value of the assets. During the fourth quarter of 2009, we reviewed our long-lived assets for indicators of impairment in accordance with SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets." Based on reduced estimates of future revenues and future negative cash flow, we identified a potential indicator of impairment. The company recorded an impairment charge, related to intangibles, of $497 for the fiscal year ended 2009. No impairment charges were recorded for the years ended 2008 and 2007.

Warranty Obligations

We provide for the estimated cost of our product warranties at the time revenue is recognized. Our warranty obligation is affected by product failure rates, material usage rates and the efficiency by which the product failure is corrected. The warranty reserve is based on historical cost data related to warranty. Should actual product failure rates, material usage rates and labor efficiencies differ from our estimates, revisions to the estimated warranty liability may be required. Actual warranty expense is typically low in the period immediately following installation.

Deferred Taxes

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Based on the uncertainty of future taxable income, we have fully reserved our deferred tax assets as of March 31, 2009, 2008 and 2007. In the event we were to determine that we would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset would increase income in the period such determination was made.

Accounting for Stock-Based Compensation

The Company has adopted several stock plans that provide for the issuance of equity instruments to the Company's employees and non-employee directors. The Company's plans include incentive and non-statutory stock options and restricted stock awards and restricted stock units ("RSUs"). Stock options and RSUs generally vest ratably over a four-year period on the anniversary date of the grant, and stock options expire ten years after the grant date. On occasion RSUs may vest on the achievement of specific performance targets. The Company also has an employee stock purchase plan (an "ESPP") that allows qualified employees to purchase Company shares at 85% of the lower of the common stock's market value on specified dates. The stock-based compensation for our ESPP was determined using the Black-Scholes option pricing model and the provisions of Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), "Share Based Payment", ("SFAS 123R").

Effective April 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), "Share Based Payment" (SFAS 123R) using the modified prospective transition method. Under that transition method, we recognized compensation expense of $1,803 for the fiscal year 2007, and $1,022 the fiscal year 2008, which included: (a) compensation expense for all share-based payments granted prior to but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based payments granted or modified on or after April 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. For the fiscal year 2009, we recognized $892 in compensation expense. Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after April 1, 2006. Results in prior periods have not been restated.

Accounting for Freight Charged to Customers

Spares and systems are typically shipped "freight collect," therefore no shipping revenue or cost is associated with the sale. When freight is charged, the amount charged to customers is booked to revenue and freight costs incurred are offset in the cost of revenue accounts pursuant to Financial Accounting Standards Board's ("FASB") EITF 00-10.

The following table sets forth certain financial items for the years indicated:

                                                           Year Ended March 31,
                                                      2009         2008         2007

Revenue                                             $ 13,070     $ 32,925     $  22,263
Cost of revenue                                        7,872       18,911        16,736
Gross profit                                           5,198       14,014         5,527
Operating expenses:
Research and development expenses                      5,210        3,705         4,646
Sales and marketing expenses                           3,156        4,163         3,909
General and administrative expenses                    4,774        4,551        10,347
Total operating expenses                              13,140       12,419        18,902
Operating (loss) income                               (7,942 )      1,595       (13,375 )
Other income (expense), net                               40       17,013           162
(Loss) income before income tax expense (benefit)     (7,902 )     18,608       (13,213 )
Tax Expense                                                -          504             -
Net (loss) income                                   $ (7,902 )   $ 18,104     $ (13,213 )

The following table sets forth certain financial data for the years indicated as a percentage of revenue:

                                                          Year Ended March 31,
                                                     2009         2008        2007

Revenue                                               100.0 %      100.0 %     100.0 %
Cost of revenue                                        60.2 %       57.4 %      75.2 %
Gross profit                                           39.8 %       42.6 %      24.8 %
Operating expenses:
Research and development                               39.9 %       11.3 %      20.9 %
Sales and marketing                                    24.1 %       12.6 %      17.6 %
General and administrative                             36.5 %       13.8 %      46.5 %
Total operating expenses                              100.5 %       37.7 %      85.0 %
Operating (loss) income                               (60.8 %)       4.8 %     (60.2 %)
Other income (expense), net                             0.3 %       51.7 %       0.9 %
(Loss) income before income tax expense (benefit)     (60.5 %)      56.5 %     (59.3 %)
Tax Expense                                               - %        1.5 %         - %
Net (loss) income                                     (60.5 %)      55.0 %     (59.3 %)

Years Ended March 31, 2009, 2008, and 2007

Revenue

Our revenue is derived from sales of new and refurbished systems, spare parts and non-warranty service. Revenue decreased 60.3% in fiscal 2009 from fiscal 2008 (to $13,070 from $32,925). The revenue decrease was due principally to the number and mix of systems sold and the global economic recession that dramatically impacted our industry. Revenue increased 47.9% in fiscal 2008 from fiscal 2007 (to $32,925 from $22,263). The revenue increase was due principally to the product mix and number of systems sold, as well as to setting higher selling prices for some of our advanced systems compared to the prior year.

International sales accounted for approximately 28%, 72%, and 67%, of total revenue in fiscal 2009, 2008, and 2007, respectively. We expect that international sales will continue to account for a significant portion of our revenue.

Gross Profit

Our gross profit as a percentage of revenue (gross margin) decreased to 39.8% in fiscal 2009 compared to 42.6% in fiscal 2008. The decrease in the gross margin in fiscal 2009 compared to 2008 was due to the number of systems sold and product mix. The principle reason for the decreased margin was increased costs associated with the introduction and integration of the new DRIE systems acquired from AMMS into our manufacturing structure. Our gross profit as a percentage of revenue (gross margin) increased to 42.6% in fiscal 2008 compared to 24.8% in fiscal 2007. The increase in the gross margin in fiscal 2008 compared to 2007 was due to the product mix and number of systems sold, as well as to cost reductions in manufacturing overhead, primarily in payroll expense.

Our gross profit as a percentage of revenue has been, and will continue to be, affected by a variety of factors, including the mix and average selling prices of systems sold and the costs to manufacture, service and support new product introductions and enhancements. Gross margins for our 6500 series systems are typically lower than those of our more mature 900 series systems due to the inefficiencies and lower vendor discounts associated with lower order volumes and increased service, installation and warranty support. Future gross profit and gross margin are highly dependent on the level and product mix included in net revenues. This includes the mix of sales between lower and higher margin products. Accordingly, we are not able to predict future gross profit levels or gross margins with certainty. However, gross profit improvement is one of our highest priorities. We believe that the completion of the integration of our new product line and the results of our expense reduction efforts will begin to exhibit themselves in gross profit improvements, especially as we expect our sales volume to increase.

During the fiscal year ended March 31, 2009, we recorded a severance charge of approximately $109 related to staff reductions of 13 employees, of which approximately $7 was classified as research and development, $70 as sales and marketing, and $32 as cost of sales. We had an outstanding severance liability of approximately $15 as of March 31, 2009.

There were no severance charges and no outstanding liability during fiscal years ended March 31, 2008 and 2007.

Research and Development

Research and development expenses consist primarily of salaries, prototype material and other costs associated with our ongoing systems and process technology development, applications and field process support efforts.

Research and development expenses increased to $5,210 in fiscal 2009 from $3,705 in fiscal 2008. The increase in spending was due primarily to increase in spending for consulting, prototype material costs, employee related costs and legal fees for patent maintenance all primarily related to the AMMS acquisition. In addition, amortization expense increased resulting from the $497 write-off of the FDSI patent. Research and development expenses decreased to $3,705 in fiscal 2008 from $4,646 in fiscal 2007. The decrease in spending was due primarily to reimbursement for prototype costs as well as lower depreciation costs.

Sales and Marketing

Sales and marketing expenses primarily consist of salaries, commissions, trade show promotion and advertising expenses. Expenses decreased to $3,156 in fiscal 2009 from $4,163 in fiscal 2008. The decrease in spending was due primarily to the decrease in agent commission, employee commission and other employee related costs. Sales and marketing expenses remained fairly flat in fiscal 2008 compared to fiscal 2007 despite a significant increase in revenue.

General and Administrative

General and administrative expenses consist of salaries, legal, accounting and related administrative services and expenses associated with general management, finance, information systems, human resources and investor relation's activities. General and administrative cost remained fairly flat in fiscal 2009 compared to fiscal 2008. General and administrative costs decreased to $4,551 in fiscal 2008 from $10,347 in fiscal 2007 primarily due to decreased legal fees as a result of the settlement of the AMS litigation (described below), a buyout provision in fiscal 2007 in the Petaluma lease and SFI consolidation costs.

Other Income (Expense), Net

In fiscal 2009 other income (expense), net, was mostly interest income offset by gains and losses on foreign exchange. In fiscal 2008 other income (expense), net, consisted principally of settling of the Sputtered Films, Inc. v. Advanced Modular Sputtering lawsuit (the "AMS litigation"), interest income, gains and losses on foreign exchange, and retirement of fixed assets. We recorded other income (expense) of $17,013 in fiscal 2008. In addition to recording the net $14,705 from the settlement of the AMS litigation, we also recorded $682 from the recognition of foreign exchange differences between current and historical valuations of investment as a result of the dissolution of our Japan subsidiary completed in December 2007. Net interest income was also higher in the current fiscal year due to higher cash balances as a result of the settlement of the AMS litigation earning higher interest. We recorded other income (expense), net of $162 in fiscal 2007.

In connection with the settlement of the AMS litigation, we agreed to make a donation of at least $350 to the University of California at Santa Barbara. The donation endowed the Director of the California Nano Systems Institute, a position currently occupied by Professor Evelyn Hu. The position is known as the Peter A. Clarke Professor and Director of the California Nano Systems Institute, in honor of Peter Clarke, the founder of Sputtered Films, Inc., which Tegal acquired in August 2002. At March 31, 2007, $350 has been expensed to other income (expense), net. This amount was paid in September 2007.

Income Taxes

In fiscal 2009 our effective tax rate was 0%.

In fiscal 2008 our effective tax rate was 2.7%. The company recorded $504 as tax expense for the income realized in fiscal 2008. Our effective tax rate was 0% in fiscal 2007. In fiscal 2006, our effective rate was a benefit of 5.7%. The Company recorded a tax benefit of $532 for the losses incurred in fiscal 2006. All deferred tax assets have been fully reserved.

In the fiscal years prior to fiscal 2006, the Company recorded a reserve for the possibility of an audit of our transfer pricing policy for sales in foreign countries. During fiscal 2006, the contingency reserve in the amount of $532 was reversed. Based on a review at that time of this reserve, and in accordance with requirements at that time, the Company believed the probability of such an audit was less than 70%, and therefore, reversed the reserve.

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