This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this document that are not purely historical are forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding future periods, financial results, revenues, margins, growth, customers, tax rates, product performance, and the impact of accounting rules on our business and the future implications of our statements regarding goals, strategy, and similar terms. We may identify these statements by the use of words such as "anticipate," "believe," "continue," "could," "estimate," "expect," "intend," "likely," "may," "might," "plan," "potential," "predict," "project," "should," "will," "would" and other similar expressions. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements, except as may otherwise be required by law.
Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain risks, uncertainties and changes in circumstances, many of which may be difficult to predict or beyond our control, including those factors referenced in Part II Item 1A "Risk Factors" and elsewhere in this document, and in Part I Item 1A "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. In particular our results could vary significantly based on changes in customer and industry spending; rate and extent of changes in product mix; adoption of new products and manufacturing processes; timing of orders, shipments, acceptance of new products; our ability to secure volume supply agreements; and general economic conditions. In evaluating our business, investors should carefully consider these factors in addition to any other risks and uncertainties set forth elsewhere. The occurrence of the events described in the risk factors and elsewhere in this report as well as other risks and uncertainties could materially and adversely affect our business, operating results and financial condition. While management believes that the discussion and analysis in this report is adequate for a fair presentation of the information presented, we recommend that you read this discussion and analysis in conjunction with the
(i) audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2011 which were included in our 2011 Annual Report on Form 10-K filed with the Securities Exchange Commission (SEC) on March 14, 2012 and (ii) our other filings with the SEC. Overview

Nanometrics Incorporated and its subsidiaries ("Nanometrics" or "we") is a leading provider of advanced, high-performance process control metrology and inspection systems used primarily in the fabrication of integrated circuits, high-brightness LEDs ("HB-LED"), data storage devices and solar photovoltaics ("solar PV"). Our automated and integrated systems address numerous process control applications, including critical dimension and film thickness measurement, device topography, defect inspection, overlay registration, and analysis of various other film properties such as optical, electrical and material characteristics. Our process control solutions are deployed throughout the fabrication process, from front-end-of-line substrate manufacturing, to high-volume production of semiconductors and other devices, to advanced wafer-scale packaging applications. Our systems enable device manufacturers to improve yields, increase productivity, and lower their manufacturing costs for the photolithographic process, thin-film metrology, critical-dimension and overlay systems and provide control of device dimension and layer alignment. Advanced packaging technology requires metrology systems to control wafer scale features for through-silicon-via ("TSV") and flip-chip-technology. Our metrology systems for materials monitor the physical, optical, and electrical characteristics of materials including, compound semiconductor, LEDs, solar PVs, and silicon wafers. Our defect inspection systems locate large area and microscopic defects on patterned and unpatterned wafers. This system can be used for inspection at nearly every stage of the semiconductor production flow.

We categorize our systems as follows:
Automated Standalone Systems

Our automated systems are made up of both semi-automated and fully automated metrology systems that are employed in both high-volume and low-volume production environments. The Atlas® II, Atlas XP/Atlas XP+ and

Atlas-M represent our line of high-performance metrology systems providing optical critical dimension ("OCD"®), thin film metrology and wafer stress for transistor and interconnect metrology applications. The OCD technology is supported by our NanoCD™ suite of solutions including our NanoDiffract® software and NanoGen® scalable computing engine that enables visualization, modeling, and analysis of complex structures. The Mosaic II™ provides cost effective overlay metrology solutions for today's advanced 300mm overlay process technologies, and is available on our Lynx™ platform. The Unifire™ system enables users to measure multiple parameters at any given process step in the advanced packaging process flow for critical dimension, overlay, and topography applications. Our SPARK defect inspection system, offers ultra-fast inspection of patterned and unpatterned semiconductor wafers.

We continue to offer automated products for 200mm factories running at 90nm nodes and above, as well as systems supporting micro-electrical mechanical systems ("MEMS"). Our Q240AT is a 200mm overlay metrology system that incorporates the same measurement technology as the Mosaic™, thereby extending the technology capability of our customers' existing factories. The IVS®-185 system supports critical dimension and overlay measurements for semiconductor, MEMS, and HB-LED manufacturing. The NanoSpec® 9100 thin film measurement system is capable of handling wafers ranging in size from 75mm to 200 mm in diameter, and is used in all segments of semiconductor manufacturing, including data storage head manufacturing.
System Platform
The Lynx™ cluster metrology platform enables improved cost of ownership to our customers by combining our Mosaic™, Atlas® II and IMPULSE® metrology systems in configurations to provide high throughput, reduced footprint systems for leading 300mm wafer metrology applications including OCD, overlay, and thin film process control.
Integrated Systems
Our integrated metrology ("IM") systems are installed directly onto wafer processing equipment to provide near real-time measurements for improved process control and maximum throughput. Our IM systems are sold directly to end customers and through OEM channels. The IMPULSE® system is our latest metrology platform for OCD, DBO, and thin film metrology and has been successfully qualified on numerous OEM platforms. Our 90x0 system is qualified for OEM and direct sales supporting thin film and OCD applications. Our NanoCD™ solutions suite is sold in conjunction with our IMPULSE® and legacy 90x0 systems. Our Trajectory™ system provides in-line measurement of layers in thin film thickness and composition in solar cell and semiconductor applications. Materials Characterization
Our materials characterization products include systems that are used to monitor the physical, optical, electrical and material characteristics of HB-LED, solar PV, compound semiconductor, strained silicon and silicon-on-insulator ("SOI") devices, including composition, crystal structure, layer thickness, dopant concentration, contamination and electron mobility.
Our Vertex™ is a photoluminescence ("PL") mapping system designed for high-volume compound semiconductor metrology applications including power control and photonics applications. The RPMBlue™ is our latest PL mapping system designed specifically for the HB-LED segment. We sell Fourier-Transform Infrared ("FTIR") automated and manual systems in the QS2200/3300 and QS1200 respectively. The FTIR systems are spectrometers designed for non-destructive wafer analysis for various applications. The NanoSpec® line of products includes the 3000 and 6100 supporting thin film measurement across all segments in both low volume production and research applications.
We are continually working to strengthen our competitive position by developing new technologies and products in our market segment. In furtherance of our goals, we have:

• Introduced new products in every core product line and primary market served;

• Diversified our product line and addressed new markets through acquisitions, such as the 2006 acquisition of Accent Optical Technologies, Inc. a supplier of overlay and thin film metrology and process control systems; the 2008 acquisition of Tevet Process Control Technologies ("Tevet"), an integrated metrology supplier serving both semiconductor and solar PV industries; the 2009 acquisition of the Unifire™ product line from Zygo Corporation ("Zygo"); and the 2011 acquisition of Nanda Technologies GmbH, a supplier of high sensitivity, high throughput defect inspection systems;

• Continued development of new measurement and inspection technologies for advanced fabrication processes; and

• Researched and developed innovative applications of existing technology to new market opportunities within the solar PV, HB-LED, and data storage industries.

Critical Accounting Policies
The preparation of our financial statements conforms to accounting principles generally accepted in the United States of America, which requires management, in applying our accounting policies, to make estimates and judgments that have an important impact on our reported amounts of assets, liabilities, revenue, expenses and related disclosures at the date of our financial statements. On an on-going basis, management evaluates its estimates including those related to bad debts, inventory valuations, warranty obligations and income taxes. Management bases its estimates and judgments on historical experience and on various other factors that are believed 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 management's estimates. Since December 31, 2011, there have been no significant changes to our critical accounting policies discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.
Recent Accounting Pronouncements
See Note 2 of the Unaudited Condensed Consolidated Financial Statements for a description of recent accounting pronouncements, including the respective dates of adoption and effects or anticipated effects on results of operations and financial condition.

Results of Operations
Three and Nine Month Periods Ended September 29, 2012 and October 1, 2011
Total net revenues - Our net revenues were comprised of the following categories
(in thousands, except percentages):

                                                Three Months Ended                                               Nine Months Ended
                             September 29,       October 1,            Changes In            September 29,       October 1,            Changes in
                                 2012               2011          Amount          %              2012               2011          Amount          %
Automated systems          $        26,588     $     33,659     $  (7,071 )     (21.0 )%   $       104,675     $    111,770     $  (7,095 )      (6.3 )%
Integrated systems                   2,663            7,540        (4,877 )     (64.7 )%             9,453           20,285       (10,832 )     (53.4 )%
Materials characterization           3,063            8,640        (5,577 )     (64.5 )%             7,600           25,994       (18,394 )     (70.8 )%
Total product revenues              32,314           49,839       (17,525 )     (35.2 )%           121,728          158,049       (36,321 )     (23.0 )%
Service revenues                    11,624            8,430         3,194        37.9  %            30,883           26,735         4,148        15.5  %
Total net revenues         $        43,938     $     58,269     $ (14,331 )     (24.6 )%   $       152,611     $    184,784     $ (32,173 )     (17.4 )%

For the three and nine month periods ended September 29, 2012, total product revenues decreased by $17.5 million and $36.3 million relative to the comparable 2011 periods. The year over year decreases were principally due to a slowdown in industry spending in the third quarter of 2012. In both the three and nine month periods ended September 29, 2012, net revenues from automated systems decreased by $7.1 million relative to the comparable 2011 periods principally due to a slowdown in industry spending in the third quarter of 2012. For the three month period ended September 29, 2012, net revenues from our integrated systems decreased by $4.9 million relative to the comparable 2011 period due principally to a decline in customer demand for our legacy 9010 series products. For the nine month period ended September 29, 2012, revenues from our integrated systems decreased by $10.8 million relative to the comparable 2011 period due principally to the decline in customer demand for our legacy 9010 series product being partially offset by an increase in demand for our integrated IMPULSE® OCD systems. Net revenues from our materials characterization products decreased by $5.6 million and $18.4 million in the three and nine month periods ended September 29, 2012 compared to the three and nine month periods ended October 1, 2011, respectively, due principally to a decline in customer demand for our FTIR and RPM systems, resulting from excess capacity in the HB-LED market and lack of expansion in the bare wafer silicon end market.
For the three and nine month periods ended September 29, 2012, service revenues increased by $3.2 million and $4.1 million relative to the comparable 2011 periods, principally due to increased sales of billable upgrades, which tend to fluctuate from quarter to quarter based on availability of new functionality from upgrades and customer production cycles which determine when customers purchase available upgrades.
With a significant portion of the world's semiconductor manufacturing capacity located in Asia, a substantial portion of our revenues continue to be generated in that region. Although sales to customers within individual countries of that region will vary from time to time, we expect that a substantial portion of our revenues will continue to be generated in Asia.

Gross margins. Our gross margin for product and services was as follows:

              Three Months Ended                 Nine Months Ended
         September 29,     October 1,                           October 1,
              2012            2011       September 29, 2012        2011
Product         49.2 %          53.7 %             46.5 %            56.0 %
Services        53.7 %          45.6 %             49.8 %            48.1 %

The calculation of product gross margin includes both cost of products and amortization of intangible assets. Product gross margin for the three and nine month periods ended September 29, 2012 was 49.2% and 46.5% respectively, reflecting a decrease of 4.5 points and 9.5 points, respectively, from the comparable periods in 2011. Although the aforementioned year over year decreases are declining, they are driven by the same factors. For both the three and nine month periods, approximately one-third of the decrease was due to higher costs and resulting in lower gross margin on production of the Atlas® II, which was launched late in the fourth quarter of 2011. Approximately one-half of the decrease resulted from lower factory absorption due to the reduced volume of system production in the three and nine month periods ended September 29, 2012 compared with the three and nine month periods ended October 1, 2011. The remaining decrease for the three and nine month periods ended September 29, 2012, compared with the comparable periods of 2011, results from changes in product mix of tools sold and an increase in amortization of intangible assets related to the acquisition of Nanda.
The gross margin for our services business was 53.7% and 49.8% for the three and nine month periods ended September 29, 2012, respectively. The services gross margin for the three month period ended September 29, 2012, increased 8.1 points compared to the three month period ended October 1, 2011, due principally to increased higher margin upgrade revenue. The services gross margin for the nine month period ended September 29, 2012, increased 1.7 points compared to the nine month period ended October 1, 2011, due principally to increased higher margin upgrade revenue that was partially offset by the effects of higher labor costs associated with increased delivery of services under contracts.
Operating expenses. Our operating expenses were comprised of the following (in thousands, except percentages):

                                              Three Months Ended                                                 Nine Months Ended
                                                  October 1,           Changes in                                    October 1,           Changes in
                         September 29, 2012          2011          Amount         %         September 29, 2012          2011          Amount         %
Research and
development            $              7,176     $      6,045     $  1,131       18.7  %   $             22,296     $     17,312     $  4,984       28.8  %
Selling                               6,308            6,862         (554 )     (8.1 )%                 20,560           20,558            2          -  %
General and
administrative                        4,861            5,817         (956 )    (16.4 )%                 16,525           16,758         (233 )     (1.4 )%
Amortization of
intangible assets                       193              126           67       53.2  %                    580              469          111       23.7  %
Total operating
expenses               $             18,538     $     18,850     $   (312 )     (1.7 )%   $             59,961     $     55,097     $  4,864        8.8  %

Research and development. Research and development expenses increased by $1.1 million for the three month period ended September 29, 2012 over the comparable period in 2011, principally due to a $0.7 million increase in development projects and related activities, a $0.2 million in increased equipment depreciation, tooling, and consumable materials, and a $0.6 million increase in labor and related costs associated with headcount increases, including those from the Nanda acquisition. These increases were partially offset by a $0.4 million decrease in bonus expense due to lower than expected 2012 revenue and operating profit. Investments in research and development personnel and associated projects are part of our strategy to ensure our products are in the forefront of current and future market demands.
Research and development expenses increased by $5.0 million for the nine month period ended September 29, 2012 over the comparable period in 2011, principally due to a $1.9 million increase in development projects and related activities, a $1.1 million in increased equipment depreciation, tooling, and consumable materials, and a $2.5 million increase in labor and related costs associated with headcount increases, including those from the Nanda acquisition. The labor and related cost increase was partially offset by a $0.5 million decrease in bonus expense due to lower than expected 2012 revenue and operating profit.

Selling. Selling expenses decreased by $0.6 million for the three month period ended September 29, 2012 as compared to the corresponding period in 2011, principally due to an $0.8 million decrease in labor and related expenses associated with pre-sales evaluation activities partially offset by a $0.6 million increase in labor and related costs, including those from the Nanda acquisition. The labor and related cost increase was partially offset by a $0.3 million decrease in bonus expense due to lower than expected 2012 revenue and operating profit.
Selling expenses were essentially flat for the nine month period ended September 29, 2012 as compared to the corresponding period in 2011, principally due to a $1.8 million decrease in labor and related expenses associated with pre-sales application evaluation activities, offset by a $2.4 million increase in labor and related costs, including those from the Nanda acquisition. The labor and related cost increase was partially offset by a $0.6 million decrease in bonus expense due to lower than expected 2012 revenue and operating profit. From time to time sales application engineers expend efforts on application development projects with the related expenses being charged to research and development projects. The aforementioned decreases in pre-sales activities of $0.8 million and $1.8 million represents increased charges to research and development projects for the three and nine month periods ended September 29, 2012, as compared to the corresponding periods in 2011.

General and administrative. General and administrative expenses decreased by $1.0 million for the three month period ended September 29, 2012, as compared to the corresponding period in 2011, principally due to a $1.1 million decrease in professional service fees compared to 2011, which included fees associated with the acquisition of Nanda, and a $0.3 million decrease in bonus expense due to lower than expected 2012 revenue and operating profit. These decreases were partially offset by a $0.4 million increase in labor and related costs, including those from the Nanda acquisition.
General and administrative expenses decreased by $0.2 million for the nine month period ended September 29, 2012 compared to the corresponding period in 2011, principally due to a $1.0 million decrease in professional service fees compared to 2011, which included fees associated with the acquisition of Nanda, and a $0.7 million decrease in bonus expense due to lower than expected 2012 revenue and operating profit. These decreases were partially offset by a $1.1 million increase in labor and related costs, including those associated with the Nanda acquisition, and a $0.4 increase in software license and maintenance fees. Amortization of intangible assets. Amortization of intangible assets increased slightly for the three and nine month periods ended September 29, 2012 when compared to the same periods in 2011, due principally to increased amortization associated with the Nanda acquisition, which was partially offset by reduced amortization on certain intangible assets that became fully amortized during the prior year.
Other Income (expense), net. Our net other income (expense) consisted of the following categories (in thousands, except percentages):

                                   Three Months Ended                                               Nine Months Ended
                 September 29,     October 1,          Changes in                                                             Changes in
                     2012             2011         Amount         %         September 29, 2012     October 1, 2011       Amount          %
Interest income $          28     $      57      $    (29 )     (50.9 )%   $              113     $          162       $     (49 )     (30.2 )%
Interest
expense                  (262 )        (324 )          62       (19.1 )%                 (795 )           (1,002 )           207       (20.7 )%
Other, net               (121 )         834          (955 )    (114.5 )%                 (345 )             (149 )          (196 )     131.5  %
Total other
income
(expense), net  $        (355 )   $     567      $   (922 )    (162.6 )%   $           (1,027 )   $         (989 )     $     (38 )       3.8  %

For the three and nine month periods ended September 29, 2012 compared to the same periods of 2011, interest income declined minimally as the total balances of cash, cash equivalents, and marketable securities remained relatively flat and interest rates for the three and nine months periods ended September 29, 2012 were lower than interest rates in the comparable prior year periods. Interest expense for the three and nine month periods ended September 29, 2012 was lower than interest expense in the comparable prior year periods due principally to prepayments of $1.4 million and $2.0 million on the mortgage on our headquarters in July of 2012 and July 2011, respectively, in addition to ongoing monthly payments, which reduced the principal amount under the loan. Other net expenses represent principally foreign exchange gains and losses resulting from

translation of our inter-company balances between subsidiaries. Foreign exchange losses were $0.1 million for the three month periods ended September 29, 2012 while foreign exchange gains were $0.7 million for the three month period ended October 1, 2011. Foreign exchange losses were $0.4 million and $0.1 million for the nine month period ended September 29, 2012 and October 1, 2011, respectively.

Income taxes.
We account for income taxes under the provisions of ASC 740, Accounting for Income Taxes. We adjust the effective tax rate each quarter to be consistent with the estimated annual effective tax rate. We also record the tax effect of unusual or infrequently occurring discrete items, including changes in judgment about valuation allowances and effects of changes in tax laws or tax rates, in the interim period in which they occur. Our effective tax rate reflects the impact of a portion of its earnings being taxed in foreign jurisdictions as well as a valuation allowance maintained on certain deferred tax assets.

We recorded a tax provision of $1.4 million and $2.9 million for the three and nine months ended September 29, 2012, respectively. We recorded a tax provision of $4.7 million and $16.1 million for the three and nine months ended October 1, 2011, respectively. The decrease in the three and nine month's provision from prior year is primarily due to a significant decrease in the our profitability as well as a $1.4 million discrete benefit for deferred tax assets recorded as a result of Internal Revenue Service (IRS) approval of certain tax elections during the three months ended June, 30 2012.

As of September 29, 2012, we continued to maintain a valuation allowance against certain net deferred tax assets as a result of uncertainties regarding the realization of the asset due to cumulative losses and uncertainty of future taxable income in various tax jurisdictions. In the event that we determine that the deferred tax assets are realizable, an adjustment to the valuation allowance will be reflected in the tax provision for the period such determination is made.
We are subject to taxation in the United States and various states including . . .