The statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words "believes," "expects," "anticipates" 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 in Part II, Item 1A "Risk Factors."

Business Overview

Electro Scientific Industries, Inc. and its subsidiaries (ESI) is a leading supplier of innovative laser-based manufacturing solutions for the microtechnology industry. Our advanced laser systems enable precise structuring of micron to submicron features in components and devices which are used in a wide variety of end products in the consumer electronics, computer, communications and other industries. These features enable our customers to achieve functionality, or improve yield and productivity in their manufacturing processes that can be critical to their profitability. Founded in 1944, ESI is headquartered in Portland, Oregon, with global operations and subsidiaries in Asia, Canada, Europe and the United States.

Our advanced laser microfabrication systems allow microelectronics, semiconductor, and other microtechnology manufacturers to physically alter select device features during high-volume production in order to increase performance and improve production yields. Laser microfabrication comprises a set of precise micron-level processes, including via drilling, wafer scribing and dicing, material ablation, semiconductor memory-link cutting, electronic device trimming, and nano-level structuring to alter material characteristics such as color and texture. These processes require 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 for flexible interconnect material, semiconductor devices, light emitting diodes (LEDs), high-density interconnect (HDI) circuits, advanced semiconductor packaging, flat panel liquid crystal displays (LCDs) and other high value components.

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

During the quarter, we decided to discontinue our investment in LED package test products as a result of ongoing overcapacity and commodization of the market.

Summary of Sequential Quarterly Results

The financial results of the quarter ended December 29, 2012, which represented the third quarter of 2013, reflected a sequential decline in sales as a result of on-going challenges in many of our markets and timing of design wins in our micromachining business. Revenue decreased to $37.9 million from $80.2 million in the second quarter of 2013 which ended September 29, 2012. Total order volume for the third quarter of 2013 declined to $26.3 million from $35.0 million in the second quarter, primarily driven by the on-going unfavorable macro-economic environment, continued absorption of capacity of flex products ordered earlier in the year, and lower follow on orders related to consumer electronics. In addition, continued overcapacity led to low demand in our memory repair, LED and passive component businesses.

Net sales of $37.9 million for the third quarter of 2013 decreased $42.3 million compared to $80.2 million for the prior quarter. Sales for our Interconnect & Microfabrication Group (IMG) products decreased $38.6 million due to our microfabrication customers absorbing capacity shipped in the first half of 2013. Components Group (CG) decreased $3.8 million as our MLCC customers utilize existing capacity. Semiconductor Group (SG) sales levels remained consistent with the previous quarter.

Gross margin was 34.9% on net sales of $37.9 million for the third quarter of 2013 compared to 41.8% on net sales of $80.2 million for the prior quarter. The decrease was driven by lower production levels and write down of inventory related to discontinuance of our 3800 LED Test platform, partially offset by more favorable product mix.

Net operating expenses of $3.8 million in the third quarter of 2013 decreased $21.8 million compared to the prior quarter. The decrease was due to net legal settlement proceeds of $15.4 million, gain on sale of property and equipment of $1.2 million, a decrease of $1.8 million in research, development and engineering (RD&E), and a decrease of $3.4 million in selling, service and administration (SS&A). RD&E expenses decreased from the prior quarter due to lower variable and share-based compensation expenses and to a lesser extent, lower project materials. SS&A expense decreased primarily due to reduced compensation, professional fees and other variable expenses based on lower business volumes.

Operating income was $9.4 million in the third quarter of 2013, an increase of $1.5 million compared to operating income of $7.9 million in the prior quarter. The increase was primarily due to the legal settlement proceeds and gain on sale of property and equipment offset by lower sales volumes and gross profit as discussed above.

The effective tax rate was 27.9% for the third quarter of 2013, resulting from an income tax provision of $2.6 million, compared to an effective rate of 34.6% for the prior quarter that resulted from an income tax provision of $2.8 million. The decrease in the effective tax rate was primarily due to the fluctuation in quarterly net income between the second and third quarters of 2013, the mix of income and relative tax rates between jurisdictions, the utilization of various tax credits associated with higher income, and a decrease in valuation allowance against state net operating losses.

Net income for the third quarter of 2013 was $6.8 million compared to net income of $5.2 million in the prior quarter. However, income for the quarter was primarily the result of the legal settlement proceeds and gain on sale of property and equipment. Excluding these items, underlying business results would have resulted in an operating loss. Given the underlying results of the quarter, we considered if a triggering event had occurred requiring consideration of impairment of our goodwill, long lived assets and deferred tax assets. We concluded it had not, however our current market capitalization does not substantially exceed our carrying value. These factors have the possibility to lead to impairment in future periods if operating result trends do not improve.

Quarter Ended December 29, 2012 Compared to Quarter Ended December 31, 2011

Results of Operations

The following table presents results of operations data as a percentage of net
sales:



                                                      Fiscal quarter ended
                                                Dec 29, 2012         Dec 31, 2011
 Net sales                                              100.0 %              100.0 %
 Cost of sales                                           65.1                 57.5

 Gross margin                                            34.9                 42.5
 Selling, service and administration                     30.8                 28.0
 Research, development and engineering                   23.0                 21.1
 Legal settlement proceeds, net                         (40.5 )                 -
 Gain on sale of property and equipment, net             (3.2 )                 -
 Restructuring costs                                       -                   1.7

 Operating income (loss)                                 24.8                 (8.3 )
 Interest and other (expense) income, net                  -                   0.1

 Income (loss) before income taxes                       24.8                 (8.2 )
 Provision for (benefit from) income taxes                7.0                 (4.4 )

 Net income (loss)                                       17.8 %               (3.8 )%

Net Sales

Net sales were $37.9 million for the third quarter of 2013, a decrease of $11.9 million or 24% compared to net sales of $49.8 million for the third quarter of 2012. The decrease in revenue was a combination of microfabrication customers absorbing capacity shipped in the first half of 2013 and slow demand for memory repair and LED scribing products.

The following table presents net sales information by product group:

                                                                              Fiscal quarter ended
(In thousands, except percentages)                          Dec 29, 2012                                Dec 31, 2011
                                                  Net Sales          % of Net Sales           Net Sales          % of Net Sales
Interconnect & Microfabrication Group (IMG)      $    30,537                    80.5 %       $    35,318                    70.9 %
Components Group (CG)                                  4,071                    10.7               6,054                    12.2
Semiconductor Group (SG)                               3,322                     8.8               8,435                    16.9

                                                 $    37,930                   100.0 %       $    49,807                   100.0 %

IMG sales in the third quarter of 2013 decreased $4.8 million or 14% compared to the third quarter of 2012. The decrease was primarily driven by lower year over year demand from our advanced micromachining and flex-circuit customers.

CG sales in the third quarter of 2013 decreased $2.0 million or 33% compared to the third quarter of 2012. The decrease stems from MLCC customers' continued utilization of existing capacity.

SG sales in the third quarter of 2013 decreased $5.1 million or 61% compared to the third quarter of 2012. The decrease was driven by lower demand for memory repair as customers continue to defer capacity additions. In addition, revenue declined in LED as a result of a continued overcapacity in the industry, especially for makers of LED backlights for display.

The following table presents net sales information by geographic region:

                                                                        Fiscal quarter ended
(In thousands, except percentages)                    Dec 29, 2012                                Dec 31, 2011
                                            Net Sales          % of Net Sales           Net Sales          % of Net Sales
Asia                                       $    28,928                    76.3 %       $    42,731                    85.8 %
Americas                                         6,990                    18.4               4,515                     9.1
Europe                                           2,012                     5.3               2,561                     5.1

                                           $    37,930                   100.0 %       $    49,807                   100.0 %

Compared to the third quarter of 2012, net sales for the third quarter of 2013 decreased $13.8 million in Asia, increased $2.5 million in the Americas and decreased $0.6 million in Europe. The majority of our systems are sold into Asia as our customers' manufacturing facilities primarily reside in that region. The decrease in Asia was driven by lower demand for memory repair and LED scribing systems coupled with capacity absorption from our advanced microfabrication and flex interconnect products. Net sales in the Americas and Europe remain a lower percentage of total sales as purchases in these regions are primarily for specialized uses or research and development purposes, as compared to the trend by our Asian customers to source their high-volume manufacturing in that region.

Gross Profit

The following table presents gross profit information:

Fiscal quarter ended (In thousands, except percentages) Dec 29, 2012 Dec 31, 2011 Gross Profit % of Net Sales Gross Profit % of Net Sales Gross Profit $ 13,233 34.9 % $ 21,161 42.5 %

Gross profit for the third quarter of 2013 was $13.2 million, a decrease of $8.0 million compared to gross profit of $21.2 million for the third quarter of 2012. Gross profit as a percentage of net sales decreased to 34.9% for the third quarter of 2013 from 42.5% for the third quarter of 2012. The decreases were primarily related to lower volumes, timing of laser repair activities, and write down of inventory related to our 3800 LED Test platform, offset partially by more favorable product mix.

Operating Expenses

The following table presents operating expense information:



                                                                            Fiscal quarter ended
(In thousands, except percentages)                          Dec 29, 2012                              Dec 31, 2011
                                                  Expense           % of Net Sales          Expense          % of Net Sales
Selling, service and administration              $  11,696                     30.8 %       $ 13,944                    28.0 %
Research, development and engineering                8,730                     23.0           10,480                    21.1
Legal settlement proceeds, net                     (15,365 )                  (40.5 )             -                       -
Gain on sale of property and equipment, net         (1,226 )                   (3.2 )             -                       -
Restructuring costs                                     -                        -               861                     1.7

                                                 $   3,835                     10.1 %       $ 25,285                    50.8 %

Selling, Service and Administration

Selling, service and administration (SS&A) expenses primarily consist of labor and other employee-related expenses including share-based compensation expense, travel expenses, professional fees, sales commissions and facilities costs.

SS&A expenses were $11.7 million for the third quarter of 2013, down from $13.9 million in the third quarter of 2012. This decrease was primarily attributable to variable expenses due to lower business volumes, labor costs, professional fees, and share-based compensation expense. The decrease in share-based compensation expense is primarily due to lower attainment rate on performance based restricted stock units and the lower grant date fair value for new awards granted in 2013.

Research, Development and Engineering

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 totaled $8.7 million for the third quarter of 2013, a decrease of $1.8 million compared to the third quarter of 2012. This decrease was primarily due to lower labor costs, professional fees, project materials and other new product development costs, partially offset by the addition of Eolite expenses.

Legal Settlement Proceeds and Costs, net

Legal settlement proceeds and costs, net for the third quarter of 2013 were $15.4 million, which consisted of the All Ring litigation legal settlement proceeds of $16.3 million partially offset by court and legal fees associated with the All Ring litigation and other non-recurring legal matters.

Gain on Sale of Property and Equipment, net

During the third quarter of 2013, we sold a facility located in China, for $2.0 million, resulting in a pre-tax gain of $1.3 million partially offset by loss on disposal of certain fixed assets primarily used in testing and development.

Restructuring Costs

During the third quarter of 2012, we initiated restructuring plans to reduce our worldwide cost structure through transition of certain procurement and manufacturing activities to Asia and additionally identified and initiated other cost reduction actions. As a result of the actions, we recognized $0.9 million of restructuring costs during the third quarter of 2012 which consisted primarily of employee severance and related benefits.

Non-operating Income and Expense

Interest and Other Income (Expense), net

Interest and other income (expense), net, consists of interest income and expense, market gains and losses on assets held for our deferred compensation plan, realized and unrealized foreign exchange gains and losses, bank charges, investment management fees and other miscellaneous non-operating items.

Income Taxes

The following table presents income tax information:



                                                          Fiscal quarter ended
(In thousands, except percentages)           Dec 29, 2012                      Dec 31, 2011
                                      Income Tax       Effective        Income Tax        Effective
                                      Provision        Tax Rate         (Benefit)         Tax Rate
Income tax provision (benefit)       $      2,625            27.9 %    $     (2,196 )           53.9 %

The income tax provision for the third quarter of 2013 was $2.6 million on pretax income of $9.4 million, an effective tax rate of 27.9%. For the third quarter of 2012, the income tax benefit was $2.2 million on pretax loss of $4.1 million, an effective tax benefit of 53.9%. The higher effective tax rate for third quarter of 2012 was primarily due to the relative quarterly income levels, the mix of income between jurisdictions and their relative tax rates, and an increase in deductions from federal tax incentives related to higher income in the third quarter.

Our effective tax rate is subject to fluctuation based upon the mix of income and relative tax rates between jurisdictions, and the occurrence and timing of numerous discrete events such as changes in tax laws or their interpretations, extensions or expirations of research and experimentation credits, closure of tax years subject to examination, finalization of income tax returns, the relationship of fixed deductions to overall changes in estimated and actual pretax income or loss and the tax jurisdictions where income or loss is generated, and the ability to fully utilize our deferred tax assets.

Net Income (Loss)

The following table presents net income information:



                                                                          Fiscal quarter ended
(In thousands, except percentages)                       Dec 29, 2012                                Dec 31, 2011
                                              Net Income          % of Net Sales          Net Loss           % of Net Sales
Net income (loss)                            $      6,768                    17.8 %       $  (1,881 )                   (3.8 )%

Net income for the third quarter of 2013 was $6.8 million, or $0.23 per basic share and diluted share, compared to a net loss of $1.9 million, or $(0.07) per diluted share for the third quarter of 2012. The increase was primarily due to the net legal settlement proceeds and gain on sale of property and equipment partially offset by lower sales volumes and gross profit in the third quarter of 2013.

Three Quarters Ended December 29, 2012 Compared to Three Quarters Ended
December 31, 2011

Results of Operations

The following table presents results of operations data as a percentage of net
sales:



                                                          Three fiscal quarters ended
                                                     Dec 29, 2012             Dec 31, 2011
Net sales                                                    100.0 %                  100.0 %
Cost of sales                                                 60.2                     56.5

Gross margin                                                  39.8                     43.5
Selling, service and administration                           24.0                     21.7
Research, development and engineering                         16.3                     15.6
Legal settlement (proceeds) costs, net                        (8.7 )                    0.3
Gain on sale of property and equipment, net                   (0.7 )                     -
Restructuring costs                                             -                       0.4

Operating income                                               8.9                      5.5
Gain on sale of previously impaired auction
rate securities                                                 -                       1.3
Interest and other income (expense), net                      (0.1 )                   (0.2 )

Income before income taxes                                     8.8                      6.6
Provision for income taxes                                     2.6                      0.6

Net income                                                     6.2 %                    6.0 %

Net Sales

Net sales were $177.1 million for the first three quarters of 2013, a decrease of $31.6 million or 15% compared to net sales of $208.7 million for the first three quarters of 2012. The decrease in revenue was primarily driven by continued low demand for SG memory repair and LED scribing products partially offset by an increase in revenue from our flex interconnect products.

The following table presents net sales information by product group:

                                                                          Three fiscal quarters ended
(In thousands, except percentages)                          Dec 29, 2012                               Dec 31, 2011
                                                 Net Sales          % of Net Sales          Net Sales          % of Net Sales
Interconnect & Microfabrication Group (IMG)      $  147,506                    83.3 %       $  134,757                    64.5 %
Components Group (CG)                                19,607                    11.1             23,349                    11.2
Semiconductor Group (SG)                              9,938                     5.6             50,631                    24.3

                                                 $  177,051                   100.0 %       $  208,737                   100.0 %

IMG sales in the first three quarters of 2013 increased $12.7 million or 9% compared to the first three quarters of 2012. The increase was primarily driven by shipment of increased flex interconnect orders received in late 2012 and early 2013. Increased sales in the flex-circuit market were driven by strong demand for smart phones and tablets which utilize an increased amount of flex circuitry in their designs.

CG sales in the first three quarters of 2013 decreased $3.7 million or 16% compared to the first three quarters of 2012. The decrease was primarily driven by slowed demand for tooling products.

SG sales in the first three quarters of 2013 decreased $40.7 million or 80% compared to the first three quarters of 2012. The decrease was driven by on-going lower demand for memory repair as customers continue to defer capacity additions. In addition, revenue declined in LED as a result of a continued overcapacity in the industry, especially for makers of LED backlights for display.

The following table presents net sales information by geographic region:

                                                                     Three fiscal quarters ended
(In thousands, except percentages)                     Dec 29, 2012                               Dec 31, 2011
                                            Net Sales          % of Net Sales          Net Sales          % of Net Sales
Asia                                        $  154,962                    87.5 %       $  185,550                    88.9 %
Americas                                        15,696                     8.9             14,375                     6.9
Europe                                           6,393                     3.6              8,812                     4.2

                                            $  177,051                   100.0 %       $  208,737                   100.0 %

Compared to the first three quarters of 2012, net sales for the first three quarters of 2013 decreased $30.6 million in Asia and $2.4 million in Europe with an increase of $1.3 million in the Americas. The majority of our systems are sold into Asia as our customers' manufacturing facilities primarily reside in that region. The decrease in Asia was driven by lower demand for memory repair and LED scribing products. In addition, we saw a decline due to our microfabrication and flex interconnect customers utilizing existing capacity. Net sales in the Americas and Europe remain a lower percentage of total sales as purchases in these regions are primarily for specialized uses or research and development purposes, as compared to the trend by our Asian customers to source their high-volume manufacturing in that region.

Gross Profit

The following table presents gross profit information:

Three fiscal quarters ended (In thousands, except percentages) Dec 29, 2012 Dec 31, 2011 Gross Profit % of Net Sales Gross Profit % of Net Sales Gross Profit $ 70,406 39.8 % $ 90,862 43.5 %

Gross profit for the first three quarters of 2013 was $70.4 million, a decrease of $20.5 million compared to gross profit of $90.9 million for the first three quarters of 2012. Gross profit as a percentage of net sales decreased to 39.8% for the first three quarters of 2013 from 43.5% for the three quarters of 2012. These decreases were primarily related to lower revenue levels, a less favorable product mix, and write down of inventory related to our 3800 LED Test platform.

Operating Expenses

The following table presents operating expense information:



                                                                     Three fiscal quarters ended
. . .