UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

 

For the transition period from             to

Commission File Number: 0-5255

COHERENT, INC.

Delaware		94-1622541
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

 

5100 Patrick Henry Drive, Santa Clara, California 95054
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (408) 764-4000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

 

Large accelerated filer ý

Accelerated filer o

Non-accelerated filer o

 

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

The number of shares outstanding of registrant’s common stock, par value $.01 per share, on August 2, 2006 was 31,252759 shares.

COHERENT, INC.

INDEX

		Page
Part I.	Financial Information
Item I.	Financial Statements
	Condensed Consolidated Statements of Operations (unaudited) Three and nine months ended July 1, 2006 and July 2, 2005	3
	Condensed Consolidated Balance Sheets (unaudited) July 1, 2006 and October 1, 2005	4
	Condensed Consolidated Statements of Cash Flows (unaudited) Nine months ended July 1, 2006 and July 2, 2005	5
	Notes to Condensed Consolidated Financial Statements (unaudited)	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32
Item 4.	Controls and Procedures	33
Part II.	Other Information
Item 1A.	Risk Factors	34
Item 6.	Exhibits	43
Signatures		44

 

FORWARD-LOOKING STATEMENTS

This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  All statements included in or incorporated by reference in this Quarterly Report on Form 10-Q, other than statements of historical fact, are forward-looking statements.  These statements are generally accompanied by words such as “trend,” “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “rely,” “believe,” “estimate,” “predict,” “intend,” “potential,” “continue,” “forecast” or the negative of such terms, or other comparable terminology, including without limitation statements made under “Future Trends”, “Our Strategy”, discussions regarding our bookings and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.  Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.  Actual results of Coherent, Inc. (referred to herein as the Company, we, our or Coherent) may differ significantly from those projected in the forward-looking statements in this report.  Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the sections captioned “Future Trends,” “Risk Factors,” “Key Performance Indicators,” as well as any other cautionary language in this quarterly report.  We undertake no obligation to update forward-looking statements to reflect events or circumstances after the date they were made.

2

PART I.  FINANCIAL INFORMATION

Item I.  FINANCIAL STATEMENTS

COHERENT, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited; in thousands, except per share data)

		Three Months Ended						Nine Months Ended
		July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005
Net sales		$	149,524		$	125,269		$	426,506		$	382,466
Cost of sales		82,697			68,589			239,664			215,763
Gross profit		66,827			56,680			186,842			166,703
Operating expenses:
Research and development		18,714			13,882			52,595			42,358
In-process research and development		—			1,577			690			1,577
Selling, general and administrative		33,827			28,855			95,369			85,991
Restructuring and other charges (recoveries)		187			(360		)	97			(100		)
Amortization of intangible assets		2,205			1,674			6,846			4,695
Total operating expenses		54,933			45,628			155,597			134,521
Income from operations		11,894			11,052			31,245			32,182
Other income (expense):
Interest and dividend income		4,815			1,341			9,441			3,389
Interest expense		(1,808		)	(492		)	(2,629		)	(1,862		)
Foreign exchange gain (loss)		453			(13		)	(1,317		)	229
Other—net		116			(112		)	1,878			665
Total other income, net		3,576			724			7,373			2,421
Income before income taxes and minority interest		15,470			11,776			38,618			34,603
Provision for income taxes		4,619			2,131			10,278			173
Income before minority interest		10,851			9,645			28,340			34,430
Minority interest in subsidiaries’ losses, net of taxes		—			—			—			180
Net income		$	10,851		$	9,645		$	28,340		$	34,610
Net income per share:
Basic		$	0.35		$	0.31		$	0.92		$	1.13
Diluted		$	0.34		$	0.31		$	0.90		$	1.11
Shares used in computation
Basic		30,868			30,856			30,915			30,655
Diluted		31,592			31,454			31,461			31,133

 

See Accompanying Notes to Condensed Consolidated Financial Statements

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COHERENT, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited; in thousands, except par value)

		July 1, 2006			October 1, 2005
ASSETS
Current assets:
Cash and cash equivalents		$	421,005		$	97,507
Restricted cash and cash equivalents		—			15,467
Short-term investments		42,427			133,407
Accounts receivable—net of allowances of $2,857 and $3,136, respectively		102,657			87,684
Inventories		106,139			102,730
Prepaid expenses and other assets		28,578			17,034
Deferred tax assets		44,005			37,892
Total current assets		744,811			491,721
Property and equipment, net		150,416			155,316
Restricted cash and cash equivalents		2,742			1,220
Goodwill		72,096			68,097
Intangible assets, net		38,694			42,186
Other assets, net		55,655			39,750
		$	1,064,414		$	798,290
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term obligations		$	—		$	12,736
Accounts payable		31,070			18,451
Income taxes payable		14,837			16,597
Other current liabilities		67,301			63,803
Total current liabilities		113,208			111,587
Long-term obligations		1,451			—
Other long-term liabilities		61,686			50,437
Convertible subordinated notes		199,733			—
Commitments and contingencies (Note 10)
Stockholders’ equity:
Common stock, par value $.01 per share:
Authorized—500,000 shares
Outstanding—31,232 shares and 31,173 shares, respectively		310			309
Additional paid-in capital		334,770			325,818
Notes receivable from stock sales		(324		)	(324		)
Accumulated other comprehensive income		45,623			30,846
Retained earnings		307,957			279,617
Total stockholders’ equity		688,336			636,266
		$	1,064,414		$	798,290

 

See Accompanying Notes to Condensed Consolidated Financial Statements.

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COHERENT, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; in thousands)

		Nine Months Ended
		July 1, 2006			July 2, 2005
Cash flows from operating activities:
Net income		$	28,340		$	34,610
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		19,774			21,448
Amortization of intangible assets		6,846			4,695
Deferred income taxes		(2,784		)	(7,645		)
Stock-based compensation		10,146			262
Excess tax benefits from stock-based payment arrangements		(278		)	—
Tax benefit from employee stock options		—			1,381
Purchased in-process research and development		690			1,577
Non-cash restructuring and other charges		97			3,061
Other		459			1,386
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable		(12,875		)	18,367
Inventories		(901		)	(5,310		)
Prepaid expenses and other assets		(9,599		)	(1,643		)
Other assets		(2,009		)	(781		)
Accounts payable		11,914			562
Income taxes payable		456			67
Other current liabilities		(154		)	(2,037		)
Other long-term liabilities		711			2,921
Net cash provided by operating activities		50,833			72,921
Cash flows from investing activities:
Decrease in restricted cash and cash equivalents		13,725			23,644
Purchases of property and equipment		(12,884		)	(12,139		)
Proceeds from dispositions of property and equipment		1,167			455
Acquisition of businesses, net of cash acquired		(5,214		)	(37,873		)
Deferred business acquisition costs		(2,303		)	—
Purchases of available-for-sale securities		(186,553		)	(311,883		)
Proceeds from sales and maturities of available-for-sale securities		277,533			282,718
Premiums paid on life insurance		—			(1,252		)
Other – net		477			(489		)
Net cash provided by (used in) investing activities		85,948			(56,819		)
Cash flows from financing activities:
Proceeds received from issuance of convertible subordinated notes		200,000			—
Debt issuance costs		(5,567		)	—
Long-term debt borrowings		1,387			—
Long-term debt payments		(12,741		)	(14,366		)
Cash overdrafts decrease		(474		)	(2,292		)
Sales of shares under employee stock plans		19,025			13,130
Repurchase of common stock		(22,250		)	—
Collection of notes receivable from stock sales		—			434
Excess tax benefits from stock-based payment arrangements		278			—
Net cash provided by (used in) financing activities		179,658			(3,094		)
Effect of exchange rate changes on cash and cash equivalents		7,059			(3,312		)
Net increase in cash and cash equivalents		323,498			9,696
Cash and cash equivalents, beginning of period		97,507			87,659
Cash and cash equivalents, end of period		$	421,005		$	97,355

 

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COHERENT, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; in thousands)

Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest		$	1,440		$	2,126
Income taxes		$	11,283		$	8,566
Cash received during the period for:
Income taxes		$	886		$	2,474
Noncash investing and financing activities:
Portion of TuiLaser acquisition included in other current liabilities		—			$	218
Portion of deferred business acquisition costs included in other current liabilities		$	1,682		—
Deferred stock compensation		—			$	3,181

 

See Accompanying Notes to Condensed Consolidated Financial Statements

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COHERENT, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.     BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations.  These interim condensed consolidated financial statements and notes thereto should be read in conjunction with the Coherent, Inc. (referred to herein as the Company, we, our or Coherent) consolidated financial statements and notes thereto filed on Form 10-K/A for the fiscal year ended October 1, 2005.  In the opinion of management, all adjustments necessary for a fair presentation have been made and include all normal recurring adjustments.  Interim results of operations are not necessarily indicative of results to be expected for the year.

During the first quarter of fiscal 2006, we established a new organizational and reporting structure whereby our previously reportable segments, Electro-Optics and Lambda Physik, were fully integrated into one operating segment.  Accordingly, we operate in one segment, the development and marketing of lasers, precision optics and related accessories.  Prior period segment information has been restated to conform to the current presentation.

2.     ACQUISITIONS

Iolon, Inc.

On November 10, 2005, we acquired the assets of privately held Iolon, Inc. (Iolon) of San Jose, California for approximately $4.9 million in cash, net of acquisition costs of $0.1 million.  Iolon designs and manufactures optical components including widely tunable lasers and filters.  We intend to utilize the acquired technology in our core portfolio.  We have accounted for the acquisition of Iolon’s assets as a business combination and the operating results of Iolon have been included in our consolidated financial statements from the date of acquisition.  Our allocation is as follows (in thousands):

 

The goodwill recognized from this acquisition resulted primarily from anticipated increases in market share from implementing the acquired technology into our core products.  All of the goodwill from this purchase is expected to be deductible for tax purposes.  The existing technology is being amortized over an estimated useful life of eight years.

At the date of acquisition, we immediately charged $0.7 million to expense, representing purchased IPR&D related to a development project that had not yet reached technological feasibility and had, in management’s opinion, no alternative future use.  The assigned value was determined by estimating the costs to develop the acquired in-process technology into commercially viable products, estimating the net cash flows from such project, and discounting the net cash flows back to its present value.  Separate projected cash flows were prepared for both the existing, as well as the in-process projects.  The key assumptions used in the valuation include, among others, the expected completion date of the in-process project identified as of the acquisition date, the estimated costs to complete the project, revenue contribution and expense projection assuming the resulting products have entered the market, and the discount rate based on the risks associated with the development life cycle of the in-process technology acquired.  The discount rate used in the present value calculations was obtained from a weighted-average cost of capital analysis, adjusted upward to account for the inherent uncertainties surrounding the successful development of the in-process research and development, the expected profitability level of such technology, and the uncertainty of technological advances that could potentially impact the estimates.  Projected net cash flows were based on estimates of revenue and operating profit (loss) of the project.  The project became commercially viable in the second quarter of fiscal 2006.

Pro forma financial information has been excluded as the information is considered immaterial.

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Excel Technology, Inc.

On February 21, 2006, we announced that we had entered into a definitive agreement to acquire Excel Technology, Inc. (“Excel Technology”) in an all-cash merger transaction. Pursuant to the agreement, each outstanding share of Excel Technology common stock will be exchanged for $30.00, for a total approximate offer value of $376.0 million, before fees and transaction costs.  The acquisition is subject to customary closing conditions, including regulatory approvals.  On July 7, 2006, the German Federal Cartel Office, or the FCO, notified us that the FCO has decided to extend its investigation into our acquisition of Excel as it relates to certain low-power range CO2 laser products. All other regulatory conditions to close, including US Department of Justice approval, have been satisfied.

3.     RECENT ACCOUNTING STANDARDS

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 151, “Inventory Costs” (“SFAS 151”), an amendment of Accounting Research Bulletin No. 43, Chapter 4.  SFAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material.  We adopted the provisions of SFAS 151 on October 2, 2005 and the adoption did not have a material effect on our consolidated results of operations or financial position.

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143” (“FIN 47”).  FIN 47 clarifies that conditional asset retirement obligations meet the definition of liabilities and should be recognized when incurred if their fair values can be reasonably estimated.  We adopted FIN 47 on October 2, 2005, and the adoption did not have a material effect on our consolidated results of operations or financial position.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109, “Accounting for Income Taxes”.  This Interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  We are currently evaluating the effect that the adoption of FIN 48 will have on its financial position and results of operations.

In June 2006, the EITF reached a consensus on EITF Issue No. 06-03, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-03). EITF 06-03 provides that the presentation of taxes assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer on either a gross basis (included in revenues and costs) or on a net basis (excluded from revenues) is an accounting policy decision that should be disclosed. The provisions of EITF 06-03 are effective for fiscal years beginning after December 15, 2006. We are currently evaluating the effect that the adoption of EITF 06-03 will have on its financial position and results of operations.

4.     REVENUE RECOGNITION

We recognize revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists, the product has been delivered or the service has been rendered, the price is fixed or determinable and collection is probable.  Revenue from product sales is recorded when all of the foregoing conditions are met and risk of loss and title passes to the customer.  Our products typically include a one-year warranty and the estimated cost of product warranty claims (based on historical experience) is recorded at the time the sale is recognized.  Sales to customers are generally not subject to any price protection or return rights.

The vast majority of our sales are made to original equipment manufacturers (“OEMs”), distributors, resellers and end-users in the non-scientific market.  Sales made to these customers do not require installation of the products by us and are not subject to other post-delivery obligations, except in occasional instances where we have agreed to perform installation or provide training.  In those instances, we defer revenue related to installation services or training until these services have been rendered.  We allocate revenue from multiple element arrangements to the various elements based upon relative fair values, which is determined based on the price charged for each deliverable on a standalone basis.

Our sales to distributors, resellers and end-user customers typically do not have customer acceptance provisions and only certain of our sales to OEM customers have customer acceptance provisions.  Customer acceptance is generally limited to performance under our published product specifications.  For the few product sales that have customer acceptance provisions because of other than published specifications, (1) the products are tested and accepted by the customer at our site or by the customer’s acceptance of the results of our testing program prior to shipment to the customer, or (2) the revenue is deferred until customer acceptance occurs.

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Sales to end-users in the scientific market typically require installation and, thus, involve post-delivery obligations; however, our post-delivery installation obligations are not essential to the functionality of our products.  We defer revenue related to installation services until completion of these services.

For most products, training is not provided, therefore, no post-delivery training obligation exists.  In cases where training is provided to our customers, it is typically priced separately and recognized as revenue after these services have been provided.

5.     SHORT-TERM INVESTMENTS

We consider all highly liquid investments with maturities of three months or less at the time of purchase to be cash equivalents.  Marketable short-term investments in debt and equity securities are classified and accounted for as available-for-sale securities and are valued based on quoted market prices.  Investments classified as available-for-sale are reported at fair value with unrealized gains and losses, net of related tax, recorded as a separate component of other comprehensive income (OCI) in stockholders’ equity until realized.  Interest and amortization of premiums and discounts for debt securities are included in interest income.  Gains and losses on securities sold are determined based on the specific identification method and are included in other income (expense).

Cash, cash equivalents and short-term investments consist of the following (in thousands):

		July 1, 2006
		Cost Basis			Unrealized Gains			Unrealized Losses			Fair Value
Cash and cash equivalents		$	423,747		$	—		$	—		$	423,747
Less: restricted cash and cash equivalents											(2,742		)
Total cash and cash equivalents											$	421,005
Short-term investments classified as available-for-sale:
U.S. government and agency obligations		$	16,676		$	149		$	(164	)	$	16,661
State and municipal obligations		16,186			197			(78		)	16,305
Corporate notes and obligations		9,366			168			(73		)	9,461
Total short-term investments		$	42,228		$	514		$	(315	)	$	42,427

 

		October 1, 2005
		Cost Basis			Unrealized Gains			Unrealized Losses			Fair Value
Cash and cash equivalents		$	114,194		$	—		$	—		$	114,194
Less: restricted cash and cash equivalents											(16,687		)
Total cash and cash equivalents											$	97,507
Short-term investments classified as available-for-sale:
Commercial paper		$	992		$	8		$	—		$	1,000
Certificates of deposit		1,000			8			—			1,008
U.S. government and agency obligations		53,646			365			(236		)	53,775
State and municipal obligations		30,981			370			(23		)	31,328
Corporate notes and obligations		46,128			293			(125		)	46,296
Total short-term investments		$	132,747		$	1,044		$	(384	)	$	133,407

 

At July 1, 2006, $1.4 million of our cash and cash equivalents were restricted pursuant to an outstanding long-term debt arrangement at a subsidiary and $1.3 million were restricted for remaining close out costs related to the purchase of the shares of Lambda Physik.  At October 1, 2005, $15.2 million of our cash and cash equivalents were restricted pursuant to our Star notes agreement (See Note 8), $1.2 million were restricted for remaining close out costs associated with our purchase of the remaining outstanding shares of Lambda Physik and $0.3 million were restricted for other purposes.

The amortized cost and estimated fair value of available-for-sale investments in debt securities at July 1, 2006 and October 1, 2005, classified as short-term investments on our condensed consolidated balance sheets were as follows (in thousands):

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In the first nine months of fiscal 2006, we received proceeds totaling $130.4 million from the sale of available-for-sale securities and realized gross losses of $0.3 million.  In the first nine months of fiscal 2005, we received proceeds totaling $12.6 million from the sale of available-for-sale securities and realized gross losses of $0.1 million.

6.     INTANGIBLE ASSETS

Components of our amortizable intangible assets are as follows (in thousands):

		July 1, 2006									October 1, 2005
		Gross Carrying Amount			Accumulated Amortization			Net			Gross Carrying Amount			Accumulated Amortization			Net
Existing technology		$	48,015		$	(18,040	)	$	29,975		$	45,359		$	(14,018	)	$	31,341
Patents		9,181			(5,238		)	3,943			8,669			(4,365		)	4,304
Drawings		1,251			(1,251		)	—			1,181			(1,043		)	138
Order backlog		4,371			(4,371		)	—			4,133			(2,766		)	1,367
Customer lists		4,226			(1,657		)	2,569			3,929			(1,309		)	2,620
Trade name		2,133			(767		)	1,366			1,958			(547		)	1,411
Non-compete agreement		2,109			(1,268		)	841			1,840			(835		)	1,005
Total		$	71,286		$	(32,592	)	$	38,694		$	67,069		$	(24,883	)	$	42,186

 

Amortization expense for intangible assets for the three and nine months ended July 1, 2006 were $2.2 million and $6.8 million, respectively.  At July 1, 2006 estimated amortization expense for the remainder of fiscal 2006, the next five succeeding fiscal years and all years thereafter are as follows (in thousands):

		Estimated Amortization Expense
2006 (remainder)		$	1,835
2007		7,194
2008		6,744
2009		6,265
2010		5,266
2011		4,257
Thereafter		7,133
Total		$	38,694

 

7.     BALANCE SHEET DETAILS:

Inventories are as follows (in thousands):

		July 1, 2006			October 1, 2005
Purchased parts and assemblies		$	19,490		$	23,778
Work-in-process		54,409			48,036
Finished goods		32,240			30,916
Inventories		$	106,139		$	102,730

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Prepaid expenses and other assets consist of the following (in thousands):

 

Other assets, net consist of the following (in thousands):

 

Other current liabilities consist of the following (in thousands):

 

In the first quarter of fiscal 2006, we exited our Fort Lauderdale, Florida facility and as a result, we recorded a facility closure charge of $0.6 million.  The facility closure charge included the estimated contractual obligations for lease and other facility costs, net of estimated sublease income.  During the nine month period ended July 1, 2006, we recorded $1.5 million of payments made against our accrued restructuring charges for remaining lease liabilities, which was partially offset by additional provisions of $0.2 million for remaining lease liabilities.  During the nine month period ended July 2, 2005, we recorded $1.1 million of payments made against the accrual.

We provide warranties on certain of our product sales (generally one year) and allowances for estimated warranty costs are recorded during the period of sale.  The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or replace the products under warranty.  We currently establish warranty reserves based on historical warranty costs for each product line.  If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to cost of sales may be required in future periods.

Components of the reserve for warranty costs during the nine months of fiscal 2006 and 2005 were as follows (in thousands):

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Other long-term liabilities consist of the following (in thousands):

 

8.     CURRENT AND LONG-TERM OBLIGATIONS

Star Notes

At October 1, 2005, our current portion of long-term obligations primarily consisted of our notes payable to finance our acquisition of Star Medical (Star notes).  The notes were repaid in full during the quarter ended July 1, 2006.

Convertible Subordinated Notes

In March 2006, we issued $200.0 million of 2.75% convertible subordinated notes due March 2011.  The notes are unsecured and subordinate to all existing and future senior debt.  The notes mature on March 1, 2011, unless earlier redeemed or converted.  Interest on the notes is payable in cash semi-annually in arrears on March 1 and September 1 of each year.

The notes may be converted, at the option of the holder, into shares of our common stock at an initial conversion rate of 26.1288 shares of our common stock per $1,000 principal amount of notes, which is equal to an initial conversion price of approximately $38.27 per share, only under the following circumstances: (1) if the closing price of our common stock reaches, or the trading price of the notes falls below, specified thresholds, (2) if specified distributions to holders of our common stock occur, (3) if a fundamental change occurs or (4) during the period from, and including February 1, 2011 to, but excluding, the maturity date.  Upon conversion, in lieu of shares of our common stock, for each $1,000 principal amount of notes a holder will receive an amount in cash equal to the lesser of (i) $1,000 or (ii) the conversion value (as defined in the indenture for the notes) of the number of shares of our common stock equal to the conversion rate.  If the conversion value exceeds $1,000 on the conversion date, we will also deliver, at our election, cash or common stock or a combination of cash and common stock with respect to the remaining common stock deliverable upon conversion.  If a holder elects to convert its notes in connection with a fundamental change, we will pay a make whole premium by increasing the conversion rate applicable to such notes.  The conversion rate is subject to adjustment from time to time as set forth in the indenture for the notes.

The indenture under which the notes were issued provides that an event of default will occur if (i) we fail to pay the principal or fundamental change purchase price of any note when they become due and payable under the terms of the agreement, (ii) we fail to pay interest on the notes and fail to cure such non-payment within 30 days, (iii) we fail to deliver when due all cash and shares of common stock deliverable upon conversion and such failure continues for 15 days, (iv) we fail to perform or observe any other term, covenant or agreement required of us in the indenture and the failure is not cured or waived within 60 days after we receive notice of such failure, or (v) we fail to pay the principal by the end of any applicable grace period or the acceleration of other indebtedness of the Company for borrowed money where the aggregate principal amount with respect to which the default or acceleration exceeds $25 million and the acceleration has not been rescinded or annulled or the indebtedness repaid within a period of 30 days after receipt of notice of default, or the default is not cured, waived, rescinded or annulled.  If any of these events of default occurs, either the trustee or the holders of at least 25% of the outstanding notes may declare the principal amount of the notes to be due and payable.  In addition, an event of bankruptcy, insolvency or reorganization involving either the Company or any of our significant subsidiaries will constitute an event of default under the indenture and, in that case, the principal amount of the notes will automatically become due and payable.

In the event of a fundamental change, holders may require us to purchase for cash all or a portion of their notes, subject to specified exceptions, at a price equal to 100% of the principal amount of the notes plus accrued and unpaid interest, if any, to the fundamental change purchase date.

The carrying value of the convertible subordinated notes approximates fair value at July 1, 2006.

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9.     STOCK-BASED COMPENSATION

Stock-Based Benefit Plans

We have two Stock Option Plans and a non-employee Directors’ Stock Option Plan.  Under these plans, we may grant options to purchase up to an aggregate of 11,800,000 and 681,000 shares of common stock, respectively.  Employee options are generally exercisable between two to four years from the grant date at a price equal to the fair market value of the common stock on the date of the grant and generally vest 25% to 50% annually.  Grants under employee plans expire six years from the original grant date. Director options are automatically granted to our non-employee directors.  Such directors initially receive a stock option for 24,000 shares exercisable over a three-year period.  Additionally, the non-employee directors receive an annual grant of 6,000 shares exercisable as to 50% of the shares on each anniversary from the date of grant.  Grants under director plans expire ten years from the original grant date.  In addition, each non-employee director receives an annual grant of 2,000 shares of restricted stock awards that vests on the third anniversary of the date of grant.

Restricted stock awards granted under our Stock Option Plans are independent of option grants and are subject to restrictions.  At July 1, 2006, we had 301,912 shares of restricted stock outstanding, including 123,247 performance-based restricted stock awards, all of which are subject to forfeiture if employment terminates prior to the release of restrictions.   During this period, ownership of the shares cannot be transferred. The service-based restricted awards generally vest three years from the date of grant.  The performance-based restricted stock grants are subject to annual vesting over three years depending upon the achievement of performance measurements tied to the Company’s internal metrics for revenue growth and EBITDA percentage and is variable, so that the number of shares earned can range from 0% to 125% of the grant target for 2006 and 0% to 200% of the grant target for 2007 and 2008.   Restricted stock has the same cash dividend and voting rights as other common stock and is considered to be currently issued and outstanding.  The cost of the awards, determined to be the fair market value of the shares at the date of grant, is expensed ratably over the period the restrictions lapse.

We have an Employee Stock Purchase Plan (“ESPP”) whereby eligible employees may authorize payroll deductions of up to 10% of their regular base salary to purchase shares at the lower of 85% of the fair market value of the common stock on the date of commencement of the offering or on the last day of the six-month offering period.  At July 1, 2006, 311,727 shares of our common stock were reserved for future issuance under the plan.

Adoption of SFAS 123(R)

Prior to October 2, 2005, our stock-based employee compensation plans were accounted for under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).  Accordingly, no compensation expense has been recorded for stock options granted with exercise prices greater than or equal to the fair value of the underlying common stock at the option grant date.  Costs of restricted stock awards granted, determined to be the fair market value of the shares at the date of grant, have been recognized as compensation expense ratably over the respective vesting period.  The ESPP qualified as a non-compensatory plan under APB 25; therefore, no compensation cost was recorded in relation to the discount offered to employees for purchases made under the ESPP.

Effective October 2, 2005, we adopted the fair value recognition provisions of SFAS No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS 123(R)”), requiring us to recognize expense related to the fair value of our stock-based compensation awards.  We elected to use the modified prospective transition method as permitted by SFAS 123(R) and therefore have not restated our financial results for prior periods.  Under this transition method, stock-based compensation expense for the three and nine months ended July 1, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of October 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, as adjusted for estimated forfeitures.  Stock-based compensation expense for all stock-based compensation awards granted subsequent to October 1, 2005 was based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R).  Under SFAS 123(R), the ESPP is considered a compensatory plan and we are required to recognize compensation cost for grants made under the ESPP.  We recognize compensation expense for all share-based payment awards on a straight-line basis over the respective requisite service period of the awards.

As a result of adopting SFAS 123(R) on October 2, 2005, our net income for the three and nine months ended July 1, 2006 was $1.9 million and $6.3 million lower, respectively, than if we had continued to account for share-based compensation under APB 25.  Basic and diluted net income per share were both $0.07 lower for the three months ended July 1, 2006, and $0.21 lower for the nine months ended July 1, 2006, than had we not adopted SFAS 123(R).

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Determining Fair Value

Valuation and amortization method—We estimate the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach.  This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term—The expected term represents the period that our stock-based awards are expected to be outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior as influenced by changes to the terms of its stock-based awards.

Expected Volatility—Our computation of expected volatility for the quarter ended July 1, 2006 is based on a combination of historical volatility and market-based implied volatility.

Risk-Free Interest Rate—The risk-free interest rate used in the Black-Scholes-Merton valuation method is based on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term.

Expected Dividend—The expected dividend assumption is based on our current expectations about our anticipated dividend policy.

The fair value of the Company’s stock options granted to employees for the three and nine months ended July 1, 2006 and July 2, 2005 was estimated using the following weighted-average assumptions:

		Employee Stock Options Plans												Employee Stock Purchase Plans
		Three Months Ended						Nine Months Ended						Three Months Ended						Nine Months Ended
		July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005
Expected life in years		4.5			2.9			4.9			3.7			0.5			0.5			0.5			0.5
Expected volatility		34.2		%	40.2		%	35.2		%	46.8		%	32.6		%	32.6		%	33.6		%	36.4		%
Risk-free interest rate		5.2		%	3.7		%	4.9		%	3.7		%	4.8		%	2.9		%	4.1		%	2.3		%
Expected dividends		none			none			none			none			none			none			none			none
Weighted average fair value		$	11.93		$	10.25		$	12.92		$	10.50		$	8.72		$	7.30		$	7.98		$	6.72

 

Stock Compensation Expense

The following table shows total stock-based compensation expense included in the Condensed Consolidated Statements of Operations for the three and nine months ended July 1, 2006 (in thousands):

 

Total stock-based compensation cost capitalized as part of inventory during the three and nine months ended July 1, 2006 was immaterial.  As required by SFAS 123(R), management made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.

At July 1, 2006, the total compensation cost related to unvested stock-based awards granted to employees under the Company’s stock option plans but not yet recognized was approximately $17.4 million, net of estimated forfeitures of $1.2 million.  This cost will be amortized on a straight-line basis over a weighted-average period of approximately 1.7 years and will be adjusted for subsequent changes in estimated forfeitures.

At July 1, 2006, the total compensation cost related to options to purchase common shares under the ESPP but not yet recognized was approximately $0.5 million.  This cost will be amortized on a straight-line basis over a weighted-average period of approximately four months.

Prior to the adoption of SFAS 123(R), we presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in our statement of cash flows.  In accordance with SFAS 123(R), the cash flows resulting from excess tax benefits (tax benefits related to the excess of proceeds from employee’s exercises of stock options over the stock-based

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compensation cost recognized for those options) are classified as financing cash flows.  During the nine months ended July 1, 2006, we recorded less than $0.3 million of excess tax benefits as a financing cash inflow.

Stock Options & Awards Activity

The following is a summary of option activity for our Stock Option Plans (in thousands, except per share amounts and remaining contractual term in years):

		Number of Shares		Weighted Average Exercise Price Per Share			Weighted Average Remaining Contractual Term in Years		Aggregate Intrinsic Value
Outstanding at October 1, 2005		4,785		$	31.63
Granted		506		33.29
Exercised		(539	)	26.64
Forfeitures and expirations		(695	)	49.42
Outstanding at July 1, 2006		4,057		$	29.43		3.5		$	20,129
Vested and expected to vest at July 1, 2006		3,967		$	29.39		3.5		$	19,880
Exercisable at July 1, 2006		2,867		$	28.80		2.6		$	16,509

 

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of our common stock for the 3.6 million options that were in-the-money at July 1, 2006.  During the three and nine months ended July 1, 2006, the aggregate intrinsic value of options exercised under the Company’s stock option plans was $3.8 million and $4.6 million, respectively, determined as of the date of option exercise.  During the three and nine months ended July 1, 2005, the aggregate intrinsic value of options exercised under the Company’s stock option plans was $1.3 million and $4.3 million, respectively, determined as of the date of option exercise.

The following table summarizes our restricted stock award activity for the nine months ended July 1, 2006 (in thousands, except per share amounts):

		Number of Shares		Weighted Average Grant Date Fair Value
Nonvested stock at October 1, 2005		96		$	33.43
Granted		209		32.94
Vested		—		—
Forfeited		(3	)	33.18
Nonvested stock at July 1, 2006		302		33.09
Vested and expected to vest at July 1, 2006		236		$	33.07

 

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Pro-forma Disclosures

The following table illustrates the effect on net income and net income per share as if we had applied the fair value recognition provisions of SFAS 123 to stock-based compensation during the three and nine month periods ended July 1, 2005 (in thousands, except per share amounts):

 

		Three Months Ended			Nine Months Ended
		July 2,  2005			July 2, 2005
Net income, as reported		$	9,645		$	34,610
Add: stock based employee compensation expense included in reported net income under APB 25, net of related tax effects		100			100
Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of income taxes		(2,131		)	(9,014		)
Pro forma net income		$	7,614		$	25,696
Net income per share:
Basic – as reported		$	0.31		$	1.13
Basic – pro forma		$	0.25		$	0.84
Diluted – as reported		$	0.31		$	1.11
Diluted – pro forma		$	0.24		$	0.83

 

For purposes of this pro forma disclosure, the value of the options was estimated using a Black-Scholes-Merton option-pricing formula and amortized on a straight-line basis over the respective vesting periods of the awards, with forfeitures recognized as they occurred.

10.  COMMITMENTS AND CONTINGENCIES

Certain claims and lawsuits have been filed or are pending against us.  In the opinion of management, all such matters have been adequately provided for, are without merit, or are of such kind that if disposed of unfavorably, would not have a material adverse effect on our consolidated financial position or results of operations.

11.  STOCKHOLDERS’ EQUITY

In September 2005, our Board of Directors authorized a share repurchase program of up to 1.5 million shares of our common stock.  Under the terms of the repurchase program, purchases may be made from time to time in both the open market and in private transactions, as conditions warrant.  The program will remain in effect through September 30, 2007, unless earlier terminated or completed.  On February 20, 2006, the repurchase program was placed on hold as a result of the announcement of our pending acquisition of Excel Technology.  During the nine months ended July 1, 2006, we purchased and cancelled a total of 721,942 shares of our common stock for approximately $22.3 million.

12.  ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

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

		Three Months Ended						Nine Months Ended
		July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005
Net income		$	10,851		$	9,645		$	28,340		$	34,610
Translation adjustment		12,171			(15,323		)	14,757			(6,189		)
Net gain (loss) on derivative instruments, net of taxes		—			34			5			6
Changes in unrealized gains (losses) on available-for-sale securities, net of taxes		41			25			15			(155		)
Total comprehensive income (loss)		$	23,063		$	(5,619	)	$	43,117		$	28,272

 

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The following summarizes activity in accumulated other comprehensive income (loss) related to derivatives, net of income taxes, held by us (in thousands):

 

Accumulated other comprehensive income (net of tax) at July 1, 2006 is comprised of accumulated translation adjustments of $46.1 million, net loss on derivative instruments of $0.1 million and unrealized losses on available-for-sale securities of $0.4 million.  Accumulated other comprehensive income (net of tax) at October 1, 2005 is comprised of accumulated translation adjustments of $31.3 million, net loss on derivative instruments of $0.1 million and unrealized loss on available-for-sale securities of $0.4 million.

13.  EARNINGS PER SHARE

Basic earnings per share is computed based on the weighted average number of shares outstanding during the period, excluding unvested restricted stock.  Diluted earnings per share is computed based on the weighted average number of shares outstanding during the period increased by the effect of dilutive stock options and awards and stock purchase contracts using the treasury stock method.

The following table presents information necessary to calculate basic and diluted earnings per common share (in thousands, except per share data):

 

A total of 1,090,360 and 1,188,000 potentially dilutive securities have been excluded from the dilutive share calculation for the three months ended July 1, 2006 and July 2, 2005, respectively, as their effect was anti-dilutive.  A total of 2,116,714 and 2,720,000 potentially dilutive securities have been excluded from the dilutive share calculation for the nine months ended July 1, 2006 and July 2, 2005, respectively, as their effect was anti-dilutive.  For the quarter ended July 1, 2006, our 2.75% convertible subordinated notes due 2011 had no impact on diluted EPS because the average stock price during the period was below $38.27 per share, and the convertible subordinated notes, if converted, would require only cash at settlement.

14.  INCOME TAXES

As a result of the consolidation of two of our entities in Japan, accumulated earnings which had previously been treated as permanently invested became available for distribution.  As a result, we recognized a net tax benefit of approximately $1.8 million in the first quarter of fiscal 2006.  The total amount of unremitted earnings of foreign subsidiaries for which we have not yet recorded federal income taxes was approximately $114.0 million at July 1, 2006.  In addition to federal income taxes (which are not practicably determinable), withholding taxes of approximately $1.8 million would be payable upon repatriation of such earnings which would result in additional foreign tax credits.

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Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

COMPANY OVERVIEW

BUSINESS BACKGROUND

We are one of the world’s leading suppliers of photonics-based solutions in a broad range of commercial and scientific research applications.  We design, manufacture and market lasers, precision optics and related accessories for a diverse group of customers.  Since inception in 1966, we have grown through internal expansion and through strategic acquisitions of complementary businesses, technologies, intellectual property, manufacturing processes and product offerings.

There are many types of lasers and one way of classifying them is by the material used to create the lasing action.  We manufacture gas, liquid, semiconductor and solid-state lasers.  Lasers can also be classified by their output wavelength: ultraviolet, visible, infrared or wavelength tunable.  There are also many options in terms of pulsed output versus continuous wave, pulse duration, output power, beam dimensions, etc.  In fact, each application has its specific requirements in terms of laser performance.  The broad technical depth at Coherent enables us to offer a diverse product line characterized by lasers targeted at growth opportunities and key technology applications.  In all cases, we aim to be the supplier of first choice by offering a high-value combination of superior technical performance and high reliability.

Photonics is quickly becoming the critical enabler for a wide array of twenty-first century industries.  As a highly-concentrated energy source, lasers are applied to a variety of research and manufacturing situations because they can do the job faster, better or more economically than conventional technology.  Lasers are also enabling new applications that were previously not possible with conventional approaches.

Key laser applications include: microtechnologies and nanotechnology; semiconductor manufacturing; medical and biotechnology; consumer electronics; industrial processing and quality control; materials processing; imaging and printing; graphic arts display; and general research.  In particular, ultraviolet (“UV”) lasers are profiting from the trend towards miniaturization, which is a driver of innovation and growth in many markets.  The short wavelength of lasers that emit light in the UV spectral region make it possible to produce extremely small structures, with maximum precision, consistent with the latest state-of-the-art technology.

During the first quarter of fiscal 2006, we established a new organizational and reporting structure whereby our previously reportable segments, Electro-Optics and Lambda Physik, were fully integrated into one operating segment.  Accordingly, we operate in one segment, the development and marketing of lasers, precision optics and related accessories.  Prior period segment information has been restated to conform to the current presentation.

We were originally incorporated in California on May 26, 1966 and reincorporated in Delaware on October 1, 1990.

FUTURE TRENDS

Microelectronics

Lasers are currently a critical technology in many mass production applications and are expanding their presence as manufacturing processes evolve.  The drive to smaller, more tightly integrated, cost-effective electronic structures is spurring a high adoption rate for laser-based processes which are faster, more precise, cleaner, and more cost-effective.  We expect our strong presence in microelectronics to continue, with increasing adoption of solid-state, CO2 and excimer lasers that enable both next-generation performance improvements and reduced process costs.  In particular, we expect solid growth in advanced electronics packaging, solar cell, and flat panel display applications.

Graphic arts and display

This is a well-established market for diode lasers with three routes to market for our products — direct diode applications, diodes within our solid-state systems, and diodes sold into other solid-state laser systems.  The trend towards direct use of diode lasers is gaining increased acceptance as a cost enabler for creative new graphics, printing, and display applications.

Materials processing

Laser technology is well-established in industrial processes including cutting, welding, joining, drilling, marking, engraving, converting, and packaging.  Laser adoption is driven by new materials, processing speed and reliability, and cost-effective operation. 

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Our portfolio of wavelengths and output power, combined with the continuous reliability improvement of our products, positions us well in this market segment.  Growth areas for our CO2 and solid-state lasers include marking, engraving, converting, and packaging.

Scientific research and government programs

The scientific community uses lasers in a wide variety of experimental and research disciplines.  Often, the research performed using lasers at universities and research institutes is the genesis of innovative, laser-based products and processes, albeit sometimes years later.  Our leadership position with the scientific community continues to stimulate innovation and create opportunities for growth with applications in ultrashort pulses and in bio-research currently being the most active.

OEM components and instrumentation

The instrumentation market is seeing a gradual migration from the use of mature laser technologies, such as water-cooled ion lasers, to new laser technologies that allow more application flexibility and reduced instrument maintenance and footprint.  Using our unique portfolio of solid-state and semiconductor lasers and our patented OPS technology, we are able to both assist and stimulate this transition; however, the majority of these activities are still in the research and development stage and we expect only moderate impacts on the laser industry in the near-term, with increases expected in future years. Nevertheless, we anticipate greater future opportunities in microscopy, flow cytometry, lab-on-a-chip and DNA sequencing based on our product enhancements and evolving market developments.

OUR STRATEGY

We strive to develop innovative and proprietary products and solutions that meet the needs of our customers and that are based on our distinctive expertise in lasers and optical technologies.  In pursuit of our strategy, we intend to:

·            Leverage our technology portfolio and application engineering to lead the proliferation of photonics into broader markets — We will continue to identify opportunities in which our technology portfolio and application engineering can be used to offer innovative solutions and gain access to new markets.

·            Optimize our leadership position in existing markets — There are a number of markets where we have historically been at the forefront of technological development and product deployment and from which we have derived a substantial portion of our revenues.  We plan to optimize our financial returns from these markets.

·            Maintain and develop additional strong collaborative customer and industry relationships — We believe that the Coherent brand name and reputation for product quality, technical performance and customer satisfaction will help us to further develop our loyal customer base.  We plan to maintain our current customer relationships and develop new ones with customers that are industry leaders and to work together with these customers to design and develop innovative product systems and solutions as they develop new technologies.

·            Develop and acquire new technologies — We will continue to enhance our market position through our existing technologies and develop new technologies through our internal research and development efforts, as well as through the acquisition of additional complementary technologies, intellectual property, manufacturing processes and product offerings.

·            Emphasize supply chain management — We will continue to focus on operational efficiency through an emphasis on supply chain management with the explicit intent of improving gross margins and increasing inventory turns.

·            Focus on long-term improvement of return on invested capital — We will continue to focus on long-term improvement of return on invested capital.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared pursuant to the rules and regulations of the SEC.  The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  We have identified the following as the items that require the most significant judgment and often involve complex estimation: revenue recognition, accounting for long-lived assets (including goodwill and intangible assets), inventory valuation, warranty reserves, stock-based compensation and accounting for income taxes.

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Revenue Recognition

We recognize revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists, the product has been delivered or the service has been rendered, the price is fixed or determinable and collection is probable.  Revenue from product sales is recorded when all of the foregoing conditions are met and risk of loss and title passes to the customer.  Our products typically include a one-year warranty and the estimated cost of product warranty claims (based on historical experience) is recorded at the time the sale is recognized.  Sales to customers are generally not subject to any price protection or return rights.

The vast majority of our sales are made to original equipment manufacturers (OEMs), distributors, resellers and end-users in the non-scientific market.  Sales made to these customers do not require installation of the products by us and are not subject to other post-delivery obligations, except in occasional instances where we have agreed to perform installation or provide training.  In those instances, we defer revenue related to installation services or training until these services have been rendered.  We allocate revenue from multiple element arrangements to the various elements based upon relative fair values, which is determined based on the price charged for each deliverable on a standalone basis.

Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.  Failure to obtain anticipated orders due to delays or cancellations of orders could have a material adverse effect on our revenue.  In addition, pressures from customers to reduce our prices or to modify our existing sales terms may result in material adverse effects on our revenue in future periods.

Our sales to distributors, resellers and end-user customers typically do not have customer acceptance provisions and only certain of our sales to OEM customers have customer acceptance provisions.  Customer acceptance is generally limited to performance under our published product specifications.  For the few product sales that have customer acceptance provisions because of other than published specifications, (1) the products are tested and accepted by the customer at our site or by the customer’s acceptance of the results of our testing program prior to shipment to the customer, or (2) the revenue is deferred until customer acceptance occurs.

Sales to end-users in the scientific market typically require installation and, thus, involve post-delivery obligations; however, our post-delivery installation obligations are not essential to the functionality of our products.  We defer revenue related to installation services until completion of these services.

For most products, training is not provided; therefore, no post-delivery training obligation exists.  However, when training is provided to our customers, it is typically priced separately and is recognized as revenue after these services have been provided.

Long-lived Assets

We evaluate long-lived assets whenever events or changes in business circumstances or our planned use of assets indicate that their carrying amounts may not be fully recoverable or that their useful lives are no longer appropriate.  Reviews are performed to determine whether the carrying values of assets are impaired based on comparison to either the discounted expected future cash flows (in the case of goodwill) or to the undiscounted expected future cash flows (for all other long-lived assets).  If the comparison indicates that impairment exists, the impaired asset is written down to its fair value.  Significant management judgment is required in the forecast of future operating results that are used in the preparation of expected discounted and undiscounted cash flows.

At July 1, 2006, we had $110.8 million of goodwill and purchased intangible assets on our condensed consolidated balance sheet.  At July 1, 2006, we had $150.4 million of property and equipment on our condensed consolidated balance sheet.  As no impairment indicators were present during the third quarter of fiscal 2006, we believe these values remain recoverable.

It is reasonably possible that the estimates of anticipated future net revenue, the remaining estimated economic life of the products and technologies, or both, could differ from those used to assess the recoverability of these assets.  In that event, impairment charges or shortened useful lives of certain long-lived assets could be required.

Inventory Valuation

We record our inventory at the lower of cost (computed on a first-in, first-out basis) or market.  We write-down our inventory to its estimated market value based on assumptions about future demand and market conditions.  Inventory write-downs are generally recorded within guidelines set by management when the inventory for a device exceeds 12 months of its estimated demand and when individual parts have been in inventory for greater than 12 months.  If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required which could materially affect our future results of operations.  We write-down our demo inventory by amortizing the cost of demo inventory over a twenty month period starting from the fourth month after such inventory is placed in service.  Due to rapidly changing forecasts and orders, additional write-downs for excess or obsolete

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inventory, while not currently expected, could be required in the future.  In the event that alternative future uses of fully written down inventories are identified, we may experience better than normal profit margins when such inventory is sold.  Differences between actual results and previous estimates of excess and obsolete inventory could materially affect our future results of operations.

Warranty Reserves

We provide warranties on certain of our product sales (generally one year) and allowances for estimated warranty costs are recorded at the time of sale.  The determination of such allowances requires us to make estimates of product failure rates and expected costs to repair or replace the products under warranty.  We currently establish warranty reserves based on historical warranty costs for each product line.  If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to cost of sales may be required in future periods.

Stock-Based Compensation

We account for stock-based compensation in accordance with the provisions of SFAS No. 123 (Revised 2004), “Share-Based Payment,” (“SFAS 123(R)”).  Under the fair value recognition provisions of SFAS 123(R), stock-based compensation cost is estimated at the grant date based on the value of the award and is recognized as expense ratably over the requisite service period of the award.  Determining the appropriate fair value model and calculating the fair value of stock-based awards at the grant date requires judgment, including estimating stock price volatility, forfeiture rates and expected option life.  If actual forfeitures differ significantly from our estimates, adjustments to compensation cost may be required in future periods.

Income Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax provision (benefit) in each of the jurisdictions in which we operate.  This process involves the estimation of our current income tax provision (benefit) together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets.

We record a valuation allowance to reduce our deferred tax assets to an amount that more likely than not will be realized.  While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the allowance for the deferred tax assets would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the allowance for the deferred tax assets would be charged to income in the period such determination was made.

Federal income taxes have not been provided for on a portion of the unremitted earnings of foreign subsidiaries either because such earnings are intended to be permanently reinvested or because foreign tax credits are available to offset any planned distributions of such earnings. As a result of the consolidation of two of our entities in Japan, accumulated earnings which had previously been treated as permanently invested became available for distribution.  Accordingly, we recognized a net tax benefit of approximately $1.8 million in the first quarter of fiscal 2006.  The total amount of unremitted earnings of foreign subsidiaries for which we have not yet recorded federal income taxes was approximately $114.0 million at July 1, 2006.  In addition to federal income taxes (which are not practicably determinable), withholding taxes of approximately $1.8 million would be payable upon repatriation of such earnings which would result in additional foreign tax credits.

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