Novanta 10Q 2005 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	For the quarterly period ended September 30, 2005

or

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File No. 000-25705

GSI Group Inc.
(Exact name of registrant as specified in its charter)

New Brunswick, Canada	98-0110412
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

39 Manning Road
Billerica, MA	01821
(Address of principal executive offices)	(Zip Code)

(978) 439-5511
(Registrant’s telephone number, including area code)

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 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 x

No o

Indicate by a check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x

No o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o

No x

As at October 31, 2005, there were 41,614 of the Registrant’s common shares, no par value, issued and outstanding.

GSI GROUP INC.

TABLE OF CONTENTS

Item No.		Page No.

PART I — FINANCIAL INFORMATION		2
ITEM 1.	FINANCIAL STATEMENTS
	CONSOLIDATED BALANCE SHEETS (unaudited)	2
	CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)	3
	CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)	4
	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)	5
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	23
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	41
ITEM 4.	CONTROLS AND PROCEDURES	42
PART II — OTHER INFORMATION		42
ITEM 1.	LEGAL PROCEEDINGS	42
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	42
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	42
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	42
ITEM 5.	OTHER INFORMATION	42
ITEM 6.	EXHIBITS	43
SIGNATURES		44

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

GSI GROUP INC.
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(U.S. GAAP and in thousands of U.S. dollars, except share amounts)

	September 30, 2005			December 31, 2004

ASSETS
Current
Cash and cash equivalents (note 8)	$	84,170		$	82,334
Short-term investments (note 5 and 8)		9,283			2,995
Accounts receivable, less allowance of $1,327 (December 31, 2004 — $2,470) (note 7, 10)		51,751			60,314
Income taxes receivable (note 11)		1,280			2,287
Inventories (note 3)		63,010			60,319
Deferred tax assets (note 11)		11,813			13,094
Other current assets (note 3)		14,183			10,311

Total current assets		235,490			231,654
Property, plant and equipment, net of accumulated depreciation of $20,716 (December 31, 2004 — $26,604)		38,263			50,220
Deferred tax assets (note 11)		19,994			18,364
Other assets (note 3)		2,846			2,906
Long-term investments (note 8)		626			5,681
Intangible assets, net of amortization of $3,550 (December 31, 2004 — $2,139) (note 2, 3)		16,199			18,152
Patents and acquired technology, net of amortization of $29,271 (December 31, 2004 — $25,883) (note 2, 3)		28,759			32,837
Goodwill (note 2, 3)		26,421			26,350

	$	368,598		$	386,164

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current
Accounts payable	$	13,471		$	18,462
Income taxes payable (note 11)		2,021			4,045
Accrued compensation and benefits		9,621			13,160
Other accrued expenses (note 3)		16,718			21,327

Total current liabilities		41,831			56,994
Deferred compensation		2,530			2,178
Deferred tax liabilities (note 11)		10,566			11,521
Other liability		27			27
Accrued minimum pension liability (note 12)		9,278			9,881

Total liabilities		64,232			80,601
Commitments and contingencies (note 10)
Stockholders’ equity (note 6)
Common shares, no par value; Authorized shares: unlimited; Issued and outstanding: 41,614,421 (December 31, 2004 — 41,449,270)		309,430			308,669
Additional paid-in capital		3,305			3,289
Retained earnings (accumulated deficit)		3,308			(1,969	)
Accumulated other comprehensive loss		(11,677	)		(4,426	)

Total stockholders’ equity		304,366			305,563

	$	368,598		$	386,164

The accompanying notes are an integral part of these financial statements.

GSI GROUP INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(U.S. GAAP and in thousands of U.S. dollars, except share amounts)

	Three Months Ended						Nine Months Ended

	September 30, 2005			October 1, 2004			September 30, 2005			October 1, 2004

Sales	$	62,600		$	90,671		$	194,291		$	250,061
Cost of goods sold		37,909			53,573			118,970			147,705

Gross profit		24,691			37,098			75,321			102,356
Operating expenses:
Research and development and engineering		6,141			6,562			18,968			17,323
Selling, general and administrative		14,375			15,627			45,037			43,639
Amortization of purchased intangibles		1,632			1,614			5,033			4,324
Acquired in-process research and development		—			—			—			430
Other income		(322	)		—			(304	)		—

Total operating expenses		21,826			23,803			68,734			65,716
Income from operations		2,865			13,295			6,587			36,640
Other income		—			119			8			104
Interest income		521			253			1,301			643
Interest expense		(58	)		(104	)		(121	)		(159	)
Foreign exchange transaction gains (losses)		(352	)		267			591			(339	)

Income before income taxes		2,976			13,830			8,366			36,889
Income tax provision		934			1,707			3,089			4,013

Net income	$	2,042		$	12,123		$	5,277		$	32,876

Net income per common share:
Basic	$	0.05		$	0.29		$	0.13		$	0.80
Diluted	$	0.05		$	0.29		$	0.13		$	0.78
Weighted average common shares outstanding (000’s)		41,598			41,209			41,526			41,071
Weighted average common shares outstanding for diluted net income per common share (000’s)		41,965			42,084			41,821			42,159

The accompanying notes are an integral part of these financial statements.

GSI GROUP INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(U.S. GAAP and in thousands of U.S. dollars, except share amounts)

	Three Months Ended						Three Months Ended

	September 30, 2005			October 1, 2004			September 30, 2005			October 1, 2004

Cash flows from operating activities:
Net income	$	2,042		$	12,123		$	5,277		$	32,876
Adjustments to reconcile net income to net cash provided by operating activities:
(Gain) loss on disposal of assets		(4	)		—			197			—
Loss on sale of investments		—			—			—			15
Translation gain on liquidation of subsidiary		—			(119	)		—			(119	)
Acquired in-process research and development		—			—			—			430
Depreciation and amortization		3,265			3,161			10,365			9,762
Unrealized loss (gain) on derivatives		1			—			(36	)		—
Stock-based compensation		106			(205	)		16			(86	)
Deferred income taxes		(1,730	)		(6,986	)		(2,848	)		(12,676	)
Changes in current assets and liabilities:
Accounts receivable		8,627			(3,914	)		6,239			(5,912	)
Inventories		473			(2,969	)		(4,771	)		(13,865	)
Other current assets		(5,991	)		(740	)		(4,432	)		(1,461	)
Accounts payable, accruals and taxes (receivable) payable		3,232			7,863			(9,301	)		18,343

Cash provided by operating activities		10,021			8,214			706			27,307
Cash flows from investing activities:
Acquisitions of businesses		—			—			(71	)		(54,744	)
Sale of assets		5,809			—			7,359			—
Other additions to property, plant and equipment		(881	)		(520	)		(2,911	)		(1,386	)
Proceeds from the sale and maturities of investments		9,300			10,119			20,300			73,224
Purchases of investments		(4,313	)		(7,990	)		(21,532	)		(47,426	)
(Increase) decrease in other assets		(1	)		(27	)		85			(180	)

Cash provided by (used in) investing Activities		9,914			1,582			3,230			(30,512	)
Cash flows from financing activities:
Repayment of other long-term liability		—			(2	)		—			(2	)
Issue of share capital from the exercise of stock options and employee share purchase plan		298			332			762			1,969

Cash provided by financing activities		298			330			762			1,967
Effect of exchange rates on cash and cash equivalents		(77	)		(98	)		(2,862	)		423

Increase (decrease) in cash and cash equivalents		20,156			10,028			1,836			(815	)
Cash and cash equivalents, beginning of period		64,014			53,192			82,334			64,035

Cash and cash equivalents, end of period	$	84,170		$	63,220		$	84,170		$	63,220

The accompanying notes are an integral part of these financial statements.

(Unaudited)
As of September 30, 2005
(U.S. GAAP and tabular amounts in thousands of U.S. dollars, except share amounts)

1. Basis of Presentation

These unaudited interim consolidated financial statements have been prepared by GSI Group Inc. (formerly known as “GSI Lumonics Inc.”) in United States (U.S.) dollars and in accordance with accounting principles generally accepted in the U.S. for interim financial statements and the rules and regulations promulgated by the U.S. Securities and Exchange Commission, including the instructions to Form 10-Q and the provisions of Regulation S-X pertaining to interim financial statements. Accordingly, these interim consolidated financial statements do not include all information and footnotes required by generally accepted accounting principles for complete financial statements. The consolidated financial statements reflect all adjustments and accruals, consisting only of adjustments and accruals of a normal recurring nature, which management considers necessary for a fair presentation of financial position and results of operations for the periods presented. The consolidated financial statements include the accounts of GSI Group Inc. and its wholly-owned subsidiaries (the “Company”). Intercompany transactions and balances have been eliminated. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. The results for interim periods are not necessarily indicative of results to be expected for the year or for any future periods. The amounts are stated in thousands of U.S. dollars, unless otherwise indicated.

A reconciliation of the differences between United States and Canadian generally accepted accounting principles (GAAP) is presented in note 14.

Comparative Amounts

Certain prior year amounts have been reclassified to conform to the current year presentation in the financial statements as of and for the three and nine months ended September 30, 2005. These reclassifications had no effect on the previously reported results of operations of the Company or its financial condition.

2. Acquisitions

Purchases

On May 14, 2004, GSI Group Inc. completed its acquisition of MicroE Systems Corp., a Delaware corporation (MicroE). The acquisition was completed by means of a merger of Motion Acquisition Corporation, a Delaware corporation and an indirect wholly owned subsidiary of the Company, with and into MicroE, pursuant to an Agreement and Plan of Merger dated as of April 12, 2004. As a result of the merger, MicroE became an indirect wholly owned subsidiary of GSI Group Inc.

During the second quarter ended July 1, 2005, the Company increased the purchase price by $0.1 million for final adjustments related to claims and final transaction costs, which increased goodwill by $0.1 million. Including these final adjustments, the Company paid the former MicroE security holders $53.8 million in cash, which is net of cash acquired of $3.5 million in exchange for all of MicroE’s outstanding capital stock. The merger consideration and the terms of the merger were determined in arms-length negotiations between the parties. The Company paid the merger consideration from existing cash. The total purchase price, net of cash acquired and including costs of the transaction of $0.8 million, is approximately $54.6 million. The purchase price was allocated to the assets and liabilities based upon their estimated fair value at the date of acquisition, as noted below.

	Estimated Fair Value at Acquisition Date

	(In millions)
Accounts receivable	$	4.6
Inventories		2.0
Property, plant and equipment		0.4
Deferred tax assets		5.1
Other assets		0.1
Accounts payable and other accrued expenses		(3.8	)
Other liabilities		(0.2	)
Deferred tax liability		(12.3	)
Intangible assets		31.9
Goodwill		26.4
Purchased in-process research and development		0.4

Total purchase price	$	54.6

The estimated fair value of intangible assets acquired was recorded as follows:

	Estimated Fair Value at Acquisition Date		Estimated Useful Life

	(In millions)		(In years)
Customer relationships	$	8.6		8
Tradename		3.0		15
Acquired technology		20.3		10

Total intangible assets	$	31.9

The fair value of the assets acquired and liabilities assumed was less than the purchase price, resulting in goodwill. This goodwill was assigned to the Company’s Precision Motion Group. The acquisition of MicroE was structured in such a manner that the Company is not expected to receive any tax benefit from the amortization of intangibles nor is the goodwill deductible. As such, in accordance with US GAAP, a deferred tax liability based on estimated tax rates has been established with a corresponding increase to goodwill. An estimated in-process research and development charge of $0.4 million was recorded in the second quarter of 2004 for purchased in-process technology related to development projects that have not reached technological feasibility, have no alternative future use, and for which successful development is uncertain. The Company’s consolidated results of operations have included MicroE activity as of the closing date of May 14, 2004. The addition of MicroE’s products and technology complements the Company’s existing portfolio of enabling precision motion component and subsystems. Pro forma results of operations, as if the purchase had occurred at the beginning of the fiscal year 2004, are presented below.

	Pro Forma Combined (Unaudited) for the Nine Months Ended October 1, 2004

Sales	$	260,623
Net income	$	33,510
Net income per common share: Basic	$	0.82
Net income per common share: diluted	$	0.79
Weighted average shares outstanding: Basic		41,071
Weighted average shares outstanding: Diluted		42,159

Excluded from the pro forma results are costs of $1.2 million related to the acquisition that MicroE incurred prior to the acquisition date.

3. Supplementary Balance Sheet Information

The following tables provide details of selected balance sheet accounts.

Inventories

	September 30, 2005		December 31, 2004

Raw materials	$	26,055	$	27,634
Work-in-process		10,336		12,092
Finished goods		19,415		16,567
Demo inventory		7,204		4,026

Total inventories	$	63,010	$	60,319

Other Assets

	September 30, 2005		December 31, 2004

Short term other assets:
Prepaid VAT and VAT receivable	$	9,300	$	3,966
Other prepaid expenses		3,501		4,086
Other current assets		1,382		2,259

Total	$	14,183	$	10,311

Long term other assets:
Deposits and other	$	611	$	780
Mortgage receivable		2,235		2,126

Total	$	2,846	$	2,906

During fiscal year 2003, the Company sold its former sites in Kananta, Ontario. As part of the sale agreement for the Kanata property, the Company entered into an interest free mortgage agreement denominated in Canadian dollars with the purchaser. The mortgage receivable of Canadian $2.7 million was discounted at a rate of 2.5%. The principal is due November 30, 2006. As part of the mortgage agreement, the purchaser was to document that they had expended certain amounts for improvements on the facility by December 2004. This had not occurred and the Company sent a notice of default to the mortgagor in December 2004. During the second quarter of 2005, the Company determined that the improvements had been made. A supplier to the purchaser has registered a claim for lien on the property of approximately Canadian $31 thousand. During the third quarter, the Company sent a notice of breach to the mortgagor demanding the lien be removed. To date, this lien has not been cleared. The Company has not recorded any write down in the value of the mortgage receivable through September 30, 2005, as it expects to recover the carrying value of the mortgage.

Intangible Assets

	September 30, 2005						December 31, 2004

	Cost			Accumulated Amortization			Cost			Accumulated Amortization

Patents and acquired technology	$	58,030		$	(29,271	)	$	58,720		$	(25,883	)

Accumulated amortization		(29,271	)					(25,883	)

Net Patents and acquired technology	$	28,759					$	32,837

	September 30, 2005						December 31, 2004

	Cost			Accumulated Amortization			Cost			Accumulated Amortization

Customer relationships	$	14,011		$	(2,408	)	$	14,407		$	(1,245	)
Trademarks and trade names		5,738			(1,142	)		5,884			(894	)

Total cost		19,749		$	(3,550	)		20,291		$	(2,139	)

Accumulated amortization		(3,550	)					(2,139	)

Net intangible assets	$	16,199					$	18,152

Goodwill

The Company accounts for goodwill pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires that goodwill no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. During the second quarter of 2005, the Company completed its annual testing of goodwill. The goodwill of $26.4 million is assigned to a reporting unit within our Precision Motion Group. There were no indications of impairment; therefore no write-down of goodwill was necessary.

Other Accrued Expenses

	September 30, 2005		December 31, 2004

Accrued warranty	$	4,425	$	5,880
Deferred revenue		2,630		1,997
Accrued audit		1,182		1,521
VAT payable		1,714		2,750
Accrued restructuring (note 9)		1,056		1,552
Unrealized loss on currency swap and hedge contracts		644		1,986
Accrual for recourse receivables		952		767
Other		4,115		4,874

Total	$	16,718	$	21,327

Accrued Warranty

	For the Three Months Ended September 30, 2005			For the Three Months Ended October 1, 2004			For the Nine Months Ended September 30, 2005			For the Nine Months Ended October 1, 2004

Balance at the beginning of the period	$	4,902		$	5,145		$	5,880		$	4,571
Charged to costs of goods sold		832			2,154			3,980			5,346
Warranty accrual established as part of acquisition		—			—			—			299
Use of provision		(1,266	)		(1,598	)		(5,265	)		(4,560	)
Foreign currency exchange rate changes		(43	)		(22	)		(170	)		23

Balance at the end of the period	$	4,425		$	5,679		$	4,425		$	5,679

The Company generally warrants its products for a period of up to 12 months for material and labor to repair and service the system. A provision for the estimated cost related to warranty is recorded at the time revenue is recognized. The estimate of costs to service the warranty obligations is based on historical experience and expectation of future conditions. To the extent the Company experiences increased warranty claims or increased costs associated with servicing those claims, revisions to the estimated warranty liability would be made.

4. New Accounting Pronouncements

Inventory Costs

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”) to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). It requires that abnormal expenditures be recognized as expenses in the current period. SFAS 151 also requires that the amount of fixed production overhead allocated to inventory be based on the normal capacity of the production facilities. The standard is effective for fiscal years beginning after June 15, 2005, and is required to be adopted by the Company effective January 1, 2006. The Company is currently evaluating the effect that the adoption of SFAS 151 will have on its consolidated results of operations and financial condition, but does not expect SFAS 151 to have a material impact.

Share-Based Payment

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaces SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) and which supersedes APB 25. SFAS 123R requires the determination of the fair value of all share-based payments to employees, including grants of employee stock options, and the recognition of the related expense over the period in which the service is received. SFAS 123R was to be effective for the first interim or annual period after June 15, 2005, with early adoption encouraged. On April 14, 2005, the Securities and Exchange Commission announced that it would allow for phased-in implementation of SFAS 123R. In accordance with this new implementation time frame, the Company is required to adopt SFAS 123R no later than January 1, 2006. The pro forma disclosures previously permitted under SFAS 123, will no longer be an alternative to financial statement recognition. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. SFAS 123R allows the use of both closed form models (e.g., Black-Scholes Model) and open form models (e.g., lattice models) to measure the fair value of the share-based payment as long as that model is capable of incorporating all of the substantive characteristics unique to share-based awards. The transition methods include modified prospective and modified retrospective adoption options. Under the modified prospective method, awards that are granted, modified, or settled after the date of adoption should be measured and accounted for in accordance with SFAS 123R. Unvested awards that were granted prior to the effective date should continue to be accounted for in accordance with Statement 123 except that the fair value compensation cost must be recognized in the statement of operations. Under the modified retrospective approach, the previously reported amounts are restated (either to the beginning of the year of adoption or for all periods presented) to reflect the SFAS 123 amounts in the income statement. Additionally, SFAS 123R requires that tax benefits received in excess of compensation cost be reclassified from operating cash flows to financing cash flows in the Consolidated Statement of Cash Flows. The Company is evaluating the requirements of SFAS 123R, but the Company expects that the adoption of SFAS 123R will have a material impact on our consolidated results of operations and earnings per share. The Company has not yet determined the method of adoption, the model that the Company will use or the effect of adopting SFAS 123R. Additionally, the Company has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123, included in note 6 to the financial statements. The total expense recorded in future periods will depend on several variables, including the number of shared-based awards that vest and the fair value of those vested awards.

Exchanges of Nonmonetary Assets

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets — an Amendment of APB Opinion No. 29” (“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do not have commercial substance. SFAS No 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for the fiscal periods beginning after June 15, 2005. The Company adopted SFAS No. 153 in the third quarter of 2005 and the adoption of SFAS 153 did not have a material impact on its consolidated results of operations or financial condition.

Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004

In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004”, which provides guidance under SFAS No. 109, “Accounting for Income Taxes,” with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the “Jobs Act”) on enterprises’ income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. The Jobs Act provides for a temporary 85% dividends received deduction on certain foreign earnings repatriated during a one-year period. The deduction would result in an approximate 5.25% federal tax rate on the repatriated earnings. To qualify for the deduction, the earnings must be reinvested in the United States pursuant to a domestic reinvestment plan established by a company’s chief executive officer and approved by its board of directors. Certain other criteria in the Jobs Act must be satisfied as well.

Our cash balances are held in numerous locations throughout the world, including amounts held outside the United States. Most of the amounts held outside the United States could not be repatriated to the United States and would not be subject to the law defined under the Jobs Act, as the Company is incorporated under the laws of New Brunswick, a Canadian province, and the majority of our foreign locations are wholly owned by the New Brunswick corporation. Repatriation of some foreign balances is restricted by local laws. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. The deduction is subject to a number of limitations. As provided for in FSP No. 109-2, the Company has not adjusted its tax expense or deferred tax liability to reflect the repatriation provisions of the Jobs Act. The Company does not expect FSP 109-2 to have a material impact on its consolidated results of operations or financial condition.

Accounting for Conditional Asset Retirement Obligations

In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”). FIN 47 clarifies that a conditional asset retirement obligation, as used in SFAS 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of the settlement are conditional on a future event that may or may not be within the control of the entity. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. FIN 47 is effective January 1, 2006, with early adoption allowed. The Company does not expect FIN 47 to have a material impact on its consolidated results of operations or financial condition, as it does not currently have any asset retirement obligations.

Accounting Changes and Error Corrections

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”). SFAS 154 is a replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. SFAS 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. The reporting of a correction of an error by restating previously issued financial statements is also addressed by SFAS 154. This Statement defines retrospective application as the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity. This Statement also redefines restatement as the revising of previously issued financial statements to reflect the correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this pronouncement beginning in fiscal year 2006 and does not expect SFAS 154 to have a material impact on its consolidated results of operations or financial condition.

5. Bank Indebtedness

At both September 30, 2005 and December 31, 2004, the Company had no lines of credit but had two bank guarantees in British Pounds Sterling and Euros with National Westminster Bank (“NatWest”), and Deutsche Bank respectively, for a total amount of available credit of $0.1 million and $0.2 million at September 30, 2005 and December 31, 2004, respectively. The NatWest bank guarantee for letters of credit, which is used for VAT and duty purposes in the United Kingdom, is valued at $46 thousand and $38 thousand at September 30, 2005 and December 31, 2004, respectively. The Deutsche Bank guarantee of $102 thousand and $116 thousand for September 30, 2005 and December 31, 2004, respectively, is for our Munich, Germany office lease. Pursuant to a security agreement between the Company and Bank of America, marketable securities totaling $5.0 million had been pledged as collateral for the Bank of America foreign currency swap agreement. This $5.0 million investment is included in short-term investments as of September 30, 2005 and long-term investments as of December 31, 2004.

6. Stockholders’ Equity

Capital Stock

The authorized capital of the Company consists of an unlimited number of common shares without nominal or par value. During the nine months ended September 30, 2005, 165,151 common shares were issued pursuant to exercised stock options for proceeds of approximately $0.8 million. During the nine months ended October 1, 2004, 287,972 common shares were issued pursuant to exercised stock options and the employee share purchase plan for proceeds of approximately $2.0 million.

Accumulated Other Comprehensive Loss

The following table provides the details of accumulated other comprehensive loss at:

	September 30, 2005			December 31, 2004

Unrealized gain on investments, net of tax of nil	$	7		$	—
Accumulated foreign currency translations		(2,406	)		5,455
Accrued minimum pension liability, net of tax of nil		(9,278	)		(9,881	)

Total accumulated other comprehensive loss	$	(11,677	)	$	(4,426	)

The components of comprehensive income (loss) are as follows:

	Three Months Ended						Nine Months Ended

	September 30, 2005			October 1, 2004			September 30, 2005			October 1, 2004

Net income	$	2,042		$	12,123		$	5,277		$	32,876
Change in unrealized loss (gain) on investments, net of tax of nil		6			24			7			(4	)
Change in accrued minimum pension liability, net of tax of nil		193			18			604			(24	)
Foreign currency translation adjustments		(1,044	)		(815	)		(7,862	)		1,026

Comprehensive income (loss)	$	1,197		$	11,350		$	(1,974	)	$	33,874

Net income per common share

Basic net income per common share was computed by dividing net income by the weighted-average number of common shares outstanding during the period. For diluted net income per common share, the denominator also includes dilutive outstanding stock options and warrants determined using the treasury stock method.

Common and common share equivalent disclosures are:

	Three Months Ended				Nine Months Ended

	September 30, 2005		October 1, 2004		September 30, 2005		October 1, 2004

	(In thousands)				(In thousands)
Weighted average common shares outstanding		41,598		41,209		41,526		41,071
Dilutive potential common shares		367		875		295		1,088

Diluted common shares		41,965		42,084		41,821		42,159

Excluded from the calculation of diluted common shares were options and warrants totaling 1,662,270 and 826,383 for the three months ended September 30, 2005 and October 1, 2004, respectively, and 1,852,898 and 801,335 for the nine months ended September 30, 2005 and October 1, 2004, respectively, because their effect would be anti-dilutive. At September 30, 2005, the Company had options and warrants outstanding entitling holders to acquire up to 3,428,213 and 51,186 common shares, respectively. At October 1, 2004, the Company had options and warrants outstanding entitling holders to acquire up to 3,819,109 and 51,186 common shares, respectively.

Shareholders Rights Plan

At the May 26, 2005 Annual and Special Meeting of Shareholders, the shareholders of the Company approved a resolution to implement a Shareholder Rights Plan (the “Plan”) for a term of three years. This Plan was substantially similar to the Shareholder Rights Plan that was approved by the shareholders on May 9, 2002 and expired on April 12, 2005.

Under this Plan one Right has been issued in respect of each common share outstanding as of that date and one Right will be issued in respect of each common share issued thereafter. Under the Plan, each Right, when exercisable, entitles the holder to purchase from the Company one common share at the exercise price of Cdn$200, subject to adjustment and certain anti-dilution provisions (the “Exercise Price”).

The Rights cannot be transferred separately from the common shares until the eighth business day (subject to extension by the Board) after the earlier of (a) the first date of public announcement that a person or group of affiliated or associated persons (excluding certain persons and groups) has acquired beneficial ownership of 20% or more of the outstanding common shares of the Company, or (b) the date of commencement of, or first public announcement of the intent of any person or group of affiliated or associated persons to commence, a take-over Bid. At such time as any person or group of affiliated or associated persons becomes an “Acquiring Person” (a “Flip-In Event”), each Right shall constitute the right to purchase from the Company that number of common shares having an aggregate Market Price on the date of the Flip-In Event equal to twice the Exercise Price, for the Exercise Price (such Right being subject to anti-dilution adjustments).

So long as the Rights are not transferable separately from the common shares, the Company will issue one Right with each new common share issued. The Rights could have certain anti-takeover effects, in that they would cause substantial dilution to a person or group that attempts to acquire the Company on terms not approved by the Board of Directors.

Performance Based Incentive Stock Awards

During the second quarter of 2005, the Compensation Committee of the Board of Directors offered executive officers and certain managers the right to earn common shares (“the 2005 Incentive Awards”) under the Second Restatement of the GSI Lumonics Inc. 1995 Equity Incentive Plan (“the Plan”). Pursuant to the 2005 Incentive Awards, common shares would be issued only if the Company reaches defined levels of annual operating income during the period 2005 - 2007. If the awards triggered the grantees would receive shares of common shares without further consideration. The maximum number of shares available under the 2005 Incentive Awards, assuming the highest level of operating income achievement, is 300,000 shares. Subsequent to making the 2005 Incentive Awards, the Company determined the Plan does not permit the issuance of performance-based restricted shares as offered and that the Plan would have to be further amended to permit performance-based restricted shares to issue.

At the meeting of the Board of Directors held on October 25, 2005, the Board voted to satisfy any 2005 Incentive Awards by making cash payments based upon the trading price of the Company’s common shares, as of the date the Board approves the audited financial statements for the year ended December 31, 2005, times the number of shares earned under the 2005 Incentive Awards, if any. It is the intention of the Board to seek shareholder approval of a new omnibus Equity Incentive Plan that will permit the issuance of performance-based restricted stock awards consistent with the 2005 Incentive Awards. At this time, the Company does not believe it is probable that it will achieve the minimum operating income threshold for awards in 2005. Therefore, no compensation expense was recorded for these awards either in the financial statements or in the disclosure of the pro forma effect of fair value stock b ased compensation on net income. Additionally, the potential share awards have not been included in the denominator for either the basic or diluted earnings per share calculation, because not all conditions have been satisfied and the Company’s year-to-date annual operating income is substantially below any of the thresholds for which an award may be achieved. The Company will continue to monitor the circumstances of these awards and make appropriate updates to the accounting as required.

Pro Forma Stock Based Compensation

Had compensation cost for the Company’s stock option plans and employee stock purchase plan been determined consistent with SFAS No. 123, the Company’s net income and net income per share would have been decreased to the pro forma amounts below.

	Three Months Ended						Nine Months Ended

	September 30, 2005			October 1, 2004			September 30, 2005			October 1, 2004

Net income:
As reported	$	2,042		$	12,123		$	5,277		$	32,876
Stock based compensation included in results of operations		(1	)		(205	)		(91	)		(86	)
Stock based compensation if fair value based method was applied		(398	)		(1,942	)		(1,541	)		(3,022	)

Pro forma	$	1,643		$	9,976		$	3,645		$	29,768
Basic net income per share:
As reported	$	0.05		$	0.29		$	0.13		$	0.80
Pro forma	$	0.04		$	0.24		$	0.09		$	0.72
Diluted income per share:
As reported	$	0.05		$	0.29		$	0.13		$	0.78
Pro forma	$	0.04		$	0.24		$	0.09		$	0.71

During the third quarter of 2005, $0.1 million of stock based compensation was issued to a non employee consultant and was valued in accordance with fair value accounting under SFAS 123.

The fair value of options was estimated at the date of grant using a Black-Scholes option-pricing model with the following assumptions:

	September 30, 2005			October 1, 2004

Risk-free interest rate		4.07	%		1.0	%
Expected dividend yield		—			—
Expected life from date of grant		4.0 years			4.0 years
Expected volatility		60	%		65	%

7. Related Party Transactions

Richard B. Black, the Chairman of the Company, is also the President and Chief Executive Officer of ECRM, Inc. ECRM, Inc. purchased $40 thousand of equipment from the Westwind business unit of GSI Group Corporation in the three months ended September 30, 2005 and $23 thousand in the three months ended October 1, 2004 at amounts and terms approximately equivalent to third-party transactions. In the nine months ended September 30, 2005 and October 1, 2004, these revenues were $0.2 million and $93 thousand, respectively. Receivables from ECRM, Inc. of $11 thousand and nil as at September 30, 2005 and December 31, 2004, respectively, are included in accounts receivable on the balance sheet.

The Company recorded sales revenue from Sumitomo Heavy Industries Ltd., a significant shareholder of the Company, of $1.3 million in the three months ended September 30, 2005 and $1.4 million in the three months ended October 1, 2004 at amounts and terms approximately equivalent to third-party transactions. In the nine months ended September 30, 2005 and October 1, 2004, these revenues were $4.5 million and $4.3 million, respectively. Receivables from Sumitomo Heavy Industries Ltd. of $0.5 million and $0.6 million as at September 30, 2005 and December 31, 2004, respectively, are included in accounts receivable on the balance sheet. The Company purchases raw materials from Sumitomo at amounts and terms approximately equivalent to third-party transactions. The Company purchased $0.1 million and nil from Sumitomo in the three months ended September 30, 2005 and October 1, 2004, respectively. In both the nine months ended September 30, 2005 and October 1, 2004, these purchases were $0.2 million. Payables due to Sumitomo Heavy Industries Ltd. of $12 thousand and $8 thousand as at September 30, 2005 and December 31, 2004 are included in accounts payable on the balance sheet.

The Company has an agreement with V2Air LLC relating to the use of V2Air LLC’s aircraft for Company purposes. The Company’s President and Chief Executive Officer, Charles D. Winston owns V2Air LLC. Pursuant to the terms of the agreement, the Company is required to reimburse V2Air LLC for certain expenses associated with the use of the aircraft for Company business travel. During the three months ended September 30, 2005 and October 1, 2004, the Company reimbursed V2Air LLC $48 thousand and $42 thousand, respectively, under the terms of the agreement. During the nine months ended September 30, 2005, the Company reimbursed V2Air LLC $83 thousand under the terms of the agreement compared to $120 thousand for the nine months ended October 1, 2004.

8. Financial Instruments

Cash Equivalents, Short-term and Long-term Investments

At September 30, 2005, the Company had $61.1 million invested in cash equivalents predominately denominated in U.S. dollars with maturity dates between October 13, 2005 and October 27, 2005. At December 31, 2004, the Company had $48.3 million invested in cash equivalents denominated in U.S. dollars with maturity dates between January 1, 2005 and March 10, 2005. Cash equivalents are stated at fair value.

At September 30, 2005, the Company had $9.3 million in short-term investments denominated in U.S. dollars with maturity dates between November 17, 2005 and December 31, 2005. Short-term and long-term investments are recorded at fair market value. At December 31, 2004 the Company had $3.0 million in short-term investments and $5.0 million in long-term investments in U.S. dollars with maturity dates between February 3, 2005 and December 31, 2005. As discussed in note 5 to the financial statements, $5.0 million of short-term investments are pledged as collateral for the Bank of America foreign currency swap agreement at September 30, 2005. Long-term investments includes a minority equity investment of a private United Kingdom company valued at GBP 0.4 million (approximately $0.6 million and $0.7 million at September 30, 2005 and December 31, 2004, respectively), that was purchased as part of the assets acquired in the Spectron asset acquisition. This investment is recorded at cost. It is not practicable to determine the fair value of this investment. Further there have been no indicators of impairment.

Derivative Financial Instruments

The Company does not designate short-term contracts as hedges. Accordingly, such contracts are recorded at fair value with changes in fair value recognized currently in income, instead of being included in accumulated other comprehensive income. Although the Company marks-to-market short-term hedge contracts to the statement of operations, the Company does not enter into hedging contracts for speculative purposes. Long-term hedge contracts are accounted for under methods allowed by SFAS 133, and changes in their fair value are included in accumulated other comprehensive income for effective long-term hedges. At September 30, 2005 there were three short-term United States dollars to British Pound Sterling forward exchange contracts outstanding to purchase $2.3 million with an aggregate fair value loss of $1 thousand recorded in foreign exchange transaction gains (losses). At December 31, 2004, the Company had twelve United States dollars to British Pound Sterling forward exchange contracts to purchase $8.6 million United States dollars and three Yen to United States dollars forward exchange contracts to purchase $11.5 million United States dollars with a combined aggregate fair value loss of $0.1 million included in foreign exchange transaction gains (losses).

At September 30, 2005 and December 31, 2004, the Company had one forward contract for a long term intercompany transaction with a notional amount of $8.7 million that was designated as a cash flow hedge. The Company records the effective portion of the gain or loss on this derivative instrument in accumulated other comprehensive income as a separate component of stockholders’ equity. The loss on the cash flow hedge instrument included in accumulated other comprehensive income was $0.6 million and $1.7 million at September 30, 2005 and December 31, 2004, respectively. These amounts are offset with the remeasurement on the hedged item, for a net amount of nil in accumulated other comprehensive income at September 30, 2005 and December 31, 2004. The Company reports the effective portion of cash flow hedges in the same financial statement line item as the changes in value of the hedged item.

9. Restructuring and Other

Restructuring Charges

Several significant markets for our products had been in severe decline from 2000 through early 2003. In response to the business environment, the Company restructured operations in an effort to bring costs in line with our expectations for sales of systems for the semiconductor and telecommunications markets. Our emphasis was predominantly on consolidating operations at various locations and reducing overhead. The Company incurred restructuring charges in each of the years from 2000 to 2003 as it continued to reduce and consolidate operations around the world. In 2004, the Company evaluated accruals that it had made as part of prior restructuring actions. In the fourth quarter of 2004, it was determined that an additional charge of $0.6 million was needed for the excess space in the Munich facility due to continued softness in the Munich commercial market. The Company estimated the restructuring charge for the Munich, Germany facility based on contractual payments required on the lease for the unused space, less the amount expected to be received for subleasing the facility. Future sublease market conditions may require the Company to make further adjustments to this restructuring reserve. The Company has taken restructuring charges on this Munich facility in each of the years from 2000 through 2004. As of December 31, 2004, the Company had $1.6 million remaining in the accruals related to all restructuring actions. Specifically, $1.5 million in accruals related to provisions for lease costs at our facility in Munich, Germany related primarily to future contractual obligations under operating leases, net of expected sublease income on a lease that expires in January 2013, which the Company cannot terminate, because this is a long-term lease that extends until 2013. The Company will draw down the amount accrued over the life of the lease. The remaining $0.1 million of the accrual related to an amount for a leased facility in Nepean, Ontario originally recorded in 2001 for future contractual obligations under an operating lease, net of expected sublease income on such lease that the Company cannot terminate. This lease expires in January 2006. In the nine months ended September 30, 2005, the only restructuring activity related to payments under the leases noted above. At September 30, 2005, the remaining restructuring accrual of $1.1 million includes $1.1 million for the Munich office and a negligible amount for the Nepean lease.

The following table summarizes changes in the restructuring provision included in other accrued expenses on the balance sheet.

	Total

	(In millions)
Provision at December 31, 2004	$	1.6
Charges during the three months ended April 1, 2005		—
Cash draw-downs during the three months ended April 1, 2005		(0.2	)

Provision at April 1, 2005		1.4
Charges during the three months ended July 1, 2005		—
Cash draw-downs during the three months ended July 1, 2005		(0.2	)

Provision at July 1, 2005		1.2
Charges during the three months ended September 30, 2005		—
Cash draw-downs during the three months ended September 30, 2005		(0.1	)

Provision at September 30, 2005	$	1.1

Other

	Three Months Ended				Nine Months Ended

	September 30, 2005		October 1, 2004		September 30, 2005			October 1, 2004

Loss on sale of Nepean facility	$	—	$	—	$	(201	)	$	—
Gain on sale of Farmington facility		4		—		4			—
Rental income on excess facilities		318		—		501			—

Other income (expense)	$	322	$	—	$	304		$	—

The Company entered into a purchase and sale agreement for its facility in Nepean, Ontario on March 17, 2005 and closed on the transaction during the second quarter. Because the estimated sales proceeds were less than the net book value of the facility, the Company recorded a write-down of $0.2 million for the estimated loss on the expected sale of the Nepean facility during the first quarter of 2005 and an additional loss of $4 thousand in the second quarter of 2005. After the sale of the facility, there is a parcel of land in Nepean with a net book value of approximately $0.1 million at September 30, 2005, that the Company still owns and intends to sell. The Company believes that it will recover its carrying value on this land and has not recorded a write-down in value.

The Company entered into a purchase and sale agreement for its facility in Farmington, Michigan on July 8, 2005 and closed on the transaction on September 15, 2005. The selling price was $6.5 million. There were $0.7 million of closing costs and allowances. The Company recorded a gain of $4 thousand on the sale during the third quarter. There is a $25 thousand escrow for final work to be done on the property, which the Company expects to complete and receive during the fourth quarter.

During the second quarter of 2005, the Company leased its excess facility in Maple Grove, Minnesota. The Company also has leased a small amount of space in its Rugby, United Kingdom facility.

10. Commitments and Contingencies

Operating leases

The Company leases certain equipment and facilities under operating lease agreements. Most of these lease agreements expire between 2005 and 2013. In the United Kingdom, where longer leases are more common, the Company has land leases that extend through 2106. The facility leases require the Company to pay real estate taxes and other operating costs. The rent on certain leases is subject to escalation clauses in future years.

Legal Proceedings and Disputes

The Company’s French subsidiary is subject to a claim by a customer of the French subsidiary that a Laserdyne 890 system, which was delivered in 1999, had unresolved technical problems that resulted in the customer’s loss of revenue and profit, plus the costs to repair the machine. In May 2001, the Le Creusot commercial court determined that the Company had breached its obligations to the customer and that it was liable for damages. An expert appointed by the Le Creusot commercial court thereafter filed an initial report, which estimated the cost to repair the machine at approximately French Franc 0.8 million (or approximately US$0.1 million). In the third quarter of 2003, the Company was notified that the customer is seeking cost of repairs, damages and lost profits of Euro 1.9 million (approximately US$2.3 million). In July 2004, a court appointed expert reviewed the monetary request and determined that the amount should be Euro 0.9 million (or approximately $1.1 million). The Le Creusot commercial court is currently reviewing the amount requested by the customer and the expert opinion, but has not rendered a decision on the claim amount. The customer has not paid Euro 0.3 million (or approximately US$0.4 million) of the purchase price for the system, which the Company believes it may offset against any damages. The Company has fully reserved this receivable. During the second quarter of 2005, the Company entered a petition of bankruptcy for its French subsidiary, which was granted by the French courts on July 7, 2005. As a result of the bankruptcy petition, any claims on this matter in excess of available assets in the bankruptcy estate would have to be brought against the French subsidiary’s parent in its home jurisdiction, which is the United Kingdom. At this time, the Company does not believe it will be required to make a payment regarding this action and nothing has been accrued in the financial statements.

The Company has made claims for indemnification and breaches of warranty under the asset purchase agreement with Lumenis Ltd and Spectron Cosmetics Limited (formerly known as Spectron Laser Systems Limited) (collectively “Spectron”). The Company filed a claim in the English courts on July 29, 2005 against Spectron in regards to defects in the line of laser products purchased under the asset agreement and other matters related to the purchase. As part of the asset purchase agreement, US$1.3 million was deposited into escrow for any potential claims by the Company. During the third quarter, the Company filed a claim for the entire escrow balance. The Company seeks additional amounts from Spectron in excess of the escrow account. The Company has recorded in other current assets a receivable of GBP 0.4 million (approximately US$0.7 million) for all indemnification claims and purchase price adjustments arising from the asset purchase from Spectron as part of its initial purchase accounting. One customer, Hapa has made a demand during the quarter for warranty problems associated with lasers sold by Spectron prior to the acquisition. Hapa has made the same demand to Spectron, and the Company has sent a formal demand to Spectron for indemnification from the Hapa claim. No lawsuit has been filed by Hapa. To date, no claims or potential claims by any customers are currently the subject of any legal proceeding. It is not possible to determine the amount of claims, if any, that we may ultimately receive from Spectron, but we anticipate that at least the amount that we have recorded as a receivable will be recovered. Additionally, it is not possible to determine any amounts that we may have to pay to satisfy Spectron customers impacted by the defective product.

On May 13, 2005, the Company gave notice of its intention to assert a claim in an amount of approximately $1.6 million against an escrow account between the Company and MicroE for certain potential tax liabilities under the agreement and plan of merger with MicroE. The parties are currently negotiating a resolution of their differences. No amounts have been recorded in the financial statements as of September 30, 2005 for either the potential tax liabilities or any potential amount to be received under the claim.

During 2003, the Company wrote-off approximately $0.6 million on notes receivable from Robotic Vision Systems Inc. (“RVSI”). Because of the default in payment of the notes receivable in March 2003, the Company terminated RVSI’s rights to use the technology and has pursued an injunction in the United States District Court for the Eastern District of New York to prevent RVSI from utilizing or licensing the Company’s technology, which the injunction was granted in January 2004. RVSI filed a bankruptcy petition in the United States Bankruptcy Court for New Hampshire and certain of its assets were then sold, including those that could potentially use the Company’s technology. RVSI and the Company thereafter entered into a settlement whereby the Company reserved its right against the purchaser of RVSI’s assets in bankruptcy, and in turn granted RVSI a release. The Company believes that the purchaser of RVSI’s assets continues to infringe the Company’s technology and the Company is currently attempting to negotiate a license with the purchaser.

As the Company has disclosed since 1994, the Lemelson Foundation and related parties commenced legal proceedings in the United States District Court for Las Vegas against a number of United States manufacturing companies, including companies that have purchased systems from the Company. The plaintiff in the proceedings has alleged that certain equipment used by these manufacturers infringes patents claimed to be held by the plaintiff. While the Company is not a defendant in any of the proceedings, several of the Company’s customers have notified the Company that, if the plaintiff successfully pursues infringement claims against them, they may require the Company to indemnify them to the extent that any of their losses can be attributed to systems sold to them by the Company. Due to (i) the relatively small number of systems sold to any one of the Company’s customers involved in this litigation, (ii) the low probability of success by the plaintiff in securing judgment(s) against the Company’s customers and (iii) the findings in a countersuit that the patents that are the basis for the litigation are unenforceable and invalid, although these findings are being appealed, the Company does not believe that the outcome of any of these claims individually will have a material adverse effect upon the Company’s financial condition or results of operations. No assurances can be given, however, that these or similar claims, if successful and taken in the aggregate, would not have a material adverse effect upon the Company’s financial condition or results of operations. In January 2004, the U.S. District Court in Las Vegas granted a declaratory judgment in favor of Cognex Corporation holding that 14 patents asserted by the Lemelson Foundation are invalid and unenforceable, and not infringed by Cognex. The Company believes that the Cognex ruling substantially reduces any potential exposure to the Company and its customers.

The Company is also subject to various legal proceedings and claims that arise in the ordinary course of business. The Company does not believe that the outcome of these claims will have a material adverse effect upon the Company’s financial conditions or results of operations, but there can be no assurance that any such claims, or any similar claims, would not have a material adverse effect upon the Company’s financial condition or results of operations.

Recourse Receivables

In Japan, where it is customary to do so, the Company discounts certain customer notes receivable at a bank with recourse. The Company’s maximum exposure was $1.0 million at September 30, 2005 and $0.8 million at December 31, 2004. The book value of the recourse receivables approximates fair value. Recourse receivables are included in accounts receivable on the balance sheet and the liability is included in accrued expenses.

Guarantees

In the normal course of operations, the Company executes agreements that provide for indemnification and guarantees to counter parties in transactions such as business dispositions, the sale of assets, sale of products and operating leases. Additionally, the by-laws of the Company require it to indemnify certain current or former directors, officers, and employees of the Company against expenses incurred by them in connection with each proceeding in which he or she is involved as a result of serving or having served in certain capacities. Indemnification is not available with respect to a proceeding as to which it has been adjudicated that the person did not act in good faith in the reasonable belief that the action was in the best interests of the Company. These indemnities and guarantees are routine and customary in the industry.

These indemnification undertakings and guarantees may require the Company to compensate the counterparties for costs and losses incurred as a result of various events including breaches of representations and warranties, intellectual property right infringement, loss of or damages to property, environmental liabilities, changes in the interpretation of laws and regulations (including tax legislation) or as a result of litigation that may be suffered by the counterparties. Also, in the context of the sale of all or a part of a business, this includes the resolution of contingent liabilities of the disposed businesses or the reassessment of prior tax filings of the corporations carrying on the business.

Certain indemnification undertakings can extend for an unlimited period and generally do not provide for any limit on the maximum potential amount. The nature of substantially all of the indemnification undertakings prevents us from making a reasonable estimate of the maximum potential amount the Company could be required to pay counterparties as some agreements do not specify a maximum amount, although our standard terms and conditions limit exposure to the sales price of our products. Additionally, the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time.

Historically, the Company has not made any significant payments under such indemnifications. At September 30, 2005 and December 31, 2004, nothing has been accrued in the consolidated balance sheet with respect to these indemnification undertakings.

Risks and uncertainties

The Company uses financial instruments that potentially subject it to concentrations of credit risk. Such instruments include cash equivalents, securities available-for-sale, trade receivables and financial instruments used in hedging activities. The Company does not believe it is exposed to any significant credit risk on these instruments.

Due to the short term nature of the Company’s investments, the Company does not believe it is exposed to any significant interest rate risk.

Certain of the components and materials included in the Company’s laser systems and optical products are currently obtained from single source suppliers. There can be no assurance that a disruption of this outside supply would not create substantial manufacturing delays and additional cost to the Company.

There is no concentration of credit risk related to the Company’s position in trade accounts receivable. Credit risk, with respect to trade receivables, is minimized because of the diversification of the Company’s operations, as well as its large customer base and its geographical dispersion.

The Company’s operations involve a number of other risks and uncertainties including, but not limited to, the cyclicality of the semiconductor and electronics markets, the effects of general economic conditions, rapidly changing technology, and international operations.

11. Income Taxes

At the end of each interim reporting period, the Company determines its estimated annual effective tax rate, which is revised, as required, at the end of each successive interim period based on facts known at that time. The estimated annual effective tax rate is applied to the year-to-date pre-tax income at the end of each interim period. The tax effect of significant unusual items is reflected in the period in which they occur. The Company’s reported effective tax rate of 36.9% for the nine months ended September 30, 2005, differed from the expected Canadian federal and provincial statutory rate, primarily due to other income tax benefits from multiple jurisdictions totaling $129 thousand and $61 thousand for the three and nine months, respectively, ended September 30, 2005.

As part of the process of preparing the consolidated financial statements, the Company is required to estimate its income tax provision (benefit) in each of the jurisdictions in which it operates. This process involves estimating the 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 the Company’s consolidated balance sheets.

For three and nine months ended September 30, 2005, net benefits to previously estimated tax liabilities were $129 thousand and $61 thousand, respectively. The adjustments recorded in the third quarter of fiscal 2005 consisted primarily of a net favorable revision to estimated tax accruals upon filing the 2004 U.S. income tax return. Additional net adjustments during the second quarter of fiscal 2005 were attributable primarily to taxes on foreign earnings.

The Company records a valuation allowance to reduce its deferred tax assets for the amount that is not “more likely than not” to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event the Company was to determine that it would be able to realize its deferred tax assets in the future in excess of the net recorded amount, an adjustment to the allowance for the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the allowance for the deferred tax asset would be charged to income in the period such determination was made.

Income taxes have not been provided for unremitted earnings of foreign subsidiaries because such earnings are intended to be permanently reinvested by the Company.

American Jobs Creation Act of 2004

Our cash balances are held in numerous locations throughout the world, including amounts held outside the United States. Most of the amounts held outside the United States could not be repatriated to the United States and would not be subject to the law defined under the American Jobs Creation Act of 2004, as the Company is incorporated under the laws of New Brunswick, a Canadian province and the majority of our foreign locations are wholly owned by the New Brunswick corporation. There are no plans to repatriate any amount of cash relative to our foreign entities as allowed by the American Jobs Creation Act of 2004. Repatriation of some foreign balances is restricted by local laws. The American Jobs Creation Act of 2004, enacted on October 22, 2004 (the “Jobs Act”), provides for a temporary 85% dividends received deduction on certain foreign earnings repatriated during a one-year period. The deduction would result in an approximate 5.25% federal tax rate on the repatriated earnings. To qualify for the deduction, the earnings must be reinvested in the United States pursuant to a domestic reinvestment plan established by a company’s chief executive officer and approved by its board of directors. Certain other criteria in the Jobs Act must be satisfied as well.

12. Defined Benefit Pension Plan

The Company’s subsidiary in the United Kingdom maintains a pension plan, known as the GSI Lumonics Ltd. United Kingdom Pension Scheme Retirement Savings Plan. The plan has two components: the Final Salary Plan, which is a defined benefit plan, and the Retirement Savings Plan, which is a defined contribution plan. Effective April 1997, membership to the Final Salary Plan was closed. Benefits under this plan were based on the employees’ years of service and compensation. In December 2002, the Company notified plan participants that it no longer wanted to sponsor the Final Salary Plan. After a consultation period, the curtailment of the plan was effective June 1, 2003, after which no additional benefits accrue to the participants.

The Company continues to follow its policy to fund pensions and other benefits based on widely used actuarial methods as permitted by regulatory authorities. The funded amounts reflect actuarial assumptions regarding compensation, interest and other projections. The assets of this plan consist primarily of equity and fixed income securities of U.K. and foreign issuers.

Pension and other benefit costs reflected in the consolidated statements of operations are based on the projected benefit method of valuation. Within the consolidated balance sheet, pension plan benefit liabilities are included in accrued compensation and benefits.

The table below sets forth the estimated net periodic cost of the Final Salary Plan of GSI Lumonics Ltd. United Kingdom Pension Scheme Retirement Savings Plan.

	Three Months Ended						Nine Months Ended

	September 30, 2005			October 1, 2004			September 30, 2005			October 1, 2004

Components of the net periodic pension cost:
Service cost	$	—		$	—		$	—		$	—
Interest cost		407			256			1,222			769
Expected return on plan assets		(260	)		(216	)		(781	)		(650	)
Amortization of unrecognized gain (loss)		97			—			290			—
Recognized actuarial gain (loss)		—			—			—			—

Net periodic pension cost	$	244		$	40		$	731		$	119

The Company’s subsidiary in Japan maintains a tax qualified pension plan. The quasi-defined benefit pension plan covers substantially all regular employees, under which the Company deposits funds under various fiduciary-type arrangements and/or purchases annuities under group contracts. Benefits are based on years of service and the employee’s compensation at retirement. For employees with less than twenty years of service to the Company, the benefit is paid out in a lump sum based on years of service and the employee’s compensation at retirement. For employees with twenty or more years of service to the Company, the benefit is guaranteed for a certain number of years and is based on years of service and the employee’s compensation at retirement. Participants may, under certain circumstances, receive a benefit upon termination of employment.

The assumptions that are used to value the costs and obligations of the plan reflect the Japanese economic environment. The Company continues to fund the plan sufficiently to meet current benefits as well as to fund a certain portion of future benefits as permitted in accordance with regulatory authorities.

The table below sets forth the estimated net periodic cost of the tax qualified pension plan.

	Three Months Ended September 30, 2005			Nine Months Ended September 30, 2005

Components of the net periodic pension cost:
Service cost	$	51		$	153
Interest cost		7			22
Expected return on plan assets		(1	)		(2	)
Amortization of unrecognized gain (loss)		17			52
Recognized actuarial gain (loss)		—			—

Net periodic pension cost	$	74		$	225

It is not practicable to provide the components of the net periodic pension cost for the three months or nine months ended October 1, 2004 as an initial actuarial valuation was performed for the year ended December 31, 2004.

13. Segment Information

General Description

There have been no significant changes to the Company’s reportable operating segments since December 31, 2004. The Company’s operating segments are the same as those described in the Annual Report on Form 10-K for the fiscal year ended December 31, 2004. The Components Group has been renamed the Precision Motion Group. This name change more accurately reflects its business, but had no change on the operation or the results of the segment.

Beginning with the first quarter of 2005, the Company and Chief Operating Decision Maker decided to include amortization of intangibles in the segments’ results of operations to reflect more fully expenses attributable to the businesses. For comparative purposes, the Precision Motion Group and Laser Group segments’ operating income for the third quarter and the year to date ending October 1, 2004 has been restated to include amortization. This change had no impact on the Company’s consolidated results of operations or its financial position. There is no amortization associated with the Laser Systems’ Group segment. The amortization of purchased intangibles not allocated to a segment is related to amortization of intangibles from the merger of General Scanning and Lumonics. The current business segment structure did not exist at the time of the merger; therefore it is impractical to allocate the amortization to a particular segment. During the third quarter of 2005, the Company determined that sales of certain parts in Asia-Pacific, which are sold by both the Lasers and Laser Systems Groups, should be included in the results of the Laser Systems Group segment to more accurately reflect which segment’s customers purchased the parts. As a result, the Company has reclassified from the Laser Group to the Laser Systems Group similar sales and cost of goods sold in the comparative three and nine months ended October 1, 2004. This reclassification had no impact on the consolidated results of operations for the Company.

Segments

Information on reportable segments is as follows:

	Three Months Ended						Nine Months Ended

	September 30, 2005			October 1, 2004			September 30, 2005			October 1, 2004

Sales:
Precision Motion Group	$	36,504		$	42,060		$	104,640		$	117,270
Laser Group		10,009			11,648			31,696			34,891
Laser Systems Group		17,898			41,217			63,612			112,376
Intersegment sales elimination		(1,811	)		(4,254	)		(5,657	)		(14,476	)

Total	$	62,600		$	90,671		$	194,291		$	250,061

Segment income from operations:
Precision Motion Group	$	5,480		$	5,687		$	13,649		$	19,165
Laser Group		108			530			200			1,230
Laser Systems Group		712			11,913			5,481			31,557

Total by segment		6,300			18,130			19,330			51,952
Unallocated amounts:
Corporate expenses		3,640			4,810			12,693			13,970
Amortization of purchased intangibles not allocated to a segment		26			25			79			912
Acquired in-process research and development		—			—			—			430
Other income not allocated to a segment		(231	)		—			(29	)		—

Income from operations	$	2,865		$	13,295		$	6,587		$	36,640

Amortization of purchased intangibles by segment included in the above segment income from operations:
Precision Motion Group	$	1,503		$	1,483		$	4,636		$	3,210
Laser Group	$	103		$	105		$	317		$	202

Management does not review asset information on a segmented basis and the Company does not maintain assets on a segmented basis, therefore a breakdown of assets by segments is not included.

Geographic Segment Information

Revenues are attributed to geographic areas on the basis of the bill-to customer location. Not infrequently, equipment is sold to large international companies, which may be headquartered in Asia-Pacific for example, but the sales of our systems are billed and shipped to locations in the United States for instance. In this example, these sales are therefore reflected in North America totals in the table below. Long-lived assets, which include property, plant and equipment, intangibles and goodwill, but exclude other assets, long-term investments and deferred tax assets, are attributed to geographic areas in which Company assets reside.

	Three Months Ended

	September 30, 2005					October 1, 2004

	Sales		% of Total			Sales		% of Total

	(In millions)					(In millions)
North America	$	24.0		38	%	$	36.6		40	%
Latin and South America		0.3		—			0.5		1
Europe (EMEA)		11.6		19			12.6		14
Japan		11.0		18			19.7		22
Asia-Pacific, other		15.7		25			21.3		23

Total	$	62.6		100	%	$	90.7		100	%

	Nine Months Ended

	September 30, 2005					October 1, 2004

	Sales		% of Total			Sales		% of Total

	(In millions)
North America	$	77.9		40	%	$	117.2		47	%
Latin and South America		1.1		1			1.1		—
Europe (EMEA)		33.9		17			38.1		15
Japan		33.7		17			44.6		18
Asia-Pacific, other		47.7		25			49.1		20

Total	$	194.3		100	%	$	250.1		100	%

	September 30, 2005		December 31, 2004

Long-lived assets and goodwill:
USA	$	75,020	$	85,636
Canada		124		2,066
Europe		32,415		38,662
Japan		553		665
Asia-Pacific, other		1,530		530

Total	$	109,642	$	127,559

14. Differences between United States and Canadian Generally Accepted Accounting Principles (GAAP)

Significant differences between United States and Canadian GAAP are described below.

(a) Cash Equivalents, Short and Long Term Investments

Under U.S. GAAP, certain marketable investments, which are considered to be “available-for-sale” securities, are measured at market value, with the unrealized gains or losses included in comprehensive income. Under current Canadian GAAP, the concept of comprehensive income is not applicable and these investments are measured at amortized cost.

(b) Property, Plant and Equipment and Intangible Assets

On March 22, 1999, Lumonics Inc. (Lumonics) and General Scanning, Inc. (General Scanning) completed a merger of equals to form the Company. Under Canadian GAAP, the merger was accounted for using the pooling of interests method and the consolidated financial statements reflect the combined historical carrying values of the assets, liabilities, stockholders’ equity and the historical operating results of the two predecessor companies.

Under U.S. GAAP, the merger has been accounted for as a purchase transaction. The purchase price, based on the fair value of General Scanning shares purchased, is allocated in the consolidated financial statements to acquired net identifiable General Scanning assets. Property, plant and equipment and acquired intangible assets were recorded at their estimated fair values at the time of the 1999 acquisition and are being amortized over their useful life. The acquired technology established as part of this merger is fully amortized and the tradename intangible asset will be fully amortized in the first quarter of 2009.

(c) Accrued Minimum Pension Liability

Under U.S. GAAP, if the accumulated benefit obligation exceeds the market value of plan assets, a minimum pension liability for the excess is recognized to the extent that the liability recorded in the balance sheet is less than the minimum liability. This additional liability is charged to comprehensive income. Current Canadian GAAP has no such requirement to record a minimum liability and does not apply the concept of comprehensive income.

(d) Stock Based Compensation

Effective January 1, 2004, under Canadian GAAP, the Company is required to measure and expense stock based compensation using a fair value method. Under U.S. GAAP, the Company uses the intrinsic value method for accounting for its stock option plans. Under this method, no stock based compensation expense is recorded in the financial statements, unless the exercise price of an option differs from the fair market value of the underlying stock on the date of grant. Further, under U.S. GAAP, if there has been a modification of terms of a stock option, which requires the use of variable accounting, stock compensation expense will be recorded with the offset included as a component of stockholders’ equity.

(e) Income Taxes

This represents the tax effect of adjustments to arrive at Canadian GAAP.

(f) Accumulated Other Comprehensive Income (Loss) and Accumulated Foreign Currency Translation Adjustments

U.S. GAAP requires the disclosure of comprehensive income which, for the Company, comprises net income under U.S. GAAP, changes in foreign currency translation amounts, unrealized gains or losses for the period less gains or losses realized during the period on “available-for-sale” securities, unrealized gains or losses for the period less gains or losses realized during the period on derivatives and the movement in the accrued minimum pension liability. The accumulation of these movements is recorded as a component of stockholders’ equity. The concept of comprehensive income is not applicable under current Canadian GAAP and the only amount that is included as a component of stockholders’ equity is accumulated foreign currency translation adjustments.

(g) Shareholders’ Equity and Retained Earnings

In 1994, the shareholders of Lumonics approved a reduction of the stated capital and deficit under Canadian GAAP totaling $40 million under the terms of the Ontario Business Corporations Act. This concept does not exist under U.S. GAAP, therefore at the time of merger between Lumonics and General Scanning for U.S. GAAP, this was not allowed.

Reconciliation of U.S. and Canadian GAAP

The letter references in the two tables below refer to the letters describing the significant differences in the accounting between U.S. and Canadian GAAP above. The difference in retained earnings (accumulated deficit) between U.S. and Canadian GAAP is an accumulation of all the differences in the results of operations from the merger date to the current time, plus the $40 million reduction of deficit noted in (g).

Net income

					For the Three Months Ended						For the Nine Months Ended

			Ref.		September 30, 2005			October 1, 2004			September 30, 2005			October 1, 2004

Net income — as reported in U.S. GAAP					$	2,042		$	12,123		$	5,277		$	32,876
Differences due to:
	•	Differences in depreciation and amortization resulting from different merger accounting methods		(b)		26			7			79			765
	•	Stock compensation recorded under fair value method		(d)		(398	)		(1,942	)		(1,541	)		(3,021	)
	•	Stock compensation recorded as a result of variable accounting		(d)		(1	)		(205	)		(91	)		(86	)
	•	Difference in taxes - additional benefit (provision)		(e)		(4	)		—			20			—

Net income — Canadian GAAP					$	1,665		$	9,983		$	3,744		$	30,534

Net income per common share — basic — Canadian GAAP					$	0.04		$	0.24		$	0.09		$	0.74
Net income per common share — diluted — Canadian GAAP					$	0.04		$	0.24		$	0.09		$	0.72

Selected balance sheet accounts where differences exist between U.S. and Canadian GAAP

	September 30, 2005											December 31, 2004

	As Reported			Ref.		Amount			Canadian GAAP			As Reported			Ref.		Amount			Canadian GAAP

Cash and cash equivalents	$	84,170			(a)	$	(7	)	$	84,163		$	82,334			(a)		—		$	82,334
Short-term investments		9,283			(a)		—			9,283			2,995			(a)		—			2,995
Income taxes receivable		1,280			(e)		2,092			3,372			2,287			(e)		—			2,287
Future tax assets, short term		11,813			(e)		—			11,813			13,094			(e)		—			13,094
Property, plant and equipment cost		58,979			(b)		30,849			89,828			76,824			(b)		30,849			107,673
Accumulated depreciation		(20,716	)		(b)		(30,849	)		(51,565	)		(26,604	)		(b)		(30,849	)		(57,453	)

Property, plant and equipment, net		38,263			(b)		—			38,263			50,220			(b)		—			50,220

Future tax assets, long term		19,994			(e)		(2,469	)		17,525			18,364			(e)		(2,714	)		15,650
Intangible assets, patents and acquired technology, net of accumulated amortization		44,958			(b)		(370	)		44,588			50,989			(b)		(445	)		50,544
Income taxes payable		2,021			(e)		—			2,021			4,045			(e)		(2,317	)		1,728
Accrued minimum pension liability		9,278			(c)		(9,278	)		—			9,881			(c)		(9,881	)		—
Shareholders’ equity common shares		309,430			(b),(g)		(67,310	)		242,120			308,669			(b),(g)		(67,310	)		241,359
Additional paid in capital - contributed surplus		3,305			(d)		11,051			14,356			3,289			(d)		9,419			12,708
Retained earnings (accumulated deficit)		3,308			(b),(d),(e),(g)		41,398			44,706			(1,969	)		(b),(d),(e),(g)		42,931			40,962
Accumulated other comprehensive income (loss) - Accumulated foreign currency translation adjustments for Canadian GAAP		(11,677	)		(c),(f)		23,385			11,708			(4,426	)		(c),(f)		23,999			19,573

Total shareholders’ equity		304,366					8,524			312,890			305,563					9,039			314,602

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(In United States dollars, and in accordance with U.S. GAAP)

You should read this discussion together with the consolidated financial statements and other financial information included in this report. This report contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those indicated in the forward-looking statements. Please see the “Special Note Regarding Forward-Looking Statements” below, as well as our annual report on Form 10-K and other reports filed with the Securities and Exchange Commission.

Overview

GSI Group develops and delivers the enabling technology solutions that bring our customers’ advanced manufacturing applications to life. Our leading brands include precision motion products, lasers, and laser systems, and are used to boost efficiency and productivity in the global medical, semiconductor, electronics, and industrial markets.

Our Laser Group produces high quality repeatable cuts, welds, holes and specialist marks on customer’s products. These include hermetically sealing (by laser) heart defibrillators and rechargeable batteries.

Our Precision Motion Group contains diversified product lines ranging from ultra high speed drills to super precise measuring devices. Applications include formatting hard drives and drilling holes in printed circuit boards. Our products allow manufacturers to perform tasks they otherwise could not perform such as drilling thousands of holes per minute with accuracy at a micron level.

Our Laser Systems Group supplies leading edge equipment to the semiconductor industry. These include systems to trim silicon wafers and repair semiconductor memory wafers.

Highlights for the Three Months Ended September 30, 2005

	•	Sales for the quarter decreased to $62.6 million from $90.7 million in the third quarter of 2004.

	•	Net income for the quarter was $2.0 million, or $0.05 per diluted share, compared to a net income of $12.1 million, or $0.29 per diluted share, in the third quarter of 2004.

	•	Bookings of orders were $60.8 million in the third quarter of 2005 compared to $67.2 million, net of adjustments of $6.2 million in the third quarter of 2004. Ending backlog was $59.9 million as compared with $77.7 million at the end of the third quarter of last year.

	•	Cash, cash equivalents and short-term investments were $93.5 million (this includes $5.0 million pledged under a security agreement) at September 30, 2005.

Results of Operations Three Months Ended September 30, 2005 Compared to Three Months Ended October 1, 2004

The following table sets forth items in the unaudited consolidated quarterly statement of operations as a percentage of sales for the periods indicated:

	Three Months Ended

	September 30, 2005			October 1, 2004

Sales		100.0	%		100.0	%
Cost of goods sold		60.6			59.1

Gross profit		39.4			40.9
Operating expenses:
Research and development and engineering		9.8			7.2
Selling, general and administrative		22.9			17.2
Amortization of purchased intangibles		2.6			1.8
Other (income) expense		(0.5	)		—

Total operating expenses		34.8			26.2

Income from operations		4.6			14.7
Other income		—			0.1
Interest income		0.8			0.3
Interest expense		(0.1	)		(0.1	)
Foreign exchange transaction (losses) gains		(0.6	)		0.3

Income before income taxes		4.7			15.3
Income tax provision		1.4			1.9

Net income		3.3	%		13.4	%

Sales by Segment. The following table sets forth sales in thousands of dollars by our business segments for the third quarter of 2005 and 2004. For 2004, certain Asia-Pacific parts sales have been reclassified from the Laser Group to the Laser Systems Group in the comparative three months ended October 1, 2004 to more accurately reflect which segment’s customers purchased the parts. This reclassification had no impact on the consolidated results of operations for the Company. Also please note that the Components Group has been renamed the Precision Motion Group. This name change more accurately reflects its business, but had no change on the operation or the results of the segment.

	Three Months Ended

	September 30, 2005			October 1, 2004			Increase (Decrease)

Sales:
Precision Motion Group	$	36,504		$	42,060		$	(5,556	)
Laser Group		10,009			11,648			(1,639	)
Laser Systems Group		17,898			41,217			(23,319	)
Intersegment sales elimination		(1,811	)		(4,254	)		2,443

Total	$	62,600		$	90,671		$	(28,071	)

Sales. Sales for the three months ended September 30, 2005 decreased by $28.1 million or 31%, to $62.6 million from $90.7 million in the quarter ended October 1, 2004.

Sales in the Precision Motion Group segment decreased by $5.6 million, or 13%, from $42.1 million for the third quarter of 2004 to $36.5 million in the same period in 2005. This decrease was primarily due to lower sales of PCB spindles, MicroE products, Encoders and other Westwind products which together contributed $6.3 million. Lower volume of internal sales to our Laser Systems Group segment contributed $1.9 million to the decrease in sales in the period as a result of the reduced volume in the Laser Systems Group segment sales. These decreased sales were partially offset by increased sales of components and printer products of $2.8 million. Smaller decreases of $0.2 million in other product lines comprised the balance of the decrease from the third quarter of last year to the third quarter of 2005. Within this segment, disk drives and printed circuit board (“PCB”) manufacturing are two of the significant industries that the Precision Motion Group serves that are subject to the most fluctuations in demand.

Sales in the Laser Group segment in the third quarter of 2005 decreased $1.6 million, or 14%, over the same quarter last year. This decrease was due to decreased sales in most product lines. Primarily sales from Sigma, Impact, Laser Mark and AM series laser based products amounted to a decrease of $1.6 million which were partially offset by increased sales in the JK laser based products of $0.2 million. There were smaller decreases in other product lines amounting to a decrease of $0.2 million which comprised the balance of the change in sales in the third quarter of 2005 compared to the same period in 2004. The markets in which the Lasers Group segment serves are experiencing a general softening.

In the third quarter of 2005, sales in the Laser Systems Group segment decreased $23.3 million, or 57%, as compared to sales in the same period last year primarily due to decreases in Memory Repair and Wafer Trim. Together these 2 products accounted for $21.9 million or 94% of the decrease in sales in the third quarter of 2005 as compared to the same period in 2004. Smaller increases and decreases in other product lines comprised the remaining net decrease of $1.4 million in sales between the two periods. Sales in our Laser Systems Group segment are heavily weighted to the semiconductor industry, which causes their sales to be very cyclical in nature. In the current period, that industry was near the bottom of the cycle; whereas one year ago, the industry was in the middle of an upturn. Our business in this segment is heavily driven by three of our product lines: wafer marking, wafer trim, and wafer repair (or memory repair). Wafer marking systems are used by wafer manufacturers and chip makers to scribe tracking codes on wafers. Wafer trim systems are used to tune power management chips. Wafer repair systems are used to enhance the production yield of NAND flash and DRAM memory. The Company is actively pursuing additional customers in this market.

Sales in our Corporate segment represent elimination of sales between our segments and are shown in the table above as intersegment sales elimination. There was a $2.4 million decrease in sales between segments for the three months ended September 30, 2005 as compared to the same period last year. This was a result of decreases in sales from our Precision Motion Group and Laser Group segments to our Laser Systems Group segment, which was in large part due to the reduced volume in the Laser Systems Group business.

Sales by Region. We distribute our systems and services via our global sales and service network and through third-party distributors and agents. Our sales territories are divided into the following regions: North America, consisting of the United States and Canada; Latin and South America; Europe, consisting of Europe, the Middle East and Africa; Japan; and Asia-Pacific, consisting of ASEAN countries, China and other Asia-Pacific countries. Sales are attributed to these geographic areas on the basis of the bill-to customer location. Not infrequently, equipment is sold to large international companies, which may be headquartered in Asia-Pacific for example, but the sales of our systems are billed and shipped to locations in the United States, although the equipment may eventually be installed in Asia-Pacific, for instance. In this example, these sales are therefore reflected in the North America totals in the table below. In this and other similar instances, the sale is attributed to the geographic area of the bill-to customer’s location. The following table shows sales in millions of dollars to each geographic region for the third quarter of 2005 and 2004, respectively.

	Three Months Ended

	September 30, 2005					October 1, 2004

	Sales		% of Total			Sales		% of Total

	(In millions)					(In millions)
North America	$	24.0		38	%	$	36.6		40	%
Latin and South America		0.3		—			0.5		1
Europe (EMEA)		11.6		19			12.6		14
Japan		11.0		18			19.7		22
Asia-Pacific, other		15.7		25			21.3		23

Total	$	62.6		100	%	$	90.7		100	%

As a percentage of sales, Asia-Pacific sales increased in the three months ended September 30, 2005 over the same period last year primarily due to the lower sales volume. There was a shift in sales of MicroE products from Asia-Pacific to North America and Japan in the three months ended September 30, 2005 as compared to one year ago. This shift relates to the mix of products sold as compared to the same period in 2004. The increase in sales in Europe as a percentage of total sales in the third quarter of 2005 as compared to the same period in 2004 is mainly the result of sales generated from our Westwind line of products which experienced some growth in this market over the prior year. Asia-Pacific is expected to be an area of growth for the Company as we are growing our footprint as a local supplier by expanding our manufacturing capabilities in China.

Backlog. We define backlog as unconditional purchase orders or other contractual agreements for products for which customers have requested delivery within the next twelve months. Order backlog at September 30, 2005 was $59.8 million compared to $77.7 million at October 1, 2004.

Gross Profit by Segment. The following table sets forth gross profit in thousands of dollars by our business segments for the third quarter of 2005 and 2004. For 2004, certain Asia-Pacific parts sales and costs associated with those sales have been reclassified from the Laser Group to the Laser Systems Group in the comparative three months ended October 1, 2004 to more accurately reflect which segment’s customers purchased the parts. This reclassification had no impact on the consolidated results of operations for the Company.

	Three Months Ended

	September 30, 2005			October 1, 2004

Gross profit:
Precision Motion Group	$	15,075		$	15,700
Laser Group		3,362			3,633
Laser Systems Group		6,277			17,974
Intersegment sales elimination and other		(23	)		(209	)

Total	$	24,691		$	37,098

Gross profit %:
Precision Motion Group		41.3	%		37.3	%
Laser Group		33.6			31.2
Laser Systems Group		35.1			43.6
Intersegment sales elimination and other		1.3			4.9
Total		39.4	%		40.9	%

Gross profit was 39.4% in the three months ended September 30, 2005 compared to 40.9% in the three months ended October 1, 2004. There are numerous factors that can influence gross profit percentage including product mix, pricing, volume, third-party costs for raw materials and outsourced manufacturing, warranty costs and charges related to excess and obsolete inventory, and the reversal thereof, at any particular time. The Company’s total gross profit is a result of the changes in gross profit at each segment level. Those changes are described below.

The gross profit for the Precision Motion Group was 41.3% for the three months ended September 30, 2005 versus 37.3% in the same period last year. The gross margin increased 4 percentage points in the third quarter of 2005 as compared to the three months ended October 1, 2005 despite lower sales volume. The gross margin gain was primarily due to product mix changes; specifically a shift away from lower margin internal sales to the Laser Systems Group and a reduced volume of sales of Westwind products. Improvements in operations and a reduced headcount also contributed to the increase.

For our Laser Group the gross profit percentage was 33.6% in the third quarter of 2005 compared to 31.2% in the third quarter of 2004. The increase in gross profit percentage is mainly attributable a more favorable mix and reduced warranty costs, partially offset by lower sales volume. Reduced warranty costs contributed a favorable 2.3 percentage points to the gross profit. Lower sales volume contributed an unfavorable 4.5 percentage points to the margins.

The gross profit for Laser Systems Group was down to 35.1% for the third quarter of 2005 from 43.6% in the same period last year mainly due to reduced volume of sales and product mix changes. Reduced sales volume negatively impacted the margin by 7.4 percentage points. Product mix changes primarily comprised the balance of the decrease in margins partially offset by reduced warranty costs of $1.2 million primarily due to lower sales.

The Gross Profit of $0.2 million for the intersegment sales elimination and other for the third quarter of 2004 included expenses associated with the variable incentive compensation program for which there were no similar charges in 2005.

Research and Development and Engineering Expenses. Research and development expenses for the three months ended September 30, 2005 were 9.8% of sales, or $6.1 million, compared with 7.2% of sales, or $6.6 million, in the three months ended October 1, 2004. Research and development expenses for the Precision Motion Group at $2.8 million in the third quarter of 2005 were a decrease of $0.2 million from the same period in 2004. The majority of the decrease is attributable to decreased project spending of $0.4 million partially offset by increases in personnel related costs of $0.2 million during the third quarter of 2005 as compared to the same quarter last year. In both the third quarter of 2005 and 2004, research and development expenses for the Laser Group segment were $1.0 million. Research and development expenses in the Laser Systems Group were $2.2 million for the three months ended September 30, 2005, a slight decrease of $0.1 million from $2.3 million the same period last year, mainly as a result of decreases in personnel due to changes made to the quarterly work schedule and decreases in temporary help costs of $0.3 million which was

partially offset by increased engineering project spending of $0.2 million. The Corporate segment research and development expenses at $0.1 million in the third quarter of 2005, decreased by $0.2 million from $0.3 million for the same period last year primarily due to a charge in the period last year for variable compensation expense for which there were no similar charges incurred in the same period this year.

Selling, General and Administrative Expenses. Selling, general and administrative (SG&A) expenses were 22.9% of sales, or $14.4 million, in the three months ended September 30, 2005, compared with 17.2% of sales, or $15.6 million, in the three months ended October 1, 2004. SG&A expenses in the Precision Motion Group segment were $5.3 million for the third quarter of 2005 compared to $5.6 million in the third quarter of 2004, which was a decrease of $0.3 million. The decrease was mainly the result of lower personnel costs of $0.5 million partially offset by increased spending on temporary help and consultants of $0.1 million and increased office related expenses for China of $0.1 million. There were smaller offsetting increases and decreases in other SG&A expenses within the Precision Motion Group that had no effect on the total increase quarter over quarter. SG&A expense in the Laser Group segment was $2.2 million in the third quarter of 2005 compared to $2.0 million in the same period in the prior year, an increase of $0.2 million. The increase primarily relates to a charge of $0.2 million in the quarter for pension expense and increased facility related costs of $0.2 million. In 2005, the Company had reclassified certain pension related expenses to the Laser Group segment. Previously these costs were a corporate expense. The pension expense has increased as a result of the underfunding of the defined benefit plan. These increases offset a reduction in consulting spending and personnel related travel costs of $0.1 million. There were smaller increases and decreases that comprised the balance of the decrease of $0.1 million.

In the Lasers Systems Group segment, SG&A expenses decreased by $0.5 million from $3.8 million in the third quarter of 2004 to $3.3 million in the third quarter of 2005. The decrease was mainly due to decreases in personnel costs of $0.2 million as a result of actions taken during the quarter and lower commissions resulting from lower sales of $0.2 million. There were other smaller increases and decreases that comprised the balance of the $0.1 million decrease. SG&A expenses in our Corporate Group were $3.6 million in the third quarter of 2005 compared to $4.2 million in the same period last year, a decrease of $0.6 million. Spending was down in most areas. Lower personnel related costs contributed $0.4 million mainly due to variable compensation. Last year there was a charge for variable compensation expense of $0.3 million included in personnel costs in the three months ended October 1, 2004. There was no similar charge in the current period. Lower facilities costs contributed $0.3 million to the decrease from last year. Smaller decreases and increases in other areas of SG&A spending contributed to the remaining net increase of $0.1 million.

Amortization of Purchased Intangibles. Amortization of purchased intangibles was $1.6 million, or 2.6% of sales, for the quarter ended July 1, 2005 primarily as a result of amortizing intangible assets from acquisitions. This compares to $1.6 million or 1.8% of sales for the same period in 2004. Beginning with the first quarter of 2005, the Company decided to include amortization of intangibles in the segments results of operations to reflect more fully expenses attributable to the businesses. This change had no impact on the Company’s consolidated results of operations or its financial position. As a result the Precision Motion Group segment is charged with 92.1% of the Company’s amortization mainly due to their recent acquisitions of MicroE, Westwind, and DRC product lines. The balance of the amortization is in the Laser Group along with a small amount that is not allocated to a particular business segment. There is no amortization associated with the Laser Systems’ segment. The amortization of purchased intangibles not allocated to a segment is related to amortization of intangibles from the merger of General Scanning and Lumonics. The current business segment structure did not exist at the time of the merger, therefore it is impractical to allocate the amortization to a particular segment; consequently it is attributed to the Corporate segment. As the Company has stated that it is continuing to pursue potential investments in or acquisitions of complementary technologies and products, future amortization expense may increase depending on the nature of assets acquired in any potential acquisition.

Other. For the three months ended September 30, 2005 the Company incurred a $4 thousand gain on the sale of a facility and rental income of $0.3 million. The Company’s building located in Farmington, Michigan was sold during the third quarter of 2005. The rental income is primarily the result of rent on the Company’s facility located in Maple Grove, Minnesota. The Company began leasing the facility during the middle of the second quarter of 2005. There were no similar gains or income items during the same period in 2004.

Income from Operations. The following table sets forth income from operations in thousands of dollars by our business segments for the third quarter of 2005 and 2004.

	Three Months Ended

	September 30, 2005			October 1, 2004

Segment income from operations:
Precision Motion Group	$	5,480		$	5,687
Laser Group		108			530
Laser Systems Group		712			11,913

Total by segment		6,300			18,130
Unallocated amounts:
Corporate expenses		3,640			4,810
Rental income not attributable to a segment		(226	)		—
Amortization of purchased intangibles not allocated to a segment		26			25
Acquired in-process research and development		—			—
Other		(5	)		—

Income from operations	$	2,865		$	13,295

Other Income (Expense). During the third quarter of 2004, the Company recorded a gain of $0.1 million on the liquidation of a subsidiary. There were no similar gains or losses during the third quarter ended September 30, 2005.

Interest Income. Interest income was $0.5 million in the third quarter of 2005 compared to $0.3 million in the third quarter of 2004. The $0.2 million increase in interest income is attributed to an increase in invested balances coupled with favorable yields on investments.

Interest Expense. Interest expense was minimal, approximately $58 thousand, in the three months ended September 30, 2005 compared to $104 thousand in the three months ended October 1, 2004. During 2005 and 2004, the Company had no bank debt. Interest expense is primarily from discounting receivables with recourse at a bank and for interest on deferred compensation.

Foreign Exchange Transaction Gain (Losses). Foreign exchange transaction losses were approximately $0.4 million in the three months ended September 30, 2005 compared to a $0.3 million gain for the three months ended October 1, 2004. These amounts arise primarily from transactions denominated in currencies other than functional currency and unrealized gains (losses) on derivative contracts.

Income Taxes. The effective tax rate for three months ended September 30, 2005 was 31.4% compared to an effective tax rate of 12.3% for the same period in 2004 and an effective tax rate of 7.8% of income before taxes for the year ended December 31, 2004. The tax rate for three months ended September 30, 2005 reflects the Company’s estimated annual effective tax rate and is driven by the jurisdictions where income is earned. The Company’s reported effective tax rate of 36.9% for the three months ended September 30, 2005, differed from the expected Canadian federal and provincial statutory rate, primarily due to other income tax benefits from multiple jurisdictions totaling $129 thousand for the three months ended September 30, 2005. The effective tax rate for the full 2004 year, which is significantly below the normal statutory tax rate, reflects the fact that we recorded a benefit for the reversal of a $14.1 million valuation allowance and we do not recognize the tax benefit from losses in certain countries where future use of the losses is uncertain.

Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” (“SFAS No. 109”) requires a valuation allowance be established when it is “more likely than not” that all or a portion of deferred tax assets will not be realized. A review of all available positive and negative evidence needs to be considered, including a company’s performance, the market environment in which the company operates, length of carry-back and carry-forward periods, existing sales backlog, future taxable income projections and tax planning strategies. We have previously provided valuation allowances against losses in the parent company and subsidiaries with an inconsistent history of taxable income and loss due to the uncertainty of their realization. In addition, the Company has provided a valuation allowance on tax credits and net operating losses, due to the uncertainty of generating earned income to claim the tax credits or use the net operating losses. In the event that actual results differ from our estimates of future taxable income, or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could have a material impact on our financial position and results of operations.

Net Income. As a result of the foregoing factors, net income for the third quarter of 2005 was $2.0 million, compared to $12.1 million in the same period in 2004.

Results of Operations for the Nine Months Ended September 30, 2005 Compared to the Nine Months Ended October 1, 2004

The following table sets forth items in the unaudited consolidated year-to-date statement of operations as a percentage of sales for the periods indicated:

	Nine Months Ended

	September 30, 2005			October 1, 2004

Sales		100.0	%		100.0	%
Cost of goods sold		61.2			59.1

Gross profit		38.8			40.9
Operating expenses:
Research and development and engineering		9.8			6.9
Selling, general and administrative		23.2			17.5
Amortization of purchased intangibles		2.6			1.7
Acquired in-process research and development		—			0.2
Other (income) expense		(0.2	)		—

Total operating expenses		35.4			26.3

Income from operations		3.4			14.6
Other income (expense)		—			—
Interest income		0.7			0.3
Interest expense		(0.1	)		(0.1	)
Foreign exchange transaction (losses) gains		0.3			(0.1	)

Income before income taxes		4.3			14.7
Income tax provision		1.6			1.6

Net income		2.7	%		13.1	%

Sales by Segment. The following table sets forth sales in thousands of dollars by our business segments for the nine months ended September 30, 2005 and October 1, 2004. For 2004, certain Asia-Pacific parts sales have been reclassified from the Laser Group to the Laser Systems Group in the comparative nine months ended October 1, 2004 to more accurately reflect which segment’s customers purchased the parts. This reclassification had no impact on the consolidated results of operations for the Company. Also please note that the Components Group has been renamed the Precision Motion Group. This name change more accurately reflects its business, but had no change on the operation or the results of the segment.

	Nine Months Ended

	September 30, 2005			October 1, 2004			Increase (Decrease)

Sales:
Precision Motion Group	$	104,640		$	117,270		$	(12,630	)
Laser Group		31,696			34,891			(3,195	)
Laser Systems Group		63,612			112,376			(48,764	)
Intersegment sales elimination		(5,657	)		(14,476	)		8,819

Total	$	194,291		$	250,061		$	(55,770	)

Sales. Sales for the nine months ended September 30, 2005 decreased by $55.8 million or 22% compared to the nine months ended October 1, 2004.

Sales for our Precision Motion Group segment decreased by $12.6 million, or 11%, for the first nine months of 2005 as compared to the same period in 2004. A full nine months of sales from the MicroE line of products, as compared to approximately four and a half months in 2004, contributed an increase of $6.1 million in sales and sales of printer products contributed an increase of $2.8 million over the same period last year. MicroE was acquired in May 2004. These increases were more than offset by decreases totaling $21.5 million including a $13.2 million decrease in Westwind products and a $7.5 million decrease in volume of internal sales to our Laser Systems Group segment.

Sales in our Laser Group segment in the nine months ended September 30, 2005 decreased by $3.2 million, or 9%, over the same period last year. Most product lines experienced a decrease in sales in the current period as compared to the nine months ended October 1, 2004. Sales from the Sigma, Spectron, JK lasers, AM series, Impact and Laser Mark together contributed $3.7 million to the decrease. Some of the decreases were due to a general slowness in the market and $0.6 million of that amount was due to decreased internal sales to Laser Systems primarily as a result of lower volume in the Laser Systems business. Increased sales from our Excimer lasers contributed $0.6 million in the period which helped to offset some of the decreases. There were smaller increases and decreases in other product lines that comprised $0.1 million of the decrease in sales in the first nine months of 2005 compared to the same period last year.

Sales in our Laser Systems Group segment decreased $48.8 million, or 43%, over sales in the same period last year primarily due to decreases in Wafer Trim, Circuit Trim and Memory Repair. Together these accounted for $48.4 million of the decrease. Semiconductor Marker sales increased $2.1 million over the same period last year which was offset by decreases in other product lines of $2.5 million during the same period.

Sales in our Corporate segment represent the elimination of sales between segments. There was an $8.8 million or 61% decrease in sales between segments for the nine months ended September 30, 2005 as compared to the same period last year. The decrease is mainly a result of the reduced volume in the Laser Systems Group business which in turn decreased the intersegment sales from the Precision Motion Group and Laser Group segments to the Laser Systems Group segment.

Sales by Region. We distribute our systems and services via our global sales and service network and through third-party distributors and agents. Our sales territories are divided into the following regions: North America, consisting of Canada and the United States; Latin and South America; Europe, consisting of Europe, the Middle East and Africa; Japan; and Asia-Pacific, consisting of ASEAN countries, China and other Asia-Pacific countries. Sales are attributed to these geographic areas on the basis of the bill to customer location. Not infrequently, equipment is sold to large international companies, which may be headquartered in Asia-Pacific for example, but the sales of our systems are billed and shipped to locations in North America. In this example, these sales are therefore reflected in the North America totals in the table below. In this and other similar instances, the sale is attributed to the geographic area of the bill-to customer’s location. The following table shows sales in millions of dollars to each geographic region for the nine months ended September 30, 2005 and October 1, 2004.

	Nine Months Ended

	September 30, 2005					October 1, 2004

	Sales		% of Total			Sales		% of Total

	(In millions)					(In millions)
North America	$	77.9		40	%	$	117.2		47	%
Latin and South America		1.1		1			1.1		—
Europe (EMEA)		33.9		17			38.1		15
Japan		33.7		17			44.6		18
Asia-Pacific, other		47.7		25			49.1		20

Total	$	194.3		100	%	$	250.1		100	%

As a percentage of sales, Asia-Pacific sales increased in the nine months ended September 30, 2005 over the same period last year, primarily due to having a full three quarters of MicroE included in the Company’s results. 43% of MicroE’s product sales this year were to the Asia-Pacific region. MicroE was acquired during the middle of the second quarter last year.

Gross Profit by Segment. The following table sets forth gross profit in thousands of dollars by our business segments for the nine months ended September 30, 2005 and October 1, 2004. For 2004, certain Asia-Pacific parts sales and costs associated with those sales have been reclassified from the Laser Group to the Laser Systems Group in the comparative nine months ended October 1, 2004 to more accurately reflect which segment’s customers purchased the parts. This reclassification had no impact on the consolidated results of operations for the Company.

	Nine Months Ended

	September 30, 2005			October 1, 2004

Gross profit:
Precision Motion Group	$	41,918		$	43,617
Laser Group		10,085			10,372
Laser Systems Group		23,320			49,494
Intersegment sales elimination and other		(2	)		(1,127	)

Total	$	75,321		$	102,356

Gross profit %:
Precision Motion Group		40.1	%		37.2	%
Laser Group		31.8			29.7
Laser Systems Group		36.7			44.0
Intersegment sales elimination and other		—			7.8
Total		38.8	%		40.9	%

Gross profit was 38.8% in the nine months ended September 30, 2005 compared to 40.9% in the nine months ended October 1, 2004. Gross profit percentage primarily decreased due to decreased sales volume and changes in mix of product sales. There are numerous factors that can influence gross profit percentage including product mix, pricing, volume, third-party costs for raw materials and outsourced manufacturing, warranty costs and charges related to excess and obsolete inventory, and the reversal thereof, at any particular time. The Company’s total gross profit is a result of the changes in gross profit at a segment level. Those changes are described below.

The gross profit for the Precision Motion Group was 40.1% for the first nine months of 2005 versus 37.2% in the same period last year. One factor that contributed to the higher gross margin is the inclusion of the MicroE product lines in the full nine months of 2005 as compared to only approximately four and a half months in the comparative 2004 period. Additionally, there was a more favorable sales mix of products with higher margins and improvements in operations including lower material costs that contributed to the increase in gross profit percent.

For our Laser Group the gross profit percentage was 31.8% in the nine months ended September 30, 2005 compared to 29.7% in the same period last year. Improvements in material costs and a change in product mix, including lower sales of Sigma parts in Asia-Pacific that are now included in the Laser Systems Group, were the main factors that contributed to the higher gross profit. This improvement was offset by a net charge of $0.3 million resulting from a UK customs issue and a severance charge of $0.3 million for a reduction in the service work force which together contributed 1.8 percentage points.

The gross profit for Laser Systems is 36.7% for the nine months of 2005 compared to 44.0% for the first nine months of 2004. Decreased sales volume was the major driver that led to the decrease in the gross profit percentage for the first nine months of 2005 compared to the same period last year. Sales volume contributed 3.2 percentage points to the decrease. Additionally, in the first nine months of 2005, inventory charges of $1.0 million were taken primarily as a result of lower sales expectations, while in the first nine months of 2004 the Company recorded a benefit of $1.6 million from selling inventory that had been previously written down. This $2.6 million change in inventory provisions contributed 4.4 percentage points to the margin decrease in the first nine months of 2005 as compared to the same period last year. There were other increases and decreases that contributed a net increase of 0.3 percentage points in gross profit.

The gross profit of $1.1 million for the intersegment sales elimination and other for the first nine months of 2004 included expenses associated with the variable incentive compensation program for which there were no similar charges in 2005.

Research and Development and Engineering Expenses. Research and development expenses for the nine months ended September 30, 2005 were 9.8% of sales, or $19.0 million, compared with 6.9% of sales, or $17.3 million, for the nine months ended October 1, 2004. Research and development expenses for the Precision Motion Group at $7.7 million in the first nine months of 2005 were $0.8 million above the $6.9 million in the same period in 2004. Increases in personnel costs of $2.3 million partially attributable to three full quarters of MicroE in the first nine months in 2005 contributed to the increase. This was partially offset by reduced spending on engineering projects of $1.6 million. There were other increases and decreases which contributed $0.1 million to the increase. In the first nine months of 2005, research and development expenses in our Laser Group segment were $3.4 million, which was a $0.6 million increase from $2.8 million in the first nine months of 2004 primarily as a result of increased personnel costs of $0.3 million, increased spending on new product development projects of $0.2 million and increased facilities costs of $0.2 million. There were smaller increases and decrease that comprised a net decrease of $0.1 million. For our Laser Systems Group segment, research and development expenses were $7.7 million for the nine months ended September 30, 2005, a $0.9 million increase from $6.8 million

the same period last year, mainly resulting from increased personnel costs of $0.3 million, increased spending on new product development projects of $0.4 million and $0.2 million increase in costs related to demo inventory. The Corporate segment research and development expenses, at $0.2 million in the first nine months of 2005, decreased by $0.6 million from $0.8 million in the same period last year primarily due to charges of $0.7 million in the first nine months of 2004 for variable compensation expense which was not experienced in the same period this year.

Selling, General and Administrative Expenses. Selling, general and administrative (SG&A) expenses were 23.2% of sales, or $45.0 million, in the nine months ended September 30, 2005, compared with 17.5% of sales, or $43.6 million, in the nine months ended October 1, 2004. SG&A expenses in the Precision Motion Group segment were $15.9 million for the first nine months of 2005 compared to $14.2 million in the same period in 2004, which was an increase of $1.7 million. The increase was mainly the result of $1.8 million in additional SG&A expense incurred as a result of three full quarters of MicroE as compared to approximately four and a half months in the same period in 2004. MicroE was acquired in May 2004. Decreases in personnel costs in other areas of Precision Motion Group contributed a $0.3 million. There were smaller increases and decreases in other areas which comprised $0.2 million of the increase in the first nine months of 2005 as compared to the first nine months of 2004. SG&A expense in the Laser Group segment increased slightly at $6.4 million for the nine months ended September 30, 2005 as compared to $6.2 million for the same period in 2004. A charge of $0.7 million for pension expense was partially offset by reduced spending on consulting of $0.3 million, and lower commissions of $0.1 million. In 2005, the Company had increased pension related expenses because of the underfunding in the defined benefit plan. There were smaller decreases in other areas of spending of $0.1 million that comprised the balance of the decrease in the nine months ended September 30, 2005 as compared to the same period last year. In the Lasers Systems Group segment, SG&A expenses decreased by $1.0 million from $11.2 million in the first nine months of 2004 to $10.2 million in the first nine months of 2005. This decrease was mainly a result of decreased legal expenses of $0.5 million and $0.4 million of lower commissions due to lower sales volume. These decreases were partially offset by increased spending in the trademark and patent area of $0.2 million. In the nine months ended October 1, 2004, there was $0.4 million of costs associated with demo inventory for which in the same period in 2005 there was no similar charge. Smaller increases and decreases in other areas of spending contributed a net increase of $0.1 million. SG&A expenses in our Corporate segment were $12.5 million in the nine months ended September 30, 2005 as compared to $12.0 million in the same period last year, an increase of $0.5 million. Higher personnel costs including fringe benefit costs of $0.9 million partially offset by a decrease in variable compensation expense of $0.7 million contributed to the increase in the nine months ended September 30, 2005 from the same period in 2004. Legal expenses increased $0.4 million from the same period last year. The remaining $0.1 million decrease is comprised of smaller increases and decreases in other areas of selling, general and administrative expenses.

Amortization of Purchased Intangibles. Amortization of purchased intangibles was 2.6% of sales, or $5.0 million, for the nine months ended September 30, 2005 primarily as a result of amortizing intangible assets from acquisitions. This compares to $4.3 million, or 1.7% of sales, for the same period in 2004. The Company decided, beginning with the first quarter of 2005, to include amortization of intangibles in the segments results of operations to reflect more fully expenses attributable to the businesses. This change had no impact on the Company’s consolidated results of operations or its financial position. As a result the Precision Motion Group segment is charged with 92.1% of the Company’s amortization for the first nine months of 2005 mainly due to their recent acquisitions of MicroE, Westwind, and DRC product lines. The $0.7 million increase in the first nine months of 2005 is primarily a result of three full quarters of amortization from the MicroE acquisition which was an increase of $1.2 million offset by a $0.8 million savings from the fully amortized General Scanning and Lumonics merger technology. The MicroE acquisition was completed in May 2004. The balance of the amortization is in the Laser Group and the Corporate segments. There is no amortization associated with the Laser Systems’ segment. The amortization of purchased intangibles included in Corporate, which is not allocated to a segment, is related to amortization of intangibles from the merger of General Scanning and Lumonics. The current business segment structure did not exist at the time of the merger, therefore it is impractical to allocate the amortization to a particular segment; consequently it is attributed to the Corporate segment. As the Company has stated that it is continuing to pursue potential investments in or acquisitions of complementary technologies and products, future amortization expense may increase depending on the nature of assets acquired in any potential acquisition.

Acquired in-process Research and Development. During the nine months ended October 1, 2004, the Company recorded a charge of $0.4 million for in-process research and development in connection with the acquisition of MicroE. The in-process research and development from the MicroE acquisition is based on the valuation of assets acquired and liabilities assumed, which the Company completed in the third quarter of 2004. There were no similar charges during the same period in 2005.

Other. In the nine months ended September 30, 2005, the Company recorded a $0.2 million loss on the sale of the Nepean facility. The sale was completed in the second quarter of 2005. The Company also incurred a $4 thousand gain on the sale of the Farmington building which was sold during the third quarter of 2005. In the nine months ended September 30, 2005, the Company recorded $0.5 million of rental income, primarily on our Maple Grove facility. A small portion of the Rugby facility was leased in 2005 and the amount of rental income received from this is negligible. There were no similar charges in nine months ended October 1, 2004.

Income from Operations. The following table sets forth income from operations in millions of dollars by our business segments for the nine months ended September 30, 2005 and October 1, 2004.

	Nine Months Ended

	September 30, 2005			October 1, 2004

Segment income from operations:
Precision Motion Group	$	13,649		$	19,165
Laser Group		200			1,230
Laser Systems Group		5,481			31,557

Total by segment		19,330			51,952
Unallocated amounts:
Corporate expenses		12,693			13,970
Rental income not allocated to a segment		(226	)		—
Amortization of purchased intangibles not allocated to a segment		79			912
Acquired in-process research and development		—			430
Other		197			—

Income from operations	$	6,587		$	36,640

Other Income (Expense). During the first nine months of 2005, the Company recorded $8 thousand in other income resulting from a dividend on the Company’s equity investment in a private United Kingdom company. During the first nine month of 2004, the Company recorded a $0.1 million gain on the disposal of a facility in Nepean, Ontario.

Interest Income. Interest income was $1.3 million in the nine months ended September 30, 2005, compared to $0.6 million in the nine months ended October 1, 2004. The average amount of interest earned on our cash balances has increased in the first nine months of 2005 as compared to the same period last year due to higher available interest rates and higher average cash balances.

Interest Expense. Interest expense was $0.1 million in the nine months ended September 30, 2005, compared to $0.2 million in the same period in 2004. Interest expense is primarily from discounted receivables with recourse at a bank and for interest on deferred compensation.

Foreign Exchange Transaction Gains (Losses). Foreign exchange transaction gains were $0.6 million for the nine months ended September 30, 2005, compared to a loss of $0.3 million in the same period in 2004. These amounts arise primarily from transactions denominated in currencies other than functional currency and unrealized gains (losses) on derivative contracts. This gain primarily results from the strengthening of the U.S. dollar against the Euro and Canadian dollar in the period as compared to the same period last year. The US dollar has gained approximately 3.0% against the Euro and approximately 7.8% against the Canadian dollar.

Income Taxes. The effective tax rate at September 30, 2005, was 36.9% of income before taxes, compared to an effective tax rate of 7.8% of income before taxes for the year ended December 31, 2004. Our effective tax rate in 2005 reflects an annualized statutory tax rate as the company operates in multiple tax jurisdictions. In addition, other tax benefits from multiple jurisdictions totaling $61 thousand, which were recorded in 2005, increased the overall tax rate reported. The effective tax rate in 2004, which is significantly below the normal statutory tax rate, reflects the fact that we recorded a benefit for the reversal of a $14.1 million valuation allowance and we do not recognize the tax benefit from losses in certain countries where future use of the losses is uncertain.

Net Income. As a result of the foregoing factors, net income for the nine months ended September 30, 2005 was $5.3 million, compared to $32.9 million in the same period in 2004.

Critical Accounting Policies and Estimates

Our consolidated financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. There is no change to our critical accounting policies included in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of the Company’s Form 10-K, for the year ended December 31, 2004.

Liquidity and Capital Resources

Cash and cash equivalents totaled $84.2 million at September 30, 2005 compared to $82.3 million at December 31, 2004. In addition, the Company had $9.3 million in marketable short-term investments and nil in marketable long-term investments at September 30, 2005 compared to $3.0 million in marketable short-term investments and $5.0 million in marketable long-term investments at December 31, 2004. Included in long-term investments at September 30, 2005 and December 31, 2004 is a minority equity investment in a private United Kingdom company valued at $0.6 million and $0.7 million, respectively. As discussed in note 5 to the consolidated financial statements, at September 30, 2005 $5.0 million of short-term investments were pledged as collateral for the Bank of America security agreement.

Cash Flows for Three Months Ended September 30, 2005 and October 1, 2004

Cash flows provided by operating activities for the three months ended September 30, 2005 were $10.0 million, compared to $8.2 million during the same period in 2004. Net income, after adjusting for gain on disposal of long lived asset, depreciation and amortization, unrealized loss on derivatives, stock-based compensation and deferred income taxes provided cash of $3.7 million in the third quarter of 2005. Decreases in accounts receivable, inventories, and increases in current liabilities provided $12.3 million in cash which was partially offset by increases in other current assets of $6.0 million. The decrease in receivables was primarily the result of collection on some of the larger semiconductor accounts. Net income, after adjusting for a gain on the liquidation of a subsidiary, depreciation and amortization, stock-based compensation and deferred income taxes, provided cash of $8.0 million in the three months ended October 1, 2004. Increases in accounts receivable, inventory and other current assets used $7.6 million and increases in current liabilities provided $7.9 million in cash the same period in 2004.

Cash flows provided by investing activities were $9.9 million during the three months ended September 30, 2005, primarily from the net sales of short-term and long-term investments of $5.0 million and the sale of the Michigan building provided $5.8 million in cash, which were offset primarily by purchases of property plant and equipment of $0.9 million during the same period in 2005. Cash flows provided by investing activities were $1.6 million during the three months ended October 1, 2004, primarily from the net maturities of short-term and long-term investments of $2.1 million offset by other long-term asset additions of $0.5 million.

Cash flows provided by financing activities during the three months ended September 30, 2005 were $0.3 million from the issue of share capital from the exercise of stock options, compared to $0.8 million for the same period in 2004.

Cash Flows for Nine Months Ended September 30, 2005 and October 1, 2004

Cash flows provided by operating activities for the nine months ended September 30, 2005 were $0.7 million, compared to $27.3 million in cash generated during the same period in 2004. Net income, after adjusting for loss on disposal of long lived asset, depreciation and amortization, unrealized gain on derivatives, stock-based compensation and deferred income taxes, provided cash of $13.0 million in the first nine months of 2005. Decreases in accounts receivable provided $6.2 million in cash. Increases in inventory, other current assets and decreases in other current liabilities used $18.5 million in cash. The increase in inventory is primarily a result of increase in systems for evaluation by customers in our Laser Systems Group. Net income, after adjusting for a loss on sale of investments, gain on the liquidation of a subsidiary, acquired in-process research and development, depreciation and amortization, stock-based compensation and deferred income taxes, provided $30.2 million in the first nine months of 2004. Increases in accounts receivable, inventories and other current assets used $21.2 million, which was offset by an increase in other current liabilities that provided $18.3 million in cash.

Cash flows provided by investing activities were $3.2 million during the nine months ended September 30, 2005, primarily from the sales of the Nepean and Michigan buildings, which together provided $7.4 million in cash. These were partially offset by net purchases of short-term and long-term investments which used $1.2 million in cash and the addition of property plant and equipment which used $2.9 million in cash during the nine months ended September 30, 2005. Cash flows used in investing activities were $30.5 million during the nine months ended October 1, 2004, primarily due to the acquisition of MicroE of $54.7 million. This was partially offset by net maturities of short-term and long-term investments, which generated $25.8 million in cash.

Cash flows provided by financing activities during the nine months ended September 30, 2005 were $0.8 million from the issue of share capital, compared to $2.0 million for the same period in 2004.

Other Liquidity Matters

There have been no significant changes in the Company’s lines of credit, pensions, contractual obligations, acquisitions or off-balance sheet arrangements since December 31, 2004.

Our future liquidity and cash requirements will depend on numerous factors, including, but not limited to, the level of sales we will be able to achieve in the future, the amount of expenses incurred, the introduction of new products and potential acquisitions of related businesses or technology. We believe that existing cash and investment balances, together with cash generated from operations, will be sufficient to satisfy anticipated cash needs to fund working capital and investments.

Special Note Regarding Forward-Looking Statements

Certain statements contained in this report on Form 10-Q constitute forward-looking statements within the meaning of the United States Private Securities Litigation Reform Act of 1995, Section 27A of the United States Securities Act of 1933, as amended, and Section 21E of the United States Securities Exchange Act of 1934, as amended. These forward-looking statements relate to anticipated financial performance, management’s plans and objectives for future operations, business prospects, customer behavior, outcome of regulatory proceedings, market conditions, tax issues and other matters. All statements contained in this report on Form 10-Q that do not relate to matters of historical fact should be considered forward-looking statements, and are generally identified by words such as “anticipate,”, “believe,” “estimate,” “expect,” “intend,” “plan” and “objective” and other similar expressions. Readers should not place undue reliance on the forward-looking statements contained in this document. Such statements are based on management’s beliefs and assumptions and on information currently available to management and are subject to risks, uncertainties and changes in condition, significance, value and effect, including risks discussed in reports and documents filed by the Company with the United States Securities and Exchange Commission and with securities regulatory authorities in Canada. Such risks, uncertainties and changes in condition, significance, value and effect, many of which are beyond our control, could cause our actual results and other future events to differ materially from those anticipated. We do not assume any obligation to update these forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting such forward-looking statements.

Risk Factors

The risks presented below may not be all of the risks that we may face. These are the factors that we believe could cause actual results to be different from expected and historical results. Other sections of this report include additional factors that could have an effect on our business and financial performance. The markets in which we compete are very competitive and change rapidly. Sometimes new risks emerge and management may not be able to predict all of them, or be able to predict how they may cause actual results to be different from those contained in any forward-looking statements. You should not rely upon forward-looking statements as a prediction of future results.

A halt in economic growth or a slowdown will put pressure on our ability to meet anticipated revenue levels. We are in the midst of a down cycle in the semiconductor and electronics markets. It is difficult to predict how long this down turn will last and when recovery will commence. As a result, many of our customers may order lower quantities or limit orders to about one quarter’s visibility or less. A large portion of our sales is dependent on the need for increased capacity or replacement of inefficient manufacturing processes, because of the capital-intensive nature of our customers’ businesses. These also tend to lag behind in an economic recovery longer than other businesses. If a down turn lasts longer than expected, if a recovery does not begin or if a general economic slowdown commences, we may not be able to meet anticipated revenue levels on a quarterly or annual basis.

We have had a history of operating losses and may not be able to sustain or grow the current level of profitability. With the exception of the first quarter of 2005, we have incurred profits from operations from the second half of 2003 through the third quarter of 2005. Prior to then, we incurred operating losses on an annual basis from 1998 through 2003. For the year ended December 31, 2004, we generated net income of $41.5 million. No assurances can be given that we will continue to be profitable from operations or what level of profitability may be achieved in the future and the market price of our common shares may decline as a result.

Our inability to remain profitable may result in the loss of significant deferred tax assets. In determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets requires subjective judgment and analysis. While we recovered a portion of our current deferred tax assets in 2004 based on profitability in 2004, and planned profits for 2005, we are consistently evaluating our deferred tax assets based on current year performance. Our ability to maintain our deferred tax assets at September 30, 2005 depends upon our ability to continue to generate future profits in the United States, United Kingdom and Canadian tax jurisdictions. If actual results differ from our plans or we do not achieve profitability, we may be required to increase the valuation allowance on our tax assets by taking a charge to the Statement of Operations, which may have a material negative result on our operations.

Our business depends significantly upon capital expenditures, including those by manufacturers in the semiconductor, electronics, machine tool and automotive industries, each of which are subject to cyclical fluctuations. The semiconductor and electronics, machine tool and automotive industries are cyclical and have historically experienced periods of oversupply, resulting in significantly reduced demand for capital equipment, including the products that we manufacture and market. The timing, length and severity of these cycles, and their impact on our business, are difficult to predict. For the foreseeable future, our operations will continue to depend upon capital expenditures in these industries, which, in turn, depend upon the market demand for their products.

The cyclical variations in these industries have the most pronounced effect on our Laser Systems Group, due in large measure to that segment’s historical focus on the semiconductor and electronics industries and our need to support and maintain a comparatively larger global infrastructure (and, therefore, lesser ability to reduce fixed costs) in that segment than in our other segments. Currently, we are in a downturn. We can not predict how long or deep this downturn may be. There is no assurance that we will not continue to be impacted from the slowdown as we were in the first nine months of 2005, that we will benefit in the future to the same extent as we did in 2004, or that we will not be materially adversely affected by future downturns or slowdowns in the semiconductor and electronics, and other industries that we serve.

The success of our business is dependent upon our ability to respond to fluctuations in demand for our products. During a period of declining demand, we must be able to quickly and effectively reduce expenses while continuing to motivate and retain key employees. Our ability to reduce expenses in response to any downturn is limited by our need for continued investment in engineering and research and development and extensive ongoing customer service and support requirements. In addition, the long lead-time for production and delivery of some of our products creates a risk that we may incur expenditures or purchase inventories for products which we cannot sell. We attempt to manage this risk by employing inventory management practices such as outsourcing portions of the development and manufacturing processes, limiting our purchase commitments and focusing on production to order rather than to stock, but no assurances can be given that our efforts in this regard will be successful in mitigating this risk or that our financial condition or results of operations will not be materially adversely affected thereby.

During a period of increasing demand and rapid growth, we must be able to increase manufacturing capacity quickly to meet customer demand and hire and assimilate a sufficient number of qualified personnel. Our inability to ramp up in times of increased demand could harm our reputation and cause some of our existing or potential customers to place orders with our competitors rather than with us.

Fluctuations in our customers’ businesses, timing and recognition of revenues from customer orders and other factors beyond our control may cause our results of operations quarter over quarter to fluctuate, perhaps substantially. Our revenues and net income, if any, in any particular period may be lower than revenues and net income, if any, in a preceding or comparable period. Factors contributing to these fluctuations, some of which are beyond our control, include:

	•	fluctuations in our customers’ businesses;

	•	timing and recognition of revenues from customer orders;

	•	timing and market acceptance of new products or enhancements introduced by us or our competitors;

	•	availability of components from our suppliers and the manufacturing capacity of our subcontractors;

	•	timing and level of expenditures for sales, marketing and product development;

	•	changes in the prices of our products or of our competitors’ products; and

	•	fluctuations in exchange rates for foreign currency.

We derive a substantial portion of our sales from products that have a high average selling price and significant lead times between the initial order and delivery of the product, which, on average, can range from five to eleven weeks, although it will vary by product. We may receive one or more large orders in one quarter from a customer and then receive no orders from that customer in the next quarter. As a result, the timing and recognition of sales from customer orders can cause significant fluctuations in our operating results from quarter to quarter. If our quarterly revenue or operating results fall below the expectations of investors or public market analysts, our common share price may decline as a result.

Gross profits realized on product sales vary depending upon a variety of factors, including production volumes, the mix of products sold during a particular period, negotiated selling prices, the timing of new product introductions and enhancements, inventory provisions, warranty costs, foreign exchange rates and manufacturing costs.

A delay in a shipment, or failure to meet our revenue recognition criteria, near the end of a fiscal quarter or year, due, for example, to rescheduling or cancellations by customers or to unexpected difficulties experienced by us, may cause sales in a particular period to fall significantly below our expectations and may materially adversely affect our operations for that period. Our inability to adjust spending quickly enough to compensate for any sales shortfall would magnify the adverse impact of that sales shortfall on gross profits and on our results of operations.

As a result of these factors, our results of operations for any quarter are not necessarily indicative of results to be expected in future periods. We believe that fluctuations in quarterly results may cause the market prices of our common shares on The NASDAQ Stock Market and the Toronto Stock Exchange to fluctuate, perhaps substantially.

Our reliance upon third party distribution channels subjects us to credit, inventory, business concentration and business failure risks beyond our control. We sell products through resellers (which include OEMs, systems integrators and distributors). Reliance upon third party distribution sources subjects us to risks of business failure by these individual resellers, distributors and OEMs, and credit, inventory and business concentration risks. In addition, our net sales depend in part upon the ability of our OEM customers to develop and sell systems that incorporate our products. Adverse economic conditions, large inventory positions, limited marketing resources and other factors influencing these OEM customers could have a substantial impact upon our financial results. No assurances can be given that our OEM customers will not experience financial or other difficulties that could adversely affect their operations and, in turn, our financial condition or results of operations.

The steps we take to protect our intellectual property may not be adequate to prevent misappropriation or the development of competitive technologies or products by others that could harm our competitive position and materially adversely affect our results of operations. Our future success depends in part upon our intellectual property rights, including trade secrets, know-how and continuing technological innovation. There can be no assurance that the steps we take to protect our intellectual property rights will be adequate to prevent misappropriation, or that others will not develop competitive technologies or products. As of October 2005, we held 172 United States and 106 foreign patents; in addition, applications were pending for 74 United States and 107 foreign patents. There can be no assurance that other companies are not investigating or developing other technologies that are similar to ours, that any patents will issue from any application filed by us or that, if patents do issue, the claims allowed will be sufficiently broad to deter or prohibit others from marketing similar products. In addition, there can be no assurance that any patents issued to us will not be challenged, invalidated or circumvented, or that the rights thereunder will provide a competitive advantage to us.

Our success depends upon our ability to protect our intellectual property and to successfully defend against claims of infringement by third parties. From time to time we receive notices from third parties alleging that our products infringe such parties’ patent or other proprietary rights. While these notices are common in the laser industry and we have in the past been able to develop non-infringing technology or license necessary patents or technology on commercially reasonable terms, there can be no assurance that we would in the future prevail in any litigation seeking damages or expenses from us or seeking to enjoin us from selling our products on the basis of such alleged infringement, or that we would be able to develop any non-infringing technology or license any valid and infringed patents on commercially reasonable terms. In the event any third party makes a valid claim against us or our customers for which a license was not available to us on commercially reasonable terms, we would be adversely affected. Our failure to avoid litigation for infringement or misappropriation of propriety rights of third parties or to protect our propriety technology could result in a loss of revenues and profits or force us to settle with these other parties.

The industries in which we operate are highly competitive and competition in our markets could intensify, or our technological advantages may be reduced or lost, as a result of technological advances by our competitors. The industries in which we operate are highly competitive. We face substantial competition from established competitors, some of which have greater financial, engineering, manufacturing and marketing resources than we do. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products. There can be no assurance that we will successfully differentiate our current and proposed products from the products of our competitors, or that the market place will consider our products to be superior to competing products. To maintain our competitive position, we believe that we will be required to continue a high level of investment in engineering, research and development, marketing and customer service and support. There can be no assurance that we will have sufficient resources to continue to make these investments, that we will be able to make the technological advances necessary to maintain our competitive position, or that our products will receive market acceptance. We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins, loss of market share and an inability to generate cash flows that are sufficient to maintain or expand our development of new products.

Our operations in foreign countries subject us to risks not faced by companies operating exclusively in the United States. In addition to operating in the United States, Canada, the United Kingdom and the People’s Republic of China (“PRC”), we currently have sales and service offices in Germany, Switzerland, Japan, Korea, Singapore, Taiwan and the PRC. We may in the future expand into other international regions. During the first nine months of 2005, approximately 60% of our revenue was derived from operations outside North America, and approximately 57% of our revenue for the year ended December 31, 2004 was derived from operations outside North America. International operations are an expanding part of our business both from a sales focus and an operating base. We are also extending further production capabilities in the PRC.

Because of the scope of our international operations, we are subject to risks, which could materially impact our results of operations, including:

	•	foreign exchange rate fluctuations;

	•	longer payment cycles;

	•	greater difficulty in collecting accounts receivable;

	•	use of different systems and equipment;

	•	difficulties in staffing and managing foreign operations and diverse cultures;

	•	protective tariffs;

	•	trade barriers and export/import controls;

	•	transportation delays and interruptions;

	•	reduced protection for intellectual property rights in some countries; and

	•	the impact of recessionary foreign economies.

We cannot predict whether the United States or any other country will impose new quotas, tariffs, taxes or other trade barriers upon the importation of our products or supplies or gauge the effect that new barriers would have on our financial position or results of operations.

We do not believe that travel advisories or health concerns have had a material effect on our business to date. However, no assurances can be given that future travel advisories or health concerns will not have an impact on our business.

We may not be able to find suitable targets or consummate acquisitions in the future, and there can be no assurance that the acquisitions we have made and do in the future make will provide expected benefits. In 2003 and 2004, we consummated four strategic acquisitions and may in the future continue to pursue other strategic acquisitions of businesses, technologies and products complementary to our own. Our identification of suitable acquisition candidates involves risks inherent in assessing the values, strengths, weaknesses, risks, synergy and profitability of acquisition candidates, including the effects of the possible acquisition on our business, diversion of management’s attention from our core businesses and risks associated with unanticipated problems or liabilities. No assurances can be given that management’s efforts in this regard will be sufficient, or that identified acquisition candidates will be receptive to our advances or, consistent with our acquisition strategy, be accretive to earnings.

Should we acquire another business, the process of integrating acquired operations into our existing operations may result in unforeseen operating difficulties or additional expenses and may require the allocation of significant financial or other resources such as personnel and management that would otherwise be available for the ongoing development or expansion of our existing business. We attempt to mitigate these risks by focusing our attention on the acquisition of businesses, technologies and products that have current relevancy to our existing lines of business and that are complementary to our existing product lines. Other difficulties we may encounter, and which we may or may not be successful in addressing, include those risks associated with the potential entrance into markets in which we have limited or no prior experience and the potential loss of key employees, particularly those of the acquired business.

Our operations could be negatively affected if we lose key executives or employees or are unable to attract and retain skilled executives and employees as needed. Our business and future operating results depend in part upon our ability to attract, groom and retain qualified management, technical, sales and support personnel for our operations on a worldwide basis. The loss of key personnel could negatively impact our operations. Competition for qualified personnel is intense and we cannot guarantee that we will be able to continue to attract, train and retain qualified personnel.

Decreased effectiveness of equity compensation could adversely affect our ability to attract and retain employees. We have historically used stock options and other forms of equity-related compensation as key components of our total rewards employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention, and provide competitive compensation packages. In recent periods, many of our employee stock options have had exercise prices in excess of our stock price, which reduces their value to employees and could affect our ability to retain or attract present and prospective employees.

Proposed changes in accounting for equity compensation could adversely affect earnings. In addition, the Financial Accounting Standards Board and other agencies have finalized changes to U.S. generally accepted accounting principles that will require us and other companies to record a charge to earnings for employee stock option grants and other equity incentives. Moreover, applicable stock exchange listing standards relating to obtaining shareholder approval of equity compensation plans could make it more difficult or expensive for us to grant options to employees in the future. As a result, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, any of which could materially adversely affect our business.

Integrating acquisitions into our enterprise resource planning (ERP) system could have a material adverse effect on our business. We are highly dependent on our systems infrastructure in order to process orders, track inventory, ship products in a timely manner, prepare invoices to our customers and otherwise carry on our business in the ordinary course. Key to the success of our strategy to drive greater productivity and cost savings is our drive to standardize recent acquisitions on our ERP and reporting systems. If we experience problems with integration, the resulting disruption could adversely affect our business, sales, results of operations and financial condition. The transition involves numerous risks, including:

•	difficulties in integrating systems with our current operations;

•	initial dependence on an unfamiliar system while training personnel in its use;

•	increased demand on our support operations; and

•	potential delay in the processing of customer orders for shipment of products.

Further, we may experience difficulties in the transition to the new software that could affect our internal control systems, processes, procedures and related documentation. There can be no assurances that the evaluation required by Section 404 of the Sarbanes-Oxley Act will not result in the identification of significant control deficiencies or that our auditors will be able to attest to the effectiveness of our internal control over financial reporting subsequent to the transition to our ERP system.

Failure to achieve and maintain effective internal controls could have a material adverse effect on our business, operating results and stock price. We document and test our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. If we fail to achieve and maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information.

We may not develop, introduce or manage the transition to new products as successfully as our competitors. The markets for our products experience rapidly changing technologies, evolving industry standards, frequent new product introductions, changes in customer requirements and short product life cycles. To compete effectively we must continually introduce new products that achieve market acceptance. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address technological changes as well as current and potential customer requirements. Developing new technology is a complex and uncertain process requiring us to be innovative and to accurately anticipate technological and market trends. We may have to manage the transition from older products to minimize disruption in customer ordering patterns, avoid excess inventory and ensure adequate supplies of new products. The introduction by us or by our competitors of new and enhanced products may cause our customers to defer or cancel orders for our existing products, which may harm our operating results. Failed market acceptance of new products or problems associated with new product transitions could harm our business.

Delays or deficiencies in research, development, manufacturing, delivery of or demand for new products or of higher cost targets could have a negative impact on our business, operating results or financial condition. We are active in the research and development of new products and technologies. Our research and development efforts may not lead to the successful introduction of new or improved products. The development by others of new or improved products, processes or technologies may make our current or proposed products obsolete or less competitive. Our ability to control costs is limited by our need to invest in research and development. Because of intense competition in the industries in which we compete, if we were to fail to invest sufficiently in research and development, our products could become less attractive to potential customers and our business and financial condition could be materially and adversely affected. As a result of our need to maintain our spending levels in this area, our operating results could be materially harmed if our net sales fall below expectations. In addition, as a result of our emphasis on research and development and technological innovation, our operating costs may increase further in the future and research and development expenses may increase as a percentage of total operating expenses and as a percentage of net sales.

In addition, we may encounter delays or problems in connection with our research and development efforts. Product development delays may result from numerous factors, including:

	•	changing product specifications and customer requirements;

	•	difficulties in hiring and retaining necessary technical personnel;

	•	difficulties in reallocating engineering resources and overcoming resource limitations;

	•	changing market or competitive product requirements; and

	•	unanticipated engineering complexities.

New products often take longer to develop, have fewer features than originally considered desirable and achieve higher cost targets than initially estimated. There may be delays in starting volume production of new products and new products may not be commercially successful. Products under development are often announced before introduction and these announcements may cause customers to delay purchases of existing products until the new or improved versions of those products are available.

Defects in our products or problems arising from the use of our products together with other vendors’ products may seriously harm our business and reputation. Products as complex as ours may contain known and undetected errors or performance problems. Defects can be found in any period immediately following introduction and initial implementation of new products or enhancements to existing products. Although we attempt to resolve all errors that we believe would be considered serious by our customers before implementation, our products are not error-free. These errors or performance problems could result in lost revenues or customer relationships or require us to incur additional costs to correct product problems and could be detrimental to our business and reputation generally. In addition, our customers generally use our products together with their own products and products from other vendors. As a result, when problems occur in a combined environment, it may be difficult to identify the source of the problem. These problems may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. To date, defects in our products or those of other vendors’ products with which ours are used by our customers have not had a material negative effect on our business. However, we cannot be certain that a material negative impact will not occur in the future.

We depend on limited source suppliers that could cause substantial manufacturing delays and additional cost if a disruption in supply occurs. While we attempt to mitigate risks associated with our reliance on single suppliers by actively managing our supply chain, we do obtain some components used in our business segments from a single source. We also rely on a limited number of independent contractors to manufacture subassemblies for some of our products, particularly in our Laser Systems Group. Despite our and their best efforts, there can be no assurance that our current or alternative sources will be able to continue to meet all of our demands on a timely basis. If suppliers or subcontractors experience difficulties that result in a reduction or interruption in supply to us, or fail to meet any of our manufacturing requirements, our business would be harmed until we are able to secure alternative sources, if any, on commercially reasonable terms.

Each of our suppliers can be replaced, either by contracting with another supplier or through internal production of the part or parts previously purchased in the market, but no assurances can be given that we would be able to do so quickly enough to avoid an interruption or delay in delivery of our products to our customers and any associated harm to our reputation and customer relationships. Unavailability of necessary parts or components, or suppliers of the same, could require us to reengineer our products to accommodate available substitutions. Any such actions would likely increase our costs and could have a material adverse effect on manufacturing schedules, product performance and market acceptance, each or all of which could be expected to have a material adverse effect on our financial condition or results of operations.

Economic, political or trade problems with foreign countries could negatively impact our business. We are increasingly outsourcing the manufacture of sub assemblies to suppliers based in the PRC and elsewhere overseas. Economic, political or trade problems with foreign countries could substantially impact our ability to obtain critical parts needed in the manufacture of our products.

Production difficulties and product delivery delays could materially adversely affect our business, operating results or financial condition. We assemble our products at our facilities in the United States, the United Kingdom and the PRC. If use of any of our manufacturing facilities was interrupted by natural disaster or otherwise, our operations could be negatively impacted until we could establish alternative production and service operations. In addition, we may experience production difficulties and product delivery delays in the future as a result of:

	•	changing process technologies;

	•	ramping production;

	•	installing new equipment at our manufacturing facilities; and

	•	shortage of key components.

If the political conditions globally do not improve or if the economic turnaround is not sustained, we may experience material adverse impacts on our business, operating results and financial condition. Our business is subject to the effects of general economic and political conditions globally. While there have been improvements in the general economy since late 2003, our revenues and operating results are subject to fluctuations from unfavorable economic conditions as well as uncertainties arising out of the threatened terrorist attacks on the United States and throughout the world, including the economic consequences of protracted military action or additional terrorist activities and associated political instability and the impact of heightened security concerns on domestic and international travel and commerce. In particular, due to these uncertainties we are subject to:

	•	the risk that future tightening of immigration controls may adversely affect the residence status of non-United States engineers and other key technical employees in our United States facilities or our ability to hire new non-United States employees in such facilities; and

	•	the risk of more frequent instances of shipping delays.

Increased governmental regulation of our business could materially adversely affect our business, operating results and financial condition. We are subject to many governmental regulations, including but not limited to the laser radiation safety regulations of the Radiation Control for Health and Safety Act administered by the National Center for Devices and Radiological Health, a branch of the United States Food and Drug Administration. Among other things, these regulations require a laser manufacturer to file new product and annual reports, to maintain quality control and sales records, to perform product testing, to distribute appropriate operating manuals, to incorporate design and operating features in lasers sold to end-users and to certify and label each laser sold to end-users as one of four classes (based on the level of radiation from the laser that is accessible to users). Various warning labels must be affixed and certain protective devices installed depending on the class of product. The National Center for Devices and Radiological Health is empowered to seek fines and other remedies for violations of the regulatory requirements. We are subject to similar regulatory oversight, including comparable enforcement remedies, in the European markets we serve.

Changes in governmental regulations may reduce demand for our products or increase our expenses. We compete in many markets in which we and our customers must comply with federal, state, local and international regulations, such as environmental, health and safety and food and drug regulations. We develop, configure and market our products to meet customer needs created by those regulations. Any significant change in regulations could reduce demand for our products, which in turn could materially adversely affect our business, operating results and financial condition.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk. Our exposure to market risk associated with changes in interest rates relates primarily to our cash equivalents, short-term investments, long-term investments and debt obligations. As described in note 8 to the consolidated financial statements, at September 30, 2005, the Company had $61.1 million invested in cash equivalents and $9.3 million in short-term marketable investments. At December 31, 2004, the Company had $48.3 million invested in cash equivalents and $8.0 million in short-term and long-term marketable investments. Due to the average maturities and the nature of the investment portfolio at September 30, 2005, a one percent change in interest rates could have approximately a $0.7 million impact on our interest income on an annual basis. We do not use derivative financial instruments in our investment portfolio. We do not hold interest rate derivative contracts.

Foreign Currency Risk. We have substantial sales and expenses and working capital in currencies other than U.S. dollars. As a result, we have exposure to foreign exchange fluctuations, which may be material. To reduce the Company’s exposure to exchange gains and losses, we generally transact sales and costs and related assets and liabilities in the functional currencies of the operations. Additionally, we may utilize currency forwards, currency swaps and currency options to hedge exposure to foreign currencies. These financial instruments are used to fix the cash flow variable of local currency costs or selling prices denominated in currencies other than the functional currency. We do not currently use currency forwards or currency options for trading purposes. The Company does not designate short-term contracts as hedges. Accordingly, such contracts are recorded at fair value with changes in fair value recognized in income, instead of included in accumulated other comprehensive income. Although the Company marks-to-market short-term hedge contracts to the statement of operations, the Company does not intend to enter into hedging contracts for speculative purposes. At September 30, 2005 there were three short-term United States dollars to British Pound Sterling forward exchange contracts outstanding to purchase $2.3 million with an aggregate fair value loss of $1 thousand recorded in foreign exchange transaction gains (losses). Additionally, we had one long-term currency swap contract, with a maturity date in December 2005, in exchange for Yen with a notional amount of $8.7 million United States dollars with an aggregate fair value loss of $0.6 million recorded in accumulated other comprehensive income. This amount is offset with the remeasurement on the hedged item, for a net amount of nil in accumulated comprehensive income.

Item 4. Controls and Procedures

The Company’s management, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, has conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a-15(b) under the United States Securities Exchange Act of 1934, as amended. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures of the Company are effective as of the end of the period covered by this report. There have been no changes in the Company’s internal control over financial reporting that occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

See the description of legal proceedings in note 10 to the Consolidated Financial Statements.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

Item 3. Defaults upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable.

Item 5. Other Information

Not applicable.

Item 6 (a). Exhibits

Exhibit Number		Description

31.1		Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Chief Executive Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Chief Financial Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.1		Management’s Discussion And Analysis Of Financial Condition And Results Of Operations — Canadian Supplement.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, GSI Group Inc., has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

GSI GROUP INC. (Registrant)

Name	Title	Date


/s/ CHARLES D. WINSTON	President and Chief Executive Officer	November 9, 2005
	(Principal Executive Officer)
Charles D. Winston

/s/ THOMAS R. SWAIN	Vice President, Finance and Chief	November 9, 2005
	Financial Officer (Principal Financial
Thomas R. Swain	and Accounting Officer)

EXHIBIT INDEX

Exhibit Number		Description

31.1		Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Chief Executive Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Chief Financial Officer Certification pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.1		Management’s Discussion And Analysis Of Financial Condition And Results Of Operations — Canadian Supplement.

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Avg

Novanta (NOVT) 10-Q2005 Q3 Quarterly report

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