Acquisitions involve numerous risks, many of which are unpredictable and beyond our control, including: - Difficulties and increased costs in connection with integration of the personnel, operations, technologies and products of acquired companies;
- Diversion of management's attention from other operational matters;
- The potential loss of key employees of acquired companies;
- Lack of synergy, or inability to realize expected synergies, resulting from the acquisition;
- The risk that the issuance of our common stock in a transaction could be dilutive to our shareholders if anticipated synergies are not realized; and
- Acquired assets becoming impaired as a result of technological advancements or worse-than-expected performance by the acquired company.
Our inability to effectively manage these acquisition risks could materially and adversely affect our business, financial condition and results of operations. In addition, if we issue equity securities to pay for an acquisition the ownership percentage of our existing shareholders would be reduced and the value of the shares held by our existing shareholders could be diluted. If we use cash to pay for an acquisition the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes. In addition, the accounting for future acquisitions could result in significant charges resulting from amortization of intangible assets related to such acquisitions. Our markets are subject to rapid technological change, and to compete effectively we must continually introduce new products that achieve market acceptance. The markets for our products are characterized by rapid technological change and innovation, frequent new product introductions, changes in customer requirements and evolving industry standards. 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. 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. We have in the past experienced a slowdown in demand for our existing products and delays in new product development, and similar delays may occur in the future. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or, where necessary, to license these technologies from others. 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;
- Difficulties with contract manufacturers;
- Changing market or competitive product requirements; and
- Unanticipated engineering complexities.
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The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Any failure to respond to technological change would significantly harm our business. We are exposed to the risks that others may violate our proprietary rights, and our intellectual property rights may not be well protected in foreign countries. Our success is dependent upon the protection of our proprietary rights. In the high technology industry, intellectual property is an important asset that is always at risk of infringement. We incur substantial costs to obtain and maintain patents and defend our intellectual property. For example, we have initiated litigation alleging that certain parties have violated various patents of ours. We rely upon the laws of the United States and of foreign countries in which we develop, manufacture or sell our products to protect our proprietary rights. These proprietary rights may not provide the competitive advantages that we expect, however, or other parties may challenge, invalidate or circumvent these rights. Further, our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States. Many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries. If we fail to adequately protect our intellectual property in these countries, it could be easier for our competitors to sell competing products in foreign countries. We may be subject to claims of intellectual property infringement. Several of our competitors hold patents covering a variety of technologies, applications and methods of use similar to some of those used in our products. From time to time, we and our customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents. Competitors or others may assert infringement claims against our customers or us in the future with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others. If claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur. If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position. These licenses, however, may not be available on satisfactory terms or at all. If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, our financial condition and results of operations could be materially and adversely affected. We are exposed to the risks of operating a global business, including risks associated with exchange rate fluctuations and legal and regulatory changes. International sales accounted for 67.9% of total net sales for the first quarter of fiscal year 2004, with 54.6% of our net sales to customers in Asia. We expect that international sales will continue to represent a significant percentage of total net sales in the future. Our non-U.S. sales and operations are subject to risks inherent in conducting business abroad, many of which are outside our control, including the following:
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- Periodic local or geographic economic downturns and unstable political conditions;
- Price and currency exchange controls;
- Fluctuation in the relative values of currencies;
- Difficulties protecting intellectual property;
- Unexpected changes in trading policies, regulatory requirements, tariffs and other barriers; and
- Difficulties in managing a global enterprise, including staffing, collecting accounts receivable, managing distributors and representatives and repatriation of earnings.
In addition, our ability to address normal business transaction issues internationally is at risk due to outbreaks of serious contagious diseases. For example, in response to the recent Severe Acute Respiratory Syndrome outbreak in Asia, management limited travel to Asia in accordance with the World Health Organization’s recommendations. Our direct sales force in Asia exposes us to the risks related to employing persons in foreign countries. We have established direct sales and service organizations in China, Taiwan, Korea and Singapore. Previously, we sold our products through a network of commission-based sales representatives in these countries. Our shift to a direct sales model in these regions involves risks. For example, we may encounter labor shortages or disputes that could inhibit our ability to effectively sell and market our products. We also are subject to compliance with the labor laws and other laws governing employers in these countries and we will incur additional costs to comply with these regulatory schemes. Additionally we will incur new operating expenses associated with the direct sales organizations, particularly payroll related costs and lease expenses. If amounts saved on commission payments formerly paid to our sales representatives do not offset these expenses, our operating results may be adversely affected. Our business is highly competitive, and if we fail to compete effectively, our business will be harmed. 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. If we are unable to compete effectively with these companies, our market share may decline and our business could be harmed. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products. Furthermore, our technological advantages may be reduced or lost as a result of technological advances by our competitors. Their greater resources in these areas may enable them to:
- Better withstand periodic downturns;
- Compete more effectively on the basis of price and technology; and
- More quickly develop enhancements to and new generations of products.
In addition, new companies may in the future enter the markets in which we compete, further increasing competition in those markets. We believe that our ability to compete successfully depends on a number of factors, including: - Performance of our products;
- Quality of our products;
- Reliability of our products;
- Cost of using our products;
- Our ability to ship products on the schedule required;
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- Quality of the technical service we provide;
- Timeliness of the services we provide;
- Our success in developing new products and enhancements;
- Existing market and economic conditions; and
- Price of our products as compared to our competitors’ products.
We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins, and loss of market share. Possibilities of terrorist attacks have increased uncertainties for our business. Like other U.S. companies, our business and operating results are subject to uncertainties arising out of the possibility of terrorist attacks, including the potential worsening or extension of the current global economic slowdown, the economic consequences of 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-U.S. engineers and other key technical employees in our U.S. facilities or our ability to hire new non-U.S. employees in such facilities;
- The risk of more frequent instances of shipping delays; and
- The risk that demand for our products may not increase or may decrease.
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Item 3. Quantitative and Qualitative Disclosures About Market RiskThere have been no material changes in our reported market risks since we filed our 2003 Annual Report on Form 10-K, with the Securities and Exchange Commission on August 27, 2003. Item 4. Controls and ProceduresAttached to this quarterly report as exhibit 31.1 and 31.2 are the certifications of our president and chief executive officer and our chief financial officer required by Section 302 of the Sarbanes-Oxley Act of 2002 (the “Section 302 Certifications”). This portion of our quarterly report on Form 10-Q is our disclosure of the conclusions of our management, including our chief executive officer and chief financial officer, regarding the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report based on management’s evaluation of those disclosure controls and procedures. You should read this disclosure in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented. Disclosure Controls and Procedures Our management has evaluated, under the supervision and with the participation of our president and chief executive officer and chief financial officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report pursuant to Rule 13a- 15(b) under the Securities Exchange Act of 1934, as amended (Exchange Act). Based on that evaluation and, in part, on changes to our internal control over financial reporting described below, our president and chief executive officer and the chief financial officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to our management, including our president and chief executive officer and our chief financial officer , as appropriate to allow timely decisions regarding required disclosure. Internal Control Over Financial Reporting In March 2003, the audit committee of our board of directors, with the assistance of outside legal counsel and forensic accountants, commenced an internal investigation of certain accounting matters. The investigation involved the review of (1) the circumstances surrounding the reversal of an accrual for employee benefits, (2) unsupported accounting adjustments and clerical errors primarily relating to inventory and cost of goods sold, and (3) certain other areas where potential accounting errors could have occurred, including revenue recognition and restructuring reserves. On July 15, 2003, we announced that the audit committee had completed its review of these matters. As a result of the review, we determined that the unaudited consolidated condensed financial statements for the three months ended August 31, 2002 and November 30, 2002 and the audited consolidated financial statements for the year ended June 1, 2002 required restatement. On August 11, 2003, we filed with the Securities and Exchange Commission the related amendments for those periods.
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In connection with management’s review of the restatement adjustments and its evaluation of our internal control over financial reporting and our disclosure controls and procedures, management previously noted to the audit committee deficiencies relating to: - Lack of complete sales documentation, particularly as it relates to customer specified acceptance criteria;
- Lack of adequate job transition/cross training and poorly documented “desk” processes and procedures in the finance/accounting area;
- Changes to accounting methodologies without notification to, or proper authorization by, accounting oversight parties (i.e., the audit committee and independent auditors); and
- Lack of adequate tracking and monitoring of finished goods inventory that was transferred out of the inventory management information system.
The independent auditors previously advised the audit committee that these internal control deficiencies constituted reportable conditions and, collectively, a material weakness as defined in statement of auditing standards No. 60. Certain of these internal control weaknesses may also constitute deficiencies in our disclosure controls. Over the last four months, we have implemented changes to our internal control over financial reporting to correct these weaknesses. During the fiscal quarter, ended August 30, 2003, we have made the following changes in our internal control over financial reporting: - The performance of additional procedures designed to ensure that these internal control deficiencies did not lead to material misstatements in our consolidated financial statements;
- The appointment of a chief accounting officer;
- Continued review and revision of our processes and procedures for applying revenue recognition policies, including more formalized training of finance, sales, order management and other personnel;
- Continued enhancement of accounting/finance training programs and desk processes and procedures documentation; and 5. Enhanced documentation for all completed systems in the inventory management information system to ensure they are properly accounted for.
We will continue to evaluate the effectiveness of our disclosure controls and our internal control over financial reporting, and will take further action as appropriate.
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PART II – OTHER INFORMATIONItem 1. Legal ProceedingsOn August 18, 2003, GSI Lumonics Corporation (GSI) filed a lawsuit in the United States District Court for the Central District of California (GSI Lumonics Inc. v. Electro Scientific Industries, Inc., Case No. CV-03-5863 PA (SHx). The lawsuit alleges that ESI infringes three GSI patents: U.S. Patent No. 6,181,728, entitled “Controlling Laser Polarization;” U.S. Patent No. 6,337,462, entitled “Laser Processing;” and U.S. Patent No. 6,573,473, entitled “Method and System for Precisely Positioning a Waist of a Material-Processing Laser Beam to Process Microstructures Within a Laser Processing Site.” These claims relate to our semiconductor yield improvement systems. GSI seeks injunctive relief, an unspecified amount of damages, costs, and attorneys’ fees. On September 2, 2003, GSI filed a First Amended Complaint, which did not change the substantive allegations of patent infringement. By Court order dated September 18, 2003, the case was transferred to the United States District Court for the Northern District of California. The case was re-assigned to a Judge in the Northern District of California and has been renumbered CV-03-04302-MHP. On October 8, 2003, ESI filed its Answer to First Amended Complaint and Counterclaim for Declatory Judgment of Invalidity and Noninfringement Pretrial discovery has not yet begun and no trial date has been set. We intend to defend this action vigorously. It is not possible at this time to reliably estimate any costs that may be incurred in connection with this lawsuit. Between March 26, 2003 and May 20, 2003, three putative class action lawsuits were filed in the United States District Court for the District of Oregon against ESI and David F. Bolender, James T. Dooley, and Joseph L. Reinhart, who are current, and/or former officers and directors of ESI. The complaints were filed on behalf of a purported class of persons who purchased ESI’s common stock between September 17, 2002 and at the latest April 15, 2003. The complaints assert causes of action (and seek unspecified damages) for alleged violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, as well as Section 20(a) of the Act. In particular, the complaints allege that the defendants were involved in making false and misleading statements during the putative class period about ESI’s business, prospects, and operations, all of which resulted in artificially inflating ESI’s stock price. The complaints have been consolidated under the name In re Electro Scientific Industries, Inc. Securities Litigation, Case No. CV 03-404-HA. Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs’ consolidated class action complaint is due to be filed on October 10, 2003. In March 2003, our audit committee commenced an investigation into certain accounting matters. As a result of the investigation, which was completed on July 11, 2003, we have restated our financial statements for the fiscal year ended June 1, 2002 and for the quarters ended August 31, 2002 and November 30, 2002. The restated financial statements for these periods are set forth in our annual report on Form 10-K/A and quarterly reports on Form 10-Q/A, each filed August 11, 2003. The consolidated class action complaint had not been filed and discovery had not yet commenced when this report was filed, and we are in the early stages of our assessment of the possible outcomes of this litigation. We expect, however, that the litigation will be costly and will to some degree divert management’s attention from daily operations. On March 31, 2003 and April 28, 2003, two separate purported shareholder derivative complaints were filed in the Circuit Court of Oregon in Washington County. The named defendants include certain current and/or former officers and directors of ESI. ESI is named as a “nominal defendant.” The complaints have been consolidated under the name In Re Electro Scientific Industries, Inc. Derivative Litigation, Lead Case No. C 031067 CV. Lead plaintiffs and lead counsel for plaintiffs have been appointed, and a consolidated complaint was filed on September 24, 2003. The consolidated complaint alleges that certain defendants breached fiduciary duties to ESI and were unjustly enriched. The complaint seeks an unspecified amount of monetary damages and seeks various equitable remedies, including a constructive trust on the proceeds received by the defendants from trading ESI common stock. As filed, the complaints are derivative in nature and do not seek monetary damages from, or the imposition of equitable remedies on, ESI. A special litigation committee of our board of directors, with the assistance of independent legal counsel, is conducting an investigation relating to the allegations asserted in the complaints and intends to seek a stay of the action pending the completion of the committee’s investigation.
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We have entered into indemnification agreements in the ordinary course of business with our officers and directors and may be obligated throughout the class action and the derivative lawsuits to advance payment of legal fees and costs incurred by the defendant current and former officers and directors pursuant to the indemnification agreements and applicable Oregon law. On February 14, 2001, Cognex Corporation (Cognex) filed a lawsuit in the United States District Court for the District of Massachusetts (Cognex Corporation v. Electro Scientific Industries, Inc., No. 01-10287 RCL). The lawsuit alleges that our CorrectPlace product and some of its predecessors infringe United States Patent 5,371,690 (the ” ‘690 patent”), which is owned by Cognex. The ‘690 patent concerns the inspection of surface mount devices that are attached to the surface of an electronic circuit board. Cognex seeks injunctive relief, damages, costs and attorneys’ fees. We filed several counterclaims, including one alleging that the ‘690 patent is unenforceable by reason of inequitable conduct and another alleging that Cognex falsely marked certain products with the ‘690 patent. After the close of discovery, on October 8, 2002, we filed a motion for summary judgment of non-infringement. Cognex filed motions for summary judgment on the issues of unenforceability and mismarking on the same day. The court denied Cognex’s motion on the issue of unenforceability on April 25, 2003. Our motion for summary judgment is still pending, as is Cognex’s motion on the issue of false marking. Additionally, certain of our customers have notified us that, in the event it is subsequently determined that their use of CorrectPlace infringes any patent, they may seek indemnification from us for damages or expenses resulting from this matter. We are subject to various other legal proceedings and claims, either asserted or unasserted, that arise in the ordinary course of business.
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Item 6. Exhibits and Reports on Form 8-K(a) Exhibits
This list is intended to constitute the exhibit index. |
