ONTO

Business Context and Reporting Period

This Form 10-Q covers Nanometrics Incorporated for the quarterly period ended September 30, 2002. The company manufactures process control equipment for the semiconductor, magnetic recording head, and flat panel display industries. The filing reflects a challenging operating environment characterized by industry overcapacity and economic slowdowns in the U.S. and Japan.

Key Financial Metrics

Margins: Cost of product sales as a percentage of product sales increased to 46% for the quarter (from 40% in 2001) and 43% for the nine-month period (from 41% in 2001). Service cost of sales decreased to 86% for the quarter (from 111% in 2001).

Material Changes vs. Prior Period

• Revenue Decline: Total net revenues decreased 15% ($1.53 million) for the quarter and 36% ($14.33 million) for the nine months compared to 2001. Product sales dropped 27% for the quarter and 42% for the nine months due to weaker demand for semiconductor process control equipment.
• Service Revenue Growth: Service revenue increased 90% ($0.91 million) for the quarter and 16% ($0.59 million) for the nine months, driven by higher accessory and maintenance sales.
• Expense Increases: Research and development expenses rose 38% for the quarter and 27% for the nine months due to increased headcount and materials. Selling and General & Administrative expenses also increased.
• Profitability Shift: The company reported a net loss of $1.82 million for the quarter and $5.07 million for the nine months, contrasting with a net loss of $0.45 million and net income of $2.71 million, respectively, in the prior year periods.
• Tax Benefit: A significant tax benefit was recorded due to additional R&D credits claimed on the 2001 Federal Income Tax Return, resulting in effective tax rates of 53% (quarter) and 45% (nine months).

Guidance, Outlook, and Risks

Liquidity and Capital Resources: As of September 30, 2002, the company held $37.42 million in cash, cash equivalents, and short-term investments. Management believes working capital is sufficient to meet needs for at least the next twelve months. The current ratio stood at 10.7 to 1.

Outlook and Risks:

• Management cites cyclicality in the semiconductor industry, customer capital spending patterns, and economic slowdowns in the U.S. and Japan as primary risks.
• Forward-looking statements warn of potential delays in customer orders, competitive pricing pressures, and fluctuations in foreign currency exchange rates (specifically the Japanese yen).
• The company does not use derivative financial instruments to hedge market risks but actively manages foreign currency balances.

Unusual Items: The adoption of SFAS No. 142 resulted in the cessation of goodwill amortization, though this was not material for the period. The company also issued remaining shares under its 1986 Employee Stock Purchase Plan and intends to cancel the plan.

Investor Verification Checklist

• Cash Burn Rate: Verify the sustainability of the $7.22 million cash outflow from operating activities over the nine-month period against the $35.43 million cash balance.
• Revenue Mix: Assess the reliance on service revenue (which grew significantly) versus the sharp decline in core product sales.
• Inventory Levels: Review the increase in Work in Process inventory (from $2.39 million to $8.11 million) to ensure it aligns with future order books.
• Tax Credit Timing: Confirm the one-time nature of the tax benefit derived from the 2001 R&D credit filing and its impact on future effective tax rates.
• Debt Obligations: Monitor the repayment schedule of the $3.64 million in debt obligations, specifically the yen-denominated mortgages in Japan.