UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2005.

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

For the transition period from                      to                      .

Commission file number: 000-26966

Registrant’s telephone number, including area code: (970) 221-4670

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

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

As of October 26, 2005, there were 44,371,141 shares of the registrant’s Common Stock, par value $0.001 per share, outstanding.

 

 

ADVANCED ENERGY INDUSTRIES, INC.
FORM 10-Q
TABLE OF CONTENTS

PART I FINANCIAL INFORMATION
		ITEM 1.		UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
				Condensed Consolidated Balance Sheets — September 30, 2005 and December 31, 2004			3
				Condensed Consolidated Statements of Operations — Three months and nine months ended September 30, 2005 and 2004			4
				Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2005 and 2004			6
				Notes to Condensed Consolidated Financial Statements			7
		ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			21
		ITEM 3.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			40
		ITEM 4.		CONTROLS AND PROCEDURES			40
PART II OTHER INFORMATION
		ITEM 1.		LEGAL PROCEEDINGS			42
		ITEM 2.		UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			42
		ITEM 3.		DEFAULTS UPON SENIOR SECURITIES			43
		ITEM 4.		SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS			43
		ITEM 5.		OTHER INFORMATION			43
		ITEM 6.		EXHIBITS			43
		SIGNATURE					44
Global Supply Agreement
Shipping Amendment to the Global Supply Agreement
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification of CEO Pursuant to Section 906
Certification of CFO Pursuant to Section 906

 

PART I FINANCIAL INFORMATION

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

ADVANCED ENERGY INDUSTRIES, INC. AND SUBSIDIARIES

     In November 2004, the FASB issued SFAS No. 151, “Inventory Costs”, an amendment of Accounting Research Bulletin No. 43, Chapter 4, “Inventory Pricing.” SFAS No. 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, it requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005 and will be applied on a prospective basis by the Company for the fiscal year beginning January 1, 2006. The adoption of SFAS No. 151 is not expected to have a material affect on the Company’s financial position and results of operations.

     On June 9, 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes”, and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS No. 154 must be adopted for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date SFAS No. 154 is issued. The Company does not expect the adoption of SFAS No. 154 to have a material impact on its financial results.

      REVENUE RECOGNITION — The Company’s standard shipping term is freight on board (“FOB”) shipping point, for which revenue is recognized upon shipment of its products, at which time title passes to the customer, the price is fixed and collectability is reasonably assured. For certain customers, the Company has FOB destination terms, for which revenue is recognized upon receipt of the products by the customer, at which time title passes to the customer, the price is fixed and collectability is reasonably assured. Revenues from contracts that contain customer acceptance provisions are deferred until customer acceptance occurs. Generally, the Company does not have obligations to its customers after its products are shipped under FOB shipping point terms, after its products are received by customers under FOB destination terms, and after the products are accepted by customers under contractual acceptance provisions, other than pursuant to warranty obligations. In limited instances, the Company provides installation of its products. In accordance with Emerging Issues Task Force (“EITF”) Issue 00-21 “Accounting for Revenue Arrangements With Multiple Deliverables”, the Company allocates revenue based on the fair value of the delivered item, generally the product, and the undelivered item, installation, based on their respective fair values. Revenue related to the undelivered item is deferred until the services have been completed. In certain limited instances, some of the Company’s customers have negotiated product acceptance provisions relative to specific orders. Under these circumstances, the Company defers revenue recognition until the related acceptance provisions have been satisfied. Revenue deferrals are reported as customer deposits and deferred revenue in the condensed consolidated balance sheets.

     In certain instances, the Company requires its customers to pay for a portion or all of their purchases prior to the Company building or shipping these products. Cash payments received prior to shipment are recorded as customer deposits and deferred revenue in the condensed consolidated balance sheets, and then recognized as revenue as appropriate based upon the shipping terms of the products. The Company does not offer price protections to its customers or allow returns, unless covered by its normal policy for repair of defective products.

      WARRANTY POLICY — The Company offers warranty coverage for its products for periods typically ranging from 12 to 24 months after shipment. The Company estimates the anticipated costs of repairing products under warranty based on the historical or expected cost of the repairs and expected failure rates. The assumptions used to estimate warranty accruals are reevaluated quarterly, at a minimum, in light of actual experience and, when appropriate, the accruals are adjusted. The Company’s determination of the appropriate level of warranty accrual is based on estimates. The industries in which the

Company operates are subject to rapid technological change and, as a result, the Company periodically introduces newer, more complex products, which tend to result in increased warranty costs. Estimated warranty costs are recorded at the time of sale of the related product, and are recorded within cost of sales in the condensed consolidated statements of operations.

     The following table summarizes the activity in the Company's warranty reserve during the three- and nine-month periods ended September 30, 2005 and 2004:

      STOCK-BASED COMPENSATION – At September 30, 2005, the Company had three active stock-based compensation plans, which are more fully described in Note 18 of the Company’s Form 10-K/A for the year ended December 31, 2004. The Company accounts for employee stock-based compensation using the intrinsic value method prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. APB Opinion No. 25 requires the use of the intrinsic value method, which measures compensation cost as the excess, if any, of the quoted market price of the stock at the measurement date over the amount an employee must pay to acquire the stock. With the exception of certain options granted in 1999 and 2000 by a shareholder of Sekidenko, Inc., prior to its acquisition by the Company, all options granted under these plans have an exercise price no less than the market value of the underlying common stock on the date of grant, therefore no stock-based compensation cost is reflected in the Company’s results of operations. The Company records compensation expense related to the grants of restricted stock units, over the period the units vest, typically four years. Had compensation cost for the Company’s plans been determined consistent with the fair value-based method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net (loss) income would have changed to the following adjusted amounts:

     For SFAS No. 123 purposes, the fair value of each option grant and purchase right granted under the Employee Stock Purchase Plan (“ESPP”) are estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

     Based on the Black-Scholes option pricing model, the weighted-average estimated fair value of stock option grants was $6.22 and $6.01 for the three months ended September 30, 2005 and 2004, respectively, and was $4.58 and $9.23 for the nine months ended September 30, 2005 and 2004, respectively. The weighted-average estimated fair value of purchase rights granted under the ESPP was $3.11 and $5.10 for the three months ended September 30, 2005 and 2004, respectively, and was $2.96 and $5.26 for the nine months ended September 30, 2005 and 2004, respectively.

     The total fair value of options granted was computed to be approximately $870,000 and $2.2 million for the three-month periods ended September 30, 2005 and 2004, respectively. The total fair value of options granted for the nine-month periods ended September 30, 2005 and 2004, was computed to be approximately $2.0 million and $9.7 million, respectively. These amounts are amortized ratably over the vesting period of the options for the purpose of calculating the pro forma disclosure above. The number of stock options exercised during the three month periods ended September 30, 2005 and 2004 was approximately 25,000 and 8,000, respectively, at a weighted average exercise price per share of $8.18 and $9.51, respectively. The number of stock options exercised during the nine month periods ended September 30, 2005 and 2004 was approximately 81,000 and 87,000, respectively, at a weighted average exercise price per share of $7.78 and $10.45, respectively.

     The Company granted approximately 51,000 restricted stock units to certain employees during the three-month period ended September 30, 2005, and 283,000 over the nine-month period September 30, 2005. The Company did not grant any restricted stock units in 2004. Upon granting of these units, deferred compensation representing an estimate of the units expected to vest at the market value at the date of grant is recorded in shareholders’ equity and subsequently amortized over the periods during which the units vest, generally 4 years. Amortization of deferred compensation relating to the restricted stock units of $90,000 and $229,000 was recorded for the three-month and nine-month periods ended September 30, 2005, respectively.

     The Company will adopt the provisions of SFAS No. 123(R) as of January 1, 2006, as further discussed under the heading “New Accounting Pronouncements” above. The adoption of this statement is expected to have a significant impact on the Company’s results of operations as the Company will be required to record compensation expense in the consolidated statement of operations rather than disclose the impact within its notes to the consolidated financial statements.

     On October 18, 2005, the Board of Directors of the Company approved the acceleration of the vesting of certain stock options. Vesting was accelerated for those options outstanding as of October 18, 2005 that have exercise prices of $15.00 per share or higher. The closing price of the Company’s common stock on October 18, 2005 was $10.69 per share. As a result, options to purchase approximately 624,000 shares of common stock that would otherwise have vested over the next 30 months became fully vested. As of

October 18, 2005, options to purchase 3.8 million shares of the Company’s common stock were outstanding. Unvested options totaling 852,000 that have an exercise price less than $15.00 per share that were outstanding as of October 18, 2005 will continue to vest on their normal schedule. The Board of Directors determined to accelerate the vesting of these options principally to reduce future compensation expense that would otherwise be required to be recorded in the statement of operations in periods following the Company’s adoption of SFAS No. 123(R).

      INCOME TAXES — The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires deferred tax assets and liabilities to be recognized for temporary differences between the tax basis and financial reporting basis of assets and liabilities, computed at current tax rates, as well as for the expected tax benefit of net operating loss and tax credit carryforwards. During the third quarter of 2003, the Company recorded valuation allowances against certain of its United States and foreign net deferred tax assets in jurisdictions where the Company has incurred significant losses. Given such experience, the Company’s management could not conclude that it was more likely than not that these net deferred tax assets would be realized. Accordingly, the Company’s management, in accordance with SFAS No. 109, in evaluating the recoverability of these net deferred tax assets, was required to place greater weight on the Company’s historical results as compared to projections regarding future taxable income. The Company will continue to evaluate its valuation allowance on a quarterly basis, and may in the future reverse some portion or all of its valuation allowance and recognize a reduction in income tax expense or increase its valuation allowance for previously unreserved assets and recognize an increase in income tax expense. A portion of the valuation allowance relates to the benefit from stock-based compensation. Any reversal of the valuation allowance for this item will be reflected as an increase in additional paid in capital. When recording acquisitions, the Company has recorded valuation allowances due to the uncertainty related to the realization of certain deferred tax assets existing at the acquisition dates. Any reversal of the valuation allowances recorded in purchase accounting is reflected as a reduction of goodwill in the period of reversal.

      COMMITMENTS AND CONTINGENCIES — The Company is involved in disputes and legal actions arising in the normal course of its business. While the Company believes that the amount of any ultimate potential loss will not be material to its financial position, the outcome of these actions is inherently difficult to predict. In the event of an adverse outcome, the ultimate potential loss could have a material adverse effect on the Company’s financial position or reported results of operations in a particular quarter. An unfavorable decision, particularly in patent litigation, could require material changes in production processes and products or result in an inability to ship products or components found to have violated third-party patent rights. The Company accrues loss contingencies in connection with its commitments and contingencies, including litigation, when it is probable that a loss has occurred and the amount of the loss can be reasonably estimated.

      GOODWILL AND OTHER INTANGIBLE ASSETS — Goodwill represents the excess of the cost over the fair market value of net tangible and identifiable intangible assets of acquired businesses.

     Goodwill and certain other intangible assets with indefinite lives are not amortized. Instead, goodwill and other indefinite-lived intangible assets are subject to periodic tests for impairment. The Company performs the annual test for impairment during the fourth quarter. For the periods presented, the Company does not have any indefinite-lived intangible assets, other than goodwill. Impairment testing is performed in two steps: (i) the Company assesses goodwill for potential impairment by comparing the fair value of its reporting unit with its carrying value, and (ii) if potential impairment is indicated because the reporting unit’s fair value is less than its carrying amount, the Company measures the amount of impairment loss by comparing the implied fair value of goodwill with the carrying amount of that goodwill.

     Finite-lived intangible assets continue to be amortized using the straight-line method over their estimated useful lives and are reviewed for impairment whenever events or circumstances indicate that their carrying amount may not be recoverable.

      RECLASSIFICATIONS — Certain prior period amounts have been reclassified to conform to the current period presentation.

      FOREIGN CURRENCY TRANSLATION — The functional currency of the Company’s foreign subsidiaries is their local currency, with the exception of the Company’s manufacturing facility in China where the United States dollar is currently the functional currency. Assets and liabilities of international subsidiaries are translated to United States dollars at period-end exchange rates, and statement of operations activity and cash flows are translated at average exchange rates during the period. Resulting translation adjustments are recorded as a separate component of stockholders’ equity.

     Transactions denominated in currencies other than the local currency are recorded based on exchange rates at the time such transactions arise. Subsequent changes in exchange rates result in foreign currency transaction gains and losses which are reflected in income as unrealized (based on period end translation) or realized (upon settlement of the transactions). Unrealized transaction gains and losses applicable to permanent investments by the Company in its foreign subsidiaries are included as cumulative translation adjustments, and unrealized translation gains or losses applicable to non-permanent intercompany receivables from or payables to the Company and its foreign subsidiaries are included in income.

(2) RESTRUCTURING CHARGES

     Restructuring charges include the costs associated with actions taken by the Company primarily in response to cyclical downturns in its business in the semiconductor capital equipment industry. These charges consist of employee severance and termination costs, facility closure costs and impairments of facility-related assets.

     The following table summarizes the components of the restructuring charges, the payments and non-cash items, and the remaining accrual as of September 30, 2005:

     In the fourth quarter of 2004, the Company recorded restructuring charges of $3.7 million, which primarily consisted of employee severance and termination costs associated with the involuntary severance of 212 employees, including 60 agency employees, at the Company’s Fort Collins facility. The need to reduce headcount in Fort Collins resulted primarily from the transfer of a substantial portion of the Company’s manufacturing operations to Shenzhen, China. Related to this operational restructuring, and the transition of certain product lines from certain of the Company’s locations in Europe and Japan, the Company recorded restructuring charges for employee severance and termination costs of $1.3 million in the first quarter of 2005, $475,000 in the second quarter of 2005 and $202,000 in the third quarter of 2005. These charges are associated with 215 employees in the United States, 11 employees in Europe and three employees in Japan. With the exception of three employees in the United States, all of these employee severance and termination costs have been paid as of September 30, 2005. Through the transition of the Company’s

manufacturing operations from the Fort Collins facility to Shenzhen, China, the Company recognized the need to retain 11 employees considered in the original reserve, and therefore in the third quarter of 2005 restructuring reserves of $180,000 have been reversed. The Company expects to pay the remaining accrual for employee severance and termination costs of approximately $101,000 by the end of the fourth quarter of 2005.

     Impairments of facility-related assets were recorded in the second quarter of 2005 for $589,000 in the United States and in the third quarter of 2005 for $157,000 in Japan, as a result of consolidation of certain of the Company’s facilities.

     The remaining facility closure cost liability is expected to be paid over the remaining lease term expiring at the end of 2006 and is reflected net of expected sublease income of $79,000.

(3) INCOME TAXES

     As of September 30, 2005, the Company had a gross federal net operating loss carryforward of approximately $102 million, of which approximately $12 million is restricted to offset income from the Aera mass flow controller United States’ operation, an alternative minimum tax credit carryforward of approximately $2 million, and research and development credit carryforwards of approximately $4 million, each of which may be available to offset future federal income tax liabilities. The federal net operating loss and research and development credit carryforwards expire at various dates through December 31, 2024, and the alternative minimum tax credit carryforward has no expiration date. The Company is unable to provide a tax benefit from its net operating loss carryforward because it has not demonstrated sustained profitability in the United States. In addition, as of September 30, 2005, the Company had a gross foreign net operating loss carryforward of $2.1 million, which may be available to offset future foreign income tax liabilities and expires at various dates through December 31, 2008.

     The income tax provision on the loss before income taxes was $1.6 million for the third quarter of 2005 and represents a negative effective tax rate of 69%, and the income tax provision on the loss before income taxes was $997,000 for the third quarter of 2004 and represents a negative effective rate of 717%. The income tax provision on income from continuing operations was $3.5 million for the first nine months of 2005 and represents an effective tax rate of 96% and the income tax provision on income from continuing operations was $4.6 million for the first nine months of 2004 and represents an effective rate of 31%. The changes in the effective tax rate from the 2004 periods to the 2005 periods are due to taxable income earned in certain foreign jurisdictions and losses in the United States which receive no corresponding tax benefit due to valuation allowances.

(4) DISCONTINUED OPERATIONS

     On June 24, 2005, the Company sold the assets of its EMCO product line to an unrelated third party for net cash proceeds of $3.7 million, as this product line was not critical to the Company’s core operations. The sale included assets with a book value of approximately $663,000, comprised of $515,000 of accounts receivable, $71,000 of inventory, $42,000 of fixed assets, and $35,000 of prepaid expenses, and liabilities of approximately $94,000. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwill of $471,000 was allocated to the sale based upon its estimated fair value relative to the portion of the reporting unit that will be retained. The Company recognized a gain on the sale of $2.6 million, which is recorded in discontinued operations in the statement of operations. The EMCO product line did not represent a significant portion of the Company’s operations, with revenues representing from 1.4% to 3.5% of quarterly consolidated sales from 2003 through its sale on June 24, 2005. Due to the insignificant impact of the EMCO product line on the Company’s results of operations, such results are included in income from operations in the accompanying condensed consolidated statements of operations.

(5) MARKETABLE SECURITIES

     MARKETABLE SECURITIES consisted of the following:

     These marketable securities are classified as available-for-sale and are stated at period end market value. The commercial paper consists of high credit quality, short-term preferreds with maturities or reset dates of approximately 120 days.

(6) ACCOUNTS RECEIVABLE

     ACCOUNTS RECEIVABLE consisted of the following:

(7) INVENTORIES

     Inventories include costs of materials, direct labor and manufacturing overhead. Inventories are stated at the lower of cost or market, computed on a first-in, first-out basis and are presented net of reserves for obsolete and excess inventory. Inventory is written down or written off when it becomes obsolete, generally because of engineering changes to a product or discontinuance of a product line, or when it is deemed excess. These determinations involve the exercise of significant judgment by management, and as demonstrated in recent periods, demand for the Company’s products is volatile and changes in expectations regarding the level of future sales can result in substantial charges against earnings for obsolete and excess inventory. Inventories consisted of the following:

(8) GOODWILL AND OTHER INTANGIBLE ASSETS

     Goodwill and other intangible assets consisted of the following as of September 30, 2005:

     Goodwill and other intangible assets consisted of the following as of December 31, 2004:

     When recording acquisitions, the Company has recorded income tax valuation allowances due to the uncertainty related to the realization of certain deferred tax assets existing at the acquisition dates. For the nine months ended September 30, 2005, due to the utilization of these net operating losses, approximately $1.2 million of the valuation allowances established in purchase accounting were reversed, with a corresponding reduction in goodwill.

     Aggregate amortization expense related to other intangibles was $504,000 in the third quarter of 2005 and $1.1 million in the third quarter of 2004, and was approximately $1.6 million for the nine-month period ended September 30, 2005 and $3.4 million for the nine-month period ended September 30, 2004. Estimated amortization expense related to the Company’s acquired intangibles fluctuates with changes in foreign currency exchange rates between the United States dollar and the Japanese yen and the euro. Estimated amortization expense related to acquired intangibles for each of the five years 2005 through 2009 is as follows:

(9) STOCKHOLDERS’ EQUITY

      STOCKHOLDERS’ EQUITY consisted of the following (in thousands, except par value):

     On August 17, 2005, the Company issued 10 million shares of common stock at a price of $9.75 per share pursuant to an underwritten public offering. On August 22, 2005, the Company issued an additional 1.5 million shares of common stock at the same price, pursuant to the underwriters’ exercise of their over-allotment option. Proceeds from this offering of 11.5 million shares of common stock were approximately $105.5 million, net of the underwriters’ discount and offering expenses of approximately $6.6 million. The net proceeds were used to fully redeem the Company’s 5.25% convertible subordinated notes due 2006, and toward the full redemption of the Company’s 5.0% convertible subordinated notes due 2006. See Note 11 for additional details of the redemption of the Company’s convertible subordinated notes.

(10) COMPREHENSIVE INCOME (LOSS)

     Comprehensive income (loss) for the Company consists of net income (loss), foreign currency translation adjustments and net unrealized holding gains on available-for-sale marketable securities as presented below (in thousands):

(11) CONVERTIBLE SUBORDINATED NOTES PAYABLE

     Convertible subordinated notes payable consisted of the following (in thousands):

     Using a portion of the $105.5 million in net proceeds from the Company’s public offering of 11.5 million shares of common stock during the third quarter of 2005, the Company redeemed in full the 5.25% convertible subordinated notes due November 15, 2006. This redemption consisted of a $66.2 million principal payment, $883,000 for redemption premium, and $1.1 million for interest through the redemption date.

     After the redemption of the 5.25% convertible subordinate notes, proceeds from the public offering of approximately $37.3 million remained. These proceeds plus $88.9 million of cash, cash equivalents and marketable securities were used to redeem in full the 5.0% convertible subordinated notes due September 1, 2006. This redemption consisted of a $121.5 million principal payment, $1.2 million for redemption premium, and $3.5 million for interest through the redemption date.

     Debt extinguishment expense recorded in the condensed consolidated statements of operations of $3.2 million is comprised of $2.1 million for redemption premium, discussed above, and $1.1 million for the write-off of deferred debt issuance costs.

(12) COMMITMENTS AND CONTINGENCIES

     The Company has inventory purchase commitments of approximately $1.3 million for the remainder of 2005 and $2.5 million for 2006 of parts, components and subassemblies from various suppliers. These inventory purchase obligations consist of minimum purchase commitments to ensure the Company has an adequate supply of critical components to meet the demand of its customers. The Company believes that these purchase commitments will be consumed in its on-going operations in the respective periods.

     The Company has also committed to advance up to $850,000 to a privately held company in exchange for an exclusive intellectual property license. The amount and timing of this advance is dependent upon the privately held company achieving certain development milestones. As of September 30, 2005, approximately $318,000 has been advanced under this agreement, which was recorded within research and development expense in the condensed consolidated statement of operations.

DISPUTES AND LEGAL ACTIONS

     The Company is involved in disputes and legal actions arising in the normal course of its business. The Company’s most significant legal actions have involved the application of patent law to complex technologies and intellectual property. The determination of whether such technologies infringe upon the Company’s or others’ patents can be highly subjective. This subjectivity introduces substantial additional risk with regard to the outcome of the Company’s disputes and legal actions related to intellectual property. In the event of any adverse outcome, the ultimate potential loss could have a material adverse effect on the Company’s financial position or reported results of operations in a particular period. An unfavorable decision, particularly in patent litigation, could require material changes in production processes and products or result in the Company’s inability to ship products or components found to have violated third-party patent rights. The Company accrues loss contingencies in connection with its litigation when it is probable that a loss has occurred and the amount of the loss can be reasonably estimated.

     In April 2003, the Company filed a claim in the United States District Court for the District of Colorado seeking a declaratory ruling that its plasma source products Xstream™ With Active Matching Network™ (“Xstream products”) were not in violation of patents held in the United States by MKS Instruments, Inc. (“MKS”). This case was transferred by the Colorado court to the United States District Court for the District of Delaware for consolidation with a patent infringement suit filed in that court by MKS in May 2003, alleging that the Company’s Xstream products infringe five patents held by MKS. On July 23, 2004, a jury returned a verdict of infringement of three MKS patents, which did not stipulate damages. On October 3, 2005, the Company executed a settlement agreement with MKS resolving all pending claims involving the Xstream products and all other toroidal plasma generator products. Pursuant to the settlement agreement, the Company paid $3.0 million in cash to MKS, which was accrued in the condensed consolidated statement of operations as of September 30, 2005. The Company also stipulated to a final judgment of infringement and an injunction prohibiting the Company from making, using, selling, offering to sell, or importing into the United States, or any country in which a counterpart patent exists, its Xstream products and all other toroidal plasma generator products, except as permitted under the settlement agreement. Sales of these products have accounted for less than 5% of the Company’s total sales each year since introduction of the products.

     On June 2, 2004, MKS filed a petition in the District Court in Munich, Germany, alleging infringement by the Company’s Xstream products of a counterpart German patent owned by MKS. On August 4, 2004, this court dismissed MKS’s petition and assessed costs of the proceeding against MKS. MKS refiled an infringement petition in the District Court of Mannheim. On April 8, 2005, the Mannheim court issued a judgment against the Company for infringement of MKS’s patent, which did not specify damages. The action was dismissed pursuant to the settlement agreement referenced above in connection with the Xstream products litigation in the United States. A petition for invalidity of MKS’s patent brought by the Company was also dismissed.

     On July 12, 2004, the Company filed a complaint in the United States District Court for the District of Delaware against MKS alleging that MKS’s Astron reactive gas source products infringe Advanced Energy’s United States Patent No. 6,046,546. The case was voluntarily dismissed on March 11, 2005 under an agreement that left the Company free to refile its claims upon conclusion of MKS’s lawsuit against the Company’s Xstream products. Pursuant to the settlement agreement referenced above in connection with the Xstream products litigation, the Company agreed to not refile its claims related to MKS’s Astron reactive gas source products.

     On June 8, 2005, the Korean Customs Service (“KCS”) issued a Pre-Taxation Notification concerning back duties and value added taxes allegedly owed on goods imported by the Company’s Korean subsidiary, Advanced Energy Industries Korea, Inc., during the five year period ended June 8, 2005. On June 27, 2005, the Company protested the notifications on the grounds that the assessment was unwarranted and based on a misapplication of international tariff rules. On September 9, 2005, the KCS rejected the protest brought by the Company. Beginning on September 19, 2005 the KCS issued a series of taxation notices for duties and penalties owed of approximately $2.2 million. In order to appeal the assessment to the Korean National Tax Tribunal, an independent review board of the Korean Ministry of Finance and Economy, the Company must pay the taxation notices. Although the Company has elected to pay the taxation notices in order to appeal the assessment, the Company does not believe such amounts represent a probable expense and therefore has not accrued such in the condensed consolidated statement of operations. The Company currently believes that the amount of any ultimate loss will not have a material adverse effect on the Company’s financial position or reported results of operations.

(13) EARNINGS PER SHARE

     Basic earnings per share (“EPS”) is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS except that the numerator is increased to exclude certain charges which would not have been incurred, and the denominator is increased to include the number of additional common shares that would have been outstanding (using the if-converted and treasury stock

methods), if securities containing potentially dilutive common shares (convertible notes payable, stock options and restricted stock units) had been converted to such common shares, and if such assumed conversion is dilutive. As of September 30, 2005 and 2004, stock options and restricted stock units totaling approximately 4.0 million and 4.6 million, respectively, were outstanding. Of these amounts, 3.0 million shares for the nine month periods ended September 30, 2005 and 2004 are not included in the computation of diluted earnings per share because the effect of including such options in the computation would be anti-dilutive. Due to the Company’s net loss for the three months ended September 30, 2005 and 2004, basic and diluted EPS are the same, as the assumed conversion of all potentially dilutive securities would be anti-dilutive. For the three and nine months ended September 30, 2005 and 2004, the affect of potential conversion of the Company’s convertible subordinated notes payable was not included in this computation because to do so would be anti-dilutive.

     The following is a reconciliation of the numerators and denominators used in the calculation of basic and diluted EPS for the three and nine months ended September 30, 2005 and 2004:

(14) FOREIGN OPERATIONS

     The Company has operations in the United States, Europe and Asia Pacific. The following is a summary of the Company’s operations by region:

(1) These sales amounts do not contemplate where the Company’s customers may subsequently transfer the products sold.

Income (loss) from operations:
United States		$	(2,086	)		$	(1,817	)		$	(4,774	)		$	5,793
Europe			652				484				825				1,382
Asia Pacific			2,873				2,770				13,226				15,386
Intercompany eliminations			1,050				418				2,015				(2,142	)
		$	2,489			$	1,855			$	11,292			$	20,419

     Intercompany sales among the Company’s geographic areas are recorded on the basis of intercompany prices established by the Company.

(15) SUPPLEMENTAL CASH FLOW DISCLOSURES

     In the first quarter of 2004, the Company made a strategic decision to further focus its marketing and product support resources on its core competencies and reorient its operating infrastructure towards sustained profitability. As a result, the Company sold its Noah chiller product line to an unrelated third party for $797,000 in cash and a $1.9 million note receivable due March 31, 2009. The note bears interest at 5.0%, payable annually on March 31. The sale included property and equipment with a book value of approximately $300,000, inventory of approximately $1.0 million, goodwill and intangible assets net of accumulated amortization of approximately $900,000, demonstration and customer service equipment of approximately $140,000, and estimated warranty obligations of approximately $140,000. The Company recognized a gain on the sale of $404,000, which has been recorded as other income and expense in the accompanying condensed consolidated financial statements. In the third quarter of 2004, the Company purchased equipment of approximately $71,000 from the buyers of the Noah chiller assets in exchange for an equivalent reduction of the note receivable due March 31, 2009.

(16) SUBSEQUENT EVENTS

     On October 3, 2005, the Company and MKS Instruments, Inc. and its subsidiary, Applied Science and Technology, Inc. (collectively, “MKS”) executed a settlement agreement in connection with patent infringement litigation pending between the Company and MKS relating to the Company’s Xstream products. Pursuant to the settlement agreement, the Company has paid MKS $3.0 million in cash, which was accrued in other accrued expenses on the condensed consolidated balance sheet as of September 30, 2005. Additionally, the Company and MKS have stipulated to a final judgment of infringement and an injunction prohibiting the Company from making, using, selling, offering to sell, or importing into the United States, or any country in which a counterpart patent exists, its Xstream products and all other toroidal plasma generator products, except as permitted under the settlement agreement. Sales of such products have accounted for less than 5% of the Company’s total sales each year since the introduction of such products.

     On October 18, 2005, the Board of Directors of the Company approved the acceleration of the vesting of certain stock options. Vesting was accelerated for those options outstanding as of October 18, 2005 that have exercise prices of $15.00 per share or higher. The closing price of the Company’s common stock on October 18, 2005 was $10.69 per share. As a result, options to purchase approximately 624,000 shares of common stock that would otherwise have vested over the next 30 months became fully vested. As of October 18, 2005, options to purchase 3.8 million shares of the Company’s common stock were outstanding. Unvested options totaling 852,000 that have an exercise price less than $15.00 per share that were outstanding as of October 18, 2005 will continue to vest on their normal schedule. The Board of Directors determined to accelerate the vesting of these options principally to reduce future compensation expense that would otherwise be required to be recorded in the statement of operations in periods following the Company’s adoption of SFAS No. 123(R).

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

Special Note on Forward-Looking Statements

     The following discussion contains, in addition to historical information, forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements that are other than historical statements of fact are forward-looking statements. For example, statements relating to our beliefs, expectations, plans and projections are forward-looking statements, as are statements that specified actions, conditions or circumstances will continue or change. Forward-looking statements involve risks and uncertainties, which are difficult to predict and many of which are beyond our control. Some of these risks and uncertainties are described below. Other factors might also contribute to differences between our forward-looking statements and our actual results. Our actual results could differ materially from the results projected or assumed in the forward-looking statements. We assume no obligation to update any forward-looking statements or the reasons why our actual results might differ.

Risk and Uncertainties

The semiconductor, semiconductor capital equipment and flat panel display industries are highly cyclical, which impacts our operating results.

     Our business and operating results depend in significant part upon capital expenditures by manufacturers of semiconductors and flat panel displays, which in turn depend upon current and anticipated demand for their products. Historically, these industries have been highly cyclical, with recurring periods of over-supply that have had a negative impact on the demand for capital equipment used to manufacture their products.

     During periods of declining demand, our customers typically reduce purchases of, and cancel orders for, our products and delay delivery of their own products. We may incur significant charges as we seek to align our cost structure with any such reduction in sales to these customers. In addition, we may not be able to respond adequately or quickly to the declining demand by reducing our costs. We may also be required to record significant reserves for excess and obsolete inventory as demand for our products changes. Our inability to reduce costs and the charges resulting from other actions taken in response to changes in demand for our products would adversely affect our business, financial condition and operating results.

Our quarterly and annual operating results fluctuate significantly and are difficult to predict.

     Our operating results may be adversely affected by a variety of factors, many of which are beyond our control and difficult to predict. These factors include:

	•		Fluctuations in demand in the semiconductor, semiconductor capital equipment and flat panel display industries and other industries in which our customers operate;
	•		The timing and nature of orders placed by our customers;
	•		Seasonal variations in capital spending by our customers;
	•		Changes in our customers’ inventory management practices;
	•		Customer cancellation or postponement of previously placed orders;
	•		Pricing competition from our competitors;

	•		Customer requests for us to reduce prices, enhance features, improve reliability, shorten delivery times and extend payment terms;
	•		Component shortages or allocations or other factors that result in delays in manufacturing and sales or result in changes to our inventory levels or causes us to substantially increase our spending on inventory;
	•		The introduction of new products by us or our competitors;
	•		Changes in macroeconomic conditions;
	•		Litigation, especially regarding intellectual property; and
	•		Currency exchange rate fluctuations. Currently, a 10% adverse change in exchange rates would have approximately a 2% to 4% adverse impact on reported revenues and expenses.

We have recently transferred the production of substantially all of our product lines to our manufacturing facility in Shenzhen, China, and may experience unforeseen difficulties and challenges with these new operations.

     We have invested significant human and financial resources to establish our manufacturing facility in Shenzhen, China. These investments were made with the goal of reducing our labor costs by increasing our workforce in China and correspondingly decreasing our workforce in the United States.

     Because our operating history in Shenzhen is limited, we cannot predict the impact that this new facility will have on our operating results. We may continue to incur costs with respect to the integration of this facility and the related workforce. While most of the products we manufacture in Shenzhen have been qualified for many of our customers, we could still incur additional qualification costs for some customers.

We might not realize all of the intended benefits of transitioning a substantial portion of our supply base to Asian suppliers.

     We anticipate purchasing a substantial portion of components for our products from high-quality, low-cost Asian suppliers by the end of 2005. These components might have unexpected quality problems and require us to incur higher than anticipated test, repair or warranty costs, which would have an adverse effect on our operating results. Customers, including major customers, might not accept our products if they contain these lower-priced components. A delay or refusal by our customers to accept such products might require us to continue to purchase higher-priced components from our existing suppliers or might cause us to lose sales to these customers, which would have an adverse effect on our business, financial condition and operating results.

Raw material, part, component and subassembly shortages, exacerbated by our dependence on sole and limited source suppliers, could affect our ability to manufacture products and systems and could delay our shipments.

     Our business depends on our ability to manufacture products that meet the rapidly changing demands of our customers. Our ability to timely manufacture our products depends in part on the timely delivery of raw materials, parts, components and subassemblies from suppliers. We rely on sole and limited source suppliers for some of our raw materials, parts, components and subassemblies that are critical to the manufacturing of our products. This reliance involves several potential risks, including the following:

	•		Inability to obtain an adequate supply of required parts, components or subassemblies;
	•		Supply shortages if a sole source provider ceases operations;
	•		Need to fund the operating losses of a sole source provider;
	•		Reduced control over pricing and timing of delivery of raw materials, parts, components or subassemblies;

	•		Need to qualify alternative suppliers which could be time consuming and lead to delays in delivery of products to our customers, as well as increased costs; and
	•		Inability of our suppliers to develop technologically advanced products to support our growth and development of new products.

     If we are unable to successfully qualify additional suppliers and manage relationships with our existing and future suppliers or if our suppliers cannot meet our performance or quality specifications, or timing requirements, we may experience shortages of raw materials, parts, components or subassemblies, increased material costs and shipping delays for our products, which would adversely affect our business, financial condition and operating results and relationships with our current and prospective customers.

A significant portion of our sales is concentrated among a few customers.

     Our ten largest customers accounted for 55% of our total sales in the third quarter of 2005 and 60% in the third quarter of 2004, and accounted for 55% of our total sales during the nine months ended September 30, 2005 and 60% during the nine months ended September 30, 2004. Our largest customer, Applied Materials, accounted for 19% of our total sales during the third quarter of 2005 and 28% in the third quarter of 2004, and accounted for 22% of our total sales during the nine months ended September 30, 2005 and 29% during the nine months ended September 30, 2004. Ulvac, Inc. accounted for 11% of our sales in both the third quarter of 2005 and 2004, 10% of sales during the nine months ended September 30, 2005, and less than 10% of our sales during the nine months ended September 30, 2004. No other customer represented greater than 10% of our total sales for any of these periods. The loss of any of our significant customers or a material reduction in any of their purchase orders would significantly harm our business, financial condition and results of operations.

     Our customers continuously exert pressure on us to reduce our prices and extend payment terms. Given the nature of our customer base and the highly competitive markets in which we compete, we may be required to reduce our prices or extend payment terms to remain competitive. We may not be able to reduce our operating expenses in an amount sufficient to offset potential margin declines.

     Certain of our largest customers also exert pressure on us to limit the sale of our products to certain OEMs, and to agree to prohibit sales to our end user customer base entirely, among other limitations. Given our size relative to certain of our largest customers, we may be required to agree to limitations of this nature to remain competitive. Limitations imposed on us with respect to our potential customer base could significantly adversely affect our business, financial condition and operating results.

We generally have no written long-term contracts with our customers, which diminishes our ability to plan for future manufacturing needs.

     As is typical in our industry, our sales are primarily made on a purchase order basis, and we generally have no written long-term purchase contracts with our customers. As a result, we are limited in our ability to predict the level of future sales or commitments from our current customers, which diminishes our ability to effectively allocate labor, materials and equipment in the manufacturing process. In addition, we may accumulate inventory in anticipation of sales that do not materialize resulting in excess and obsolete inventory write-offs.

If we are unable to adjust our business strategy successfully for some of our product lines to reflect the increasing price sensitivity on the part of our customers, our business and financial condition could be harmed.

     Our business strategy for many of our product lines has been focused on product performance and technology innovation to provide enhanced efficiencies and productivity. As a result of recent economic conditions and changes in various markets that we serve, our customers have experienced significant cost pressures and, as a result, we have observed increased price sensitivity on the part of our customers. If competition for any of our product lines should come to focus solely on price rather than on product performance and technology innovation, we will need to adjust our business strategy and product offerings

accordingly and, if we are unable to do so, our business, financial condition and operating results could be materially and adversely affected.

The markets in which we operate are highly competitive.

     We face substantial competition, primarily from established companies, some of which have greater financial, marketing and technical resources than we do. We expect our competitors will continue to develop new products in direct competition with ours, improve the design and performance of their products and introduce new products with enhanced performance characteristics.

     To remain competitive, we must improve and expand our products and product offerings. In addition, we may need to maintain a high level of investment in research and development and expand our sales and marketing efforts, particularly outside of the United States. We might not be able to make the technological advances and investments necessary to remain competitive. Our inability to improve and expand our products and product offerings would have an adverse affect on our sales and results of operations.

Our competitive position could be weakened if we are unable to convince end users to specify that our products be used in the equipment sold by our customers.

     Our competitive success often depends upon factors outside of our control. For example, in some cases, particularly with respect to mass flow controller products, semiconductor device and flat panel display manufacturers may direct equipment manufacturers to use a specified supplier’s product in their equipment at a particular facility. Accordingly, for such products, our success will depend in part on our ability to have end users specify that our products be used at their facilities. In addition, we may encounter difficulties in changing established relationships of competitors that already have a large installed base of products within such facilities. If device manufacturers do not specify the use of our products, our sales may be reduced which would negatively affect our business, financial condition and operating results.

We must achieve design wins to retain our existing customers and to obtain new customers, although design wins achieved do not necessarily result in substantial sales.

     The constantly changing nature of semiconductor fabrication and flat panel display technology causes equipment manufacturers to continually design new systems. We must work with these manufacturers early in their design cycles to modify our equipment or design new equipment to meet the requirements of their new systems. Manufacturers typically choose one or two vendors to provide the components for use with the early system shipments. Selection as one of these vendors is called a design win. It is critical that we achieve these design wins in order to retain existing customers and to obtain new customers.

     We believe that equipment manufacturers often select their suppliers based on factors such as long-term relationships. Accordingly, we may have difficulty achieving design wins from equipment manufacturers who are not currently our customers. In addition, we must compete for design wins for new systems and products of our existing customers, including those with whom we have had long-term relationships. If we are not successful in achieving design wins, our business, financial condition and operating results will be adversely impacted.

     Once a manufacturer chooses a component for use in a particular product, it is likely to retain that component for the life of that product. Our sales and growth could experience material and prolonged adverse effects if we fail to achieve design wins. However, design wins do not always result in substantial sales, as sales of our products are dependent upon our customers’ sales of their products.

Material weaknesses in our internal control over financial reporting require us to perform additional analyses and pre and post-closing procedures that if not performed effectively may prevent us from reporting our financial results in an accurate and timely manner.

     We have identified the following two material weaknesses in our internal control over financial reporting: a lack of appropriate segregation of duties defined within our enterprise resource planning system, and the combination of a lack of information system integration and uniformity regarding our Japan operations and a lack of sufficient human resources for proper segregation of duties and oversight in Japan. Management also has identified, and is developing remediation plans to address, certain significant deficiencies and other control deficiencies which our management did not determine to be material weaknesses. In addition, our internal control over financial reporting might not prevent or detect all misstatements, including immaterial misstatements and misstatements created by collusion or fraud.

     In light of these material weaknesses and the inherent limitations of internal control over financial reporting, we perform additional analyses and other pre and post-closing procedures to ensure that our condensed consolidated financial statements are presented fairly in all material respects in accordance with generally accepted accounting principles in the United States. These procedures include monthly business reviews led by our Chief Executive Officer and monthly operating and financial statement reviews by various levels of our management team, including our executive officers. We also vigorously enforce our policies and code of ethical conduct applicable to our employees, including the obligation to act in good faith and with due care in connection with the reporting of our financial results, which enforcement has included reassignment of duties, terminations of employment and other appropriate measures.

     If the additional analyses and pre and post-closing procedures are not effective or if actions to remediate these material weaknesses are not successfully implemented or if other material weaknesses are identified in the future, our ability to report our quarterly and annual financial results on a timely and accurate basis could be adversely affected. In addition, if our controls become inadequate because of changes in conditions or our degree of compliance with our own policies or procedures deteriorates, our ability to report our quarterly and annual financial results on a timely and accurate basis could be adversely affected.

Our ability to borrow under our revolving line of credit may be restricted if we do not maintain compliance with certain financial covenants. Restrictions in our ability to borrow under our revolving line of credit could limit our flexibility in reacting to periods of increasing demand and amplify our vulnerability to general adverse economic and industry conditions.

     Although we currently have no outstanding borrowings under our $40 million revolving line of credit, we may in the future need to borrow under this line of credit. Advances under the line of credit would bear interest at the prime rate (6.75% at October 26, 2005) minus 1% and would be due and payable in July 2005. Our borrowings under the line of credit agreement are limited based upon letters of credit outstanding under this agreement and the lenders borrowing base calculation, which considers among other factors, our accounts receivable and inventory balances. As a condition of borrowing and maintaining an outstanding balance under the line of credit, we are subject to covenants that provide certain restrictions related to working capital, net worth, acquisitions and payment and declaration of dividends. We were in compliance with all such covenants at September 30, 2005.

     Our ability to comply with these covenants may be affected by changes in our business condition or results of our operations, or other events beyond our control or difficult to predict. The breach of any of these covenants would result in a default under the line of credit. There can be no assurance that a breach of any of the covenants will not occur in the future, nor can there be any assurance that our lender will waive any such breach. A breach of any of the covenants would permit our lender to restrict our borrowings and accelerate the maturity of any outstanding balances under the line of credit agreement and to take ownership of the assets securing them, which could adversely affect our business, financial condition and results of operations.

We might not be able to compete successfully in international markets or meet the service and support needs of our international customers.

     Our sales to customers outside the United States were approximately 51% in the third quarter of 2005 and 47% in the third quarter of 2004. Our sales to customers outside the United States were approximately 48% during the nine months ended September 30, 2005 and were approximately 46% during the nine months ended September 30, 2004. Our success in competing in international markets is subject to our ability to manage various risks and difficulties, including, but not limited to:

	•		Our ability to effectively manage our employees at remote locations who are operating in different business environments from the United States;
	•		Our ability to develop relationships with suppliers and other local businesses;
	•		Compliance with product safety requirements and standards that are different from those of the United States;
	•		Variations in enforcement of intellectual property and contract rights in different jurisdictions;
	•		Trade restrictions, political instability, disruptions in financial markets and deterioration of economic conditions;
	•		The ability to provide sufficient levels of technical support in different locations;
	•		Collecting past due accounts receivable from foreign customers; and
	•		Changes in tariffs, taxes and foreign currency exchange rates.

     Our ability to implement our business strategies, maintain market share and compete successfully in international markets will be compromised if we are unable to manage these and other international risks successfully.

Unfavorable currency exchange rate fluctuations may lead to lower operating margins, or may cause us to raise prices which could result in reduced sales.

     Currency exchange rate fluctuations could have an adverse effect on our sales and results of operations and we could experience losses with respect to our forward exchange contracts. Unfavorable currency fluctuations could require us to increase prices to foreign customers which could result in lower net sales by us to such customers. Alternatively, if we do not adjust the prices for our products in response to unfavorable currency fluctuations, our operating results could be adversely affected. In addition, most sales made by our foreign subsidiaries are denominated in the currency of the country in which these products are sold and the currency they receive in payment for such sales could be less valuable at the time of receipt as a result of exchange rate fluctuations. We enter into forward exchange contracts and local currency purchased options to reduce currency exposure arising from intercompany sales of inventory. However, we cannot be certain that our efforts will be adequate to protect us against significant currency fluctuations or that such efforts will not expose us to additional exchange rate risks which could adversely affect our operating results.

Changes in the value of the Chinese renminbi could impact the cost of our operation in Shenzhen, China.

     The Chinese government is continually pressured by its trading partners to allow its currency to float in a manner similar to other major currencies. The recent revaluation of the renminbi has not had a material impact on our operations. Any further change may impact our ability to control the cost of our products in the world market. Specifically, the decision by the Chinese government to allow the renminbi to begin to float against the United States dollar could significantly increase the labor and other costs incurred in the operation of our Shenzhen facility and the cost of raw materials, parts, components and subassemblies that we source in China, thereby negatively affecting our financial condition and operating results.

Warranty costs on certain products may be in excess of historical experience.

     In recent years, we have experienced higher than expected levels of warranty costs on some products. We have been required to repair, rework and, in some cases, replace these products. Our warranty costs generally increase when we introduce newer, more complex products. We recorded warranty expense of approximately $2.4 million for the third quarter of 2005 and $2.2 million for the third quarter of 2004, and $8.4 million for the nine months ended September 30, 2005 and $7.7 million for the nine months ended

September 30, 2004. These expenses represented approximately 2.9% of sales for the third quarter of 2005 and 2.4% of sales for the third quarter of 2004, and 3.3% of sales for the nine months ended September 30, 2005 and 2.5% of sales for the nine months ended September 30, 2004. Within the last several years, our warranty expense has been as high as $13.2 million, or 5.5% of our total sales, which occurred in 2002. If our level of warranty costs increases in the future, our financial condition and operating results would be adversely affected.

We are highly dependent on our intellectual property.

     Our success depends significantly on our proprietary technology. We attempt to protect our intellectual property rights through patents and non-disclosure agreements; however, we might not be able to protect our technology, and competitors might be able to develop similar technology independently. In addition, the laws of some foreign countries might not afford our intellectual property the same protections as do the laws of the United States. Our intellectual property is not protected by patents in several countries in which we do business, and we have limited patent protection in other countries, including China. The cost of applying for patents in foreign countries and translating the applications into foreign languages requires us to select carefully the inventions for which we apply for patent protection and the countries in which we seek such protection. Generally, our efforts to obtain international patents have been concentrated in the European Union and certain industrialized countries in Asia, including, Korea, Japan and Taiwan. If we are unable to protect our intellectual property successfully, our business, financial condition and operating results could be adversely affected.

Intellectual property rights are difficult to enforce in China.

     Commercial law in China is relatively undeveloped compared to the commercial law in the United States. Limited protection of intellectual property is available under Chinese law. Consequently, manufacturing our products in China may subject us to an increased risk that unauthorized parties may attempt to copy our products or otherwise obtain or use our intellectual property. We cannot give assurance that we will be able to protect our intellectual property rights effectively or have adequate legal recourse in the event that we encounter infringements of our intellectual property in China.

Historically, we have incurred significant legal expenses in connection with our patent litigation. In the future we may be involved in additional patent litigation, which likely would result in substantial costs and could also result in restrictions on our ability to sell certain products and an inability to prevent others from using technology we have developed.

     On October 3, 2005, we executed a settlement agreement with MKS Instruments, Inc. (“MKS”), resolving all pending claims worldwide relating to our Xstream™ With Active Matching Network ™ reactive gas generator products. Pursuant to the settlement agreement, we paid $3.0 million in cash to MKS and stipulated to a final judgment of infringement and an injunction prohibiting us from making, using, selling, offering to sell, or importing into the United States, or any country in which a counterpart patent exists, our Xstream products and all other toroidal plasma generator products, except as permitted under the settlement agreement. Sales of these products have accounted for less than 5% of our total sales each year since introduction of the products. Pursuant to the settlement agreement, we also agreed to not refile our claims related to MKS’s Astron reactive gas source products.

     Future patent litigation might:

	•		Cause us to incur substantial costs in the form of legal fees, fines and royalty payments;
	•		Result in restrictions on our ability to sell certain products;
	•		Result in an inability to prevent others from using technology we have developed; and
	•		Require us to redesign products or seek alternative technologies.

     Any of these events could have a significant adverse effect on our business, financial condition and results of operations.

     Even apart from patent litigation, our own intellectual property rights may be subject to challenge by other parties. In many countries in which we hold patent rights, for example, procedures are available that permit third parties to contest, oppose, or request reexamination of our issued patents. Defending against these proceedings might cause us to incur substantial costs in the form of legal fees and may result in an inability to prevent others from using technology we have developed. On October 21, 2004, one of our competitors, Huettinger Electronik, and two customers, von Ardenne Anlagentechnik and Interpane Entwicklungs, petitioned for Opposition of our European patent directed to pulsed-DC reactive sputtering technology. In the event we are unsuccessful in defending against this Opposition, our ability to prevent others from using this technology in Europe may be limited.

We are subject to numerous governmental regulations.

     We are subject to federal, state, local and foreign regulations, including environmental regulations and regulations relating to the design and operation of our products and control systems. We might incur significant costs as we seek to ensure that our products meet safety and emissions standards, many of which vary across the states and countries in which our products are used. In the past, we have invested significant resources to redesign our products to comply with these directives. Compliance with future regulations, directives and standards could require us to modify or redesign some products, make capital expenditures or incur substantial costs. If we do not comply with current or future regulations, directives and standards:

	•		We could be subject to fines;
	•		Our production or shipments could be suspended; or
	•		We could be prohibited from offering particular products in specified markets.

     Any inability to comply with current or future regulations, directives and standards could adversely affect our business, financial condition or operating results.

We do not intend to pay dividends in the foreseeable future, and therefore investors must rely solely on the market value of our shares to realize a return on their investment.

     We have not declared or paid any cash dividends on our shares since we made our initial public offering in 1995. We currently intend to retain any future earnings to fund the development and growth of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future.

The market price of our common stock has fluctuated and may continue to fluctuate for reasons over which we have no control.

     The stock market has from time to time experienced, and is likely to continue to experience, extreme price and volume fluctuations. Prices of securities of technology companies have been especially volatile and have often fluctuated for reasons that are unrelated to their operating performance. In the past, companies that have experienced volatility in the market price of their stock have been the objects of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management’s attention and resources.

Future sales of our common stock by our Chairman of the Board may negatively affect the market price of our common stock.

     Douglas S. Schatz, our Chairman of the Board, beneficially owns approximately 24% of our outstanding common stock as of October 26, 2005. The sale of a substantial amount of the shares owned by him could negatively affect the market price of our common stock. Mr. Schatz has entered into a written trading plan pursuant to Rule 10b5-1 under the Securities Exchange Act of 1934, which provides for the sale of up to 542,000 shares of common stock if certain price targets and other conditions are met.

Our Chairman of the Board owns a significant percentage of our outstanding common stock, which could enable him to control our business and affairs.

     Douglas S. Schatz, our Chairman of the Board, beneficially owns approximately 24% of our outstanding common stock as of October 26, 2005. This stockholding and influence gives Mr. Schatz significant voting power. Depending on the number of shares that abstain or otherwise are not voted on a particular matter, Mr. Schatz may be able to elect all of the members of our board of directors and to control our business affairs for the foreseeable future in a manner with which our other stockholders may not agree.

Critical Accounting Policies

     The following discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. In preparing our financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ materially from these estimates under different assumptions or conditions.

     We believe that the following critical accounting policies, as discussed in our Form 10-K/A for the year ended December 31, 2004, filed with the Securities and Exchange Commission on July 11, 2005, affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements:

	•		Valuation of intangible assets
	•		Long-lived assets
	•		Reserve for excess and obsolete inventory
	•		Reserve for warranty
	•		Commitments and contingencies
	•		Revenue recognition
	•		Stock-based compensation
	•		Deferred income taxes

   OVERVIEW

     We design, manufacture and support a group of key components and subsystems primarily for vacuum process systems. Our primary products consist of complex power conversion and control systems. Our products also control the flow of gases into the process chambers for semiconductor equipment and provide thermal control and sensing within the chamber. Our customers use our products in plasma-based thin-film processing equipment that is essential to the manufacture of, among other things:

	•		Semiconductor devices for electronics applications;
	•		Flat-panel displays for hand-held devices, computer and television screens;
	•		Compact discs, DVDs and other digital storage media; and
	•		Optical coatings for architectural glass, eyeglasses and solar panels.

     We also sell spare parts and provide support, educational and consulting services worldwide through our customer service and technical support organization.

     We market and sell our products primarily to large, original equipment manufacturers, or OEM’s, of semiconductor, flat panel display, data storage and other industrial thin-film manufacturing equipment. Sales to customers in the semiconductor capital equipment industry comprised 57% of our sales in the third quarter of 2005, 61% of sales in the third quarter of 2004, 59% of our sales in the nine months ended September 30, 2005 and 64% of our sales in the nine months ended September 30, 2004. Sales to customers in the flat panel display industry comprised 14% of our sales in the third quarter of 2005, 14% of sales in the third quarter of 2004, 13% of our sales in the nine months ended September 30, 2005 and 12% of our sales in the nine months ended September 30, 2004. We anticipate that the semiconductor capital equipment industry and the flat panel display industry will continue to constitute a substantial part of the market for our products for the foreseeable future.

     In the third quarter of 2005, we generated a pre-tax loss of $2.3 million on sales of $82.0 million compared to the third quarter of 2004, when we generated a pre-tax loss of $139,000 on sales of $93.6 million. In the nine months ended September 30, 2005, we generated income from continuing operations before income taxes of $3.7 million on sales of $255.5 million, compared to the nine months ended September 30, 2004, when we generated income from continuing operations before income taxes of $14.9 million on sales of $306.9 million. The decline in sales of 12% from the third quarter of 2004 to the third quarter of 2005, and the decline in sales of 17% from the nine months ended September 30, 2004 to the nine months ended September 30, 2005, was caused principally by a decline in demand in the semiconductor capital equipment, flat panel display and data storage industries, partially offset by increased demand from advanced product applications. Despite the decline in sales level, our gross margin increased from 31.8% of sales in third quarter of 2004 to 37.0% of sales in the third quarter of 2005, and from 34.3% of sales in the nine months ended September 30, 2004 to 35.8% in the nine months ended September 30, 2005, due primarily to our operational restructuring, including our transition of our high-volume manufacturing to China and our supply base to Asian suppliers. In the nine months ended September 30, 2005, we recognized income from discontinued operations of $2.6 million related to a gain on the sale of discontinued assets (see Note 4 within Part I, Item 1 of this Form 10-Q).

     During the third quarter of 2005, we completed the sale of 11.5 million shares of common stock through an underwritten public offering and realized approximately $105.5 million in proceeds, net of the underwriters’ discount and offering expenses. We used the proceeds plus cash, cash equivalents and marketable securities on hand to redeem all of our convertible subordinated notes with a total principal balance of $187.7 million. As a result, our pre-tax loss reflects debt extinguishment expenses of $3.2 million, comprised of $2.1 million for redemption premium and $1.1 million for the write-off of deferred debt issuance costs.

     On October 3, 2005, we executed a settlement agreement with MKS Instruments, Inc. (“MKS”), resolving all pending claims worldwide relating to our Xstream™ With Active Matching Network™ reactive gas generator products. Pursuant to the settlement agreement, we paid MKS $3.0 million in cash, which was accrued in other accrued expenses on the condensed consolidated balance sheet as of September 30, 2005. We also stipulated to a final judgment of infringement and an injunction prohibiting us from making, using, selling, offering to sell, or importing into the United States, or any country in which a counterpart patent exists, our Xstream products and all other toroidal plasma generator products, except as permitted under the settlement agreement. Sales of these products have accounted for less than 5% of our total sales each year since introduction of the products.