ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

        The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes included in Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. This discussion contains forward-looking statements, which involve risk and uncertainties. Our actual results could differ materially from those anticipated in the forward looking statements as a result of certain factors, including but not limited to those discussed in "Risk Factors" and elsewhere in this Annual Report on Form 10-K. See "Special Note Regarding Forward Looking Statements" at the beginning of the Annual Report on Form 10-K.

OVERVIEW

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

        We have two reportable business segments: Electro-Optics and Lambda Physik, which work with customers to provide cost-effective photonics-based solutions. The Electro-Optics segment focuses on markets such as semiconductor and related manufacturing, materials processing, OEM laser components, scientific research, biotechnology, medical OEM's, advanced packaging and interconnect, thermal imaging, printing and reprographics. Lambda Physik, our 60% owned subsidiary with headquarters located in Göttingen, Germany, focuses on markets including lasers for the production of flat panel displays, lithography, GPS systems, mobile telephones, ink jet printers, automotive, environmental research, refractive surgery, scientific research, medical OEM's, materials processing and micro-machining applications.

        On November 6, 2002, we decided to terminate the activities of our Coherent Telecom Actives Group (CTAG), an operating segment that had been aggregated with our Photonics Group in our Electro-Optics reportable segment. Based on new market information and insights and the status of our development projects at CTAG obtained subsequent to September 30, 2002, we determined that our return on investment for at least the next several years would have been unsatisfactory and, therefore, additional investments were no longer justified. In connection with our CTAG operating segment, we expect to record an estimated after-tax restructuring and impairment charge of $8.0 to $10.0 million ($13.0 to $15.0 million before income taxes) in the first quarter of fiscal 2003. The charge results primarily from the write-down of equipment to net realizable value, an accrual for the estimated contractual obligation for lease and other facility costs of the building, in San Jose, formerly occupied by CTAG and the write-down of our option to purchase Picometrix, Inc.

        In the year ended September 30, 2002, we formed a Technical Advisory Board to facilitate our assessment of new and emerging technologies across a broad range of disciplines affecting the field of photonics. The Technical Advisory Board is comprised of outside experts in various disciplines within the photonics universe and will assist our internal Technology Council in the evaluation of emerging opportunities and lend their expertise to our technology review process. The inaugural membership of the Technical Advisory Board includes Dr. Martin Fejer of Stanford University, Dr. David Hanna From the University of Southampton, Dr. Detief Hommel from the University of Bremen and Dr. Erich Ippen from Massachusetts Institute of Technology, all of who have each accepted a two year appointment.

        In the year ended September 30, 2002, we recognized an impairment loss on equipment of $11.0 million ($6.7 million after-tax). The impairment loss primarily resulted from management's

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decision to cease most of our activities related to the telecom passives component market as short to mid-term opportunities no longer justified the investments made.

        In the year ended September 30, 2002, we also recognized a loss of $104.2 million ($79.2 million after-tax) to reflect the other-than-temporary decline in market value of our investment in Lumenis common stock, acquired as a result of our April 2001 sale of our Medical segment to Lumenis.

        In fiscal 2001, we took the steps we considered necessary to strategically focus on those high growth markets, technologies and opportunities that are best complemented by our core competencies. On April 30, 2001, we completed the sale of our Medical segment to Lumenis, Inc. (formerly ESC Medical Systems Ltd.) for a combination of cash, notes and Lumenis common stock with an estimated value of $236.0 million plus a potential earnout of an additional $25.0 million. The sale resulted in a one-time after-tax gain of $71.8 million, which is reflected in our results for fiscal 2001. In June 2002, we reached a purchase price settlement with Lumenis, resulting in an additional after-tax gain of $1.9 million, which is reflected in our results from discontinued operations for the year ended September 30, 2002. The operations of our Medical segment during fiscal 2001 are presented as income from discontinued operations on our Statements of Operations and Cash Flows.

RESULTS OF OPERATIONS—YEARS ENDED SEPTEMBER 30, 2002, 2001 AND 2000

Consolidated Summary

        Loss from continuing operations for fiscal 2002 was $70.8 million, or $2.46 per diluted share, including impairment charges of $115.3 million ($85.9 million after-tax or $2.99 per diluted share), a $3.0 million ($0.10 per diluted share) tax benefit related to a refund of prior year taxes, a gain on sale of real estate of $1.7 million ($1.0 million after-tax or $0.03 per diluted share), royalty revenue of $2.0 million ($0.7 million after-tax and net of minority interest or $0.03 per diluted share) and a non-recurring favorable inventory adjustment of $1.6 million ($0.7 million after-tax and minority interest or $0.02 per diluted share). During fiscal 2001, our income from continuing operations was $27.5 million, or $0.95 per diluted share, including a $10.7 million ($5.8 million after-tax and minority interest or $0.20 per diluted share) charge, net of minority interest, for excess inventory and open purchase order commitments at Lambda Physik and a $2.5 million ($1.6 million after-tax or $0.06 per diluted share) write-off of purchased in-process research and development (IPR&D). During fiscal 2000, our income from continuing operations was $61.2 million, or $2.24 per diluted share, including the fourth quarter $55.1 million ($33.5 million after-tax or $1.23 per diluted share) gain (the Lambda gain) as a result of an increase in the value of our 60.4% ownership interest in Lambda Physik following its initial public offering.

        The fiscal 2002 impairment charges include a $104.2 million ($79.2 million after-tax) write-down of the value of the Lumenis stock we acquired as a result of the April 2001 sale of our Medical segment to Lumenis as well as a $11.0 million ($6.7 million after-tax) charge for equipment impairment due to management's decision to cease most of our activities related to the telecom passives component market.

        The fiscal 2002 decrease in income from continuing operations was primarily attributable to the impairment charges mentioned above, lower sales volumes, lower gross margins as a percentage of sales and lower interest and dividend income, partially offset by the fiscal 2001 charge for excess inventory and open purchase order commitments at Lambda Physik, the fiscal 2002 tax benefit related to a refund of prior year taxes, the fiscal 2001 IPR&D charge, the fiscal 2002 gain on sale of real estate, the non-recurring favorable inventory adjustment in fiscal 2002 and the cessation of goodwill amortization due to the adoption of SFAS No. 142 in fiscal 2002.

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        The fiscal 2001 decrease in income from continuing operations was primarily attributable to the fiscal 2000 $33.5 million (after-tax) Lambda gain, offset by increases in sales volumes, lower selling, general and administrative expenses as a percentage of net sales and higher interest income.

Consolidated

        During fiscal 2002, net sales decreased by $80.6 million, or 17%, to $397.3 million from $477.9 million in fiscal 2001 as a result of decreased sales volumes in both reportable segments. Domestic sales decreased at a higher rate than international sales for a total decrease of $54.1 million, or 25%. International sales were 60% of net sales in fiscal 2002 and 55% in fiscal 2001.

        During fiscal 2001, net sales increased by $93.9 million, or 24%, to $477.9 million from $384.0 million in fiscal 2000 as a result of increased sales volumes in both reportable segments. Domestic sales increased at a higher rate than international sales for a total increase of $57.7 million, or 37%. International sales were 55% of net sales in fiscal 2001 and 59% in fiscal 2000.

Electro-Optics

        Electro-Optics net sales decreased by $49.2 million, or 14%, in fiscal 2002 to $307.6 million from $356.8 million in fiscal 2001. Domestic sales decreased by $32.5 million, or 19%, and international sales decreased by $16.7 million, or 9%, in fiscal 2002. Sales decreased primarily due to lower sales volumes in semiconductor and related manufacturing markets, including semiconductor lasers for non-metal printed circuit board or PCB and hole drilling applications as well as lower optical telecommunications sales volumes.

        Electro-Optics net sales increased by $66.6 million, or 23%, in fiscal 2001 to $356.8 million from $290.2 million in fiscal 2000. Domestic sales increased by $37.7 million, or 28%, and international sales increased by $28.9 million, or 19%, in fiscal 2001. Sales increased primarily due to higher sales volumes

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in commercial solid-state products, including semiconductor lasers to the non-metal printed circuit board or PCB, hole drilling, optical telecommunications and computer-to-plate markets.

Lambda Physik

        Lambda Physik net sales decreased by $31.4 million, or 26%, in fiscal 2002 to $89.7 million from $121.1 million in fiscal 2001. Domestic sales decreased by $21.6 million, or 53%, and international sales decreased by $9.8 million, or 12%. The decrease in sales was primarily due to weakness in the overall lithography market as well as lower demand with medical OEM customers, partially offset by $2.0 million in fiscal 2002 royalty revenue.

        Lambda Physik net sales increased by $27.4 million, or 29%, in fiscal 2001 to $121.1 million from $93.7 million in fiscal 2000. Domestic sales increased by $20.0 million, or 97%, and international sales increased by $7.4 million, or 10%. The increase in sales was primarily due to increased shipments of commercial products, especially lasers used in the manufacture of flat-panel display systems and lithography.

Gross Profit

Consolidated

        The consolidated gross profit rate decreased by 1.3% to 40.5% in fiscal 2002 from 41.8% in fiscal 2001. The decrease in the gross profit rate was primarily due to lower sales of higher margin commercial solid-state products and underutilization of capacity in the Electro-Optics segment, partially offset by higher margins in the Lambda Physik segment. The increase in gross profit rate in the Lambda Physik segment was primarily due to the fiscal 2001 unusual charge of $13.9 million for excess inventory and open purchase order commitments (11.4% negative impact on fiscal 2001 margin) and the fiscal 2002 $2.0 million royalty revenue (1.5% favorable impact) offset by lower volume of higher margin lithography shipments, underutilization of capacity and lower margins on service revenue.

        The consolidated gross profit rate decreased by 4.1% to 41.8% in fiscal 2001 from 45.9% in fiscal 2000. The decrease in the gross profit rate was primarily due to an unusual charge of $13.9 million for excess inventory and open purchase order commitments in the Lambda Physik segment (2.9% negative impact), under-utilization of capacity due to the ramp-up of new optics and telecommunications manufacturing facilities and unfavorable manufacturing variances in the Electro-Optics segment and higher inventory excess and obsolescence (E&O) costs and under utilization of capacity due to the ramp-up of lithography manufacturing facilities in the Lambda Physik segment as well as the weakening of the US dollar against foreign currencies in both segments.

Electro-Optics

        The gross profit rate decreased by 3.9% to 41.7% in fiscal 2002 from 45.6% in fiscal 2001. The decrease was primarily due to lower sales of higher margin commercial solid-state products and under-utilization of capacity due to lower sales volumes.

        The gross profit rate decreased by 1.5% to 45.6% in fiscal 2001 from 47.1% in fiscal 2000. The decrease was primarily due to under utilization of capacity due to the ramp-up of new optics and telecommunications manufacturing facilities, unfavorable manufacturing variances and the weakening of the US dollar against foreign currencies, as an increasing portion of our sales denominated in US dollars are built at our European manufacturing facilities.

Lambda Physik

        The gross profit rate increased by 6.6% to 36.7% in fiscal 2002 from 30.1% in fiscal 2001. The increase in gross profit rate was primarily due to the fiscal 2001 unusual charge of $13.9 million for

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excess inventory and open purchase order commitments (11.4% negative impact on fiscal 2001 margin) and the fiscal 2002 $2.0 million royalty revenue (1.5% favorable impact) offset by lower volume of higher margin lithography shipments, underutilization of capacity and lower margins on service revenue.

        The gross profit rate decreased by 11.8% to 30.1% in fiscal 2001 from 41.9% in fiscal 2000. The decrease in the gross profit rate was primarily due to an unusual charge of $13.9 million for excess inventory and open purchase order commitments (11.4% negative impact), higher inventory E&O costs and under utilization of capacity due to the ramp-up of lithography manufacturing facilities as well as the weakening of the US dollar.

        Fiscal 2002 operating expenses decreased by $4.3 million, or 3%, from fiscal 2001. As a percentage of net sales, operating expenses increased to 40.6% in fiscal 2002 from 34.6% in fiscal 2001. Exclusive of the fiscal 2002 impairment loss on equipment and the fiscal 2001 write-off of purchased in-process research and development, operating expenses decreased by $12.8 million, or 8%, but as a percentage of net sales increased to 37.8% from 34.1%.

        Fiscal 2001 operating expenses increased by $32.4 million, or 24%, from fiscal 2000. As a percentage of net sales, operating expenses decreased to 34.6% in fiscal 2001 from 34.7% in fiscal 2000. Exclusive of the fiscal 2001 write-off of purchased in-process research and development, operating expenses increased by $29.9 million, or 22%, and as a percentage of net sales decreased to 34.1% from 34.7%.

Research and development

        Fiscal 2002 research and development expenses decreased by $0.3 million, or 1%, from fiscal 2001 but increased to 13.2% from 11.1% of net sales. The dollar decrease was primarily due to the implementation of cost savings programs, partially offset by increased spending on telecom projects as well as the integration of DEOS. The increase as a percentage of net sales is due to the decrease in fiscal 2002 net sales. Fiscal 2002 and 2001 research and development expenses include $6.3 million and $5.0 million, respectively, for the CTAG operating segment, which was terminated effective November 6, 2002.

        Fiscal 2001 research and development expenses increased by $12.3 million, or 30%, from fiscal 2000 and increased to 11.1% from 10.6% of net sales. The increase was primarily due to increased spending for headcount and supplies on optical telecommunications and lithography projects. Fiscal 2001 and 2000 research and development expenses include $5.0 million and $1.4 million, respectively, for the CTAG operating segment, which was terminated effective November 6, 2002.

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In-process research and development

        Fiscal 2001 IPR&D expenses of $2.5 million resulted from our acquisitions of DEOS and MicroLas. See Note 3 of Notes to Consolidated Financial Statements.

Selling, general and administrative

        Fiscal 2002 selling, general and administrative expenses decreased by $10.6 million, or 10%, from fiscal 2001, but increased as a percentage of net sales from 21.9% to 23.7%. The dollar decrease was primarily due to lower commissions as a result of lower sales volumes and lower employment-related expenses due to headcount reductions and lower incentive compensation, partially offset by increased investments in information technology. The increase as a percentage of net sales is due to the decrease in fiscal 2002 net sales.

        Fiscal 2001 selling, general and administrative expenses increased by $15.3 million, or 17%, from fiscal 2000, but decreased as a percentage of net sales from 23.3% to 21.9%. The dollar increase was primarily due to higher commissions as a result of higher sales, increased investments in information technology, higher costs for the Lambda Physik segment to comply with legal and stock exchange requirements and higher payroll-related expenses.

Impairment loss on equipment

        In fiscal 2002, we evaluated the carrying value of certain long-lived assets, consisting primarily of production equipment and buildings and improvements recorded on the balance sheet in accordance with SFAS No. 121 during fiscal 2002. As a result, we recognized an impairment loss of $11.0 million related to the write-off of equipment due to management's decision to cease most of our activities related to the telecom passives component market. A significant portion of the assets impaired was recently acquired in connection with capacity expansions in anticipation of future demand and had not yet been placed in service. We plan to complete the disposal of the impaired equipment within the next year. The remaining impaired assets which are part of the electro-optics segment, are held for sale at September 30, 2002, and we have written these assets down to their estimated realizable value, net of expected selling expenses.

Intangibles amortization

        Fiscal 2002 intangibles amortization expense decreased by $1.8 million, or 35%, primarily due to the cessation of goodwill amortization due to the adoption of SFAS No. 142, partially offset by the amortization of intangibles resulting from the acquisitions of MicroLas, DEOS and Crystal.

        Fiscal 2001 intangibles amortization expenses increased by $2.2 million, or 74%, primarily due to the acquisitions of MicroLas and DEOS in April 2001, Crystal Associates in November 2000 and LaserTec in May 2000.

Other income (expense)

        Other income, net of other expense, decreased $106.2 million from income of $8.8 million to an expense of $97.4 million. Fiscal 2002 includes a $104.2 million charge due to the write-down of our investment in Lumenis common stock (investment write-down) due to an other-than-temporary impairment. Exclusive of the investment writedown, other income, net of other expense, decreased $2.0 million primarily due to lower interest income and lower dividends due to the purchase of MicroLas, partially offset by the gain on sale of real estate and rental income from the sublease of the Condensa facility to Lumenis.

        Other income, net of other expenses, decreased by $46.8 million during fiscal 2001 compared to fiscal 2000. The decrease was primarily due to the fiscal 2000 $55.1 million gain as a result of an

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increase in the value of our ownership interest in Lambda Physik AG following its initial public offering, partially offset by increased interest income, dividends and gains on increased investments as a result of our fiscal 2000 public offering, our subsidiary Lambda Physik's fiscal 2000 initial public offering and the fiscal 2001 sale of our medical segment.

Minority interest in subsidiaries earnings

        Minority interest in subsidiaries earnings decreased by $0.1 million during fiscal 2002 compared to fiscal 2001 primarily due to increased losses in our Lambda Physik segment.

        Minority interest in subsidiaries earnings decreased by $1.4 million during fiscal 2001 compared to fiscal 2000 primarily due to lower profitability in our Lambda Physik segment.

Income taxes

        The effective tax rate on income (loss) from continuing operations (before minority interest) for fiscal 2002 was (27.8%) compared to 35.1% for fiscal 2001. The effective tax rate decreased as a result of a valuation allowance recorded on a portion of the write-down of Lumenis stock due to capital loss limitations (including a $16.6 million valuation allowance provided on the Lumenis capital loss deferred tax asset) and changes in the distribution of taxable income among jurisdictions, partially offset by the proportionately lower impact of tax credits due to the large fiscal 2002 loss from continuing operations before income taxes.

        The effective tax rate on income from continuing operations (before minority interest) for fiscal 2001 was 35.1% compared to 36.1% for fiscal 2000. The effective tax rate decreased as a result of the non-recurrence of the fiscal 2000 $33.5 million after-tax gain on the issuance of Lambda Physik subsidiary stock (3.9% rate impact) and increased foreign tax credits, partially offset by changes in the distribution of taxable income among jurisdictions with varying rates.

RECENT ACQUISITIONS

        In August 2002, we entered into a loan agreement with Picometrix, Inc. (Picometrix) of Michigan. Picometrix develops and manufactures ultra high-speed photoreceivers and instrumentation for the telecommunication, data communication and test and measurement markets, focusing on epitaxial growth, photodetector design and microfabrication, high-speed microwave packaging, hybrid circuit assembly and high-speed testing. Under the loan agreement, we provided Picometrix with $6.0 million of debt financing in exchange for (1) a nine-month option to purchase 100% of the equity of Picometrix for $6.0 million plus a two-year earn-out of up to $25.0 million and (2) the repayment of the $6.0 million of loan principal at maturity and interest at the greater of prime (4.25% at September 30, 2002) minus 0.5% or 3.0% payable monthly over its term. The maturity date varies depending on whether we exercise the option to acquire Picometrix. At September 30, 2002, we recorded the purchase option at its fair value of $1.4 million and the note at its fair value of $4.6 million, and are amortizing the discount to interest income over the 18-month term of the note. On November 22, 2002, we terminated our purchase option and, as a result, the note is payable to us in full on May 26, 2003. The write-off of the option will be included in our charge for the termination of activities of CTAG in the first quarter of fiscal 2003.

        See Note 3 for discussion on acquisitions in fiscal 2001 and 2000.

FINANCIAL CONDITION

Liquidity and capital resources

        Our ratio of current assets to current liabilities was 5.3:1 at September 30, 2002 compared to 5.1:1 at September 30, 2001.

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        At September 30, 2002, our primary sources of liquidity were cash, cash equivalents, short-term investments and available-for-sale securities of $243.9 million. In addition, we held $21.1 million of restricted Lumenis common stock. The Lumenis common stock is unregistered and its trading is subject to restrictions under Rule 144 of the Securities Act of 1933 and other contractual restrictions as defined in the definitive agreement. Additional sources of liquidity were a multi-currency line of credit and bank credit facilities totaling $65.5 million as of September 30, 2002, of which $60.9 million was unused and available. During fiscal 2002, these credit facilities were used in the United States, Japan and Europe. We believe that cash generated from operations, together with the liquidity provided by existing cash balances and financing capacity, is sufficient to satisfy liquidity requirements for the next 12 months. We are subject to certain financial covenants related to our lines of credit. At September 30, 2002, we were in compliance with these covenants.

        During the second quarter of fiscal 2002, we renewed a lease for 216,000 square feet of office, research and development and manufacturing space in Santa Clara, California, a portion of which we are subleasing to our former Medical segment, which is a part of Lumenis. The lease expires in February 2007. Upon expiration of the lease, we have an option to purchase the property for $24.6 million, renew the lease for an additional five years or at the end of the lease arrange for the sale of the property to a third party with Coherent retaining an obligation to the owner for the difference between the sale price, if less than $24.6 million, and $21.3 million, subject to certain provisions of the lease. If we do not purchase the property or arrange for its sale as discussed above, we would be obligated for an additional lease payment of $21.3 million. We occupied the building in July 1998 and commenced lease payments at that time. The lease requires us to maintain specified financial covenants including maintaining a minimum tangible net worth, minimum quick ratio, debt to tangible net worth ratio and leverage ratio as well as limiting the number of quarters per year in which net losses are allowed, all of which we were in compliance with as of September 30, 2002.

        We have committed $4.0 million to purchase equipment for our Electro-Optics facilities in Santa Clara, California; Tampere, Finland and Leicester, England. We have committed $1.1 million to purchase equipment for our Lambda Physik facility in Göttingen, Germany. We have committed $0.8 million in building improvements for our Electro-Optics clean rooms in San Jose, California and Tampere, Finland.

        During fiscal 2002, we modified the covenants associated with the notes used to finance our acquisition of Star Medical (Star notes). The Star notes include financial covenants such as maintaining a minimum tangible net worth and minimum consolidated debt to capitalization and fixed charge coverage ratios as well as non-financial covenants such as providing quarterly statements to the bondholders. In connection with the modification of covenant terms, we agreed to prepay $7.3 million of the Star notes, with no prepayment penalty, and made such payment in October 2002.

(1)

Operating lease payments are exclusive of sublease income.

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Changes in financial condition

        Cash, cash equivalents and short-term investments (excluding our investment in Lumenis common stock) increased $17.1 million, or 8%, from $226.8 million at September 30, 2001 to $243.9 million at September 30, 2002. Cash and cash equivalents at September 30, 2002 increased $53.6 million, or 69%, from September 30, 2001.

        Cash provided by operating activities in fiscal 2002 of $101.8 million included income from continuing operations (net of the write-down of our investment in Lumenis and the impairment loss on equipment) of $44.4 million, net proceeds from sales of short-term investments of $36.5 million, depreciation and amortization of $27.5 million, $22.0 million provided by operating assets and liabilities and other of $1.7 million, partially offset by $30.3 million provided for deferred taxes. Of the $22.0 million provided by operating activities, $24.5 million was provided by inventory reductions and $15.3 million was provided by a reduction in accounts receivable, partially offset by accounts payable reductions of $8.3 million and reductions of other current liabilities of $7.9 million.

        Cash used by investing activities in fiscal 2002 of $41.9 million included $34.9 million used to acquire property and equipment, net, $6.0 million used in our investment in Picometrix, and $1.0 million used for other investing activities.

        Cash used by financing activities in fiscal 2002 of $8.6 million included net debt of repayments of $18.2 million offset by $9.6 million from the sale of shares under our employee stock plans.

        Changes in exchange rates in fiscal 2002 provided $2.3 million.

        Short-term investments decreased $124.5 million (48%) from September 30, 2001 to September 30, 2002 primarily due to the $104.2 million write-down of our investment in Lumenis common stock as management determined it was other-than-temporarily impaired.

        Prepaid expenses and other assets increased $14.7 million (61%) from September 30, 2001 to September 30, 2002 primarily due to the reclassification of the note receivable from Lumenis from non-current to current as it is now collectible within 12 months.

        Deferred tax assets increased $30.1 million (116%) from September 30, 2001 to September 30, 2002 primarily due to deferred taxes provided on the write-off of our investment in Lumenis common stock and our impairment loss on equipment.

        Other assets decreased $14.9 million (17%) from September 30, 2001 to September 30, 2002 primarily due to the reclassification of the note receivable from Lumenis from non-current to current as it is now collectible within 12 months, lower deferred tax assets due to the write-off of the Lumenis common stock as we had provided deferred taxes on the temporary decline in market value as of September 30, 2001 and the amortization of intangible assets.

        Short-term borrowings decreased $6.7 million (31%) from September 30, 2001 to September 30, 2002 primarily due to increased cash available to pay down borrowings by Lambda Physik and our international subsidiaries.

        Accounts payable decreased $4.2 million (24%) from September 30, 2001 to September 30, 2002 primarily due to decreased inventory levels and purchases resulting from lower sales volumes and more restrictive spending efforts.

        Total long-term obligations, including current portion, decreased $9.9 million (15%) from September 30, 2001 to September 30, 2002 primarily due to scheduled principal payments on the notes used to finance our acquisition of Star Medical.

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        Accumulated other comprehensive income (loss) increased $15.8 million primarily due to the write-off of the Lumenis common stock as we had recorded the temporary decline in market value as of September 30, 2001 in other comprehensive income (loss).

ADOPTION OF ACCOUNTING STANDARDS

        In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations". SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. The adoption of SFAS No. 141 did not have a material impact on our financial position, results of operations or cash flows.

        Effective October 1, 2001 we adopted SFAS No. 142, "Goodwill and Other Intangible Assets" which establishes new standards for goodwill acquired in a business combination and other intangible assets, eliminates amortization of existing goodwill balances, and requires annual evaluation of goodwill for impairment. SFAS No. 142 was effective for fiscal years beginning after December 15, 2001, with early adoption allowed for companies with fiscal years beginning after March 15, 2001. Upon adoption of SFAS No. 142, we stopped the amortization of goodwill with a net carrying value of $32.1 million at September 30, 2001 and annual amortization of $4.1 million, including amortization resulting from the acquisitions of Crystal Associates, Inc. in November 2000 and DeMaria Electro-Optics Systems, Inc. and MicroLas Laser System GmbH in April 2001, that resulted from business combinations initiated prior to the adoption of SFAS No. 141, "Business Combinations".

        Under SFAS No. 142, material amounts of goodwill attributable to each of our reporting units were tested for impairment by comparing the fair value of each reporting unit with its carrying value. Fair value was determined using a discounted cash flow methodology. These impairment tests are required to be performed at adoption and at least annually thereafter. On an ongoing basis (absent any impairment indicators), we perform our impairment tests during the fourth quarter (based on our third quarter financial statements), in conjunction with our annual budgeting process. As part of our adoption of SFAS No. 142, we completed the initial impairment tests during the second quarter of fiscal 2002 and the annual impairment tests during the fourth quarter of fiscal 2002 and these tests resulted in no impairment charges.

RECENT ACCOUNTING PRONOUNCEMENTS

        In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," it retains many of the fundamental provisions of SFAS No. 121. SFAS No. 144 also supersedes the accounting and reporting provisions of APB No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for the disposal of a segment of a business. However, it retains the requirement in APB No. 30 to report separately discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. Companies are required to adopt SFAS No. 144 for fiscal years beginning after December 15, 2001, but early adoption is permitted. We adopted SFAS No. 144 on October 1, 2002. We do not expect the adoption to have a material effect on our operating results or financial condition.

        In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally Emerging Issues Task Force ("EITF") Issue

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No. 94-3. We will adopt the provisions of SFAS No. 146 for restructuring activities initiated after December 28, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost was recognized at the date of our commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized.

        During July 2002, President George W. Bush signed the Sarbanes-Oxley Act of 2002 (the "Act") into law. The Act prescribes, among other items, sweeping corporate governance and oversight changes, new reporting responsibilities for internal controls, and requires our Chief Executive Officer and Chief Financial Officer to certify the accuracy of filed reports. The various provisions of the Act have phase-in provisions and become effective at different times in the future. Subsequent to the signing of the Act into law, we have been actively engaged in defining policies and procedures that will bring the Company into compliance with the provisions of the Act. Although the Act contains significant changes to corporate governance, places greater emphasis on internal controls, and requires certification of financial statements, we do not expect the provisions of the Act to have a material impact upon our financial condition or the results of operations.

        In November 2002, the EITF reached a consensus on Issue No. 00-21 "Accounting for Revenue Arrangements with Multiple Deliverables". The EITF concluded that revenue arrangements with multiple elements should be divided into separate units of accounting if the deliverables in the arrangement have value to the customer on a standalone basis, if there is objective and reliable evidence of the fair value of the undelivered elements, and as long as there are no rights of return or additional performance guarantees by the Company. The provisions of EITF Issue No. 00-21 are applicable to agreements entered into after June 15, 2003. We are currently determining what effect, if any, the provisions of EITF Issue No. 00-21will have on our operating results or financial condition.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

        Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We have identified the following as the items that require the most significant judgment and often involve complex estimation: revenue recognition, accounting for our marketable equity securities, accounting for long-lived assets, inventory reserves, warranty reserves and accounting for income taxes.

Revenue Recognition

        We recognize revenue in accordance with Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," (SAB 101). Accordingly, revenue is recognized when persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed or determinable and collection is probable. Delivery is generally considered to have occurred when shipped.

        Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected. Failure to obtain anticipated orders due to delays or cancellations of orders could have a material adverse effect on our revenue. In addition, pressures from customers to reduce our prices, or to modify our existing sales terms may result in material adverse effects on our revenue in future periods. Our products typically include a one-year warranty. The estimated cost of product warranty claims is accrued at the time the sale is recognized, based on historical experience.

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        We generally recognize product revenue at the time of delivery and, for certain products for which we perform product installation services, the cost of installation is generally accrued at the time product revenue is recognized.

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

        The vast majority of our sales are made to original equipment manufacturers (OEM's), distributors and resellers and end-users in the non-scientific market. Sales made to these customers do not require installation of the products by us and are not subject to other post-delivery obligations, except in occasional instances where, for example, we have agreed to perform installation or provide training. In those instances, we either defer revenue related to installation services until installation is completed or, if the installation services are inconsequential or perfunctory, we accrue installation costs at the time that product revenue is recognized. We defer revenue on training services until training services are provided.

        Sales to end-users in the scientific market typically require installation and, thus, involve post-delivery obligations, however, our post delivery installation obligations are not essential to the functionality of our products. For a limited number of products or arrangements where management considers installation to be significant in comparison to the value of the product sold, we defer revenue related to installation services until completion of these services.

        For most products, training is not provided and thus no post-delivery training obligation exists. However, when training is provided to our customers, it is typically priced separately and is recognized as revenue when the training service is provided.

Marketable Equity Securities

        We classify our marketable equity investments, primarily consisting of our 5,432,099 shares of Lumenis stock, as short-term available-for-sale investments. These investments are carried at fair value, based on quoted market prices, and unrealized gains and losses, net of taxes, are included as a component of other comprehensive income (loss), which is reflected as a separate component of stockholders' equity. Gains are recognized in our statement of operations when realized, and losses are recognized at the earlier of realization and management's determination that a decline in value is other-than-temporary.

        In determining if and when a decline in the value of our Lumenis stock is other-than-temporary, management evaluates the length of time that the market value has been below cost, the severity of the decline relative to cost, current and expected future market conditions, the financial condition of Lumenis and other relevant criteria. As of June 29, 2002, the market value of our investment in Lumenis had declined from our initial valuation of $124.4 million to $20.2 million. This decline was deemed to be other-than-temporary and an impairment loss of $104.2 million ($79.2 million after income taxes of $25.0 million) was recognized in the quarter ended June 29, 2002. At September 30, 2002, the market value of our investment in Lumenis was $21.1 million. Unrealized gains and losses from the new cost basis will be recorded in accumulated other comprehensive income (loss). If the market value of the Lumenis stock continues to decline, we may recognize additional losses on this investment.

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Accounting for Long-Lived Assets

        We evaluate long-lived assets, including goodwill and purchased intangible assets, whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Reviews are performed to determine whether the carrying value of assets is impaired based on comparison to the undiscounted expected future cash flows. If the comparison indicates that there is impairment, the impaired asset is written down to fair value. Significant management judgment is required in the forecast of future operating results that is used in the preparation of expected discounted cash flows. At September 30, 2002, we had $55.2 million of goodwill and purchased intangible assets on the balance sheet, the value of which we believe is reasonable based on the estimated future cash flows of the associated products and technologies. It is reasonably possible that the estimates of anticipated future net revenue, the remaining estimated economic life of the products and technologies, or both, could differ from those used to assess the recoverability of these assets. In that event, additional impairment charges or shortened useful lives of certain long-lived assets could be required.

        During the year ended September 30, 2002, we recorded a charge of $11.0 million for the write-down of equipment resulting primarily from management's decision to cease most of the Company's activities related to the telecom passives components market.

        On November 6, 2002, we decided to terminate the activities of our Coherent Telecom Actives Group (CTAG), an operating segment that had been aggregated with our Photonics Group in our Electro-Optics reportable segment. Based on new market information and insights and the status of our development projects at CTAG obtained subsequent to September 30, 2002, we determined that our return on investment for at least the next several years would have been unsatisfactory and, therefore, additional investments were no longer justified. In connection with our CTAG operating segment, we expect to record an estimated after-tax restructuring and impairment charge of $8.0 to $10.0 million ($13.0 to $15.0 million before income taxes) in the first quarter of fiscal 2003. The charge results primarily from the write-down of equipment to net realizable value, an accrual for the estimated contractual obligation for lease and other facility costs of the building, in San Jose, formerly occupied by CTAG and the write-down of our option to purchase Picometrix, Inc. (see Note 4).

Inventory Reserves

        We record our inventory at the lower of cost (computed on a first-in, first-out basis) or market. We record inventory reserves equal to the difference between the cost of inventory and the estimated market value based on assumptions about future demand and market conditions. Inventory reserves are generally recorded, within guidelines set by management, when the inventory for a device exceeds 12 months of demand for the device and when individual parts have been in inventory for greater than 12 months. If actual market conditions are less favorable than those projected by management, additional inventory reserves may be required which could materially affect our future results of operations. We record reserves on demo inventory by amortizing the cost of demo inventory over a two-year period from the fourth month it is placed in service. During the year ended September 30, 2001, we recorded a charge of $13.9 million for excess inventory and open purchase order commitments due to decreased marketability resulting from the slowdown in the Lithography business at Lambda Physik, which was reflected in postponed delivery dates, cancelled orders and further expected order cancellations from customers. Due to rapidly changing forecasts and orders, additional write-downs for excess or obsolete inventory, while not currently expected, could be required in the future. Differences between actual results and previous estimates of excess and obsolete inventory could result in material adverse effects on our future results of operations.

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Warranty Reserves

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

Income Taxes

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

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

        Federal income taxes have not been provided for on a portion of the unremitted earnings of foreign subsidiaries either because such earnings are intended to be permanently reinvested or because foreign tax credits are available to offset any planned distributions of such earnings.

RISK FACTORS

Risks Related to our Business

We may experience quarterly and annual fluctuations in our net sales and operating results in the future, which may result in volatility in our stock price.

        Our net sales and operating results may vary significantly from quarter to quarter and from year to year in the future. A number of factors, many of which are outside of our control, may cause these variations, including:

•

general economic uncertainties;



•

fluctuations in demand for, and sales of, our products or prolonged downturns in the industries that we serve;



•

ability of our suppliers to produce and deliver components and parts, including sole or limited source components, in a timely manner, in the quantity and quality desired and at the prices we have budgeted;



•

timing or cancellation of customer orders and shipment scheduling;



•

fluctuations in our product mix;



•

foreign currency fluctuations;

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•

introductions of new products and product enhancements by our competitors, entry of new competitors into our markets, pricing pressures and other competitive factors;



•

our ability to develop, introduce, manufacture and ship new and enhanced products in a timely manner without defects;



•

rate of market acceptance of our new products;



•

delays or reductions in customer purchases of our products in anticipation of the introduction of new and enhanced products by us or our competitors;



•

our ability to control expenses;



•

level of capital spending of our customers;



•

potential obsolescence of our inventory; and



•

costs related to acquisitions of technology or businesses.

        In addition, we often recognize a substantial portion of our sales in the last month of the quarter. Our expenses for any given quarter are typically based on expected sales and if sales are below expectations in any given quarter, the adverse impact of the shortfall on our operating results may be magnified by our inability to adjust spending quickly to compensate for the shortfall. We also base our manufacturing on our forecasted product mix for the quarter. If the actual product mix varies significantly from our forecast, we may not be able to fill some orders during that quarter, which would result in delays in the shipment of our products. Accordingly, variations in timing of sales, particularly for our higher priced, higher margin products, can cause significant fluctuations in quarterly operating results.

        Due to these and other factors, we believe that quarter-to-quarter and year-to-year comparisons of our past operating results may not be meaningful. You should not rely on our results for any quarter or year as an indication of our future performance. Our operating results in future quarters and years may be below public market analysts' or investors' expectations, which would likely cause the price of our common stock to fall. In addition, over the past several quarters, the stock market has experienced extreme price and volume fluctuations that have affected the stock prices of many technology companies. These factors, as well as general economic and political conditions or investors' concerns regarding the credibility of corporate financial statements and the accounting profession, may have a material adverse affect on the market price of our stock in the future.

Our business has been adversely impacted by the general worldwide economic slowdown and related uncertainties affecting markets in which we operate.

        Adverse economic conditions worldwide have contributed to the current technology industry slowdown and impacted our business resulting in:

•

reduced demand for some of our products;



•

increased risk of excess and obsolete inventories;



•

increased rate of order cancellations or delays;



•

excess manufacturing capacity under current market conditions; and



•

higher overhead costs, as a percentage of revenues.

        Recent political and social turmoil in many parts of the world, including terrorist and military actions, may continue to put pressure on global economic conditions. These political, social and economic conditions are making it very difficult for us, our customers and our vendors to forecast and plan future business activities. This level of uncertainty severely challenges our ability to operate

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profitably or to grow our business. In particular, it is difficult to develop and implement strategy, sustainable business models, efficient operations and effectively manage supply chain relationships. For example, the fiscal 2001 slowdown in the Lithography market resulted in postponed delivery dates and cancelled orders. During the year ended September 30, 2001, we recorded a charge of $13.9 million for excess inventory and open purchase order commitments, which was reflected in postponed delivery dates, cancelled orders and further expected order cancellations from customers. Additionally, during the year ended September 30, 2002, we recognized an impairment loss on equipment of $11.0 million resulting from our decision to cease most of our activities related to the telecom passives component market.

        On November 6, 2002, we decided to terminate the activities of our Coherent Telecom Actives Group (CTAG), an operating segment that had been aggregated with our Photonics Group in our Electro-Optics reportable segment. Based on new market information and insights and the status of our development projects at CTAG obtained subsequent to September 30, 2002, we determined that our return on investment for at least the next several years would have been unsatisfactory and, therefore, additional investments were no longer justified. In connection with our CTAG operating segment, we expect to record an estimated after-tax restructuring and impairment charge of $8.0 to $10.0 million ($13.0 to $15.0 million before income taxes) in the first quarter of fiscal 2003. The charge results primarily from the write-down of equipment to net realizable value, an accrual for the estimated contractual obligation for lease and other facility costs of the building, in San Jose, formerly occupied by CTAG and the write-down of our option to purchase Picometrix, Inc. (see Note 4).

        If the economic or market conditions continue or further deteriorate, this may have a material adverse impact on our financial position, results of operations and cash flow.

We depend on sole source or limited source suppliers for some of the key components and materials, including exotic materials and crystals, in our products, which makes us susceptible to supply shortages or price fluctuations that could adversely affect our business.

        We currently purchase several key components and materials used in the manufacture of our products from sole source or limited source suppliers. Some of these suppliers are relatively small private companies that may discontinue their operations at any time. We typically purchase our components and materials through purchase orders and we have no guaranteed supply arrangement with any of these suppliers. We may fail to obtain these supplies in a timely manner in the future. We may experience difficulty identifying alternative sources of supply for certain components used in our products. We would experience further delays while identifying, evaluating and testing the products of these potential alternative suppliers. Furthermore, financial or other difficulties faced by these suppliers or significant changes in demand for these components or materials could limit their availability. Any interruption or delay in the supply of any of these components or materials, or the inability to obtain these components and materials from alternate sources at acceptable prices and within a reasonable amount of time, would impair our ability to meet scheduled product deliveries to our customers and could cause customers to cancel orders.

        We rely exclusively on our own production capability to manufacture certain strategic components, optics and optical systems, crystals, semiconductor lasers, lasers and laser-based systems. Because we manufacture, package and test these components, products and systems at our own facilities, and such components, products and systems are not readily available from other sources, any interruption in manufacturing would adversely affect our business. In addition, our failure to achieve adequate manufacturing yields of these items at our manufacturing facilities may materially and adversely affect our operating results and financial condition.

Our future success depends on our ability to increase our sales volumes and decrease our costs to offset anticipated declines in the average selling prices of our products and, if we are unable to realize greater sales volumes and lower costs, our operating results may suffer.

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        Our future success depends on the continued growth of the markets for lasers, laser systems, precision optics and related accessories, as well as our ability to identify, in advance, emerging markets for laser-based systems. We cannot assure you that we will be able to successfully identify, on a timely basis, new high-growth markets in the future. Moreover, we cannot assure you that new markets will develop for our products or our customers' products, or that our technology or pricing will enable such markets to develop. Future demand for our products is uncertain and will depend to a great degree on the continued technological development and the introduction of new or enhanced products. If this does not continue, sales of our products may decline and our business will be harmed.

        We have historically been the industry's high quality, high priced supplier of laser systems. We have in the past experienced decreases in the average selling prices of some of our products. We anticipate that as competing products become more widely available, the average selling price of our products may decrease. If we are unable to offset the anticipated decrease in our average selling prices by increasing our sales volumes, our net sales will decline. In addition, to maintain our gross margins, we must continue to reduce the cost of our products. Further, as average selling prices of our current products decline, we must develop and introduce new products and product enhancements with higher margins. If we cannot maintain our gross margins, our operating results could be seriously harmed, particularly if the average selling prices of our products decrease significantly.

Our future success depends on our ability to develop and successfully introduce new and enhanced products that meet the needs of our customers.

        Our current products address a broad range of commercial and scientific research applications in the photonics markets. We cannot assure you that the market for these applications will continue to generate significant or consistent demand for our products. Demand for our products could be significantly diminished by new technologies or products that replace them or render them obsolete.

        Over the last three fiscal years, our research and development expenses have been in the range of 11% to 13% of net sales. Our future success depends on our ability to anticipate our customers' needs and develop products that address those needs. Introduction of new products and product enhancements will require that we effectively transfer production processes from research and development to manufacturing and coordinate our efforts with those of our suppliers to achieve volume production rapidly. If we fail to effectively transfer production processes, develop product enhancements or introduce new products in sufficient quantities to meet the needs of our customers as scheduled, our net sales may be reduced and our business may be harmed.

We face risks associated with our international sales that could harm our financial condition and results of operations.

        For fiscal years 2002, 2001, and 2000, 60%, 55% and 59%, respectively, of our net sales were derived from international sales. We anticipate that international sales will continue to account for a significant portion of our revenues in the foreseeable future. The recent global economic slowdown has already had and is likely to continue to have a negative effect on various international markets in which we operate. This may cause us to simplify our international legal entity structure and reduce our presence in certain countries, which may negatively affect the overall level of business in such countries. A portion of our international sales occurs through our international sales subsidiaries and the remainder of our international sales result from exports to foreign distributors, resellers and customers. Our international operations and sales are subject to a number of risks, including:

•

longer accounts receivable collection periods;



•

the impact of recessions in economies outside the United States;



•

unexpected changes in regulatory requirements;



•

certification requirements;

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•

reduced protection for intellectual property rights in some countries;



•

potentially adverse tax consequences;



•

political and economic instability; and



•

preference for locally produced products.

        We are also subject to the risks of fluctuating foreign exchange rates, which could materially adversely affect the sales price of our products in foreign markets as well as the costs and expenses of our international subsidiaries. While we use forward exchange contracts, currency swap contracts, currency options and other risk management techniques to hedge our foreign currency exposure, we remain exposed to the economic risks of foreign currency fluctuations. For additional discussion about our foreign currency risks, see "Item 7A—Quantitative and Qualitative Disclosures About Market Risk."

We may not be able to protect our proprietary technology, which could adversely affect our competitive advantage.

        We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We currently hold approximately 286 US and foreign patents, and we have approximately 93 additional pending patent applications that have been filed. We cannot assure you that our patent applications will be approved, that any patents that may be issued will protect our intellectual property or that any issued patents will not be challenged by third parties. Other parties may independently develop similar or competing technology or design around any patents that may be issued to us. We cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. See "Business—Intellectual Property."

We could become subject to litigation regarding intellectual property rights, which could seriously harm our business.

        The laser industry is characterized by a very large number of patents, many of which are of questionable validity and some of which appear to overlap with other issued patents. As a result, there is a significant amount of uncertainty in the industry regarding patent protection and infringement. In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. In the future, we may be a party to litigation to protect our intellectual property or as a result of an alleged infringement of others' intellectual property. These claims and any resulting lawsuit, if successful, could subject us to significant liability for damages or invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:

•

stop manufacturing, selling or using our products that use the infringed intellectual property;



•

obtain from the owner of the infringed intellectual property right a license to sell or use the relevant technology, although such license may not be available on reasonable terms, or at all; or



•

redesign the products that use the technology.

        If we are forced to take any of these actions, our business may be seriously harmed. We do not have insurance to cover potential claims of this type.

        We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights to protect these rights or to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could result in costly litigation and the diversion of our technical and management personnel.

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We depend on skilled personnel to operate our business effectively in a rapidly changing market, and if we are unable to retain existing or hire additional personnel when needed, our ability to develop and sell our products could be harmed.

        Our future success depends upon the continued services of our executive officers and other key engineering, sales, marketing, manufacturing and support personnel. None of our officers or key employees in the United States are bound by an employment agreement for any specific term and these personnel may terminate their employment at any time. In addition, we do not have "key person" life insurance policies covering any of our employees.

        In addition, the significant downturn in our business environment has had a negative impact on our operations, and as a result, we have restructured our operations to reduce our workforce and implement other cost reduction activities. Although we believe these various changes and actions will improve our organizational effectiveness and competitiveness, they could lead, in the short term, to disruptions in our business, reduced employee morale and productivity, increased attrition and problems with retaining existing employees and recruiting future employees and increased financial costs.

        Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. Recruiting and retaining highly skilled personnel continues to be difficult. At certain locations where we operate, the cost of living is extremely high and it may be difficult to retain key employees and management at a reasonable cost. We may not be successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs. Our failure to attract additional employees and retain our existing employees could adversely affect our growth and our business.

We may experience volatility in our stock price, which could negatively affect your investment.

        The market price of our common stock has fluctuated, and may continue to fluctuate, significantly in response to a number of factors, some of which are beyond our control, including:

•

quarterly variations in operating results;



•

changes in financial estimates by securities analysts;



•

changes in market valuations of other similar companies;



•

announcements by us or our competitors of new products or of significant technical innovations, contracts, acquisitions, strategic partnerships or joint ventures;



•

additions or departures of key personnel;



•

any deviations in net sales or in levels of profitability from levels expected by securities analysts; and



•

future sales of common stock.

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        Your investment may also be affected by any fluctuations in the stock price of Lumenis, which we received in 2001 as consideration for the sale of our Medical segment. At April 30, 2001, we estimated the value of the Lumenis stock at $124.4 million. As of June 29, 2002, the market value of our investment in Lumenis had declined from our initial valuation of $124.4 million to $20.2 million. The decline was deemed to be other-than-temporary and an impairment loss of $79.2 million (net of income taxes of $25.0 million) was recognized in the quarter ended June 29, 2002. At September 30, 2002, we estimated the value of the stock at $21.1 million. Currently, we do not hedge our investment in Lumenis stock. The Lumenis stock received is unregistered and its trading is subject to restrictions under the Securities and Exchange Commission Rule 144 and other restrictions. Any further reduction in the stock price of Lumenis could decrease our total assets, which could negatively impact our stock price.

        In addition, the stock market has recently experienced extreme volatility that has often been unrelated to the performance of particular companies. These market fluctuations may cause our stock price to fall regardless of our performance.

The long sales cycles for our products may cause us to incur significant expenses without offsetting revenues.

        Customers often view the purchase of our products as a significant and strategic decision. As a result, customers typically expend significant effort in evaluating, testing and qualifying our products before making a decision to purchase them, resulting in a lengthy initial sales cycle. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses to customize our products to the customer's needs. We may also expend significant management efforts, increase manufacturing capacity and order long- lead-time components or materials prior to receiving an order. Even after this evaluation process, a potential customer may not purchase our products. As a result, these long sales cycles may cause us to incur significant expenses without ever receiving revenue to offset those expenses.

The markets in which we sell our products are intensely competitive and increased competition could cause reduced sales levels, reduced gross margins or the loss of market share.

        Competition in the various photonics markets in which we provide products is very intense. We compete against a number of companies, including Thermo Electron Corporation's Spectra-Physics Lasers business unit, JDS Uniphase, Inc., Cymer, Inc., Gigaphoton, Rofin-Sinar, Lightwave Electronics and Excel Technology. Some of our competitors are large companies that have significant financial, technical, marketing and other resources. These competitors may be able to devote greater resources than we can to the development, promotion, sale and support of their products. Several of our competitors that have large market capitalizations or strong cash reserves are much better positioned than we are to acquire other companies in order to gain new technologies or products that may displace our product lines. Any of these acquisitions could give our competitors a strategic advantage. Any business combinations or mergers among our competitors, forming larger competitors with greater resources, could result in increased competition, price reductions, reduced margins or loss of market share, any of which could materially and adversely affect our business, results of operations and financial condition.

        Additional competitors may enter the market and we are likely to compete with new companies in the future. We may encounter potential customers that, due to existing relationships with our competitors, are committed to the products offered by these competitors. As a result of the foregoing factors, we expect that competitive pressures may result in price reductions, reduced margins and loss of market share. For a more detailed discussion of our competition, see "Business—Competition."

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Some of our laser systems are complex in design and may contain defects that are not detected until deployed by our customers, which could increase our costs and reduce our revenues.

        Laser systems are inherently complex in design and require ongoing regular maintenance. The manufacture of our lasers, laser products and systems involves a highly complex and precise process. As a result of the technical complexity of our products, changes in our or our suppliers' manufacturing processes or the inadvertent use of defective materials by us or our suppliers could result in a material adverse effect on our ability to achieve acceptable manufacturing yields and product reliability. To the extent that we do not achieve such yields or product reliability, our business, operating results, financial condition and customer relationships would be adversely affected. We provide warranties on certain of our product sales, and allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires us to make estimates of product return rates and expected costs to repair or replace the products under warranty. We currently establish warranty reserves based on historical warranty costs for each product line. If actual return rates and/or repair and replacement costs differ significantly from our estimates, adjustments to recognize additional cost of sales may be required in future periods.

        Our customers may discover defects in our products after the products have been fully deployed and operated under peak stress conditions. In addition, some of our products are combined with products from other vendors, which may contain defects. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to fix defects or other problems, we could experience, among other things:

•

loss of customers;



•

increased costs of product returns and warranty expenses;



•

damage to our brand reputation;



•

failure to attract new customers or achieve market acceptance;



•

diversion of development and engineering resources; and



•

legal actions by our customers.

        The occurrence of any one or more of the foregoing factors could seriously harm our business, financial condition and results of operations.

If we fail to accurately forecast component and material requirements for our products, we could incur additional costs and incur significant delays in shipments, which could result in loss of customers.

        We use rolling forecasts based on anticipated product orders and material requirements planning systems to determine our product requirements. It is very important that we accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials. We depend on our suppliers for most of our product components and materials. Lead times for components and materials that we order vary significantly and depend on factors including the specific supplier requirements, the size of the order, contract terms and current market demand for components. For substantial increases in our sales levels, some of our suppliers may need at least six months lead-time. If we overestimate our component and material requirements, we may have excess inventory, which would increase our costs. If we underestimate our component and material requirements, we may have inadequate inventory, which could interrupt and delay delivery of our products to our customers. Any of these occurrences would negatively impact our net sales, business and operating results.

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Our increased reliance on contract manufacturing and our excess manufacturing capacity may adversely impact our financial results and operations.

        We have changed our manufacturing strategy so that more of our products will be sourced from contract manufacturers. We have decided to transfer our printed circuit board manufacturing activities in Auburn, California, to a global electronics contract manufacturer who has factories in North America, Asia and Europe. The transition should be completed by June 2003. Our ability to resume internal manufacturing operations for those products will be severely limited. The cost, quality, performance and availability of contract manufacturing operations are and will be essential to the successful production and sale of many of our products. The inability of any contract manufacturer to meet our cost, quality, performance and availability standards could adversely impact our financial condition or results of operations. We may not be able to provide contract manufacturers with product volumes that are high enough to achieve sufficient cost savings. If shipments fall below forecasted levels, we may incur increased costs or be required to take ownership of the inventory. Also, our ability to control the quality of products produced by contract manufacturers may be limited and quality issues may not be resolved in a timely manner, which could adversely impact our financial condition or results of operations. The smooth transition from internal manufacturing to contract manufacturing by a third party is critical to our success. Failure to implement and manage a successful transition may cause severe disruptions in our supply chain that will affect the cost, quality and availability of products.

        Furthermore, because we have outsourced some manufacturing operations to contract manufacturers, have experienced lower sales volumes and have exited the passive telecom business, we now have excess manufacturing capacity in existing facilities. We are currently restructuring our operations, including the consolidation of CO ₂ manufacturing operations at our Bloomfield, Connecticut office, and implementing cost reduction activities to eliminate this excess capacity. Our ability to reduce our excess manufacturing capacity and to consolidate facilities may be made more difficult by further weakening of the seminconductor industry and worsening of general economic conditions in the United States and globally. If we are unable to reduce our excess manufacturing capacity and facilities, this may negatively impact our operations, cost structure and financial performance.

Cost containment and expense reductions are critical to maintaining positive cash flow from operations and profitability.

        We are continuing efforts to reduce our expense structure. We believe strict cost containment and expense reductions are essential to maintaining positive cash flow from operations in future quarters and maintaining profitability (excluding impairment charges), especially since the outlook for future quarters is subject to numerous challenges. Additional measures to contain costs and reduce expenses may be undertaken if revenues and market conditions do not improve. A number of factors could preclude us from successfully bringing costs and expenses in line with our revenues, such as our inability to accurately forecast business activities and further deterioration of our revenues. If we are unable to continue to reduce expenses and contain our costs, this could harm our operating results.

If we fail to manage our growth effectively, our business could be disrupted, which could harm our operating results.

        Our ability to successfully offer our products and implement our business plan in evolving markets requires an effective planning and management process. We continue to expand the scope of our operations domestically and internationally. The growth in employee headcount and in sales, combined with the challenges of managing geographically-dispersed operations, has placed, and our anticipated growth in future operations will continue to place, a significant strain on our management systems and resources, particularly our information technology systems. We expect that we will need to continue to improve our information technology systems, reporting systems and procedures and continue to expand,

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train and manage our work force worldwide. The failure to effectively manage our growth could disrupt our business and harm our operating results.

Any acquisitions we make could disrupt our business and harm our financial condition.

        We have in the past made strategic acquisitions of other corporations, and we continue to evaluate potential strategic acquisitions of complementary companies, products and technologies. In the event of any future acquisitions, we could:

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issue stock that would dilute our current stockholders' percentage ownership;



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pay cash;



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incur debt;



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assume liabilities; or



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incur expenses related to in-process research and development, impairment of goodwill and amortization and impairment of other intangible assets.

        These purchases also involve numerous risks, including:

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problems combining the acquired operations, technologies or products;



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unanticipated costs or liabilities;



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diversion of management's attention from our core businesses;



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adverse effects on existing business relationships with suppliers and customers; and



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potential loss of key employees, particularly those of the purchased organizations.

        We cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might acquire in the future, which may harm our business. Refer further discussion on acquisitions in "recent acquisitions" section of Management's Discussion and Analysis of Results of Operations and Financial Condition.

We use standard laboratory and manufacturing materials that could be considered hazardous; and we could be liable for any damage or liability resulting from accidental environmental contamination or injury.

        Although most of our products do not incorporate hazardous or toxic materials and chemicals, some of the gases used in our excimer lasers and some of the liquid dyes used in some of our scientific laser products are highly toxic. In addition, our operations involve the use of standard laboratory and manufacturing materials that could be considered hazardous. Also, if a facility fire were to occur at our Tampere, Finland site and spread to a reactor used to grow semiconductor wafers, it could release highly toxic emissions. We believe that our safety procedures for handling and disposing of such materials comply with all federal, state and offshore regulations and standards; however, the risk of accidental environmental contamination or injury from such materials cannot be entirely eliminated. In the event of such an accident involving such materials, we could be liable for any damage and such liability could exceed the amount of our liability insurance coverage and the resources of our business.

If our facilities were to experience catastrophic loss, our operations would be seriously harmed.

        Our facilities could be subject to a catastrophic loss from fire, flood, earthquake or terrorist activity. A substantial portion of our research and development activities, manufacturing, our corporate headquarters and other critical business operations are located near major earthquake faults in Santa Clara, California, an area with a history of seismic events. Any such loss at any of our facilities could disrupt our operations, delay production, shipments and revenue and result in large expenses to repair or replace the facility. While we have obtained insurance to cover most potential losses, after reviewing

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the costs and limitations associated with earthquake insurance, we have decided not to procure such insurance. We believe that this decision is consistent with decisions reached by numerous other companies located nearby. We cannot assure you that our existing insurance coverage will be adequate against all other possible losses.

Provisions of our charter documents, Delaware law, our Common Shares Rights Plan and our Change-of-Control Severance Plan may have anti-takeover effects that could prevent or delay a change in control.

        Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition or make removal of incumbent directors or officers more difficult. These provisions may discourage takeover attempts and bids for our common stock at a premium over the market price. These provisions include:

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the ability of our board of directors to alter our bylaws without stockholder approval;



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limiting the ability of stockholders to call special meetings;



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limiting the ability of our stockholders to act by written consent; and



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establishing advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

        We are subject to Section 203 of the Delaware General Corporation Law, which prohibits a publicly held Delaware corporation from engaging in a merger, asset or stock sale or other transaction with an interested stockholder for a period of three years following the date such person became an interested stockholder, unless prior approval of our board of directors is obtained or as otherwise provided. These provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us without obtaining the prior approval of our board of directors, which may cause the market price of our common stock to decline. In addition, we have adopted a change of control severance plan, which provides for the payment of a cash severance benefit to each eligible employee based on the employee's position and years of service to us. If a change of control occurs, our successor or acquirer will be required to assume and agree to perform all of our obligations under the change of control severance plan.

        Our common shares rights agreement permits the holders of rights to purchase shares of our common stock to exercise the stock purchase rights following an acquisition of or merger by us with another corporation or entity, following a sale of 50% or more of our consolidated assets or earning power, or the acquisition by an individual or entity of 20% or more of our common stock. Our successor or acquirer is required to assume all of our obligations and duties under the common shares rights agreement, including in certain circumstances the issuance of shares of its capital stock upon exercise of the stock purchase rights. The existence of our common shares rights agreement may have the effect of delaying, deferring or preventing a change of control and, as a consequence, may discourage potential acquirers from making tender offers for our shares.

Risks related to our industry

         Our market is unpredictable and characterized by rapid technological changes and evolving standards, and, if we fail to address changing market conditions, our business and operating results will be harmed.

        The photonics industry is characterized by extensive research and development, rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. Because this market is subject to rapid change, it is difficult to predict its potential size or

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future growth rate. Our success in generating revenues in this market will depend on, among other things:

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maintaining and enhancing our relationships with our customers;



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the education of potential end-user customers about the benefits of lasers, laser systems and precision optics; and



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our ability to accurately predict and develop our products to meet industry standards.

        For our fiscal years ended September 30, 2002, 2001 and 2000, our research and development costs were $52.6 million, or 13%, $53.0 million, or 11%, and $40.7 million, or 11%, of net sales, respectively. We cannot assure you that our expenditures for research and development will result in the introduction of new products or, if such products are introduced, that those products will achieve sufficient market acceptance. Our failure to address rapid technological changes in our markets could adversely affect our business and results of operations. See "Business—Research and Development."

A continued downturn in the semiconductor manufacturing industry could adversely affect our business, financial condition and results of operations.

        Our net sales depend in part on the demand for our products by semiconductor equipment companies. The semiconductor industry is highly cyclical and has historically experienced periodic and significant downturns, which have often severely affected the demand for semiconductor manufacturing equipment, including laser-based tools and systems. We are currently experiencing such a downturn, which is resulting in decreased demand for semiconductor manufacturing equipment and consequently a decreased demand for our products. Although such a downturn could reduce our sales, we would not be able to reduce expenses commensurately, due in part to the need for continual spending in research and development and the need to maintain extensive ongoing customer service and support capability. Accordingly, any sustained downturn in the semiconductor industry could have a material adverse effect on our financial condition and results of operations.

Our reported results may be adversely affected by changes in accounting principles generally accepted in the United States of America.

        We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP). GAAP is subject to interpretation by the American Institute of Certified Public Accountants, the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in these policies or interpretations can have a significant effect on our reported results, and may even affect the reporting of transactions completed prior to the announcement of a change.

Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses.

        Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules, are creating uncertainty for companies such as ours. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards, and this investment will result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.

Pro forma financial information that we disclose concerning our operations does not conform to generally accepted accounting principles and may not comply with finalized SEC regulations.

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        We prepare and release quarterly unaudited and annual audited financial statements prepared in accordance with generally accepted accounting principles (GAAP). We also disclose and discuss certain pro forma financial information in our related earnings releases and investor conference calls. We believe the disclosure of pro forma financial information helps investors more meaningfully evaluate the results of our ongoing operations and that the securities analysts who cover our stock evaluate our performance on this basis. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q and our Annual Reports on Form 10-K that are filed with the Securities and Exchange Commission and our quarterly earnings releases and compare that GAAP financial information with the pro forma financial results disclosed in our quarterly earnings releases and investor calls, as well as in some of our other reports.