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Nanometrics 10-Q 2006
Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 


FORM 10-Q

 


(Mark One)

x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2006

OR

 

¨ Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from              to             

Commission file number 0-13470

 


NANOMETRICS INCORPORATED

(Exact name of registrant as specified in its charter)

 


 

Delaware   94-2276314

(State or other jurisdiction of

incorporation or organization)

 

(I. R. S. Employer

Identification No.)

1550 Buckeye Drive, Milpitas, CA   95035
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (408) 435-9600

 


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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨                        Accelerated filer  x                        Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of October 27, 2006, there were 18,058,918 shares of common stock, $0.001 par value per share, issued and outstanding.

 



Table of Contents

NANOMETRICS INCORPORATED

INDEX TO QUARTERLY REPORT ON FORM 10-Q

FOR QUARTER ENDED SEPTEMBER 30, 2006

 

             Page

PART I.

   

FINANCIAL INFORMATION

  
  Item 1.  

Financial Statements (Unaudited)

  
   

Condensed Consolidated Balance Sheets at September 30, 2006 and December 31, 2005

   3
   

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2006 and October 1, 2005

   4
   

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and October 1, 2005

   5
   

Notes to Condensed Consolidated Financial Statements

   6
  Item 2.  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   19
  Item 3.  

Quantitative and Qualitative Disclosures About Market Risk

   26
  Item 4.  

Controls and Procedures

   27

PART II.

   

OTHER INFORMATION

  
  Item 1.  

Legal Proceedings

   27
  Item 1A.  

Risk Factors

   28
  Item 2.  

Unregistered Sales of Equity Securities and Use of Proceeds

   36
  Item 3.  

Defaults Upon Senior Securities

   36
  Item 4.  

Submission of Matters to a Vote of Security Holders

   36
  Item 5.  

Other Information

   37
  Item 6.  

Exhibits

   37

Exhibit Index

   37

Signatures

   39

 

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Table of Contents

PART I — FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

NANOMETRICS INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands except share amounts)

(Unaudited)

 

    

September 30,

2006

  

December 31,

2005

ASSETS

     

Current Assets:

     

Cash and cash equivalents

   $ 15,126    $ 40,445

Short-term investments

     —        4,949

Accounts receivable, net of allowances of $836 and $592, respectively

     27,533      18,983

Inventories

     47,916      25,656

Prepaid expenses and other

     4,710      1,259
             

Total current assets

     95,285      91,292

Property, plant and equipment, net

     43,247      42,928

Goodwill

     51,993      —  

Intangible assets

     30,727      639

Other assets

     2,168      1,441
             

Total assets

   $ 223,420    $ 136,300
             

LIABILITIES AND SHAREHOLDERS’ EQUITY

     

Current Liabilities:

     

Revolving line of credit

   $ —      $ 1,186

Accounts payable

     9,254      3,060

Accounts payable to related party

     534      288

Accrued payroll and related expenses

     4,609      1,540

Deferred revenue

     12,743      3,448

Accrued warranty

     4,287      1,440

Other current liabilities

     5,825      2,429

Income taxes payable

     958      770

Current portion of debt obligations

     354      400
             

Total current liabilities

     38,564      14,561

Deferred income taxes and other long-term liabilities

     160      —  

Debt obligations

     1,136      1,396
             

Total liabilities

     39,860      15,957

Contingencies

     

Shareholders’ Equity:

     

Preferred stock, $0.001 par value; 3,000,000 shares authorized; no shares issued or outstanding

     —        —  

Common stock, $0.001 par value; 47,000,000 shares authorized; 18,026,167 and 12,990,894, respectively, outstanding

     18      107,294

Additional paid-in capital

     179,684      —  

Retained earnings

     2, 174      12,218

Accumulated other comprehensive income

     1,684      831
             

Total shareholders’ equity

     183,560      120,343
             

Total liabilities and shareholders’ equity

   $ 223,420    $ 136,300
             

See Notes to Unaudited Condensed Consolidated Financial Statements

 

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Table of Contents

NANOMETRICS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands except per share amounts)

(Unaudited)

 

     Three Months Ended     Nine Months Ended  
    

September 30,

2006

   

October 1,

2005

   

September 30,

2006

   

October 1,

2005

 

Net revenues:

        

Products

   $ 24,772     $ 11,772     $ 60,865     $ 49,317  

Service

     4,319       2,459       10,592       7,000  
                                

Total net revenues

     29,091       14,231       71,457       56,317  
                                

Costs and expenses:

        

Cost of product sales

     14,599       6,234       33,220       24,429  

Cost of service

     4,780       2,629       11,340       7,810  

Research and development

     4,208       3,291       9,798       10,126  

Selling

     5,850       2,395       12,892       8,389  

General and administrative

     5,447       3,348       14,303       7,746  

Asset impairment

     —         —         —         2,232  

Merger termination fee

     —         —         —         (8,300 )
                                

Total costs and expenses

     34,884       17,897       81,553       52,432  
                                

Income (loss) from operations

     (5,793 )     (3,666 )     (10,096 )     3,885  
                                

Other income (expense):

        

Interest income

     156       288       787       611  

Interest expense

     (13 )     —         (44 )     (35 )

Other, net

     (648 )     (18 )     (375 )     (494 )
                                

Total other income (expense), net

     (505 )     270       368       82  
                                

Income (loss) before income taxes

     (6,298 )     (3,396 )     (9,728 )     3,967  

Provision for income taxes

     268       7       316       398  
                                

Net income (loss)

   $ (6,566 )   $ (3,403 )   $ (10,044 )   $ 3,569  
                                

Net income (loss) per share:

        

Basic

   $ (0.40 )   $ (0.26 )   $ (0.71 )   $ 0.28  
                                

Diluted

   $ (0.40 )   $ (0.26 )   $ (0.71 )   $ 0.27  
                                

Shares used in per share computation:

        

Basic

     16,573       12,854       14,226       12,686  
                                

Diluted

     16,573       12,854       14,226       13,448  
                                

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

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Table of Contents

NANOMETRICS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

(Unaudited)

 

     Nine Months Ended  
    

September 30,

2006

   

October 1,

2005

 

Cash flows from operating activities:

    

Net income (loss)

   $ (10,044 )   $ 3,569  

Reconciliation of net income to net cash used in operating activities:

    

Depreciation and amortization

     4,374       1,878  

Stock-based compensation

     3,411       2,232  

Asset impairment

     —         (4 )

Changes in assets and liabilities, net of acquisitions:

    

Accounts receivable

     1,335       2,400  

Inventories, net

     (9,833 )     325  

Prepaid expenses and other

     (1,831 )     (744 )

Accounts payable, accrued and other current liabilities

     (4,512 )     1,238  

Deferred revenue

     8,501       (654 )

Income taxes payable

     183       (405 )
                

Net cash provided by (used in) operating activities

     (8,416 )     9,835  
                

Cash flows from investing activities:

    

Purchase of certain net assets in connection with acquisitions, net of cash acquired

     (7,477 )     30  

Purchase of short-term investments

     —         (44,832 )

Sales/maturities of short-term investments

     4,949       37,000  

Purchases of property, plant and equipment

     (435 )     (204 )
                

Net cash used in investing activities

     (2,963 )     (8,006 )
                

Cash flows from financing activities:

    

Proceeds from issuance of debt obligations

     —         1,789  

Repayments of debt obligations

     (15,383 )     (1,174 )

Proceeds from sale of shares under employee stock option plan and purchase plan

     1,083       2,551  
                

Net cash provided by (used in) financing activities

     (14,300 )     3,166  
                

Net increase (decrease) in cash and cash equivalents

     (25,679 )     4,995  

Effect of exchange rate changes on cash and cash equivalents

     360       (239 )
                

Cash and cash equivalents, beginning of period

     40,445       15,949  
                

Cash and cash equivalents, end of period

   $ 15,126     $ 20,705  
                

Supplemental disclosure of cash flow information:

    

Cash paid for interest

   $ 38     $ 52  
                

Cash paid (refunded) for income taxes

   $ (43 )   $ 1,079  
                

Fair value of Nanometrics shares issued to Accent stockholders

   $ 67,481     $ —    
                

Fair value of Nanometrics shares issuable to former Accent optionees

   $ 344     $ —    
                

See Notes to Unaudited Condensed Consolidated Financial Statements.

 

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Table of Contents

NANOMETRICS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Consolidated Financial Statements

In the opinion of management, the accompanying Unaudited Consolidated Interim Financial Statements (the “financial statements”) of Nanometrics Incorporated and its wholly-owned subsidiaries (collectively, “Nanometrics” or the “Company”) have been prepared on a consistent basis with the December 31, 2005 audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary to fairly present the information set forth therein. The financial statements have been prepared in accordance with the regulations of the United States Securities and Exchange Commission (the “SEC”), and, therefore, omit certain information and footnote disclosure necessary to present the statements in accordance with accounting principles generally accepted in the United States of America. The operating results for interim periods are not necessarily indicative of the operating results that may be expected for the entire year. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2005, which were included in the Company’s Annual Report on Form 10-K, filed with the SEC on March 24, 2006.

Fiscal Period – Nanometrics uses a 52/53 week fiscal year ending on the Saturday nearest to December 31. All references to the quarter refer to Nanometrics’ fiscal quarter. The fiscal quarters presented herein include 13 weeks. The Company’s current year will end December 31, 2006 and include 52 weeks.

Note 2. Recent Accounting Pronouncements

In September 2006, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108 (“SAB 108”), which provides guidance regarding the process of quantifying financial statement misstatements. SAB 108 clarifies the treatment of financial statement misstatements that affects the financials in both the current reporting year and prior periods and provides guidance on how to determine which treatment methods are acceptable under generally accepted accounting principles. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company’s adoption of the provisions of SAB 108 is not expected to impact its financial condition or results of operations.

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 158, Employers’ Accounting for Defined Benefit Pension and Other Post Retirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS No. 158”). SFAS No. 158 requires entities to recognize the funded status of their defined benefit pension plans in the balance sheet, measured as the difference between the fair value of the plan assets less the projected benefit obligation. Any resulting asset or liability will be fully recognized in the balance sheet. SFAS No. 158 also requires the actuarial measurement date to be at the end of the entity’s fiscal year and expanded disclosure in the footnotes to the financial statements. SFAS No. 158 is effective for fiscal years ending after December 15, 2006 for entities with publicly traded equity securities, and requires prospective application, with the initial recognition of the funded status being recognized as a component of other comprehensive income. The Company does not have defined benefit plans and the provisions of SFAS No. 158 are not expected to impact its financial condition or results of operations.

In September 2006, the FASB finalized SFAS No. 157, “Fair Value Measurements” which will become effective in 2008. This Statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements; however, it does not require any new fair value measurements. The provisions of SFAS No. 157 will be applied prospectively to fair value measurements and disclosures in the Company’s financial statements beginning in the first quarter of 2008.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), which provides clarification related to the process associated with accounting for uncertain tax positions recognized in the Company’s Consolidated Financial Statements. FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken, or expected to be taken, in a tax return. FIN 48 also provides guidance related to, among other things, classification, accounting for interest and penalties associated with tax positions, and disclosure requirements. The Company is required to adopt FIN 48 on January 1, 2007, which is when the Company plans to adopt FIN 48. The Company is currently evaluating the impact of adopting FIN 48 on its consolidated financial statements and, therefore, the effect of adoption cannot be quantified at this time. However, the Company, in the normal course of business, makes reserves for tax contingencies, in accordance with SFAS No. 5, “Accounting for Contingencies”. Upon adoption of FIN 48 by the Company on January 1, 2007, an adjustment to tax liabilities and retained earnings may be made.

 

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In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Instruments—An Amendment of FASB Statements No. 133 and No. 144” (“SFAS No. 155”). SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133, and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. Furthermore, SFAS No. 155 clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and it amends SFAS No. 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of the first fiscal year beginning after September 15, 2006. The Company’s adoption of the provisions of SFAS No. 155 is not expected to impact its financial condition or results of operations.

Note 3. Acquisitions

Soluris Inc.

On March 15, 2006, Nanometrics announced that it had acquired Soluris Inc., (“Soluris”) a Concord, Massachusetts-based privately held corporation focused on overlay and CD measurement technology. The acquisition of Soluris, which was renamed Nanometrics IVS Division, is expected to enhance Nanometrics’ line of overlay products and provide access to new customers. Under the terms of the merger agreement, which was an all-cash transaction, the total consideration to purchase all the outstanding stock of Soluris was $7.0 million including $0.4 million in transaction fees, including legal, valuation and accounting fees. The merger has been accounted for under the purchase method of accounting in accordance with SFAS No. 141, Business Combinations. Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and identifiable intangible assets of Soluris acquired in connection with the merger, based on their respective estimated fair values. The results of operations of Soluris were included in the Company’s condensed consolidated statements of operations from the date of the acquisition.

The preliminary allocation of the Soluris purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed was based on management’s estimates of fair value at the date of acquisition. When estimating fair values of assets acquired and liabilities assumed, management considered a number of factors, including valuations, appraisals and assumptions which are subject to change. The primary areas of the purchase price allocation that are not yet finalized relate to the completion of the Soluris income tax returns, and the impact of adjustments on management’s estimates of fair values of inventories and accounts receivables. We expect management’s valuation process to be completed during the fourth quarter of fiscal 2006.

 

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Table of Contents

The preliminary allocation of the Soluris purchase price is summarized below (in thousands):

 

Assets acquired:

  

Cash

   $ 67  

Accounts receivable

     474  

Inventories

     1,559  

Other assets

     112  
        

Total assets acquired

     2,212  
        

Liabilities assumed:

  

Accounts payable

     (562 )

Accrued compensation

     (450 )

Deferred revenue

     (846 )

Other accrued liabilities

     (504 )
        

Total liabilities assumed

     (2,362 )
        

Net liabilities assumed

     (150 )

Deferred income tax liabilities

     (160 )

Goodwill and other intangible assets:

  

Goodwill

     3,638  

Customer relationships

     2,500  

Patented technology

     700  

Non-compete agreements

     50  

Trademark

     400  
        

Total goodwill and other intangible assets

     7,288  
        

Net estimated purchase price

   $ 6,978  
        

The patented technology is being amortized over an estimated useful life of ten years and customer relationship is being amortized on an accelerated basis over an estimated useful life of nine years designed to match the amortization to the benefits where applicable. The amount allocated to the trademark has been determined to have an indefinite life. In accordance with SFAS No. 142, Goodwill and other Intangible Assets, the Company will not amortize the goodwill and trademark, but will evaluate them annually for impairment or whenever events or circumstances occur which indicate that they might be impaired.

If the Company had acquired Soluris at the beginning of the periods presented, the Company’s unaudited pro forma net revenues, net income (loss) and net income (loss) per share from continuing operations would have been as follows (in thousands, except per share amounts):

 

     Three Months Ended     Nine Months Ended
    

September 30,

2006

   

October 1,

2005

   

September 30,

2006

   

October 1,

2005

Net revenues

   $ 29,091     $ 16,093     $ 72,572     $ 62,682

Net income (loss)

     (6,566 )     (3,745 )     (10,702 )     2,204

Net income (loss) per share:

        

Basic

   $ (0.40 )   $ (0.29 )   $ (0.75 )   $ 0.17

Diluted

   $ (0.40 )   $ (0.29 )   $ (0.75 )   $ 0.16

Accent Optical Technologies, Inc.

On July 21, 2006, Nanometrics completed its acquisition of Accent Optical Technologies, Inc. (“Accent”), a Bend Oregon-based privately held corporation focused on overlay and thin film metrology and process control systems. The acquisition of Accent is expected to enhance Nanometrics’ line of overlay and thin film products and to provide access to new customers, especially in Europe. Under the terms of the merger agreement relating to the acquisition, the total estimated purchase price of $72.6 million includes the exchange of Nanometrics common stock valued at $67.5 million, assumed stock options with a fair value of $0.3 million, a loan made to Accent prior to completion of the acquisition of $2.5 million and estimated direct transaction costs of $2.2 million. The merger has been accounted for under the purchase method of accounting in accordance with SFAS No. 141, Business Combinations. Under the purchase method of accounting,

 

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the total estimated purchase price is allocated to the net tangible and identifiable intangible assets of Accent acquired in connection with the merger, based on their respective estimated fair values. The results of operations of Accent were included in the Company’s condensed consolidated statements of operations from the date of the acquisition.

The purchase price includes the issuance of 4.865 million shares of Nanometrics common stock at an average market price per share of Nanometrics common stock of $13.87 reflecting the average of the closing market price of Nanometrics common stock for the period beginning two trading days before and ending two trading days after the merger was announced.

Under the terms of the merger agreement, each outstanding in-the-money option to purchase Accent stock and each option granted on or after January 23, 2006 (whether in-the-money or not) to purchase Accent stock was assumed and converted into an option to purchase Nanometrics common stock. Nanometrics assumed stock options to purchase Accent common stock, which are exercisable for 0.2 million shares of Nanometrics common stock. The fair value of the vested options assumed was determined using a Black-Scholes valuation model with the following weighted-average assumptions: volatility of 66.3%; risk-free interest rate of 4.3%, expected life of 4.5 years and dividend yield of zero.

The preliminary allocation of the Accent purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed was based on management’s estimates of fair value at the date of acquisition. When estimating fair values of assets acquired and liabilities assumed, management considered a number of factors, including valuations, appraisals and assumptions which are subject to change. The primary areas of the preliminary purchase price allocation that are not yet finalized relate to the completion of Accent’s income tax returns, finalization of the independent appraisal and the impact of adjustments on management’s estimates of fair values of inventories and accounts receivables. We expect management’s valuation process to be completed during the first half of fiscal 2007.

The total preliminary estimated purchase price of the merger is as follows (in thousands):

 

Estimated fair value of Nanometrics shares issued to Accent stockholders

   $ 67,481

Estimated fair value of Nanometrics shares issuable to former Accent optionees

     344

Loan to Accent

     2,500

Estimated direct transaction fees and expenses

     2,230
      

Total preliminary estimated purchase price

   $ 72,555
      

The preliminary allocation of the Accent purchase price is summarized below (in thousands):

 

Assets acquired:

  

Cash

   $ 3,845  

Accounts receivable

     9,612  

Inventories

     11,281  

Fixed assets

     1,256  

Other assets

     1,933  
        

Total tangible assets acquired

     27,927  
        

Liabilities assumed:

  

Accounts payable

     (4,369 )

Accrued compensation

     (3,284 )

Short term loans

     (14,021 )

Accrued interest

     (1,717 )

Accent Optical transaction expenses

     (5,011 )

Deferred revenue

     (354 )

Other accrued liabilities

     (4,081 )
        

Total liabilities assumed

     (32,837 )
        

Net liabilities assumed

     (4,910 )

Goodwill and other intangible assets:

  

Goodwill

     48,355  

Customer relationships

     13,200  

Developed technology

     9,100  

Brand names

     3,600  

Backlog

     3,210  
        

Total goodwill and other intangible assets

     77,465  
        

Net estimated purchase price

   $ 72,555  
        

 

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The patented technology and brand names are being amortized over an estimated average useful life of eight years and customer relationships are being amortized on an accelerated basis over an estimated useful life of nine years designed to match the amortization to the benefits where applicable. In accordance with SFAS No. 142, the Company will not amortize the goodwill, but will evaluate it annually for impairment or whenever events or circumstances occur which indicate that it might be impaired.

Pursuant to the merger agreement, 486,505 shares of Nanometrics common stock delivered as consideration in the merger were withheld and deposited in an escrow fund in order to secure Accent and its former stockholders’ performance of indemnification obligations under the merger agreement. Upon closing, Nanometrics has an immediate claim on the escrow for a number of shares equal to the Accent transaction costs that exceed $4.2 million, which is currently anticipated to be approximately $1.0 million, divided by the ten-day average closing price of Nanometrics common stock prior to submission of the claim. Nanometrics expects to file its claim prior to December 31, 2006.

If the Company had acquired Accent at the beginning of the periods presented, the Company’s unaudited pro forma net revenues, net income (loss) and net income (loss) per share from continuing operations would have been as follows (in thousands, except per share amounts):

 

     Three Months Ended     Nine Months Ended
    

September 30,

2006

   

October 1,

2005

   

September 30,

2006

   

October 1,

2005

Net revenues

   $ 30,232     $ 21,606     $ 96,595     $ 88,991

Net income (loss)

     (8,096 )     (6,211 )     (13,238 )     168

Net income (loss) per share:

        

Basic

   $ (0.49 )   $ (0.35 )   $ (0.93 )   $ 0.01

Diluted

   $ (0.49 )   $ (0.35 )   $ (0.93 )   $ 0.01

Note 4. Stock-Based Compensation

On January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), Share-Based Payment, (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan (collectively “Employee Stock Purchases”) based on estimated fair values. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the SEC issued SAB 107 relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. In accordance with the modified prospective transition method, the Company’s financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s consolidated statements of operations, because the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s consolidated statement of operations for the three- and nine-month periods ended September 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the consolidated statement of operations for the three- and nine-month periods ended September 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company’s estimated forfeiture rates for the three months ended April 1, 2006, July 1, 2006 and September 30, 2006 of 14.1%, 15.3%

 

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and 15.3%, respectively, were based on historical forfeiture experience. In the Company’s pro forma information, required under SFAS No. 123 for the periods prior to fiscal 2006, the Company estimated forfeitures at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differed from those estimates.

SFAS 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash flows. There were no such tax benefits during the three- and nine-month periods ended September 30, 2006. Prior to the adoption of Statement SFAS 123(R) those benefits would have been reported as operating cash flows had the Company received any tax benefits related to stock option exercises.

Valuation and Expense Information under SFAS 123(R)

The fair value of stock-based awards to employees is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company’s stock options. The Black-Scholes model requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted was calculated using the simplified method allowed by SAB 107. The risk-free rate is based on the U.S Treasury rates in effect during the corresponding period of grant. The expected volatility is based on the historical volatility of Nanometrics’ stock price. These factors could change in the future, which would affect the stock-based compensation expense in future periods.

The weighted-average fair value of stock-based compensation to employees is based on the single option valuation approach. Forfeitures are estimated and it is assumed no dividends will be declared. The estimated fair value of stock-based compensation awards to employees is amortized using the straight-line method over the vesting period of the options. The weighted-average fair value calculations are based on the following average assumptions:

 

    

Three Months
Ended
September 30,

2006

    Nine Months
Ended
September 30,
2006
 

Stock Options:

    

Expected life

   4.5 years     4.5 years  

Volatility

   70.3 %   71.9 %

Risk free interest rate

   4.69 %   4.75 %

Dividends

   —       —    

Employee Stock Purchase Plan:

    

Expected life

   0.5 years     0.5 years  

Volatility

   42.7 %   40.9 %

Risk free interest rate

   2.43 %   2.06 %

Dividends

   —       —    

The weighted average fair values per share of the stock options awarded in the three and nine months ended September 30, 2006 was $5.41 and $7.01, respectively, based on the fair market value of the Company’s common stock on the grant dates.

The following table summarizes stock-based compensation expense for all share-based payment awards made to the Company’s employees and directors pursuant to the Employee Stock Purchases under SFAS 123(R) for the three and nine months ended September 30, 2006 which was allocated as follows (in thousands):

 

    

Three Months
Ended
September 30,

2006

  

Nine Months
Ended
September 30,

2006

Cost of products

   $ 82    $ 225

Cost of service

     84      209

Research and development

     362      915

Selling

     276      670

General and administrative

     601      1,392
             

Stock-based compensation expense included in costs and expenses

     1,405      3,411
             

Total stock-based compensation expense related to employee stock options and employee stock purchases

   $ 1,405    $ 3,411
             

 

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The table below reflects net income (loss) and basic and diluted net income (loss) per share for the three and nine months ended September 30, 2006 compared with the pro forma information for the three and nine months ended October 1, 2005 as follows (in thousands except per-share amounts):

 

     Three Months Ended     Nine Months Ended  
     September 30,
2006
   

October 1,

2005

    September 30,
2006
   

October 1,

2005

 

Net income (loss)—as reported for the prior period (1)

     N/A     $ (3,403 )     N/A     $ 3,569  

Stock-based compensation expense related to employee stock options (2)

     (1,405 )     (895 )     (3,411 )     (2,989 )
                                

Net income (loss), including the effect of stock-based compensation expense (3)

   $ (6,566 )   $ (4,298 )   $ (10,044 )   $ 580  
                                

Net income (loss) per share—as reported for the prior period (1)

        

Basic

     $ (0.26 )     $ 0.28  

Diluted

     $ (0.26 )     $ 0.27  

Net income (loss) per share, including the effect of stock-based compensation expense (3)

        

Basic

   $ (0.40 )   $ (0.33 )   $ (0.71 )   $ 0.05  

Diluted

     (0.40 )   $ (0.33 )     (0.71 )     0.04  

Shares used to compute income per share

        

Basic

     16,573       12,854       14,226       12,686  

Diluted

     16,573       12,854       14,226       13,448  
                                

(1) Net income (loss) and net income (loss) per share prior to fiscal 2006 did not include stock-based compensation expense for employee stock options under SFAS No. 123 because the Company did not adopt the recognition provisions of SFAS No. 123.
(2) Stock-based compensation expense prior to fiscal 2006 is calculated based on the pro forma application of SFAS No. 123.
(3) Net income (loss) and net income (loss) per share prior to fiscal 2006 represents pro forma information based on SFAS No.123.

A summary of option activity under the Company’s stock option plans during the nine months ended September 30, 2006 is as follows:

 

     Shares
Available
    Number of
Shares
    Weighted
Average
Exercise Price
  

Weighted Average
Remaining
Contractual Term

(in Years)

  

Aggregate
Intrinsic Value

(in Thousands)

Options

            

Outstanding at December 31, 2005

   1,979,761     2,570,758     $ 10.01      

Shares added through 2005 Option Plan

   389,726     —         —        

Exercised

   —       (42,544 )     6.99      

Granted

   (263,200 )   263,200       14.00      

Canceled

   39,805     (59,805 )     13.12      
                        

Outstanding at April 1, 2006

   2,146,092     2,731,609     $ 10.38    4.85    $ 10,955

Exercised

   —       (30,799 )     6.44      

Granted

   (599,500 )   599,500       12.96      

Canceled

   41,743     (41,743 )     13.89      
                        

Outstanding at July 1, 2006

   1,588,335     3,258,567     $ 10.84    5.01    $ 4,395

Options assumed from the Accent Stock Option Plan

   —       205,108       13.87      

Exercised

   —       (65,621 )     5.65      

Granted

   (381,000 )   381,000       9.08      

Canceled

   169,436     (171,669 )     13.65      

Outstanding at September 30, 2006

   1,376,771     3,607,385     $ 10.69    5.11    $ 3,812
                              

Exercisable at September 30, 2006

     1,769,132     $ 9.04    3.82    $ 3,687
                          

 

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The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Company’s closing stock price of $9.25 as of September 30, 2006, $9.93 as of July 1, 2006 and $13.85 as of April 1, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. The total intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $0.3 million and $0.9 million, respectively. The fair value of options vested was $1.5 million and $2.4 million for the three and nine months ended September 30, 2006, respectively.

In connection with the acquisition of Accent Optical Technologies, Inc. in the third quarter of fiscal 2006 (Note 3), each outstanding stock option under the Accent Stock Option Plan was converted into an option to purchase shares of the Company’s common stock and, as a result, outstanding options to purchase 205,108 shares of the Company’s common stock were assumed. No further options may be granted under the Accent Stock Option Plan.

The following table summarizes significant ranges of outstanding and exercisable options as of September 30, 2006.

 

Range of Exercise Prices

   Options Outstanding    Options Exercisable
   Number
Outstanding
   Weighted Average
Remaining
Contractual Life
(Years)
   Weighted
Average
Exercise
Price
   Number
Exercisable
   Weighted
Average
Exercise
Price

$ 0.49– $ 5.54

   92,768    3.04    $ 3.51    92,768    $ 3.51

$ 5.70– $ 5.70

   726,214    3.71    $ 5.70    726,214    $ 5.70

$ 6.33– $ 8.89

   649,919    5.50    $ 8.17    325,503    $ 7.48

$ 9.87– $11.77

   486,767    5.88    $ 10.92    82,720    $ 10.60

$12.02– $12.03

   376,300    5.61    $ 12.03    159,750    $ 12.03

$12.29– $13.65

   675,234    6.15    $ 13.35    75,454    $ 12.67

$13.75– $15.98

   381,800    5.82    $ 15.16    118,250    $ 14.44

$16.10– $22.90

   199,883    2.56    $ 18.30    169,973    $ 18.56

$25.24– $25.24

   15,000    1.75    $ 25.24    15,000    $ 25.24

$29.20– $29.20

   3,500    1.88    $ 29.20    3,500    $ 29.20
                  

$0.49– $29.20

   3,607,385    5.11    $ 10.69    1,769,132    $ 9.04
                  

As of September 30, 2006, total unrecognized compensation costs related to unvested stock options was $8.2 million, including approximately $0.4 million related to the acquisition of Accent, which is expected to be recognized as compensation expense over a weighted average period of approximately 1.4 years.

Pro Forma Information Under SFAS 123 for Periods Prior to Fiscal 2006

Prior to fiscal 2006, the weighted-average fair value of stock-based compensation to employees was based on the single option valuation approach. Forfeitures were estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differed from those estimates. It was assumed no dividends would be declared. The estimated fair value of stock-based compensation awards to employees was amortized using the straight-line method over the vesting period of the options. The weighted-average fair value calculations were based on the following weighted-average assumptions:

 

    

Three Months
Ended
October 1,

2005

   

Nine Months
Ended
October 1,

2005

 

Stock Options:

    

Expected life

   3.7 years     3.4 years  

Volatility

   75.9 %   77.2 %

Risk free interest rate

   3.38 %   3.60 %

Dividends

   —       —    

Employee Stock Purchase Plan:

    

Expected life

   0.5 years     0.5 years  

Volatility

   53.0 %   55.0 %

Risk free interest rate

   1.70 %   1.59 %

Dividends

   —       —    

 

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Table of Contents

Note 5. Sale of Accounts Receivable

The Company maintains arrangements under which eligible accounts receivable are sold without recourse to unrelated third-party financial institutions. These receivables were not included in the consolidated balance sheet as the criteria for sale treatment established by SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” had been met. Under SFAS No. 140, after a transfer of financial assets, an entity stops recognizing the financial assets when the control has been surrendered. The agreement met the criteria of a true sale of these assets since the acquiring party retained the title to these receivables and had assumed the risk that the receivables will be collectible. The Company pays administrative fees as well as interest ranging from 1.375% to 1.625% based on the anticipated length of time between the date the sale is consummated and the expected collection date of the receivables sold. For the three and nine months ended September 30, 2006 there were no material gains or losses on the sale of such receivables. For the three and nine months ended September 30, 2006, $2.5 million and $6.2 million, respectively, of receivables were sold under the terms of the agreement. The Company did not sell any receivables under the terms of the agreement during the comparable periods of 2005. There were no amounts due from the financial institution at September 30, 2006 and December 31, 2005.

Note 6. Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following (in thousands):

 

     September 30,
2006
  

December 31,

2005

Raw materials and subassemblies

   $ 23,140    $ 14,175

Work in process

     8,422      5,021

Finished goods

     16,354      6,460
             

Total inventories

   $ 47,916    $ 25,656
             

Note 7. Related Party Transactions

A member of the Company’s executive staff is a significant shareholder of a major supplier of assembly parts to the Company. Purchases of assembly parts from the related party were $1.9 million and $4.6 million during the three and nine months ended September 30, 2006, respectively, and $0.4 million and $1.7 million during the three and nine months ended October 1, 2005, respectively. Consulting services received from the related party were $0.2 million and $0.5 million during the three and nine months ended September 30, 2006, respectively, and $0.2 million and $0.6 million during the three and nine months ended October 1, 2005. Amounts due to the related party as of September 30, 2006 and December 31, 2005 were $0.5 million and $0.3 million, respectively.

Note 8. Goodwill and Intangible Assets

Goodwill represents the excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired in a business combination. In accordance with SFAS No. 142, goodwill is reviewed annually or whenever events or circumstances occur which indicate that goodwill might be impaired. For the three and nine months ended September 30, 2006, the Company recorded goodwill of $48.5 million and $52.0 million, respectively, as a result of the Company’s acquisitions of Soluris and Accent.

Intangible assets with an indefinite life are evaluated annually for impairment or whenever events or circumstances occur which indicate that those assets might be impaired. On March 15, 2006, as a result of the Company’s acquisition of Soluris, the Company acquired a trademark with a value of $0.4 million with an indefinite life.

Finite-lived intangible assets are recorded at cost, less accumulated amortization. Finite-lived intangible assets as of September 30, 2006 and December 31, 2005 consist of the following (in thousands):

 

September 30, 2006

   Gross
Carrying
Amount
   Accumulated
Amortization
   Net
Intangible
Assets

Developed technology acquired in business combinations

   $ 9,800    $ 279    $ 9,521

Customer relationships

     15,700      737      14,963

Brand names

     3,600      94      3,506

Patented technology

     1,790      1,342      448

Backlog

     3,210      1,344      1,866

Non-compete agreement

     50      27      23

Other

     250      250      —  
                    

Total

   $ 34,400    $ 4,073    $ 30,327
                    

 

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Table of Contents

December 31, 2005

   Gross
Carrying
Amount
   Accumulated
Amortization
   Net
Intangible
Assets

Patented technology

   $ 1,790    $ 1,151    $ 639

Other

     250      250      —  
                    

Total

   $ 2,040    $ 1,401    $ 639
                    

The amortization of finite-lived intangibles is computed using the straight-line method except for customer relationships which is computed using an accelerated method. Estimated lives of finite-lived intangibles range from five to ten years, except for the non-compete agreement and backlog which are amortized over one year. Amortization expense for developed technology acquired in a business combination, patented technology and backlog is included in cost of product sales whereas amortization expense for customer relationships, brand names and non-compete agreements is included in selling expense in the Company’s condensed consolidated statements of operations. Total amortization expense was $2.4 million and $0.1 million for the three months ended September 30, 2006 and October 1, 2005, respectively and $2.7 million and $0.2 million for the nine months ended September 30, 2006 and October 1, 2005.

The estimated future amortization expense as of September 30, 2006 is as follows (in thousands):

 

Fiscal Years

    

2006 (remaining three months)

   $ 3,029

2007

     5,148

2008

     4,881

2009

     4,257

2010

     3,675

2011 and after

     9,337
      

Total amortization

   $ 30,327
      

Note 9. Other Current Liabilities

Other current liabilities consist of the following (in thousands):

 

    

September 30,

2006

  

December 31,

2005

Accrued professional services

     1,363      1,518

Other

     4,462      911
             

Total other current liabilities

   $ 5,825    $ 2,429
             

Note 10. Shareholders’ Equity

Net Income (Loss) Per Share—Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period, less $0.4 million weighted average shares held in escrow for the Accent acquisition. Diluted net income per share gives effect to all potentially dilutive common shares outstanding during the period, which include certain stock options, calculated using the treasury stock method. A reconciliation of the share denominator of the basic and diluted net income (loss) per share computations is as follows (in thousands):

 

     Three Months Ended    Nine Months Ended
    

September 30,

2006

  

October 1,

2005

  

September 30,

2006

  

October 1,

2005

Weighted average common shares outstanding-shares used in basic net income (loss) per share computation

   16,573    12,854    14,226    12,686

Potentially dilutive common stock equivalents, using the treasury stock method

   —      —      —      762
                   

Shares used in diluted net income (loss) per share computation

   16,573    12,854    14,226    13,448
                   

For the three and nine months ended September 30, 2006, the Company had securities outstanding which could potentially dilute basic earnings per share in the future, which were excluded from the computation of diluted net loss per share in the periods presented as their impact would have been antidilutive. Weighted average common share equivalents, consisting of stock options excluded from the calculation of diluted net loss per share were 2.4 million and 2.0 million in the three and nine months ended September 30, 2006, respectively.

 

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Table of Contents

At October 1, 2005, diluted net income per share excludes common equivalent shares outstanding of 1.1 million, as their effect was anti-dilutive.

Note 11. Merger Termination Fee

On January 21, 2005, Nanometrics and August Technology Corporation entered into a definitive merger agreement. On June 28, 2005, August Technology Corporation and the Company announced the termination of the merger agreement. In accordance with the terms of the merger agreement, August Technology paid Nanometrics a merger termination fee of $8.3 million on June 28, 2005. Also, in accordance with the terms of the merger agreement, August Technology paid $2.6 million to the Company as reimbursement of the Company’s expenses associated with the merger agreement on the same date.

Note 12. Asset Impairment and Disposition

During the quarter ended July 2, 2005, Nanometrics recorded an asset impairment charge of $2.2 million related to certain assets of the flat panel display (“FPD”) business unit. Under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company should assess the recoverability of assets when events become known which would indicate potential impairment. The Company evaluated the estimated future cash flows of the FPD business unit and determined the undiscounted estimated future cash flows would be insufficient to recover the carrying value of those assets. The impairment charge was measured based on the excess carrying value of the asset group in excess of the associated discounted future cash flows. Accordingly, the Company recorded an asset impairment charge during the second quarter of fiscal 2005.

In September 2005, Nanometrics announced it had entered into an agreement to sell its FPD business unit to Toho Technology Corporation (“Toho”); the agreement became effective in October 2005. The Company decided to sell the FPD business unit as it had experienced a significant decline in revenues and related gross profit as other competitors have entered the market. Toho received a non-exclusive perpetual license to use and sell Nanometrics Film Thickness Measurements Systems in the flat panel market in exchange for $1.5 million. In addition, Toho will pay a 7% royalty on future sales in excess of ¥800 million. Toho also purchased certain other existing assets at net book value from Nanometrics including $0.9 million of inventory and $0.1 million of equipment related to the FPD business unit. The Company also agreed with Toho to continue to provide sales efforts for FPD products and maintenance service for installed units in certain Asian countries. The Company will receive a commission from Toho on their future sales of FPD products in designated countries. Due to this continuing involvement, the Company does not consider the FPD business unit to be a discontinued operation.

Note 13. Comprehensive Income (Loss)

The Company’s comprehensive income (loss) was as follows (in thousands):

 

     Three Months Ended     Nine Months Ended  
    

September 30,

2006

   

October 1,

2005

   

September 30,

2006

   

October 1,

2005

 

Net income (loss)

   $ (6,566 )   $ (3,403 )   $ (10,044 )   $ 3,569  

Foreign currency translation adjustment, net of tax

     305       (197 )     853       (834 )
                                

Total comprehensive income (loss)

   $ (6,261 )   $ (3,600 )   $ (9,191 )   $ 2,735  
                                

Substantially all of the accumulated other comprehensive income reflected as a separate component of shareholders’ equity consists of accumulated foreign currency translation adjustment for all periods presented.

Note 14. Warranties

Product Warranty- The Company sells the majority of its products with a 12 month repair or replacement warranty from the date of acceptance which generally represents the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to the cost of products sold. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by the warranty periods, sales volumes, product failure rates, material usage, labor and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage, labor or replacement costs differ from the Company’s estimates, revisions to the estimated warranty obligations would be required. For new product introductions where limited or no historical information exists, the Company may use warranty information from other previous product introductions to guide it in estimating its warranty accrual. The warranty accrual

 

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Table of Contents

represents the best estimate of the amount necessary to settle future and existing claims on products sold as of the balance sheet date. The Company periodically assesses the adequacy of its reported warranty reserve and adjusts the amounts in accordance with changes in these factors. Components of the warranty accrual, which was included in the accompanying consolidated balance sheets with other current liabilities, were as follows (in thousands):

 

     Nine Months Ended  
    

September 30,

2006

   

October 1,

2005

 

Balance as of beginning of period

   $ 1,440     $ 1,055  

Warranties assumed

     1,038       —    

Actual warranty costs

     (1,694 )     (1,277 )

Provision for warranty

     3,503       1,677  
                

Balance as of end of period

   $ 4,287     $ 1,455  
                

Intellectual Property Indemnification Obligations – In addition to product warranties, the Company will, from time to time, in the normal course of business, indemnify certain customers with whom it enters into contractual relationships. The Company has agreed to hold these customers harmless against third party claims that Nanometrics’ products, when used for their intended purpose(s), infringe the intellectual property rights of such third parties or other claims made against the customer. It is not possible to determine the maximum potential amount of liability under these indemnification obligations due to the limited history of prior indemnification claims and the unique facts and circumstances that are likely to be involved in each particular claim. Historically, the Company has not made payments under these obligations and believes that the estimated fair value of these agreements is minimal. Accordingly, no liabilities have been recorded for these obligations on the consolidated balance sheets as of September 30, 2006 and December 31, 2005.

Note 15. Income Taxes

Income tax provisions for interim periods are based on the Company’s estimated annual income tax rate. For the nine month period ended September 30, 2006, the Company’s income tax provision of $0.3 million on a pre-tax loss is a result of foreign taxes. The income tax provision of $0.4 million for the nine month period ended October 1, 2005 reflects the Company’s obligation for foreign taxes and U.S. Federal alternative minimum taxes. The estimated annual tax rate differs from the combined United States federal and state statutory income tax rate of 40% primarily due to estimated utilization of the Company’s net operating losses and various tax credits and reduction of the associated deferred tax valuation allowance.

Note 16. Contingencies

On March 9, 2005, Nova Measuring Instruments Ltd. (“Nova”) filed suit against the Company in the United States District Court for the Northern District of California. The complaint alleges that certain of the Company’s products infringe a Nova patent and seeks a preliminary and permanent injunction against their sale and unspecified damages. The Company does not believe any of its products infringe any valid claim of the Nova patent and intends to vigorously and aggressively defend itself in the litigation. On March 29, 2006, Nanometrics filed suit against Nova in the United States District Court for the Northern District of California. The complaint alleges that certain of Nova’s products infringe one of Nanometrics’ patents and seeks damages. On October 11, 2006, we filed another complaint in the United States District Court for the Northern District of California against Nova for patent infringement. The patents at issue relate to Nanometrics’ optical critical dimension technology, commonly referred to as scatterometry.

In August 2005, KLA-Tencor Corporation, (“KLA”), filed a complaint against the Company in the United States District Court for the Northern District of California. The complaint alleges that certain of the Company’s products infringe two of KLA’s patents. On January 30, 2006, KLA added a third patent to their claim. The complaint seeks a preliminary and permanent injunction against the sale of these products as well as the recovery of monetary damages and attorneys’ fees. The Company does not believe that any of its products infringe the intellectual property of any third party and it intends to vigorously and aggressively defend itself in the litigation. As part of such defense, the Company has filed a request for re-examination of the three allegedly infringed KLA patents with the U.S. Patent & Trademark Office (“PTO”). These requests for re-examination were recently accepted for review by the PTO. In March 2006, the Company filed a motion for and was granted a stay in the patent litigation case until such re-examination is completed.

Note 17. Geographic and Significant Customer Information

Prior to the Accent acquisition, Nanometrics had operations in four primary geographic operating locations: the United States, Japan, South Korea and Taiwan. With the acquisition of Accent, the Company’s operations now include Europe. All such operating locations have similar economic characteristics, as defined in SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, and accordingly, Nanometrics operates in one reportable segment: the sale, design,

 

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manufacture, marketing and support of thin film, optical critical dimension and overlay dimension metrology systems. The following table summarizes total net revenues and long-lived assets attributed to significant countries (in thousands):

 

     Three Months Ended    Nine Months Ended
    

September 30,

2006

  

October 1,

2005

  

September 30,

2006

  

October 1,

2005

Total net revenues:

           

United States

   $ 10,215    $ 7,847    $ 35,665    $ 17,373

Japan

     5,172      2,582      12,622      12,550

South Korea

     5,790      2,102      10,426      16,211

Taiwan

     4,282      520      6,676      7,352

Europe

     3,595      1,180      6,031      2,651

Other

     37      —        37      180
                           

Total net revenues*

   $ 29,091    $ 14,231    $ 71,457    $ 56,317

* Net revenues are attributed to countries based on the deployment and service locations of systems.

 

    

September 30,

2006

  

December 31,

2005

Long-lived assets:

     

United States

   $ 37,410    $ 37,622

Japan

     2,377      2,391

South Korea

     4,903      4,333

Europe

     624      23

Taiwan

     101      —  
             

Total long-lived assets**

   $ 45,415    $ 44,369
             

** Long-lived assets include tangible assets only.

As of September 30, 2006, no customer accounted for more than 10% of total accounts receivable. As of December 31, 2005, one customer accounted for 31.4% of total accounts receivable.

The following customers accounted for 10% or more of total revenue:

 

     Three Months Ended    Nine Months Ended
     September 30,
2006
   October 1,
2005
   September 30,
2006
   October 1,
2005

Applied Materials

   $ 3,966    $ 3,412    $ 15,466    $ 10,695

Hynix

     8,001      ***      11,928      ***

Intel

     ***      1,729      ***      ***

Ebara

     ***      1,585      ***      6,449

Samsung

     4,897      ***      14,454      10,168
                           

*** The customer accounted for less than 10% of total revenue during the specified period.

 

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

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this document that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding our business in future periods. We may identify these statements by the use of words such as “anticipate”, “believe”, “continue”, “could”, “estimate”, “expect”, “intend”, “may”, “might”, “plan”, “potential”, “predict”, “project”, “should”, “will”, “would” and other similar expressions. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements, except as may otherwise be required by law.

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain risk factors, including those set forth in Part II Item 1A “Risk Factors” and elsewhere in this document. In evaluating our business, current and prospective investors should carefully consider these factors in addition to the other information set forth in this document. We believe that it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. You should be aware that the occurrence of the events described in such risk factors and elsewhere in this report could materially and adversely affect our business, operating results and financial condition. While management believes that the discussion and analysis in this report is adequate for a fair presentation of the information presented, we recommend that you read this discussion and analysis in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2005, which were included in our Annual Report on Form 10-K filed with the Securities Exchange Commission on March 24, 2006.

Overview

We are a leading provider of integrated and stand-alone metrology and process control technology to the global semiconductor manufacturing industry. Our systems are designed to precisely monitor film thickness and critical dimensions that are necessary to control the manufacturing process and provide increased production yields and performance.

Capital expenditures by manufacturers of semiconductors, especially in Asia, and their suppliers are critical to our success. The demand by these manufacturers and suppliers is driven by the expected market demand for new products and new applications. The increasing complexity of the 300mm manufacturing processes for semiconductors is an important factor in the demand for our innovative metrology systems. The incorporation of smaller features sizes, copper interconnect technology, and optical critical dimension technology are expected to result in increased demand for metrology and closed-loop process control. Our strategy is to solidify our competitive position and leverage our channel in each of the high-growth markets we operate by focusing on key customers, gaining scale and market share and cross-selling our integrated and standalone products.

Our revenues are derived from product sales and customer service, which include sales of accessories and service for the installed base of our products. In the year ended December 31, 2005, we derived 86.5% of our total net revenues from product sales and 13.5% of our total net revenues from services.

Important Themes and Significant Trends

The semiconductor equipment industry is characterized by cyclical growth. Recently, the industry emerged from an exceptionally long, cyclical downturn. Changing trends in the semiconductor industry are increasing the need for metrology as a major component of manufacturing systems. These trends include:

 

    Conversion to 300mm Wafer Size. Semiconductor manufacturers are converting to 300mm wafers to achieve better production efficiencies. Most facilities are incorporating this wafer size, and our newest products are well-positioned to serve these facilities. It is important that we are successful in product evaluations with these new 300mm facilities in order to continue to gain market share.

 

    Incorporation of Optical Critical Dimension Metrology in the Patterning Process. Our customers use photolithographic processes to create patterns on wafers. Critical dimensions must be carefully controlled during this process. Our proprietary optical critical dimension systems can provide the critical process control of these circuit dimensions that is necessary for successful manufacturing of these state of the art devices.

 

    Copper Interconnect Technology. The need for ever increasing device circuit speed coupled with lower power consumption has pushed semiconductor device manufacturers to begin the replacement of the subtractive aluminum interconnect process with copper damascene technology. This new copper processing technology has driven the need for new metrology techniques such as non-destructive laser profiling and the use of optical critical dimension (OCD) technology for control of the copper process.

 

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    Incorporation of 65nm and 45nm Feature Sizes. In an effort to reduce costs and increase device performance, semiconductor manufacturers are decreasing both the die size and feature size. Monitoring the increased tolerance requirements on smaller features sizes requires increased use of metrology systems. Our thin film and critical dimension metrology systems are well suited and are being adopted for these next generation processes.

 

    Reduced Number of Customers. Because of the escalating cost of 300mm manufacturing facilities, fewer semiconductor manufacturers can afford the significant investment in these next generation facilities. Therefore, fewer opportunities for semiconductors equipment companies exist. Given that the available number of potential customers is decreasing, previous customer relationships, product positioning and critical mass take on greater importance.

 

    Adoption of New Types of Thin Film Materials. Manufacturers are adopting new processes and technologies that increase the importance and utilization of thin film metrology systems. To achieve greater semiconductor device speed, manufacturers are utilizing copper and new, low dielectric constant (low k) insulating materials. Our advanced metrology solutions are required in the manufacturing process to characterize these materials.

 

    Need for Improved Process Control to Drive Process Efficiencies. Competitive forces influencing semiconductor device manufacturers, such as price-cutting and shorter product life cycles, place pressure on manufacturers to rapidly achieve production efficiency. Device manufacturers are using our integrated and standalone metrology systems throughout the fab to ensure that manufacturing processes scale rapidly, are accurate and can be repeated on a consistent basis.

Critical Accounting Policies

The preparation of our financial statements conforms with accounting principles generally accepted in the United States of America, which requires management to make estimates and judgments in applying our accounting policies that have an important impact on our reported amounts of assets, liabilities, revenue, expenses and related disclosures at the date of our financial statements. On an on-going basis, management evaluates its estimates including those related to bad debts, inventory valuations, warranty obligations, value of stock options and income taxes. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from management’s estimates. We believe that the application of the following accounting policies requires significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including those discussed below, see Note 1 to The Consolidated Financial Statements included in our Annual Report on Form 10-K filed with the SEC on March 24, 2006.

Revenue Recognition – We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed or determinable, and collectibility is reasonably assured. Product revenue includes hardware and also software that is incidental to the products. For product sales to existing customers, revenue recognition generally occurs at the time of shipment, as our terms are FOB shipping point, if we have met defined customer acceptance experience levels with both the customer and the specific type of equipment. All other product revenue is recognized upon customer acceptance including deemed acceptances. In Japan, where risk of loss and title transfers to the customer upon customer technical acceptance, revenue is recognized upon customer technical acceptance.

All of our products are assembled prior to shipment to our customers. We often perform limited installation for our customers; however such installation is inconsequential and perfunctory as it may also be performed by third parties. Revenue related to spare parts sales is recognized generally upon shipment and is included as part of service revenue. Service revenue also includes service contracts and non-warranty, billable repairs of systems. Whereas service revenue related to service contracts is recognized ratably over the period under contract, service revenue related to billable repairs of systems is recognized as services are performed. On occasion, customers request a warranty period longer than our standard 12 month warranty. In those instances where extended warranty services are separately quoted to the customer, we follow the guidance of Financial Accounting Standards Board Technical Bulletin 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts,” associated revenue is deferred and recognized to income ratably over the term of the contract. Unearned maintenance and service contract revenue is included in deferred revenue. Furthermore, generally we do not provide our customers with any return rights. Service contracts may be purchased by the customer when the warranty period expires.

In limited situations we have multiple deliverables in our customer arrangements. Those situations arise with the sale of repair services and parts together. Revenues on such sales are recognized when both the services and parts have been delivered. We also provide technical support to our customers as part of our warranty program. Upon recognition of product revenue, a liability is recorded for anticipated warranty costs.

 

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Allowance for Doubtful Accounts – We maintain allowances for estimated losses resulting from the inability of our customers to make required payments. Credit limits are established through a process of reviewing the financial history and stability of our customers. Where appropriate and available, we obtain credit rating reports and financial statements of customers when determining or modifying their credit limits. We regularly evaluate the collectibility of our trade receivable balances based on a combination of factors such as the length of time the receivables are past due, customary payment practices in the respective geographies and our historical collection experience with customers. We believe that our allowance for doubtful accounts reflects our risk associated with smaller rather than larger customers and that our reported allowances are adequate. If, however, the financial conditions of customers were to deteriorate, resulting in their inability to make payments, we would assess the necessity to record additional allowances which would result in additional general and administrative expenses being recorded for the period in which such determination was made.

Inventories – We are exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in our market, our ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of key components from our suppliers. We have established inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon our assumptions about future demand for our products and market conditions. We regularly evaluate our ability to realize the value of our inventory based on a combination of factors including the following: historical usage rates, forecasted sales of usage, product end-of-life dates, estimated current and future market values and new product introductions. For demonstration inventory, we also consider the age of the inventory and potential cost to refurbish the inventory prior to sale. When recorded, our reserves are intended to reduce the carrying value of our inventory to its net realizable value. If actual demand for our products deteriorates, or market conditions are less favorable than those that we project, additional reserves may be required. Inventories are stated at the lower of cost, using the first-in, first-out method, or market value.

Product Warranties – We sell the majority of our products with a twelve-month repair or replacement warranty from the date of acceptance which generally represents the date of shipment. We provide an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to the cost of products sold. The estimated future warranty obligations related to product sales are reported in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by the warranty periods, sales volumes, product failure rates, material usage, labor and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage, labor or replacement costs differ from our estimates, revisions to the estimated warranty obligations would be required. For new product introductions where limited or no historical information exists, we may use warranty information from other previous product introductions to guide us in estimating our warranty accrual. The warranty accrual represents the best estimate of the amount necessary to settle future and existing claims on products sold as of the balance sheet date. We periodically assess the adequacy of our recorded warranty reserve and adjust the amounts in accordance with changes in these factors.

Goodwill and Intangible Assets—Goodwill is initially recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. Under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142), intangible assets with finite lives are amortized over their useful lives while goodwill and indefinite lived assets are not amortized but tested annually for impairment. Our impairment review process, which is completed as of the last day of November of each year, compares the fair value of our reportable segment (which we have determined to be our reporting unit) to its carrying value, including the goodwill related to the segment. To determine the fair value, our review process uses the income method and is based on a discounted future cash flow approach that uses estimates including the following for our reportable segment: revenue, based on assumed market growth rates and our assumed market share; estimated costs; and appropriate discount rates based on the particular business’s weighted average cost of capital. Our estimates of market segment growth, our market segment share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. Our business consists of both established and emerging technologies and our forecasts for emerging technologies are based upon internal estimates and external sources rather than historical information. If future forecasts are revised, they may indicate or require future impairment charges. We also considered our market capitalization on the dates of our impairment tests under SFAS No. 144, in determining the fair value of the respective businesses.

Our fair value estimates are based on the extensive use of management’s estimates and assumptions, and the result of these processes can have a significant impact on our future operating results.

We are presently in the process of evaluating the impact of the Soluris and Accent acquisitions on the determination of our reporting unit(s) for purposes of SFAS No. 142.

 

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Income Tax Assets and Liabilities – We account for income taxes based on SFAS No. 109, Accounting for Income Taxes, whereby deferred tax assets and liabilities must be recognized using enacted tax rates for the effect of temporary differences between the book and tax accounting for assets and liabilities. Also, deferred tax assets must be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized in the future. We evaluate the deferred tax assets on a quarterly basis to determine whether or not a valuation allowance is appropriate. Factors used in this determination include future expected income and the underlying asset or liability which generated the temporary tax difference. Our income tax provision is primarily impacted by federal statutory rates, state and foreign income taxes and changes in our valuation allowance.

Stock-Based Compensation – Upon adoption of SFAS 123(R) on January 1, 2006, we began estimating the value of employee stock options on the date of grant using the Black-Scholes model. Prior to the adoption of SFAS 123(R), the value of each employee stock option was estimated on the date of grant using the Black-Scholes model for the purpose of the pro forma financial disclosure in accordance with SFAS No. 123. The determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. The expected term of options granted is calculated based on the simplified method allowed by SAB 107. The expected volatility is based on the historical volatility of our stock price.

Recent Accounting Pronouncements

See Note 2 of the Condensed Consolidated Financial Statements for a description of recent accounting pronouncements, including the respective dates of adoption and effects on results of operations and financial condition.

Acquisitions

On March 15, 2006, we announced that we had acquired Soluris Inc., (“Soluris”) a privately held corporation focused on overlay and CD measurement technology and headquartered in Concord, Massachusetts. Its flagship product, the IVS 155, is a tool for use in the 200mm and smaller semiconductor overlay and CD measurement market. Under the terms of the merger agreement, which was an all-cash transaction, the total consideration to purchase all of the outstanding stock of Soluris was $7.0 including $0.4 million in transaction fees, including legal, valuation and accounting fees. The merger has been accounted for under the purchase method of accounting in accordance with SFAS No. 141, Business Combinations. Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and identifiable intangible assets of Soluris acquired in connection with the merger, based on their respective estimated fair values. The results of operations of Soluris were included in our condensed consolidated statement of operations from the date of the acquisition. We believe the acquisition of Soluris will create an immediate impact on our share of the Overlay market.

On July 21, 2006, Nanometrics completed its acquisition of Accent Optical Technologies, Inc. (“Accent”), a Bend Oregon-based privately held corporation focused on overlay and thin film metrology and process control systems. The acquisition of Accent is expected to enhance Nanometrics’ line of overlay and thin film products and provide access to various other new customers. Under the terms of the merger agreement relating to the acquisition, the total estimated purchase price of $72.6 million includes the exchange of Nanometrics common stock valued at $67.5 million, assumed stock options with a fair value of $0.3 million, a loan made to Accent prior to completion of the acquisition of $2.5 million and estimated direct transaction costs of $2.2 million. The merger has been accounted for under the purchase method of accounting in accordance with SFAS No. 141, Business Combinations. Under the purchase method of accounting, the total estimated purchase price is allocated to the net tangible and identifiable intangible assets of Accent acquired in connection with the merger, based on their respective estimated fair values. The results of operations of Accent were included in the Company’s condensed consolidated statements of operations from the date of the acquisition.

 

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Results of Operations

Three and nine months ended September 30, 2006 and October 1, 2005

Total net revenues. Our net revenues were comprised of the following categories (in thousands):

 

     Three Months Ended   

Percentage
Change

    Nine Months Ended   

Percentage
Change

 
    

September 30,

2006

  

October 1,

2005

     September 30,
2006
   October 1,
2005
  

Automated systems

   $ 19,076    $ 6,184    208 %   $ 40,336    $ 31,557    28 %

Integrated systems

     5,696      5,588    2 %     20,529      17,760    16 %

Total product revenue

     24,772      11,772    110 %     60,865      49,317    23 %

Service

     4,319      2,459    76 %     10,592      7,000    51 %
                                

Total net revenues

   $ 29,091    $ 14,231    104 %   $ 71,457    $ 56,317    27 %
                                

For the three months ended September 30, 2006, net revenues from automated systems increased from the comparable period in 2005 resulting from the additional revenues from Accent customers of $6.2 million and higher demand of $6.7 million for semiconductor process control equipment as semiconductor manufacturers continue their conversion to 300mm wafer to achieve better production efficiencies. We believe that increased consumer demand for high performance electronics drives technology advancement in semiconductor design and manufacturing, which has in turn, promoted the purchase of semiconductor capital equipment featuring the latest advances in technology. Service revenue increased $1.9 million as a result of our Accent and Soluris acquisitions, which contributed higher sales of parts and services, due in part to a large installed base of systems.

For the nine months ended September 30, 2006, net revenues from automated systems increased 28% as compared to the same period in 2005 resulting from the additional revenues from Accent customers and by higher demand for our automated products as semiconductor manufacturers continue their conversion to 300mm wafer to achieve better production efficiencies. The increase in revenues was partially offset by a decrease of $1.9 million of revenue included in the first half of fiscal 2005 due to the sale of our FPD business unit effective in October 2005. Sales of our integrated systems increased as our channel distributors continue to integrate our products with growing end customers’ demand. Service revenue increased as a result of our Accent and Soluris acquisitions and due to more customers signing up for post-warranty service contracts.

Gross margins. Our gross margin breakdown was as follows (in percent):

 

     Three Months Ended     Nine Months Ended  
     September 30,
2006
    October 1,
2005
    September 30,
2006
   

July 2,

2005

 

Products

   41 %   47 %   45 %   50 %

Services

   (11 )%   (7 )%   (7 )%   (12 )%

In the three and nine month periods ended September 30, 2006, the product gross margin decreased from the comparable periods of 2005 due to higher warranty costs as well as acquisition related charges of $1.6 million related to the intangible assets amortization for developed technology and backlog related to the Accent and Soluris acquisitions. Services gross margin decreased as compared to the same periods in 2005 as we have not been able to fully recover the higher costs associated with meeting our customers’ increasing service demands. The lower margins were partially offset by the positive service margins received from the Accent and Soluris operations.

 

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Operating expenses. Our operating expenses were comprised of the following categories (in thousands):

 

     Three Months Ended   

Percentage
Change

    Nine Months Ended    

Percentage
Change

 
     September 30,
2006
   October 1,
2005
    

September 30,

2006

  

October 1,

2005

   

Research and development

   $ 4,208    $ 3,291    28 %   $ 9,798    $ 10,126     (3 )%

Selling

     5,850      2,395    144 %     12,892      8,389     54 %

General and administrative

     5,447      3,348    63 %     14,303      7,746     85 %

Asset impairment

     —        —      —   %     —        2,232     (100 )%

Merger termination fee

     —        —      —   %     —        (8,300 )   (100 )%

Research and development. Research and development expenses for the three months ended September 30, 2006 increased $0.9 million over the comparable period of fiscal 2005. The increase in research and development expenses reflects the additional expenses of $1.4 million associated with Accent which was acquired on July 21, 2006 and $0.2 million of additional research and development expenses associated with the acquisition of Soluris on March 15, 2006, and stock-based compensation charges of $0.4 million related to our adoption in the first quarter of 2006 of SFAS 123(R), “Share-Based Payment”, or SFAS 123(R). The increases in research and development expenses were partially offset by our cost cutting initiatives undertaken in the fourth quarter of 2005 of $0.8 million including the reductions in headcount related expenses in the United States and the sale of our flat panel display business unit in Japan and its related research and development function of $0.2 million.

Research and development expenses for the nine months ended September 30, 2006 decreased $0.3 million over the comparable period of fiscal 2005. The decrease in research and development expenses reflects our cost cutting initiatives undertaken in the fourth quarter of 2005 including the sale of our flat panel display business unit in Japan and its related research and development function of $0.6 million and reductions in headcount related expenses in the United States. The reductions in research and development expenses were partially offset by the additional expenses of $1.4 million and $0.6 million associated with the acquisition of Accent and Soluris, respectively. We also incurred stock-based compensation charges of $0.9 million related to our adoption of SFAS 123(R).

Selling. Selling expenses for the three months ended September 30, 2006 increased $3.5 million over the comparable period of fiscal 2005 due to the addition of $1.4 million of selling expenses associated with the acquisitions of Accent on July 21, 2006 and $0.3 million of additional selling expenses associated with the acquisition of Soluris on March 15, 2006 as well as $0.8 of charges related to amortization of customer relationships and brand names intangible assets. In addition we incurred stock-based compensation charges of $0.3 million related to our adoption in the first quarter of 2006 of SFAS 123(R).

The increase in selling expenses for the nine months ended September 30, 2006 increased $4.5 million over the comparable period of fiscal 2005 due to the addition of $1.9 million associated with our acquisitions of Accent on July 21, 2006 and $1.2 million associated with Soluris on March 15, 2006. In addition we have incurred stock-based compensation charges of $0.7 million related to our adoption of SFAS 123(R).

General and administrative. General and administrative expenses for the three and nine months ended September 30, 2006 increased $2.1 million and $6.5 million, respectively over the comparable periods of fiscal 2005. For the three months ended September 30, 2006 the increase in expenses was due to $1.1 million of additional general and administrative expense from Accent and Soluris operations, higher legal expenses of $0.3 million associated with our patent infringement lawsuits with KLA Tencor Corporation and with Nova Measuring Instruments Ltd., increased headcount-related expenses of $0.6 million as we have expanded and enhanced our finance and administrative functions and stock-based compensation charges of $0.6 million related to our adoption of SFAS 123(R) partially offset by lower charges for professional services associated with compliance with regulatory requirements under the Sarbanes Oxley Act of 2002 of $0.5 million.

For the nine months ended September 30, 2006 we incurred increased headcount-related expenses of $2.2 million as we have expanded and enhanced our finance and administrative functions, higher legal expenses of $1.6 million associated with our patent infringement lawsuits with KLA Tencor Corporation and with Nova Measuring Instruments Ltd., additional general and administrative expense from our acquisitions of Accent and Soluris of $1.5 million, stock-based compensation charges of $1.4 million related to our adoption of SFAS 123(R) and $0.3 million of higher charges for professional services associated with compliance with regulatory requirements under the Sarbanes Oxley Act.

Merger termination fee. On January 21, 2005, we entered into a definitive merger agreement with August Technology Corporation. On June 28, 2005, we and August Technology Corporation announced the termination of the

 

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merger agreement. On that date, in accordance with the terms of the merger agreement, August Technology paid us a merger termination fee of $8.3 million plus $2.6 million as reimbursement of our expenses associated with the merger agreement which we had capitalized in the first and second quarters of 2005.

Asset impairment. During the three months ended July 2, 2005 we recorded an asset impairment charge of $2.2 million related to certain assets in our FPD business unit. Under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we should assess the recoverability of assets when events become known which would indicate potential impairment. We evaluated the estimated future cash flows of certain asset groups in our FPD business unit and determined the undiscounted estimated future cash flows would be insufficient to recover the carrying value of those assets. The impairment charge was measured based on the excess carrying value of the asset groups in excess of the associated discounted future cash flows. Accordingly, we recorded an asset impairment charge during the second quarter of 2005.

Other income (expense). Our net other income (expense) consisted of the following categories (in thousands):

 

     Three Months Ended     Nine Months Ended  
     September 30,
2006
   

October 1,

2005

    September 30,
2006
   

October 1,

2005

 

Interest income

   $ 156     $ 288     $ 787     $ 611  

Interest expense

     (13 )     —         (44 )     (35 )

Foreign exchange gain (loss)

     (501 )     (22 )     (480 )     (506 )

Other income (loss)

     (147 )     4       105       12  
                                

Total other income (expense), net

   $ (505 )   $ 270     $ 368     $ 82  

The lower interest income is due to lower average cash and investment balances and higher yields obtained on our investments. Interest expenses relate to our debt obligations in Japan and are expected to decrease, before exchange rate adjustments, with the balance of the debt. With the acquisition of Accent, we incurred foreign exchange losses due to exchange rate fluctuations associated with extensive intercompany balances assumed with the transaction. Other income (expense) includes a gain on the sale of assets, commission income and rental income and miscellaneous expenses.

Provision for income taxes. Income tax provisions for interim periods are based on the Company’s estimated annual income tax rate. The income tax provision of $0.3 million on a pre-tax loss of $9.7 million for the nine months ended September 30, 2006 was a result of foreign taxes. For the comparable period of 2005, the Company recorded an income tax provision of $0.4 million reflecting the Company’s obligation for foreign taxes and U.S. Federal alternative minimum taxes. The estimated annual tax rate differs from the combined United States federal and state statutory income tax rate of 40% primarily due to estimated utilization of the Company’s net operating losses and various tax credits and reduction of the associated deferred tax valuation allowance. We have established significant valuation allowances for our deferred tax assets and we will continue to assess the realizability of our deferred tax assets particularly if we establish a pattern of profitability in future quarters.

Liquidity and Capital Resources

At September 30, 2006, our cash and cash equivalents totaled $15.1 million as compared to $40.4 million at December 31, 2005. At September 30, 2006, we had working capital of $56.7 million compared to $76.7 million at December 31, 2005. The $25.8 million decrease in cash, cash equivalents and investments for the nine months ended September 30, 2006 resulted primarily from cash used in operating activities of $8.4 million, costs associated with our acquisitions of Soluris and Accent Optical of $7.5 million and repayment of debt of $15 million in connection with the Accent merger, partially offset by maturities of short term investments of $5.0 million and the sale of shares under our employee stock option and purchase plans of $1.1 million. As the Company has successfully closed both the Soluris and Accent Optical transactions, the ongoing need for cash associated with these transactions is expected to be substantially reduced.

We maintain arrangements under which eligible accounts receivable are sold without recourse to unrelated third-party financial institutions. The sale of these receivables accelerates our cash collection and reduces our credit exposure. See note 5 of the Condensed Consolidated Financial Statements for more information.

Net cash used in operating activities was $8.4 million for the nine months ended September 30, 2006, compared to net cash provided by operating activities of $9.8 million for the nine months ended October 1, 2005. Cash used in operating activities during the nine months ended September 30, 2006 was comprised of a net loss of $10.0 million, increases in working capital of $6.2 million offset by non-cash expenses of $7.8 million. The higher non-cash expenses were driven by depreciation and amortization of acquired intangible associated with our acquisitions of Accent and Soluris of $4.2 and by stock-based compensation of $3.4 million. For comparison, cash provided by operating activities during the nine months ended October 1, 2005 was comprised of net income of $3.6 million, non-cash expenses of $4.1 million including an asset impairment charge of $2.2 million, offset by uses of cash for working capital of $1.9 million.

 

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Cash used by investing activities was $3.0 million for the nine months of September 30, 2006 due to cash outlays of $7.5 million related to our acquisitions of Soluris and Accent Optical Technologies and purchases of property, plant and equipment of $0.4 million, partially offset, by maturities of short-term investments in the amount of $5.0 million. In comparison, investing activities used $8.0 million in the nine months ended October 1, 2005, primarily due to purchases of short-term investments of $44.8 million and purchases of property, plant and equipment offset by sales of short-term investments in the amount of $37.0 million.

Financing activities used $14.3 million for the nine months ended September 30, 2006 due to repayments of short-term and long-term debt in Japan of $1.4 million and repayment of $14.0 million of debt assumed in the Accent merger. These amounts were partially offset by proceeds from the sale of stock from the exercise of employee stock options of $1.1 million. In comparison, financing activities provided $3.2 million for the nine months ended October 1, 2005, due to borrowings of $1.8 million under our line of credit in Japan and the proceeds from issuance of stock from the exercise of employee stock options of $2.6 million, which were offset to some extent by repayment of $1.2 million of long-term debt in Japan.

We have evaluated and will continue to evaluate the acquisition of products, technologies or businesses that are complementary to our business. These activities may result in product and business investments, which may affect our cash position and working capital balances. Some of these activities might require significant cash outlays. However, we believe that our current working capital will be sufficient to maintain current and planned operations through at least the next twelve months. We may require additional cash to fund acquisitions or investment opportunities or other events. In these instances, we may seek to raise such additional funds through public or private equity or debt financings or from other sources. We may not be able to obtain adequate or favorable financing at that time. Any equity financing we obtain may dilute your ownership interests and any debt financing could contain covenants that impose limitations on the conduct of our business.

Contractual Obligations

The following table summarizes our contractual cash obligations as of September 30, 2006, and the effect such obligations are expected to have on liquidity and cash flow in future periods (in thousands):

 

     Total    Remaining
three months of
fiscal 2006
   1-3 Years    4-5 Years   

More than

5 Years

Debt obligations (1)

   $ 1,567    $ 97    $ 1,124    $ 346    $ —  

Operating leases

     2,083      1,003      1,080      —        —  
                                  

Total

   $ 3,650    $ 1,100    $ 2,204    $ 346    $ —  

(1) Our debt obligations primarily relate to the expansion of our Japanese facilities and include related interest.

We maintain certain open inventory purchase commitments with our suppliers to ensure a smooth and continuous supply chain for key components. Our liability in these purchase commitments is generally restricted to a forecasted time-horizon as mutually agreed upon between the parties. This forecast time-horizon can vary among different suppliers. We estimate our open inventory purchase commitment as of September 30, 2006 was approximately $13.3 million. Actual expenditures will vary based upon the volume of the transactions and length of contractual service provided. In addition, the amounts paid under these arrangements may be less in the event that the arrangements are renegotiated or cancelled. Certain agreements provide for potential cancellation penalties.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk does not differ materially from that discussed in our Annual Report as Form 10-K for the year ended December 31, 2005. With the Accent and Soluris acquisitions, the Company has assumed greater foreign exchange currency exposure from operations in overseas locations. However, we cannot give any assurance as to the effect that future changes in interest rates or foreign currency rates will have on our consolidated financial position, results of operations or cash flows.

 

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of September 30, 2006 (the “Evaluation Date”), an evaluation was carried out under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”). There are inherent limitations to the effectiveness of any system of disclosure controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable, not absolute, assurance of achieving their control objectives. However, because our remediation of the material weakness identified in the fourth quarter of fiscal 2005 and described below is not yet complete, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures were not effective as of the end of the period covered by this report.

Changes in Internal Controls

As disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2005. As a result of such evaluation, management identified a material weakness in our internal control over financial reporting as of December 31, 2005 related to our Japan operations. Specifically, internal control weaknesses in Japan included the lack of:

 

    sufficient sample size for testing before our year-end due to late remediation of controls,

 

    review of Japanese language sales documentation by U.S. personnel,

 

    evidence regarding tracking of inventory movements,

 

    segregation of duties in cash disbursements, purchasing and inventory activities and posting of journal entries,

 

    availability of supporting documentation for non-inventory purchases due to our office move and personnel turnover, and

 

    control over service/parts sales processing.

These control weaknesses did not result in the recording of any year-end audit adjustments prior to the issuance of our consolidated financial statements.

During the three months ended September 30, 2006, we have taken the following steps to remediate the material weakness described above:

 

    added Japanese financial personnel with experience in US GAAP reporting requirements,

 

    increased oversight and monitoring of accounting procedures and review of our Japanese operations,

 

    increased operating controls surrounding the movement of service parts inventory, and

 

    enhanced segregation of duties within the existing enterprise resource planning system.

While we have made significant improvements to our internal control over financial reporting related to our Japan operations during fiscal 2006, we now expect all changes in internal controls to be fully implemented by the quarter ended December 30, 2006 and testing of our internal controls subsequent to this date will determine whether the controls are operating effectively at our Japanese location.

Other than as noted above, there were no changes in our internal control over financial reporting during the three months ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On March 9, 2005, Nova Measuring Instruments Ltd., or Nova, filed suit against us in the United States District Court for the Northern District of California. The complaint alleges that certain of our products infringe a Nova patent and seeks a preliminary and permanent injunction against their sale and unspecified damages. We do not believe any of our products infringe any valid claim of the Nova patent. We intend to vigorously and aggressively defend ourselves in the litigation. While the results of such litigation matters and claims cannot be predicted with certainty, we believe the final outcome of such matters will not have a material adverse impact on our financial position or results operations.

 

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In August 2005, KLA-Tencor Corporation, or KLA, filed a complaint against us in the United States District Court for the Northern District of California. The complaint alleges that certain of our products infringe two of KLA’s patents. On January 30, 2006, KLA added a third patent to their claim. The complaint seeks a preliminary and permanent injunction against the sale of these products as well as the recovery of monetary damages and attorneys’ fees. We do not believe that any of our products infringe the intellectual property of any third party and we intend to vigorously and aggressively defend ourselves in the litigation. As part of such defense, we have filed a request for re-examination of the three allegedly infringed KLA-Tencor patents with the U.S. Patent & Trademark Office, or PTO. These requests for re-examination were recently accepted for review by the PTO. In March 2006, we filed a motion for and were granted a stay in the patent litigation case until such re-examination is completed.

On March 29, 2006, we filed suit against Nova in the United States District Court for the Northern District of California. The complaint alleges that certain of Nova’s products infringe one of our patents relating to ultraviolet reflectometry and optical critical dimension tools, and seeks damages. On October 11, 2006, we filed another complaint in the United States District Court for the Northern District of California against Nova for patent infringement. The patents at issue relate to Nanometrics’ optical critical dimension technology, commonly referred to as scatterometry.

ITEM 1A. RISK FACTORS

You should carefully consider the risks described below together with all of the other information included in this Quarterly Report on Form 10-Q before making an investment decision. The risks and uncertainties described below are not the only ones that we face. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. In such case, the trading price of our common stock could decline, and you could lose all or part of your investment.

Risks Related to Our Business

Cyclicality in the semiconductor industry has led to substantial fluctuations in demand for our systems and may, from time to time, continue to do so.

Our operating results have varied significantly from period to period due to the cyclical nature of the semiconductor industry. The majority of our business depends upon the capital expenditures of semiconductor device and equipment manufacturers. These manufacturers’ capital expenditures, in turn, depend upon the current and anticipated market demand for semiconductors and products using semiconductors. The semiconductor industry is cyclical and has historically experienced periodic downturns. These downturns have often resulted in substantial decreases in the demand for semiconductor manufacturing equipment, including metrology systems. We have found that the resulting decrease in capital expenditures has typically been more pronounced than the downturn in semiconductor device industry revenues. We expect the cyclical nature of the semiconductor industry, and therefore, our business, to continue in the foreseeable future.

Because we derive a significant portion of our revenues from sales in Asia, our revenues and results of operations could be adversely affected by the instability of Asian economies.

Revenues from customers in Asian markets represented approximately 65.5%, 68.8% and 72.7% of our total net revenues in 2005, 2004 and 2003, respectively. Countries in the Asia Pacific region, including Japan, South Korea and Taiwan, each of which accounted for a significant portion of our business in that region, experienced general economic weaknesses in 2002 and 2003, which adversely affected our revenues at that time. We anticipate that we will continue to rely upon customers in Asia for a majority of our revenues and any future weaknesses or instabilities in the economies of countries in Asia may continue to have a material adverse effect on our results of operations and financial condition.

We depend on Applied Materials, Inc. and other OEM suppliers for sales of our integrated metrology systems, and the loss of Applied Materials or any of our other OEM suppliers as a customer could harm our business.

We believe that sales of integrated metrology systems will continue to be an important source of our revenues. Sales of our integrated metrology systems depend upon the ability of Applied Materials to sell semiconductor equipment products that include our metrology systems as components. If Applied Materials is unable to sell such products, or if Applied Materials chooses to focus its attention on products that do not integrate our systems, our business could suffer. If we were to lose Applied Materials as a customer for any reason, our ability to realize sales from integrated metrology systems would be significantly diminished, which would harm our business.

 

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Our largest customers account for a substantial portion of our revenue, and our revenue would materially decline if one or more of these customers were to purchase significantly fewer of our systems or if they delayed or cancelled a large order.

Historically, a significant portion of our revenues in each quarter and each year has been derived from sales to a relatively few number of customers, and we expect this trend to continue. There are only a limited number of large companies operating in the semiconductor industry. Accordingly, we expect that we will continue to depend on a small number of large customers for a significant portion of our revenues for the foreseeable future. If any of our key customers were to purchase significantly fewer systems, or if a large order were delayed or cancelled, our revenues could significantly decline. In 2005, sales to Applied Materials accounted for 20.6% and sales to Samsung accounted for 15.9% of our total net revenues, respectively. In 2004, sales to Applied Materials accounted for 21.4% and sales to Samsung accounted for 14.7% of our total net revenues, respectively. In 2003, sales to Applied Materials accounted for 15.4% and sales to Hynix accounted for 12.0% of our total net revenues, respectively.

The success of our product development efforts depends on our ability to anticipate market trends and the price, performance and functionality requirements of semiconductor device manufacturers. In order to anticipate these trends and ensure that critical development projects proceed in a coordinated manner, we must continue to collaborate closely with our customers. Our relationships with our customers provide us with access to valuable information regarding industry trends, which enables us to better plan our product development activities. If our current relationships with our large customers are impaired, or if we are unable to develop similar collaborative relationships with important customers in the future, our long-term ability to produce commercially successful systems could be adversely affected.

If we are unable to successfully address the material weakness in our internal controls, our ability to report our financial results on a timely and accurate basis may be adversely affected. As a result, current and potential stockholders could lose confidence in our financial reporting which could have a material adverse effect on our business, operating results and stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal controls over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal controls over financial reporting in all annual reports. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management’s assessment of our internal controls over financial reporting.

A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, involving Nanometrics have been, or will be, detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and we cannot assure you that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

For the year ended December 31, 2005, our management concluded that there was a material weakness regarding the internal controls of our Japanese operations. A material weakness means that there is more than a remote likelihood that a material misstatement to our annual or interim financial statements would not be detected or prevented. Our management has identified certain steps designed to address our material weakness, and has been executing on remediation plans.

Any failure to implement in a timely manner and maintain the improvements in the controls over our financial reporting that we are currently putting in place, or difficulties encountered in the implementation of these improvements in our controls, could cause us to fail to meet our reporting obligations, to fail to produce reliable financial reports or to prevent fraud. Any failure to improve our internal controls to address this identified weakness could also cause investors to lose confidence in our reported financial information, which could have a negative impact on our business, operating results and stock price.

Our current and potential competitors have significantly greater resources than we do, and increased competition could impair sales of our products.

We operate in the highly competitive semiconductor industry and face competition from a number of companies, many of which have greater financial, engineering, manufacturing, marketing and customer support resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or market developments by devoting greater resources to the development, promotion and sale of products, which could impair sales of our products. Moreover, there has been merger and acquisition activity among our competitors and potential competitors. These

 

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transactions by our competitors and potential competitors may provide them with a competitive advantage over us by enabling them to rapidly expand their product offerings and service capabilities to meet a broader range of customer needs. Many of our customers and potential customers in the semiconductor industry are large companies that require global support and service for their metrology systems. Some of our larger or more geographically diverse competitors might be better equipped to provide this global support.

If any of our systems fail to meet or exceed our internal quality specifications, we cannot ship them until such time as they have met such specifications. If we experience significant delays or are unable to ship our products to our customers as a result of our internal processes, or for any other reason, our business and reputation may suffer.

Our products are complex and require technical expertise to design and manufacture properly. Various problems occasionally arise during the manufacturing process that may cause delays and/or impair product quality. We must actively monitor our manufacturing processes to ensure that our products meet our internal quality specifications. Any significant delays stemming from the failure of our products to meet or exceed our internal quality specifications, or for any other reasons, would delay our shipments. Shipment delays could harm our business and reputation in the industry.

If we deliver systems with defects, our credibility will be harmed, revenue from, and market acceptance of, our systems will decrease and we could expend significant capital and resources as a result of such defects.

Notwithstanding our internal quality specifications, our systems have sometimes contained errors, defects and bugs when introduced. If we deliver systems with errors, defects or bugs, our credibility and the market acceptance and sales of our systems would be harmed. Further, if our systems contain errors, defects or bugs, we may be required to expend significant capital and resources to alleviate such problems. Defects could also lead to product liability as a result of product liability lawsuits against us or against our customers. We have agreed to indemnify our customers in some circumstances against liability arising from defects in our systems. In the event of a successful product liability claim, we could be obligated to pay damages significantly in excess of our product liability insurance limits.

Successful infringement claims by third parties could result in substantial damages, lost product sales and the loss of important intellectual property rights by us.

Our commercial success depends, in part, on our ability to avoid infringing or misappropriating patents or other proprietary rights owned by third parties. From time to time we may receive communications from third parties asserting that our metrology systems may contain design features which are claimed to infringe on their proprietary rights. For example, we announced on March 14, 2005 that we had received notice of a patent infringement lawsuit brought by Nova Measuring Instruments, Ltd., alleging infringement of United States Patent No. 6,752,689. In August 2005, we were served with a complaint by KLA-Tencor Corporation alleging that certain of our products infringe two of KLA’s patents, Patent No. 6,483,580 and Patent No. 6,590,656. In January 2006, KLA added Patent No. 6,611,330 to its claim. There can be no assurance that Nanometrics’ new or current products do not infringe any valid intellectual property rights. Even if our products do not infringe, we may be required to expend significant sums of money to defend against infringement claims, as in the Nova Measuring Instruments, Ltd. lawsuit described above, or to actively protect our intellectual property rights through litigation.

We obtain some of the components and subassemblies included in our systems from a single source or a limited group of suppliers, and the partial or complete loss of one of these suppliers could cause production delays and significant loss of revenue.

We rely on outside vendors to manufacture many components and subassemblies. Certain components, subassemblies and services necessary for the manufacture of our systems are obtained from a sole supplier or limited group of suppliers. We do not maintain any long-term supply agreements with any of our suppliers. We have entered into arrangements with J.A. Woollam Company for the purchase of the spectroscopic ellipsometer component incorporated in our advanced measurement systems. Our reliance on a sole or a limited group of suppliers involves several risks, including the following:

 

    we may be unable to obtain an adequate supply of required components;

 

    we have reduced control over pricing and the timely delivery of components and subassemblies; and

 

    our suppliers may be unable to develop technologically advanced products to support our growth and development of new systems.

Some of our suppliers have relatively limited financial and other resources. Because the manufacturing of certain of these components and subassemblies involves extremely complex processes and requires long lead times, we may experience delays or shortages caused by our suppliers. If we were forced to seek alternative sources of supply or to manufacture such components or subassemblies internally, we could be forced to redesign our systems, which could cause production delays

 

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and prevent us from shipping our systems to customers on a timely basis. Any inability to obtain adequate deliveries from our suppliers, or any other circumstance that would restrict our ability to ship our products, could damage relationships with current and prospective customers, harm our business and result in significant loss of revenue.

Variations in the amount of time it takes for us to sell our systems may cause fluctuations in our operating results, which could adversely affect our stock price.

Variations in the length of our sales cycles could cause our revenues to fluctuate widely from period to period. Our customers generally take long periods of time to evaluate our metrology systems. We expend significant resources educating and providing information to our prospective customers regarding the uses and benefits of our systems. The length of time that it takes for us to complete a sale depends upon many factors, including:

 

    the efforts of our sales force and our independent sales representatives;

 

    the complexity of the customer’s metrology needs;

 

    the internal technical capabilities and sophistication of the customer;

 

    the customer’s budgetary constraints; and

 

    the quality and sophistication of the customer’s current processing equipment.

Because of the number of factors influencing the sales process, the period between our initial contact with a customer and the time at which we recognize revenue from that customer, if at all, varies widely. Our sales cycles, including the time it takes for us to build a product to customer specifications after receiving an order, typically range from three to six months. Occasionally our sales cycles can be much longer, particularly with customers in Asia who may require longer evaluation periods. During the sales cycles, we commit substantial resources to our sales efforts in advance of receiving any revenue, and we may never receive any revenue from a customer despite our sales efforts.

If we do complete a sale, customers often purchase only one of our systems and then evaluate its performance for a lengthy period of time before purchasing additional systems. The purchases are generally made through purchase orders rather than through long-term contracts. The number of additional products that a customer purchases, if any, depends on many factors, including a customer’s capacity requirements. The period between a customer’s initial purchase and any subsequent purchases is unpredictable and can vary from three months to a year or longer. Variations in the length of this period could cause fluctuations in our operating results, which could adversely affect our stock price.

Relatively small fluctuations in our system sales volume may cause our operating results to vary significantly each quarter.

During any quarter, a significant portion of our revenue is derived from the sale of a relatively small number of systems. Our automated metrology systems range in price from approximately $200,000 to over $1,000,000 per system, our integrated metrology systems range in price from approximately $80,000 to $400,000 per system and our tabletop metrology systems range in price from approximately $50,000 to $200,000 per system. Accordingly, a small change in the number or mix of systems that we sell could cause significant changes in our operating results.

We depend on orders that are received and shipped in the same quarter, and therefore our results of operations may be subject to significant variability from quarter to quarter.

Our net sales in any given quarter depend upon a combination of orders received in that quarter for shipment in that quarter and shipments from backlog. Our backlog at the beginning of each quarter does not include all systems sales needed to achieve expected revenues for that quarter. Consequently, we are dependent on obtaining orders for systems to be shipped in the same quarter that the order is received. Moreover, customers may reschedule shipments, and production difficulties could delay shipments. Accordingly, we have limited visibility into future product shipments, and our results of operations may be subject to significant variability from quarter to quarter.

Because of the high cost of switching equipment vendors in our markets, it is sometimes difficult for us to attract customers from our competitors even if our metrology systems are superior to theirs.

We believe that once a semiconductor customer has selected one vendor’s metrology system, the customer generally relies upon that system and, to the extent possible, subsequent generations of the same vendor’s system, for the life of the application. Once a vendor’s metrology system has been installed, a customer must often make substantial technical modifications and may experience downtime in order to switch to another vendor’s metrology system. Accordingly, unless our systems offer performance or cost advantages that outweigh a customer’s expense of switching to our systems, it will be difficult for us to achieve significant sales from that customer once it has selected another vendor’s system for an application.

 

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If we are not successful in developing new and enhanced metrology systems we will likely lose market share to our competitors.

We operate in an industry that is subject to technological changes, changes in customer demands and the introduction of new, higher performance systems with short product life cycles. To be competitive, we must continually design, develop and introduce in a timely manner new metrology systems that meet the performance and price demands of semiconductor manufacturers and suppliers. We must also continue to refine our current systems so that they remain competitive. We may experience difficulties or delays in our development efforts with respect to new systems, and we may not ultimately be successful in developing them. Any significant delay in releasing new systems could adversely affect our reputation, give a competitor a first-to-market advantage or cause a competitor to achieve greater market share.

Lack of market acceptance for our new products may affect our ability to generate revenue and may harm our business.

We have recently introduced several products to the market including the Atlas-M and Orion. We have invested substantial time and resources into the development of these products. However, we cannot accurately predict the future level of acceptance of our new products by our customers. As a result, we may not be able to generate anticipated revenue from sales of these products. While we anticipate that our new products will become an increasingly larger component of our business, their failure to gain acceptance with our customers could materially harm our business. Additionally, if our new products do gain market acceptance, our ability to sell our existing products may be impeded. As a result, there can be no assurance that the introduction of these products will be commercially successful or that these products will result in significant additional revenues or improved operating margins in future periods.

Our intellectual property may be infringed upon by third parties despite our efforts to protect it, which could threaten our future success and competitive position and adversely affect our operating results.

Our future success and competitive position depend in part upon our ability to obtain and maintain proprietary technology for our principal product families, and we rely, in part, on patent, trade secret and trademark law to protect that technology. If we fail to adequately protect our intellectual property, it will be easier for our competitors to sell competing products. We own or may license patents relating to our metrology systems, and have filed applications for additional patents. Any of our pending patent applications may be rejected, and we may not in the future be able to develop additional proprietary technology that is patentable. In addition, the patents we own, have been issued, or may license may not provide us with competitive advantages and may be challenged by third parties. Third parties may also design around these patents.

In addition to patent protection, we rely upon trade secret protection for our confidential and proprietary information and technology. We routinely enter into confidentiality agreements with our employees. However, in the event that these agreements may be breached, we may not have adequate remedies. Our confidential and proprietary information and technology might also be independently developed by or become otherwise known to third parties. We may be required to initiate litigation in order to enforce any patents issued to or licensed by us, or to determine the scope or validity of a third party’s patent or other proprietary rights. Any such litigation, regardless of outcome, could be expensive and time consuming, and could subject us to significant liabilities or require us to re-engineer our product or obtain expensive licenses from third parties, any of which would adversely affect our business and operating results.

If we choose to acquire new and complementary businesses, products or technologies instead of developing them ourselves, we may be unable to complete these acquisitions or may not be able to successfully integrate an acquired business in a cost-effective and non-disruptive manner.

Our success depends on our ability to continually enhance and broaden our product offerings in response to changing technologies, customer demands and competitive pressures. To achieve this, from time to time we have acquired complementary businesses, products, or technologies instead of developing them ourselves and may choose to do so in the future. For example, we recently consummated our merger with Accent Optical, a leading supplier of process control and metrology systems to the global semiconductor manufacturing industry. At the outset, we do not know if we will be able to complete any acquisitions, or whether we will be able to successfully integrate any acquired business, operate them profitably or retain their key employees. Integrating any business, product or technology that we acquire could be expensive and time consuming, disrupt our ongoing business and distract our management. In addition, in order to finance any acquisitions, we may be required to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on terms that are not favorable to us and, in the case of an equity financing, that result in dilution to our stockholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business will suffer.

 

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We must attract and retain key personnel with relevant industry knowledge to help support our future growth.

Our success depends to a significant degree upon the continued contributions of our key management, engineering, sales and marketing, customer support, finance and manufacturing personnel. We generally do not enter into employment contracts with any of our key personnel. The loss of any of these key personnel, who would be difficult to replace, could harm our business and operating results. To support our future growth, we will need to attract and retain additional qualified employees. Competition for such personnel in our industry is ongoing, and we may not be successful in attracting and retaining qualified employees.

We manufacture all of our systems at a limited number of facilities, and any prolonged disruption in the operations of those facilities could reduce our revenues.

We produce all of our systems in our manufacturing facilities located in Milpitas, California, York, England and, to a lesser extent, through our subsidiary in South Korea and, beginning with our acquisition of Soluris in March 2006, in Concord, Massachusetts, and our contract manufacturer in Japan. Our manufacturing processes are highly complex and require sophisticated, costly equipment and specially designed facilities. As a result, any prolonged disruption in the operations of our manufacturing facilities, such as those resulting from a severe fire or earthquake, could seriously harm our ability to satisfy our customer order deadlines.

Our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States.

In 2005, 2004 and 2003, 66.7%, 71.8% and 74.8%, respectively, of our total net revenues were derived from sales to customers in foreign countries, including certain countries in Asia, such as Japan, South Korea and Taiwan, The laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States, and many U.S. companies have encountered substantial problems in protecting their proprietary rights against infringement in such countries. If we fail to adequately protect our intellectual property in these countries, it would be easier for our competitors to sell competing products.

Continuing economic and political instability could affect our business and results of operations.

The ongoing threat of terrorism targeted at the United States or other regions where we conduct business increases the uncertainty in our markets and the economy in general. This uncertainty is likely to result in economic stagnation, which would harm our business. In addition, increased international political instability may hinder our ability to do business by increasing our costs of operations. For example, our transportation costs, insurance costs and sales efforts may become more expensive as a result of geopolitical tension. These tensions may also negatively affect our suppliers and customers. If this international economic and political instability continues or increases, our business and results of operations could be harmed.

We incur increased costs as a result of changes in laws and regulations affecting public companies.

Compliance with changes in laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, has resulted in and, we expect, will continue to result in increased accounting, legal and administrative costs. In particular, Section 404 of the Sarbanes-Oxley Act of 2002 and the rules of the Securities and Exchange Commission and the Public Company Accounting Oversight Board impose requirements with respect to the evaluation of the effectiveness of our internal controls. The cost of complying with these requirements is substantial.

Our results of operations could vary as a result of the methods, estimates and judgments we use in applying our accounting policies.

The methods, estimates and judgments we use in applying our accounting policies have a significant impact on our results of operations, see “Critical Accounting Policies” in Part I, Item 2 of this Form 10-Q. Such methods, estimates and judgments are, by their nature, subject to substantial risks, uncertainties and assumptions, and factors may arise over time that lead us to change our methods, estimates and judgments. Changes in those methods, estimates and judgments could significantly affect our results of operations. In particular, the calculation of share-based compensation expense under SFAS No. 123(R) requires us to use valuation methodologies (which were not developed for use in valuing employee stock options) and a number of assumptions, estimates and conclusions regarding matters such as expected forfeitures, expected volatility of our share price, the expected dividend rate with respect to our common stock and the exercise behavior of our employees. Furthermore, there are no means, under applicable accounting principles, to compare and adjust our expense if and when we learn of additional information that may affect the estimates that we previously made, with the exception of changes in expected forfeitures of share-based awards. Factors may arise over time that lead us to change our estimates and assumptions

 

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with respect to future share-based compensation arrangements, resulting in variability in our share-based compensation expense over time. Changes in forecasted share-based compensation expense could impact our gross margin percentage; research and development expenses; marketing, general and administrative expenses; and our tax rate.

Our quarterly operating results have varied in the past and probably will continue to vary significantly in the future, which will cause volatility in our stock price.

Our quarterly operating results have varied significantly in the past and are likely to vary in the future, which volatility could cause our stock price to decline. Some of the factors that may influence our operating results and subject our stock to extreme price and volume fluctuations include:

 

    changes in customer demand for our systems;

 

    economic conditions in the semiconductor industries;

 

    the timing, cancellation or delay of customer orders and shipments;

 

    market acceptance of our products and our customers’ products;

 

    competitive pressures on product prices and changes in pricing by our customers or suppliers;

 

    the timing of new product announcements and product releases by us or our competitors and our ability to design, introduce and manufacture new products on a timely and cost-effective basis;

 

    the timing of acquisitions of businesses, products or technologies;

 

    the levels of our fixed expenses, including research and development costs associated with product development, relative to our revenue levels; and

 

    fluctuations in foreign currency exchange rates, particularly the Japanese yen.

If our operating results in any period fall below the expectations of securities analysts and investors, the market price of our common stock would likely decline.

We are highly dependent on international sales and operations, which exposes us to foreign political and economic risks.

Sales to customers in foreign countries accounted for approximately 66.7%, 71.8% and 74.8% of our total net revenues in 2005, 2004 and 2003, respectively. We maintain facilities in Japan, Taiwan, South Korea and the European Union. We anticipate that international sales will continue to account for a significant portion of our revenues. International sales and operations carry inherent risks such as: regulatory limitations imposed by foreign governments, obstacles to the protection of our intellectual property, political, military and terrorism risks, disruptions or delays in shipments caused by customs brokers or other government agencies, unexpected changes in regulatory requirements, tariffs, customs, duties and other trade barriers, difficulties in staffing and managing foreign operations, and potentially adverse tax consequences resulting from changes in tax laws. If any of these risks materialize and we are unable to manage them, our international sales and operations would suffer.

We are exposed to fluctuations in the exchange rates of foreign currency.

As a global concern, we face exposure to adverse movements in foreign currency exchange rates. With our operations in Japan, South Korea, Taiwan and with the acquisition of Soluris and Accent, the European Union and Singapore, a significant percentage of our cash flows are exposed to foreign currency risk. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results and cash flow.

We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business, operating results and financial condition.

Some of our operations use substances regulated under various federal, state, local, and international laws governing the environment, including those relating to the storage, use, discharge, disposal, labeling, and human exposure to hazardous and toxic materials. We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental laws. Liability under environmental laws can be joint and several and without regard to comparative fault. Compliance with current or future environmental laws and regulations could restrict our ability to expand our facilities or require us to acquire additional expensive equipment, modify our manufacturing processes, or incur other significant expenses. There can be no assurance that violations of environmental laws or regulations will not occur in the future as a result of the inability to obtain permits, human error, equipment failure or other causes.

 

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Risks Relating to our Recently Completed Merger with Accent Optical Technologies, Inc.

Nanometrics has incurred significant costs in connection with the merger.

We incurred direct transaction costs of $2.2 million in connection with the merger of which approximately $2.0 million had been paid as of September 30, 2006. We believe that the combined company will continue to incur charges to operations to reflect the costs of integrating the two companies, but cannot reasonably estimate those costs at this time,. There can be no assurance that the combined company will not incur additional material charges in subsequent quarters to reflect additional costs associated with the merger.

The combined company must continue to retain and motivate executives and key employees and recruit new employees, and failure to do so could seriously harm the combined company.

In order to be successful, the combined company must continue to retain and motivate executives and other key employees and recruit new employees. Employees of the combined company may experience uncertainty about their future roles during the integration period after closing. These potential distractions may adversely affect the combined company’s ability to attract, motivate and retain executives and key employees and keep such executives and key employees focused on strategic corporate goals. Any failure by the combined company to retain and motivate executives and key employees could seriously harm our business.

The merger may cause customers, distributors, resellers and others to delay or defer decisions concerning purchases from the combined company, which may harm the combined company’s results of operations.

Customers, distributors, resellers and others may be uncertain about the combined company’s plans for each of Nanometrics’ and Accent Optical’s products. This uncertainty may cause customers, distributors, resellers and others to delay or defer purchasing decisions, or elect to switch to other suppliers, which could negatively affect the businesses and results of operations of the combined company. Prospective customers might also be reluctant to purchase the combined company’s products due to uncertainty about the direction of its products and its willingness to support and service existing products. Customers, distributors, resellers and others may also seek to change existing agreements with Nanometrics or Accent Optical as a result of the merger. These and other actions by customers, distributors, resellers and others could negatively affect the businesses and results of operations of Nanometrics and/or Accent Optical.

Significant amounts of goodwill and intangible assets after the completion of Accent Optical transaction could make our reported results more volatile.

Goodwill is tested for impairment annually or when an event occurs indicating the potential for impairment. The evaluation is prepared based on our current and projected performance for the identified reporting units. The fair value of our reporting units is determined using a combination of the cash flow and market comparable approaches. If we conclude at any time that the carrying value of our goodwill and other intangible assets for any of our reporting units exceeds its implied fair value, we will be required to recognize an impairment, which could materially reduce operating income and net income in the period in which such impairment is recognized.

In the application of these methodologies, we were required to make estimates of future operating trends and judgments on discount rates and other variables. Actual future results and other assumed variables could differ from these estimates, including changes in the economy, the business environment in which we operate, and/or our own relative performance. Any differences in actual results compared to our estimates could result in further future impairments. Accordingly, our future earnings may be subject to significant volatility, particularly on a period-to-period basis.

Governmental authorities could seek to challenge the merger.

Even though the merger has been completed, government authorities could seek to challenge the merger, impose conditions or require asset divestitures as they deem necessary or desirable in the public interest. In addition, in some jurisdictions, a competitor, customer or other third party could initiate a private action under the antitrust laws challenging the merger. We may not prevail in such action, and significant legal fees and costs may be incurred even if we are ultimately successful.

Challenges involved in integrating Accent Optical’s finance organization may negatively impact Nanometrics efforts to evolve its financial and managerial control and reporting systems and processes, including with respect to its internal control over financial reporting.

The combined company’s ability to successfully offer its products and implement its business plan in a rapidly evolving market will require an effective planning and management process. The combined company will need to continue to improve its financial and managerial control and its reporting systems and procedures in order to manage its business effectively in the future.

 

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Accent Optical has not been required to prepare a report on the effectiveness of its internal controls over financial reporting because it is not subject to the registration requirements of the Securities Exchange Act of 1934, as amended.

The merger will require significant integration efforts by management. Additionally, unanticipated factors may hinder the effectiveness or delay the integration of Nanometrics’ and Accent Optical’s control systems and as such, there can be no assurances regarding the combined company’s ability to remediate deficiencies in its internal controls over financial reporting. Unless the combined company is able to evolve its current capabilities with respect to control systems and procedures, its ability to file reports with the SEC in a timely manner may be adversely affected.

Any future acquisitions we make, or attempt to make, could disrupt our business and harm our financial condition if we are not able to timely and successfully close the acquisition or successfully integrate acquired businesses and technologies.

We have made and may continue to make acquisitions of business and technologies to enhance our business. Acquisitions involve numerous risks, including problems combining the purchased operations and key employees, technologies or products, unanticipated costs, diversion of management’s attention from our core business, adverse effects on existing business relationships with suppliers and customers, risks associated with entering markets in which we have no or limited prior experience and potential loss of key employees. The integration of businesses that we have acquired or that we may acquire in the future into our business has been and will continue to be a complex, time consuming and expensive process. Failure to operate as a combined organization utilizing common information and communication systems, operating procedures, financial controls and human resources practices could adversely impact the success of any business combination.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company held a special meeting of shareholders on July 21, 2006.

At the special meeting of shareholders, the shareholders took the following action:

The shareholders approved the issuance of up to a maximum of 5,212,286 shares of Nanometrics common stock in connection with the merger with Accent Optical Technologies, Inc., and the other principal terms of the merger. There were 9,551,310 votes cast for the merger, 133,504 votes cast against the merger, 19,068 abstentions and 0 broker non-votes.

The Company held its annual meeting of shareholders on September 28, 2006.

At the 2006 annual meeting of shareholders, the shareholders elected the following seven candidates nominated by the board of directors to serve until the next annual meeting of shareholders at which their respective successors are elected and qualified, or until their earlier death, resignation or removal:

 

Name

   Votes For    Votes Withheld

Vincent J. Coates

   15,301,593    1,174,441

J. Thomas Bentley

   15,260,205    1,215,829

John D. Heaton

   15,302,743    1,173,291

Stephen J Smith

   15,313,953    1,162,081

Edmond R. Ward

   15,260,205    1,215,829

William G. Oldham

   15,260,205    1,215,829

Bruce C. Rhine

   15,241,795    1,234,239

Also at the 2006 annual meeting of shareholders, the shareholders took the following actions:

 

    The shareholders approved the reincorporation of the Company under the laws of the State of Delaware through a merger with Big League Merger Corporation, a wholly-owned subsidiary of the Company. There were 9,897,280 votes cast for the reincorporation, 3,355,711 votes cast against the reincorporation, 47,168 abstentions and 3,175,875 broker non-votes.

 

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    The shareholders approved the proposal of the provision in the proposed charter documents of the Company limiting the Company’s stockholders’ right to call special meetings of stockholders. There were 7,311,741 votes cast for the proposal, 5,978,398 votes cast against the proposal, 10,020 abstentions and 3,175,875 broker non-votes.

 

    The shareholders approved the proposal of the provision in the proposed charter documents of the Company limiting the Company’s stockholders’ ability to act by written consent. There were 7,318,662 votes cast for the proposal, 5,963,177 votes cast against the proposal, 18,320 abstentions and 3,175,875 broker non-votes.

 

    The shareholders did not approve the proposal of the provision in the proposed charter documents of the Company requiring a super-majority vote of the Company’s stockholders to amend certain provisions of its certificate of incorporation. There were 6,242,401 votes cast for the proposal, 7,048,248 votes cast against the proposal, 9,510 abstentions and 3,175,875 broker non-votes.

 

    The shareholders did not approve the proposal of the provision in the proposed charter documents of the Company requiring a super-majority vote of the Company’s stockholders to amend certain provisions of the Company’s bylaws. There were 6,242,581 votes cast for the proposal. 7,049,180 votes cast against the proposal, 10,398 abstentions and 3,175,875 broker non-votes.

 

    The shareholders did not approve the proposal of the provision in the proposed charter documents of the Company limiting the Company’s stockholders’ right to remove directors from the board without cause. There were 6,282,402 votes cast for the proposal. 6,970,895 votes cast against the proposal, 46,862 abstentions and 3,175,875 broker non-votes.

 

    The shareholders approved the proposal of the provision in the proposed charter documents of the Company for the classification of the board of directors into separate classes with staggered terms. There were 7,781,485 votes cast for the proposal, 5,509,024 votes cast against the proposal, 9,650 abstentions and 3,175,875 broker non-votes.

 

    The shareholders approved the proposal of the provision in the proposed charter documents of the Company eliminating cumulative voting in connection with the election of directors. There were 8,262,130 votes cast for the proposal, 4,089,168 votes cast against the proposal, 948,861 abstentions and 3,175,875 broker non-votes.

 

    The shareholders approved the ratification of the appointment of BDO Seidman, LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 30, 2006. There were 16,354,204 votes cast for the ratification, 49,719 votes cast against the ratification and 72,111 abstentions.

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS

Exhibit Index

The following exhibits are filed or incorporated by reference with this Quarterly Report on Form 10-Q:

 

Exhibit No.  

Description

3.(i)   Certificate of Incorporation
3.1(1)   Certificate of Incorporation of the Registrant
3.(ii)   Bylaws

 

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3.2(1)   Bylaws of the Registrant
4   Instruments Defining the Rights of Security Holders, Including Indentures
4.1   Form of Registrant’s Common Stock Certificate
10   Material Contracts
10.1(1)   Employment Agreement with John D. Heaton
10.2(1)   Description of certain compensation to be paid to Douglas J. McCutcheon
10.3(2)   Employment Agreement with Bruce Rhine
10.4(2)   Employment Agreement with Bruce Crawford
31   Rule 13a-14(a)/15d-14(a) Certifications
31.1   Certification of John D. Heaton, principal executive officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2   Certification of Douglas J. McCutcheon, principal financial officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32   Section 1350 Certifications
32.1   Certification of John D. Heaton, principal executive officer of the Registrant, and Douglas J. McCutcheon, principal financial officer of the Registrant, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Incorporated by reference to the Registrant’s Current Report on Form 8-K filed on October 5, 2006
(2) Incorporated by reference to Annexes to Registrant’s Registration Statement on Form S-4 filed on June 19, 2006 (Commission Registration No. 333-133033)

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

NANOMETRICS INCORPORATED
(Registrant)
By:  

/s/ Douglas J. McCutcheon

  Douglas J. McCutcheon
 

EVP, Finance and Administration and

Chief Financial Officer

Dated: November 9, 2006

 

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