UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K/A

Amendment No. 1

(Mark One)

For the Fiscal Year Ended October 2, 2004

or

Commission File Number: 0-5255

COHERENT, INC.

5100 Patrick Henry Drive, Santa Clara, California 95054

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (408) 764-4000

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.01 par value

Common Stock Purchase Rights

(Title of Class)

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 ý  No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes ý  No o

As of December 1, 2004, 30,554,982 shares of common stock were outstanding.  The aggregate market value of the voting shares (based on the closing price reported by the NASDAQ National Market System on April 2, 2004) of Coherent, Inc., held by nonaffiliates was $617,038,552.  For purposes of this disclosure, shares of common stock held by persons who own 5% or more of the outstanding common stock and shares of common stock held by each officer and director have been excluded in that such persons may be deemed to be “affiliates” as that term is defined under the Rules and Regulations of the Act.  This determination of affiliate status is not necessarily conclusive.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement to be filed prior to January 31, 2005, pursuant to Regulation 14A of the Securities Exchange Act of 1934, are incorporated by reference into Part III of this report.

EXPLANATORY NOTE

This Annual Report on Form 10-K/A (“Form 10-K/A”) is being filed as Amendment No. 1 to the Registrant’s Annual Report on Form 10-K for the fiscal year ended October 2, 2004 filed with the Securities and Exchange Commission solely for the purpose of correcting certain typographical errors.  These corrections primarily include amending Note 18, “Segment Information” in the Notes to the Consolidated Financial Statements to correct the descriptive titles of two line items for information presented for fiscal 2002 and to include certain line items for fiscal 2003 (which were previously disclosed in the Registrant’s Annual Report on Form 10-K for the fiscal year ended September 27, 2003) to provide consistent presentation.

PART I.

This Annual Report contains forward-looking statements.  These forward-looking statements include, without limitation, statements regarding our future:

•            net sales;

•            results of operations;

•            gross profits;

•            research and development projects and expenses;

•            selling, general and administrative expenses;

•            warranty reserves;

•            legal proceedings;

•            claims against third parties for infringement of our proprietary rights;

•            benefits from our acquisition of Positive Light, Inc.;

•            liquidity and sufficiency of existing cash, cash equivalents and short-term investments for near-term requirements;

•            development and acquisition of new technology and intellectual property;

•            write-downs for excess or obsolete inventory;

•            competitors and competitive pressures;

•            growth of applications for our products and increase of market share;

•            obtain components and materials in a timely manner;

•            identify alternative sources of supply for components;

•            achieve adequate manufacturing yields;

•            impact of recent acquisitions;

•            leverage of power and energy management products into our next generation products;

•            operating efficiencies and minimization of redundant costs;

•            compliance with environmental regulations;

•            participation in the bio-agent detection market;

•            leveraging of our technology portfolio and application engineering;

•            optimize our leadership position in existing markets;

•            collaborative customer and industry relationships;

•            emphasis on supply chain management;

•            use of financial market instruments;

•            simplifications of our foreign legal structure and reduction of our presences in certain countries; and

•            focus on long-term improvement of return on invested capital.

In addition, we include forward-looking statements under the “Our Strategy” and “Future Trends” sections set forth below in “Business.”

You can identify these and other forward-looking statements by the use of the words such as “may,” “will,” “could,” “would,” “should,” “expects,” “plans,” “anticipates,” “estimates,” “intends,” “potential,” “continue,” or the negative of such terms, or other comparable terminology.  Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below in “Business,” “Management’s Discussion and Analysis of Results of Operations and Financial Condition” and under the heading “Risk Factors.”  All forward-looking statements included in this document are based on information available to us on the date hereof.  We undertake no obligation to update these forward-looking statements as a result of events or circumstances or to reflect the occurrence of unanticipated events.

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ITEM 1.  BUSINESS

GENERAL

Business Overview

Our fiscal year ends on the Saturday closest to September 30.  Fiscal years 2004, 2003 and 2002 ended on October 2, September 27 and September 28, respectively.  Fiscal year 2004 includes 53 weeks, whereas fiscal years 2003 and 2002 include 52 weeks.  For convenience, we use September 30 as our fiscal year-end dates throughout this Annual Report in order to correspond to the accompanying consolidated financial statements.

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

We have two reportable business segments: Electro-Optics and Lambda Physik, both of which work with customers to provide cost-effective photonics-based solutions.  Our Electro-Optics segment focuses on markets such as semiconductor and related manufacturing, materials processing, original equipment manufacturer (OEM) laser components and instrumentation, scientific research and government programs and graphic arts and display.  Lambda Physik AG (Lambda Physik), our 95.01% owned subsidiary with headquarters located in Göttingen, Germany, focuses on markets using lasers for the production of thin-film transistors (TFT) used in flat panel displays, microlithography applications in the semiconductor industry, ink jet printers, automotive, environmental research, scientific research, medical OEMs, materials processing and micro-machining applications.

We were originally incorporated in California on May 26, 1966 and reincorporated in Delaware on October 1, 1990.

Additional information about Coherent, Inc. (referred to herein as the Company, we, our, or Coherent) is available on our web site at www.coherent.com.  We make available, free of charge on our web site, access to our Annual Report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we file them electronically with or furnish them to the Securities and Exchange Commission (SEC).  Information contained on our web site is not part of this Annual Report on Form 10-K or our other filings with the SEC.

INDUSTRY BACKGROUND

The word “laser” is an acronym for “light amplification by stimulated emission of radiation.”  A laser works by causing an energy source to excite, or pump, an optical gain medium, converting the energy from the source into an emission of photons, the fundamental particles of light.  These photons stimulate the release of more photons in the gain medium as they are reflected back and forth between the mirrors that make up the laser’s resonator.  The resulting build-up in the number of photons is usually emitted in the form of a light beam, the laser beam, through a partially reflective mirror at the output end of the laser.

The four types of lasers commonly available today are gas, liquid, semiconductor and solid-state, each of which derives its classification from the lasing material it uses.  Laser beams can be emitted in either continuous waves or in pulses with varying repetition rates, can have different operating wavelengths and emission bandwidths, and can emit light in a wide range of energies and powers.  Depending on the application, lasers can be designed for a specific power, pulse width, repetition rate and wavelength.  In addition, the laser’s cost of ownership can dictate its suitability for a particular application.

As lasers become less expensive, smaller and more reliable, they are increasingly replacing conventional tools and enabling technological advances in a variety of applications and industries including microtechnologies and nanotechnologies; semiconductor inspection; microlithography; measurement, test and repair of electronic circuits; medical and biotechnology; consumer electronics; industrial process and quality control; materials processing; imaging and printing; display; and research and development.  Ultraviolet (UV) lasers are profiting from the trend towards miniaturization, which is a driver of innovation and growth in many markets.  The short wavelength of lasers that emit light in the UV spectral region make it possible to produce extremely small structures with maximum precision consistent with the latest state of the art technology.

OUR STRATEGY

We strive to develop innovative and proprietary products and solutions that meet the needs of our customers and that are based on our core expertise in lasers and optical technologies.  In pursuit of our strategy, we intend to:

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•            Leverage our technology portfolio and application engineering to lead the proliferation of photonics into broader markets – We will continue to identify opportunities in which our technology portfolio and application engineering can be used to offer innovative solutions and gain access to new markets.

•            Optimize our leadership position in existing markets – There are a number of markets where we have historically been at the forefront of technological development and product deployment and from which we have derived a substantial portion of our revenues.  We plan to optimize our financial returns from these markets.

•            Maintain and develop additional strong collaborative customer and industry relationships – We believe that the Coherent brand name and reputation for product quality, technical performance and customer satisfaction will help us to further develop our loyal customer base.  We plan to maintain our current customer relationships and develop new ones with customers that are industry leaders and work together with these customers to design and develop innovative product systems and solutions as they develop new technologies.

•            Develop and acquire new technologies – We will continue to enhance our market position through our existing technologies and develop new technologies through our internal research and development efforts, as well as through the acquisition of additional complementary technologies, intellectual property, manufacturing processes and product offerings.

•            Emphasize supply chain management – We will continue to focus on operational efficiency through an emphasis on supply chain management with the explicit intent of improving gross margins and increasing inventory turns.

•            Focus on long-term improvement of Return on Invested Capital – We will continue to focus on long-term improvement of return on invested capital.

APPLICATIONS

Our products address a broad range of applications.  Both of our reportable business segments are focused on several areas of the photonics market including: microelectronics, graphic arts and display, materials processing, scientific research and government programs and OEM components and instrumentation.

Microelectronics

The use of semiconductors has expanded beyond computer systems to a wide array of applications such as telecommunications and data communication systems, automotive products, consumer goods, medical products, household appliances, industrial automation and control systems.

Semiconductor manufacturers are continually seeking to improve their process and design technologies to manufacture smaller, more powerful and more reliable devices at a lower cost per function.  A major factor in fabricating such devices is the ability to reduce circuit geometries, measured in nanometers (a billionth of a meter), and defined in terms of critical, or smallest, feature size.  Reduced circuit geometries permit semiconductor manufacturers to increase the number of integrated components per area of silicon.

Lasers are particularly useful in manufacturing products that require fine precision and small feature sizes such as semiconductor and microelectronic devices where beam shape and delivered power are important. We provide lasers to semiconductor equipment manufacturers for use in lithography, mask writing, wafer inspection, mask repair and packaging processes for their semiconductor manufacturing systems.

Deep ultraviolet (DUV) lithography

Lithography is one of the most critical and expensive steps in the manufacturing process of complex semiconductor devices fabricated on silicon wafers.  This process requires a system that projects light through a photomask containing the master image of a particular circuit layer onto a light sensitive material coated on the wafer.  The critical feature size of a semiconductor device depends upon the resolution capability of the lithography system.  Resolution capability is a function of the projected wavelength of the light source and the numerical aperture of the lens.  A shorter wavelength or higher numerical aperture enables smaller feature sizes.

We currently provide, through our 95.01% owned Lambda Physik subsidiary, NovaLine lasers with stable, line-narrowed, 2 kilohertz (kHz) operation at 248 nanometers (nm) (20 W); 4 kHz operation at 193nm (20 W); and we developed the new dual-chamber 193nm LithoTex (50 W) at 4kHz with spectral purity less than 0.2 pm, FWHM.  In December 2004, our Lambda Physik subsidiary decided to discontinue future product development and investments in the semiconductor lithography market.  As a result of this decision, we

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anticipate recognizing a charge of between $3.0 million and $6.0 million in the quarter ending January 1, 2005, primarily to recognize the write-downs of potentially excessive and obsolete inventories.

Direct writing of photomasks

The photomask used in the lithography process is made by a laser beam that directly “writes” a circuit pattern of a semiconductor chip onto a piece of chrome-coated quartz glass.  The mask, which is conceptually similar to a negative in photography, is used in lithography systems to make numerous copies of the pattern image on semiconductor wafers.  Our Innova Sabre and Innova SabreFreD ion lasers and our NovaTex excimer lasers are used in laser systems for these applications.

Semiconductor inspection, metrology, test and repair

As semiconductor device geometries decrease in size, devices become increasingly susceptible to smaller defects during each phase of the manufacturing process.  One of the semiconductor industry’s responses to the increasing vulnerability of semiconductor devices to smaller defects has been to employ defect detection and inspection that is closely linked to the manufacturing process.  Automated inspection systems are used to detect and locate defects as small as 0.1 microns, which may not be observable by conventional optical microscopes.  These detection systems use advanced image processing and innovative laser scanning technologies to achieve high sensitivity and speed.

Detecting the presence of defects is only the first step in preventing their recurrence.  After detection, defects must be examined in order to identify their size, shape and the process step in which the defect occurred.  This examination is called defect classification.  Identification of the sources of defects in the lengthy and complex semiconductor manufacturing process has become essential for maintaining high yield production.  Semiconductor manufacturing has become an around-the-clock operation and it is important for inspection, measurement and testing products to be reliable and have long lifetimes.

Our AZURE, Compass 315M, Compass 415M and Verdi diode-pumped solid-state lasers are used to detect defects in photomasks, semiconductor chips and printed circuit boards.  The Innova iLine argon ion laser is used to inspect the photomasks and patterned wafers.  Our Vector laser is used to repair defects that may occur in the photomask or semiconductor device.

The fabrication process typically creates numerous patterned layers on each wafer.  Laser-based systems have been developed to measure the characteristics of metal or opaque layers in order to determine the functionality and conformance of these devices.  Our Vitesse laser generates an ultrafast laser light pulse that produces a localized temperature rise in the materials, which generates a sound wave, a portion of which is reflected back to the surface.  By measuring the returning echoes, the laser system can detect layer thickness, adhesion and composition.

Flat panel display manufacturing

The high volume consumer market is driving the production of flat panel displays in applications such as digital cameras, personal digital assistants (PDAs), mobile telephones, car navigation systems, laptop computers and television monitors.  The most common type of flat panel display is the active-matrix crystal display, which uses a matrix of TFT switches to control each pixel of the screen.

The conversion of amorphous silicon to polycrystalline silicon induced by excimer lasers, commonly referred to as excimer laser annealing (ELA), is a pivotal technology for the next generation of TFT devices.  In the ELA process, the excimer laser light is absorbed into the amorphous silicon without heating the underlying substrate.  As a result, it is possible to use inexpensive glass substrates instead of quartz, which makes the ELA process potentially more economical than previous techniques.  Because the ELA technique leaves the substrate virtually unaffected, there are many potential applications for the ELA process including the use of plastic as a substrate material, which would enable flexible high brightness displays.  The Lambda STEEL, developed and marketed by Lambda Physik, is a high-powered 315 W excimer laser designed for industrial TFT annealing.

Our Avia and Diamond lasers are also used in the production of flat panel displays for cutting, patterning, marking and yield improvement.

Advanced packaging and interconnects

Lasers are used for via hole drilling of rigid and flexible printed circuit boards.  Microvias are essential for enabling high-density circuitry commonly used in mobile handsets and advanced computing systems.  Our Avia^TM solid-state ultraviolet laser, Diamond^TM carbon dioxide, or CO₂, and GEM^TM QS CO₂ family of lasers are used for this application.  The ability of our pulsed lasers to operate at very high repetition rates translates into faster drilling speeds and increased throughput in such materials processing applications.  Lasers also produce smaller, cleaner holes than conventional cutting tools, and laser beams do not wear down from use as do conventional drills.

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Lasers are also increasingly being used in scribing, machining and drilling microelectronic materials and components and in microelectronics manufacturing to adjust electronic components.  Our Vector, Avia, Diamond and GEM QS lasers are used for these applications.  Lasers are also being used for direct writing of circuit patterns directly on printed circuit boards.  Our Paladin laser is used for this application.

Graphic arts and display

The printing industry has traditionally depended upon silver-halide films and chemicals to engrave printing plates.  This chemical engraving process is accomplished in several time consuming steps.  Working with professionals in the printing industry, we design semiconductor and diode-pumped lasers that are used in complex computer-to-plate printing systems that simplify the engraving process.

Our Compass 315M DPSS and semiconductor lasers are widely used for computer-to-plate printing, an environmentally-friendly process that saves production time by writing directly to plates.

Our Innova ion lasers and Paladin DPSS lasers are used to write data on master disks that are used to mass-produce compact disks and digital video disks for consumer use.

Our Sapphire^TM 460 laser is 90% smaller, consumes 98% less power and dissipates 98% less heat than a comparable air-cooled argon-ion laser.  It is used for graphic arts applications, including photo finishing, film writing and the emerging area of laser projection used for cinema and television.

Our diode laser bars, recognized as an industry leader in both high slope efficiency and high temperature performance, have enabled new applications in both the commercial and military markets including imaging in the reprographics market.

Materials processing

Lasers are widely accepted today as part of many important manufacturing applications.  While many laser companies have developed high power lasers for the increasingly competitive area of metal processing, we have chosen to concentrate our efforts on developing compact low to medium power lasers specifically for the growing area of nonmetals processing and micromachining.  This includes such applications as the cutting and joining of plastics using both our CO₂ and semiconductor lasers; the cutting, perforating and scoring of paper and packaging materials; and various cutting and patterning applications in the textile industry.

Our fiscal 2001 acquisition of DeMaria Electro-Optics Systems, Inc. (DEOS) has also enabled us to play a leading role as an OEM supplier to the laser marking and coding industry.  This area is growing as laser marking is starting to seriously compete with ink jet coding due to both aesthetic and environmental pressures.  In fiscal 2003, we were successful with lasers used commercially for cutting and fading fabric and for processing leather in the garment industry.

At the end of the size and wavelength spectrum, the AVIA UV lasers are now being used extensively in the processing and micromachining of a wide range of materials (and industries) including both silicon and glass.  These technically important materials are being laser processed to produce medical devices, microelectromechanical systems (MEMS) and in flat panel display and semiconductor manufacturing.

In 2002, Lambda Physik received its first order for excimer lasers used in the treatment of engine cylinder surfaces in the automotive industry and in 2004, the first excimer laser treated diesel engines were made commercially available.

Our LPX excimer laser models are high duty cycle lasers, offering high energy per pulse with modest repetition rates for scientific and industrial applications.  They are used for marking surface mounts and medical devices, stripping thin wires in disk drives, cleaning bare semiconductor wafers and writing fiber bragg gratings for optical telecommunications.

Scientific research and government programs

The scientific market has historically provided an ideal test market for leading-edge laser technology, including water-cooled gas lasers, high-energy flash lamp-pumped Yttrium Aluminum Garnet (YAG) lasers and ultrafast systems.  Our installed base includes tens of thousands of lasers.  Current applications for lasers in the scientific market include pump lasers for ultrafast (UF) and continuous wave (CW) systems, CW tunable systems, UF oscillator and amplifiers, and non-linear generation systems (SHG, THG, and OPO’s).  Main scientific applications include biology (multiphoton and confocal microscopy), physics (atomic and molecular spectroscopy, atom cooling, non-linear optics, X-ray generation, solid state and semiconductor studies), chemistry (quantum control, time-resolved and Raman spectroscopy) and engineering (material processing, remote sensing, metrology).

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Our Mira Titanium Sapphire laser and RegA regenerative amplifier are examples of ultrafast laser systems used for these applications.

Our Innova ion lasers are also sold to instrument manufacturers, the largest component of which is bio-instrumentation, for applications such as cell sorting, DNA and protein sequencing, as well as drug and clinical screening.

Our optically pumped (OPS) laser, the Sapphire, is sold for several bio-instrumentation applications including flow cytometry, drug discovery and DNA sequencing.

Our Chameleon laser combines a unique blend of features and hands-off performance, making it an ideal tool for Multi-Photon Excitation (MPE) microscopy and a powerful tool for many other fields of ultrafast research such as time-resolved photoluminescence, nonlinear spectroscopy, fluorescence upconversion, quantum optics, materials characterization and terahertz imaging.

Our MBR and 899 CW tunable lasers provide unsurpassed resolution and stability for spectroscopy applications.

Our diode-pumped Verdi laser has established itself as the benchmark in reliability for any pumping application where Ti:Sapphire lasers like our Mira, RegA and 899 are used.  A number of Verdi lasers are currently used as laboratory tools to pump Coherent lasers, as well as lasers from our competitors.

Our DEOS subsidiary provides custom waveguide CO₂ lasers, far-infrared lasers and other systems to a wide variety of commercial and government customers.  In some cases, these custom products are only slightly modified versions of our standard commercial and scientific laser products.  In other cases, a custom product may incorporate significant modifications while still building on the design expertise acquired in the development of our high-volume commercial laser products.  We are also heavily involved in the development of optically pumped far-infrared (FIR) lasers like the SIFIR-50, a THz laser system.  These designs utilize many aspects of our highly reliable sealed resonator technologies to produce compact and dependable turn-key systems with FIR operation.

The integration of our fiscal 2003 acquisition of Positive Light, Inc. (PLI), a recognized leading designer and manufacturer of advanced solid-state lasers for the scientific and industrial markets, with our scientific business has enabled us to gain access to one of the largest scientific markets, the high-energy UF amplifier systems, which covers energy ranges from 1 mJ and above and peak powers up to 50 Terawatt.  PLI products are used for a variety of physics and chemistry applications, inclusive of X-ray generation and non-linear optics.

OEM components and instrumentation

Our substantial experience with optics, optical coatings, and diode lasers for optical pumping and harmonic generation enable our OEM components business.  We provide value-added optical solutions and both directly-coupled and fiber-coupled optical pumping diode laser packages to laser manufacturers participating in other OEM markets such as materials processing, scientific, and medical.

Instrumentation is one of our more mature commercial applications.  Representative applications within this segment include flow cytometry, high-throughput screening for pharmaceutical discovery, genomic and proteomic analysis, Raman spectroscopy, forensics, veterinary science, and bio-threat detection.  Our OPS laser, the Sapphire, is sold for several bio-instrumentation applications including DNA sequencing, flow cytometry and drug discovery.  Our Innova ion lasers are also sold to bio-instrument manufacturers for applications such as cell sorting, DNA and protein sequencing, as well as drug and clinical screening.

Flow cytometry

Flow cytometry is a laser-based micro fluorescence technique for analyzing single cells or populations of cells in a heterogeneous mixture.  Its numerous applications include cell biology, immunology, reproductive biology, oncology, and infectious disease such as Acquired Immune Deficiency Syndrome (AIDS).  Flow cytometry is both a powerful research tool and an indispensable mainstream clinical diagnostic and prognostic tool.  Commercially available instruments typically measure more than six simultaneous discriminating factors at analysis speeds of thousands of cells per second and many instruments have the capability to selectively sort individual cells for subsequent analysis or cell culture.  The recent design trend in flow cytometry is toward more compact, powerful, and reliable instruments.  Our Sapphire solid-state 488nm laser, Compass 215M and Radius laser diode modules are the lasers of choice in the current generation of cutting-edge instrumentation replacing the bulkier, inefficient and sometimes unreliable air-cooled argon-ion and helium neon laser systems that were used in the past.

Genomics and Proteomics

Laser-based fluorescence techniques abound within the study of Genomics and Proteomics (human genome and proteome) and allied fields.  As with the flow cytometry application, a challenge to manufacturers of analytical devices is to produce instruments of increasing complexity and capability, while at the same time minimizing their size.  This is particularly important in fields such as

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these where often times many instruments are deployed in a single location for the purpose of parallel processing.  Our Sapphire, Compass 215M and Radius lasers are used in instrument techniques ranging from DNA sequencing to micro array scanners, to lab-on-chip and fluorescence correlation spectroscopy.

Raman spectroscopy

Raman spectroscopy is the spectral measurement of inelastic scattering of monochromatic radiation from molecular species.  Depending on the molecular species, physical state thereof, and the experimental paradigm, laser sources for Raman can range from infrared to UV.  Raman measurements are useful for process monitoring, environmental monitoring, and biomedical applications to name a few.  Our Innova and Compass product lines are widely deployed in Raman applications, both at the commercial and scientific level.  Exciting new research at the university level also suggests that our powerful tunable deep-UV source, the Indigo, will prove to be a very useful tool in deciphering protein secondary structure.

Bio-agent detection

A number of laser-based techniques for point source and standoff detection of pathogens or other bio-toxins are being explored in the government and private sectors.  Systems of this type could be deployed to guard military facilities, major sporting events or other large gatherings of citizens, or vital infrastructure components such as subways, airports, or industrial hubs.  We have a number of laser systems under evaluation for such systems and are well positioned to actively participate in this segment.

Forensics

Lasers have been employed in criminal forensics for a number of decades.  Applications include latent fingerprint detection and trace evidence illumination and identification.  In the past, laser usage was often limited to forensics labs due to the physical size and complexities of the lasers.  Portable models seldom generated enough output for use in high ambient light conditions and for large-scale sweeps of the crime scene.  Owing to recent advances in optical output versus physical size, forensic scientists now have the capability to bring an unprecedented level of latent fingerprint and trace evidence detection directly to the crime scene.  Our IncriminatorÔ 532nm 10 W fiber-coupled laser system directly addresses the needs of large-scale criminal investigation organizations by providing a superior combination of high brightness and portability to bear on the most difficult forensic analysis.

Medical OEM

We sell a variety of components and lasers to medical laser companies in end-user applications such as ophthalmology, aesthetic, surgical, therapeutic and dentistry.  Innova ion laser tubes and our GEM series CO₂ lasers are widely deployed in ophthalmic, aesthetic and surgical markets.  Additionally, our Compass 215M series and Sapphire 488 series lasers are deployed in the retinal scanning market in diagnostic imaging systems.

FUTURE TRENDS

Microelectronics

After several years of process development, lasers are now used in mass production applications and the industry is benefiting in the form of enhanced performance and increased productivity.  Having experienced strong recovery across all segments during fiscal 2004, the microelectronics industry has showed some signs of stabilization, however, we anticipate capital spending to recover as the industry sees stronger capacity utilization.  We anticipate future demands in the advanced packaging market will shift towards the use of ultraviolet laser-based tools, as they are capable of producing sub-50 micron features that are critical for next generation chip-scale and wafer-level packages.  Our recent introduction of the high-power, Avia Thor™ laser will increase the throughput of packaging tools, thereby enhancing productivity and lowering cost-of-ownership.

Graphic arts and display

The graphic arts and display market experienced a migration in technologies towards the use of direct diode laser systems as these systems have been adopted at a much faster rate during fiscal 2004.  If the adoption of newer digital technologies continues beyond fiscal 2004 levels, we anticipate this will have the effect of driving purchases of new printing technology.  As we move into fiscal 2005, we anticipate a number of our newer products such as a version of our Paladin™ laser and new diode laser technology will gain traction in the marketplace.

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Materials processing

Anticipated drivers for expansion in the materials processing market include providing aggressive gains in cost-of ownership for products and continuing increased expansion into geographical areas.  The market for materials processing in Asian countries drove much of the growth in the first half of fiscal 2004, but has since stabilized, primarily due to foreign policies established to slow economic growth.  We anticipate growth to resume once the effects of these policies are felt and active measures to stimulate the economy begin to arise.

Scientific research and government programs

The scientific research market has historically grown at a rate similar to the growth rate experienced in the general U.S. economy, however, demand was up sharply in fiscal 2004, partially due to our acquisition of PLI.  We anticipate modest growth rates in fiscal 2005 and that applications in ultrashort pulses and in bio-research will be the drivers of anticipated growth within the scientific research market.

OEM components and instrumentation

The instrumentation market has seen a migration from the use of mature laser technologies, mainly ion lasers, to new technologies primarily based on solid state and semiconductors.  Because of this migration, new markets are expected to surface in areas such as security, including the detection of bio-agents and the monitoring of people and goods.  These markets are likely to require an increased number of lasers, however, the majority of these activities are still in the research and development stage and we expect only moderate impacts on the laser industry in fiscal 2005, with increases anticipated in future years.  Furthermore, we anticipate future opportunities in microscopy, lab-on chip and DNA sequencing based on our continuous product enhancements.

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PRODUCTS

We design, manufacture and market lasers, laser-based systems, precision optics and related accessories for a diverse group of customers.  The following table shows selected products together with their applications, the markets they serve and the technologies upon which they are based.

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We design, manufacture and market a wide variety of lasers, laser-based systems and optical components and instruments, some of which are described below.

Semiconductor lasers

Semiconductor lasers use the same principles as more conventional types of lasers but miniaturize the entire assembly into a monolithic structure using semiconductor wafer fabrication processes.  The advantages of this type of laser include smaller size, longer life, enhanced reliability and greater efficiency.  We manufacture a wide range of semiconductor laser products with wavelengths ranging from 650nm to 1000nm and output powers ranging from less than 1 W for individual emitters to 60 W for bars, to several hundred watts for stacked bars. These products are available in various forms of complexity including the following: bar diodes on heat sinks, fiber-coupled single emitters and bars, stacked bars and fully integrated modules and microprocessor-controlled units that contain power supplies and active coolers.  Our infrared semiconductor lasers, which are manufactured from proprietary materials grown in our facility in Tampere, Finland, differ from most other lasers in that they contain no aluminum in the active region.  This provides our lasers with longer lifetimes and the ability to operate at broader temperature ranges.

Our OPS laser is a semiconductor chip that is pumped by a semiconductor laser.  A wide range of wavelengths can be achieved by varying the materials used in this device and doubling the frequency of the laser beam.  The OPS is a compact, rugged, high power, single-mode laser.  Our frequency doubled OPS lasers are all solid-state devices operating continuously in the blue region of the optical spectrum and are particularly well suited to the bio-instrumentation and graphic art markets.

Another primary application for our semiconductor lasers is for use in computer-to-plate printing machines.  These machines contain a series of semiconductor lasers that are used to direct the printing of computer images directly to paper without the need for film or developing chemicals.

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Our semiconductor lasers are also used in machine-processing applications such as soldering connections on printed circuit boards and welding flat panel displays and in medical applications for the treatment of the wet “classical” form of age-related macular degeneration and hair removal.  They are also used as the pump laser in DPSS laser systems that are manufactured by us and several of our competitors.

Diode-pumped solid-state lasers

DPSS lasers use semiconductor lasers to pump a crystal to produce a laser beam.  By changing the energy, optical components and the types of crystals used in the laser, different wavelengths and types of laser light can be produced.

The efficiency, reliability, longevity and relatively low cost of DPSS lasers make them ideally suited for a wide range of OEM and end-user applications, particularly those requiring 24-hour operations.  Our DPSS systems are compact and self-contained sealed units.  Unlike conventional tools and other lasers, our DPSS lasers require minimal maintenance since they do not have internal controls or components that require adjusting and cleaning to maintain consistency.  They are also less affected by environmental changes in temperature and humidity, which can alter alignment and inhibit performance in many systems.

We manufacture a variety of types of DPSS lasers for different applications including semiconductor inspection; advanced packaging and interconnects; repair, test and measurement; computer-to-plate printing; writing data to master disks; entertainment; photo finishing: marking, welding, engraving, cutting and drilling; drug discovery; forensics; laser Doppler velocimetry; bio-agent detection; medical; rapid prototyping; DNA sequencing; flow cytometry; laser pumping and spectroscopy.

SALES AND MARKETING

We market our products domestically through a direct sales force.  Our foreign sales are made principally to customers in Europe, Japan and other Asia-Pacific countries.  We sell internationally through direct sales personnel located in Japan, the United Kingdom, Germany, Italy, Austria, France, Belgium, the Netherlands, Korea and the People’s Republic of China, as well as through independent representatives in other parts of the world.  Foreign sales accounted for 61% of our total net sales in both fiscal 2004 and fiscal 2003 and 60% of net sales in fiscal 2002.  Sales made to independent representatives and distributors are generally priced in U.S. dollars.  Foreign sales that we make directly to customers are generally priced in local currencies and are therefore subject to currency exchange fluctuations.  Foreign sales are also subject to other normal risks of foreign operations such as protective tariffs, export and import controls and political instability.  Our products are broadly distributed and no one customer accounted for more than 10% of total net sales during fiscal 2004, 2003 or 2002.

We maintain a customer support and field service staff in major markets within the United States, Europe, Japan and other Asia-Pacific countries.  This organization works closely with customers, customer groups and independent representatives in servicing equipment, training customers to use our products and exploring additional applications of our technologies.

We typically provide one-year parts and service warranties on our lasers, laser-based systems, optical and laser components and related accessories and services.  Warranties on some of our products and services may be shorter or longer than one year.  Warranty reserves, as reflected on our consolidated balance sheets, have generally been sufficient to cover product warranty repair and replacement costs.

RESEARCH AND DEVELOPMENT

We are committed to the development of new products, as well as the improvement and refinement of existing products, including better cost-of-ownership.  We are primarily focusing our research and development efforts on the development of microelectronics, materials processing and bio-instrumentation markets and excimer lasers for DUV lithography and ELA.  Research and development expenditures for fiscal 2004 were $62.5 million, or 12.6% of net sales, compared to $50.8 million, or 12.5% of net sales, for fiscal 2003 and $52.6 million, or 13.2% of net sales, for fiscal 2002.  We maintain separate research and development staffs for both of our reportable business segments.  We work closely with customers, both individually and through our sponsored seminars, to develop products to meet customer application and performance needs.  In addition, we are working with leading research and educational institutions to develop new photonics-based solutions.  In the first quarter of fiscal 2003, we terminated the activities of our Coherent Telecom-Actives Group (CTAG) operating segment.  Expenditures for research and development related to CTAG were $1.9 million in fiscal 2003 and $6.3 million in fiscal 2002.

In fiscal 2002, we formed a Technical Advisory Board to facilitate our assessment of new and emerging technologies across a broad range of disciplines affecting the field of photonics.  The Technical Advisory Board is comprised of outside experts in various disciplines within the photonics universe and will assist our internal Technology Council in the evaluation of emerging opportunities and lend their expertise to our technology review process.

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MANUFACTURING

Strategies

One of our core manufacturing strategies is to tightly control our supply of key parts, components and assemblies.  We believe this is essential in order to maintain high quality products and enable rapid development and deployment of new products and technologies.

Committed to quality and customer satisfaction, we design and produce many of our own components and sub-assemblies in order to retain quality control.  We provide customers with 24-hour technical expertise and quality that is ISO certified at our principal manufacturing sites.  In June 2003, we transferred our printed circuit board manufacturing activities in Auburn, California, to a global electronics contract manufacturer, Venture, which has factories in North America, Asia and Europe.  We also completed the restructuring of our CO₂ operations, resulting in the consolidation of all CO₂ manufacturing operations at our Bloomfield, Connecticut location.  In fiscal 2004, Lambda Physik consolidated the manufacturing operations of its German subsidiary into its Göttingen facility.

We have designed and implemented proprietary manufacturing tools, equipment and techniques in an effort to provide products that differentiate us from our competitors.  These proprietary manufacturing techniques are utilized in a number of our product lines including both ion and CO₂ laser production, optics fabrication, optics coating and assembly operations, as well as the wafer growth for our semiconductor laser product family.

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

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

Operations

Our electro-optical products are manufactured at sites in Santa Clara and Auburn, California; Portland, Oregon; East Hanover, New Jersey; Bloomfield, Connecticut; Lübeck, Germany; Leicester, England; Glasgow, Scotland; and Tampere, Finland.  Our ion lasers, a portion our DPSS lasers (Verdi, Avia and Vitesse), semiconductor lasers, and ultrafast scientific lasers are manufactured in Santa Clara, California and Glasgow, Scotland.  Our CO₂ lasers are manufactured in Bloomfield, Connecticut.  Our optical component products are manufactured at our facilities in Auburn, California and Leicester, England.  Our laser instrumentation products and test and measurement equipment are manufactured in Portland, Oregon.  We manufacture exotic crystals in East Hanover, New Jersey.  We make DPSS lasers at our facility in Lübeck, Germany, including the 315M and 501Q lasers.  Our facility in Tampere, Finland grows the aluminum-free materials that are incorporated into our semiconductor lasers.  We make a range of advanced solid-state lasers used in developing applications including scientific research and semiconductor test equipment in Glasgow, Scotland.

Our excimer laser products, including the lasers used in DUV lithography systems and Lambda Physik’s DPSS product, are manufactured at Lambda Physik’s facilities in Göttingen, Germany.

INTELLECTUAL PROPERTY

We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights.  We currently hold more than approximately 400 U.S. and foreign patents and we have approximately 60 additional pending patent applications that have been filed.  The issued patents cover various products in all of the major markets that we serve.

We cannot assure you that our patent applications will be approved, that any patents that may be issued will protect our intellectual

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property or that any issued patents will not be challenged by third parties.  Other parties may independently develop similar or competing technology or design around any patents that may be issued to us.  We cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.

We believe that we own or have the right to use the basic patents covering our products.  However, the laser industry is characterized by a very large number of patents, many of which are of questionable validity and some of which appear to overlap with other issued patents.  As a result, there is a significant amount of uncertainty in the industry regarding patent protection and infringement.  A U.S. patent application is published eighteen months after the claimed priority date unless it is stated by the applicant that the application will not be filed in a foreign country, in which case the application is maintained in secrecy until a patent is issued.  Foreign-filed patent applications are maintained in secrecy for up to eighteen months.  Because of this we can conduct only limited searches to determine whether our technology infringes any patents held by others.

In recent years, there has been a significant amount of litigation in the United States involving patents and other intellectual property rights. In the future, we may be a party to litigation to protect our intellectual property or as a result of an alleged infringement of others’ intellectual property.  These claims and any resulting lawsuit, if successful, could subject us to significant liability for damages and invalidation of our proprietary rights.  These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention.  Any potential intellectual property litigation also could force us to do one or more of the following:

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

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

•            redesign the products that use the infringed intellectual property.

If we are forced to take any of these actions, our business may be seriously harmed.  Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed.

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

COMPETITION

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

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

BACKLOG

At September 30, 2004, our backlog of orders scheduled for shipment was approximately $154.6 million compared to $127.7 million at September 30, 2003 and $124.4 million at September 30, 2002.  Orders used to compute backlog are generally cancelable without substantial penalties.  Historically, the rate of cancellation experienced by us has not been significant.  Backlog at September 30, 2004 was higher than backlog at September 30, 2003 in both our Electro-Optics and Lambda Physik reportable segments.  Backlog at September 30, 2003 was higher than backlog at September 30, 2002 in our Electro-Optics reportable segment and lower than backlog at September 30, 2002 in our Lambda Physik reportable segment.  Backlog at September 30, 2002 was lower than at September 30, 2001 in both reportable segments.

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EMPLOYEES

As of September 30, 2004, we had 2,218 full-time employees.  Approximately 346 of our employees are involved in research and development; 1,149 of our employees are involved in operations, manufacturing, service and quality assurance; and 723 of our employees are involved in sales, marketing, finance, legal and other administrative functions.  Our success will depend in large part upon our ability to attract and retain employees.  We face competition in this regard from other companies, research and academic institutions, government entities and other organizations.

ACQUISITIONS

During fiscal 2003, we acquired Molectron Detector, Inc. (Molectron) of Portland, Oregon and PLI of Los Gatos, California for approximately $11.5 million and $38.9 million in cash, respectively.  Molectron designs and manufactures laser test and measurement equipment used across all photonics-based applications and markets.  The acquisition of Molectron has enabled us to leverage their well-regarded power and energy management products into our next generation products in both the scientific research and commercial markets.  PLI designs and manufactures advanced solid-state lasers for the scientific research and industrial markets.  The acquisition of PLI has enabled us to gain market share in the scientific research and industrial markets through additional product and service offerings.

In fiscal 2003, we initiated a tender offer to purchase the remaining 5,250,000 (39.62%) outstanding shares of our Lambda Physik subsidiary for approximately $10.50 per share.  As a result of the tender offer and the purchase of additional outstanding shares subsequent to the tender offer, we owned 95.01% of the outstanding shares of Lambda Physik at September 30, 2004.  The acquisition of these additional shares has enabled us to increase operating efficiencies by providing management and technical expertise, as well as minimizing redundant administrative costs.  In May 2004, a resolution was passed at Lambda Physik’s shareholders’ meeting that permits us to acquire all remaining shares outstanding.  In November 2004, we agreed to increase the price to be paid to those minority shareholders who did not accept the squeeze out proposal to approximately $18.88 per share in exchange for their agreement to waive rights to a court appraisal.  We anticipate that the Göttingen court will approve the merger in the first calendar quarter of 2005.  Once the approval is in place, we plan to purchase the remaining shares of Lambda Physik and complete the integration.

RESTRUCTURINGS AND CONSOLIDATION

In fiscal 2004, our Lambda Physik subsidiary initiated and completed plans to restructure its manufacturing sites in Göttingen, Germany, to optimize operating efficiency.  As a result, we recognized a charge of $1.1 million ($1.0 million net of minority interest) in fiscal 2004 related to these initiatives.

In fiscal 2003, we undertook several initiatives aimed at both changing business strategy and improving operational efficiencies.  Changes in business strategy included the termination of the activities of CTAG.  In order to improve operational efficiencies, we outsourced the production of printed circuit boards, reassessed the planned utilization of certain long-lived assets at various operating sites and consolidated the activities of a foreign subsidiary.  As a direct result of these initiatives, we recognized $31.1 million in restructuring, impairment and other charges in fiscal 2003.  These initiatives are discussed further in “Management’s Discussion and Analysis of Results of Operations and Financial Condition.”

GOVERNMENT REGULATION

Environmental regulation

Our operations are subject to various federal, state and local environmental protection regulations governing the use, storage, handling and disposal of hazardous materials, chemicals, various radioactive materials and certain waste products.  In the United States, we are subject to the federal regulation and control of the Environmental Protection Agency.  Comparable authorities are involved in other countries.  We believe that compliance with federal, state and local environmental protection regulations will not have a material adverse effect on our capital expenditures, earnings and competitive and financial position.

Although we believe that our safety procedures for using, handling, storing and disposing of such materials comply with the standards required by federal and state laws and regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials.  In the event of such an accident involving such materials, we could be liable for damages and such liability could exceed the amount of our liability insurance coverage and the resources of our business.

SEGMENT INFORMATION

Financial information relating to segment operations for the years ended September 30, 2004, 2003 and 2002, is set forth in Note 18, “Segment Information” of our Notes to Consolidated Financial Statements.

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FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES

Financial information relating to foreign and domestic operations for the years ended September 30, 2004, 2003 and 2002, is set forth in Note 18, “Segment Information” of our Notes to Consolidated Financial Statements.

ITEM 2.  PROPERTIES

At September 30, 2004, our primary locations were as follows:

We maintain sales and service offices under varying leases expiring from 2005 through 2014 in Korea, China, France, Italy, the United Kingdom and the Netherlands.

We consider our facilities to be both suitable and adequate to provide for current and near term requirements.

ITEM 3.  LEGAL PROCEEDINGS

Certain claims and lawsuits have been filed or are pending against us.  In the opinion of management, all such matters have been adequately provided for, are without merit, or are of such kind that if disposed of unfavorably, would not have a material adverse effect on our consolidated results of operations or financial position.

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

Not applicable.

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PART II

ITEM 5.  MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is quoted on the NASDAQ National Market under the symbol “COHR.”  The following table sets forth the high and low closing prices for each quarterly period during the past two fiscal years as reported on the NASDAQ National Market.

The number of stockholders of record as of December 1, 2004 was 1,631.  No cash dividends have been declared or paid since Coherent was founded and we have no present intention to declare or pay cash dividends.  Our agreements with certain financial institutions restrict the payment of dividends on our Common Stock.  See Note 9, “Short-term Borrowings” in our Notes to Consolidated Financial Statements.

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ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data for each of the last five fiscal years have been derived from our audited financial statements.  The following selected consolidated financial data reflects our former Medical segment as discontinued operations.  See Note 3, “Discontinued Operations” in our Notes to Consolidated Financial Statements.

The information set forth below is not necessarily indicative of results of future operations and should be read in conjunction with “Management’s Discussion and Analysis of Results of Operations and Financial Condition” and the Consolidated Financial Statements and Notes to Consolidated Financial Statements.

(1)          Includes a $33.5 million after-tax gain on issuance of stock by our Lambda Physik AG subsidiary.

(2)          Includes a $5.8 million after-tax charge for write-offs of inventory and open purchase commitments in our Lambda Physik segment.  Also includes a $1.6 million after-tax charge for the write-off of purchased in-process research and development associated with the acquisitions of DEOS and MicroLas.

(3)          Includes a $79.2 million after-tax impairment charge on our Lumenis common stock; a $6.7 million after-tax asset impairment charge resulting primarily from a decision to cease most of our activities related to the telecom passives component market; a $3.0 million tax benefit relating to a refund of prior year taxes; $1.0 million after-tax gain on sale of real estate; $0.7 million after-tax and minority interest royalty revenues; and a $0.7 million after-tax and minority interest non-recurring favorable inventory adjustment.

(4)          Includes a $10.2 million impairment charge on our Lumenis common stock; a $9.2 million after-tax charge related to the termination of activities in our Telecom-Actives group; a $7.9 million after-tax charge for the write-down of manufacturing facilities and equipment to net realizable value due to excess capacity and consolidation of operations; a $6.3 million charge for the write-off of purchased in-process research and development associated with our acquisition of Positive Light, Inc and step acquisition of Lambda Physik; a $5.6 million valuation allowance against Lambda Physik’s deferred tax assets; a $2.7 million after-tax impairment charge to write down our Lincoln, California facility to net realizable value; a $2.3 million after-tax charge to write down our loan to Picometrix, Inc. (Picometrix) to net realizable value; a $1.8 million, net of minority interest, impairment charge to write off goodwill associated with Lambda Physik’s lithography business; severance costs at Lambda Physik of $1.3 million, after-tax and net of minority interest; a $1.0 million after-tax charge related to early lease termination costs associated with our Santa Clara, California facility; a $2.1 million tax benefit relating to refund of prior years’ taxes; a customer contract settlement fee of $2.0 million, after-tax and net of minority interest received by Lambda Physik; and a gain of $1.5 million related to the sale of 5.2 million shares of Lumenis, Ltd.

(5)          Fiscal 2004 includes 53 weeks, whereas all other fiscal years presented include 52 weeks.  Includes $3.9 million of net sales from an entity consolidated under Financial Accounting Standards Board Interpretation No. 46R (FIN 46R); additionally, this entity’s net income of $0.5 million was eliminated through minority interest.  Fiscal 2004 also includes a $0.6 million after-tax gain on the sale of certain technology and a $2.0 million after-tax recovery on the sale of a previously impaired note receivable.

(6)          See Note 2, “Significant Accounting Policies” and Note 17, “Earnings (Loss) Per Share” in our Notes to Consolidated Financial Statements for an explanation of the determination of the number of shares used in computing income (loss) per share.

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

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

KEY PERFORMANCE INDICATORS

The following is a summary of some of the quantitative performance indicators (as defined below) that may be used to assess our results of operations and financial condition (dollars in thousands):

Definitions and analysis of these performance indicators are as follows:

Bookings

Bookings represent orders expected to be shipped within 12 months.  Bookings are generally cancelable without substantial penalty and, historically, we generally have not experienced a significant rate of cancellation.  Bookings for a period are calculated by adding current period net sales to the increase or decrease in ending backlog during the period.

In our Electro-Optics segment, fiscal 2004 bookings increased 26.6% from fiscal 2003.  Current year bookings, compared to fiscal 2003, increased in the microelectronics, scientific and government programs, OEM components and instrumentation and materials processing markets, partially offset by decreases in the graphic arts and display market.  Fiscal 2003 bookings increased 12.2% from fiscal 2002, with increases in the scientific and government programs, graphic arts and display, microelectronic and materials processing markets, partially offset by decreases in the OEM components and instrumentation market.

The continued strength in our microelectronics bookings is a direct result of our prior investment decisions.  Today, a significant portion of our revenue is derived from sales to customers investing in emerging manufacturing technologies.  This has allowed us to withstand recent downturns in capacity-driven demand.  Orders for lasers used in wafer processing were mixed.  Emerging technologies for use in the 65nm and 45nm nodes remained strong, especially for photomask inspection and repair tools.  Demand for lasers for wafer metrology tools has been stable.  Bookings for the wafer inspection market slowed down as these are mostly capacity driven.  Service revenues across all applications were healthy.  Bookings in the advanced packaging market were led by increasing interconnect density and demand for motherboards and chip packages for consumer electronics.  Many of the laser-based tools sold into this market are dual-head systems, which means they contain two lasers of different wavelengths, ultraviolet and infrared.  This configuration allows manufacturers to process different materials and feature sizes.  We believe future demand will shift towards the ultraviolet for two reasons.  First, the ultraviolet tools are capable of producing sub-50 micron features that are critical for next generation chip-scale and wafer-level packages.  Second, our recent introduction of the high-power, Avia Thor™ laser will increase the throughput of the packaging tools, thereby enhancing productivity and lowering cost-of-ownership.  Order volume was solid for laser direct imaging for printed circuit board manufacturing and market penetration continued to increase.  The keys to broader penetration are higher throughput and more leverage on the cost-of-ownership model.  We are committed to addressing both drivers with our next

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platform, the Paladin 8000™, which we expect to have in production next spring.

For scientific and government programs, demand was up sharply in both the U.S. and Europe, while demand in Asia slowed.  We received record orders for our Chameleon hands-free femtosecond laser system from the biological imaging market.  The Chameleon is a critical component in producing high-resolution, 3-dimensional images.  We also experienced strong demand for our high performance UF amplifiers for biological imaging and high-energy physics.

Bookings increased in the OEM components and instrumentation market as we continue to expand our share in the bioinstrumentation market with the addition of two new moderate volume OEM accounts for our Sapphire™ product and organic growth of the market.  There are new opportunities for a higher power Sapphire laser.  Among these opportunities is confocal microscopy, a technique used to resolve 3D structure in a variety of samples from biological tissues to semiconductors.  We have established a presence in this market with our first volume order for the 200mW Sapphire.  Future applications for the high power Sapphire include lab-on-a-chip and DNA sequencing.  Activity in the medical market laser was also solid paced by orders for carbon dioxide lasers, diode lasers, and optics.

The year-on-year growth in the materials processing market was disappointing since we believe this is an under-penetrated market.  There are several factors that influenced the results.  The Asian market, and China specifically, drove much of the growth through the first half of fiscal 2004.  Then, growth slowed due to new credit policies established mid-year by the Chinese central government to slow economic growth and high energy prices resulted in reduced investments for manufacturing infrastructure.  Lastly, the market is looking for aggressive gains in the cost-of-ownership, which requires more than simple changes to the existing product portfolio.  To this end, we are planning to introduce several new products for medium to high-volume marking, engraving and desktop manufacturing.  We expect these products to contribute revenues in the upcoming quarters.

The decrease in graphic arts and display orders is due more to technology migration than market conditions.  Direct diode lasers have been adopted at a much faster rate during fiscal 2004.  They displaced certain types of visible lasers due to their size, efficiency and cost.  In fact, the difference in average selling prices (ASP) between a direct diode laser and a visible diode-pumped solid-state laser can be more than $5,000 per unit.  The volume gains have been insufficient to offset the ASP reduction.  As we move into fiscal 2005, we expect a number of newer products, such as a version of our Paladin^™ laser and new diode laser technology; will gain traction in the marketplace.

In our Lambda Physik segment, fiscal 2004 bookings increased 39.1% from fiscal 2003.  Bookings increases in the industrial and scientific and medical markets were partially offset by decreases in the lithography market.  Fiscal 2003 bookings decreased 21.2% from fiscal 2002 bookings, with decreases in the lithography and industrial markets partially offset by increases in the scientific and medical market.

Bookings in the industrial market continued to dominate orders.  Demand for lasers used to produce LTPS (low-temperature poly-silicon) flat panel displays remained solid, with increasing penetration of LTPS displays and more rapid deployment of OLEDs driving the strength in orders.  We encountered increased activity in the ink-jet market where Lambda Physik’s excimer lasers are used to drill nozzles in the ink-jet heads.  In addition, we are seeking several new applications in product security and display technologies.

Bookings in the scientific and medical market increased primarily due to our OPTex lasers in the medical market. We are also experiencing renewed interest from the scientific market stemming from laser-assisted deposition of exotic materials.  While still in a research mode, these techniques could rapidly migrate into the commercial realm.

Bookings decreased in the lithography market primarily due to shifts in technology mix, whereby demands for high productivity wafer scanners at 248nm and 193nm have surfaced.  To address these demands, Lambda Physik introduced the LithoTex^TM, its new high-power 193nm laser at Semicon West in fiscal 2004.

Net Sales

Net sales include sales of lasers, laser-based systems, precision optics, related accessories and service contracts.  Net sales for fiscal 2004 increased 26.2% in our Electro-Optics segment and 4.6% in our Lambda Physik segment from fiscal 2003.  Net sales for fiscal 2003 increased 5.4% in our Electro-Optics segment and decreased 8.7% in our Lambda Physik segment from fiscal 2002.  For a more complete description of the reasons for changes in net sales, we refer you to the “Results of Operations” section of this Annual Report.

Gross Profit as a Percentage of Net Sales

Gross profit as a percentage of net sales (gross profit percentage) is calculated as gross profit for the period divided by net sales for the period.  Gross profit percentage in fiscal 2004 increased from 39.3% to 44.3% in our Electro-Optics segment and increased from 26.2% to 30.9% in our Lambda Physik segment from fiscal 2003.  Gross profit percentage for fiscal 2003 decreased from 41.7% to 39.3% in our

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Electro-Optics segment and decreased from 36.7% to 26.2% in our Lambda Physik segment from fiscal 2002.  For a more complete description of the reasons for changes in gross profit percentage, we refer you to the “Results of Operations” section of this Annual Report.

Research and Development as a Percentage of Net Sales

Research and development as a percentage of net sales (R&D percentage) is calculated as research and development expense for the period divided by net sales for the period.  Management considers R&D spending to be an important indicator in managing our business as investing in new technologies is a key to future growth.  R&D percentage increased from 12.5% in fiscal 2003 to 12.6% in fiscal 2004 and decreased from 13.2% in fiscal 2002 to 12.5% in fiscal 2003.  For a more complete description of the reasons for changes in R&D percentage, refer to the “Results of Operations” section of this Annual Report.

Net Cash Provided by Continuing Operating Activities

Net cash provided by continuing operating activities shown on our Consolidated Statements of Cash Flows primarily represents the excess of cash collected from billings to our customers and other receipts, including tax refunds, over cash paid to our vendors for expenses and inventory purchases to run our business.  This amount represents cash generated by current operations to pay for equipment, technology, and other investing activities, to repay debt, fund acquisitions and for other financing purposes.  We believe this is an important performance indicator since cash generation over the long term is essential to maintaining a healthy business and providing funds to help fuel growth.  We believe generating consistent cash from operations is an indication that our products are achieving a high level of customer satisfaction and we are appropriately monitoring our expenses and inventory levels.  For a more complete description of the components of cash flows from continuing operating activities, we refer you to the Consolidated Statements of Cash Flows and the “Changes in Financial Condition” section of this Annual Report.

Daily Sales Outstanding in Inventories

We calculate daily sales outstanding (DSO) in inventories as net inventories at the end of the period divided by net sales of the period and then multiplied by the number of days in the period, using 360 days for years.  This indicates how well we are managing our inventory levels, with lower DSO in inventories resulting in more working capital available.  The more money we have tied up in inventory, the less money we have available for research and development, acquisitions, expansions, marketing and other activities to grow our business.  Our DSO in inventories for fiscal 2004 decreased 12.5 days from fiscal 2003 to 76.2 days.  The improvement in DSO in inventories is primarily due to better management of inventory levels in relation to sales volumes.

Daily Sales Outstanding in Receivables

We calculate daily sales outstanding (DSO) in receivables as net receivables at the end of the period divided by net sales during the period and then multiplied by the number of days in the period, using 360 days for years.  This indicates how well we are managing our collection of receivables, with lower DSO in receivables resulting in more working capital available.  The more money we have tied up in receivables, the less money we have available for research and development, acquisitions, expansions, marketing and other activities to grow our business.  Our DSO in receivables for fiscal 2004 increased 5.6 days from fiscal 2003.  The deterioration in DSO in receivables is primarily due to increased sales volumes towards the end of fiscal 2004 compared to the end of fiscal 2003.

Capital Spending as a Percentage of Net Sales

Capital spending as a percentage of net sales (capital spending percentage) is calculated as capital expenditures for the period divided by net sales for the period.  This indicates the extent to which we are expanding or modernizing our operations, including investments in technology.  Management monitors capital spending levels as this assists management in measuring our cash flows, net of capital expenditures.  Our capital spending percentage increased from 6.3% to 9.4% compared to fiscal 2003 primarily due to our purchase of our previously leased facility in Santa Clara, California, in the first quarter of fiscal 2004.  Our capital spending percentage decreased from 10.0% in fiscal 2002 to 6.3% in fiscal 2003 primarily due to higher investments in the expansion of manufacturing capacity in fiscal 2002.  We anticipate that capital spending for fiscal 2005 will be approximately 5% to 6% of net sales.

SIGNIFICANT EVENTS

On June 3, 2003, we initiated a tender offer to purchase the 5,250,000 (39.62%) outstanding shares of our Lambda Physik subsidiary that were owned by other shareholders (the minority interest) for approximately $10.50 per share.  During fiscal 2003, we purchased 4,489,823 outstanding shares of Lambda Physik for approximately $47.7 million, resulting in a total ownership percentage of 94.26% (inclusive of shares previously owned) as of September 30, 2003.  During fiscal 2004, we purchased an additional 98,677 of outstanding shares of Lambda Physik for approximately $1.3 million, resulting in a total ownership percentage of 95.01% (inclusive of shares previously owned) as of September 30, 2004.  On May 5, 2004, a resolution was passed at Lambda Physik’s shareholders’ meeting that permits us to acquire all remaining shares in accordance with the German Stock Corporation Act.  Upon acquisition of the

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minority interest, we plan on converting Lambda Physik from a stock corporation to a limited liability company, which will result in the Lambda Physik shares being de-listed from the Frankfurt Stock Exchange.  On November 2, 2004, we agreed to increase the price to be paid to those minority shareholders who did not accept the squeeze out proposal to approximately $18.88 per share in exchange for their agreement to waive rights to a court appraisal.  On November 17, 2004, the Göttingen court approved this definitive agreement and, as a result, the registration of the squeeze out resolution of the May 5, 2004 shareholders meeting has been applied for. We anticipate that the Göttingen court will approve the merger in the first calendar quarter of 2005 following a statutory notification and review period.  Once the approval is in place, we plan to purchase the remaining shares of Lambda Physik and complete the integration.

In September 2004, we sold our note receivable from Picometrix for $4.0 million, resulting in a recovery of approximately $3.2 million of the impairment charge previously recognized in fiscal 2003 (see Note 8 “Balance Sheet Details” in our Notes to Consolidated Financial Statements).

In December 2004, our Lambda Physik subsidiary decided to discontinue future product development and investments in the semiconductor lithography market.  As a result of this decision, we anticipate recognizing a charge of between $3.0 million and $6.0 million in the quarter ending January 1, 2005, primarily to recognize the write-downs of potentially excessive and obsolete inventories.

RESULTS OF OPERATIONS—YEARS ENDED SEPTEMBER 30, 2004, 2003 AND 2002

Fiscal 2004 includes 53 weeks, whereas fiscal 2003 and fiscal 2002 included 52 weeks.

Consolidated Summary

Income from continuing operations for fiscal 2004 was $17.5 million ($0.57 per diluted share), including a recovery of $3.2 million on the sale of our Picometrix note receivable and a $1.2 million gain related to the sale of certain technology.

Loss from continuing operations for fiscal 2003 was $46.5 million ($1.58 per diluted share) including restructuring, impairment and other charges of $35.2 million, a $10.2 million impairment charge related to the write-down of our shares of Lumenis, a $6.3 million write-off of purchased in-process research and development (IPR&D) related to the acquisitions of PLI and 33.88% of Lambda Physik, a $5.6 million net of minority interest charge to reflect the establishment of a valuation allowance against Lambda Physik’s deferred tax assets and severance costs at Lambda Physik of $2.5 million ($2.2 million net of minority interest), partially offset by a settlement

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fee of $4.4 million ($3.4 million net of minority interest) received by Lambda Physik related to the cancellation of a customer contract dating back to the fourth quarter of fiscal 2001, gains of $2.1 million relating to refunds of prior year taxes and a gain of $1.5 million related to the sale of 5.2 million shares of Lumenis.  The fiscal 2003 restructuring, impairment and other charges of $35.2 million included a $14.8 million restructuring and impairment charge related to the termination of activities of our CTAG operating segment, impairment charges of $9.6 million relating to manufacturing facilities and equipment due to excess capacity and consolidation of operations, a $3.7 million allowance against our note receivable from Picometrix, a $3.1 million write-down of our Lincoln, California facility to estimated net realizable value at December 28, 2002, goodwill impairment of $2.4 million ($1.8 million net of minority interest) and $1.7 million of early lease termination costs relating to our operating lease for our facility in Santa Clara, California, partially offset by the recovery of $0.1 million in excess of estimated net realizable value for assets previously impaired and classified as held for sale.

During fiscal 2002, loss from continuing operations was $70.8 million ($2.46 per diluted share), including impairment charges of $115.3 million, a $3.0 million tax benefit related to a refund of prior year taxes, a gain on sale of real estate of $1.7 million, royalty revenue of $2.0 million ($1.5 million net of minority interest) and a non-recurring favorable inventory adjustment of $1.6 million ($1.2 million net of minority interest).  The fiscal 2002 impairment charges included a $104.2 million write-down of the value of the Lumenis stock we acquired as a result of the April 2001 sale of our Medical segment to Lumenis, as well as an $11.0 million charge for equipment impairment due to management’s decision to cease most of our activities related to the telecom passives component market.

The fiscal 2004 increase in income from continuing operations as compared to fiscal 2003 was primarily attributable to the prior year’s larger restructuring, impairment and other charges, higher sales volumes, higher gross margins as a percentage of sales, the prior year’s impairment charge on Lumenis shares, the prior year’s IPR&D charges, the prior year’s higher valuation allowance provision against Lambda Physik’s deferred tax assets and the current year’s recovery on the sale of our Picometrix note receivable, partially offset by higher research and development spending, higher selling, general and administration expenses and the prior year’s gain on settlement contracts.

The fiscal 2003 decrease in loss from continuing operations as compared to fiscal 2002 was primarily attributable to fiscal 2002’s impairment charges, fiscal 2003’s gain on settlement contracts and fiscal 2003’s gain on sale of Lumenis shares, partially offset by fiscal 2003’s restructuring, impairment and other charges, lower gross margins as a percentage of sales, fiscal 2003’s impairment charge on Lumenis shares, fiscal 2003’s IPR&D charges, fiscal 2003’s valuation allowance against Lambda Physik’s deferred tax assets, fiscal 2003’s severance costs at Lambda Physik, lower interest and dividend income, fiscal 2002’s gain on sales of real estate, fiscal 2002’s royalty revenue and fiscal 2002’s favorable inventory adjustment.

Net Sales

The following table sets forth, for the periods indicated, the amount of net sales for our operating segments and their relative percentages of total net sales.

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Consolidated

During fiscal 2004, net sales increased by $88.7 million, or 22%, to $495.0 million from $406.2 million in fiscal 2003 as a result of increased sales volumes in both reportable segments.  Foreign sales increased $53.0 million, or 21%, and domestic sales increased $35.7 million, or 23%.  Foreign sales were 61% of net sales in both fiscal 2004 and 2003.  We anticipate that our microelectronics and material processing markets will show the greatest growth potential in the future as feature sizes continue to shrink and new materials are introduced.  The scientific research and OEM components and instrumentation markets are projected to show more modest growth, while the graphic arts and display market continues to hold solid opportunities.  Lambda Physik’s growth in fiscal 2004 was led by strength in the industrial market and we believe this trend should continue.

During fiscal 2003, net sales increased by $8.9 million, or 2%, to $406.2 million from $397.3 million in fiscal 2002 as a result of increased sales volumes in the Electro-Optics segment, partially offset by decreased sales volumes in the Lambda Physik segment.  Foreign sales increased $11.0 million, or 5%, while domestic sales decreased $2.1 million, or 1%.  Foreign sales were 61% of net sales in fiscal 2003 and 60% in fiscal 2002.

Electro-Optics

Electro-Optics net sales increased by $85.0 million, or 26%, in fiscal 2004 to $409.3 million from $324.3 million in fiscal 2003. Foreign sales increased by $45.9 million, or 25%, and domestic sales increased by $39.1 million, or 27%, from fiscal 2003.  Sales increased across all five primary market segments: microelectronics, scientific research and government programs, OEM components and instrumentation, materials processing and graphic arts and display and were impacted favorably by the strengthening of the Euro, Yen and Pound Sterling against the U.S. dollar.  Microelectronics application sales increased $51.4 million, or 95%, compared to fiscal 2003, primarily due to improving fundamentals in the semiconductor equipment and consumer electronics markets.  Net sales within the scientific research and government programs lines of business improved by $16.4 million, or 16%, compared to fiscal 2003, primarily as a result of the increase in sales from our acquisition of PLI ($7.2 million), increased sales from new scientific products and the consolidation of Picometrix ($3.9 million) for six months in fiscal 2004.  OEM components and instrumentation application sales increased $8.6 million, or 9%, primarily due to significantly increased bioinstrumentation volumes.  Materials processing application sales increased $8.3 million, or 16%, primarily due to strong orders for marking, engraving and textile processing.  Sales in the graphic arts and display applications increased $0.3 million, or 1%, from fiscal 2003.  Although we experienced increases in orders received over the past several quarters and we continue to have a sizeable backlog of orders, current market conditions make it difficult to predict future orders.

Electro-Optics net sales increased by $16.7 million, or 5%, in fiscal 2003 to $324.3 million from $307.6 million in fiscal 2002.  Foreign sales increased by $14.8 million, or 9%, and domestic sales increased by $1.9 million, or 1%, from fiscal 2002.  Sales increased primarily due to the acquisitions of Molectron and PLI and across all five primary market segments: microelectronics, graphic arts and display, materials processing, scientific research and government programs, and OEM components and instrumentation.  Net sales within the scientific and government lines of business improved by approximately $4.8 million, or 5%, compared to fiscal 2002 primarily as a result of the increase in sales from PLI ($9.6 million), partially offset by a decline in other scientific business.  The microelectronics market application net sales increased $3.9 million, or 8%, from fiscal 2002 due to improving fundamentals in the semiconductor equipment and consumer electronics markets.  Graphic arts and display benefited from a transition to more environmentally friendly digital processes in both the computer-to-plate and photo-finishing applications, resulting in a $3.4 million, or 16% increase in sales from fiscal 2002.  The materials processing market application net sales increased $2.3 million, or 5%, from fiscal 2002 as the laser replaced conventional machine tools for cutting, marking, and coding, and benefited from an increase in sales to Asia, although growth was somewhat tempered as a result of the spread of SARS in the region.  Our OEM components and instrumentation net sales increased $2.2 million, or 2%, resulting from increased demand and sales of bio-instrumentation products offset by a decline in sales to Lumenis.  Additionally, the strengthening of the Euro and Yen against the U.S. dollar also resulted in an increase to net sales.

In fiscal 2004 and 2003, no customers accounted for greater than 10% of Electro-Optics net sales.

Lambda Physik

Lambda Physik net sales increased by $3.7 million, or 5%, in fiscal 2004 to $85.7 million from $81.9 million in fiscal 2003.  Foreign sales increased by $7.1 million, or 11%, while domestic sales decreased by $3.4 million, or 23%.  Net sales increased primarily due to the strengthening of the Euro and Yen against the U.S. dollar, higher sales volumes in the industrial market due to increases in the flat panel and ink jet system business and increased demand with medical OEM customers, partially offset by lower systems sales volumes in the lithography market.

Lambda Physik net sales decreased by $7.8 million, or 9%, in fiscal 2003 to $81.9 million from $89.7 million in fiscal 2002.  Domestic

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sales decreased by $4.0 million, or 21%, and foreign sales decreased by $3.8 million, or 5%.  The decrease in sales was primarily due to lower sales volumes in the industrial market due to weakness in the flat panel business, lower royalty revenue and lower demand with medical OEM customers, partially offset by the strengthening of the Euro against the U.S. dollar and higher sales volumes in the lithography market due to the introduction of the new 193nm wavelength lasers, following a period of decline caused by the downturn in the semiconductor industry.

In fiscal 2004, one customer accounted for 31% of Lambda Physik’s net sales.  In fiscal 2003, one customer accounted for 18% of Lambda Physik’s net sales while another customer accounted for 11% of Lambda Physik net sales.

Gross Profit

Consolidated

The consolidated gross profit rate increased by 5.3% to 41.9% in fiscal 2004 from 36.6% in fiscal 2003.  The increase in the gross profit rate was primarily due to more effective leveraging of manufacturing overhead (2.6%) due to higher sales volumes and consolidation of manufacturing operations; more favorable manufacturing variances (0.8%) resulting from outsourcing the manufacture of certain components and the sale of previously written down inventories; favorable product mix (0.8%) with lower shipments of low margin OEM components products, higher ASPs on scientific products and higher shipments of higher margin microelectronics products in the Electro-Optics segment as well as higher sales of Lambda Physik’s high margin industrial systems, partially offset by lower ASPs in Electro-Optics’ bioinstrumentation market and lower sales of high margin lithography systems and higher sales of lower margin medical and scientific products in the Lambda Physik segment, lower warranty expenses (0.6%) in Lambda Physik’s lithography business and lower additional inventory provisions (0.5%) in the Electro-Optics segment.

Our consolidated gross profit rates have been and will continue to be affected by a variety of factors including foreign and domestic sales mix, manufacturing efficiencies, excess and obsolete inventory write-downs, warranty costs, pricing by competitors or suppliers, new product introductions, production volume, customization and reconfiguration of systems, foreign currency fluctuations and field service margins.  We plan to add 2 to 4 percentage points to the Electro-Optics gross profit over the next 24 months.  We expect to accomplish this by better exercising our buying power to reduce material costs, strengthening of our supply chain and migrating to more common components and product platforms.  Lambda Physik’s gross profit will benefit from a full year of improved product reliability, reduced warranty costs and improving margins on service contracts but will impacted by charges recognized from its decision to discontinue future development in the semiconductor lithography market.

The consolidated gross profit rate decreased by 3.9% to 36.6% in fiscal 2003 from 40.5% in fiscal 2002.  The decrease in the gross profit rate was primarily due to changes in product mix with higher shipments of lower margin commercial solid state systems to the materials processing market in the Electro-Optics segment (1.6%) and lower shipments of higher margin industrial systems in the Lambda Physik segment (1.2%), higher manufacturing expenses as a percentage of sales in the Lambda Physik segment (0.6%) due to lower sales volumes, higher inventory valuation reserve requirements due to a lower forecasted outlook for the lithography business and higher warranty expenses in both segments.

Electro-Optics

The gross profit rate increased by 5.0% to 44.3% of net sales in fiscal 2004 from 39.3% in fiscal 2003.  The increase was primarily due to more effective leveraging of manufacturing overhead (2.7%) due to higher sales volumes and consolidation of manufacturing operations, more favorable manufacturing variances (0.9%) resulting from outsourcing the manufacture of certain components and the sale of previously written down inventories, favorable product mix (0.6%) with lower shipments of low margin OEM components products, higher average selling prices (ASPs) on scientific products and higher shipments of higher margin microelectronic products, partially offset by lower ASPs in the bioinstrumentation market and lower additional inventory provisions (0.6%).

The gross profit rate decreased by 2.4% to 39.3% in fiscal 2003 from 41.7% in fiscal 2002.  The decrease was primarily due to higher shipments of lower margin commercial CO₂ gas laser systems to the materials processing market (1.9%) and higher warranty expenses due to new product introductions (1.1%), partially offset by more favorable manufacturing variances (0.5%) due to lower scrap and rework charges.

Lambda Physik

The gross profit rate increased by 4.7% to 30.9% in fiscal 2004 from 26.2% in fiscal 2003.  The increase in gross profit rate was due to lower warranty expenses (3.2%) primarily in the lithography business and changes in mix (1.5%) with higher sales of high margin TFT and ink jet industrial systems, partially offset by lower sales of high margin lithography systems and higher sales of lower margin medical and scientific products.

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The gross profit rate decreased by 10.5% to 26.2% in fiscal 2003 from 36.7% in fiscal 2002.  The decrease in the gross profit rate was primarily due to changes in mix (7.0%) with lower shipments of higher margin industrial systems and higher manufacturing expenses as a percentage of sales (3.5%), as well as due to lower sales volumes, higher inventory valuation reserve requirements due to a lower forecasted outlook for the lithography business and higher warranty expenses in the industrial business.

Operating Expenses

Research and development

Fiscal 2004 research and development (R&D) expenses increased $11.7 million, or 23%, from fiscal 2003 and increased to 12.6% from 12.5% of net sales.  The increase is primarily due to increased labor and material spending related to new projects in our Electro-Optics ($5.1 million) and Lambda Physik ($2.3 million) segments, the impact of the strengthening of the Euro against the U.S. dollar ($3.0 million) and the consolidation of Picometrix under FIN 46R ($1.3 million).  We anticipate R&D expenses to continue to be approximately 12% of net sales in fiscal 2005.

Fiscal 2003 R&D expenses decreased $1.9 million, or 4%, from fiscal 2002 and decreased to 12.5% from 13.2% of net sales.  The decrease is primarily due to the termination of our CTAG operations in the first quarter of fiscal 2003 ($4.4 million) and lower spending on projects in our Electro-Optics and Lambda Physik segments ($1.9 million), partially offset by the strengthening of the Euro against the U.S. dollar in our Lambda Physik segment ($3.3 million) and increased research and development activities related to individually addressable semiconductor laser bar products in our Electro-Optics segment ($1.1 million).  Fiscal 2003 and 2002 research and development expenses included $1.9 million and $6.3 million, respectively, for our CTAG operating segment, which was terminated in the first quarter of fiscal 2003.

In-process research and development

Fiscal 2003 IPR&D expense of $6.3 million resulted from our acquisition of PLI ($4.4 million) and our acquisition of an additional 33.88% of the minority interest ownership of Lambda Physik ($1.9 million).  The values assigned to purchased IPR&D were determined by identifying research projects in areas for which technological feasibility were not established and that had no alternative future use.  The values were determined by estimating the costs to develop the acquired in-process technologies into commercially viable products, estimating the resulting net cash flows from such projects, and discounting the net cash flows back to their present value.

Selling, general and administrative

Fiscal 2004 selling, general and administrative (SG&A) expenses increased by $9.4 million, or 9%, from fiscal 2003, but decreased as a percentage of net sales from 25.6% to 22.9%.  The dollar increase was primarily due to the strengthening of the Euro and Yen against the U.S. dollar ($2.8 million), higher consulting and depreciation expense related to our investments in information technology systems ($2.1 million), higher headcount related expenses ($1.9 million), higher facilities expenses due to building remodeling and consolidations ($1.4 million), higher legal, audit and tax consulting expenses ($1.1 million), higher sales commissions due to higher sales volumes ($0.9 million), the consolidation of Picometrix under FIN 46R ($0.8 million), higher marketing communications expenses ($0.5 million), partially offset by the fiscal 2003 severance costs in our Lambda Physik segment ($2.5 million).  We are focused on reducing SG&A as a percent of sales.  We anticipate SG&A expenses will be approximately 22% of net sales in fiscal 2005.

Fiscal 2003 selling, general and administrative expenses increased by $9.8 million, or 10%, from fiscal 2002, and increased as a percentage of net sales from 23.7% to 25.6%.  The increase was primarily due to the acquisitions of Molectron and PLI ($4.1 million), the impact of the strengthening of the Euro against the U.S. dollar ($3.1 million), severance costs in our Lambda Physik segment ($2.5

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