VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES INC - 10-Q Quarterly Report

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

Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

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

Varian Semiconductor Equipment Associates, Inc. (“Varian Semiconductor”) designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits to customers located both in the U.S. and in international markets. Varian Semiconductor faces risk factors similar to all companies in the semiconductor manufacturing equipment market including, but not limited to, competition, market downturn, technological change, international operations and related foreign currency risks and ability to recruit and retain key employees.

These unaudited interim consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These unaudited interim consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the annual report on Form 10-K filed by Varian Semiconductor with the Securities and Exchange Commission for the fiscal year ended October 3, 2003. In the opinion of Varian Semiconductor, the unaudited interim consolidated financial statements include all adjustments, consisting of only normal recurring adjustments, necessary to present fairly the information required to be set forth therein. The results of operations for the three- and nine-month periods ended July 2, 2004 are not necessarily indicative of the results to be expected for a full year or for any other period.

Certain items in the prior year’s consolidated financial statements have been reclassified to conform to the current presentation of the financial statements.

Varian Semiconductor accounts for stock compensation plans in accordance with APB Opinion No. 25. An immaterial amount of compensation expense has been recognized in the financial statements for stock compensation plans. If Varian Semiconductor had elected to recognize compensation cost based on the fair value of all stock awards at grant date as prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 123, the net income and net income per basic and diluted share for the three- and nine-month periods ended July 2, 2004 and June 27, 2003 would have been reduced to the pro forma amounts shown below:

Basic net income per share is calculated based on net income and the weighted average number of common stock outstanding during the reporting period. Diluted net income per share includes additional dilution from stock issuable pursuant to the exercise of stock options outstanding. For purposes of the diluted net income per share calculation, the additional shares issuable upon exercise of stock options are determined using the treasury stock method.

A reconciliation of the numerator and denominator used in the net income per share calculations is presented as follows:

For the three- and nine-month periods ended July 2, 2004, options to purchase 906,738 and 821,733 common shares at a weighted average exercise price of $48.51 and $49.36, respectively (an exercise price that exceeded the market value of the underlying common stock), were excluded from the computation of diluted earnings per share as inclusion would be anti-dilutive. For the three- and nine-month periods ended June 27, 2003, options to purchase 2,545,555 and 2,519,258 common shares at a weighted average exercise price of $34.56 and $34.87, respectively (an exercise price that exceeded the market value of the underlying common stock), were excluded from the computation of diluted earnings per share.

As of July 2, 2004, Varian Semiconductor had outstanding options to purchase an aggregate of 4,008,684 shares of its common stock at a weighted average price of $28.78. Of these options, options to purchase an aggregate of 2,894,470 shares of its common stock at a weighted average price of $26.92 were exercisable.

Varian Semiconductor considers currency on hand, demand deposits, and all highly liquid investments with an original purchase maturity of three months or less to be cash and cash equivalents. The carrying amounts of cash and cash equivalents approximate estimated fair value because of the short-term maturities of those financial instruments. Cash equivalents at July 2, 2004 and October 3, 2003 were $222.1 million and $304.3 million, respectively. Short-term investments consist primarily of U.S. Treasury and government agency securities, certificates of deposit and corporate bonds with ratings AA or better. All of Varian Semiconductor’s short-term investments are classified as available-for-sale at the respective balance sheet dates. Varian Semiconductor manages its cash equivalents and short-term investments as a single portfolio of highly marketable securities that is intended to be available to meet Varian Semiconductor’s current cash requirements. As of July 2, 2004, an accumulated net unrealized loss on short-term investments of $543,000 had been recorded as accumulated other comprehensive loss.

Varian Semiconductor warrants that its products will be free from defects in materials and workmanship and will conform to standard published specifications in effect at the time of delivery, for a period of three to twelve months from the date the customer accepts the products. Additionally, Varian Semiconductor warrants that maintenance services will be performed in a workmanlike manner consistent with generally accepted industry standards for a period of ninety days from the completion of any agreed-upon services. Varian Semiconductor provides for the estimated cost of product warranties, primarily from historical information, at the time product revenue is recognized. Varian Semiconductor’s warranty obligation is affected by a number of factors, including product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should these factors or other factors affecting warranty costs differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.

Product warranty activity for the first nine months of fiscal year 2004 was as follows:

Long-term accrued expenses are comprised of accruals for environmental costs not expected to be expended within the next year. The current portion is recorded within accrued expenses.

Note 10. Operating Segments, Significant Customers and Geographic Information

Varian Semiconductor operates in one business segment: the manufacturing, marketing and servicing of ion implantation systems. Since Varian Semiconductor operates in one segment, all financial segment information required by SFAS No. 131, “Segment Reporting,” can be found in the consolidated financial statements.

During the third quarter of fiscal year 2004, revenue from one customer accounted for 11% of Varian Semiconductor’s total revenue. During the third quarter of fiscal year 2003, revenue from three customers accounted for 19%, 16% and 12% of Varian Semiconductor’s total revenue. During the first nine months of fiscal year 2004, revenue from one customer accounted for 15% of Varian Semiconductor’s total revenue. During the first nine months of fiscal year 2003, revenue from three customers accounted for 19%, 13% and 11% of Varian Semiconductor’s total revenue.

As of July 2, 2004, one customer accounted for 12% of the total accounts receivable balance. As of October 3, 2003, one customer accounted for 12% of the total accounts receivable balance.

The following table summarizes revenue based on final geographic destination and long-lived assets by geography:

Varian Semiconductor is currently a defendant in a number of legal actions and could incur an uninsured liability in one or more of them. In the opinion of management, the outcome of such litigation will not have a material adverse effect on the consolidated financial position, results of operations or cash flows of Varian Semiconductor.

As permitted under Delaware law, Varian Semiconductor has agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was, serving in such capacity at the request of Varian Semiconductor. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments Varian Semiconductor could be required to make under these indemnification agreements is unlimited; however, Varian Semiconductor has a Director and Officer insurance policy that limits its exposure and enables Varian Semiconductor to recover a portion of any future amounts paid. As a result of Varian Semiconductor’s insurance policy coverage, management believes the estimated fair value of these indemnification agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of July 2, 2004.

Varian Semiconductor enters into indemnification agreements in the normal course of business. Pursuant to these agreements, Varian Semiconductor indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our customers, in connection with any patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments Varian Semiconductor could be required to make under these indemnification agreements is unlimited. Management believes the estimated fair value of these agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of July 2, 2004.

Varian Semiconductor also indemnifies certain customers with respect to damages, losses and liabilities they may suffer or incur relating to personal injury, personal property damage, product liability, and environmental claims relating to the use of Varian Semiconductor’s products and services or resulting from the acts or omissions of Varian Semiconductor, its employees, officers, authorized agents or subcontractors. Varian Semiconductor has general and umbrella insurance policies that limit its exposure under these indemnification obligations and guarantees. As a result of our insurance policy coverage, Varian Semiconductor believes the estimated fair value of these indemnification agreements is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for these agreements as of July 2, 2004.

Prior to the spin-off of Varian Semiconductor from Varian Associates, Inc. (“VAI”) on April 2, 1999, Varian Semiconductor’s business was operated as the Semiconductor Equipment Business (“SEB”) of VAI. On April 2, 1999, VAI contributed its SEB to Varian Semiconductor, its Instruments Business (“IB”) to Varian, Inc. (“VI”), and changed its name to Varian Medical Systems, Inc. (“VMS”). These transactions were accomplished under the terms of several agreements by and among Varian Semiconductor, VI and VMS (collectively, the “Distribution Related Agreements”). VAI has been named by the United States

Environmental Protection Agency or third parties as a potentially responsible party under CERCLA, at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also involved in various stages of environmental investigation and/or remediation under the direction of, or in consultation with, foreign, federal, state and/or local agencies at certain current or former VAI facilities (including facilities disposed of in connection with VAI’s sale of its Electron Devices business during fiscal year 1995, and the sale of its Thin Film Systems (“TFS”) business during fiscal year 1997). The Distribution Related Agreements provide that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.

For certain of these sites and facilities, various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate the future costs of such activities if undertaken. Varian Semiconductor has accrued $1.3 million in estimated environmental investigation and remediation costs for these sites and facilities as of July 2, 2004. As to other sites and facilities, sufficient knowledge has been gained to be able to reasonably estimate the scope and costs of future environmental activities. As such, Varian Semiconductor has accrued $4.8 million, which represents future costs discounted at 7%, net of inflation, to cover Varian Semiconductor’s portion of these costs. This reserve is in addition to the $1.3 million previously described.

As of July 2, 2004, Varian Semiconductor’s environmental liability, based upon future environmental-related costs estimated by VMS as of that date and included in current and long-term accrued expenses, totaled $6.1 million, of which $1.3 million is classified as current.

The amounts set forth in the foregoing paragraph are only estimates of anticipated future environmental-related costs, and the amounts actually spent in the years indicated may be greater or less than such estimates. The aggregate range of cost estimates reflects various uncertainties inherent in many environmental investigation and remediation activities and the large number of sites where VMS is undertaking such investigation and remediation activities. VMS believes that most of these cost ranges will narrow as investigation and remediation activities progress. Varian Semiconductor believes that its reserves are adequate, but as the scope of the obligations becomes more clearly defined, these reserves may be modified and related charges against income may be made.

Although any ultimate liability arising from environmental-related matters described herein could result in significant expenditures that, if aggregated and assumed to occur within a single fiscal year, would be material to Varian Semiconductor’s financial statements, the likelihood of such occurrence is considered remote. Based on information currently available to management and its best assessment of the ultimate amount and timing of environmental-related events, Varian Semiconductor’s management believes that the costs of these environmental-related matters are not reasonably likely to have a material adverse effect on the consolidated financial statements of Varian Semiconductor.

Varian Semiconductor evaluates its liability for environmental-related investigation and remediation in light of the liability and financial wherewithal of potentially responsible parties and insurance companies where Varian Semiconductor believes that it has rights to contribution, indemnity and/or reimbursement. Claims for recovery of environmental investigation and remediation costs already incurred, and to be incurred in the future, have been asserted against various insurance companies and other third parties. In 1992, VAI filed a lawsuit against 36 insurance companies with respect to most of the above-referenced sites and facilities. VAI received certain cash settlements with respect to these lawsuits in prior years. VMS has also reached an agreement with an insurance company under which the insurance company agreed to pay a portion of Varian Semiconductor’s past and future environmental-related expenditures. Varian Semiconductor therefore has a receivable of $1.1 million included in other assets at July 2, 2004, as its portion of the insurance recoveries. Although VMS intends to aggressively pursue additional insurance recoveries, Varian Semiconductor has not reduced any liability in anticipation of recovery with respect to claims made against third parties.

As part of the purchase of Varian Semiconductor’s facility located in Newburyport, Massachusetts, the Company has indemnified the lender for any violation of any local, state and federal laws pertaining to environmental regulations, contamination or clean-up. Varian Semiconductor believes the estimated fair value of this indemnification is minimal. Accordingly, Varian Semiconductor has not recorded any liabilities for this agreement as of July 2, 2004.

In September 2000, Varian Semiconductor and Applied Materials settled patent infringement and antitrust litigation. After recording a payment to Applied Materials and legal expenses, Varian Semiconductor recorded a gain of $16.0 million ($10.8 million after taxes) relating to this litigation settlement. Varian Semiconductor maintains a reserve to cover any residual indemnification obligations. Included in current liabilities and classified as an estimated loss contingency was $2.7 million as of July 2, 2004 and October 3, 2003. It is reasonably possible that the amount in this loss contingency could be reduced in the near future, as obligations have been minimal.

Varian Semiconductor has agreed to indemnify VMS and VI for any costs, liabilities or expenses relating to Varian Semiconductor’s legal proceedings, including the Applied Materials matter. Under the Distribution Related Agreements, Varian Semiconductor has agreed to reimburse VMS for one-third of the costs, liabilities, and expenses, adjusted for any related tax benefits recognized or realized by VMS, with respect to certain legal proceedings relating to discontinued operations of VMS. Varian Semiconductor believes the estimated fair value of the indemnification agreements is minimal, except as already recorded on the financial statements.

Varian Semiconductor’s operations are subject to various foreign, federal, state and/or local laws relating to the protection of the environment. These include laws regarding discharges into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. In addition, several countries are reviewing proposed regulations that would require manufacturers to dispose of their products at the end of a product’s useful life. These laws have the effect of increasing costs and potential liabilities associated with the conduct of certain operations.

Varian Semiconductor is currently the plaintiff in several legal disputes related to breach of contract, and the infringement of certain of Varian Semiconductor’s patents by third parties. The outcome of these claims, the amount, which may be significant, and the timing is uncertain.

Varian Semiconductor’s business is cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. The semiconductor industry has historically experienced periodic downturns, and in response Varian Semiconductor has occasionally recorded restructuring charges in connection with cost reduction initiatives implemented in response to the industry downturns. Restructuring charges typically consist of severance, benefits and outplacement services offered to terminated employees, and charges for remaining lease payments on facilities that are closed.

During fiscal year 2003, Varian Semiconductor recognized approximately $1.4 million in restructuring costs. The restructuring costs related to a reduction in headcount of approximately 55 employees and were severance-related. All of the remaining restructuring reserve balance of $0.1 million as of July 2, 2004 is expected to be paid by the end of fiscal year 2006.

Below is a table summarizing the restructuring reserve activity in the first nine months of fiscal 2004:

The restructuring reserve of $0.1 million is included in accrued expenses on the balance sheet.

Varian Semiconductor uses derivative instruments to protect its interests from fluctuations in earnings and cash flows caused by volatility in currency exchange rates. Varian Semiconductor continued its policy of hedging its current exposures and in the third quarter of fiscal year 2004 began to hedge a portion of its anticipated foreign currency exposures with hedging instruments having terms of up to twelve months.

Varian Semiconductor’s international sales are primarily denominated in United States dollars. For foreign currency denominated sales, however, the volatility of the foreign currency markets represents risk to Varian Semiconductor. Upon forecasting the exposure, Varian Semiconductor enters into hedges with forward sales contracts whose critical terms are designed to match those of the underlying exposure. These hedges are evaluated for effectiveness at least quarterly using the change in value of the forward contracts to the change in value of the underlying transaction, with the effective portion of the hedge accumulated in Other Comprehensive Income (“OCI”). Any measured ineffectiveness is included immediately in marketing, general and administrative expenses in the consolidated statements of operations. There has been no amount of ineffectiveness recognized during the three-month period ended July 2, 2004. OCI associated with hedges of sales denominated in foreign currencies are reclassified to revenue upon recognition in income of the underlying hedged exposure. All amounts reported in OCI at July 2, 2004 are anticipated to be reclassified to revenue within seven months. OCI activity during the year (in thousands):

This Form 10-Q contains certain forward-looking statements. For purposes of the safe harbor provisions under The Private Securities Litigation Reform Act of 1995, any statements using the terms “believes,” “anticipates,” “expects,” “plans” or similar expressions are forward-looking statements. The forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected. There are a number of important factors that could cause Varian Semiconductor’s actual results to differ materially from those indicated by forward-looking statements made in this report and presented by management from time to time. Some of the important risks and uncertainties that may cause Varian Semiconductor’s financial results to differ are under the heading “Risk Factors” in this report and in the annual report on Form 10-K for the fiscal year ended October 3, 2003, filed with the Securities and Exchange Commission on December 12, 2003.

The following information should be read in conjunction with the unaudited interim consolidated financial statements and notes thereto included in “Item 1. Consolidated Financial Statements” of this quarterly report and the audited consolidated financial statements and notes thereto and the section titled “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Varian Semiconductor’s annual report on Form 10-K for the fiscal year ended October 3, 2003 filed with the Securities and Exchange Commission on December 12, 2003.

Critical Accounting Policies and Significant Judgments and Accounting Estimates

Varian Semiconductor’s discussion and analysis of its financial condition and results of operations are based upon Varian Semiconductor’s consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States. The preparation of these consolidated financial statements requires Varian Semiconductor to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On a continual basis, Varian Semiconductor evaluates its estimates, including those related to inventories, accounts receivable, intangible assets, income taxes, warranty obligations, post-retirement benefits, contingencies, and functional currencies. Varian Semiconductor operates in a highly cyclical and competitive industry that is influenced by a variety of diverse factors including, but not limited to, technological advances, product life cycles, customer and supplier lead times, and macroeconomic and geographic economic trends. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. See also the factors discussed below under the section titled “Risk Factors.”

Varian Semiconductor believes that the following sets forth the critical accounting policies used by Varian Semiconductor in the preparation of its consolidated financial statements.

Varian Semiconductor recognizes revenue from product sales upon shipment, provided title and risk of loss has passed to the customer, evidence of an arrangement exists, fees are contractually fixed or determinable, collectibility is reasonably assured through historical collection results and regular credit evaluations, and there are no uncertainties regarding customer acceptance.

For established and new products, a portion of the total purchase price is typically not due until installation occurs and the customer accepts the product. For established products, the lesser of the amount allocated to the equipment or the contractual amount due upon delivery is recorded as product revenue upon delivery. The amount deferred is recognized as revenue upon customer acceptance of all material terms of the customer acceptance criteria. For new products, revenue allocated to the equipment is recognized upon customer acceptance. Revenue related to spare parts and upgrade sales is recognized upon the later of delivery or when the title and risk of loss passes to the customer.

Products are classified as established products if post-delivery acceptance provisions and the installation process have been determined to be routine (due to the fact that the acceptance provisions are generally a replication of pre-shipment procedures) and there is a demonstrated history of achieving predetermined installation cost targets. The majority of products are designed and manufactured to meet contractual customer specifications. To ensure customer specifications are satisfied, the systems are

tested at Varian Semiconductor’s manufacturing facility prior to shipment. To the extent that customers’ conditions cannot be replicated in Varian Semiconductor’s facilities or if there is not a demonstrated history of meeting newer customer specifications, then the product is treated as new for revenue recognition purposes. Varian Semiconductor has predetermined criteria for changing the classification of a new product to an established product. A new product must achieve a set number of acceptances and a set target for installation cost. Once the criteria have been achieved for a new product, the product is considered established.

Service revenue includes revenue from maintenance and service contracts, paid service and installation services. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Revenue related to paid service is recorded when earned and revenue related to installation is recorded upon fulfillment of the service obligation. Royalty and license revenue is recognized when contractual obligations are met, evidence of an arrangement exists, fees are fixed or determinable and collection is reasonably assured.

When fees are not fixed or determinable, revenue is recorded when payments become due.

Varian Semiconductor’s transactions frequently include the sale of systems and services under multiple element arrangements. Revenue under these arrangements is allocated to all elements, except systems, based upon the fair market value of those elements. The amount allocated to installation is based upon hourly rates at the estimated time to complete the service. The fair value of all other elements is based upon the price charged when these amounts are sold separately and unaccompanied by other elements. The amount of revenue allocated to systems is done on a residual method basis. Under this method, the total value of the arrangement is allocated first to the undelivered elements based on their fair values, with the remainder being allocated to systems revenue.

Varian Semiconductor values its inventory at the lower of cost or market. The determination of lower of cost or market requires that Varian Semiconductor make significant assumptions about future demand for products and the transition to new product offerings from legacy products. Estimating product demand beyond a relatively short forecasting horizon is difficult and prone to forecasting error due to the cyclical nature and inherent lack of visibility in the industry. Varian Semiconductor also provides for losses on those open purchase order commitments in which Varian Semiconductor’s estimated obligation to receive inventory under these commitments exceeds expected production demand. These assumptions include, but are not limited to, future manufacturing schedules, customer demand, supplier lead time and technological and market obsolescence. Once inventory is written down and a new cost basis has been established, it is not written back up if demand increases. If market conditions are less favorable than those projected by management, additional inventory provisions may be required. If market conditions are more favorable than those projected by management, and specific products previously reserved against are subsequently sold, gross profit would improve by the amount of the specific reserve reversed in the quarter the product is sold. In the case of purchase order commitments, more favorable market conditions or successful negotiations with suppliers will result in a reduction of provisions in the quarter the excess purchase order commitments are reduced.

Varian Semiconductor maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments for products and services. Accounts with known financial issues are first reviewed and specific estimates are recorded. The remaining accounts receivable balances are then grouped in categories by the amount of days the balance is past due and the estimated loss is calculated as a percentage of the total category based upon past history. If the financial conditions of Varian Semiconductor’s customers were to deteriorate resulting in their inability to make payments, additional allowances may be required. If accounts previously identified as a risk and reserved for subsequently stabilize and are deemed to no longer be at risk for collection or categories past due decrease, the allowance for doubtful accounts may be reduced. As a result, a reduction to bad debt expense would be recognized in the period the determination was made.

Varian Semiconductor’s effective tax rate is affected by the relative levels of taxable income in domestic and foreign tax jurisdictions, U.S. tax credits generated and utilized for research and development expenditures, the U.S. extraterritorial income exclusion and other tax incentives specific to domestic and foreign operations. From time to time, Varian Semiconductor is subject to various domestic and foreign tax audits pertaining to income tax filings for prior periods. Accordingly, foreign and domestic income tax payments could differ from previously recorded income tax provisions depending on the outcome of those audits.

Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. On a quarterly basis, Varian Semiconductor evaluates both the positive and negative evidence bearing upon the realizability of its deferred tax assets. Varian Semiconductor considers future taxable income, ongoing prudent and feasible tax planning strategies, and the ability to utilize tax losses and credits in assessing the need for a valuation allowance. Management has concluded that no valuation allowance is required at this time. Should Varian Semiconductor determine that it is not able to realize all or part of its deferred tax assets in the future, a valuation allowance would be required resulting in an expense recorded within the provision for income taxes line in the Statement of Income in the period in which such determination was made. It is reasonably possible that the amount of the deferred tax asset considered realizable could be reduced in the near term if future taxable income is reduced. Varian Semiconductor’s effective tax rate is affected by levels of taxable income in domestic and foreign tax jurisdictions, U.S. tax credits generated and utilized for research and development expenditures, U.S. foreign income exclusion, investment tax credits and other tax incentives specific to domestic and foreign operations. Varian Semiconductor, from time to time, is subject to various domestic and foreign tax audits pertaining to income tax filings for prior periods. Accordingly, foreign and domestic income tax payments could differ from previously recorded income tax provisions depending on the outcome of those audits.

Varian Semiconductor provides for the estimated cost of product warranties, the amount of which is based primarily upon historical information, at the time product revenue is recognized. While Varian Semiconductor engages in extensive product quality programs and processes including actively monitoring and evaluating the quality of its component supplies, Varian Semiconductor’s warranty obligation is affected by product failure rates, utilization levels, material usage, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to Varian Semiconductor. Should actual product failure rates, utilization levels, material usage, service delivery costs or supplier warranties on parts differ from Varian Semiconductor’s estimates, revisions to the estimated warranty liability would be required.

Liabilities are recorded when environmental assessments and/or remedial efforts are probable and the costs can be reasonably estimated. Generally, the timing of these accruals coincides with completion of a feasibility study or Varian Semiconductor’s commitment to a formal plan of action. In situations where the various uncertainties make it difficult to assess the likelihood and scope of further investigation or remediation activities or to estimate then future costs, the lower limit of an estimated range is accrued on a non-discounted basis. All other liabilities, which are usually where Varian Semiconductor has generally sufficient knowledge to be able to better estimate the scope of costs and future activities, are accrued on a discounted basis. Should new information become available and/or different assumptions be applied in the estimation of environmental liabilities, revisions to the accrued environmental liability would be required.

As a multinational company, Varian Semiconductor faces exposure to adverse movements in foreign currency exchange rates. This exposure may change over time as Varian Semiconductor’s business practices evolve and could have a material adverse impact on Varian Semiconductor’s financial results. Historically, Varian Semiconductor’s primary exposures have resulted from non-U.S. dollar-denominated sales and purchases in Europe and Asia. Varian Semiconductor does not enter into forward exchange contracts for trading purposes. Varian Semiconductor’s forward exchange contracts generally range from one to six months in original maturity.

Varian Semiconductor designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits. The Company’s business is highly cyclical and depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits and products utilizing integrated circuits. Other factors that affect customers’ demand for tools include device size and performance and wafer size.

The following table sets forth revenue by category for the three- and nine-month periods ended July 2, 2004 and June 27, 2003:

During the third quarter and first nine months of fiscal year 2004, product revenue was $127.1 million and $322.9 million, respectively, compared to $63.0 million and $219.1 million for the same periods a year ago. The increases in product revenue during the third quarter and first nine months of fiscal year 2004 were due to an increased demand for ion implanters, parts and upgrades for our installed base of existing customer machines due to customer requirements to increase wafer production capacity. In addition, the industry is increasing 300mm wafer capacity, thereby increasing demand for 300mm ion implanters.

Service revenue during the third quarter of fiscal year 2004 was $16.7 million, compared to $17.5 million for the same period a year ago, and for the first nine months of fiscal year 2004 was $46.3 million, compared to $51.9 million for the same period a year ago. The decreases in service revenue for the third quarter and first nine months of fiscal 2004 were partially due to the timing of installation revenue. Installation revenue is influenced by shipment volume of ion implanters, product mix and customer mix, and timing of customer acceptance. In addition, as products have matured and the installation requires less effort to complete, the fair market value of installation revenue has been lowered and product revenue simultaneously increased.

Pursuant to the terms of a Settlement and License Agreement between Varian Semiconductor and Lam Research Corporation (“Lam”), Lam continues to make quarterly cash payments of $1.25 million, which are included in the royalty revenue in the first, second and third quarters of fiscal year 2004. Lam is required to make quarterly cash payments of $1.25 million through December 2004 for future use of certain of Varian Semiconductor’s patents. Royalty and license revenue is recognized in the period it becomes due. Fluctuations in royalty revenue are dependent upon shipment volume of products related to several other licensed patents and can fluctuate in any one period.

During the third quarter of fiscal year 2004, revenue from one customer accounted for 11% of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. During the third quarter of fiscal year 2003, revenue from three customers accounted for 19%, 16% and 12% of Varian Semiconductor’s total revenue.

During the first nine months of fiscal year 2004, revenue from one customer accounted for 15% of Varian Semiconductor’s total revenue. During the first nine months of fiscal year 2003, revenue from three customers accounted for 19%, 13% and 11% of Varian Semiconductor’s total revenue.

As of July 2, 2004, one customer accounted for 12% of the total accounts receivable balance. As of October 3, 2003, one customer accounted for 12% of the total accounts receivable balance.

Fluctuations in the timing and mix of product shipments, customer requirements for machines, and the completion of the installation of the product will continue to have a significant impact on the timing and amount of revenue in any given period (see also “Risk Factors” and “Critical Accounting Policies - Revenue Recognition”).

Cost of Product and Service Revenue. Cost of product revenue was $68.4 million and gross margin was 46% for the third quarter of fiscal year 2004, compared to cost of product revenue of $35.8 million and gross margin of 43% for the third quarter of fiscal year 2003. For the first nine months of fiscal year 2004, cost of product revenue was $178.9 million and gross margin was 45%, compared to cost of product revenue of $133.5 million and gross margin of 39% for the same period of fiscal year 2003.

Increased production in the third quarter and first nine months of fiscal year 2004 relating to increased customer demand resulted in more efficient factory (primarily overhead absorption) and supply chain operations than the same period a year ago.

In addition, the increased volume of parts and upgrade sales favorably impacted gross margin for both the third quarter and first nine months of fiscal year 2004. Gross margin in the third quarter and first nine months of fiscal year 2003 was favorably impacted by $1.5 million and $5.7 million, respectively, from the sale of certain inventory for which the carrying value had been reduced in previous periods and from the reduction of adverse inventory purchase commitments. Varian Semiconductor has historically, and may in the future, sustain inventory-related charges resulting from numerous factors, including changes in customers’ purchase commitments, changes in commitments to Varian Semiconductor vendors, technology changes and Varian Semiconductor’s manufacturing lead times.

Cost of service revenue was $10.8 million and gross margin was 35% for the third quarter of fiscal year 2004, compared to a cost of service revenue of $10.4 million and gross margin of 40% for the third quarter of fiscal year 2003. For the first nine months of fiscal year 2004, cost of service revenue was $29.4 million and gross margin was 36%, compared to cost of service revenue of $30.5 million and gross margin of 41% for the first nine months of fiscal year 2003. The decrease in gross margin for cost of service revenue for the three- and nine-month periods ended July 2, 2004 was partially a result of less installation revenue (refer to service revenue). In addition, product mix of service contracts and installations completed affected gross margin for cost of service revenue.

Research and Development. Research and development expenses were $17.5 million for the third quarter of fiscal year 2004, compared to $15.6 million for the third quarter of fiscal year 2003. Research and development expenses for the first nine months of fiscal 2004 were $50.7 million, compared to $43.6 million for the first nine months of fiscal 2003. The increase in research and development expenses in the three- and nine-month periods ended July 2, 2004 was a result of increased labor and material spending associated with the development of new products, particularly new generation high current implanters.

Marketing, General and Administrative. Marketing, general and administrative expenses were $21.7 million for the third quarter of fiscal year 2004, compared to $18.3 million in the same period in 2003. For the first nine months of fiscal year 2004, marketing, general and administrative expenses were $62.6 million, compared to $57.0 million for the first nine months of fiscal year 2003. The increase in the three- and nine-month periods ended July 2, 2004 was the result of supporting increased revenue volume and higher legal expenses, primarily associated with patent enforcement actions, compared to the same respective period a year ago. Furthermore, the third quarter of fiscal year 2003 included the recovery of $1.0 million of customer accounts receivable that were previously included in the allowance for doubtful accounts.

Interest Income and Interest Expense. During the third quarter of fiscal year 2004, Varian Semiconductor earned $1.0 million in net interest income, compared to $0.9 million for the third quarter of fiscal year 2003. Net interest income for the first nine months of fiscal year 2004 was $2.8 million, compared to $3.1 million for the first half of fiscal year 2003. Despite increased investment balances, net interest income for the nine-month period ended July 2, 2004 decreased from the same period in 2003 due to the interest expense related to the debt assumed as part of the purchase of the facility in Newburyport, Massachusetts in February 2003 and slightly lower interest rates.

Other Expense, Net. Other expense, net, was $0.4 million and $0.3 million for the three-month periods ended July 2, 2004 and June 27, 2003, respectively, and $0.5 million and $0.4 million for the nine-month periods ended July 2, 2004 and June 27, 2003, respectively. Other expense, net is primarily comprised of foreign exchange translation gains and losses.

Provision for Income Taxes. Varian Semiconductor’s effective income tax rate was 32% in the third quarter and first nine months of fiscal year 2004 and 33% in the third quarter and first nine months of fiscal year 2003. The effective tax rate differs from the statutory U.S. federal rate of 35%, primarily due to the extraterritorial income exclusion and tax credits. Future tax rates may vary from the historic rates depending on the worldwide composition of earnings and the continuing availability of income tax credits, the extra territorial income exclusion, as well as the potential resolution of tax contingencies.

Net Income. As a result of the foregoing factors, in the third quarter of fiscal year 2004 Varian Semiconductor recorded net income of $19.3 million, compared to net income of $1.4 million for the third quarter of fiscal year 2003. The net income per diluted share was $0.52 for the third quarter of fiscal year 2004, compared to net income per diluted share of $0.04 for the third quarter of fiscal year 2003. For the nine-month period ended July 2, 2004, Varian Semiconductor recorded net income of $38.1 million and $1.03 per diluted share, as compared with net income of $9.7 million and $0.28 per diluted share in the same period of fiscal year 2003.

Varian Semiconductor generated $32.3 million of cash from operations during the first nine months of fiscal year 2004, compared to $22.1 million of cash generated from operations during the first nine months of fiscal year 2003. Cash used in operations in the first nine months of fiscal year 2004 was primarily due to increases in accounts receivable of $37.3 million and inventories of $39.3 million. Accounts receivable increased due to a substantial increase in shipments during the quarter.

Inventories increased as a result of increased customer orders. These increases were partially offset by increases in accounts payable of $13.4 million and deferred revenue of $25.3 million, in addition to net income of $38.1 million and a tax benefit of $13.7 million from stock option exercises. In the first nine months of fiscal year 2003, cash provided by operations was primarily a result of a decrease in accounts receivable of $12.5 million and inventory of $24.2 million.

Varian Semiconductor used $150.5 million and $42.3 million of cash and cash equivalents for the purchase of short-term investments during the first nine months of fiscal year 2004 and 2003, respectively, and $7.1 million and $9.6 million of cash and cash equivalents for the purchase of property, plant and equipment during the first nine months of fiscal year 2004 and 2003, respectively. These were partially offset by proceeds from sales and maturities of short-term investments of $23.1 million during the first nine months of fiscal year 2004 and $2.1 million during the first nine months of fiscal year 2003.

During the nine-month period ended July 2, 2004, Varian Semiconductor generated $23.3 million of cash from financing activities, primarily due to $25.3 million from the issuance of common stock upon the exercise of stock options and under the Employee Stock Purchase Plan, partially offset by repayments on long-term borrowings. During the first nine months of fiscal year 2003, $5.5 million of cash was generated by financing activities, primarily due to $6.4 million from the issuance of common stock upon the exercise of stock options and under the Employee Stock Purchase Plan, partially offset by repayments on short-term borrowings.

Varian Semiconductor’s liquidity is affected by many factors, some based on the normal operations of the business and others related to the uncertainties of the industry and global economies. Varian Semiconductor believes that cash, cash equivalents and short-term investments of $398.2 million at July 2, 2004 will be sufficient to satisfy working capital requirements, commitments for capital expenditures and other purchase commitments, environmental contingencies and cash requirements for the foreseeable future.

Varian Semiconductor does not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance-sheet arrangements or other contractually narrow or limited purposes. As such, Varian Semiconductor is not exposed to any financing, liquidity, market or credit risk that could arise if Varian Semiconductor had engaged in such relationships.

Under GAAP, certain obligations and commitments are not required to be included in the consolidated balance sheets and statements of income. These obligations and commitments, while entered into in the normal course of business, may have a material impact on liquidity. The following commitments as of July 2, 2004 have not been included in the consolidated balance sheets and statements of income included under Item 1. Consolidated Financial Statements; however, they have been disclosed in the following table in order to provide a more accurate picture of Varian Semiconductor’s financial position and liquidity.

Operations prior to April 2, 1999 had been part of the former VAI, now known as Varian Medical Systems, Inc. (See also Note 11 in the Notes to the Unaudited Interim Consolidated Financial Statements.) On April 2, 1999, VAI contributed its SEB to Varian Semiconductor, then distributed to the holders of record of VAI common stock one share of common stock of Varian Semiconductor for each share of VAI common stock owned on March 24, 1999. At the same time, VAI contributed its Instruments Business (“IB”) to VI and distributed to the holders of record of VAI common stock one share of common stock of IB for each share of VAI common stock owned on March 24, 1999. VAI retained its Health Care Systems business and changed its name to Varian Medical Systems, Inc. (“VMS”) effective as of April 2, 1999. These transactions were accomplished under the terms of a Distribution Agreement by and among Varian Semiconductor, VAI, hereafter referred to as

VMS for periods following the spin-off and VI (the “Distribution Agreement”). For purposes of providing an orderly transition and to define certain ongoing relationships between and among Varian Semiconductor, VMS and VI after the spin-off Varian Semiconductor, VMS and VI also entered into certain other agreements which include an Employee Benefits Allocation Agreement, an Intellectual Property Agreement, a Tax Sharing Agreement and a Transition Services Agreement (collectively, the “Distribution Related Agreements”).

The Distribution Related Agreements provide that from and after the spin-off, VMS, VI, and Varian Semiconductor will indemnify each and their respective subsidiaries, directors, officers, employees and agents against all losses arising in connection with shared liabilities (including certain environmental and legal liabilities). All shared liabilities will be managed and administered by VMS and expenses and losses, net of proceeds and other receivables, will be borne one-third each by VMS, VI, and Varian Semiconductor. The Distribution Related Agreements also provide that Varian Semiconductor shall assume all of its liabilities, other than shared liabilities (including accounts payable, accrued payroll and pension liabilities) in accordance with their terms. During fiscal years 2003, 2002 and 2001, Varian Semiconductor was charged $1.4 million, $4.0 million and $3.0 million, respectively, by VMS in settlement of these obligations. During the first nine months of fiscal years 2004 and 2003, Varian Semiconductor was charged by VMS $1.3 million and $1.1 million, respectively, in settlement of these obligations.

The semiconductor industry is cyclical, and a slowdown in demand for Varian Semiconductor’s semiconductor manufacturing equipment could negatively affect financial results.

The semiconductor industry historically has been cyclical in nature and has experienced periodic downturns. The industry is currently experiencing volatility in product pricing and in product demand. Volatility may result in significant reductions and delays in the purchase of semiconductor manufacturing equipment and the construction of new fabrication facilities. Even though Varian Semiconductor’s revenues fluctuate significantly from period to period, in order to remain competitive Varian Semiconductor continues to invest in research and development and to maintain its worldwide customer service and support capability. These investments in the business may adversely affect Varian Semiconductor’s financial results.

Varian Semiconductor faces intense competition in the semiconductor equipment industry.

Significant competitive factors in semiconductor equipment manufacturing include the strength of customer relationships, pricing, technological performance and timing, distribution capabilities and financial viability. Varian Semiconductor believes that in order to remain competitive in this industry, it will need to devote significant financial resources to research and development, to offer and market a broad range of products, and maintain and enhance customer service and support centers worldwide. The semiconductor equipment industry is increasingly dominated by large manufacturers who have resources to support customers worldwide, and some of Varian Semiconductor’s competitors have substantially greater financial resources and more extensive engineering, manufacturing, marketing, service and support than does Varian Semiconductor. With fewer resources, Varian Semiconductor may not be able to match the product offerings or customer service and technical support offered by its competitors. In addition, there are several smaller companies which provide innovative technology that may have performance advantages over Varian Semiconductor’s systems. If these manufacturers continue to improve their product performance and pricing, enter into strategic relationships or consolidate with large equipment manufacturers, sales of Varian Semiconductor’s products may suffer.

Varian Semiconductor derives a substantial portion of its revenues from a small number of customers, and its business may be harmed by the loss of any one significant customer.

Varian Semiconductor has historically sold at least half of its systems in any particular period to its major customers, some of which include AMD, IBM, Infineon, Intel, Micron, Samsung, Sony, ST Microelectronics, Texas Instruments, TSMC and UMC. During some quarters, some of these customers have individually accounted for more than ten percent of Varian Semiconductor’s total revenue. Varian Semiconductor expects that sales of its products to relatively few customers will continue to account for a high percentage of its revenue in the foreseeable future. Furthermore, Varian Semiconductor may have difficulty attracting additional large customers because its sales depend, in large part, upon the decision of a prospective customer to increase manufacturing capacity in an existing fabrication facility or to transfer a manufacturing process to a new fabrication facility, both of which typically involve a significant capital commitment. Once a semiconductor manufacturer has selected a particular supplier’s capital equipment, the manufacturer generally relies upon that equipment for the specific production line application and frequently will attempt to consolidate its other capital equipment requirements with the same supplier. Consequently, Varian Semiconductor may experience difficulty in selling to a prospective customer if that customer initially selects a competitor’s capital equipment.

Varian Semiconductor’s quarterly results of operations are likely to fluctuate, and as a result, Varian Semiconductor may fail to meet the expectations of its investors and securities analysts, which may cause the price of its common stock to decline.

Varian Semiconductor has experienced and expects to continue to experience significant fluctuations in its quarterly financial results. From time to time, customers may accelerate, postpone, or cancel shipments, or production difficulties could delay shipments. A cancellation, delay in shipment or delay in customer acceptance of the product upon installation in any quarter may cause revenue in such quarter to fall significantly below expectations, which could cause the market price of Varian Semiconductor’s common stock to decline. Varian Semiconductor’s financial results also fluctuate based on gross profit realized on sales. Gross profit as a percentage of revenue may vary based on a variety of factors, including the mix and average selling prices of products sold, costs to manufacture and customize systems and inventory management. In addition, a number of other factors could impact Varian Semiconductor’s quarterly financial results, including, but not limited to the following:

Because Varian Semiconductor’s operating expenses are based on anticipated capacity levels and a high percentage of Varian Semiconductor’s expenses are relatively fixed, a variation in the timing of recognition of revenue and the level of gross profit from a single transaction could cause financial results to vary significantly from quarter to quarter.

It is difficult for Varian Semiconductor to predict the quarter in which it will be recognizing revenue from large product orders.

During a quarter Varian Semiconductor customarily sells a relatively small number of ion implantation systems. Consequently, Varian Semiconductor’s revenue and financial results could be negatively impacted for a particular quarter if anticipated orders from even a few customers are not received in time to permit shipment and customer acceptance of the installation during that quarter. Varian Semiconductor, depending upon contractual commitments and whether a product is an established or new product, typically recognizes a portion of the revenue upon product shipment and the remainder upon customer acceptance. As a result, it is often difficult to determine both the timing of a product shipment and the completion of the installation of the product at the customer’s location. In addition, Varian Semiconductor’s product order backlog at the beginning of each quarter may not include all systems needed to achieve expected revenues for that quarter. Because Varian Semiconductor may build systems according to forecast, the absence of a significant backlog for an extended period of time could adversely affect financial results.

Varian Semiconductor’s future business depends, in part, on its ability to successfully introduce and manage the transition to new products, and Varian Semiconductor may not succeed in accomplishing these goals.

Varian Semiconductor believes that its future success will depend on its ability to develop, manufacture and successfully introduce new systems and product lines with improved capabilities and to continue enhancing existing products; in particular, products that respond to the trend toward single wafer processing and 300mm wafer processing. Varian Semiconductor derives virtually all of its revenue from sales and servicing of ion implantation systems and related products and services. Varian Semiconductor must accurately forecast the demand for new products while managing the transition from older products. In addition, Varian Semiconductor may be unable to complete the development or meet the technical specifications of new systems or enhancements or to manufacture and ship these systems or enhancements in volume and on time, which may harm its reputation and business. In the past, Varian Semiconductor has experienced some delays in manufacturing and shipping systems and enhancements. If any of Varian Semiconductor’s new products have reliability or quality problems, Varian Semiconductor may incur additional warranty and service expenses, experience a decline in product orders or incur higher manufacturing costs to correct such problems, all of which could adversely affect financial results.

Varian Semiconductor is subject to the risks of operating internationally and it derives a substantial portion of its revenues from outside the United States.

International revenue has accounted for 61%, 61%, and 71% of Varian Semiconductor’s revenue in fiscal years 2003, 2002, and 2001, respectively; and specifically, revenue in Asia has accounted for a substantial portion of this revenue. Sales to Asia accounted for 46%, 44%, and 50% of revenue in fiscal years 2003, 2002, and 2001, respectively. Because Varian Semiconductor relies on sales to customers in Asia for a substantial portion of its revenue, its business is very likely to be adversely impacted by economic downturns and instability in that region. Varian Semiconductor’s business in Asia is affected by demand in each country. In addition, international sales are subject to risks, including, but not limited to:

If Varian Semiconductor is unable to protect its proprietary rights adequately, it may lose its ability to compete effectively in the semiconductor equipment industry.

Varian Semiconductor relies on obtaining and maintaining patent, copyright and trade secret protection for significant new technologies, products and processes and obtaining key licenses because of the length of time and expense associated with bringing new products through the development process to market. Varian Semiconductor intends to continue to file applications as appropriate for patents covering new products and manufacturing processes. However, Varian Semiconductor cannot provide assurance of the following:

Varian Semiconductor also has agreements with third parties for licensing of patented or proprietary technology. These agreements include royalty-bearing licenses and technology cross-licenses.

In addition, Varian Semiconductor maintains and enforces its trademarks to increase customer recognition of its products. If its trademarks are used by unauthorized third parties, its business may be harmed. Varian Semiconductor also relies on contractual restrictions on disclosure, copying and transferring title, including confidentiality agreements with vendors, strategic partners, co-developers, employees, consultants and other third parties to protect its proprietary rights. If these contractual agreements are breached, Varian Semiconductor may not have adequate remedies for any such breaches. Varian Semiconductor also cannot provide assurance that its trade secrets will not otherwise become known to or be independently developed by others.

Patent claims may be expensive to pursue, defend or settle and may substantially divert Varian Semiconductor’s resources and the attention of management.

Varian Semiconductor could incur substantial costs and diversion of management resources in defending patent suits brought against it or in asserting its patent rights against others. If the outcome of any such litigation is unfavorable to Varian Semiconductor, its business may be harmed. Varian Semiconductor may not be aware of pending or issued patents held by third parties that relate to its products or technologies. In the event that a claim is asserted against Varian Semiconductor, it may need to acquire a license to or contest the validity of a competitor’s patent. Varian Semiconductor cannot be certain that it could acquire such a license on commercially acceptable terms, if at all, or that it would prevail in such a proceeding. From time to time Varian Semiconductor has received notices from and has issued notices to such third parties alleging infringement of patent and other intellectual property rights relating to its products. If Varian Semiconductor is subject to future claims of patent infringement, it may be required to make substantial settlement or damages payments and may have to devote substantial resources to reengineering its products.

Varian Semiconductor depends on limited groups of suppliers or single source suppliers, the loss of which could impair its ability to manufacture products and systems.

Varian Semiconductor obtains some of the components and subassemblies included in its products from a limited group of suppliers, or in some cases a single source supplier. The loss of any supplier, including any single source supplier, would require obtaining one or more replacement suppliers and may also require devoting significant resources to product development to incorporate new parts from other sources into Varian Semiconductor’s products. The need to change suppliers or to alternate between suppliers might cause delays in delivery or significantly increase Varian Semiconductor’s costs. Although Varian Semiconductor has insurance to protect against loss due to business interruption from these and other sources, Varian Semiconductor cannot provide assurance that such coverage will be adequate or that it will remain available on commercially acceptable terms. Although Varian Semiconductor seeks to reduce its dependence on these limited source suppliers, disruption or loss of these sources could negatively impact its business and damage customer relationships.

Varian Semiconductor’s indemnification obligations under the Distribution Related Agreements could be substantial, and Varian Semiconductor may not be fully indemnified in accordance with this agreement for the expenses it incurs.

Under the terms of the Distribution Related Agreements, each of VMS, VI and Varian Semiconductor has agreed to indemnify the other parties (and certain related persons) from and after the spin-off with respect to certain indebtedness, liabilities and obligations which could be significant. The availability of such indemnities will depend upon the future financial strength of the companies. There is a risk that one or more of these companies will not be able to satisfy their indemnification obligations. In addition, the Distribution Related Agreements generally provides that if a court prohibits a company from satisfying its indemnification obligations, then such obligations will be shared equally by the other companies.

Failure to comply with present or future environmental regulations could subject Varian Semiconductor to penalties and environmental remediation costs.

Varian Semiconductor is subject to a variety of foreign, federal, state and local laws regulating the discharge of materials into the environment and the protection of the environment. These regulations include discharges into the soil, water and air and the generation, handling, storage and transportation and disposal of waste and hazardous substances. These laws increase the costs and potential liabilities associated with the conduct of Varian Semiconductor’s operations.

VAI has been named by the U.S. Environmental Protection Agency and third parties as a potentially responsible party under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended (“CERCLA”), at eight sites where VAI is alleged to have shipped manufacturing waste for recycling or disposal. VAI is also in various stages of environmental investigation and or remediation under the direction of, or in consultation with foreign, federal, state and local agencies at certain current or former VAI facilities (including facilities disposed of in connection with VAI’s sale of its Electron Devices business during fiscal year 1995, and the sale of its TFS business during fiscal year 1997). The Distribution Related Agreements provides that each of VMS, Varian Semiconductor and VI will indemnify the others for one-third of these environmental investigation and remediation costs, as adjusted for any insurance proceeds and tax benefits expected to be realized upon payment of these costs.

These accrued amounts are only estimates of anticipated future environmental-related costs, and the amounts actually spent may be greater than such estimates. Accordingly, Varian Semiconductor may need to make additional payments to cover its indemnification obligations that would exceed current estimates. In addition, Varian Semiconductor’s present and past facilities have been in operation for many years, and over that time in the course of those operations, such facilities have used substances which are or might be considered hazardous. Varian Semiconductor also may have generated and disposed of wastes which are or might be considered hazardous. Therefore, it is possible that additional environmental issues may arise in the future that Varian Semiconductor cannot now predict.

Varian Semiconductor’s ability to manage potential growth or decline, integration of potential acquisitions, and potential disposition of product lines and technologies creates risks.

The cyclical nature of the semiconductor industry may cause Varian Semiconductor to experience rapid growth or decline in demand for products and services. As a result, Varian Semiconductor may face significant challenges in maintaining adequate management processes, information systems and procedures on a timely basis and training, managing and appropriately sizing the work force. Current conditions in the semiconductor equipment industry challenge management to control spending on operating activities. There can be no assurance that Varian Semiconductor will be able to perform such actions successfully. An important element of Varian Semiconductor’s management strategy is to review acquisition prospects that would complement existing products, augment market coverage and distribution ability, or enhance technological capabilities. In the future, Varian Semiconductor may make acquisitions of complementary companies, products or technologies, or may reduce or dispose of certain product lines or technologies that no longer fit Varian Semiconductor’s long-term strategies. Managing an acquired business, disposing of product technologies or reducing personnel entail numerous operational and financial risks, including difficulties in assimilating acquired operations and new personnel or separating existing business or product groups, diversion of management’s attention to other business concerns, amortization of acquired intangible assets, the incurrence of debt and contingent liabilities and potential loss of key employees or customers of acquired or disposed operations, among others. Varian Semiconductor’s success will depend, to a significant extent, on the ability of its executive officers and other members of its senior management to identify and respond to these challenges effectively. In addition, any acquisitions could result in dilutive issuances of equity securities. There can be no assurance that Varian Semiconductor will be able to achieve and manage successfully any such growth, decline, integration of potential acquisitions, disposition of product lines or technologies, or reduction in personnel, or that management, personnel or systems will be adequate to support continued operations. Any such inabilities or inadequacies would have a material adverse effect on Varian Semiconductor’s business, operating results, financial condition, cash flows and/or the price of Varian Semiconductor common stock.

Varian Semiconductor manufactures its products at one primary manufacturing facility and is thus subject to risk of disruption.

Varian Semiconductor has one primary manufacturing facility, located in Gloucester, Massachusetts, and its operations are subject to disruption for a variety of reasons, including, but not limited to natural disasters, work stoppages, operational facility constraints and terrorism. Such disruption could cause delays in shipments of products to Varian Semiconductor’s customers and could result in cancellation of orders or loss of customers and could seriously harm Varian Semiconductor’s business.

Varian Semiconductor loses key employees or is unable to attract and retain key employees, it may be unable to pursue business opportunities.

Varian Semiconductor’s future success depends to a significant extent on the continued service of key managerial, technical and engineering personnel. Competition for such personnel is intense, particularly in the labor markets around Varian Semiconductor’s facilities in Massachusetts. The available pool of qualified candidates is limited, and Varian Semiconductor may not be able to retain its key personnel or to attract, train, assimilate or retain other highly qualified engineers and technical and managerial personnel in the future. The loss of these persons or Varian Semiconductor’s inability to hire, train or retrain qualified personnel could harm Varian Semiconductor’s business and results of operations.

Varian Semiconductor has anti-takeover defenses that could delay or prevent an acquisition and could adversely affect the price of its common stock.

Provisions of Varian Semiconductor’s certificate of incorporation and by-laws and of Delaware law could delay, defer or prevent an acquisition or change in control of Varian Semiconductor or otherwise adversely affect the price of its common stock. For example, Varian Semiconductor’s Board of Directors is classified into three classes, and stockholders do not have the right to call special meetings of stockholders. Varian Semiconductor’s certificate of incorporation also permits its Board of Directors to issue shares of preferred stock without stockholder approval. In addition to delaying or preventing an acquisition, the issuance of a substantial number of preferred shares could adversely affect the price of the common stock. Varian Semiconductor has also adopted a stockholders rights plan that may significantly dilute the equity interests of a person seeking to acquire control of Varian Semiconductor without the approval of the Board of Directors.

Varian Semiconductor does not anticipate paying dividends on its common stock in the future.

Varian Semiconductor has not paid and does not anticipate paying dividends on its common stock. Varian Semiconductor’s Board of Directors has discretion to make decisions to pay dividends to common stockholders in the future. The decision will depend on a number of factors, including results of operations, financial conditions and contractual restrictions, that the Board, in its opinion, deems relevant.

Varian Semiconductor hedges currency exposures that are associated with certain of its assets and liabilities denominated in various non-U.S. dollar denominated currencies. The aggregate exchange gain was immaterial for the third quarter of fiscal year 2004.

Varian Semiconductor also hedges currency exposures that are associated with certain of its product sales denominated in Japanese Yen. In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” these forward foreign exchange contracts are designated as hedges of anticipated product sales, and accordingly the gains and losses resulting from the impact of currency rate movements on these contracts are not recognized in income until the underlying hedged transactions are recognized. Upon recognition, such gains and losses are recorded in revenue as an adjustment to the carrying amount of the underlying transactions in the period in which these transactions are recognized. Should the hedged anticipated product sales not occur within two months of the expiration of the forward foreign exchange contract, any unrealized gain or loss would be recorded in other (loss) income. There were three forward foreign exchange contracts designated as hedges of anticipated product sales in Japanese Yen outstanding at July 2, 2004 totaling $9.3 million.

Although payments under certain of Varian Semiconductor’s overseas borrowing facilities are tied to market indices, Varian Semiconductor is not exposed to material interest rate risk from these borrowing facilities.

Varian Semiconductor has no material cash flow exposure due to rate changes for cash equivalents and short-term investments. Varian Semiconductor maintains cash investments primarily in U.S. Treasury, government agency securities, and investment- quality municipal securities as well as short-term time deposits with investment grade financial institutions. Cash equivalents at July 2, 2004 and October 3, 2003 were $222.1 million and $304.3 million, respectively. At July 2, 2004 and October 3, 2003, Varian Semiconductor’s short-term investments were $166.6 million and $40.0 million, respectively and consist primarily of U.S. Treasury and government agency securities, certificates of deposit and corporate bonds with ratings AA or better.

The management of Varian Semiconductor, with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) of Varian Semiconductor as of July 2, 2004. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of July 2, 2004, the disclosure controls and procedures of Varian Semiconductor were (1) designed to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to the Chief Executive Officer and Chief Financial Officer by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

No change in Varian Semiconductor’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended July 2, 2004 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

Information required by this Item is provided in Note 11. Commitments, Contingencies and Guarantees to the Unaudited Interim Consolidated Financial Statements.

A Current Report on Form 8-K was furnished on April 29, 2004. The report contained information announcing Varian Semiconductor Equipment Associates, Inc.’s press release issued on April 29, 2004.

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


VARIAN SEMICONDUCTOR EQUIPMENT ASSOCIATES, INC.
Registrant

By:		/s/ ROBERT J. HALLIDAY
		Robert J. Halliday
		Vice President and Chief Financial Officer
		(Principal Financial Officer and Duly Authorized Officer)


35 Dory Road, Gloucester, Massachusetts		01930
(Address of principal executive offices)		(Zip code)


Item Number		Page Number
PART I. FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements

	Consolidated Balance Sheets at July 2, 2004 and October 3, 2003	1
	Consolidated Statements of Income for the three- and nine-month periods ended July 2, 2004 and June 27, 2003	2
	Consolidated Statements of Cash Flows for the nine-month periods ended July 2, 2004 and June 27, 2003	3
	Notes to the Consolidated Financial Statements	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23

Item 4.	Controls and Procedures	24

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	25

Item 2.	Changes in Securities and Use of Proceeds	25

Item 3.	Defaults Upon Senior Securities	25

Item 4.	Submission of Matters to a Vote of Security Holders	25

Item 5.	Other Information	25

Item 6.	Exhibits and Reports on Form 8-K	25
	Signatures	26


	July 2, 2004			October 3, 2003
	(Amounts in thousands, except share data)
ASSETS
Current assets
Cash and cash equivalents	$	231,619		$	310,481
Short-term investments		166,597			40,021
Accounts receivable, net		101,158			63,048
Inventories		91,478			59,228
Deferred income taxes		28,721			28,486
Other current assets		16,174			19,906

Total current assets		635,747			521,170
Property, plant and equipment, net		51,272			47,013
Goodwill		12,280			12,280
Other assets		2,761			3,071

Total assets	$	702,060		$	583,534

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Notes payable and current portion of long-term debt	$	4,252		$	5,805
Accounts payable		35,951			22,530
Accrued expenses		41,869			36,086
Product warranty		7,263			7,684
Deferred revenue		48,911			23,392

Total current liabilities		138,246			95,497
Long-term accrued expenses		4,995			5,198
Deferred income taxes		4,321			4,321
Long-term debt		4,262			4,551

Total liabilities		151,824			109,567

Commitments, contingencies and guarantees (Note 11)

Stockholders’ equity
Preferred stock, $0.01 par value; 5,000,000 shares authorized; none issued or outstanding		—			—
Common stock, $0.01 par value; 150,000,000 shares authorized; 36,366,482 and 34,977,788 shares issued and outstanding at July 2, 2004 and October 3, 2003, respectively		364			350
Capital in excess of par value		329,481			290,443
Retained earnings		221,308			183,212
Deferred compensation		(109	)		—
Accumulated other comprehensive loss		(808	)		(38	)

Total stockholders’ equity		550,236			473,967

Total liabilities and stockholders’ equity	$	702,060		$	583,534


	Fiscal Three Months Ended						Fiscal Nine Months Ended
	July 2, 2004			June 27, 2003			July 2, 2004			June 27, 2003
	(Amounts in thousands, except per share data)
Revenue
Product	$	127,059		$	62,968		$	322,866		$	219,052
Service		16,727			17,488			46,297			51,891
Royalty		2,349			2,295			6,141			6,716

Total revenue		146,135			82,751			375,304			277,659

Cost of revenue
Product		68,372			35,763			178,877			133,459
Service		10,813			10,409			29,400			30,475

Total cost of revenue		79,185			46,172			208,277			163,934

Gross profit		66,950			36,579			167,027			113,725

Operating expenses
Research and development		17,497			15,644			50,720			43,623
Marketing, general and administrative		21,737			18,287			62,556			56,991
Restructuring		—			1,138			—			1,296

Total operating expenses		39,234			35,069			113,276			101,910

Operating income		27,716			1,510			53,751			11,815
Interest income		1,285			1,108			3,463			3,566
Interest expense		(275	)		(203	)		(693	)		(434	)
Other expense, net		(386	)		(266	)		(498	)		(401	)

Income before income taxes		28,340			2,149			56,023			14,546
Provision for income taxes		9,069			708			17,927			4,800

Net income	$	19,271		$	1,441		$	38,096		$	9,746

Weighted average shares outstanding - basic		36,314			34,199			35,984			34,085
Weighted average shares outstanding - diluted		37,054			35,018			36,963			34,920
Net income per share - basic	$	0.53		$	0.04		$	1.06		$	0.29
Net income per share - diluted	$	0.52		$	0.04		$	1.03		$	0.28


	Fiscal Nine Months Ended
	July 2, 2004			June 27, 2003
	(Amounts in thousands)
Cash flow from operating activities:
Net income	$	38,096		$	9,746
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		9,723			10,293
Tax benefit from stock options exercised and employee stock purchase plan		13,668			2,649
Deferred income taxes		(235	)		5,998
Amortization of investment premiums		770			—
Changes in assets and liabilities:
Accounts receivable		(37,345	)		12,492
Inventories		(39,339	)		24,230
Other current assets		3,732			(1,725	)
Accounts payable		13,389			(4,270	)
Accrued expenses		4,814			(8,756	)
Product warranty		(480	)		(640	)
Deferred revenue		25,278			(27,384	)
Other		214			(532	)

Net cash provided by operating activities		32,285			22,101

Cash flows from investing activities:
Purchase of property, plant and equipment		(7,131	)		(9,600	)
Proceeds from sales and maturities of short-term investments		23,126			2,116
Purchase of available-for-sale securities		(150,472	)		(42,326	)

Net cash used in investing activities		(134,477	)		(49,810	)

Cash flows from financing activities:
Proceeds from the issuance of common stock		25,275			6,396
Repayment of notes payable		(1,654	)		(789	)
Repayment of long-term debt		(289	)		(117	)

Net cash provided by financing activities		23,332			5,490

Effects of exchange rates on cash		(2	)		352

Net decrease in cash and cash equivalents		(78,862	)		(21,867	)
Cash and cash equivalents at beginning of period		310,481			307,840

Cash and cash equivalents at end of period	$	231,619		$	285,973

Non-cash purchase of property and plant in exchange for debt	$	—		$	5,099

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	Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
	(Amounts in thousands)
Bank certificates of deposit	$	24,641	$	—	$	—		$	24,641
U.S. Treasury and agency securities		104,963		90		(455	)		104,598
Corporate bonds		37,536		2		(180	)		37,358

	$	167,140	$	92	$	(635	)	$	166,597

Short-term investment maturities are as follows:
	Maturities by Period
	Total		Less than 1 Year		1-3 Years			4-5 Years
	(Amounts in thousands)
Short-term investments	$	166,597	$	79,085	$	80,949		$	6,563


	July 2, 2004			October 3, 2003
	(Amounts in thousands)
Billed receivables	$	102,923		$	65,040
Allowance for doubtful accounts		(1,765	)		(1,992	)

Accounts receivable, net	$	101,158		$	63,048


	Amount of Liability
	(Amounts in thousands)
Balance as of October 3, 2003	$	7,684
Accruals for warranties issued during the period		1,780
Decrease to pre-existing warranties		(223	)
Settlements made during the period		(2,237	)

Balance as of January 2, 2004	$	7,004
Accruals for warranties issued during the period		2,344
Decrease to pre-existing warranties		(374	)
Settlements made during the period		(2,148	)

Balance as of April 2, 2004	$	6,826
Accruals for warranties issued during the period		2,720
Increase to pre-existing warranties		264
Settlements made during the period		(2,547	)

Balance as of July 2, 2004	$	7,263


	North America		Europe		Taiwan		Korea		Singapore		Other		Consolidated
			(Amounts in thousands)
Revenue - Three months ended:
July 2, 2004	$	24,489	$	21,695	$	26,327	$	32,585	$	15,497	$	25,542	$	146,135
June 27, 2003		32,999		11,093		12,003		12,172		1,601		12,883		82,751
Revenue - Nine months ended:
July 2, 2004	$	72,579	$	50,102	$	70,800	$	84,990	$	35,854	$	60,979	$	375,304
June 27, 2003		121,269		34,371		26,905		53,953		7,421		33,740		277,659
Property, plant and equipment, net as of:
July 2, 2004	$	45,713	$	434	$	343	$	4,017	$	19	$	746	$	51,272
October 3, 2003		40,853		705		360		4,062		20		1,013		47,013


	Reduction in Work Force			Facility Closures			Total
	(Amounts in thousands)
Balance as of October 3, 2003	$	264		$	118		$	382
Cash payments		(264	)		(2	)		(266	)
Reversal of charges		—			(24	)		(24	)

Balance as of July 2, 2004	$	—		$	92		$	92


Balance, October 3, 2003	$	—
Effective portion of cash flow hedging instruments		(264	)
Reclassified to revenue		—

Balance, July 2, 2004	$	(264	)


	Fiscal Three Months Ended					Fiscal Nine Months Ended
	July 2, 2004			June 27, 2003		July 2, 2004			June 27, 2003
	(Amounts in thousands)
Net income	$	19,271		$	1,441	$	38,096		$	9,746
Other comprehensive income (loss):
Effective portion of cash flow hedging instruments		(264	)		—		(264	)		—
Unrealized gain (loss) on short-term investments		(590	)		23		(506	)		23

Comprehensive income	$	18,417		$	1,464	$	37,326		$	9,769


			Payments Due by Period
	Total		Less than 1 Year		1-3 Years		4-5 Years
	(Amounts in thousands)
Operating leases	$	2,665	$	1,640	$	970	$	55
Purchase order commitments		63,300		62,300		1,000		—
Letter of credit		1,900		1,900		—		—

Total commitments	$	67,865	$	65,840	$	1,970	$	55


	July 2, 2004					October 3, 2003
	Notional Value		Contract Rate	Fair Value		Notional Value		Contract Rate	Fair Value
	(Amounts in thousands)
Foreign currency purchase contracts:
New Taiwan Dollar	$	719	33.53	$	713	$	591	33.87	$	590
British Pound		145	0.55		144		277	0.64		296
Japanese Yen		490	108.30		490		—	—		—
Korean Won		2,056	1,152.99		2,055		—	—		—
Euro		88	0.81		88		200	0.86		200

Total foreign currency purchase contracts	$	3,498		$	3,490	$	1,068		$	1,086

Foreign currency sell contracts:
Korean Won	$	8,025	1,173.51	$	8,163	$	3,380	1,176.28	$	3,457
Euro		2,098	0.82		2,088		2,358	0.93		2,554
Japanese Yen		1,413	111.03		1,448		4,225	115.12		4,389
New Taiwan Dollar		77	33.69		77		104	33.73		103
Israeli Shekel		49	4.57		50		127	4.48		129

Total foreign currency sell contracts		11,662			11,826		10,194			10,632

Total contracts	$	15,160		$	15,316	$	11,262		$	11,718



31.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14 under the Securities Exchange Act of 1934.

31.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14 under the Securities Exchange Act of 1934.

32.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.