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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

or

FSI INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)

952-448-5440
(Registrant’s telephone number, including area code)

N/A
(Former name, former address and former fiscal year, if changed since last report)

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.

x YES  o NO

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

o YES  o NO  x NOT APPLICABLE

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practical date:

Common Stock, No Par Value — 29,465,170 shares outstanding as of December 30, 2002

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

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PART I. ITEM 1. FINANCIAL INFORMATION

FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
NOVEMBER 30, 2002 AND AUGUST 31, 2002
(unaudited)
(in thousands)

ASSETS

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
NOVEMBER 30, 2002 AND AUGUST 31, 2002
(continued)
(unaudited)
(in thousands)

LIABILITIES AND STOCKHOLDERS’ EQUITY

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
FOR THE QUARTERS ENDED NOVEMBER 30, 2002 AND NOVEMBER 24, 2001
(unaudited)
(in thousands, except per share amounts)

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
FOR THE QUARTERS ENDED NOVEMBER 30, 2002 AND NOVEMBER 24, 2001
(unaudited)
(in thousands)

See accompanying notes to consolidated condensed financial statements.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

(1) Description of Business and Summary of Significant Accounting Principles

Description of Business

     FSI International, Inc. is a global supplier of processing equipment used at key production steps to manufacture microelectronics, including semiconductor devices and thin film heads. The Company develops, manufactures, markets and supports products used in the technology areas of microlithography and surface conditioning. FSI International’s customers include microelectronics manufacturers located throughout North America, Europe, Japan and the Asia Pacific region.

Consolidated Condensed Financial Statements

     The accompanying consolidated condensed financial statements have been prepared by the Company without audit and reflect all adjustments (consisting only of normal and recurring adjustments, except as disclosed in the notes) which are, in the opinion of management, necessary to present a fair statement of the results for the interim periods presented. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission but omit certain information and footnote disclosures necessary to present the statements in accordance with accounting principles generally accepted in the United States. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual 10-K Report for the fiscal year ended August 31, 2002 previously filed with the Securities and Exchange Commission.

Revenue Recognition

     The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable and collectibility is reasonably assured. Certain of the Company’s product sales are accounted for as multiple-element arrangements. If the Company has met defined customer acceptance experience levels with both the customer and the specific type of equipment, the Company recognizes equipment revenue upon shipment and transfer of title, with the remainder of the total revenue recognized as the earnings process is completed for other elements. All other product sales with customer acceptance provisions, which the Company has not previously met, are recognized upon customer acceptance. Revenue related to spare part sales is recognized upon shipment. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts.

Other Comprehensive Income (Loss)

     Other comprehensive income (loss) pertains to revenues, expenses, gains, and losses that are not included in net income (loss), but rather are recorded directly in stockholders’ equity. For the first quarters of fiscal 2003 and 2002, the only item of other comprehensive income (loss) was related to the foreign currency translation adjustment.

Cash and Cash Equivalents

     All highly liquid investments purchased with an original effective maturity of three months or less are considered to be cash equivalents.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

Marketable Securities

     The Company classifies its marketable debt securities as available-for-sale and carries these securities at amounts that approximate fair market value.

Trade Accounts Receivable

     Trade accounts receivable are recorded net of an allowance for doubtful accounts.

Inventories

     Inventories are valued at the lower of cost, determined by the first in, first out method, or net realizable value.

Property, Plant and Equipment

     Building and related costs are carried at cost and depreciated on a straight-line basis over a 30-year period. Leasehold improvements are carried at cost and amortized over a 3 to 5 year period or the term of the underlying lease, whichever is shorter. Equipment is carried at cost and depreciated on a straight-line method over its estimated economic life. Principal economic lives for equipment are 1 to 7 years. Software developed for internal use is amortized over 3 to 5 years beginning when the system is placed in service. When assets are retired or disposed of, the cost and accumulated depreciation thereon are removed from the accounts and gains or losses are included in other income (expense). Maintenance and repairs are expensed as incurred; significant renewals and improvements are capitalized.

Intangible Assets

     Patents, license fees and other intangible assets are capitalized based on their estimated fair value and amortized over their estimated economic or legal lives, whichever is shorter, ranging from 3 to 9 years.

     In July 2001, the Financial Accounting Standards Board issued SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets” which change the accounting for business combinations and goodwill. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. Thus, amortization of goodwill, including goodwill recorded in past business combinations, ceased upon adoption of that Statement. The Company adopted SFAS No. 142 in the first quarter of fiscal 2002 and accordingly evaluated its existing intangible assets and goodwill that were acquired in a prior business combination, and determined there were no reclassifications necessary in order to conform with the new criteria in SFAS 141 for recognition apart from goodwill. Upon adoption of SFAS 142, the Company reassessed the useful lives and residual values of all intangible assets acquired in business combinations, and determined that there were no amortization period adjustments necessary. If an intangible asset is identified as having an indefinite useful life, the Company is required to test the intangible asset for impairment in accordance with the provisions of SFAS 142 within the first year of adoption. Other than goodwill, the Company has no intangible assets with indefinite useful lives.

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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     In connection with the transitional goodwill impairment evaluation, SFAS 142 required the Company to perform an assessment of whether there is an indication that goodwill is impaired as of the date of adoption. To accomplish this, the Company identified its reporting units and determined the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. The Company determined the fair value of each reporting unit and compared it to the reporting unit’s carrying amount. As of August 26, 2001, each reporting unit’s fair value exceeded its carrying amount, and therefore there was no indication that the reporting unit’s goodwill was impaired. Accordingly, the Company was not required to perform the second step of the transitional impairment test.

     In the second step, the Company would be required to compare the implied fair value of the reporting unit’s goodwill, determined by allocating the reporting unit’s fair value to all of its assets (recognized and unrecognized) and liabilities (in a manner similar to a purchase price allocation) to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end of the year of adoption. The Company did not record any transitional impairment loss. As of the date of adoption, the Company had approximately $5.4 million of unamortized goodwill subject to the transition provisions of SFAS 141 and 142.

     Due to a significant decline in the Company’s stock price in the fourth quarter of fiscal 2002, the continued downturn in the industry and the overall global economic conditions, another impairment review was completed as of August 31, 2002. As a result, the balance of goodwill was deemed impaired and the Company recorded a charge to selling, general and administrative expenses of $5.4 million in the fourth quarter of fiscal 2002. The estimated aggregate amortization of intangible assets for the next five years is $1,717,000, in the last nine months of fiscal 2003, $2,266,000 in fiscal 2004, $690,000 in fiscal 2005, $436,000 in fiscal 2006, $436,000 in fiscal 2007 and $109,000 in the first quarter of fiscal 2008.

     Intangible assets as of November 30, 2002 and August 31, 2002 consisted of the following (in thousands):

     Intangible assets were reviewed for impairment in connection with the review of goodwill conducted as of August 31, 2002, and were deemed not impaired. The Company will continue to review intangible assets for impairment on an annual basis or as it deems necessary.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

Investment in Affiliates

     The Company’s investment in affiliated companies consists of a 21% interest in Metron Technology and a 49% interest in m•FSI Ltd. Each investment is accounted for by the equity method utilizing a three-month and a two-month lag due to the affiliates’ respective May and June year ends.

     The Company defers recognition of the profit on sales to affiliates which remain in the affiliates’ inventory based on the Company’s ownership percentage of the affiliate.

     The book value of the Company’s long-term investment in affiliates is reviewed for other than temporary impairment on an annual basis or as deemed necessary. (See Note 2.)

Income Taxes

     Deferred income taxes are provided in amounts sufficient to give effect to temporary differences between financial and tax reporting. The Company accounts for tax credits as reductions of income tax expense in the year in which such credits are allowable for tax purposes.

Product Warranty

     The Company, in general, warrants new equipment manufactured by the Company to the original purchaser to be free from defects in material and workmanship for one to two years, depending upon the product or customer agreement. Provision is made for the estimated cost of maintaining product warranties at the time the product is sold.

Inventory Reserves

     The Company records reserves for inventory shrinkage and for potentially excess, obsolete and slow moving inventory. The amounts of these reserves are based upon historical loss trends, inventory levels, physical inventory and cycle count adjustments, expected product lives and forecasted sales demand.

Allowance for Doubtful Accounts

     The Company must make estimates of the uncollectibility of accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.

Foreign Currency Translation

     Assets and liabilities denominated in foreign currencies are translated into U.S. dollars at current exchange rates. Operating results for investees are translated into U.S. dollars using the average rates of exchange prevailing during the period. Foreign currency translation adjustments are included in the accumulated other comprehensive loss account in stockholders’ equity.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

Net Loss Per Common Share

     Basic earnings per share are computed by dividing net income or loss by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share is computed using the treasury stock method to compute the weighted average common stock outstanding assuming the conversion of potential dilutive common shares. Net loss per share does not include the effect of common stock equivalents as their inclusion would be antidilutive. Common stock equivalents of 3,742 were excluded in the first quarter of fiscal 2003 and common stock equivalents of 237,778 were excluded in the first quarter of fiscal 2002.

Derivative Instruments and Hedging Activities

     The Company does not use derivative financial instruments for trading or speculative purposes. The Company did not engage in any hedging activities during the first quarter of fiscal 2003 or 2002.

Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that could affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Employee Stock Plans

     In accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company elected to continue to apply the provisions of Accounting Principles Board’s Opinion No. 25 (APB No. 25), “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its employee stock option and stock purchase plans and therefore is not required to recognize compensation expense in connection with these plans as long as the quoted market price of the Company’s stock at the date of grant equals the amount the employee must pay to acquire the stock. Companies that continue to use APB No. 25 are required to present in the notes to the consolidated financial statements, on an annual basis, the pro forma effects on reported net income and earnings per share as if compensation expense had been recognized based on the fair value of options granted.

New Accounting Pronouncements

     In August 2001, the Financial Accounting Standards Board approved SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 addresses the financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” However, this statement retains the fundamental provisions of SFAS No. 121 for (a) recognition and measurement of the impairment of long-lived assets to be held and used and (b) measurement of long-lived assets to be disposed of by sale.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     SFAS No. 144 also supersedes the accounting and reporting provisions of APB Opinion No. 30, “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” for the disposal of a segment of a business. However, this Statement retains the requirement of APB No. 30 to report discontinued operations separately from continuing operations and extends that reporting to a component of an entity that either has been disposed of or is classified as held for sale. This statement also amends ARB No. 51, “Consolidated Financial Statements” to eliminate the exception to consolidation for a temporarily controlled subsidiary. The Company adopted the provisions of SFAS No. 144 in the first quarter of fiscal 2003, and the adoption did not have an impact on the Company’s financial statements.

     In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. Management will apply the provisions of SFAS No. 146 to restructuring charges initiated, if any, after December 31, 2002. SFAS No. 146 could have a significant impact on the timing of recognizing charges related to such future restructurings.

Reclassifications

     Certain fiscal 2002 amounts have been reclassified to conform to the current year presentation.

(2) Transition Agreement with Metron Technology and Related Charges

     On October 9, 2002, the Company entered into a Transition Agreement with Metron Technology related to the early termination of the Company’s distribution agreements with Metron Technology for Europe and the Asia-Pacific region, effective March 1, 2003 (“Closing Date”). Under the terms of the Transition Agreement, the Company will assume direct sales, service and applications support and logistics responsibilities for the surface conditioning and microlithography products in Europe and the Asia-Pacific region as of the Closing Date, while Metron Technology will continue to represent FSI products in Israel.

     In conjunction with this transaction, the Company agreed to advance up to $4.0 million to Metron Technology on a secured basis. The Company advanced $3.0 million pursuant to a note receivable shortly after it entered into the Transition Agreement and had a potential obligation to advance up to an additional $1.0 million. After conducting a preliminary review of Metron Technology’s inventory, the Company determined that it is not required to and will not advance the additional $1.0 million. On the Closing Date, the advance will be applied toward the repurchase by the Company of inventory and equipment that Metron Technology currently holds to support its obligations under the current distribution arrangement.

     Under the terms of the Transition Agreement, the Company agreed to pay Metron Technology on the Closing Date an early termination fee of approximately $2.8 million. The Company will surrender on the Closing Date approximately 1.154 million Metron Technology common shares now owned by the Company in payment of this early termination fee as approved by Metron Technology’s shareholders. The Company recorded a non-cash charge of approximately $2.8 million to selling, general and administrative expenses in the first quarter of fiscal 2003 associated with the early termination fee. The Company also recorded a non-cash impairment charge of approximately $10.2 million to other expense in the first quarter of fiscal 2003 for the 2.690 million shares of Metron Technology that the Company owns. The impairment charges were based upon the difference between the $6.17 per share carrying value and the $2.38 per share value agreed upon for purposes of the Transition Agreement. The $2.38 per share value reflected the average closing price of the common stock of Metron Technology for the five business days prior to the execution of the Transition Agreement.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     It is anticipated that approximately 90 Metron Technology employees who are currently dedicated to sales, technical service and applications engineering activities related to the distribution of the Company’s products in Europe and the Asia-Pacific region will be offered employment by the Company on the Closing Date.

     The Company would own 1.536 million shares, or approximately 12.9% of Metron Technology, after the transaction closes on March 1, 2003. The transaction is subject to a number of closing conditions.

(3) Inventories

     Inventories are summarized as follows (in thousands):

(4) Supplementary Cash Flow Information

     The following summarizes supplementary cash flow items (in thousands):

(5) Comprehensive Income (Loss)

     Other comprehensive income (loss) pertains to revenues, expenses, gains and losses that are not included in the net loss but rather are recorded directly in stockholders’ equity. For the quarters ended November 30, 2002 and November 24, 2001, the only item of other comprehensive income was related to foreign currency translation. For the quarters ended November 30, 2002 and November 24, 2001, the net loss item of other comprehensive income and the comprehensive loss were as follows (in thousands):

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

(6) Segment Information

     The Company has two segments, Surface Conditioning Division (SCD) and the Microlithography Division (MLD).

     The Surface Conditioning segment markets and supports equipment that uses wet, vapor, cyrogenic and other chemistry techniques to clean, strip or etch the surfaces of silicon wafers. The Microlithography segment supplies photoresist processing equipment and support services for the semiconductor and thin film head markets. General corporate expenses were not allocated to the segments prior to fiscal 2003. The Company started allocating general corporate expenses equally to the two divisions beginning in fiscal 2003. For comparable purposes, fiscal 2002 amounts have been restated to reflect the allocation consistent with fiscal 2003.

     Segment information is as follows (in thousands):

     In the quarter ended November 30, 2002, the segment operating loss for each division included $1.4 million related to the early termination of the distribution agreements with Metron Technology.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

(7) Litigation

     In the fall of 1995, pursuant to the Employee Stock Purchase and Shareholder Agreement dated November 30, 1990 between Eric C. Hsu and Semiconductor Systems, Inc. (“SSI”) (the “Shareholder Agreement”) and in connection with Mr. Hsu’s termination of his employment with SSI in August 1995, the former shareholders of SSI purchased the shares of SSI common stock then held by Mr. Hsu. In April 1996, FSI acquired SSI, and SSI became a wholly owned subsidiary of FSI. In October 1996, Eric C. and Angie L. Hsu (the “plaintiffs”) filed a lawsuit in the Superior Court of California, County of Alameda, Southern Division, against SSI and the former shareholders of SSI. The plaintiffs alleged that such purchase breached the Shareholder Agreement and violated the California Corporations Code, breached the fiduciary duty owed plaintiffs by the individual defendants and constituted fraud.

     In September and October 2000, certain of Mr. Hsu’s claims were tried to a jury in Alameda County Superior Court in Oakland, California. At the conclusion of the trial, the jury found that SSI breached the Shareholder Agreement between it and Mr. Hsu and that the damages that resulted were approximately $2.4 million. In addition, each of the individual defendant shareholders was found liable for conversion and damages of $4.2 million were awarded. Certain individual defendants were also found to have intentionally interfered with Mr. Hsu’s prospective economic advantage and damages of $3.2 million were awarded. Finally, several individual defendants and SSI were found to have violated certain provisions of the California Corporation Code and damages of $2.4 million were awarded.

     In proceedings subsequent to the trial, the Court determined that plaintiffs are entitled to an award against SSI of prejudgment interest on the breach of contract damages (approximately $2.4 million) at 10 percent per annum from October 1996. In addition, the Court awarded plaintiffs approximately $127,000 in costs and approximately $1.8 million in attorneys’ fees against SSI and the individual defendants. On November 16, 2001, the court signed its final judgment reflecting the jury’s awards, interest, attorneys’ fees and costs assessed against each of the defendants.

     Following the entry of judgment, SSI and the other defendants filed post-trial motions seeking reduction in the jury’s damage awards and/or a new trial. The court denied these post-trial motions and there was no reduction in damages against SSI. Subsequent to February 23, 2002, Mr. Hsu was awarded an additional $431,000 for attorneys fees and expenses incurred since the judgment was rendered in November 2001. The total judgment against SSI together with post judgment interest and attorneys’ fees as of November 30, 2002 aggregated approximately $6.6 million.

     SSI and the individual defendants have filed an appeal on a variety of grounds, and the Company posted an appeal bond on behalf of SSI and defendants in the amount of $8.3 million. As part of the posting of the bond, the Company entered into a letter of credit in the amount of $2.5 million with a surety company. This letter of credit was collateralized with restricted cash of approximately the same amount.

     The Company, on behalf of SSI, has made a claim with respect to the lawsuit under the escrow created at the time of the Company’s acquisition of SSI. The escrow was established to secure certain indemnification obligations of the former shareholders of SSI. The escrow consists of an aggregate of 250,000 shares of FSI Common Stock paid to the former shareholders of SSI as consideration in the acquisition. The former shareholders have agreed to hold FSI and SSI harmless from any claim arising out of any securities transactions between SSI and the shareholders or former shareholders of SSI. The indemnification obligations of the individual SSI shareholders are capped at approximately $4.2 million in the aggregate. Any shares in the escrow returned to FSI to satisfy any indemnification obligations will be valued at $12.125 per share, the per-share price of FSI Common Stock at the time of the SSI acquisition.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(unaudited)

     Given the escrowed shares and the additional indemnification by the individual SSI shareholders, along with the Company’s litigation reserve, the Company believes it is adequately reserved for this potential liability. However, there is considerable uncertainty as to the ultimate resolution of this matter and the respective liability, if any, of SSI. The Company will continue with its appeal process and defense.

     In September 1995, CFM Technologies, Inc. and CFMT, Inc. (collectively “CFM”) filed a complaint in United States District Court for the District of Delaware against YieldUP. YieldUP was acquired by the Company in October 1999. YieldUP is now known as SCD Mountain View, Inc., a wholly owned subsidiary of the Company. The complaint alleged that the drying process incorporated in certain YieldUP products infringes a patent held by CFM. On October 14, 1997, the United States District Court held that CFM had failed to produce evidence on three separate elements of the patent claim. On June 30, 1998, the United States District Court of Delaware granted CFM’s petition for re-argument of the issue. During the third quarter of fiscal 2002, the re-argument of the issue was held and the court has ruled not to sustain the judge’s earlier ruling. As a result, the litigation may proceed to trial, and the litigation and the associated costs may, and an unfavorable adjudication could, have a material adverse impact on FSI. CFM is asking for monetary damages and an injunction against YieldUP’s use of the products at issue. A loss, if any, resulting from an unfavorable adjudication, cannot presently be estimated. The Company plans to vigorously defend its intellectual property rights against any and all claims.

     CFM filed an additional complaint against YieldUP in United States District Court for the District of Delaware on December 30, 1998. The complaint alleged that the cleaning process incorporated in certain of YieldUP’s products infringes two patents held by CFM: U.S. Patent Nos. 4,917,123 and 4,778,532.

     On April 4, 2000 the United States District Court for the District of Delaware granted YieldUP’s motion for summary judgment that the ‘123 and ‘532 patents are invalid. CFM’s motion for rehearing has been denied. On July 29, 2000, the issue of whether CFM or its inventors engaged in inequitable conduct in prosecuting the ‘123 and ‘532 patents was tried before the court. On June 6, 2001, the judge issued his opinion finding that the CFM inventors engaged in inequitable conduct during the prosecution of the patent application. On June 7, 2001, the judge ordered that judgment be entered in favor of YieldUP and against CFM on YieldUP’s defenses of lack of enablement and inequitable conduct. An appeal of that judgment is pending. A loss, if any, resulting from an unfavorable adjudication, cannot presently be estimated. Any loss and associated costs resulting from an unfavorable adjudication could have a material adverse impact on FSI. Once judgment is entered based upon the District Court’s granting YieldUP’s summary judgment motion, the District Court’s order may be appealed by CFM.

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FSI INTERNATIONAL, INC. AND SUBSIDIARIES

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

     The information in this report, except for the historical information contained herein, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and is subject to the safe harbor created by that statute. Typically, we identify forward-looking statements by use of an asterisk “*.” In some cases, you can identify forward-looking statements by terminology such as “expects,” “anticipates,” “intends,” “may,” “should,” “plans,” “believes,” “seeks,” “estimates,” “could,” “would,” or the negative of such terms or other comparable terminology. Such statements are subject to various risks and uncertainties, both known and unknown. Factors that could cause actual results to differ include the length and extent of the current industry downturn; additional order delays or cancellations; lower than expected savings from our cost-cutting measures; general economic conditions; changes in customer capacity; the extent of demand for our products and our ability to meet demand; global trade policies; worldwide economic and political stability; our successful execution of internal performance plans; the cyclical nature of our business; volatility of the market for certain products; performance issues with key suppliers and subcontractors, the transition to 300mm products; the level of new orders; the timing and success of current and future product and process development programs; the success of our affiliated distributors; legal proceedings; the transition from an affiliated distributor to a direct sales and support organization in Europe and the Asia-Pacific region; and the potential impairment of long-lived assets; as well as other factors listed from time to time in our SEC reports including, but not limited to, the Risk Factors included in this report. Readers also are cautioned not to place undue reliance on these forward-looking statements as actual results could differ materially. In addition, we have previously announced that we are exploring strategic partnership opportunities for our Microlithography business. Future results could differ depending upon whether or not such efforts are completed or on the specific terms of any such opportunity. We undertake no duty to update any of the forward-looking statements after the date of this report.

     This discussion and analysis should be read in conjunction with the Consolidated Condensed Financial Statements and footnotes thereto appearing elsewhere in this report.

Industry:

     During the first quarter of fiscal 2003, the microelectronics industry continued to experience poor industry conditions. With limited visibility, our customers delayed new orders we were anticipating.

     With concerns about a pending war with Iraq, weak global economic conditions and continued slow consumer demand for products containing microelectronics, industry analysts now expect a sustainable industry recovery to begin in the second half of calendar 2003.

     During the first quarter of fiscal 2003, we used $9.1 million in cash, cash equivalents and marketable securities to fund operating and investing activities. In addition, a $3.0 million advance was made to Metron Technology under the terms of the Transition Agreement.

     With no significant improvement in industry conditions anticipated for the next few quarters, we will need to implement cost reduction actions to lower our breakeven sales level and reduce our cash usage. We are currently evaluating cost reduction opportunities, including pursuing a strategic partner or partners for our Microlithography business.*

     We believe that any significant increase in equipment spending by device manufacturers will be led by the investment in 300mm capacity, smaller device feature sizes, and process technology required for new materials such as copper and low-K dielectrics.* These are all technology areas where we have successfully focused our research and development investment the past few years and represent applications for which we continue to receive orders.

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Application of Critical Accounting Policies:

     In accordance with recent Securities and Exchange Commission guidance, those material accounting policies that we believe are the most critical to an investor’s understanding of our financial results and condition and require complex management judgment are discussed below.

     Our critical accounting policies are as follows:

	•		revenue recognition;
	•		valuation of long-lived and intangible assets and goodwill; and
	•		estimating valuation allowances and accrued liabilities; specifically product warranty, inventory obsolescence, allowance for doubtful accounts and assessment of the probability of the outcome of current litigation.

Revenue Recognition

     We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable and collectibility is reasonably assured. Certain of our product sales are accounted for as multiple-element arrangements. If we have met defined customer acceptance experience levels with both the customer and the specific type of equipment, we recognize equipment revenue upon shipment and transfer of title, with the remainder of the total revenue recognized as the earning process is completed for other elements. All other product sales with customer specific acceptance provisions, which we have not previously met, are recognized upon customer acceptance. Future revenues may be negatively impacted if we are unable to meet customer-specific acceptance criteria. Revenue related to spare part sales is recognized upon shipment. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts.

     Timing of revenue recognition is dependent on the mix of revenue recognized upon shipment versus acceptance and for revenue recognized upon acceptance, it is dependent upon when the acceptance certificates are actually received or customer specific criteria are met.

Valuation of Long-Lived and Intangible Assets and Goodwill

     We assess the impairment of identifiable intangibles, long-lived assets and related goodwill and enterprise level goodwill at least annually, and whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

     If we do determine that the carrying value of intangibles, long-lived assets and related goodwill and enterprise level goodwill may not be recoverable, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model or another valuation technique. Net intangible assets and long-lived assets amounted to $67.7 million as of November 30, 2002.

     In 2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” became effective and as a result, we ceased to amortize approximately $5.4 million of goodwill. In lieu of amortization, we were required to perform an initial impairment review of our goodwill in 2002 and an annual impairment review thereafter.

     We did not record an impairment charge upon completion of the initial impairment review. Due to a significant decline in our stock price in the fourth quarter of fiscal 2002, the continued downturn in the industry and overall global economic conditions, we completed an impairment review as of August 31, 2002. As a result, the balance of the goodwill was deemed impaired, and we recorded a charge to selling, general and administrative expenses of $5.4 million in the fourth quarter of fiscal 2002.

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     Our investment in our affiliate, Metron Technology, is accounted for by the equity method of accounting and has a carrying value on the balance sheet as of November 30, 2002 of approximately $6.3 million or $2.34 per share. The fair value of Metron Technology is subject to stock market fluctuations. The stock price of Metron Technology ranged from $0.57 to $3.19 per share during the first quarter of fiscal 2003. Based on the closing stock price of Metron Technology of $2.00 per share on November 29, 2002, the fair value of our investment in Metron Technology was approximately $5.4 million, or $0.9 million less than the carrying value on our balance sheet. While we determined at August 30, 2002 that our investment in Metron Technology was not other than temporarily impaired, our decision on October 8, 2002 to use Metron Technology shares with a value of $2.38 to settle the termination fee payment with Metron Technology triggered an impairment loss on that date for all of the shares we held. Accordingly, the difference between the $6.17 per share carrying value and the $2.38 per share value agreed upon for purposes of the Transaction Agreement on the shares held was recorded as non-cash impairment charges of $10.2 million in our quarter ending November 30, 2002. The $2.38 per share value reflected the average closing price of the common stock of Metron Technology for the five business days prior to the execution of the Transition Agreement. Under our policy, we will continue to review our long-term investment in affiliates for other than temporary impairment as deemed necessary.

Product Warranty Estimation

     We record a liability for warranty claims at the time of sale. The amount of the liability is based on the trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting warranty claim, anticipated releases of new products and other factors. The warranty periods range from 12 to 24 months. Although management believes the likelihood to be relatively low, claims experience could be materially different from actual results because of the introduction of new, more complex products; a change in our warranty policy in response to industry trends, competition or other external forces; manufacturing changes that could impact product quality; or as yet unrecognized defects in products sold.

Inventory Reserves Estimation

     We record reserves for inventory shrinkage and for potentially excess, obsolete and slow moving inventory. The amounts of these reserves are based upon historical loss trends, inventory levels, physical inventory and cycle count adjustments, expected product lives and forecasted sales demand. Results could be materially different if demand for our products decreased because of economic or competitive conditions, length of the industry downturn, or if products become obsolete because of technical advancements in the industry or by us.

Allowance for Doubtful Accounts Estimation

     Management must make estimates of the uncollectibility of our accounts receivables. The most significant risk is the risk of sudden unexpected deterioration in financial condition of a significant customer which is not considered in the allowance. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Results could be materially impacted if the financial condition of a significant customer deteriorated and related receivables are deemed uncollectible.

Litigation Liability Estimation

     Management’s current estimated range of liability related to some of the pending litigation is based on claims for which our management can estimate the amount and range of loss. We have recorded the minimum estimated liability related to those claims, where there is a range of loss. Because of the uncertainties related to both the amount and range of loss on the pending litigation, management is not always able to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability related to our pending litigation and revise our estimates. Such revisions in our estimates of the potential liability could materially impact our results of operation and financial position.

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FIRST QUARTER OF FISCAL 2003 COMPARED WITH FIRST QUARTER OF 2002

The Company:

     The following table sets forth for the fiscal quarter indicated, certain income and expense items as a percent of our total sales.

Sales Revenue and Shipments:

     Sales revenue decreased 39 percent to $25.9 million for the first quarter of fiscal 2003, as compared to $42.6 million for the first quarter of fiscal 2002. Sales revenues for the Surface Conditioning Division decreased from $24.7 million in the first quarter of fiscal 2002 to $10.9 million in the first quarter of fiscal 2003. Sales revenues for the Microlithography Division decreased from $17.9 million in the first quarter of fiscal 2002 to $15.0 million in the first quarter of fiscal 2003. Both divisions experienced revenue decreases due to the continued industry downturn, competitive pricing pressures and the global recession.

     Shipments in the first quarter of fiscal 2003 increased to $27 million from $15 million in the first quarter of fiscal 2002. Surface Conditioning Division shipments increased to $13 million in the first quarter of fiscal 2003 from $8 million in the first quarter of fiscal 2002. Microlithography Division shipments increased to $14 million in the first quarter of fiscal 2003 from $7 million in the first quarter of fiscal 2002.

     International sales were $5.8 million, representing 22% of total sales during the first quarter of fiscal 2003 and $6.6 million, representing 15% of total sales, during the first quarter of fiscal 2002. Because of its broader customer base, the Surface Conditioning Division has a higher percentage of international sales than the Microlithography Division.

     Deferred revenue was approximately $8.6 million as of November 30, 2002. Deferred profit of $4.9 million as of November 30, 2002, as reported on the consolidated balance sheet, reflected deferred revenue less deferred cost of goods sold.

     Sales in the second quarter of fiscal 2003 are expected to be approximately $22 to $25 million.* However, the transition from distributing through our affiliate, Metron Technology, to a direct sales and support organization could impact the timing of revenue recognition for certain orders that ship prior to March 1, 2003, the end of our second quarter.* In addition, we will be recording sales returns for the inventory we buy back from Metron Technology.* We expect shipments to be approximately $25 to $29 million for the second quarter of fiscal 2003, as compared to the $27 million in the first quarter of 2003.*

Gross Profit:

     Our gross profit margin fluctuates due to a number of factors, including the mix of products sold, as Surface Conditioning products generally have higher margins than the Microlithography products; the proportion of international sales, as international sales generally have lower margins as a result of selling through distributors; competitive pricing pressures; and utilization of manufacturing capacity.

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     Gross profit as a percentage of sales was 26.3% for the first quarter of fiscal 2003 and was 31.1% for the first quarter of fiscal 2002. The decrease in margins was primarily related to the product mix, as Microlithography products generally have lower margins, and competitive pricing pressures.

     We expect gross margins to be in the range of 28 to 30% in the second quarter of fiscal 2003, due to a product mix shift to higher margin Surface Conditioning products, partially offset by the continued underutilization of manufacturing capacity.*

Selling, General and Administrative Expenses:

     Selling, general and administrative expenses decreased 19% to $8.8 million in the first quarter of fiscal 2003, as compared to $10.8 million in the first quarter of fiscal 2002. The decrease related to cost reduction efforts.

     We expect the dollar amount of selling, general and administrative expenses in the second quarter of fiscal 2003 to be in the range of $9.8 to $10.3 million as we continue to incur incremental costs associated with establishing our direct distribution organization in the Europe and Asia-Pacific regions.* We anticipate hiring approximately 90 Metron Technology employees upon the closing of the Transition Agreement.* We expect the costs associated with these employees, including infrastructure costs, to be in the range of $2.0 to $2.5 million per quarter beginning in the third quarter of fiscal 2003.*

Transition Agreement Termination Fee:

     In the first quarter of fiscal 2003 we recorded a non-cash charge of approximately $2.8 million associated with the early termination of the distribution agreements with Metron Technology.

Research and Development Expenses:

     Research and development expenses were $8.3 million for the first quarter of fiscal 2003 and 8.3 million for the first quarter of fiscal 2002. Despite the impact on near term financial results, we expect to continue investing in key applications and product development initiatives.* We made a conscious decision not to significantly reduce our research and development spending as part of our recent cost reductions.

     The majority of our research and development is focused on reducing product costs, improving our product performance, the MAGELLAN™ product launch and expanding the applications capabilities of a number of our products.

     Research and development expenses for the second quarter of fiscal 2003 are expected to be in the range of $8.3 to $8.6 million as we focus on product launch and development activities.*

Other Income (Expense), Net:

     Other income (expense), net was approximately $10.0 million of expense for the first quarter of fiscal 2003, as compared to $359,000 of income for the first quarter of fiscal 2002. The change relates to an approximately $10.2 million non-cash impairment charge in the first quarter of fiscal 2003 for the 2.690 million shares of Metron Technology that we own. The impairment charges were based upon the difference between our $6.17 per share carrying value and the $2.38 per share value agreed upon for purposes of the Transition Agreement. The $2.38 per share value reflected the average closing price of the common stock of Metron Technology for the five business days prior to the execution of the Transition Agreement.

     Interest income is expected to be between $125,000 and $175,000 for the second quarter of fiscal 2003, given our current cash position and anticipated interest rates.*

Income Tax (Benefit) Expense:

     We recorded $25,000 of tax expense in the first quarter of fiscal 2003, as compared to no income tax expense for the first quarter of fiscal 2002. The change in fiscal 2003 related to state income taxes.

     Our deferred tax assets on the balance sheet as of November 30, 2002 have been fully reserved for with a valuation allowance. We do not expect to significantly reduce our valuation allowance until we are consistently profitable on a quarterly basis.

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     Overall, we have net operating loss carryforwards for federal purposes of approximately $103.4 million, which will begin to expire in fiscal 2011 through fiscal 2019 if not utilized. Of this amount, approximately $15.0 million is subject to Internal Revenue Code Section 382 limitations on utilization. This limitation is approximately $1.4 million per year.

Equity in (Losses) Earnings of Affiliates:

     The equity in (losses) earnings of affiliates was approximately $603,000 of losses for the first quarter of fiscal 2003, compared to approximately $733,000 of income for the first quarter of fiscal 2002. Our affiliates, m•FSI in Japan and Metron Technology, have also been impacted by the global industry recession.

     We expect equity in losses of affiliates to be between $900,000 to $1.1 million in the second quarter of fiscal 2003 due to the impact of current industry conditions on our affiliates.* However, the increase in losses from the first quarter of fiscal 2003 is primarily due to the restructuring charges and deferred tax asset valuation allowance recorded by Metron Technology in their second quarter.

Net loss:

     Assuming that we can achieve the expected revenues, gross margin, operating expenses and affiliate loss levels, we expect to report a net loss of approximately $11 to $13 million in the second quarter of fiscal 2003.*

LIQUIDITY AND CAPITAL RESOURCES

     Our cash, restricted cash, cash equivalents and marketable securities were approximately $51.8 million as of November 30, 2002, a decrease of $12.1 million from the end of fiscal 2002. The decrease in cash, restricted cash, cash equivalents and marketable securities was primarily due to $9.7 million of cash used in operating activities, including a $3.0 million advance to Metron Technology under the terms of the Transition Agreement. In addition, we acquired $2.4 million of property, plant and equipment during the first quarter of fiscal 2003.

     Our accounts receivable increased slightly to $19.8 million as of November 30, 2002, as compared to $19.4 million at the end of fiscal 2002. The increase is related to the higher shipment levels.

     Our inventory decreased approximately $3.7 million to $41.0 million at November 30, 2002, compared to $44.7 million at the end of fiscal 2002. The decrease was primarily in work-in-process related to increased shipments in the first quarter of fiscal 2003, as compared to the fourth quarter of fiscal 2002. Inventory reserves were $8.8 million as of November 30, 2002 as compared to $8.3 million at the end of fiscal 2002.

     As of November 30, 2002, our current ratio of current assets to current liabilities was 3.8 to 1, working capital was $88.5 million and we had no lines of credit or guarantees of affiliates.

     Our contractual cash obligations related to operating leases at November 30, 2002 are summarized as follows (in thousands):

     As previously discussed, we have outstanding litigation regarding the Hsu matter. The total judgment against SSI together with post judgment interest as of November 30, 2002 aggregated approximately $6.6 million. SSI and the individual defendants have filed an appeal on a variety of grounds. In the third quarter of fiscal 2002, we posted an appeal bond on behalf of SSI and defendants in the amount of $8.3 million. As part of the posting of the bond, we entered into a letter of credit in the amount of $2.5 million with the surety company. This letter of credit is collateralized with restricted cash of approximately the same amount. The total balance of restricted cash as of November 30, 2002 was $3.1 million.

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     Acquisitions of property, plant and equipment were approximately $2.4 million in the first quarter of fiscal 2003 and $490,000 in the first quarter of fiscal 2002. We expect to invest between $5 and $6 million in fiscal 2003 in property, plant and equipment, with depreciation and amortization of $13 to $14 million.*

     We anticipate consuming approximately $9 to $10 million of cash from operations in the second quarter of fiscal 2003.* With limited visibility on the timing of any significant industry improvement, we expect to implement cost reduction actions to lower our breakeven sales level and reduce our cash usage.* We are currently evaluating cost reduction opportunities, including pursuing a strategic partner or partners for our Microlithography business.*

     We believe that with existing cash, cash receipts, cash equivalents, marketable securities and internally generated funds, there will be sufficient funds to meet our currently projected working capital requirements and to meet other cash requirements through at least fiscal 2003.*

     We believe that success in our industry requires substantial capital to maintain the flexibility to take advantage of opportunities as they arise. One of our strategic objectives is, as market and business conditions warrant, to consider divestitures, investments or acquisitions of businesses, products or technologies particularly those that are complementary to our surface conditioning business.* We may fund such activities with additional equity or debt financings.* The sale of additional equity or debt securities, whether to maintain flexibility or to meet strategic objectives, could result in additional dilution to our shareholders.*

NEW ACCOUNTING PRONOUNCEMENT

     In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. Management will apply the provisions of SFAS No. 146 to restructuring charges initiated, if any, after December 31, 2002. SFAS No. 146 could have a significant impact on the timing of recognizing charges related to such future restructurings.*.

RISK FACTORS

     Our business faces significant risks. The risks described below are not the only risks we face. Additional risks and uncertainties not presently known to us or that we currently believe are immaterial also may impair our business operations. If any of the events or circumstances described in the following risks occurs, our business, operating results or financial condition could be materially adversely affected. The following risk factors should be read in conjunction with the other information and risks set forth in this report.

Because our business depends on the amount that manufacturers of microelectronics spend on capital equipment, downturns in the microelectronics industry may adversely affect our results.

     The microelectronics industry experiences periodic downturns, which may have a negative effect on our sales and operating results. Our business depends on the amounts that manufacturers of microelectronics spend on capital equipment. The amounts they spend on capital equipment depend on the existing and expected demand for semiconductor devices and products that use semiconductor devices. The microelectronics industry has experienced downturns in business activity in the past; and the industry currently is experiencing a significant downturn. When a downturn occurs, some semiconductor manufacturers experience lower demand and increased pricing pressure for their products. As a result, they are likely to purchase less semiconductor processing equipment and have sometimes delayed making decisions to purchase capital equipment. In some cases, semiconductor manufacturers have canceled or delayed orders for our products. The semiconductor industry experienced a downturn in 1998 and 1999, which seriously harmed our operating results during that period. Typically, the semiconductor equipment industry has experienced more pronounced decreases in net sales than the semiconductor industry as a whole.

     We, along with others in the industry, have recently experienced a significant downturn in orders for new equipment as well as delays in or cancellations of existing orders. We cannot predict the extent and length of the current downturn. In addition:

•

the semiconductor industry may experience other, possibly more severe and prolonged, downturns in the future;

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	•		any future recovery of the semiconductor industry may not result in an increased demand by semiconductor manufacturers for capital equipment or our products; and
	•		the semiconductor industry may not improve in the near future or at all.

Our inability to implement additional cost reduction actions, including pursing a strategic partner or partners for our Microlithography business, could adversely affect our cash flows and results of operations.

     With no significant improvement industry conditions anticipated for the next few quarters, we will need to implement cost reduction actions to reduce our cash usage.

     We are currently evaluating cost reduction opportunities, including pursuing a strategic partner or partners for our Microlithography business. Our inability to implement cost reduction actions, including obtaining a strategic partner or partners for our Microlithography business, may adversely affect our cash flows and results of operations.

If we do not continue to develop new products, we will not be able to compete effectively.

     Our business and results of operations could decline if we do not develop and successfully introduce new or improved products that the market accepts. The technology used in microelectronics manufacturing equipment and processes changes rapidly. Industry standards change constantly and equipment manufacturers frequently introduce new products. We believe that microelectronics manufacturers increasingly rely on equipment manufacturers like us to:

	•		design and develop more efficient manufacturing equipment;
	•		design and implement improved processes for microelectronics manufacturers to use; and
	•		make their equipment compatible with equipment made by other equipment manufacturers.

     To compete, we must continue to develop, manufacture, and market new or improved products that meet changing industry standards. To do this successfully, we must:

	•		select appropriate products;
	•		design and develop our products efficiently and quickly;
	•		implement our manufacturing and assembly processes efficiently and on time;
	•		make products that perform well for our customers;
	•		market and sell our products effectively; and
	•		introduce our new products in a way that does not unexpectedly reduce sales of our existing products.

Failure of our products to gain market acceptance would adversely affect our financial condition.

     We believe that our growth prospects depend upon our ability to gain customer acceptance of our products and technology, particularly 300mm products. Market acceptance of products depends upon numerous factors, including:

	•		compatibility with existing manufacturing processes and products;
	•		ability to displace incumbent suppliers or processes or tools of record;
	•		perceived advantages over competing products; and
	•		the level of customer service available to support such products.

     Moreover, manufacturers often rely on a limited number of equipment vendors to meet their manufacturing

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equipment needs. As a result, market acceptance of our products may be affected adversely to the extent potential customers utilize a competitor’s manufacturing equipment. There can be no assurance that sales of new products will remain constant or grow or that we will be successful in obtaining broad market acceptance of our systems and technology.

     We expect to spend a significant amount of time and resources to develop new systems and enhance existing systems. In light of the long product development cycles inherent in our industry, we will make these expenditures well in advance of the prospect of deriving revenue from the sale of any new systems. Our ability to commercially introduce and successfully market any new systems is subject to a wide variety of challenges during this development cycle, including start-up bugs, design defects and other matters that could delay introduction of these systems to the marketplace. In addition, since our customers are not obligated by long-term contracts to purchase our systems, our anticipated product orders may not materialize or orders that do materialize may be canceled. As a result, if we do not achieve market acceptance of new products, we may not be able to realize sufficient sales of our systems in order to recoup research and development expenditures. The failure of any of our new products to achieve market acceptance would harm our business, financial condition, and results of operations and cash flows.

Product or process development problems could harm our results of operations.

     Our products are complex, and from time to time have defects or bugs that are difficult and costly to fix. This can harm our results of operations in the following ways:

	•		we may incur substantial costs to ensure the functionality and reliability of products early in their life cycle;
	•		repeated defects or bugs can reduce orders, increase manufacturing costs, adversely impact working capital and increase service and warranty expenses; and
	•		we may require significant lead times between product introduction and commercialization.

     As a result, we may have to write off inventory and other assets related to products and could lose customers and revenue. There is no assurance that we will be successful in preventing product and process development problems that could potentially harm our results of operations.

Future acquisitions may dilute our shareholders’ ownership interests and have other adverse consequences.

     Because of consolidations in the semiconductor equipment industry we serve and other competitive factors, our management will seek to acquire additional product lines, technologies, and businesses if suitable opportunities develop. Acquisitions may result in the issuance of our stock, which may dilute our shareholders’ ownership interests and reduce earnings per share. Acquisitions also may increase debt levels and the related goodwill and other intangible assets, which could have a significant negative effect on our financial condition and operating results. In addition, acquisitions involve numerous risks, including:

	•		difficulties in absorbing the new business, product line, or technology;
	•		diversion of management’s attention from other business concerns;
	•		entering new markets in which we have little or no experience; and
	•		possible loss of key employees of the acquired business.

Certain of our long-lived assets have and others may become other than temporarily impaired, including our investment in affiliates.

     During the fourth quarter of fiscal 2002, our $5.4 million balance of goodwill was deemed other than temporarily impaired and a charge of $5.4 million was recorded to selling, general and administrative expenses. Our investment in our affiliate, Metron Technology, has a carrying value on the balance sheet of approximately $6.3 million as of November 30, 2002. While we determined at August 31, 2002 that our investment in Metron Technology was not other than temporarily impaired, our decision on October 8, 2002 to use Metron Technology shares with a value of $2.38 to settle the termination payment with Metron Technology triggered an impairment loss on that date for all of

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the shares we held. Accordingly, the difference between the $6.17 per share carrying value and the $2.38 per share value agreed upon for purposes of the Transition Agreement on the shares held was recorded as non-cash impairment charges of $10.2 million in our quarter ending November 30, 2002. The $2.38 per share value reflected the average closing price of the common stock of Metron Technology for the five business days prior to the execution of the Transition Agreement. The fair value of Metron Technology is subject to stock market fluctuations. Based on the closing stock price of Metron Technology of $2.00 per share on November 29, 2002, the fair value of our investment in Metron Technology was approximately $5.4 million, or $0.9 million less than the carrying value on our balance sheet. There can be no assurance that additional impairment charges will not be necessary depending on the impact of economic and industry conditions.

Because of the volatility of our stock price, the ability to trade FSI shares may be adversely affected and our ability to raise capital through future equity financing may be reduced.

     Our stock price has been volatile in the past and may continue to be so in the future. In the 2002 fiscal year, for example, our stock price ranged from $4.10 to $16.25 per share. In the first quarter of fiscal 2003 our stock price ranged from $2.10 to $4.79 per share.

     The trading price of our common shares is subject to wide fluctuations in response to various factors, some of which are beyond our control, including factors discussed elsewhere in this report and the following:

	•		failure to meet the published expectations of securities analysts for a given quarterly period;
	•		changes in financial estimates by securities analysts;
	•		press releases or announcements by, or changes in market values of, comparable companies;
	•		stock market price and volume fluctuations, which are particularly common among securities of high technology companies;
	•		stock market price and volume fluctuations attributable to inconsistent trading volume levels;
	•		additions or departures of key personnel; and
	•		involvement in or adverse results from litigation.

     The prices of technology stocks, including ours, have been particularly affected by extreme fluctuations in price and volume in the stock market generally. These broad stock market fluctuations may have a negative effect on our future stock price.

     In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. In the future we could be the target of this type of litigation. Securities litigation may result in substantial costs and divert management’s attention and resources, which can seriously harm our business.

Because our quarterly operating results are volatile, our stock price could decrease.

     In the past, our operating results have fluctuated from quarter to quarter and are likely to do so in the future. These fluctuations may have a significant impact on our stock price. The reasons for the fluctuations in our operating results, such as sales, gross profits, and net income, include:

	•		The Timing of Significant Customer Orders and Customer Spending Patterns. During industry downturns, our customers may ask us to delay or even cancel the shipment of equipment orders. Delays and cancellations may adversely affect our operating results in any particular quarter if we are unable to recognize revenue for particular sales in the quarter in which we expected those sales.
	•		The Timing of New Product and Service Announcements By Us or Our Competitors. New product announcements by us and our competitors could cause our customers to delay a purchase or to decide to purchase products of one of our competitors which would adversely affect our revenue and, therefore, our

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			results of operations. New product announcements by others may make it necessary for us to reduce prices on our products or offer more service options, which could adversely impact operating margins and net income.
	•		The Mix of Products Sold and the Market Acceptance of Our New Product Lines. The mix of products we sell varies from period to period, and because margins vary among or within different product lines, this can adversely affect our results of operations. If we fail to sell our products which generate higher margins, our average gross margins may be lower than expected. If we fail to sell our new product lines, our revenue may be lower than expected.
	•		General Global Economic Conditions or Economic Conditions in a Particular Region. When economic conditions in a region or worldwide worsen, customers may delay or cancel their orders. There also may be an increase in the time it takes to collect payment from our customers or even outright payment defaults. This can negatively affect our cash flow and our results.

     As a result of these factors, our future operating results are difficult to predict. Further, we base our current and future expense plans in significant part on our expectations of our longer-term future revenue. As a result, we expect our expense levels to be relatively fixed in the short-run. An unanticipated decline in revenue for a particular quarter may disproportionately affect our net income in that quarter. If our revenue is below our projections, then our operating results will also be below expectations. Any one of the factors we list above, or a combination of them, could adversely affect our quarterly results of operations, and consequently may cause a decline in our share price.

Because of our equity position in our affiliated distributors, adverse results of these affiliates could adversely affect our results.

     The profits or losses of our affiliated distributors, Metron Technology B.V. and m•FSI Ltd., can also significantly affect our financial results. As of November 30, 2002, we had a 21% ownership interest in Metron Technology and a 49% interest in m•FSI. Metron Technology and m•FSI also distribute or sell products for companies other than us. If these affiliates lose the business of a significant company for which they distribute or sell products, lose a significant customer, or otherwise became less financially viable, it could have a negative effect on our financial condition.

The transition of our European and Asia-Pacific sales and service from our distributor, Metron Technology, to a direct model may result in additional costs and risks.

     Sales through Metron Technology for fiscal 2002 were $22.1 million, or 15.4% of our total 2002 sales. On October 9, 2002, we entered into a Transition Agreement with Metron Technology related to the early termination of our distribution agreements with Metron Technology for Europe and the Asia-Pacific region effective March 1, 2003. Under the terms of the Transition Agreement, we will assume direct sales, service and applications support and logistics responsibilities for our surface conditioning and microlithography products in Europe and the Asia-Pacific region as of the closing date, while Metron Technology will continue to represent our products in Israel.

     It is anticipated that approximately 90 Metron Technology employees who are currently dedicated to sales, technical service and applications engineering activities related to the distribution of our products in Europe and the Asia-Pacific region will be offered employment with us at the closing date. Our success in selling our products direct in these regions will be dependent upon hiring and retaining key support employees, implementing targeted marketing plans and developing direct relationships with our international customers’ key procurement personnel.

     Because of our limited experience in selling our products directly in Europe and the Asia-Pacific region, we expect to incur additional costs during the ramp-up period.

     The success of our transition to a primarily direct sales model in Europe and the Asia-Pacific region may be adversely impacted if we fail to have the appropriate systems and processes in place as of the Closing Date.

Failure to close the Transition Agreement with Metron Technology could negatively impact our business and the market price of our common shares.

     The Transition Agreement with Metron Technology, whereby our distribution arrangements with Metron Technology will be substantially terminated, is subject to the satisfaction of a number of conditions prior to effectiveness. These conditions include the transfer of certain permits and product registrations from Metron