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Article by DailyStocks_admin    (02-11-08 04:28 AM)

The Daily Magic Formula Stock for 02/09/2008 is Intevac Inc. According to the Magic Formula Investing Web Site, the ebit yield is 56% and the EBIT ROIC is >100 %.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


Dailystocks.com makes NO RECOMMENDATIONS whatsoever, and provides this for informational purpose only.

BUSINESS OVERVIEW

Overview

We are the world’s leading provider of disk sputtering equipment to manufacturers of magnetic media used in hard disk drives and we are developing equipment that we plan sell to semiconductor manufacturers. We also develop and provide leading technology for extreme low light imaging sensors, cameras and systems. We operate two businesses: Equipment and Imaging.

Our Equipment business designs, manufactures, markets and services complex capital equipment which deposits, or sputters, highly engineered thin-films onto magnetic disks used in hard disk drives. We believe our systems represent approximately 60% of the installed capacity of disk sputtering systems worldwide. Our customers are manufacturers of magnetic disks for hard disk drives, and include Fuji Electric, Hitachi Global Storage Technologies and Seagate Technology. We believe the rapid growth of the storage of digital data, including new consumer applications, such as personal audio and video recorders, emerging HDTV applications, streaming video and video game platforms; increasing enterprise data storage requirements; the proliferation of personal computers into emerging markets in Asia and Eastern Europe; along with new technology advances in the industry, provide us with a significant opportunity to sell magnetic media manufacturing equipment. In addition, we plan to enter the market for complex capital equipment sold to the semiconductor manufacturing industry. The vast majority of our revenue is currently derived from our Equipment business, and we expect that the majority of our revenues for the next several years will continue to be derived from our Equipment business.

Our Imaging business develops and manufactures electro-optical sensors, cameras, and systems that permit highly sensitive detection of photons in the visible and near infrared portions of the spectrum, allowing imaging or analytical detection in extreme low light situations. We develop imaging technology and equipment for military applications. To date, our revenues have been derived primarily from research and development contracts funded by the U.S. government, rather than product sales. Applications for our imaging technology include sensors and cameras for use in extreme low light situations and systems for positive identification of targets at long range. We also develop and market commercial cameras and systems addressing markets within life science, physical science, industrial inspection and security.

Intevac was incorporated in October 1990 in California and completed a leveraged buyout of a number of divisions of Varian Associates in February 1991. The technologies acquired from Varian formed the foundation for our Equipment and Imaging businesses. Our principal executive offices are located at 3560 Bassett Street, Santa Clara, California 95054, and our phone number is (408) 986-9888. Our Internet home page is located at www.intevac.com ; however the information in, or that can be accessed through, our home page is not part of this report. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to such reports are available, free of charge, on or through our Internet home page as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. The public may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website ( www.sec.gov ) that contains reports, proxy and information statements and other information regarding us that we file electronically with the SEC.

“LIVAR ® ,” “D-STAR ® ,” “NightVista ® ,” “200 Lean ® ,” and “MOSIRTM,” among others, are our trademarks.

Equipment Business

Our Equipment business designs, manufactures, markets and services complex capital equipment used to sputter thin-films of material onto magnetic disks which are used in hard disk drives, and equipment to lubricate those disks. Hard disk drives are the primary storage medium for digital data. These magnetic disks are created in a sophisticated manufacturing process involving many steps, including plating, annealing, polishing, texturing, sputtering and lubrication. We are utilizing our expertise in complex manufacturing equipment to develop new products that address semiconductor manufacturing markets.

Storage Market Growth Drivers

Data storage requirements have rapidly increased from kilobytes for documents, to megabytes for audio and still images, to gigabytes for video. Hard disk drives are the primary devices used for storing and retrieving large amounts of digital data where re-recordable capability is necessary. We believe there are a number of emerging trends and applications that require cost effective storage intensive solutions.


• New consumer electronics applications, such as digital video and audio recorders, video game platforms, emerging HDTV applications and streaming video.

• Personal computers have evolved from devices operating simple applications such as word processing, to powerful machines that are capable of playing, recording and creating multimedia content, such as images, audio and video.

• Proliferation of personal computers into the emerging markets of Asia and Eastern Europe.

• Enterprise data storage requirements are increasing, as regulations and other business factors require companies to archive more information, such as documents and email. Additionally, companies are transitioning from paper-based storage to digital data-based storage and digital backup.

• Certain traditional analog storage applications are transitioning to digital hard disk-based storage. For example, the video surveillance industry, including home security, law enforcement, private security services, retail, transportation and government agencies, is transitioning from analog video tapes to digital hard disk storage.

As a result of these and other storage applications, TrendFocus reported that hard disk drive shipments grew by 14.2% during 2006 to 435 million units and projects 14.4% annual growth in hard disk drive units through 2010.

Hard Disk Drive Market Dynamics

Areal Density Increasing. Areal density, defined as the density of information stored on magnetic disks, continues to increase, albeit at a slower rate than in past years. Higher areal density allows more information to be stored on each magnetic disk, which enables hard disk drive manufacturers to provide greater data storage capacity at a lower cost per gigabyte.

Transition from Longitudinal to Perpendicular Recording. Historically, magnetic disk manufacturers have been able to increase the areal density of a disk by improving existing longitudinal recording processes, a storage method where magnetized data bits are parallel to the disk. In the past few years, the rate of increase in areal density for longitudinal recording processes has slowed, as the magnetized data bits were packed closer and closer together, increasing instability. In order to continue increasing capacity per disk, the magnetic disk industry has begun the transition to perpendicular recording. In perpendicular recording the data bits are oriented perpendicular to the disk surface, and this approach makes it possible for the bits to be recorded at a higher density than in longitudinal recording.

New Equipment Required for Perpendicular Recording. The legacy equipment that magnetic disk manufacturers purchased in the mid to late 1990s could generally accommodate up to twelve process stations, which was sufficient for longitudinal recording. However, disk manufacturers need to replace or retool their existing disk manufacturing equipment to support increasing production of disks capable of perpendicular recording. Economically producing disks capable of perpendicular recording may require as many as twenty or more process stations. As a result, disk manufacturers have been investing in new equipment, such as the 200 Lean, since 2004. In 2007 we believe that some of our customers will begin making significant replacements of their legacy equipment with 200 Leans.

Consolidation of Equipment Suppliers. Beginning in 1995, most magnetic disk manufacturers undertook aggressive expansion plans. A reduction in disks per drive, possible because of rapid increases in areal density, combined with these capacity expansions, resulted in substantial excess disk production capacity from 1998 through 2002. Even though total storage capacity of all hard disk drives shipped increased from 1997 to 2003, disk manufacturers did not make significant investments in disk sputtering equipment. As a result, the supplier base of disk sputtering equipment was reduced. Intevac and one other manufacturer now supply the majority of disk sputtering equipment capable of economically manufacturing media suitable for perpendicular recording.

Industry Consolidation. Two types of companies purchase disk sputtering equipment; vertically integrated companies that manufacture both disks and the hard drives that use those disks, and merchant suppliers that manufacture magnetic disks for sale to hard disk manufacturers. Both drive and disk manufacturers were adversely affected by the overcapacity of 1998 through 2002, and the industry underwent significant consolidation. For instance, in 2001 Maxtor acquired Quantum’s hard disk drive operations, and Fujitsu ceased manufacturing hard disk drives for the personal storage market. In 2002, IBM sold its hard disk drive business to Hitachi. In 2004, Showa Denko acquired Trace Storage Technology. In 2006, Seagate completed its acquisition of Maxtor. This consolidation substantially reduced the number of magnetic disk manufacturers able to respond to any increasing demand for disks for hard disk drives.

Equipment Selection Criteria. To evaluate the performance of competing disk sputtering equipment, magnetic disk manufacturers consider the following criteria:


• Cost of Ownership. Cost of ownership of disk sputtering equipment includes factors such as equipment price, manufacturing yield, throughput, consumables cost, factory floor footprint and uptime. A lower cost of ownership for disk sputtering equipment is a key factor in lowering the manufacturer’s product cost.

• Extendibility and Flexibility. We believe magnetic disk manufacturers need sputtering equipment that can address the needs of their evolving technology roadmaps. This equipment must be capable of incorporating new process steps and new technical capabilities, including the processes needed for producing magnetic disks capable of perpendicular recording. Additionally, these manufacturers are improving longitudinal processes and further developing the processes necessary for perpendicular recording, and as a result, they demand a flexible system that supports process reconfigurations and expansions with a minimum of effort.

• Compatibility with Existing Equipment. We believe magnetic disk manufacturers prefer to standardize their processes around a single disk sputtering equipment supplier. Once a disk manufacturer has selected a particular supplier’s equipment, that manufacturer generally relies upon that supplier’s equipment and generally will continue to purchase any additional equipment from the same supplier. There are significant economies of scale related to the use of a single supplier’s disk manufacturing system in product design, product qualification, manufacturing and support.

• Long-term Commitment of Supplier. We believe magnetic disk manufacturers need sputtering equipment suppliers that are committed to meeting current and future technology requirements and to supporting this equipment throughout its useful life. As a result, magnetic disk manufacturers demand a supplier with the stability and capability to be a long-term technology partner.

Our Competitive Strengths

We are the leading provider of disk sputtering equipment to manufacturers of magnetic media used in hard disk drives. We believe that our industry leadership is the result of the following key competitive strengths:


• Broad Installed Base with Industry Leading Customers. Our MDP-250 disk sputtering system gained wide acceptance in the magnetic disk manufacturing industry and by the late 1990s was being used in the manufacture of approximately half of the magnetic disks used in hard disk drives worldwide. Our 200 Lean, introduced in 2003, continues our strong industry position. We believe that there are approximately 111 legacy MDP-250 systems and 80 next generation 200 Lean systems currently available for use in production and research and development applications by customers such as Fuji Electric, Hitachi Global Storage Technology and Seagate. We believe there is significant potential for these customers to continue adding capacity and to upgrade the technical capability of their installed base to permit production of higher density disks capable of perpendicular recording.

• Technology Leadership with Modular Next Generation Advanced Platform. In December 2003, we first delivered our latest-generation disk sputtering system, the 200 Lean, which provides enhanced capabilities relative to our installed base of MDP-250 systems. The 200 Lean’s compact design enables more disks to be manufactured per square-foot of factory clean-room space. The flexible design of the 200 Lean allows rapid reconfiguration to accommodate product changeovers and new disk technology. The modular design of the 200 Lean also allows disk manufacturers to add additional process stations, as advanced magnetic disk technologies, such as perpendicular recording, are introduced. We believe the Intevac 200 Lean system accounts for the majority of installed production capacity of next generation perpendicular-capable systems.

• Long-Term Commitment to Hard Disk Drive Industry. We have been a hard disk drive equipment provider since 1991. We continue to develop new technologies, and introduced the 200 Lean disk sputtering system to meet the need for additional process stations necessary to economically produce magnetic disks capable of perpendicular recording. In addition, our headquarters and our support centers in Singapore, China and Malaysia are located in close proximity to many of our customers’ hard disk drive development centers and manufacturing facilities.

Based on these competitive strengths, we believe that we are well positioned to maintain our market leading position in the magnetic disk sputtering equipment market.

Our Equipment Strategy

We believe we can leverage our leadership position in disk sputtering equipment to increase our sales to magnetic disk manufacturers and apply our technology to new markets. The key elements of our strategy are as follows:


• Be a Preferred Solutions Provider in the Magnetic Disk Industry. Our goal is to be a preferred solutions provider to magnetic disk manufacturers. We believe that our 200 Lean provides our customers with an advanced modular platform that can address their future disk sputtering needs. We believe we are also the leading provider of disk lubrication equipment, which is used to apply ultra-thin coatings of lubricant to magnetic disks after sputtering.

• Leverage Existing Technology into New Markets. In addition to expansion within our existing customer base, we are targeting other markets where we can apply our expertise in complex manufacturing equipment. Our expertise includes the ability to design and manufacture complex, highly automated vacuum manufacturing systems. We are currently developing a new manufacturing system that addresses the etch segment of the semiconductor manufacturing market. We are devoting a significant portion of our business development and technical resources to developing this new product, and we plan to deliver evaluation units for this new system to multiple customers during 2007. We expect our initial customers will test evaluation systems for as long as twelve months before deciding whether to purchase production systems. Accordingly, we do not expect to recognize revenues from the sale of this new system until 2008.


• Deliver Highest Customer Value Proposition. Our goal is to maintain our leadership in complex manufacturing equipment by providing flexible, extendable equipment having the lowest cost of ownership. For example, the 200 Lean’s modular design provides customers the ability to reconfigure their disk manufacturing systems for rapid technology shifts and evolving technology roadmaps, and its compact footprint and increased throughput relative to the legacy MDP-250 systems enable increased output per square foot of factory clean-room space.

• Expand Consumables, Spare Parts and Service Offerings. We plan to increase the sale of disk sputtering equipment consumables, spare parts and service in order to increase our revenue opportunity per customer. This will enable us to deepen and enhance our customer relationships. We believe that the close proximity of our service centers in Singapore, Shenzhen, China and Kulim, Malaysia to our customers’ facilities gives us a competitive advantage. We plan to add additional support centers as required in order to maintain close proximity to our customers’ operations.

Our Equipment Products

200 Lean Disk Sputtering System

The 200 Lean is our latest generation disk sputtering system. The 200 Lean provides significantly enhanced capabilities relative to the installed base of approximately 111 legacy MDP-250 systems. The 200 Lean provides higher throughput from a smaller footprint in a flexible modular system, which enables more disks to be manufactured per square-foot of factory floor space, and is designed to lower overall cost of ownership.

The key features of the 200 Lean include:


• Modular Design. The 200 Lean’s modular design allows our customers to accommodate any number of disk manufacturing process steps required by their evolving technology roadmaps. The 200 Lean consists of a front-end robotic module that loads and unloads disks to and from the system, combined with any number of four-station process modules. Typical configurations of the 200 Lean have five of these four-station process modules, which results in systems capable of up to 20 process steps. Additional process modules can be easily added to already installed systems.

• Easy to Reconfigure. Magnetic disk manufacturers produce many different designs that have short product life cycles, leading to frequent reconfiguration of disk sputtering equipment. The mechanical design and software control system of the 200 Lean allow rapid reconfiguration of systems by our customers. The 200 Lean is also easily reconfigured to process disks with glass or aluminum substrates of varying diameters and thicknesses.

• Higher Throughput with Smaller Footprint. The 200 Lean offers higher throughput (up to 800 disks per hour) and more process stations in a more compact package than our legacy MDP-250 system. We believe that the 200 Lean has the highest disk throughput per square foot of factory space for a system capable of manufacturing perpendicular media.

• High Availability. The 200 Lean is designed to operate seven days a week, 24 hours a day with high availability. The 200 Lean can be run continuously for a week or more between preventative maintenance cycles.

• Single Disk Processing. The 200 Lean processes each individual disk sequentially through a series of single-disk, vacuum-isolated, process chambers. “Single-disk” processing assures that each individual disk follows an identical path through the system, which leads to disk-to-disk uniformity, since each disk sees the same process conditions.

• High-Vacuum Capability. The 200 Lean operates at significantly better vacuum levels compared to the installed base of MDP-250s. Better vacuum levels generally lead to improved magnetic media performance.

• Suite of Process Station Options. The 200 Lean offers a wide range of process stations, providing capabilities such as metal deposition, heating, cooling and carbon overcoating onto both aluminum and glass disks.

DLS-100 Disk Lubrication System

Disk lubrication is the manufacturing step that immediately follows deposition. During lubrication, a microscopic layer of lubricant is applied to the disk’s surface to improve durability and reduce surface friction between the disk and the read/write head assembly.

The Intevac DLS-100 is a disk lubrication system for uniformly lubricating disks in a temperature controlled, low vibration and contamination free environment.

Equipment Business Sales and Marketing

Our Equipment business sales are made primarily through our direct sales force, although in Japan, we sell our products through a distributor, Matsubo. The selling process for our equipment products is a multi-level and long-term process, involving individuals from marketing, engineering, operations, customer service and senior management. The process involves making sample disks for the prospective customer and responding to its needs for moderate levels of machine customization. Customers often require a significant number of product presentations and demonstrations before making a purchasing decision.

Installing and integrating new equipment requires a substantial investment by a customer. Sales of our systems depend, in significant part, upon the decision of a prospective customer to replace obsolete equipment or to increase manufacturing capacity by upgrading or expanding existing manufacturing facilities or by constructing new manufacturing facilities, all of which typically involve a significant capital commitment. After making a decision to select our equipment, our customers typically purchase one or more engineering systems to develop and qualify their production process prior to ordering and taking delivery of multiple production systems. Accordingly, our systems have a lengthy sales cycle, during which we may expend substantial funds and management time and effort with no assurance that a sale will result.

The production of large complex systems requires us to make significant investments in inventory both to fulfill customer orders and to maintain adequate supplies of spare parts to service previously shipped systems. In some cases we manufacture subsystems and/or complete systems prior to receipt of a customer order to smooth our production flow and/or reduce our lead time. We maintain inventories of spare parts in Santa Clara, Singapore and other locations to support our customers. We typically require our customers to pay for systems in three installments, with a portion of the system price billed upon receipt of an order, a portion of the price billed upon shipment, and the balance of the price and any sales tax due upon completing installation and acceptance of the system at the customer’s factory. All customer product payments are recorded as customer advances pending revenue recognition.

Equipment Business Customers

Our disk sputtering equipment customers include magnetic disk manufacturers such as Fuji Electric and vertically integrated hard disk drive manufacturers, such as Hitachi Global Storage Technology and Seagate. The majority of our customers’ product development programs are located in the United States and Japan. Our customers’ manufacturing facilities are primarily located in California, China, Japan, Malaysia and Singapore.

Our customers’ businesses tend to be cyclical, with their peak sales occurring during the second half of the year. As a result, our customers have a tendency to order equipment for delivery and installation by midyear, so that they have new capacity in place for their peak production period. However, during both 2005 and 2006 our customers were capacity constrained, demand did not follow normal seasonal patterns, and we realized our highest revenues during the fourth fiscal quarter.

Equipment Business Customer Support

We provide process and applications support, customer training, installation, start-up assistance and emergency service support to our equipment customers. We conduct training classes for our customers’ process engineers, machine operators and machine service personnel. Additional training is also given to our customers during the machine installation. We have a subsidiary in Singapore and field offices in China, Malaysia and Japan to support our customers in Asia. We are planning to add additional support centers to maintain close proximity to our customers’ factories as they deploy our systems.

We generally offer a one year warranty on our equipment. In some cases we market extended warranty periods beyond 12 months to our customers. During this warranty period any necessary non-consumable parts are supplied and installed without charge. Our employees provide field service support in the United States, Singapore, Malaysia, China and Japan. In Japan, field service support is also supplemented by our distributor, Matsubo.

Equipment Business Competition

The principal competitive factors affecting the markets for our equipment products include price, product performance and functionality, integration and manageability of products, customer support and service, reputation and reliability. We have historically experienced intense competition worldwide for magnetic disk sputtering equipment from competitors including Anelva Corporation, Ulvac and Oerlikon, formerly Unaxis Holdings, Ltd., each of which has sold substantial numbers of systems worldwide. Anelva, Ulvac and Oerlikon all have substantially greater financial, technical, marketing, manufacturing and other resources than we do. To our knowledge, Intevac, Anelva and Oerlikon are the only companies that have delivered products that economically address the sputtering requirements for manufacture of advanced perpendicular magnetic disks. However, there can be no assurance that any of our competitors will not develop enhancements to, or future generations of, competitive products that offer superior price or performance features or that new competitors will not enter our markets and develop such enhanced products. In addition, as we enter the semiconductor equipment market, we anticipate that we will experience competition from competitors such as Applied Materials, LAM Research and Tokyo Electron, Ltd.

Given the lengthy sales cycle and the significant investment required to integrate equipment into the manufacturing process, we believe that once a magnetic disk manufacturer has selected a particular supplier’s equipment for a specific application, that manufacturer generally relies upon that supplier’s equipment and frequently will continue to purchase any additional equipment for that application from the same supplier. Accordingly, competition for customers in the equipment industry is intense, and suppliers of equipment may offer substantial pricing concessions and incentives to attract new customers or retain existing customers.

Imaging Business

Our Imaging business develops and manufactures electro-optical sensors, cameras and systems that permit highly sensitive detection of photons in the visible and near infrared portions of the spectrum, allowing vision or analytical detection in extreme low light situations. The majority of our imaging revenue to date has been derived from contracts related to the development of electro-optical sensors, cameras and systems and funded by the U.S. Government, its agencies and contractors.

Imaging Industry Overview

Imaging is the capture and display of an image by collecting light or heat emitted or reflected from an object. Low light imaging involves the capture and display of light at intensities of approximately one millionth, or less, of daytime light levels.

Low light imaging technology that provides superior vision in nighttime creates a significant tactical combat advantage. Accordingly, the U.S. military has funded the development of various night vision technologies, which have evolved to today’s widely deployed “Generation-III” night vision tubes. Typically, Generation-III night vision tubes are placed in front of a user’s eyes, like a pair of binoculars, and produce a direct-view, “green glow” image. The U.S. military is now funding the development of compact digitally enhanced night vision goggles that incorporate imagery from both low light and thermal sensors. The commercial sector has taken a different approach to extreme low light imaging than the military. The initial extreme low light cameras for the commercial sector were based on charged coupled device, or CCD, technology, which is able to directly produce a digital output. CCD technology has been applied in a wide variety of applications requiring low light level detection or imaging such as astronomy, spectroscopy, life sciences and industrial products monitoring.

As a result, two distinct forms of low light level imaging have evolved: the Generation-III night vision tube technology developed by the military, which provides direct-view analog imagery; and CCD technology, which can provide digital imagery, but is not well suited to dynamic applications.

Our Imaging Solution

We have developed imaging technology that combines the low light capability of Generation-III night vision technology with silicon-based digital video technology that we believe will enable us to provide a family of cost-effective low light sensors and cameras. Elements of our proprietary solutions include:

Advanced Photocathode Technology — A photocathode is a semiconductor compound with the ability to convert light into electrons. We manufacture a family of photocathodes designed to optimize sensitivity at specific wavelengths ranging from the visible (0.40 microns) to the near infrared (1.65 microns). Our photocathodes are extremely sensitive to incoming light. Some of our detectors incorporating such photocathodes can detect incoming light at levels of a single photon, the ultimate level of sensitivity.

Use of Low Power CMOS Imaging Chips — Complementary Metal Oxide Semiconductor, or CMOS sensors, which are generally lower cost and require less power than comparable CCD sensors, have been developed for consumer imaging applications. We have developed proprietary technologies and capabilities to incorporate CMOS sensors into our products to take advantage of these improvements. We have also developed proprietary CMOS devices optimized for use in our night vision sensors. As a result, we believe we will be able to offer cost effective, compact, low power, extreme low light imaging sensors.

Increased Silicon Sensor Sensitivity — We have developed proprietary technology to enable CMOS and CCD sensors to efficiently capture electrons emitted from the photocathode. Increasing the electron capture efficiency directly increases extreme low light imaging performance.

Compact Ultra-High Vacuum Sensor Packaging — Our compact ultra-high vacuum sensor package enables us to combine an imaging chip with a photocathode in a thin package, which is particularly well suited for portable applications where size and weight are critical.

Low Light Imaging Market Opportunity

Head Mounted Night Vision Systems — Generation-III based night vision goggles, which have excellent extreme low light imaging performance, were widely deployed by the U.S. military for use by soldiers during the 1990’s. In 2005 the U.S. military awarded contracts for procurement of up to $3.2 billion of Generation-III night vision equipment over a five-year period. However, these goggles lack video output. Additionally, potential adversaries are now deploying Generation-II+ goggles manufactured outside the United States with performance levels approaching that of Generation-III. Accordingly, the U.S. Army has developed a roadmap to maintain extreme low light imaging dominance for the individual soldier. The roadmap includes developing the Digital Enhanced Night Vision Goggle (“DENVG”), a compact head mounted system, that integrates a visible imager, an infrared imager and a video display. This approach allows the low light and the infrared imagery to be viewed individually, or to be overlaid on each other (“fused”) at the option of the soldier, and also enables connectivity to a wireless network for distribution of the imagery and other information. The U.S. Army plans to begin production of this type of system in 2010.

Long Range Target Identification — Current long-range military nighttime surveillance systems are based on expensive thermal imaging camera systems, which image the thermal profile of a target. Long-range thermal systems are relatively large, which is a disadvantage for airborne and portable applications. Accordingly, there is a need for a cost effective, compact, long-range imaging solution that identifies targets at a distance that is greater than an adversary’s detection range capability.

Physical Sciences — Companies in the physical sciences use extreme low light imaging to investigate the chemistry and physics of a wide variety of substances such as foods, medicines, materials and biological compounds. They need wider spectral coverage, high sensitivity, increased speed and increased resolution to increase the accuracy of their measurements and the productivity of their measurement tools.

Life Sciences — The life sciences market focuses on increasing the understanding of biology at the cellular level to improve health and quality of life. To image single living cells, this market needs extreme low light cameras that operate at speeds significantly higher than cameras that are available today.

Our Imaging Strategy

Collaborate with Leading Development Organizations — We collaborate with and receive significant funding from leading government research organizations for the development of our extreme low light technology. These organizations strongly influence development and procurement of advanced technologies by the U.S. military. For example, we have collaborated with the U.S. Army Night Vision Labs, the world leader in night vision technology, to facilitate the development and adoption of our night vision technology.

Become Leading Provider of Extreme Low Light Imaging Sensor, Camera, and System Products for the Military — We are actively marketing our extreme low light imaging technology-based products to the military.


• Night Vision Camera Modules — Our extreme low-light sensor technology was selected in 2004 for use in a digital head-mounted and rifle-sight system for the military of a NATO ally. During 2006, we completed the development of a night-vision sensor and camera module for this application and entered into a purchasing agreement with our NATO customer to deliver 32,000 camera modules over seven years, valued in excess of $50 million over the term of the agreement. Orders under this agreement may be released annually. We expect to deliver pilot production units in 2007 and volume production units in 2008.

• Digitally Enhanced Night Vision Goggles (“DENVG”) — We are jointly developing, with DRS Technologies, DENVG night vision goggle prototypes for the U.S. Army. These compact digital systems are being designed to display the imagery from our low-light night vision sensors in combination with imagery from DRS Technology’s thermal imaging sensors. In 2007, we expect to deliver prototypes to the U.S. Army for field-testing and to pursue additional contracts to fund further development of this product.

• Laser Illuminated Viewing and Ranging (“LIVAR”) — Our LIVAR target identification system can be used to identify targets at distances of up to twenty kilometers and has been incorporated into U.S. weapons development programs such as the Airborne Laser (“ABL”), the Cost Effective Targeting System (“CETS”), and the Long-Range Identification System (“LRID”) programs. We expect to begin volume production deliveries of LIVAR cameras late in 2007.

• Intensified Photodiodes — We are developing devices that enable single photon detection at extremely high data rates and are designed for use in target identification and other military applications.

Become Leading Provider of Camera and Systems Products, based on Proprietary Sensor Technology, to Address Emerging Commercial Markets — We are also using our extreme low-light imaging expertise in sensor and camera technology to develop products for commercial markets. We believe the modular design of our camera electronics and software, coupled with use of our proprietary CMOS chips in configurable sensors, will help decrease development time and cost.


• MOSIR Near Infrared Cameras — We began shipping our MOSIR line of commercial cameras during 2006. This camera provides previously unavailable high sensitivity in the near infrared portion of the spectrum and is well suited for low-light spectroscopy applications. We plan to continue to enlarge our product offerings of high-performance cameras for physical science, life science and industrial applications within the commercial imaging market.

• Raman Spectrometers — On February 1, 2007, we completed an acquisition of the assets and certain liabilities of DeltaNu, LLC, a company that pioneered development of miniature Raman spectrometer systems. Raman spectroscopy systems are used to identify materials by illuminating the material with a laser and measuring the characteristic spectrum of light scattered from the material. The process enables real- time, non-destructive identification of liquids and solids outside of the laboratory and is well suited to applications such as hazmat, forensics, homeland security, geology, gemology, medical, pharmaceutical and industrial quality assurance.


• Near Infrared Raman Spectrometers — Raman spectrometers typically use lasers in the visible spectrum, which can lead to excessive background noise, or fluorescence, as well as potential eye-safety issues. These limitations can now be significantly reduced by using near infrared lasers in combination with our proprietary near infrared sensor technology. We plan to develop a new class of high-performance Raman spectrometer systems that integrate Intevac’s near infrared sensors with DeltaNu’s low cost Raman spectrometers.

Low Manufacturing Costs — The market for our cameras and sensors is price sensitive, and low-cost manufacturing will be critical to the rapid proliferation of our products. Our use of low-cost proprietary CMOS sensors and wafer level die manufacturing, as opposed to single die manufacturing, are elements of our strategy to reduce product cost. Additionally, we have developed proprietary ultra-high vacuum assembly equipment to automate the assembly of the photocathode and the imaging device. This system is designed to decrease unit costs by increasing throughput and improving process controls and yields.

Imaging Sales and Marketing

Sales of our products for military applications are primarily made to the end user through our direct sales force. In cases where our products are enabling technology for more complex systems, we also sell to leading defense contractors such as Boeing, Lockheed Martin Corporation and Northrop Grumman Corporation. To date, the majority of our Imaging revenue has been derived from research and development contracts, rather than product sales. During 2006, revenue from product sales grew to $1.7 million from $888,000 in 2005. We expect that product sales will contribute an increasing percentage of Imaging revenue over the next several years.

We are subject to long sales cycles because many of our products, such as our LIVAR system, typically must be designed into our customers’ products, which are often complex and state-of-the-art. These development cycles are often multi-year, and our sales are contingent on our customer successfully integrating our product into its product, completing development of its product and then obtaining production orders for its product. Sales of these products are also often dependent on ongoing government funding of defense programs by the U.S. government and its allies. Additionally, sales to international customers are subject to issuance of export licenses by the United States government, which cannot always be obtained.

Sales of our commercial products, which have not been significant to date, will be made through a combination of direct sales, system integrators, distributors and value added resellers and can also be subject to long sales cycles.

Our Imaging business generally invoices its research and development customers either as costs are incurred, or as program milestones are achieved, depending upon the particular contract terms. As a government contractor, we invoice customers using estimated annual rates approved by the Defense Contracts Audit Agency (“DCAA”). A majority of our contracts are Cost Plus Fixed Fee (“CPFF”) contracts. On any CPFF contract, 15% of the fee is withheld pending completion of the program and DCAA’s annual audit of our actual rates. The withheld portion of the fee is included in accounts receivable until paid.

CEO BACKGROUND
Mr. Pond is a founder of Intevac and has served as Chairman of the Board since February 1991. Mr. Pond served as President and Chief Executive Officer from February 1991 until July 2000 and again from September 2001 through January 2002. Mr. Pond holds a BS in physics from the University of Missouri at Rolla and an MS in physics from the University of California at Los Angeles.

Mr. Fairbairn joined Intevac as President and Chief Executive Officer in January 2002 and was appointed a director in February 2002. Before joining Intevac, Mr. Fairbairn was employed by Applied Materials from July 1985 to January 2002, most recently as Vice-President and General Manager of the Conductor Etch Organization with responsibility for the Silicon and Metal Etch Divisions. From 1996 to 1999, Mr. Fairbairn was General Manager of Applied Materials’ Plasma Enhanced Chemical Vapor Deposition Business Unit and from 1993 to 1996, he was General Manager of Applied Materials’ Plasma Silane CVD Product Business Unit. Mr. Fairbairn holds an MA in engineering sciences from Cambridge University.

Dr. Barnes joined Intevac as Vice President and Chief Technical Officer in February 2006. Before joining Intevac, Dr. Barnes was General Manager of the High Density Plasma Chemical Vapor Deposition Business Unit at Novellus Systems from March 2004 to February 2006. From January 2004 to March 2004, he was Vice President, Technology at Nanosys, and from August 2003 to January 2004, he was Vice President, Engineering at OnWafer Technologies. Dr. Barnes was employed by Applied Materials from April 1998 to August 2003, first as a Managing Director and subsequently as Vice President, Etch Engineering and Technology. Dr. Barnes holds a BS, MS and PhD in electrical engineering from the University of Michigan.

Ms. Burk has served as Human Resources Director since May 2000. Prior to joining Intevac, Ms. Burk served as Human Resources Manager of Moen, Inc. from 1999 to 2000 and served as Human Resources Manager of Lawson Mardon from 1994 to 1999. Ms. Burk holds a BS in sociology from Northern Illinois University.

Mr. Eddy has served as Vice President, Finance and Administration, Chief Financial Officer, Treasurer and Secretary since April 1991. Mr. Eddy holds a BS in engineering science from the University of Virginia and an MBA from Dartmouth College.

Mr. Kerns joined Intevac as Vice President, Business Development of the Equipment Products Division in August 2003. Before joining Intevac, Mr. Kerns was employed by Applied Materials from April 1997 to November 2002, most recently as Managing Director for Business Development for the Process Modules Group. Previously, Mr. Kerns was General Manager of Applied Materials’ Metal Etch Division from 2000 to 2002. From 1998 to 2000, Mr. Kerns was Senior Director for Applied Materials’ North America Multinational Accounts and from 1997 to 1998, he was General Manager of Applied Materials’ Dielectric Etch Division. Mr. Kerns holds a BS in chemistry from the University of Idaho and a PhD in theoretical chemistry from Princeton University.

Mr. Marusiak joined Intevac as Chief Operating Officer in April 2004. Before joining Intevac, Mr. Marusiak was employed by Applied Materials from July 1991 to April 2004, most recently as Senior Director of North American Operations. Previously, Mr. Marusiak managed Applied Materials’ Field Operations in North America. Mr. Marusiak holds a BS in electrical engineering from Gannon University and an MS in teleprocessing science from the University of Southern Mississippi.

Mr. Pietras joined Intevac as Vice President and General Manager of the Imaging Business in August 2006. Before joining Intevac, Mr. Pietras was employed by the Sarnoff Corporation from March 2005 to July 2006 as General Manager of Sarnoff Imaging Systems. From September 1998 to March 2005, he was employed by Roper Scientific as Vice President, Operations. Mr. Pietras holds a BS in Physics from the Stevens Institute of Technology and a MA and PhD in Physics from Columbia University.

Mr. Aebi has served as Chief Technology Officer of our Imaging business since August 2006. Previously, Mr. Aebi served as President of the Photonics Division from July 2000 to July 2006 and as General Manager of the Photonics Division since May 1995. Mr. Aebi was elected as a Vice President of the Company in September 1995. From 1988 through 1994, Mr. Aebi was the Engineering Manager of our night vision business, where he was responsible for new product development in the areas of advanced photocathodes and image intensifiers. Mr. Aebi holds a BS in physics and an MS in electrical engineering from Stanford University.

Mr. Birt joined Intevac as Vice President, Customer Support of the Equipment Products Division in September 2004. Before joining Intevac, Mr. Birt was employed by Applied Materials from July 1992 to September 2004, most recently as Director, Field Operations/Quality North America. Mr. Birt holds a BS in electrical engineering from Texas A&M University.

Mr. Bluck rejoined Intevac as Vice President, Technology of the Equipment Products Division in August 2004. Mr. Bluck had previously worked at Intevac from December 1996 to November 2002 in various engineering positions. The business unit Mr. Bluck worked for was sold to Photon Dynamics in November 2002 and he was employed there as Vice President, Rapid Thermal Process Product Engineering until August 2004. Mr. Bluck holds a BS in physics from San Jose State University.

Mr. Justyn has served as Vice President, Equipment Manufacturing since April 1997. Mr. Justyn joined Intevac in February 1991 and has served in various roles in our Equipment Products Division and our former night vision business. Mr. Justyn holds a BS in chemical engineering from the University of California, Santa Barbara.

Mr. Kelly joined Intevac in December 2006 as Vice President, Engineering of the Imaging business. Before joining Intevac, Mr. Kelly was employed by Redlake MASD LLC, a division of Roper Industries from January 2004 to December 2006, most recently as Vice President, Engineering and Custom Service. From November 2000 to December 2003, he was employed by Fast Technology AG as Vice President, Engineering. Mr. Kelly holds a BS and a MS in mechanical engineering from the University of Michigan.

MANAGEMENT DISCUSSION FROM LATEST 10K

Overview

Our operations include two businesses, Equipment and Imaging. The Equipment business designs, manufactures, markets and services complex capital equipment that deposits highly engineered thin films of material onto disks used in hard disk drives and we are developing equipment that we plan sell to semiconductor manufacturers. Our Imaging business develops and manufactures electro-optical sensors, cameras and systems that permit highly sensitive detection of photons in the visible and near infrared portions of the spectrum, allowing vision in extreme low light situations. The vast majority of our revenue is currently derived from our Equipment business, and we expect that the majority of our revenues for the next several years will continue to be derived from our Equipment business.

Equipment Business

In the early 1990s we developed a system, the MDP-250, to deposit magnetic films and protective overcoats onto magnetic disks used in hard disk drives. This system gained wide acceptance and by the late 1990s was being used to manufacture approximately half of the disks used in hard disk drives worldwide. In late 2003, we introduced a new system, the 200 Lean. We believe that there are a total of approximately 111 MDP-250 and 80 200 Lean systems currently available for use in production and research and development applications at magnetic disk and hard disk drive manufacturers worldwide. The hard disk drive industry has gone through significant consolidation, and there are now only seven significant manufacturers of magnetic disks, some of whom also manufacture hard disk drives. As a result of the small number of customers and the high average selling price of our products, our Equipment revenues tend to be volatile from quarter to quarter. In addition, our Equipment business has historically been subject to capital spending cycles. For example, in the period from 1995 through the middle of 1998, we sold $300 million of disk manufacturing equipment. In the period from the middle of 1998 thru 2003, our disk equipment revenues averaged approximately $20 million per year and consisted of the sale of a limited number of systems, technology upgrades, parts and service for the installed base of our systems. In 2006, our sales of disk manufacturing equipment grew to $248 million in annual revenues.

We believe there is significant potential for magnetic disk manufacturers to continue adding capacity. We believe that the introduction of high density disks based on perpendicular recording techniques will also require disk manufacturers to significantly upgrade the technical capability of their installed base of manufacturing equipment to accommodate the additional number of process steps predicted to be required by perpendicular recording technology roadmaps.

In the past we also manufactured both deposition and rapid thermal processing equipment used in the manufacture of flat panel displays. In late 2002, we sold our rapid thermal processing product line and stopped actively marketing our deposition product line. From 2000 through 2004, cumulative revenues from sales of flat panel display manufacturing systems totaled $36.8 million. 2005 revenues included $5 million related to selling a license to one of our flat panel patents and recognizing revenue on the last flat panel system we shipped.

Imaging Business

Our Imaging business develops and manufactures electro-optical sensors, cameras and systems that permit highly sensitive detection of photons in the visible and near infrared portions of the spectrum, allowing imaging in extreme low light situations. Our military products include extreme low light sensors and cameras for use in short- to medium-range military applications and LIVAR cameras and systems for positive target identification at long range. The majority of the funding for our Imaging business activities has historically been derived from research and development contracts with the United States Government and its contractors, with the balance being funded internally.

Developing advanced products for the military involves long development cycles, as products move through successive multi-year stages of technology demonstration, engineering and manufacturing product development, prototype production and then product deployment. Each stage in this process requires ongoing government funding. To date, substantially all of our Imaging business revenues has been derived from contract research and development, rather than product sales. In July 2002, in order to shorten the time to market and to increase the number of markets for our imaging products, we began to fund development of imaging products for commercial markets. In early 2007, we acquired DeltaNu, LLC, a manufacturer of Raman spectrometers. Although product revenues from these activities have not yet been significant, we expect revenues from product shipments to significantly increase as a percentage of 2007 Imaging revenues.

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“US GAAP”) requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 2 of Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies, as defined below.

A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial conditions and results of operations. Specifically, critical accounting estimates have the following attributes: 1) we are required to make assumptions about matters that are highly uncertain at the time of the estimate; and 2) different estimates we could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on our financial condition or results of operations.

Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they become known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. Many of these uncertainties are discussed in the prior section entitled “Risk Factors.” Based on a critical assessment of our accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that our consolidated financial statements are fairly stated in accordance with US GAAP, and provide a meaningful presentation of our financial condition and results of operation.

We believe the following critical accounting policies affect the more significant judgments and estimates we make in preparing our consolidated financial statements. We also have other key accounting policies and accounting estimates related to the collectibility of trade receivables and prototype product costs. We believe that these other accounting policies and other accounting estimates either do not generally require us to make estimates and judgments that are as difficult or subjective, or it is less likely that they would have a material impact on our reported results of operation for a given period.

Revenue Recognition

Certain of our system sales with customer acceptance provisions are accounted for as multiple-element arrangements. If we have previously met defined customer acceptance levels with the specific type of system, then we recognize revenue for the fair market value of the system upon shipment and transfer of title, and recognize revenue for the fair market value of installation and acceptance services when those services are completed. We estimate the fair market value of the installation and acceptance services based on our actual historical experience. For systems that have generally not been demonstrated to meet a particular customer’s product specifications prior to shipment, revenue recognition is typically deferred until customer acceptance. For example, while initial shipments of our 200 Lean system were recognized for revenue upon customer acceptance during 2004, revenue was recognized upon shipment for the majority of 200 Leans shipped in 2005 and 2006. Most of the systems in backlog at December 31, 2006 are for customers where we have met defined customer acceptance levels, and we expect to recognize revenue upon shipment for those systems.

In some instances, hardware that is not essential to the functioning of the system may be delivered after acceptance of the system. In these cases, we estimate the fair market value of the non-essential hardware as if it had been sold on a stand-alone basis, and defer recognizing revenue on that value until the hardware is delivered.

In certain cases, we sell limited rights to our intellectual property. Revenue from the sale of any intellectual property license is generally recognized at the inception of the license term.

We perform best efforts research and development work under various government-sponsored research contracts. These contracts are a mixture of cost-plus-fixed-fee (“CPFF”) and firm fixed-price (“FFP”). Revenue on CPFF contracts is recognized in accordance with contract terms, typically as costs are incurred. Revenue on FFP contracts is generally recognized on the percentage-of-completion method based on costs incurred in relation to total estimated costs. Provisions for estimated losses on government-sponsored research contracts are recorded in the period in which such losses are determined.

Inventories

Inventories are priced using average actual costs, which approximate first-in, first-out, and are stated at the lower of cost or market. The carrying value of inventory is reduced for estimated excess and obsolescence by the difference between its cost and the estimated market value based on assumptions about future demand. We evaluate the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional inventory adjustments would be required, which could have a material adverse effect on our business, financial condition and results of operation. A cost-to-market reserve is established for work-in-progress and finished goods inventories when the value of the inventory plus the estimated cost to complete exceeds the net realizable value of the inventory.

Warranty

We provide for the estimated cost of warranty when revenue is recognized. Our warranty is per contract terms, and for our systems, the warranty typically ranges between 12 and 24 months from customer acceptance. We use estimated repair or replacement costs along with our actual warranty experience to determine our warranty obligation. We exercise judgment in determining the underlying estimates. Should actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on our business, financial condition and results of operations.

Income Taxes

We account for income taxes in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes,” (“SFAS 109”), which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between book and tax bases of recorded assets and liabilities. SFAS 109 also 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. Based on our history of losses through 2004, our deferred tax asset was fully offset by a valuation allowance as of December 31, 2005. During 2006, the deferred tax asset and the related valuation allowance were both reduced due to the usage of our remaining NOL and credit carry-forwards. As of December 31, 2006, $4.6 million of the deferred tax asset was valued on the balance sheet, net of a valuation allowance of $2.8 million. This represents the amount of the deferred tax asset from which we expect to realize a benefit. We cannot predict with certainty when, or if, we will realize the benefit of the portion of the deferred tax asset currently offset with a valuation allowance.

On a quarterly basis, we provide for income taxes based upon an annual effective income tax rate. The effective tax rate is highly dependent upon the level of our projected earnings, the geographic composition of worldwide earnings, tax regulations governing each region, net operating loss carry-forwards, availability of tax credits and the effectiveness of our tax planning strategies. We carefully monitor the changes in many factors and adjust our effective income tax rate on a timely basis. If actual results differ from the estimates, this could have a material effect on our business, financial condition and results of operations. For example, as our projected level of earnings increased throughout 2006, we increased the annual effective tax rate from 3.0% at the end of the first quarter, to 8.8% at the end of the second quarter, to 10.0% at the end of the third quarter and to 12% at the end of the fourth quarter.

The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material effect on our business, financial condition and results of operations.

Net revenues consist primarily of sales of equipment used to manufacture thin-film disks, and, to a lesser extent, equipment used to manufacture flat panel displays, related equipment and system components; flat panel equipment technology license fees; contract research and development related to the development of electro-optical sensors, cameras and systems; and low light imaging products.

The increase in Equipment revenues in 2006 was the result of the sale of forty-six 200 Lean systems, thirteen disk lubrication systems and a significant increase in revenue from disk equipment technology upgrades and spare parts. During 2005, we sold twenty-three 200 Lean systems, six MDP-250 systems and fourteen disk lubrication systems. 2005 revenues also included $5.0 million of flat panel equipment and license sales. During 2004, we sold eleven 200 Lean systems and two MDP-250 systems.

The magnetic disk manufacturing industry consists of a small number of large manufacturers. In 2006 Seagate acquired Maxtor, which further concentrates our customer base. We believe that the majority of our active customers utilize most of their capacity and that there is significant potential for these customers to both continue adding capacity and to upgrade the technical capability of their installed base to permit production of high density disks for perpendicular recording rather than the current longitudinal technology. We currently have twenty-five 200 Lean systems in backlog, which are scheduled for revenue recognition during the first half of 2007.

Imaging revenues increased by 43% to $11.4 million in 2006, which consisted of $1.7 million of product revenue and $9.7 million of contract research and development revenue. The $7.9 million in 2005 Imaging revenues consisted of $888,000 of product revenue and $7.0 million of contract research and development revenue. The increase in product revenue resulted from higher sales of LIVAR systems and commercial products. The increase in contract research and development revenue was the result of a better mix of fully funded vs. partially funded programs. The decrease in Imaging revenues in 2005 as compared to 2004 was the result of a reduction in the level of orders received for funded development programs. In 2007, we expect the Imaging business revenue to grow significantly, with increases in both contract research and development revenue and product revenue. Although we do not anticipate our Imaging business to be profitable in 2007, we expect the loss to be reduced from 2006. Substantial growth in future Imaging revenues is dependent on proliferation of our technology into major military weapons programs, the ability to obtain export licenses for foreign customers, obtaining production subcontracts for these programs, and development and sale of commercial products.

Our backlog of orders at December 31, 2006 was $125.0 million, as compared to a December 31, 2005 backlog of $84.5 million. The $125.0 million of backlog at December 31, 2006 consisted of $119.4 million of Equipment backlog and $5.6 million of Imaging backlog. The $84.5 million of backlog at December 31, 2005 consisted of $81.7 million of Equipment backlog and $2.8 million of Imaging backlog. The increase in Equipment backlog was primarily the result of orders for 200 Lean disk sputtering systems.

Significant portions of our revenues in any particular period have been attributable to sales to a limited number of customers. In 2006 sales to Seagate, our Japanese distributor, Matsubo, and Hitachi Global Storage Technologies each accounted for more than 10% of our revenues, and in aggregate accounted for 93% of revenues. In 2005, Seagate, Matsubo, Hitachi Global Storage Technologies and Maxtor each accounted for more than 10% of our revenues, and in aggregate accounted for 90% of revenues. In 2004, Seagate and Matsubo each accounted for more than 10% of our revenues, and in aggregate accounted for 74% of revenues. Our largest customers tend to change from period to period.

International sales totaled $233.4 million, $97.5 million and $47.1 million, in 2006, 2005 and 2004, respectively, accounting for 90%, 71% and 68% of net revenues. The increase in international sales in 2006 and in 2005 was primarily due to an increase in net revenues from disk sputtering systems. Substantially all of our international sales are to customers in Asia, which includes products shipped to overseas operations of U.S. companies. Our mix of domestic versus international sales will change from period to period depending on the location of our largest customers in each period.

Cost of net revenues consists primarily of purchased materials and costs attributable to contract research and development, and also includes fabrication, assembly, test and installation labor and overhead, customer-specific engineering costs, warranty costs, royalties, provisions for inventory reserves and scrap. Cost of net revenues for 2006 included $428,000 of equity-based compensation expense.

Equipment gross margin improved to 39.1% in 2006 from 33.0% in 2005. Our product mix, increased average selling prices, cost reduction programs and increased volume all contributed to the higher gross margin for the year. 2005 Equipment gross margin improved over the gross margin achieved in 2004 due primarily to lower manufacturing costs and a higher average selling price for 200 Lean systems. The flat panel manufacturing system recognized for revenue in 2005 was originally shipped in 2003 and contributed minimal gross profit. Equipment gross margin in 2004 was adversely impacted by costs incurred during the rapid production, installation and start-up of the initial production run of 200 Lean systems, by costs for scrap, rework and inventory obsolescence related primarily to design changes on our 200 Lean system, and by favorable pricing offered to our first 200 Lean customer. We expect the gross margin for the Equipment business to improve in 2007, primarily as a result of continued cost reduction efforts undertaken on the 200 Lean system. Gross margins in the Equipment business will vary depending on a number of factors, including product cost, system configuration and pricing, factory utilization, and provisions for excess and obsolete inventory.

Imaging gross margin improved to 33.3% in 2006 from 12.0% in 2005. The increase in Imaging gross margin resulted from a higher percentage of contract research and development revenue being derived from fully funded contracts, favorable adjustments related to closing out prior year government rate audits and increased product shipments. The improvement in Imaging gross margin in 2005 as compared to 2004 was primarily due to a reduction in cost-shared research and development contracts. Imaging gross margin in 2004 was negatively impacted by our military head-mounted display development program, the initial phase of which was partially funded by the U.S. Government and our NATO customer.

Research and development expense consists primarily of prototype materials, salaries and related costs of employees engaged in ongoing research, design and development activities for disk manufacturing equipment, flat panel manufacturing equipment and Imaging products.

Research and development spending increased in both Equipment and in Imaging during 2006 as compared to 2005 and in 2005 as compared to 2004. The increase in Equipment was due primarily to spending on the development of a new product line to serve the semiconductor market and, to a lesser extent, spending for continuing development of our disk sputtering products. The increase in Imaging was due to both spending on the design of a proprietary CMOS sensor for use in our military low light level cameras and spending on the development of our commercial Imaging products. Engineering headcount has grown from 68 at the end of 2004, to 89 at the end of 2005, and to 129 at the end of 2006. Included in research and development spending for 2006 was $1.4 million of equity-based compensation expense. We expect that research and development spending will increase again in 2007 due primarily to expenditures related to our new semiconductor equipment product line, and the addition of key engineering personnel.

Research and development expenses do not include costs of $6.1 million, $5.3 million, and $6.9 million in 2006, 2005, and 2004, respectively, which are related to contract research and development and included in cost of net revenues. Selling, general and administrative expense consists primarily of selling, marketing, customer support, financial and management costs and also includes production of customer samples, travel, liability insurance, legal and professional services and bad debt expense. All domestic sales and international sales of disk sputtering products in Asia, with the exception of Japan, are typically made by Intevac’s direct sales force, whereas sales in Japan of disk sputtering products and other products are typically made by our Japanese distributor, Matsubo, who provides services such as sales, installation, warranty and customer support. We also have subsidiaries in Singapore and in Hong Kong, along with field offices in Japan, Malaysia, Korea and Shenzhen, China to support our equipment customers in Asia.

The increase in selling, general and administrative spending in 2006 was primarily the result of increases in costs related to business development, customer service and support in the Equipment business, legal expenses associated with the Unaxis litigation and provisions for employee profit sharing and bonus plans. Included in selling, general and administrative spending for 2006 was $1.5 million of equity-based compensation expense. Our selling, general and administrative headcount increased from 63 at the end of 2005 to 77 at the end of 2006. The increase in 2005 over 2004 was primarily the result of increases in costs related to customer service and support in the Equipment business, provisions for employee profit sharing and bonus plans and costs related to Sarbanes-Oxley compliance activities. We expect that selling, general and administrative expenses will increase in 2007 over the amount spent in 2006 due primarily to a projected increase in costs related to customer service and support for the Equipment business, the addition of key business development and administrative personnel and increasing legal expenses.

Interest income and other, net in 2006 consisted of $390,000 of dividends from 601 California Avenue LLC, $3.5 million of interest income on investments and $113,000 in net other expense. The increase in interest income in 2006 was driven by higher interest rates on our investments and a higher average invested balance. Interest income and other, net in 2005 consisted of $390,000 of dividends from 601 California Avenue LLC, $1.3 million of interest income on investments and $155,000 of foreign currency gains and losses and other income. Interest income and other, net in 2004 consisted of $390,000 of dividends from 601 California Avenue LLC, $634,000 of interest income on investments and $46,000 of other income. We expect interest income and other, net to increase in 2007 due to higher interest income generated from our investments.

In 2006, we accrued income tax using an effective tax rate of 12% of pretax income. This rate is based on an estimate of our annual tax rate calculated in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”. Our tax rate differs from the applicable statutory rates due to the utilization of net operating loss carry-forwards and deferred credits. At the end of 2006, we reversed $831,000 of the deferred tax asset valuation allowance, reflecting the amount of the deferred tax asset from which we expect to realize the benefit in 2007. Our deferred tax asset of $7.4 million is partially offset by a valuation allowance, resulting in a net deferred tax asset of $4.6 million at December 31, 2006. We expect our effective tax rate to significantly increase in 2007 due to the utilization of our remaining net operating loss carry-forwards in 2006.

For 2005, we accrued income tax using an effective tax rate of 2.5% of pretax income. Our net deferred tax asset totaled zero at December 31, 2005, net of a $15.0 million valuation allowance.

In 2004, we recorded income tax expense of $110,000, due primarily to the recording of $115,000 of expense as a result of a claim we received from the California Franchise Tax Board, partially offset by a net credit for taxes owed by our Singapore subsidiary. Our net deferred tax asset totaled zero at December 31, 2004, net of a $19.9 million valuation allowance.

Liquidity and Capital Resources

At December 31, 2006, we had $103.0 million in cash, cash equivalents, and investments compared to $49.7 million at December 31, 2005. During fiscal 2006, cash and cash equivalents increased by $24.2 million, due to the cash provided by operating and financing activities, partially offset by the net purchase of investments and fixed assets.

Cash provided by operating activities in 2006 totaled $55.2 million compared to $1.4 million in 2005. The increase in cash provided from operating activities was due primarily to the net income earned in 2006, adjusted to exclude the effect of non-cash charges including depreciation and equity-based compensation, and to increases in accounts payable, accrued payroll and other accrued liabilities. Accounts receivable totaled $40.0 million at December 31, 2006 compared to $42.9 million at December 31, 2005. The decrease of $2.9 million in the receivable balance was due to the year-end collection of customer advances billed in the fourth quarter of 2006. At the end of 2005, $10.8 million of receivables were outstanding related to products that had not shipped. Net inventories increased by $13.1 million during 2006 due primarily to an increase in raw materials and work-in-progress, which will be used to support the December 31, 2006 backlog of $125.0 million. Accounts payable totaled $16.0 million at December 31, 2006 compared to $7.0 million at December 31, 2005. The increase of $9.0 million relates to the increase in inventory purchases and the general growth of our business. Accrued payroll and related liabilities increased by $6.3 million during 2006 due to increases in our headcount and accruals for bonuses and employee profit-sharing. Other accrued liabilities totaled $7.7 million at December 31, 2006 compared to $6.9 million at December 31, 2005. The increase of $5.1 million relates primarily to accruals for our warranty obligations. Customer advances increased by $3.1 million during 2006. The increase was due to advances billed or received for orders that will be shipped during 2007.

Investing activities in 2006 used cash of $37.3 million. Purchases of investments, net of proceeds from sales and maturities, totaled $28.9 million. Capital expenditures in 2006 totaled $8.4 million. Our investing activities in 2005 used cash of $5.9 million as the result of the net purchase of investments and $4.1 million in capital expenditures.

Financing activities provided cash of $6.2 million in 2006 due to the sale of Intevac common stock to our employees through our employee benefit plans and tax benefits from equity-based compensation. Financing activities provided cash of $2.3 million in 2005 due to the sale of Intevac common stock to our employees through our employee benefit plans.

We have generated operating income for the last two years, after incurring annual operating losses from 1998 through 2004. We expect our Equipment business to be profitable again in 2007. We also expect to continue to invest in Imaging during 2007, but with lower losses than in 2006.

We believe that our existing cash, cash equivalents and short-term investments, combined with the cash we anticipate generating from operating activities will be sufficient to meet our cash requirements for the foreseeable future. We intend to undertake approximately $15 million in capital expenditures during the next 12 months.

Contractual Obligations

In the normal course of business, we enter into various contractual obligations that will be settled in cash. These obligations consist primarily of operating lease and purchase obligations. The expected future cash flows required to meet these obligations as of December 31, 2006 are shown in the table below. More information on the operating lease obligations is available in Part II, Item 8, “Financial Statements and Supplementary Data.”

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Critical Accounting Policies and Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“US GAAP”) requires management to make judgments, assumptions and estimates that affect the amounts reported. Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Item 8 of our Annual Report on Form 10-K. Certain of these significant accounting policies are considered to be critical accounting policies, as defined below.

A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial conditions and results of operations. Specifically, critical accounting estimates have the following attributes: 1) We are required to make assumptions about matters that are highly uncertain at the time of the estimate; and 2) different estimates we could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on our financial condition or results of operations.

Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they become known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. Many of these uncertainties are discussed in the section below entitled “Risk Factors.” Based on a critical assessment of our accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that our consolidated financial statements are fairly stated in accordance with US GAAP, and provide a meaningful presentation of our financial condition and results of operation.

We believe the following critical accounting policies affect the more significant judgments and estimates we make in preparing our consolidated financial statements. We also have other key accounting policies and accounting estimates related to the collectibility of trade receivables and prototype product costs. We believe that these other accounting policies and other accounting estimates either do not generally require us to make estimates and judgments that are as difficult or subjective, or are less likely to have a material impact on our reported results of operation for a given period.

Revenue Recognition

Certain of our system sales with customer acceptance provisions are accounted for as multiple-element arrangements. If we have previously met defined customer acceptance levels with the specific type of system, then we recognize revenue for the fair market value of the system upon shipment and transfer of title, and recognize revenue for the fair market value of installation and acceptance services when those services are completed. We estimate the fair market value of the installation and acceptance services based on our actual historical experience. For systems that have generally not been demonstrated to meet a particular customer’s product specifications prior to shipment, revenue recognition is typically deferred until customer acceptance. For example, while initial shipments of our 200 Lean System were recognized for revenue upon customer acceptance during 2004, revenue was recognized upon shipment for the majority of 200 Leans shipped in 2005, 2006 and 2007 to date. The system in backlog at September 29, 2007 is for a customer where we have met defined customer acceptance levels, and we expect to recognize revenue upon shipment for this system.

In some instances, hardware that is not essential to the functioning of the system may be delivered after acceptance of the system. In these cases, we estimate the fair market value of the non-essential hardware as if it had been sold on a stand-alone basis, and defer recognizing revenue on that value until the hardware is delivered.

Revenue from technology upgrades, spare parts, consumables and products built by the Imaging business are typically recognized when title passes to our customer. In certain cases, technology upgrade sales are accounted for as multiple-element arrangements, usually split between delivery of the parts and installation on the customer’s systems. In these cases, we recognize revenue for the fair market value of the parts upon shipment and transfer of title, and recognize revenue for the fair market value of installation services when those services are completed.

In certain cases, we sell limited rights to our intellectual property. Revenue from the sale of any intellectual property license will generally be recognized at the inception of the license term.

We perform best efforts research and development work under various government-sponsored research contracts. These contracts are a mixture of cost-plus-fixed-fee (“CPFF”) and firm fixed-price (“FFP”). Revenue on CPFF contracts is recognized in accordance with contract terms, typically as costs are incurred. Revenue on FFP contracts is generally recognized on the percentage-of-completion method based on costs incurred in relation to total estimated costs. Provisions for estimated losses on government-sponsored research contracts are recorded in the period in which such losses are determined.

Inventories

Inventories are priced using average actual costs, which approximate first-in, first-out, and are stated at the lower of cost or market. The carrying value of inventory is reduced for estimated excess and obsolescence by the difference between its cost and the estimated market value based on assumptions about future demand. We evaluate the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional inventory adjustments would be required, which could have a material adverse effect on our business, financial condition and results of operation. A cost-to-market reserve is established for work-in-progress and finished goods inventories when the value of the inventory plus the estimated cost to complete exceeds the net realizable value of the inventory.

Warranty

We provide for the estimated cost of warranty when revenue is recognized. Our warranty is per contract terms and for our systems the warranty typically ranges between 12 and 24 months from customer acceptance. We use estimated repair or replacement costs along with our actual warranty experience to determine our warranty obligation. We exercise judgment in determining the underlying estimates. Should actual warranty costs differ substantially from our estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on our business, financial condition and results of operations.

Income Taxes

We account for income taxes in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes,” (“SFAS 109”), which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between book and tax bases of recorded assets and liabilities. SFAS 109 also 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. Based on our history of losses through 2004, our deferred tax asset was fully offset by a valuation allowance as of December 31, 2005. During 2006, the deferred tax asset and the related valuation allowance were both reduced due to the usage of our remaining NOL and credit carry-forwards. As of December 31, 2006, $4.6 million of the deferred tax asset was valued on the balance sheet, net of a valuation allowance of $2.8 million. This represents the amount of the deferred tax asset from which we expect to realize a benefit. We cannot predict with certainty when, or if, we will realize the benefit of the portion of the deferred tax asset currently offset with a valuation allowance.

On a quarterly basis, we provide for income taxes based upon an annual effective income tax rate. The effective tax rate is highly dependent upon the level of our projected earnings, the geographic composition of worldwide earnings, tax regulations governing each region, net operating loss carry-forwards, availability of tax credits and the effectiveness of our tax planning strategies. We carefully monitor the changes in many factors and adjust our effective income tax rate on a timely basis. If actual results differ from the estimates, this could have a material effect on our business, financial condition and results of operations. For example, as our projected level of earnings increased throughout 2006, we increased the annual effective tax rate from 3.0% at the end of the first quarter, to 8.8% at the end of the second quarter, to 10.0% at the end of the third quarter and to 12% at the end of the fourth quarter. Similarly, as we reduced our projected level of earnings for 2007, we decreased our effective tax rate at the end of the third quarter of 2007 to 24.0% from 26.9% at the end of the second quarter of 2007 and from 31.6% at the end of the first quarter of 2007.

The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material effect on our business, financial condition and results of operations.

Net revenues consist primarily of sales of equipment used to manufacture thin-film disks, related equipment and system components, flat panel equipment technology license fees, contract research and development related to the development of electro-optical sensors, cameras and systems and low light imaging products.

Equipment revenues for the three months ended September 29, 2007 included revenue recognition for four 200 Lean systems and a significant quarter over quarter increase in revenue from disk equipment technology upgrades and spare parts. Revenue for the three months ended September 30, 2006 included revenue recognition of nine 200 Lean systems and three disk lubrication systems. We expect Equipment revenues in the fourth quarter of 2007 will be significantly lower than the comparable period of 2006, due primarily to a slowdown in orders for new 200 Lean systems. Additionally, shipments of disk equipment technology upgrades are expected to decline relative to the third quarter. We have limited visibility into 2008.

Imaging revenue for the three months ending September 29, 2007 consisted of $4.5 million of research and development contract revenue and $1.2 million of product sales. Revenue for the three months ended September 30, 2006 consisted of $2.7 million of contract research and development revenue and $465,000 of product sales. Product revenue included contributions from our new DeltaNu subsidiary, which was acquired on January 31, 2007. Substantial growth in future Imaging revenues is dependent on proliferation of our technology into major military weapons programs, the ability to obtain export licenses for foreign customers, obtaining production subcontracts for these programs, and development and sale of commercial products.

Our backlog of orders at September 29, 2007 was $31.2 million, as compared to $57.5 million at June 30, 2007 and $129.7 million at September 30, 2006. Backlog as of September 29, 2007 includes one 200 Lean system, as compared to four on June 30, 2007 and twenty-four on September 30, 2006. Our outlook for orders for new systems in the second half of 2007 has been negatively impacted by Western Digital’s announced acquisition of Komag and the decision of one of our customers to use legacy systems for the production of first generation perpendicular media. We include in backlog the value of purchase orders for our products that have scheduled delivery dates. We do not recognize revenue on this backlog until we have met the criteria contained in our revenue recognition policy, including customer acceptance of newly developed systems.

International sales decreased by 29% to $35.0 million for the three months ended September 29, 2007 from $49.2 million for the three months ended September 30, 2006. International revenues include products shipped to overseas operations of U.S. companies. The decrease in international sales was primarily due to a decrease in net revenues from disk sputtering systems. Substantially all of our international sales are to customers in Asia. International sales constituted 69% of net revenues for the three months ended September 29, 2007 and 90% of net revenues for the three months ended September 30, 2006.

Cost of net revenues consists primarily of purchased materials and costs attributable to contract research and development, and also includes fabrication, assembly, test and installation labor and overhead, customer-specific engineering costs, warranty costs, royalties, provisions for inventory reserves and scrap. Cost of net revenues for the three months ended September 29, 2007 and September 30, 2006 included $168,000 and $70,000, respectively, of equity-based compensation expense.

Equipment gross margin improved to 48.9% in the three months ended September 29, 2007 from 42.5% in the three months ended September 30, 2006. The increase in gross margin was due primarily to cost reduction programs and product mix. We expect the gross margin for the Equipment business in the fourth quarter of 2007 to be lower than in the third quarter and the comparable quarter of 2006, primarily as a result of lower revenue. Gross margins in the Equipment business will vary depending on a number of factors, including product mix, product cost, system configuration and pricing, factory utilization, and provisions for excess and obsolete inventory.

Imaging gross margin improved to 44.5% in the three months ended September 29, 2007 from 41.1% in the three months ended September 30, 2006. The increase in gross margin resulted primarily from higher margins on development contracts, favorable adjustments related to contract closeouts and contributions from our DeltaNu subsidiary. We expect Imaging gross margin in the fourth quarter of 2007 will be higher than in the fourth quarter of 2006, but lower than in the third quarter due primarily due the elimination of one-time adjustments recognized in the three months ended September 29, 2007.

Research and development expense consists primarily of prototype materials, salaries and related costs of employees engaged in ongoing research, design and development activities for disk sputtering equipment, semiconductor equipment and Imaging products. Research and development expense for the three months ended September 29, 2007 and September 30, 2006 included $556,000 and $376,000, respectively, of equity-based compensation expense.

Research and development spending increased in Equipment during the three months ended September 29, 2007 as compared to the three months ended September 30, 2006, while spending in Imaging declined quarter over quarter. The increase in Equipment was due primarily to spending on the development of our Lean EtchTM product line to serve the semiconductor market and, to a lesser extent, spending for continuing development of our disk sputtering products. Engineering headcount increased from 115 at September 30, 2006 to 135 at September 29, 2007. We expect that research and development spending in the fourth quarter of 2007 will be at approximately the same level as incurred in the third quarter.

Research and development expenses do not include costs of $2.4 million and $1.7 million for the three-month periods ended September 29, 2007 and September 30, 2006, respectively, which are related to contract research and development and included in cost of net revenues.

Selling, general and administrative expense consists primarily of selling, marketing, customer support, financial and management costs and also includes production of customer samples, travel, liability insurance, legal and professional services and bad debt expense. All domestic sales and international sales of disk sputtering products in Asia, with the exception of Japan, are typically made by Intevac’s direct sales force, whereas sales in Japan of disk sputtering products and other products are typically made by our Japanese distributor, Matsubo, who provides services such as sales, installation, warranty and customer support. We also have offices in China, Japan, Korea, Malaysia, and Singapore to support our equipment customers in Asia. Selling, general and administrative expense for the three months ended September 29, 2007 and September 30, 2006 included $1,112,000 and $432,000, respectively, of equity-based compensation expense.

The increase in selling, general and administrative spending in the three months ended September 29, 2007 as compared to the three months ended September 30, 2006 was primarily the result of increases in costs related to business development, customer service and support in both the Equipment and Imaging businesses and higher equity-based compensation expense. Our selling, general and administrative headcount increased from 71 at September 30, 2006 to 97 at September 29, 2007. We expect that selling, general and administrative expenses will be lower in the fourth quarter of 2007 due primarily to lower provisions for employee profit-sharing and bonus plans, as a result of our decreased profits.

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