UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K
For Annual and Transition Reports Pursuant to Section 13 or #15D of the Securities and Exchange Act of 1934

Commission file number: 0-26824

Tegal Corporation

Registrant’s Telephone Number, Including Area Code: (707) 763-5600

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:

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

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

        Indicate by check mark if the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes o No þ  

        The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 10, 2003, based on the closing sale price of the common stock on September 30, 2002 as reported on the Nasdaq National Market, was $6,275,787. As of June 10, 2003, 16,091,762 shares of the registrant’s common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the Proxy Statement for registrant’s 2003 Annual Meeting of Stockholders to be held August 26, 2003 will be filed with the Commission within 120 days after the close of the registrant’s fiscal year and are incorporated by reference in Part III.

TABLE OF CONTENTS

PART I

Item 1. Business

        Information contained or incorporated by reference herein contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate” or “continue” or the negative thereof or other variations thereon or comparable terminology or which constitute projected financial information. The following contains cautionary statements identifying important factors with respect to such forward-looking statements, including certain risks and uncertainties, that could cause actual results to differ materially from those in such forward-looking statements. See “Risk Factors.”

The Company

        Tegal Corporation, a Delaware corporation (“Tegal”), designs, manufactures, markets and services plasma etch and deposition systems that enable the production of integrated circuits (“ICs”), memory and related microelectronics devices used in personal computers, wireless voice and data telecommunications, contact-less transaction devices, radio frequency identification devices (“RFID’s”), smart cards, data storage and micro-level actuators. Etching and deposition constitute two of the principal IC and related device production process steps and each must be performed numerous times in the production of such devices.

        We were formed in December 1989 to acquire the operations of the former Tegal Corporation, a division of Motorola, Inc. (“Motorola”). Our predecessor company was founded in 1972 and acquired by Motorola in 1978. We completed our initial public offering in October 1995.

        On August 30, 2002, we acquired all of the outstanding common stock of Sputtered Films, Incorporated (“SFI”), a privately held California corporation pursuant to an Agreement and Plan of Merger dated August 13, 2002. Sputtered Films is a leader in the design, manufacture and service of high performance physical vapor deposition sputtering systems for the semiconductor and semiconductor packaging industry. SFI was founded in 1967 with the development of the S-Gun, core technology of the acquired company.

Semiconductor Industry Background

Growth of Semiconductor and Semiconductor Equipment Industries

        The semiconductor industry has experienced significant growth over the last 20 years. This growth has resulted from the increasing demand for ICs from traditional IC markets, such as personal computers, telecommunications, consumer electronics, automotive electronics and office equipment, as well as developing markets, such as wireless communications, multimedia and portable and network computing. As a result of this increased demand, semiconductor device manufacturers have periodically expended significant amounts of capital to build new semiconductor fabrication facilities (“fabs”) and to expand existing fabs. In spite of the continuing growth in demand for semiconductors, the industry periodically experiences cycles of excess supply and excess capacity as additions to capacity are brought online in large increments which exceed the short-term growth in demand for ICs. The industry periodically experiences such fluctuations, and is currently experiencing a significant slowdown in the purchase of equipment for the manufacture of ICs.

        Growth in the semiconductor industry has been driven, in large part, by advances in semiconductor performance at a decreasing cost per function. Advanced semiconductor processing technologies increasingly allow semiconductor manufacturers to produce ICs with smaller features, thereby increasing processing speed and expanding device functionality and memory capacity. As ICs have become more complex, however, both the number and price of state of the art process tools required to manufacture ICs have increased significantly. As a result, the cost of semiconductor manufacturing equipment has become an increasingly large part of the total cost of producing advanced ICs. Today, a typical 200 millimeter wafer fab may cost as much as $1.5 to $2.0 billion, with semiconductor manufacturing equipment costs representing the majority of total fab costs.

Semiconductor Production Processes

        To create an IC, semiconductor wafers are subjected to a large number of complex process steps. The three primary steps in manufacturing ICs are (1) deposition, in which a layer of insulating or conducting material is deposited on the wafer surface, (2) photolithography, in which the circuit pattern is projected onto a light sensitive material (the photoresist), and (3) etch, in which the unmasked parts of the deposited material on the wafer are selectively removed to form the IC circuit pattern.

        Each step of the manufacturing process for ICs requires specialized manufacturing equipment. Today, plasma-based systems are used for the great majority of both deposition and etching processes. During physical vapor deposition (also known as “PVD”), the semiconductor wafer is exposed to a plasma environment that forms continuous thin films of electrically insulating or electrically conductive layers on the semiconductor wafer. During a plasma etch process (also known as “dry etch”), a semiconductor wafer is exposed to a plasma composed of a reactive gas, such as chlorine, which etches away selected portions of the layer underlying the patterned photoresist layer.

Segmentation of the Deposition and Etch Markets

        The deposition market is generally divided into the following market segments, defined according to the underlying technology used to create the deposited thin film: electrochemical deposition (also known as “electroplating”), chemical vapor deposition (also known as “CVD”, of which plasma-enhanced chemical vapor deposition “PECVD” is a major sub-segment), atomic layer deposition (also known as “ALD”), and physical vapor deposition (also known as “PVD”).

        Certain deposition technologies or processes are better suited than others for depositing different types of materials (films). In silicon-based microelectronic fabrication, electrochemical deposition of copper is the essential basis for creating the multi-level metal electrical interconnects found in advanced logic and memory ICs. CVD and PECVD deposition of dielectric materials like silicon dioxide and silicon nitride is used to create layers of electrical insulation between active circuit elements in the integrated circuit. CVD and PECVD are also used for polysilicon and silicide deposition, to create the electrically conductive thin films used in the active circuit elements. ALD is a technique whereby, in a process repeated many times, a monolayer of chemical reactant adsorbed on the IC wafer surface forms a single atomic layer of a dielectric or a metallic film. Physical vapor deposition is used for both metallic thin film deposition and, in reactive PVD processes, for dielectric thin film deposition.

        Further segmentation occurs within the PVD market according to specific applications. One important application for PVD is the deposition of thin films where residual film stress must be closely controlled in order to create specific desired electrical results, as in precision thin film resistor fabrication, or to avoid physically deforming the substrate, as in the fabrication of power MOS devices on ultra-thin silicon wafers. The ability to control film stress is also critical for the deposition of multi-layer thin film stacks on photomasks used in advanced microelectronic photolithography applications such as extreme ultraviolet lithography (also known as “EUVL”) for development of 45nm and 32nm fabrication processes. If stress is not low and controlled in this step, the masks can become distorted.

        We believe that enabling tight control of stress and other process parameters, along with minimizing overall contamination levels during PVD thin film deposition processes, will be increasingly recognized by IC makers as key features that differentiate PVD tool products and PVD tool makers. We also believe these capabilities will be important to device makers in the related industries of compound semiconductor device fabrication, LED fabrication, optical communication device manufacturing, in micro electromechanical systems (also known as “MEMS”) fabrication, and in the field of advanced packaging processes for microelectronic devices.

        The dry etch market is generally segmented into the following market segments, defined according to the class of film being etched: polysilicon, oxide (dielectric) and metal. New films are continually being developed in each of these three market segments.

        Certain dry etch technologies or processes are better suited for etching different types of materials (films) and, as a result, the dry etch market may be segmented according to the type of film being etched. In addition, as ICs become increasingly complex, certain etch steps required to manufacture a state of the art IC demand leading edge (or “critical”) etch performance. For example, to produce a 64-megabit DRAM device, semiconductor manufacturers are required to etch certain device features at dimensions as small as 0.13 micron. Nonetheless, even in the most advanced ICs, production steps can be performed with less demanding (or “non-critical”) etch performance. As a result, we believe the etch market has also begun to segment according to the required level of etch performance — critical or non-critical.

        Today, the semiconductor industry is faced with the need to develop and adopt an unprecedented number of new materials as conventional films are running out of the physical properties needed to support continuing shrinks in die size and to provide improved performance. Certain of these new materials present unique etch production problems. For example, the use of certain films, such as platinum, iridium and Lead Zirconium Titanate (“PZT”), currently being used in the development of non-volatile, ferroelectric random access memory (“FRAM”) devices, is presenting new challenges to semiconductor manufacturers. While these new films contribute to improved IC performance and reduced die size, their unique properties make them particularly difficult to etch and, therefore, require more advanced etch process technologies. Similarly, customers seek to achieve zero corrosion of metal etched wafers within 48 to 72 hours after completion of the etch process, regardless of the line geometries involved. The reaction byproducts of a chlorine based metal etch process tend to redeposit on the wafer and corrode when exposed to water in the atmosphere. Removal of these contaminants from the wafer is essential to prevent this corrosion.

Market Segmentation and Tool Costs

        PVD systems have become one of the most expensive pieces of capital equipment found in modern IC wafer fabs. PVD tool system architecture is generally of modular, or cluster-tool style, with as many as six active process chambers placed around a central robotic handling system, plus separate loadlocks for the entry and exit of wafers. Each active chamber, the system loadlocks, and the central core wafer handler must be configured for high vacuum operation. Average selling prices for a typical fully-configured PVD system have increased from an estimated $2,600,000 in 1994 to an estimated $7,000,000 today.

        Over time, the disparity in relative prices for etch systems capable of etching at non-critical versus critical dimensions has grown significantly. We believe that in 1993, the cost of an eight-inch wafer-capable system ranged from approximately $500,000 to $700,000. Given the relatively modest price differential among etchers, manufacturers of ICs and similar devices tended to purchase one system (the one they believed provided the most technologically advanced solution for their particular etch requirements) to perform all of their etching. In contrast, the cost today of an eight inch capable etch system ranges from approximately $500,000, for reliable, non-critical etchers, to more than $2.5 million, for advanced, state of the art critical etchers. Consequently, in periods of high equipment utilization we believe it is no longer cost effective to use state of the art etchers to perform both critical and non-critical etching. When critical etching is required in the production process, we believe that the leading purchasing factor for a semiconductor manufacturer will continue to be, ultimately, the product’s etch performance. However, when non-critical etching is required in the production process, we believe the leading purchasing factor for a semiconductor manufacturer will be the overall product cost, with particular emphasis on the system’s sale price. In either case, however, the semiconductor manufacturer is driven to make a value-oriented purchasing decision which minimizes the overall etch system costs, while meeting the required etch process performance. We believe that a well-implemented “mix and match” purchasing philosophy could allow a semiconductor manufacturer to realize significant etch system savings.

Business Strategy

        We have a large installed base of etch and deposition equipment exceeding 1,700 systems and we believe that over the years we have earned a reputation as a supplier of reliable, value-oriented systems along with systems incorporating unique, advanced process technologies. Our systems are sold throughout the world to both domestic and international customers. In our fiscal year ended March 31, 2003, approximately 66% of our revenues resulted from international sales. To support our systems sales, we maintain local service and support in every major geographic market in which we have an installed base, backed up by a spares logistics system designed to provide delivery within 24 hours anywhere in the world.

        Tegal’s strategy is to become the leading provider of integrated etch and deposition process solutions for a defined set of new and emerging materials central to the production of a broad array of advanced semiconductor devices. Incorporation of these new, exotic materials is essential to achieving the higher device densities, lower power consumption and novel functions exhibited by the newest generation of cell phones, computer memories, fiber optic switches and remote sensors. Currently, Tegal is the leading supplier of etch solutions to makers of advanced “non-volatile” ferro-electric (“FeRAM”) and magnetic (“MRAM”) devices. FeRAM is just now entering commercial production with chips for the newest generation of cell phones, PDA’s, smart cards and radio-frequency identification devices (“RFID’s”), used for applications such as inventory tracking and cashier-less transaction processing. Rounding out Tegal’s portfolio of new materials expertise are so-called “compound-semi” materials, such as GaAs, GaN and InP, widely used in telecom device production.

        Our long-term growth strategy is to build on the Company’s technical knowledge, experience and reputation in semiconductor capital equipment, both through organic growth in the markets in which it specializes and through selective acquisitions of complementary technologies. Through its recent acquisition of Sputtered Films, Inc., Tegal secured a source for a complementary deposition technology for its new materials strategy and gained a key foothold in the advanced EUV mask market.

Products

6500 Series “Critical Etch” Products

        We offer several models of our 6500 series critical etch products configured to address film types and applications desired by our customers. We introduced the 6500 series tool in 1994 and since that time have expanded the product line to address new applications including:

        All 6500 series models offer one and two-chamber configurations and a rinse/strip option. Prices for 6500 series systems typically range between $1.8 million and $3.0 million.

        Our 6500 series systems have been engineered to provide process flexibility and competitive throughput for wafers and substrates up to eight inches in diameter, while minimizing cost and space requirements. The 6550 Spectra chamber is 300mm capable and is currently being used on the 200mm 6500 platform. Customer demand for new materials is at the 200mm node. However, having 300mm capability is important for future customer needs. A dual chamber platform design allows for either parallel or integrated etch processes. We seek to maximize the 6500 series systems’ average throughput by incorporating a process chamber technology and system architecture designed to minimize processing down-time required for cleaning and maintenance. Each 6500 series system has a central wafer handling system with full cassette vacuum loadlocks, non-contact optical wafer alignment and a vacuum transport system. Individual process module servicing is possible without shutting down the system or other chambers. Contamination control features in the 6500 series systems include pick and place wafer handling with no moving parts above the wafer, four-level vacuum isolation from the atmosphere to the etch chamber, and individual high-throughput, turbo-pumped vacuum systems for the cassettes, wafer handling platform and each process module. These and other features of the 6500 series are designed to enable a semiconductor manufacturer to reduce wafer particle contamination to a level that we believe exceeds industry standards and to improve etch results and process flexibility.

        In addition, our 6500 series systems incorporate a software system that has been designed and tested to minimize the risk of the system operator “crashing” the system or interrupting wafer fabrication, while being easy to use. This software system incorporates a software architecture designed to operate in multiple interface modes, including operator, maintenance engineer, process engineer and diagnostic modes. Features include icon-based touch screen menus for ease of use. In addition, the software provides a quick-response interface which allows the semiconductor manufacturer access to all necessary system information for factory automation. The system includes data in-situ process manufacturing archiving and remote, real time diagnostics.

900 Series “Non-Critiecal Etech” Products

        We introduced our 900 series family of etch systems in 1984 as a critical etch tool of that era. Over the years, we have enhanced the 900 series family as non-critical etch systems capable of performing the etch steps required in the production of silicon-based IC devices and, more recently, as critical etch tools for new specialty devices such as gallium arsenide for high-speed telecommunications devices. In 1994, we introduced an eight-inch wafer capable 900 series system (capable of etching five inch to eight-inch wafers). The 900 series non-critical etch systems are aimed at pad, zero layer, non-selective nitride, backside, planarization and small flat panel display applications, thin film etch applications used in the manufacture of read-write heads for the disk drive industry and gallium arsenide and other III-V materials used in high-speed digital wireless telecommunications applications. Our 900 series systems typically sell for a price of $250,000 to $600,000.

        The 900 series systems incorporate a single process chamber on a non-loadlocked modular platform for reliability and ease of maintenance, which we believe results in higher average throughput and lower operating costs. Continued improvements in both reliability and performance have enabled us to offer the 900 series systems as a solution for a broad range of applications involving line widths down to 0.8 microns.

        The i900 was introduced in July 2000. This system has enhanced the functionality of the 900 series with added features such as user-friendly GUI (graphical user interface) touch screens, better process control and an improved transport system that will increase efficiency, while preserving the durability for which the tool is known.

Endeavor Series Critical Deposition Products

        We offer several models of our Endeavor series critical deposition products configured to address film types and applications desired by the customer. We introduced the Endeavor series tool in 1992 and since that time have expanded the product line to address new applications. Deposition applications addressed by the Endeavor series system include:

        All Endeavor series models offer one to five process modules, and can be configured as single or dual cassette module systems. The system is fully field upgradeable. Prices for Endeavor series systems typically range between $1.8 million and $3.0 million.

        Our Endeavor series systems have been engineered to provide process flexibility and competitive throughput for wafers and substrates up to eight inches in diameter, or six inches square while minimizing cost and space requirements. The Endeavor cassette module is SMIF compatible. Fast and efficient, the system’s capability is enhanced by parallel processing and scheduled downtime is minimized by its modularity. Each Endeavor series system has a central wafer handling system with full vacuum loadlocks, non-contact optical wafer alignment and a vacuum transport system. Individual process module servicing is possible without shutting down the system or other chambers. Contamination control features in the Endeavor series systems include sputter-up processing, and a gentle and reliable handling system that allows the transport and process of wafers without clamping or mechanical pressure, and no backside contact of the wafer or substrate at any time. All processing is done under high vacuum, using individual high-throughput, turbo-pumped vacuum systems for the cassette module and transfer module and each process module. These and other features of the Endeavor series are designed to enable a semiconductor manufacturer to reduce wafer particle contamination to a level that we believe exceeds industry standards and to improve deposition results and process flexibility.

        In addition, our Endeavor series systems employs a user-friendly software system that is equipped with full safety interlocks and is four-level password protected. This software system incorporates a graphical user interface with software architecture designed to operate in multiple interface modes, including operator, maintenance engineer, process engineer and diagnostic modes. The software provides a quick-response interface which allows the semiconductor manufacturer access to all necessary system information for factory automation. The software and automation are completely functional from remote locations via ISDN line. This remote access can be used to download software upgrades, or as a powerful diagnostic tool, providing our customers with immediate factory support.

Customers

        We sell our systems to semiconductor and related electronic device component manufacturers throughout the world. Major customers over the last three fiscal years have included the following:

        Of these 20 customers, five ordered one or more systems in fiscal 2003. The composition of our top five customers has changed from year to year, but net system sales to our top five customers in each of fiscal 2003, 2002 and 2001 accounted for 88.2%, 54.4% and 42.0%, respectively, of our total net system sales. International Rectifier, University Francois, ST Microelectronics and OKI represented 32.2%, 22.7%, 12.5% and 12.0%, respectively, of our net system sales in 2003. STMicroelectronics, Nortel, Analog and NEC represented 24.2%, 17.1%, 10.1% and 13.1%, respectively, of our net system sales in 2002. Nortel and Sony represented 17.6% and 13.0%, respectively, of our net system sales in 2001. Other than the above customers, no single customer represented more than 10% of our net system sales in fiscal 2003, 2002 or 2001. Although the composition of the group comprising our largest customers may vary from year to year, the loss of a significant customer or any reduction in orders by any significant customer, including reductions due to market, economic or competitive conditions in the semiconductor and related device manufacturing industry, may have a material adverse effect on us.

Backlog

        We schedule production of our systems based upon order backlog and customer commitments. We include in our backlog only orders for which written purchase orders have been accepted and shipment dates within the next 12 months have been assigned. As of May 30, 2003 and 2002, our order backlog was approximately $6.0 million and $2.0 million, respectively. Booked system orders are subject to cancellation by the customer, but with substantial penalties except in the case of orders for evaluation systems or for systems that have not yet incurred production costs. Orders may be subject to rescheduling with limited or no penalty. Some orders are received for systems to be shipped in the same quarter as the order is received. As a result, our backlog at any particular date is not necessarily indicative of actual sales for any succeeding period.

Marketing, Sales and Service

        We sell our systems worldwide through a network of eight direct sales personnel and three independent sales representatives in sales offices located throughout the world. In the United States of America, we market our systems through direct sales personnel located in two regional sales offices and at our Petaluma, California headquarters. In addition, we provide field service and applications engineers out of our regional locations and our Petaluma headquarters in order to ensure dedicated technical and field process support throughout the United States of America on short notice.

        We maintain sales, service and process support capabilities in Japan, Taiwan, Germany, Italy and the United Kingdom and service/support operations in Austria and China. In addition to our international direct sales and support organizations, we also market our systems through independent sales representatives in China, Israel, South Korea and Singapore and selected markets in Japan.

        International sales, which consist of export sales from the United States of America either directly to the end user or to one of our foreign subsidiaries, accounted for approximately 66%, 67% and 61% of total revenue for fiscal 2003, 2002 and 2001, respectively. Revenues by region for each of the last three fiscal years were as follows:

        We generally sell our systems on 30-to-60 day credit terms to our domestic and European customers. Customers in the Pacific Rim countries, other than Japan, are generally required to deliver a letter of credit payable in U.S. dollars upon system shipment. Sales to other international customers, including Japan, are billed either in local currency or U.S. dollars. We anticipate that international sales will continue to account for a significant portion of revenue in the foreseeable future.

        We generally warrant our new systems for 12 months and our refurbished systems for six months from shipment. Our field engineers provide customers with call-out repair and maintenance services for a fee. Customers may also enter into repair and maintenance service contracts covering our systems. We train customer service engineers to perform routine service for a fee and provide telephone consultation services generally free of charge.

        The sales cycles for our systems vary depending upon whether the system is an initial design-in, reorder or used equipment. Initial design-in sales cycles are typically 12 to 18 months, particularly for 6500 and Endeavor series systems. In contrast, reorder sales cycles are typically four to six months, and used system sales cycles are generally one to three months. The initial design-in sales cycle begins with the generation of a sales lead, which is followed by qualification of the lead, an analysis of the customer’s particular applications needs and problems, one or more presentations to the customer (frequently including extensive participation by our senior management), two to three wafer sample demonstrations, followed by customer testing of the results and extensive negotiations regarding the equipment’s process and reliability specifications. Initial design-in sales cycles are monitored by senior management for correct strategic approach and resource prioritization. We may, in some rare instances, need to provide the customer with an evaluation system for three to six months prior to the receipt of a firm purchase order.

Research and Development

        The market for semiconductor capital equipment is characterized by rapid technological change. We believe that continued and timely development of new systems and enhancements to existing systems is necessary for us to maintain our competitive position. Accordingly, we devote a significant portion of our personnel and financial resources to research and development programs and seek to maintain close relationships with our customers in order to be responsive to their system needs.

        Our research and development encompasses the following areas: plasma and sputtering technology, process characterization and development, material sciences applicable to etch and deposition environments, systems design and architecture, electro-mechanical design and software engineering. Management emphasizes advanced plasma and reactor chamber modeling capabilities in order to accelerate bringing advanced chamber designs to market. We employ multi-discipline teams to facilitate short engineering cycle times and rapid product development.

        As of March 31, 2003, we had 28 full-time employees dedicated to equipment design engineering, process support and research and development. Research and development expenses for fiscal 2003, 2002 and 2001 were $4.8 million, $5.9 million and $8.9 million, respectively, and represented 34.2%, 27.4% and 23.4% of total revenue, respectively. Such expenditures were primarily used for the development of new processes, continued enhancement and customization of existing systems, processing customer samples in our demonstration labs and providing process engineering support at customer sites.

Manufacturing

        Our etch systems are produced at our headquarters in Petaluma, California. Deposition systems are currently produced at our facility in Santa Barbara, California. Our manufacturing activities consist of assembling and testing components and sub-assemblies, which are then integrated into finished systems. We have structured our production facilities to be driven either by orders or by forecasts and have adopted a modular system architecture to increase assembly efficiency and design flexibility. We have also implemented “just-in-time” manufacturing techniques in our assembly processes. Through the use of such techniques, 900 series system manufacturing cycle times take approximately 14 days and cycle times for our Endeavor systems and our 6500 series products take two to three months.

Competition

        The semiconductor capital equipment industry is highly competitive. We believe that the principal competitive factor in the critical segments of the etch industry is technical performance of the system, followed closely by the existence of customer relationships, the system price, the ability to provide service and technical support on a global basis and other related cost factors. We believe that the principal competitive factor in the non-critical segments of the etch industry is system price, followed closely by the technical performance of the system, the existence of established customer relationships, the ability to provide service and technical support on a global basis and other related cost factors.

Intellectual Property

        We hold an exclusive license or ownership of 54 United States of America patents, including our dual frequency tri-electrode control system, and 27 corresponding foreign patents covering various aspects of our systems. We have also applied for seven additional United States of America patents and 52 additional foreign patents. Of these patents, a few expire as early as 2003, others expire as late as 2021 with the average expiration occurring in approximately 2013. We believe that the duration of such patents generally exceeds the life cycles of the technologies disclosed and claimed therein. We believe that although the patents we have exclusively licensed or hold directly will be of value, they will not determine our success, which depends principally upon our engineering, marketing, service and manufacturing skills. However, in the absence of patent protection, we may be vulnerable to competitors who attempt to imitate our systems, processes and manufacturing techniques. We have signed a non-exclusive field of use license to two of our patents, relating to our strategic application sets. In addition, other companies and inventors may receive patents that contain claims applicable to our systems and processes. The sale of our systems covered by such patents could require licenses that may not be available on acceptable terms, if at all. We also rely on trade secrets and other proprietary technology that we seek to protect, in part, through confidentiality agreements with employees, vendors, consultants and other parties. There can be no assurance that these agreements will not be breached, that we will have adequate remedies for any breach or that our trade secrets will not otherwise become known to or independently developed by others.

        The original version of the system software for our 6500 series systems was jointly developed by us and Realtime Performance, Inc., a third party software vendor. We hold a perpetual, non-exclusive, non-royalty bearing license to use and enhance this software. The enhanced version of the software currently used on our 6500 series systems has undergone multiple releases of the original software, and such enhancements were developed exclusively by us. Neither the software vendor nor any other party has any right to use our current release of the system software. However we cannot make any assurances that this software will not be illegally copied or reversed-engineered by either customers or third-parties.

Employees

        As of March 31, 2003, we had a total of 81 regular employees and two part-time contract personnel. Of our regular employees, eight are in engineering, 10 are in research and development, 21 are in manufacturing and operations, 31 are in marketing, sales and customer service and support and 11 are in executive and administrative positions. Many of our employees are highly skilled, and our success will depend in part upon our ability to attract, retain and develop such employees. Skilled employees, especially employees with extensive technological backgrounds, remain in demand. There can be no assurance we will be able to attract or retain the skilled employees that may be necessary to continue our research and development, manufacturing or marketing programs. The loss of any such persons, as well as the failure to recruit additional key personnel in a timely manner, could have a material adverse effect on us.

        None of our employees is represented by a labor union or covered by a collective bargaining agreement. We consider our employee relations to be good.

Risk Factors

We have incurred operating losses and may not be profitable in the future; Our plans to maintain and increase liquidity may not be successful.

        We incurred net losses of $12.6 million and $8.7 million for the years ended March 31, 2003 and 2002, respectively, and generated negative cash flows from operations of $6.0 million and $3.6 million in these years. These factors raise substantial doubt as to our ability to continue as a going concern, and our auditors have included a going concern uncertainty in their opinion. Our plans to maintain and increase liquidity include the restructuring executed during fiscal 2002, which reduced headcount from 155_employees to 81 employees and has reduced our cost structure entering fiscal 2004. We believe the cost reduction and a projected increase in sales during fiscal 2004 will generate sufficient cash flows to fund our operations through March 31, 2004. However, these projected sales are to a limited number of new and existing customers and are based, for the most part, on internal and customer provided estimates of future demand, not firm customer orders. If the projected sales do not materialize, we will need to reduce expenses further and raise additional capital through the issuance of debt or equity securities. If additional funds are raised through the issuance of preferred stock or debt, these securities could have rights, privileges or preferences senior to those of our common stock, and debt covenants could impose restrictions on our operations. The sale of equity or debt could result in additional dilution to current stockholders, and such financing may not be available to us on acceptable terms, if at all. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amount or classification of liabilities or any other adjustments that might be necessary should we be unable to continue as a going concern.

The semiconductor industry is cyclical and may experience periodic downturns that may negatively affect customer demand for our products and result in losses such as those experienced in the past.

        Our business depends upon the capital expenditures of semiconductor manufacturers, which in turn depend on the current and anticipated market demand for integrated circuits. The semiconductor industry is highly cyclical and historically has experienced periodic downturns, which often have had a material adverse effect on the semiconductor industry’s demand for semiconductor capital equipment, including etch and deposition systems manufactured by us. In response to the current prolonged industry slow-down, we have initiated a substantial cost containment program and a corporate-wide restructuring to preserve our cash. However, the need for continued investment in research and development, possible capital equipment requirements and extensive ongoing customer service and support requirements worldwide will continue to limit our ability to reduce expenses in response to the current downturn.

Our competitors have greater financial resources and greater name recognition than we do and therefore may compete more successfully in the semiconductor capital equipment industry than we can.

        We believe that to be competitive, we will require significant financial resources in order to offer a broad range of systems, to maintain customer service and support centers worldwide and to invest in research and development. Many of our existing and potential competitors, including, among others, Applied Materials, Inc., Lam Research Corporation, Novellus and Tokyo Electron Limited, have substantially greater financial resources, more extensive engineering, manufacturing, marketing and customer service and support capabilities, larger installed bases of current generation etch, deposition and other production equipment and broader process equipment offerings, as well as greater name recognition than we do. We cannot assure you that we will be able to compete successfully against these companies in the United States of America or worldwide.

If we fail to meet the continued listing requirements of the Nasdaq Stock Market, our stock could be delisted.

        Our stock is currently listed on The Nasdaq SmallCap Market. The Nasdaq Stock Market’s Marketplace Rules impose certain minimum financial requirements on us for the continued listing of our stock. One such requirement is the minimum bid price on our stock of $1.00 per share. Beginning in 2002, there have been periods of time during which we have been out of compliance with the $1.00 minimum bid requirements of the Nasdaq SmallCap Market.

        On September 6, 2002, we received notification from Nasdaq that for the 30 days prior to the notice, the price of our common stock had closed below the minimum $1.00 per share bid price requirement for continued inclusion under Marketplace Rule 4450(a)(5) (the “Rule”), and were provided 90 calendar days, or until December 5, 2002, to regain compliance. Our bid price did not close above the minimum during that period. On December 6, 2002, we received notification from Nasdaq that our securities would be delisted from The Nasdaq National Market, the exchange on which our stock was listed prior to May 6, 2003, on December 16, 2002 unless we either (i) applied to transfer our securities to The Nasdaq SmallCap Market, in which case we would be afforded additional time to come into compliance with the minimum $1.00 bid price requirement; or (ii) appealed the Nasdaq staff’s determination to the Nasdaq’s Listing Qualifications Panel (the “Panel”). On December 12, 2002 we requested an oral hearing before the Panel and such hearing took place on January 16, 2003 in Washington, D.C. Our appeal was based, among other things, on our intention to seek stockholder approval for a reverse split of our outstanding common stock. On April 28, 2003 at a special meeting of our stockholders, our board of directors was granted the authority to effect a reverse split of our common stock within a range of two-for-one to fifteen-for-one. The timing and ratio of a reverse split, if any, is at the sole discretion of our board of directors. On May 6, 2003, we transferred the listing of our common stock to the Nasdaq SmallCap Market. In connection with this transfer, Nasdaq granted us an extension until December 1, 2003, to regain compliance with the Rule’s minimum $1.00 per share bid price requirement for continued inclusion on the Nasdaq SmallCap Market.

        If we are out of compliance in the future with Nasdaq listing requirements, we may take actions in order to achieve compliance, which actions may include a reverse split of our common stock. If an initial delisting decision is made by the Nasdaq’s staff, we may appeal the decision as permitted by Nasdaq rules. If we are delisted and cannot obtain listing on another major market or exchange, our stock’s liquidity would suffer, and we would likely experience reduced investor interest. Such factors may result in a decrease in our stock’s trading price. Delisting also may restrict us from issuing additional securities or securing additional financing.

We depend on sales of our advanced products to customers that may not fully adopt our product for production use.

        We have designed our advanced etch and deposition products for customer applications in emerging new films, polysilicon and metal which we believe to be the leading edge of critical applications for the production of advanced semiconductor and other microelectronic devices. Revenues from the sale of our advanced etch and deposition systems accounted for 25% and 36% of total revenues in fiscal 2003 and 2002, respectively. Our advanced systems are currently being used primarily for research and development activities or low volume production. For our advanced systems to achieve full market adoption, our customers must utilize these systems for volume production. There can be no assurance that the market for devices incorporating emerging films, polysilicon or metal will develop as quickly or to the degree we expect.

        If our advanced systems do not achieve significant sales or volume production due to a lack of full customer adoption, our business, financial condition, results of operations and cash flows will be materially adversely affected.

Our potential customers may not adopt our products because of their significant cost or because our potential customers are already using a competitor’s tool.

        A substantial investment is required to install and integrate capital equipment into a semiconductor production line. Additionally, we believe that once a device manufacturer has selected a particular vendor’s capital equipment, that manufacturer generally relies upon that vendor’s equipment for that specific production line application and, to the extent possible, subsequent generations of that vendor’s systems. Accordingly, it may be extremely difficult to achieve significant sales to a particular customer once that customer has selected another vendor’s capital equipment unless there are compelling reasons to do so, such as significant performance or cost advantages. Any failure to gain access and achieve sales to new customers will adversely affect the successful commercial adoption of our products and could have a material adverse effect on us.

Our quarterly operating results may continue to fluctuate.

        Our revenue and operating results have fluctuated and are likely to continue to fluctuate significantly from quarter to quarter, and there can be no assurance as to future profitability.

        Our 900 series etch systems typically sell for prices ranging between $250,000 and $600,000, while prices of our 6500 series critical etch systems and our Endeavor deposition system typically range between $1.8 million and $3.0 million. To the extent we are successful in selling our 6500 and Endeavor series systems, the sale of a small number of these systems will probably account for a substantial portion of revenue in future quarters, and a transaction for a single system could have a substantial impact on revenue and gross margin for a given quarter.

        Other factors that could affect our quarterly operating results include:

        Additionally, potential acquisitions may result in significant expenses, including amortization of purchased software, which is reflected in cost of revenues, as well as charges for in-process research and development and amortization of acquired identifiable intangible assets, which are reflected in operating expenses.

Because technology changes rapidly, we may not be able to introduce our products in a timely enough fashion.

        The semiconductor manufacturing industry is subject to rapid technological change and new system introductions and enhancements. We believe that our future success depends on our ability to continue to enhance our existing systems and their process capabilities, and to develop and manufacture in a timely manner new systems with improved process capabilities. We may incur substantial unanticipated costs to ensure product functionality and reliability early in our products’ life cycles. There can be no assurance that we will be successful in the introduction and volume manufacture of new systems or that we will be able to develop and introduce, in a timely manner, new systems or enhancements to our existing systems and processes which satisfy customer needs or achieve market adoption.

Some of our sales cycles are lengthy, exposing us to the risks of inventory obsolescence and fluctuations in operating results.

        Sales of our systems depend, in significant part, upon the decision of a prospective customer to add new manufacturing capacity or to expand existing manufacturing capacity, both of which typically involve a significant capital commitment. We often experience delays in finalizing system sales following initial system qualification while the customer evaluates and receives approvals for the purchase of our systems and completes a new or expanded facility. Due to these and other factors, our systems typically have a lengthy sales cycle (often 12 to 18 months in the case of critical etch and deposition systems) during which we may expend substantial funds and management effort. Lengthy sales cycles subject us to a number of significant risks, including inventory obsolescence and fluctuations in operating results over which we have little or no control.

We may not be able to protect our intellectual property or obtain licenses for third parties’ intellectual property and therefore we may be exposed to liability for infringement or the risk that our operations may be adversely affected.

        Although we attempt to protect our intellectual property rights through patents, copyrights, trade secrets and other measures, we may not be able to protect our technology adequately and competitors may be able to develop similar technology independently. Additionally, patent applications that we may file may not be issued and foreign intellectual property laws may not protect our intellectual property rights. There is also a risk that patents licensed by or issued to us will be challenged, invalidated or circumvented and that the rights granted thereunder will not provide competitive advantages to us. Furthermore, others may independently develop similar systems, duplicate our systems or design around the patents licensed by or issued to us.

        Existing litigation and any future litigation could result in substantial cost and diversion of effort by us, which by itself could have a material adverse effect on our financial condition, operating results and cash flows. Further, adverse determinations in such litigation could result in our loss of proprietary rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties or prevent us from manufacturing or selling our systems. In addition, licenses under third parties’ intellectual property rights may not be available on reasonable terms, if at all.

Our customers are concentrated and therefore the loss of a significant customer may harm our business.

        Our top five customers accounted for 88.2%, 54.4% and 42.0% of our systems revenues in fiscal 2003, 2002 and 2001, respectively. Four customers accounted for more than 10% of net systems sales in fiscal 2003. Although the composition of the group comprising our largest customers may vary from year to year, the loss of a significant customer or any reduction in orders by any significant customer, including reductions due to market, economic or competitive conditions in the semiconductor manufacturing industry, may have a material adverse effect on our business, financial condition, results of operations and cash flows. Our ability to increase our sales in the future will depend, in part, upon our ability to obtain orders from new customers, as well as the financial condition and success of our existing customers and the general economy, which is largely beyond our ability to control.

We are exposed to additional risks associated with international sales and operations.

        International sales accounted for 66%, 67% and 61% of total revenue for fiscal 2003, 2002 and 2001, respectively. International sales are subject to certain risks, including the imposition of government controls, fluctuations in the U.S. dollar (which could increase the sales price in local currencies of our systems in foreign markets), changes in export license and other regulatory requirements, tariffs and other market barriers, political and economic instability, potential hostilities, restrictions on the export or import of technology, difficulties in accounts receivable collection, difficulties in managing distributors or representatives, difficulties in staffing and managing international operations and potentially adverse tax consequences. There can be no assurance that any of these factors will not have a material adverse effect on our operations and financial results.

        Sales of our systems in certain countries are billed in local currency, and we have a line of credit denominated in Japanese Yen. We generally attempt to offset a portion of our U.S. dollar denominated balance sheet exposures subject to foreign exchange rate remeasurement by purchasing forward currency contracts for future delivery. There can be no assurance that our future results of operations and cash flows will not be adversely affected by foreign currency fluctuations. In addition, the laws of certain countries in which our products are sold may not provide our products and intellectual property rights with the same degree of protection as the laws of the United States of America.

We must integrate our recent acquisition of Sputtered Films and we may need to make additional future acquisitions to remain competitive. The process of identifying, acquiring and integrating future acquisitions may constrain valuable management resources, and our failure to effectively integrate future acquisitions may result in the loss of key employees and the dilution of stockholder value and have an adverse effect on our operating results.

        We acquired Sputtered Films, Inc. in August 2002. We may in the future seek to acquire or invest in additional businesses, products or technologies that we believe could complement or expand our business, augment our market coverage, enhance our technical capabilities or that may otherwise offer growth opportunities. We may encounter problems with the assimilation of Sputtered Films or businesses, products or technologies acquired in the future including:

        If we are unable to successfully integrate our acquired companies or to create new or enhanced products and services, we may not achieve the anticipated benefits from our acquisitions. If we fail to achieve the anticipated benefits from the acquisitions, we may incur increased expenses and experience a shortfall in our anticipated revenues and we may not obtain a satisfactory return on our investment. In addition, if a significant number of employees of acquired companies fail to remain employed with us, we may experience difficulties in achieving the expected benefits of the acquisitions.

        Completing any potential future acquisitions could cause significant diversions of management time and resources. Financing for future acquisitions may not be available on favorable terms, or at all. If we identify an appropriate acquisition candidate for any of our businesses, we may not be able to negotiate the terms of the acquisition successfully, finance the acquisition or integrate the acquired business, products, technologies or employees into our existing business and operations. Future acquisitions may not be well-received by the investment community, which may cause our stock price to fall. We have not entered into any agreements or understanding regarding any future acquisitions and cannot ensure that we will be able to identify or complete any acquisition in the future.

        If we acquire businesses, new products or technologies in the future, we may be required to amortize significant amounts of identifiable intangible assets and we may record significant amounts of goodwill that will be subject to annual testing for impairment. If we consummate one or more significant future acquisitions in which the consideration consists of stock or other securities, our existing stockholders’ ownership could be significantly diluted. If we were to proceed with one or more significant future acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash.

Our workforce reductions and financial performance may adversely affect the morale and performance of our personnel and our ability to hire new personnel.

        We have made reductions in our workforce in order to reduce costs and bring staffing in line with our anticipated requirements. There were costs associated with the workforce reductions related to severance and other employee-related costs, and our restructuring may yield unanticipated costs and consequences, such as attrition beyond our planned reduction in staff. In addition, our common stock has declined in value below the exercise price of many options granted to employees pursuant to our stock option plans. Thus, the intended benefits of the stock options granted to our employees, the creation of performance and retention incentives, may not be realized. In addition, workforce reductions and management changes create anxiety and uncertainty and may adversely affect employee morale. As a result, we may lose employees whom we would prefer to retain. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies perceived as having less volatile stock prices.

Provisions in our agreements, charter documents, stockholder rights plan and Delaware law may deter takeover attempts, which could decrease the value of your shares

        Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. Our board of directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Delaware law imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock. In addition, we have adopted a stockholder rights plan that makes it more difficult for a third party to acquire us without the approval of our board of directors. These provisions apply even if the offer may be considered beneficial by some stockholders.

Our stock price is volatile and could result in a material decline in the value of your investment in Tegal.

        We believe that factors such as announcements of developments related to our business, fluctuations in our operating results, sales of our common stock into the marketplace, failure to meet or changes in analysts’ expectations, general conditions in the semiconductor industry or the worldwide economy, announcements of technological innovations or new products or enhancements by us or our competitors, developments in patents or other intellectual property rights, developments in our relationships with our customers and suppliers, natural disasters and outbreaks of hostilities could cause the price of our common stock to fluctuate substantially. In addition, in recent years the stock market in general, and the market for shares of small capitalization stocks in particular, have experienced extreme price fluctuations, which have often been unrelated to the operating performance of affected companies. There can be no assurance that the market price of our common stock will not experience significant fluctuations in the future, including fluctuations that are unrelated to our performance.

Potential disruption of our supply of materials required to build our systems could have a negative effect on our operations and damage our customer relationships.

        Materials delays have not been significant in recent years. Nevertheless, we procure certain components and sub-assemblies included in our systems from a limited group of suppliers, and occasionally from a single source supplier. For example, we depend on MECS Corporation, a robotic equipment supplier, as the sole source for the robotic arm used in all of our 6500 series systems. We currently have no existing supply contract with MECS Corporation, and we currently purchase all robotic assemblies from MECS Corporation on a purchase order basis. Disruption or termination of certain of these sources, including our robotic sub-assembly source, could have an adverse effect on our operations and damage our relationship with our customers.

Any failure by us to comply with environmental regulations imposed on us could subject us to future liabilities.

        We are subject to a variety of governmental regulations related to the use, storage, handling, discharge or disposal of toxic, volatile or otherwise hazardous chemicals used in our manufacturing process. We believe that we are currently in compliance in all material respects with these regulations and that we have obtained all necessary environmental permits generally relating to the discharge of hazardous wastes to conduct our business. Nevertheless, our failure to comply with present or future regulations could result in additional or corrective operating costs, suspension of production, alteration of our manufacturing processes or cessation of our operations.

Special Note Regarding Forward Looking Statements

        This Form 10-K includes or incorporates by reference forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Forward-looking statements, which are based on assumptions and describe our future plans, strategies and expectations, are generally identifiable by the use of the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “project,” or similar expressions. These forward-looking statements are subject to risks, uncertainties and assumptions about us. Important factors that could cause actual results to differ materially from the forward-looking statements we make in this Form 10-K are set forth under the caption “Risk Factors” and elsewhere in this prospectus and the documents incorporated by reference in this Form 10-K. If one or more of these risks or uncertainties materialize, or if any underlying assumptions prove incorrect, our actual results, performance or achievements may vary materially from any future results, performance or achievements expressed or implied by these forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirely by the cautionary statements in this paragraph.

Item 2. Properties

        We maintain our headquarters, encompassing our executive office, manufacturing, engineering and research and development operations, in one leased 45,064 square foot facility in Petaluma, California. The lease, which was entered into on June 9, 2003, and is filed as an exhibit to this Form 10-K, expires on December 31, 2009. The prior lease for the same facility was due to expire in March 2004. The Company was leasing 120,000 sq. ft. and occupying 80,000 sq. ft. with the balance subleased or available for sublease. The new lease for 45,064 sq. ft. is for the occupied space only and the sub-tenants’ leases have been assigned to the landlord. Other than certain large pieces of capital equipment leased by us, we own substantially all of the machinery and equipment used in our facilities. We believe that our existing facilities are adequate to meet our requirements for several years.

        We lease an 18,000 square foot facility in Santa Barbara, California for manufacturing and support of Sputtered Films tools. We currently occupy about 10,700 sq. ft. with the remaining portion being sublet. The lease expires in September 2005 with an option to extend for three additional years.

        We lease sales, service and process support space in Munich, Germany; Kawasaki, Japan; Catania, Italy; and Hsin Chu City, Taiwan.

Item 3. Legal Proceedings

        On September 1, 1999, we filed a patent infringement action against Lam Research Corporation (the ‘Lam’ case), asserting infringement of two of our patents directed to dual frequency plasma processing technologies (the “'618 and the ‘223 patents). We sought injunctive relief barring Lam from manufacturing, selling and supporting products that incorporate our patented technology. We further sought enhanced damages for willful infringement of our patents. The suit was initially filed in United States District Court for the Eastern District of Virginia, but was transferred by that court to the United States District Court of the Northern District of California.

        Following an adverse decision from the United States Court of Appeals for the Federal Circuit in a prior case against Tokyo Electron Limited, Tegal voluntarily dismissed the ‘223 patent from the Lam case. A Markman hearing was held on the ‘618 patent in July 2002, and in September 2002 the Court issued a claim interpretation ruling in which it determined that the claim term “low frequency” means “less than approximately 1Mhz.” In October 2002, Lam filed a motion for summary judgment of non-infringement of the ‘618 patent. On January 14, 2003, after modifying its original Markman ruling and further interpreting “low frequency” to have an upper limit of 1.4 Mhz, the Court granted Lam’s motion for summary judgment of noninfringement of the ‘618 patent. Following the disposition of all of Tegal’s claims of infringement, Lam sought an award of attorney’s fees based on the allegation that Tegal’s pursuit of the case should be deemed “exceptional.” On June 5, 2003, the Court granted Tegal’s motion for entry of judgment and request for a determination that the case is not exceptional (effectively denying Lam’s demand for attorneys fees). Tegal is considering whether or not to appeal the summary judgment ruling of noninfringement of the ‘618 patent. At the present time we cannot assure you of the outcome of any such appeal may have on our business.

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

        No matters were submitted to a vote of security holders during the fiscal fourth quarter ended March 31, 2003.

        On April 28, 2003 at a special meeting of our stockholders, our board of directors was granted the authority to effect a reverse split of our common stock within a range of two-for-one to fifteen-for-one. The timing and ratio of a reverse split, if any, is at the sole discretion of our board of directors.

EXECUTIVE OFFICERS OF THE REGISTRANT

        The following sets forth certain information regarding our executive officers as of March 31, 2003:

        Michael L. Parodi joined us as Director, President and Chief Executive Officer in December 1997 and assumed the additional role of Chairman of the Board in March 1999. From 1991 to 1996, Mr. Parodi was Chairman of the Board, President and Chief Executive Officer of Semiconductor Systems, Inc. (“SSI”), a manufacturer of photolithography processing equipment sold to the semiconductor and thin film head markets until SSI was merged with FSI International (“FSI”). Mr. Parodi remained with FSI as Executive Vice President and General Manager of SSI from the time of the merger to December 1997, integrating SSI into FSI. In 1990, Mr. Parodi led the acquisition of SSI from General Signal Corporation. Prior to 1990, Mr. Parodi held various senior engineering and operations management positions with General Signal Corporation, Signetics Corporation, Raytheon Company, Fairchild Semiconductor Corporation and National Semiconductor Corporation. Mr. Parodi currently is a member of the Semiconductor Equipment and Materials International Board of Directors.

        Thomas R. Mika joined us in August 2002 as Executive Vice President and Chief Financial Officer. Mr. Mika has served as a director of Tegal since June 1992. From January 1982 until December 2001, he was the Managing Director of IMTEC, a private investment firm. During his tenure at IMTEC, Mr. Mika served as President and Chief Executive Officer of Soupmasters International, Inc., which filed for Chapter 11 protection in April 2000. On July 12, 2001, that company’s plan of reorganization was confirmed by the Federal Bankruptcy Court and the bankruptcy proceedings were closed on October 19, 2001. Mr. Mika was also Managing Director of DISC International, Inc., a software company headquartered in England, and President of its U.S.-based subsidiary. While at IMTEC, he was involved in the financing and start-up of several companies, and acted as a financial advisor to several companies in merger and acquisition activities. Prior to founding IMTEC, Mr. Mika was a managing consultant with Cresap, McCormick & Paget and a science policy analyst for the National Science Foundation. He received a Masters in Business Administration from the Harvard Graduate School of Business.

        Carole Anne Demachkie joined Sputtered Films in January of 1997 as Director of Corporate Communications. In 1999, Ms. Demachkie assumed the additional role of Manager of Customer Service and in 2001 was asked to increase her responsibilities to include general management of the day-to-day operations of the Company, reporting directly to the President, Peter Clarke. When the Company merged with Tegal Corporation in August of 2002, Ms. Demachkie became Vice President of Tegal, and General Manager of Sputtered Films. From 1986 to 1996, Ms. Demachkie owned and operated Clarke Design, a full service advertising and design agency in Santa Barbara, serving a variety of high-tech and development firms, including Sputtered Films.

        Stephen P. Deornellas joined us in July 1990 as Vice President of Marketing and Technology, served as Vice President of Process Technology from April 1995 until June 1996, at which time he was appointed Vice President, Technology and Corporate Development and Chief Technical Officer. From 1989 to 1990 he was Vice President of Marketing for the Wafer Inspection Systems Division of KLA Instruments Corporation (“KLA”). From 1981 to 1989 he held a variety of product development and marketing management positions, including Vice President Marketing from 1987 to 1989, Vice President of Process Engineering from 1983 to 1987, and Senior Process Engineer from 1981 to 1983, with Lam Research Corporation where he had responsibility for the development and introduction of the Lam Autoetch and Rainbow product lines.

        George B. Landreth joined us in November 1992 as Manager of Mechanical Engineering where he was responsible for directing the development of our 6500 series critical etch systems platform. From June 1996 until April 1997 he served as Director of Program Development, at which time he was promoted to Vice President, Product Development. Prior to joining us, Mr. Landreth held product development engineering management and design engineering positions with KLA, Silicon Valley Group, Inc., Optoscan Corporation, Eaton Corporation, Siltec Corporation and Peterbilt Motors.

        James D. McKibben joined us in June 1996 as Vice President, Worldwide Sales. In November 1998, he assumed the additional role of Vice President, Marketing. Prior to joining us, from 1995 to 1996 and from 1988 to 1992, Mr. McKibben was Vice President, Marketing, Sales and Customer Support for MRS Technology, Inc., a lithography equipment manufacturer for flat panel displays. From 1993 to 1995, he served as Director of Marketing and Sales for SSI. From 1992 to 1993, he was Regional Manager for Kulicke and Soffa Industries, Inc., a maker of wire bonders and other back-end assembly equipment for the IC industry. Prior to 1988, Mr. McKibben held several sales and service management positions with Wild/Lietz, Inc., GCA Corporation and J.T. Baker Chemical Company.

        There are no family relationships between any director, executive officer or person nominated to become a director or executive officer.

PART II

Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters

        Since May 6, 2003, our common stock has traded on the Nasdaq SmallCap Market under the symbol TGAL. Prior to this date, our common stock traded on the Nasdaq National Market since October 19, 1995. The following table sets forth the range of high and low sales prices for our common stock for each quarter during the prior two fiscal years.

        The approximate number of record holders of our common stock as of March 31, 2003 was 297. We have not paid any cash dividends since our inception and do not anticipate paying cash dividends in the foreseeable future. Further, our domestic line of credit restricts the declaration and payment of cash dividends.

Equity Compensation Plan Information

_________________

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

        Information contained herein contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate” or “continue” or the negative thereof or other variations thereon or comparable terminology or which constitute projected financial information. The following contains cautionary statements identifying important factors with respect to such forward-looking statements, including certain risks and uncertainties, that could cause actual results to differ materially from those in such forward-looking statements. See “Risk Factors.”

Company Overview

        Tegal Corporation, a Delaware corporation (“Tegal”), designs, manufactures, markets and services plasma etch and deposition systems that enable the production of integrated circuits (“ICs”), memory and related microelectronics devices used in personal computers, wireless voice and data telecommunications, contact-less transaction devices, radio frequency identification devices (“RFID’s”), smart cards, data storage and micro-level actuators. Etching and deposition constitute two of the principal IC and related device production process steps and each must be performed numerous times in the production of such devices.

        We were formed in December 1989 to acquire the operations of the former Tegal Corporation, a division of Motorola, Inc. (“Motorola”). Our predecessor company was founded in 1972 and acquired by Motorola in 1978. We completed our initial public offering in October 1995.

        On August 30, 2002, we acquired Sputtered Films, Incorporated (“SFI”), a privately held California corporation, pursuant to an Agreement and Plan of Merger dated August 13, 2002. SFI is a leader in the design, manufacture and service of high performance physical vapor deposition sputtering systems for the semiconductor and semiconductor packaging industry. SFI was founded in 1967 with the development of the S-Gun, a core technology of the acquired company.

Critical Accounting Policies and Estimates

        Our discussion and analysis of the financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to inventory, warranty obligations, purchase order commitments, bad debts, income taxes, intangible assets, restructuring and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

        We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Revenue Recognition

        Revenue is only recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed or determinable, and collectibility is reasonably assured. We defer revenue recognition for new product sales until both installation and customer acceptance have occurred. For sales of existing products, upon the transfer of title and risk of loss, revenue is recorded at the lesser of the fair value of the equipment or the contractual amount billable upon shipment. The remainder is recorded as deferred revenue and recognized as revenue upon installation and customer acceptance. Revenue for spare part sales is generally recognized upon shipment. Services revenue is recognized as the related services are provided, unless services are paid for in advance according to service contracts, in which case revenue is deferred and recognized over the service period using the straight-line method.

Accounts Receivable – Allowance for Doubtful Accounts

        We maintain an allowance for doubtful accounts receivable for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, or even a single customer was otherwise unable to make payments, additional allowances may be required. Given the average selling prices of our systems, a single customer default could have a material adverse effect on our consolidated financial position, results of operations, and cash flows.

Inventory

        We estimate the effects of excess and obsolescence on the carrying values of our inventories based upon estimates of future demand and market conditions. We reserve inventories in excess of production demand. Should actual production demand differ from our estimates, additional inventory write-downs may be required, as was the case in the second quarter of fiscal 2003.

Impairment of Long-Lived Assets

        Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If undiscounted expected future cash flows are less than the carrying value of the assets, an impairment loss is recognized based on the excess of the carrying amount over the fair value of the assets.

Warranty Obligations

        We provide for the estimated cost of our product warranties at the time revenue is recognized. Our warranty obligation is affected by product failure rates, material usage rates and the efficiency by which the product failure is corrected. Should actual product failure rates, material usage rates and labor efficiencies differ from our estimates, revisions to the estimated warranty liability may be required.

Deferred Taxes

        We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Based on the uncertainty of future pre-tax income, we have fully reserved our deferred tax assets as of March 31, 2003. In the event we were to determine that we would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset would increase income in the period such determination was made.

Results of Operations

        Tegal designs, manufactures, markets and services plasma etch and deposition systems that enable the production of integrated circuits (“ICs”), memory and related microelectronics devices used in personal computers, wireless voice and data telecommunications, contact-less transaction devices, radio frequency identification devices (“RFID’s”), smart cards, data storage and micro-level actuators. With the acquisition of Sputtered Films on August 30, 2002 for stock consideration and assumed liabilities of approximately $1.6 million, we now also provide deposition capabilities. The acquisition of Sputtered Films secured a source for a complementary deposition technology for our new materials strategy.

        The following table sets forth certain financial data for the years indicated as a percentage of revenue:

Years Ended March 31, 2003, 2002 and 2001

Revenue

        Our revenue is derived from sales of new and refurbished systems, spare parts and non-warranty service. Revenue decreased 35 percent in fiscal 2003 from fiscal 2002 (to $14.1 million from $21.6 million). The revenue decrease in fiscal 2003 compared to fiscal 2002 was principally attributable to a sharp decrease in the sale of our 900 series systems during the economic slow down and two fewer 6500 series system sales, offset in part by the sale of one Endeavor system, in addition to lower spares and service sales. We believe the lower spares and service sales is the result of lower usage of the systems previously installed, occurring naturally as a result of lower capacity utilization by our customers. We believe that we have seen a “bottoming-out” of spares and service revenues, indicating higher utilization of our equipment. Revenue decreased 43 percent in fiscal 2002 from fiscal 2001 (to $21.6 million from $38.2 million). The revenue decrease in fiscal 2002 compared to fiscal 2001 was principally attributable to a sharp decrease in the sale of our 900 series systems during the economic slow down and lower spares sales.

        International sales accounted for approximately 66, 67 and 61 percent of total revenue in fiscal 2003, 2002 and 2001, respectively. We expect that international sales will continue to account for a significant portion of our revenue.

Gross Profit (Loss)

        Our gross profit (loss) as a percentage of revenue (gross margin) decreased to (0.5) percent in fiscal 2003 compared to 31 percent in fiscal 2002. The gross margin decrease in fiscal 2003 as compared to fiscal 2002 was principally due to an inventory write down of approximately $1.9 million in the second quarter, accompanied by lower gross margins for systems because of lower volumes and continued high overhead costs. Our gross profit as a percentage of revenue (gross margin) decreased to 31 percent in fiscal 2002 compared to 36 percent in fiscal 2001. The gross margin decrease in fiscal 2002 as compared to fiscal 2001 was principally due to lower gross margins for systems because of lower volumes offset slightly by increased margins in spares and service.

        Our gross profit as a percentage of revenue has been, and will continue to be, affected by a variety of factors, including the mix and average selling prices of systems sold and the costs to manufacture, service and support new product introductions and enhancements. Gross margins for our 6500 series systems are typically lower than those of our more mature 900 series systems due to the inefficiencies and lower vendor discounts associated with lower order volumes and increased service, installation and warranty support. However, gross profit improvement is one of our highest priorities. We believe that the results of our overhead reductions, along with a reclassification of certain assets will begin to exhibit themselves in gross profit improvements, especially as our sales volume increases.

Research and Development

        Research and development expenses consist primarily of salaries, prototype material and other costs associated with our research and product development efforts. In absolute dollars, research and development expenses decreased to $4.8 million in fiscal 2003 from $5.9 million in fiscal 2002. The absolute dollar decrease in fiscal 2003 expenses from fiscal year 2002 was due primarily to cuts in expenses within non-essential programs. As a percentage of revenue, research and development increased to 34.2 percent in fiscal 2003 from 27.4 percent in fiscal 2002. In absolute dollars, research and development expenses decreased to $5.9 million in fiscal 2002 from $8.9 million in fiscal 2001. Research and development as a percentage of revenue increased to 27.4 percent in fiscal 2002 from 23.4 percent in fiscal 2001. The absolute dollar decrease in fiscal 2002 expenses from fiscal year 2001 was due primarily to strategic cuts in expenses. Although our R&D expense in absolute dollars is decreasing year over year, we continue to maintain active process development efforts in support of our new materials strategy. For several years, our research and development efforts have been focused primarily on customer needs for process solutions rather than hardware developments, which typically require substantially more investment.

Sales and Marketing

        Sales and marketing expenses primarily consist of salaries, commissions, trade show promotion and advertising expenses. In absolute dollars, sales and marketing expenses decreased to $2.9 million in fiscal year 2003 from $4.0 million in fiscal 2002. As a percentage of revenue, sales and marketing expenses increased to 20.7 percent in fiscal year 2003 from 18.5 percent in fiscal 2002. The absolute dollar decrease in fiscal 2003 from fiscal year 2002 was primarily due to our cuts in expenses, such as a reduced presence at regional trade shows and conferences and lower advertising expenses. We naturally have lower commission expense due to reduced system sales, and have converted from direct sales to manufacturer’s representatives in some foreign markets where business is very soft. Nevertheless, we believe that we have sufficient coverage in all markets to ensure that we are under consideration by customers who are in a position to commit funds to capital equipment purchases. In absolute dollars, sales and marketing expenses decreased to $4.0 million in fiscal year 2002 from $5.1 million in fiscal 2001. As a percentage of revenue, sales and marketing expenses increased to 18.5 percent in fiscal year 2002 from 13.5 percent in fiscal 2001. The absolute dollar decrease in fiscal 2002 from fiscal year 2001 was primarily due to our strategic cuts in expenses.

General and Administrative

        General and administrative expenses consist of salaries, legal, accounting and related administrative services and expenses associated with general management, finance, information systems, human resources and investor relations activities. General and administrative expenses in absolute dollars decreased slightly to $4.8 million in fiscal 2003 from $5.0 million in fiscal 2002. The absolute dollar decreases in spending were related to continued strategic expense cuts, offset in part by the cost of the acquisition of Sputtered Films and their operations in August 2002. As a percentage of revenues, general and administrative expenses increased to 34.1 percent, up from 23.1 percent in fiscal 2002. General and administrative expenses in absolute dollars decreased to $5.0 million in fiscal 2002 from $7.1 million in fiscal 2001. As a percentage of revenues, general and administrative expenses increased to 23.1 percent, up from 18.4 percent in fiscal 2001. We continue to seek improvements in productivity in all general and administrative expense areas through reduction and cross-training of personnel, tighter management of outside service providers and the lowering of costs associated with being a public company.

Other Income (Expense), Net

        Other income (expense), net, consists principally of royalty income, interest income, interest expense, gains and losses on foreign exchange and the sale of fixed assets. We recorded net non-operating expense of $8 thousand in fiscal 2003 and $0.5 million in fiscal 2002. In 2003, interest expense was greatly reduced due to reduced borrowings on both the Japanese and domestic lines of credit. We recorded net non-operating expense of $0.5 million in fiscal 2002 and income of $8.3 million in fiscal 2001. In 2002, net non-operating expense was primarily due to interest expense while in 2001, net non-operating income was primarily due to licensing fees received for non-exclusive patent rights.

Provision for Income Taxes

        Our effective tax rate was zero percent in fiscal 2003 and 2002 and 2.3 percent in fiscal 2001. We recorded a small provision for federal alternative minimum tax in fiscal year 2001. No tax benefit was recorded for the losses incurred in fiscal 2003 and 2002 due to uncertainty related to the realization of such benefits.

Cumulative Effect of Change in Accounting Principle

        In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”). SAB 101 summarizes certain areas of the Staff’s views in applying generally accepted accounting principles to revenue recognition. Prior to the adoption of SAB 101, we recognized revenue from the sales of our products when title passed to the customer, and accrued for the costs of installation and estimated warranty costs. Under the new accounting method adopted retroactively to April 1, 2000, no revenues are recognized until both title and risk of loss have passed to the customer and we defer revenue recognition for new product sales until installation and customer acceptance have occurred. For sales of existing products, upon the transfer of title and risk of loss, revenue is recorded at the lesser of the fair value of the equipment or the contractual amount billable upon shipment. The remainder is recorded as deferred revenue and recognized as revenue upon installation and customer acceptance. Revenue recognition for spare part sales has generally not changed under the provisions of SAB 101. Services revenue recognition is also unchanged, with such revenue recognized as the related services are provided, unless services are paid for in advance according to service contracts, in which case revenue is deferred and recognized over the service period using the straight-line method. In all cases, revenue is only recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, our price is fixed or determinable, and collectibility is reasonably assured.

        During the fourth quarter of fiscal 2001, we implemented SAB 101, retroactive to the beginning of the fiscal year. This was reported as a cumulative effect of a change in accounting principle as of April 1, 2000. The cumulative effect of the change in accounting principle on prior years resulted in a charge to income of $372,000 (net of income taxes of $0), which has been included in income for the year ended March 31, 2001. For fiscal 2001, we recognized $478,000 in revenue that is included in the cumulative effect of the change in accounting principle.

Liquidity and Capital Resources

        Net cash used in operations was $6.0 million in fiscal 2003, due principally to a loss of $11.6 million (after adjusting for depreciation and amortization) and a decrease in accounts payable, accrued liabilities, and deferred revenue, offset in part by a decrease in accounts receivable, inventory and prepaid assets. Net cash used in operations was $3.6 million in fiscal 2002 due principally to a loss of $7.8 million (after adjusting for depreciation and amortization) and a decrease in accounts payable and other current liabilities, offset in part by a decrease in accounts receivable, inventory and prepaid expenses. Net cash used in operations was $2.9 million in fiscal 2001 due principally to income of $2.1 million (after adjusting for depreciation and amortization) and an increase in accounts payable and other accrued liabilities, offset by an increase in accounts receivable, inventory and prepaid expenses.

        Net capital expenditures totaled $0.5 million, $0.5 million and $0.9 million, in fiscal 2003, 2002 and 2001, respectively. Capital expenditures in all three years were incurred principally for demonstration equipment, leasehold improvements and to acquire design tools, analytical equipment and computers. Fiscal 2003 investing activities also included $0.2 million of cash transaction costs related to the SFI acquisition, net of cash acquired.

        Net cash used in financing activities totaled $0.8 million for fiscal 2003 due principally to decreased borrowings against the domestic line of credit. Net cash used in financing activities totaled $0.7 million for fiscal 2002 due principally to decreased borrowings against the domestic line of credit, partially offset by the $2.2 million of net proceeds from the sale of common stock and warrants. Net cash provided by financing activities totaled $3.6 million for fiscal 2001 due principally to increased borrowings against the domestic line of credit.

        As of March 31, 2003, we had $0.9 million of cash and cash equivalents. In addition to cash and cash equivalents, our other principal sources of liquidity consist of unused portions of several bank borrowing facilities. As of March 31, 2003, we had available $10.0 million of unused domestic credit line availability based on borrowing ratios with no borrowing against that line. The domestic credit line bears interest at prime plus 1 percent, or 5.25% as of March 31, 2003. The domestic line of credit has a $10 million maximum borrowing capacity secured by substantially all of our assets and is limited by the amounts of eligible accounts receivable and inventory on the balance sheet. This facility will be available until July 24, 2004. In addition to the foregoing facility, as of March 31, 2003, our Japanese subsidiary had a line of credit available for a total of 150 million Yen (approximately $1.3 million at exchange rates prevailing on March 31, 2003) collateralized by Japanese customer promissory notes held by such subsidiary in advance of payment on customers’ accounts receivable with 8.4 million yen borrowed (approximately $0.07 million at exchange rates prevailing on March 31, 2003). The Japanese bank line bears interest at Japanese prime (1.375 percent as of March 31, 2003) plus 1.0 percent.

        The Company incurred net losses of $12.6 million and $8.7 million for the years ended March 31, 2003 and 2002, respectively, generated negative cash flows from operations of $6.2 million and $3.6 million in these years, and has a cash balance of $912 at March 31, 2003, which raises substantial doubt about its ability to continue as a going concern. The Company’s plans with respect to this matter include (1) the restructuring executed in the third and fourth quarters of fiscal 2003, which further reduced employee headcount, (2) the restructuring of the Company’s Petaluma facility lease which reduced both available square footage and expected fiscal 2004 payments to the lessor (see note 6) and (3) ongoing negotiations to raise debt financing. The Company believes the cost reductions and a projected increase in sales during fiscal 2004 will generate sufficient cash flows to fund its operations through March 31, 2004. However, the projected sales are to a limited number of new and existing customers and are based on internal and customer provided estimates of future demand, not firm customer orders. If the projected sales do not materialize, the Company will need to reduce expenses further and raise additional capital through the issuance of debt or equity securities. If additional funds are raised through the issuance of preferred stock or debt, these securities could have rights, privileges or preferences senior to those of common stock, and debt covenants could impose restrictions on the Company’s operations. The sale of equity or debt could result in additional dilution to current stockholders, and such financing may not be available to the Company on acceptable terms, if at all.

        The following summarizes our contractual obligations at March 31, 2003, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in thousands):

        Certain sales contracts of the Company include provisions under which customers would be indemnified by the Company in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to the Company’s products. There are no limitations on the maximum potential future payments under these guarantees. The Company has accrued no amounts in relation to these provisions as no such claims have been made and the Company believes it has valid, enforceable rights to the intellectual property embedded in its products.

Item 7A. Quantitative and Qualitative Disclosure about Market Risk

Market Risk Disclosure

        We are exposed to financial market risks, including changes in foreign currency exchange (“FX”) rates and interest rates. To mitigate the risks associated with FX rates, we utilize derivative financial instruments. We do not use derivative financial instruments for speculative or trading purposes.

        We manufacture the majority of our products in the United States of America; however, we service customers worldwide and thus have a cost base that is diversified over a number of European and Asian currencies as well as the U.S. dollar. This diverse base of local currency costs serves to mitigate partially the earnings effect of potential changes in value of our local currency denominated revenue. Additionally, we denominate our export sales in U.S. dollars, whenever possible.

        We manage short-term exposures to changing FX rates with financial market transactions, principally through the purchase of forward FX contracts to offset the earnings and cash-flow impact of the nonfunctional currency-denominated receivables. Forward FX contracts are denominated in the same currency as the receivable being hedged, and the term of the forward FX contract matches the term of the underlying receivable. The receivables being hedged arise from trade transactions and other firm commitments affecting us.

        We do not hedge our foreign currency exposures in a manner that would entirely eliminate the effects of changes in FX rates on our operations. Accordingly, our reported revenue and results of operations have been, and may in the future be, affected by changes in the FX rates. We have utilized a sensitivity analysis for the purpose of identifying market risk in relation to underlying transactions that are sensitive to FX rates including foreign currency forward exchange contracts and nonfunctional currency denominated receivables. The net amount that is exposed to changes in foreign currency rates was evaluated against a 10% change in the value of the foreign currency versus the U.S. dollar. Based on this analysis, we believe that we are not materially sensitive to changes in foreign currency rates on our net exposed FX position.

        A 49 basis-point move in the weighted average interest rates (10% of our weighted average interest rates in 2003) affecting our floating rate financial instruments as of March 31, 2003 would have an immaterial effect on our pretax results of operations over the next fiscal year.

        All of the potential changes noted above are based on sensitivity analyses performed on our balances as of March 31, 2003.

Item 8. Financial Statements and Supplementary Data

TEGAL CORPORATION

CONSOLIDATED BALANCE SHEETS

        See accompanying notes to consolidated financial statements.

TEGAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

        See accompanying notes to consolidated financial statements.

TEGAL CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

        See accompanying notes to consolidated financial statements.

TEGAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

Supplemental Schedule of Non Cash Investing Activities (amounts in thousands, except shares):

        The Company reclassified finished goods inventory of $3,698 to property and equipment during the quarter ended September 30, 2002 as the systems are being used for customer testing, training and demonstration purposes and the Company does not believe such equipment will be sold in the upcoming twelve months.

        On August 30, 2002, the Company acquired the outstanding capital stock of Sputtered Films, Inc. Consideration totaled $1,560 and consisted of 1,499,987 shares of the Company’s common stock valued at $1,185 and transaction costs of $375. The purchase price was allocated as follows:

        See accompanying notes to consolidated financial statements.

TEGAL CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All amounts in thousands, except per share data and share
data, unless otherwise noted)

Note 1. Description of Business and Summary of Significant Accounting Policies

Description of Business

        Tegal Corporation, a Delaware corporation (“Tegal”), designs, manufactures, markets and services plasma etch and deposition systems that enable the production of integrated circuits (“ICs”), memory and related microelectronics devices used in personal computers, wireless voice and data telecommunications, contact-less transaction devices, radio frequency identification devices (“RFID’s”), smart cards, data storage and micro-level actuators. Etching and deposition constitute two of the principal IC and related device production process steps and each must be performed numerous times in the production of such devices.

        On August 30, 2002, the Company acquired Sputtered Films, Incorporated (“SFI”), a privately held California corporation, pursuant to an Agreement and Plan of Merger dated August 13, 2002. SFI is a leader in the design, manufacture and service of high performance physical vapor deposition sputtering systems for the semiconductor and semiconductor packaging industry. SFI was founded in 1967 with the development of the S-Gun, a core technology of the acquired company (see Note 8).

Basis of Presentation

        The consolidated financial statements contemplate the realization of assets and the satisfaction of liabilities in the normal course of business. The Company incurred net losses of $12.6 million and $8.7 million for the years ended March 31, 2003 and 2002, respectively, generated negative cash flows from operations of $6.0 million and $3.6 million in these years, and has a cash balance of $0.9 million at March 31, 2003, which raises substantial doubt about its ability to continue as a going concern. The Company’s plans with respect to this matter include (1) the restructuring executed in the third and fourth quarters of fiscal 2003, which further reduced employee headcount, and (2) the restructuring of the Company’s Petaluma facility lease which reduced both available square footage and expected fiscal 2004 payments to the lessor (see note 6). The Company believes the cost reductions, and a projected increase in sales during fiscal 2004 will generate sufficient cash flows to fund its operations through March 31, 2004. However, the projected sales are to a limited number of new and existing customers and are based on internal and customer provided estimates of future demand, not firm customer orders. If the projected sales do not materialize, the Company will need to reduce expenses further and raise additional capital through the issuance of debt or equity securities. If additional funds are raised through the issuance of preferred stock or debt, these securities could have rights, privileges or preferences senior to those of common stock, and debt covenants could impose restrictions on the Company’s operations. The sale of equity or debt could result in additional dilution to current stockholders, and such financing may not be available to the Company on acceptable terms, if at all. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amount or classification of liabilities or any other adjustments that might be necessary should the Company be unable to continue as a going concern.

        The consolidated financial statements include the accounts of the Company and all of its subsidiaries. Intercompany transactions and balances are eliminated in consolidation. Accounts denominated in foreign currencies are translated using the foreign currencies as the functional currencies. Assets and liabilities of foreign operations are translated to U.S. dollars at current rates of exchange and revenues and expenses are translated using weighted average rates. The effects of translating the financial statements of foreign subsidiaries into U.S. dollars are reported as accumulated other comprehensive income, a separate component of stockholders’ equity. Gains and losses from foreign currency transactions are included as a separate component of other income (expense).

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

Cash and Cash Equivalents

        The Company considers all highly liquid debt instruments having a maturity of three months or less on the date of purchase to be cash equivalents.

        At March 31, 2003 and 2002, all of the Company’s investments are classified as cash equivalents on the consolidated balance sheet. The investment portfolio at March 31, 2003 and 2002 is comprised of money market funds. At March 31, 2003 and 2002, the fair value of the Company’s investments approximated cost.

Financial Instruments Disclosures

        The carrying amount of the Company’s financial instruments, including cash and cash equivalents, accounts receivable and accounts payable, approximates fair value due to their relatively short maturity. The Company has foreign subsidiaries which operate and sell the Company’s products in various global markets. As a result, the Company is exposed to changes in foreign currency exchange rates. The Company utilizes hedge instruments, primarily forward contracts, to manage its exposure associated with firm third-party transactions denominated in non-functional currencies. The Company does not hold derivative financial instruments for speculative purposes. Realized and unrealized gains and losses related to forward contracts considered to be effective hedges are deferred until settlement of the hedged items. They are recognized as other gains or losses when a hedged transaction is no longer expected to occur. Realized and unrealized gains and losses on ineffective hedges are recorded to other income (expense). Deferred gains and losses were not significant at March 31, 2003 or 2002. Foreign currency gains and losses included in other income (expense) were not significant for the years ended March 31, 2003, 2002 and 2001 (see note 2).

        At March 31, 2003, the Company had forward exchange contracts maturing at various dates throughout fiscal 2004 to exchange 85.0 million Japanese Yen into $0.7 million. At March 31, 2002, the Company had forward exchange contracts maturing at various dates throughout fiscal 2003 to exchange 255 million Japanese Yen into $1.9 million. The fair value of these instruments was immaterial at March 31, 2003 and 2002.

Concentration of Credit Risk

        Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of temporary cash investments and accounts receivable. Substantially all of the Company’s temporary investments are invested in money market funds. The Company’s accounts receivable are derived primarily from sales to customers located in the U.S., Europe, and Asia. The Company performs ongoing credit evaluations of its customers and generally requires no collateral. The Company maintains reserves for potential credit losses. Write-offs during the periods presented have been insignificant. As of March 31, 2003, one customer accounted for approximately 38 percent of the accounts receivable balance. As of March 31, 2002, two customers accounted for approximately 27 percent and 11 percent of the accounts receivable balance.

Inventory

        Inventory is stated at the lower of cost or market, reduced by provision for excess and obsolescence. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis and includes material, labor and manufacturing overhead costs.

Warranty Costs

        A warranty is provided under the terms of our system contract. Typically, the warranty period is six to 12 months depending on the contract specifications. The Company provides for these costs at the time of revenue recognition based upon prior experience (see Note 2).

Property and Equipment

        Property and equipment is recorded at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, ranging from three to seven years. Leasehold improvements are stated at cost and are amortized using the straight-line method over the shorter of the estimated useful life of the improvements or the lease term. When assets are disposed of, the cost and related accumulated depreciation are removed from the accounts and the resulting gains or losses are included in the results of operations. The Company generally depreciates their assets over the following periods:

Impairment of Long-Lived Assets

        Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If undiscounted expected future cash flows are less than the carrying value of the assets, an impairment loss is recognized based on the excess of the carrying amount over the fair value of the assets.

Income Taxes

        Deferred income taxes are recognized for the differences between the tax bases of assets and liabilities and their financial reporting amounts based on enacted tax rates. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

Revenue Recognition

        In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”). SAB 101 summarizes certain areas of the Staff’s views in applying generally accepted accounting principles to revenue recognition. Prior to the adoption of SAB 101, the Company recognized revenue from the sales of its products when title passed to the customer, and accrued for the costs of installation and estimated warranty costs. Under the new accounting method adopted retroactively to April 1, 2000, no revenues are recognized until both title and risk of loss have passed to the customer and we defer revenue recognition for new product sales until installation and customer acceptance have occurred. For sales of existing products, upon the transfer of title and risk of loss, revenue is recorded at the lesser of the fair value of the equipment or the contractual amount billable upon shipment. The remainder is recorded as deferred revenue and recognized as revenue upon installation and customer acceptance. Revenue recognition for spare part sales generally occurs upon shipment, which is unchanged under the provisions of SAB 101. Services revenue recognition is also unchanged, with such revenue recognized as the related services are provided, unless services are paid for in advance according to service contracts, in which case revenue is deferred and recognized over the service period using the straight-line method. In all cases, revenue is only recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed or determinable, and collectibility is reasonably assured.

        During the fourth quarter of fiscal 2001, the Company implemented SAB 101, retroactive to the beginning of the fiscal year. This was reported as a cumulative effect of a change in accounting principle as of April 1, 2000. The cumulative effect of the change in accounting principle on prior years resulted in a charge to income of $372 (net of income taxes of $0), or $0.03 per share, which has been included in income for the year ended March 31, 2001. For fiscal 2000, the Company recognized $478 in revenue that is included in the cumulative effect of the change in accounting principle as of April 1, 2001. The results for the first three quarters of the year ended March 31, 2001 were restated in accordance with SAB 101.

Earnings Per Share

        Basic earnings per share (“EPS”) is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is computed using the weighted average number of common shares outstanding plus any potentially dilutive securities, except when antidilutive.

Stock-Based Compensation

        The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, including FASB Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation — an interpretation of APB Opinion No. 25.” The Company’s policy is to grant options with an exercise price equal to the closing market price of the Company’s stock on the grant date. Accordingly, no compensation cost for stock option grants has been recognized in the Company’s statements of operations. Additional proforma disclosures assuming the Company applied the fair value method of accounting for employee stock compensation under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” follows.

        As required by SFAS No. 123 for proforma disclosure purposes only, the Company has calculated the estimated grant date fair value of its stock option awards using the Black-Scholes model. The Black-Scholes model, as well as other currently accepted option valuation models, was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions. These models also require highly subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated grant date fair value.

        The following assumptions are included in the estimated grant date fair value calculations for the Company’s stock option awards and Employee Qualified Stock Purchase Plan (“Employee Plan”):

        The weighted average estimated grant date fair value, as defined by SFAS No. 123, for stock option awards granted during fiscal 2003, 2002 and 2001 was $0.62, $1.02 and $2.23 per option, respectively.

        The following table summarizes information with respect to stock options outstanding as of March 31, 2003 (number of shares in thousands):

        Compensation cost (included in proforma net income (loss) and net income (loss) per share amounts only) for the grant date fair value, as defined by SFAS No. 123, of the purchase rights granted under the Employee Plan was calculated using the Black-Scholes model and the assumptions outlined above. The weighted average estimated grant date fair values per share, as defined by SFAS No. 123, for rights granted under the employee stock purchase plan during fiscal 2003, 2002 and 2001 were $0.29, $0.47 and $1.29, respectively.

        Had the Company recorded compensation costs based on the estimated grant date fair value (as defined by SFAS 123) for awards granted under its stock option plans and Employee Plan, the Company’s net loss and loss per share would have been increased to the proforma amounts below for the years ended March 31, 2003, 2002 and 2001:

Comprehensive Income (Loss)

        Comprehensive income (loss) is defined as the change in equity of a company during a period from transactions and other events and circumstances excluding transactions resulting from investments by owners and distributions to owners. The primary difference between net income (loss) and comprehensive income (loss) for Tegal is attributable to foreign currency translation adjustments. Comprehensive income (loss) is shown in the statement of stockholders’ equity.

New Accounting Pronouncements

        On June 28, 2002, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 146 (“SFAS No. 146”), “Accounting for Exit or Disposal Activities”, effective for exit or disposal activities that are initiated after December 31, 2002. SFAS No. 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for pursuant to the guidance that the Emerging Issues Task Force (“EITF”) has set forth in EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". A fundamental conclusion reached in SFAS No. 146 is that an entity’s commitment to a plan, by itself, does not create a present obligation to others that meets the definition of a liability. Therefore, this Statement eliminates the definition and requirements for recognition of exit costs in EITF Issue 94-3. This Statement also establishes that fair value is the objective for initial measurement of the liability. The scope of SFAS No. 146 also includes (1) costs related to terminating a contract that is not a capital lease and (2) termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. The Company does not believe that the implementation of this pronouncement will have a material impact on its consolidated financial position, results of operations or cash flows.

        In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a rollforward of the entity’s product warranty liabilities. At March 31, 2003, no guarantees were issued by the Company. The Company has accrued warranty costs and included additional disclosures in accordance with FIN 45 in note 2.

        In November 2002, the Emerging Issues Task Force reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” This issue addresses how revenue arrangements with multiple deliverables should be divided into separate units of accounting and how the arrangement consideration should be allocated to the identified separate accounting units. EITF No. 00-21 is effective for fiscal periods beginning after June 15, 2003. The Company has not yet determined the impact of adopting EITF No. 00-21 on its consolidated financial statements.

        In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation Costs—Transition and Disclosure”. This statement amends SFAS No. 123, “Accounting for Stock-Based Compensation”, and provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based compensation. It also requires additional disclosures about the effects on reported net income of an entity’s accounting policy with respect to stock-based employee compensation. The Company accounts for stock-based compensation in accordance with Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” and has adopted the disclosure-only alternative of FAS 123. The Company adopted the disclosure provisions of SFAS No. 148 in December 2002.

        The FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities”, (“FIN 46”) in January 2003. FIN 46 provides accounting guidance for consolidation of variable interest entities (“VIE”), formerly referred to as special purpose entities. FIN 46 applies to enterprises that have a controlling interest or business or contractual relationship with a VIE. FIN 46 requires consolidation of existing, non-controlled affiliates if the VIE is unable to finance its operations without investor support, or where the other investors do not have exposure to the significant risks and rewards of ownership. The Company will adopt the provisions of FIN 46 in the quarter ending September 30, 2003. The Company does not expect this pronouncement to have an effect on the Company’s consolidated financial position, results of operations or cash flows.

        In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 changes the accounting guidance for certain financial instruments that, under previous guidance, could be classified as equity or “mezzanine” equity by now requiring those instruments to be classified as liabilities (or assets in some circumstances) in the statement of financial position. Further, SFAS No. 150 requires disclosure regarding the terms of those instruments and settlement alternatives. SFAS No. 150 is generally effective for all financial instruments entered into or modified after May 31, 2003, and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The Company is currently assessing the impact of SFAS No. 150 on its financial position and results of operations.

Note 2. Balance Sheet and Income Statement Detail

Property and equipment, net, consisted of:

        Machinery and equipment at March 31, 2003 and 2002, includes approximately $56 and $252, respectively, of assets under leases that have been capitalized. Accumulated amortization for such equipment approximated $13 and $199, respectively.

        A summary of accrued expenses and other current liabilities follows:

        Product warranty and guarantees:

        The Company provides warranty on all system sales based on the estimated cost of product warranties at the time revenue is recognized. The warranty obligation is affected by product failure rates, material usage rates, and the efficiency by which the product failure is corrected. Warranty activity for the years ended March 31, 2003 and 2002 is as follows:

        Certain of the Company’s sales contracts include provisions under which customers would be indemnified by the Company in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to the Company’s products. There are no limitations on the maximum potential future payments under these guarantees. The Company has accrued no amounts in relation to these provisions as no such claims have been made and the Company believes it has valid, enforceable rights to the intellectual property embedded in its products

        Other income (expense), net, consisted of the following:

Note 3. Earnings Per Share

        SFAS No. 128, “Earnings Per Share,” requires dual presentation of basic and diluted net income (loss) per share on the face of the statement of operations. Basic EPS is computed by dividing income (loss) available to common stockholders (numerator) by the weighted average number of common shares outstanding (denominator) for the period. Diluted EPS gives effect to all dilutive potential common shares outstanding during the period. The computation of diluted EPS uses the average market prices during the period. All amounts in the following table are in thousands except per share data.

        Stock options and warrants outstanding at March 31, 2003 of 4,739,559 and at March 31, 2002 of 4,153,413 were excluded from the computations of diluted net income (loss) per share because of their anti-dilutive effect on diluted income (loss) per share.

Note 4. Notes Payable

        In June 2002, the Company replaced its prior line of credit with a line of credit totaling $10 million with a U.S. financial institution. This line of credit is available until July 2004. There was no borrowing on this line of credit as of March 31, 2003. The amount outstanding as of March 31, 2002, under the prior line of credit arrangement, was $0.7 million. The current line bears interest at prime plus 1.0 percent (5.25 percent at March 31, 2003), is secured by a blanket security on all of the Company’s assets, and further limited by the amounts of accounts receivable and inventories on the balance sheet. The line of credit restricts the declaration and payment of cash dividends and includes, among other terms and conditions, requirements that the Company maintain certain levels of tangible net worth. The Company was in compliance with the tangible net worth covenant as of March 31, 2003.

        The Company’s Japanese subsidiary has a line of credit available for a total of 150 million Yen (approximately $1.3 million at exchange rates prevailing on March 31, 2003) collateralized by Japanese customer promissory notes held by such subsidiary in advance of payment on customers’ accounts receivable. The Japanese bank line bears interest at Japanese prime (1.375 percent as of March 31, 2003) plus 1.0 percent. Outstanding balances on the lines in U.S. dollars as of March 31, 2003 and 2002 were $0.07 and $0.2 million.

        Notes payable as of March 31, 2003 consisted of two outstanding notes to the California Trade and Commerce Agency and to a retiring officer of Sputtered Films, Inc. for $233,000 and $75,000, respectively. These two notes are payable on demand. The unsecured note from the California Trade and Commerce Agency carries an annual interest rate of 5.75 percent with monthly interest only payments of approximately $4,200 per month. Although the payment deadlines are being met, the note is currently in technical default due to the acquisition of Sputtered Films by Tegal Corporation. The unsecured note from the retiring officer of Sputtered Films, Inc carries an annual interest rate of 10 percent.

Note 5. Income Taxes

        The components of income (loss) before provision for income taxes and cumulative effect of change in accounting principle are as follows:

        The income tax provision differs from the amount computed by applying the statutory U.S. federal income tax rate as follows: