COGNEX CORP - Quarter Report: 2006 October (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

þ		Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the quarterly period ended October 1, 2006 or

o		Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the transition period from                      to                     

COGNEX CORPORATION

Massachusetts				04-2713778
(State or other jurisdiction of				(I.R.S. Employer
incorporation or organization)				Identification No.)

One Vision Drive
Natick, Massachusetts 01760-2059
(508) 650-3000

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ                    No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o                    No þ

     As of October 29, 2006, there were 44,589,706 shares of Common Stock, $.002 par value, of the registrant outstanding.

 

 

INDEX

PART I		FINANCIAL INFORMATION			1
Item 1.		Financial Statements			1
		Consolidated Statements of Operations for the three-month and nine-month periods ended October 1, 2006 and October 2, 2005			1
		Consolidated Balance Sheets at October 1, 2006 and December 31, 2005			2
		Consolidated Statement of Shareholders’ Equity for the nine-month period ended October 1, 2006			3
		Consolidated Condensed Statements of Cash Flows for the nine-month periods ended October 1, 2006 and October 2, 2005			4
		Notes to Consolidated Financial Statements			5
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			23
Item 4.		Controls and Procedures			23
PART II		OTHER INFORMATION			24
Item 1.		Legal Proceedings			24
Item 1A.		Risk Factors			25
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3.		Defaults Upon Senior Securities			25
Item 4.		Submission of Matters to a Vote of Security Holders			25
Item 5.		Other Information			25
Item 6.		Exhibits			25
		Signatures			26
Ex-31.1 Section 302 Certification of CEO
Ex-31.2 Section 302 Certification of CFO
Ex-32.1 Section 906 Certification of CEO
Ex-32.2 Section 906 Certification of CFO

PART I: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

COGNEX CORPORATION

(In thousands, except per share amounts)

		Three Months Ended								Nine Months Ended
		October 1,				October 2,				October 1,				October 2,
		2006				2005				2006				2005
		(unaudited)								(unaudited)
Revenue
Product		$	52,249			$	52,634			$	163,250			$	138,688
Service			5,756				5,622				16,869				17,369
			58,005				58,256				180,119				156,057
Cost of revenue
Product (1)			12,031				11,890				38,055				34,776
Service (1)			3,416				3,865				10,695				10,834
			15,447				15,755				48,750				45,610
Gross margin
Product			40,218				40,744				125,195				103,912
Service			2,340				1,757				6,174				6,535
			42,558				42,501				131,369				110,447
Research, development, and engineering expenses (1)			7,997				7,224				24,496				20,724
Selling, general, and administrative expenses (1)			23,414				21,351				72,470				60,353
Operating income			11,147				13,926				34,403				29,370
Foreign currency loss			(282	)			(410	)			(707	)			(602	)
Investment and other income			1,518				1,156				4,856				3,599
Income before provision for income taxes			12,383				14,672				38,552				32,367
Income tax provision			2,267				3,814				8,202				8,415
Net income		$	10,116			$	10,858			$	30,350			$	23,952
Net income per common and common-equivalent share:
Basic		$	0.23			$	0.23			$	0.66			$	0.51
Diluted		$	0.22			$	0.22			$	0.64			$	0.50
Weighted-average common and common-equivalent shares outstanding:
Basic			44,825				46,931				45,905				46,536
Diluted			45,682				48,469				47,086				47,703
Cash dividends per common share		$	0.085			$	0.08			$	0.245			$	0.24

Product cost of revenue		$	191			$	—			$	544			$	—
Service cost of revenue			222				—				650				—
Research, development, and engineering			941				—				2,671				—
Selling, general, and administrative			2,121				—				6,071				—
Total stock-based compensation expense		$	3,475			$	—			$	9,936			$	—

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

COGNEX CORPORATION

(In thousands)

		October 1,				December 31,
		2006				2005
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	89,550			$	72,856
Short-term investments			120,638				169,156
Accounts receivable, less reserves of $2,451 and $2,370 in 2006 and 2005, respectively			39,893				42,051
Inventories, net			28,195				18,819
Deferred income taxes			7,646				7,667
Prepaid expenses and other current assets			13,969				16,104
Total current assets			299,891				326,653
Long-term investments			56,773				70,246
Property, plant, and equipment, net			24,335				24,175
Deferred income taxes			15,809				10,227
Intangible assets, net			46,300				50,049
Goodwill			82,976				79,807
Other assets			3,399				3,405
		$	529,483			$	564,562
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	5,989			$	7,118
Accrued expenses			49,477				43,476
Customer deposits			1,655				2,142
Deferred revenue			6,178				5,305
Total current liabilities			63,299				58,041
Commitments (Notes 3, 7, 8, 9, and 13)
Shareholders’ equity:
Common stock, $.002 par value – Authorized: 140,000 shares, issued: 44,535 and 47,171 shares in 2006 and 2005, respectively			89				94
Additional paid-in capital			155,075				216,031
Retained earnings			323,537				304,454
Accumulated other comprehensive loss			(12,517	)			(14,058	)
Total shareholders’ equity			466,184				506,521
		$	529,483			$	564,562

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

COGNEX CORPORATION

(In thousands)

																		Accumulated
										Additional								Other								Total
		Common Stock								Paid-in				Retained				Comprehensive				Comprehensive				Shareholders’
		Shares				Par Value				Capital				Earnings				Loss				Income				Equity
Balance at December 31, 2005			47,171			$	94			$	216,031			$	304,454			$	(14,058	)						$	506,521
Issuance of stock under stock option, stock purchase, and other plans			442				1				9,197																9,198
Stock-based compensation expenses											9,936																9,936
Excess tax benefit from stock option exercises											1,201																1,201
Payment of dividends															(11,267	)											(11,267	)
Repurchase of Common Stock			(3,078	)			(6	)			(81,290	)															(81,296	)
Comprehensive income:
Net income															30,350							$	30,350				30,350
Gains on long-term intercompany loans, net of losses on currency swaps, net of tax of $98																			166				166				166
Net unrealized gain on available-for-sale investments, net of tax of $282																			480				480				480
Foreign currency translation adjustment																			895				895				895
Comprehensive income																						$	31,891
Balance at October 1, 2006 (unaudited)			44,535			$	89			$	155,075			$	323,537			$	(12,517	)						$	466,184

The accompanying notes are an integral part of these consolidated condensed financial statements.

COGNEX CORPORATION

(In thousands)

		Nine Months Ended
		October 1,				October 2,
		2006				2005
		(unaudited)
Cash flows from operating activities:
Net income		$	30,350			$	23,952
Adjustments to reconcile net income to net cash provided by operating activities:
Stock-based compensation expense			9,936				—
Depreciation and amortization			8,702				8,739
Excess tax benefit from stock option exercises			995				4,236
Deferred income tax benefit			(5,822	)			(469	)
Change in current assets and current liabilities			(1,676	)			(6,099	)
Other			48				309
Net cash provided by operating activities			42,533				30,668
Cash flows from investing activities:
Purchase of investments			(351,528	)			(618,271	)
Maturity and sale of investments			413,210				731,967
Purchase of property, plant, and equipment			(3,231	)			(2,909	)
Cash paid for business acquisitions, net of cash acquired			(3,188	)			(111,591	)
Net cash provided by (used in) investing activities			55,263				(804	)
Cash flows from financing activities:
Payment of dividends			(11,267	)			(11,173	)
Repurchase of common stock			(81,296	)			—
Issuance of stock under stock option plans			9,198				21,248
Excess tax benefit from stock option exercises			103				—
Net cash provided by (used in) financing activities			(83,262	)			10,075
Effect of foreign exchange rate changes on cash			2,160				(2,184	)
Net increase in cash and cash equivalents			16,694				37,755
Cash and cash equivalents at beginning of period			72,856				54,270
Cash and cash equivalents at end of period		$	89,550			$	92,025

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

COGNEX CORPORATION

NOTE 1: Summary of Significant Accounting Policies

As permitted by the rules of the Securities and Exchange Commission applicable to Quarterly Reports on Form 10-Q, these notes are condensed and do not contain all disclosures required by generally accepted accounting principles. Reference should be made to the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

In the opinion of the management of Cognex Corporation, the accompanying consolidated unaudited financial statements contain all adjustments, consisting of only normal, recurring adjustments, necessary to present fairly the Company’s financial position at October 1, 2006, and the results of its operations for the three-month and nine-month periods ended October 1, 2006 and October 2, 2005, and changes in shareholders’ equity and cash flows for the periods presented.

The results disclosed in the Consolidated Statements of Operations for the three-month and nine-month periods ended October 1, 2006 are not necessarily indicative of the results to be expected for the full year.

NOTE 2: New Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes,” which is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes.” FIN No. 48 (“Interpretation”) clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. The Interpretation also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 will require disclosure at the end of the annual reporting period of the nature of uncertain tax positions and related events if it is reasonably possible that those positions and events could change the associated recognized tax benefit within the next twelve months. In addition, a quantitative range of any reasonably possible change and open tax years in major jurisdictions will need to be disclosed. The Company will adopt FIN No. 48 beginning in the first quarter of 2007, and has not yet determined the impact of adopting the Interpretation on its consolidated financial statements.

NOTE 3: Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and investments consisted of the following (in thousands):

		October 1,				December 31,
		2006				2005
Cash		$	79,900			$	72,856
Cash equivalents			9,650				—
Total cash and cash equivalents			89,550				72,856
Municipal bonds			104,263				140,718
Commercial paper			9,875				24,584
Agency notes			4,000				—
Corporate bonds			2,500				2,500
Treasury bills			—				1,354
Total short-term investments			120,638				169,156
Municipal bonds			45,827				59,863
Limited partnership interest			10,946				10,383
Total long-term investments			56,773				70,246
		$	266,961			$	312,258

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3: Cash, Cash Equivalents, and Investments (continued)

On June 30, 2000, Cognex Corporation became a Limited Partner in Venrock Associates III, L.P., a venture capital fund. A director of the Company is a Managing General Partner of Venrock Associates. The Company has committed to a total investment in the limited partnership of up to $22,500,000 through December 31, 2010.

As of October 1, 2006, the Company had contributed $18,463,000 to the partnership. During the nine months ended October 1, 2006, the Company made $1,013,000 in contributions to the partnership, of which $563,000 was contributed in the quarter ended October 1, 2006. In addition, a distribution of $450,000 was received from the partnership that was accounted for as a return of capital in the quarter ended April 2, 2006. At October 1, 2006, the carrying value of this investment was $10,946,000 compared to an estimated fair value, as determined by the General Partner, of $11,468,000.

NOTE 4: Inventories

Inventories consisted of the following (in thousands):

		October 1,				December 31,
		2006				2005
Raw materials		$	14,940			$	8,958
Work-in-process			2,352				3,406
Finished goods			10,903				6,455
		$	28,195			$	18,819

In the fourth quarter of 2001, the Company recorded a $16,300,000 charge in “Cost of product revenue” on the Consolidated Statements of Operations for excess inventories and purchase commitments resulting from an extended slowdown in the semiconductor and electronics industries, as well as the expected transition to newer Cognex hardware platforms by the Company’s OEM customers. A total of $12,500,000 of this charge represented reserves against existing inventories and was accordingly included in “Inventories” on the Consolidated Balance Sheet. The remaining $3,800,000 of the charge represented commitments to purchase excess components and systems from various suppliers and accordingly was included in “Accrued Expenses” on the Consolidated Balance Sheet.

The following table summarizes the changes in the inventory-related reserves established in the fourth quarter of 2001 (in thousands):

		Balance Sheet								Statement of
						Accrued				Operations
		Inventories				Expenses				Benefits
Reserve balance at December 31, 2005		$	5,884			$	1,400
Benefits to cost of product revenue recorded in the nine-month period ended October 2, 2005										$	472
Inventory sold to customers			(902	)			—			$	902
Inventory sold to brokers			(352	)			—				—
Write-off and scrap of inventory			(118	)			—				—
Reserve balance at October 1, 2006		$	4,512			$	1,400
Benefits to cost of product revenue recorded in the nine-month period ended October 1, 2006										$	902

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 4: Inventories (continued)

A favorable settlement of the remaining purchase commitments would result in a recovery of a portion of the remaining $1,400,000 accrued at October 1, 2006.

NOTE 5: Intangible Assets

Amortized intangible assets consisted of the following (in thousands):

		Gross								Net
		Carrying				Accumulated				Carrying
		Amount				Amortization				Amount
October 1, 2006
Distribution networks		$	38,060			$	4,655			$	33,405
Customer contracts and relationships			12,725				3,659				9,066
Completed technologies			6,803				3,831				2,972
Other			1,365				508				857
		$	58,953			$	12,653			$	46,300

		Gross								Net
		Carrying				Accumulated				Carrying
		Amount				Amortization				Amount
December 31, 2005
Distribution networks		$	38,060			$	2,191			$	35,869
Customer contracts and relationships			12,186				2,520				9,666
Completed technologies			9,028				5,491				3,537
Other			1,264				287				977
		$	60,538			$	10,489			$	50,049

The cost and related accumulated amortization of certain fully-amortized completed technologies totaling $2,369,000 were removed from the accounts during the quarter ended April 2, 2006. Aggregate amortization expense for the three-month and nine-month periods ended October 1, 2006 was $1,487,000 and $4,406,000, respectively, and $1,418,000 and $2,868,000 for the same periods in 2005.

Estimated amortization expense for the remainder of the current fiscal year and succeeding fiscal years is as follows (in thousands):

Year		Amount
2006			1,493
2007			5,588
2008			5,588
2009			5,400
2010			5,271
Thereafter			22,960
Total		$	46,300

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6: Goodwill

The Company has two reporting units with goodwill, the Modular Vision Systems Division (MVSD) and the Surface Inspection Systems Division (SISD), which are also reportable segments.

The changes in the carrying amount of goodwill during the nine-month period ended October 1, 2006 were as follows (in thousands):

		MVSD				SISD				Consolidated
Balance at December 31, 2005		$	77,266			$	2,541			$	79,807
Assistware business acquisition (Note 13)			2,962				—				2,962
Siemens contingent payment (Note 13)			190				—				190
DVT purchase price adjustment (Note 13)			(298	)			—				(298	)
Foreign exchange rate changes			135				180				315
Balance at October 1, 2006		$	80,255			$	2,721			$	82,976

On May 20, 2006, the Company acquired Assistware Technology. The allocation of the purchase price is subject to adjustment through the second quarter of 2007.

NOTE 7: Warranty Obligations

The Company warrants its hardware products to be free from defects in material and workmanship for periods ranging from six months to two years from the time of sale based upon the product being purchased and the terms of the customer’s contract. Estimated warranty obligations are evaluated and recorded at the time of sale based upon historical costs to fulfill warranty obligations. Provisions may also be recorded subsequent to the time of sale whenever specific events or circumstances impacting product quality become known that would not have been taken into account using historical data. Warranty obligations are included in “Accrued Expenses” on the Consolidated Balance Sheets.

The changes in the warranty obligation were as follows (in thousands):

Balance at December 31, 2005		$	1,447
Provisions for warranties issued during the period			725
Fulfillment of warranty obligations			(831	)
Foreign exchange rate changes			64
Balance at October 1, 2006		$	1,405

NOTE 8: Indemnification Provisions

Except as limited by Massachusetts law, the by-laws of the Company require it to indemnify certain current or former directors, officers, and employees of the Company against expenses incurred by them in connection with each proceeding in which he or she is involved as a result of serving or having served in certain capacities. Indemnification is not available with respect to a proceeding as to which it has been adjudicated that the person did not act in good faith in the reasonable belief that the action was in the best interests of the Company. The maximum potential amount of future payments the Company could be required to make under these provisions is unlimited. The Company has never incurred significant costs related to these indemnification provisions. As a result, the Company believes the estimated fair value of these provisions is minimal.

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8: Indemnification Provisions (continued)

The Company accepts standard limited indemnification provisions in the ordinary course of business, whereby it indemnifies its customers for certain direct damages incurred in connection with third-party patent or other intellectual property infringement claims with respect to the use of the Company’s products. The term of these indemnification provisions generally coincides with the customer’s use of the Company’s products. The maximum potential amount of future payments the Company could be required to make under these provisions is subject to fixed monetary limits. The Company has never incurred significant costs to defend lawsuits or settle claims related to these indemnification provisions. As a result, the Company believes the estimated fair value of these provisions is minimal.

The Company also accepts limited indemnification provisions from time to time, whereby it indemnifies customers for certain direct damages incurred in connection with bodily injury and property damage arising from the installation of the Company’s products. The term of these indemnification provisions generally coincides with the period of installation. The maximum potential amount of future payments the Company could be required to make under these provisions is limited and is likely recoverable under the Company’s insurance policies. As a result of this coverage, and the fact that the Company has never incurred significant costs to defend lawsuits or settle claims related to these indemnification provisions, the Company believes the estimated fair value of these provisions is minimal.

NOTE 9: Income Taxes and Standby Letters of Credit

On March 20, 2006, the Company provided standby letters of credit totaling 3,359,825,000 Yen (or approximately $28,444,000 based upon the exchange rate at October 1, 2006) to taxing authorities in Japan that are collateralized by investments on the Consolidated Balance Sheet. The Tokyo Regional Taxation Bureau (TRTB) asserted that Cognex Corporation had a permanent establishment in Japan that would require certain income, previously reported on U.S. tax returns for the years ended December 31, 1997 through December 31, 2001, to be subject instead to taxation in Japan. In September 2003, the Company filed a request with the Internal Revenue Service Tax Treaty Division for competent authority assistance.

During the three-month period ended October 1, 2006, the Company reached an agreement with the TRTB through the competent authority proceedings. The agreement resulted in an adjustment of the intercompany transfer price between the US parent and its Japanese subsidiary. The resulting additional tax to be paid to the TRTB, net of refunds due from US tax authorities, resulted in increased tax expense of $1,058,000 during the quarter.

During the three-month period ended October 1, 2006, the Company also recorded a $1,220,000 reduction in tax expense resulting from the expiration of the statute of limitations on an open tax year, and a $405,000 reduction resulting from the true-up of the tax provision recorded in 2005 as compared to the actual tax returns as filed. The three-month period ended July 2, 2006 included a reduction of tax expense of $869,000 from the settlement of a multi-year state tax audit during the quarter.

NOTE 10: Stock-Based Compensation Expense

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R requires companies to recognize compensation expense for all share-based payments to employees at fair value. Recognizing compensation expense using the intrinsic value based method described in Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” and disclosing the pro-forma impact of using the fair value based method described in SFAS No. 123 is no longer an alternative.

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10: Stock-Based Compensation Expense (continued)

SFAS No. 123R was adopted by the Company on January 1, 2006 using the modified prospective method in which compensation expense is recognized beginning on the effective date. Under this transition method, compensation expense recognized for the nine-month period ended October 1, 2006 includes: (1) compensation expense for all share-based payments granted prior to but not yet vested as of December 31, 2005, based on the grant-date fair value estimated under SFAS No. 123, and (2) compensation expense for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated under SFAS No. 123R. In accordance with the modified prospective method, the Company’s results of operations and financial position have not been restated.

The Company’s share-based payments that result in compensation expense consist solely of stock option grants. At October 1, 2006, the Company had 10,827,520 shares available for grant under three stock option plans: the 1998 Stock Incentive Plan, 3,323,520; the 1998 Non-Employee Director Stock Option Plan, 4,000; and the 2001 General Stock Option Plan, 7,500,000. Each of these plans expire ten years from the date the plan was approved. The Company has not granted any stock options from the 2001 General Stock Option Plan.

On April 21, 1998, the shareholders approved the 1998 Stock Incentive Plan, under which the Company initially was able to grant stock options and stock awards to purchase up to 1,700,000 shares of common stock. Effective January 1, 1999 and each January 1^st thereafter during the term of the 1998 Stock Incentive Plan, the number of shares of common stock available for grants of stock options and stock awards is increased automatically by an amount equal to 4.5% of the total number of issued shares of common stock as of the close of business on December 31^st of the preceding year.

Stock options are generally granted with an exercise price equal to the market value of the Company’s common stock at the grant date, generally vest over four years based on continuous service, and generally expire ten years from the grant date.

A summary of the Company’s stock option activity for the nine-month period ended October 1, 2006 was as follows (shares and values in thousands):

										Weighted-
						Weighted-				Average
						Average				Remaining				Aggregate
						Exercise				Contractual				Intrinsic
		Shares				Price				Term				Value
Outstanding at December 31, 2005			10,675			$	25.36
Granted			1,657				28.78
Exercised			(437	)			20.67
Forfeited or Expired			(432	)			29.15
Outstanding at October 1, 2006			11,463			$	25.89				6.75			$	24,769
Exercisable at October 1, 2006			6,943			$	25.34				5.52			$	21,383

Historically, the majority of the Company’s stock options have been granted during the first quarter of each year to reward existing employees for their performance. In addition, the Company grants stock options throughout the year for new employees and promotions.

The fair values of stock options granted after January 1, 2006 were estimated on the grant date using a binomial lattice model with the assistance of an outside valuation advisor. The fair values of options granted prior to January 1, 2006 were estimated using the Black-Scholes option pricing model for footnote disclosure under SFAS No. 123. The Company believes that a binomial lattice model results in a better estimate of fair value because it identifies patterns of exercises based on triggering events, tying the results to possible future events instead of a single path of actual historical events.

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10: Stock-Based Compensation Expense (continued)

The fair values of stock options granted in each period presented were estimated using the following weighted-average assumptions:

		Three Months Ended								Nine Months Ended
		October 1,				October 2,				October 1,				October 2,
		2006				2005				2006				2005
Risk-free rate			4.9	%			4.0	%			4.6	%			3.4	%
Expected dividend yield			1.25	%			1.08	%			1.11	%			1.27	%
Expected volatility			46	%			35	%			45	%			35	%
Expected term (in years)			5.0				2.9				4.1				2.8

Risk-free rate

The risk-free rate was based on a treasury instrument whose term was consistent with the contractual term of the option for 2006 grants, and the expected term of the option for 2005 grants.

Expected dividend yield

The current dividend yield is calculated by annualizing the cash dividend declared by the Company’s Board of Directors for the current quarter and dividing that result by the closing stock price on the grant date. Although dividends are declared at the discretion of the Company’s Board of Directors, for this purpose, the Company anticipates continuing to pay a quarterly dividend that approximates the current dividend yield.

Expected volatility

The expected volatility for 2006 grants was based on a combination of historical volatility of the Company’s common stock over the contractual term of the option and implied volatility for traded options of the Company’s stock. The expected volatility for 2005 grants was based on the historical volatility of the Company’s common stock over the expected term of the option.

Expected term

The expected term for 2006 grants was derived from the binomial lattice model from the impact of events that trigger exercises over time. The expected term for 2005 grants, which is an input to the Black-Scholes model, was based on historical option exercise behavior.

The weighted-average grant-date fair value of stock options granted during the nine-month periods ended October 1, 2006 and October 2, 2005 was $11.03 and $5.98, respectively. The Company recognizes compensation expense using the graded attribution method, in which expense is recognized on a straight-line basis over the service period for each separately vesting portion of the stock option as if the option was, in substance, multiple awards.

The amount of compensation expense recognized at the end of the vesting period is based on the number of stock options for which the requisite service has been completed. No compensation expense is recognized for options that are forfeited for which the employee does not render the requisite service. The term “forfeitures” is distinct from “expirations” and represents only the unvested portion of the surrendered option. The Company currently expects that approximately 62% of its stock options will actually vest, and therefore, has applied a weighted-average annual forfeiture rate of 11% to all unvested options. This rate will be revised, if necessary, in subsequent periods if actual forfeitures differ from this estimate. Ultimately, compensation expense will only be recognized over the vesting period for those options that actually vest. Prior to January 1, 2006, the Company accounted for actual forfeitures as they occur for footnote disclosure under SFAS No. 123.

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10: Stock-Based Compensation Expense (continued)

The total stock-based compensation expense and the related income tax benefit recognized for the nine-month period ended October 1, 2006 was $9,936,000 and $3,491,000, respectively. The total stock-based compensation expense and the related income tax benefit recognized for the three-month period ended October 1, 2006 was $3,475,000 and $1,222,000, respectively. No compensation expense was capitalized at October 1, 2006. Prior to January 1, 2006, the Company recognized compensation expense using the intrinsic value based method described in APB Opinion No. 25, and accordingly, no compensation expense was recorded since stock options were granted with an exercise price equal to the market value of the Company’s common stock at the grant date. The total intrinsic value of stock options exercised for the nine-month periods ended October 1, 2006 and October 2, 2005 was $3,410,000 and $13,289,000, respectively.

At October 1, 2006, total unrecognized compensation expense related to non-vested stock options was $14,622,000, which is expected to be recognized over a weighted-average period of 1.3 years.

The following table details the effect on net income and net income per share had stock-based compensation expense been recorded against income for the three-month and nine-month periods ended October 2, 2005 using the fair value based method described in SFAS No. 123. The reported and pro-forma net income and net income per share for the three-month and nine-month periods ended October 1, 2006 are the same since stock-based compensation expense was recorded under the provisions of SFAS No. 123R.

		Three Months				Nine Months
		Ended				Ended
		October 2,				October 2,
		2005				2005
Net income, as reported		$	10,858			$	23,952
Less: Total stock-based compensation expense determined under fair value based method, net of tax			(2,360	)			(7,040	)
Net income, pro forma			8,498				16,912
Basic net income per share, as reported		$	0.23			$	0.51
Basic net income per share, pro forma		$	0.18			$	0.36
Diluted net income per share, as reported		$	0.22			$	0.50
Diluted net income per share, pro forma		$	0.18			$	0.35

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 11: Net Income Per Share

Net income per share was calculated as follows (in thousands, except per share amounts) :

		Three Months Ended								Nine Months Ended
		October 1,				October 2,				October 1,				October 2,
		2006				2005				2006				2005
Net income		$	10,116			$	10,858			$	30,350			$	23,952
Basic:
Weighted-average common shares outstanding			44,825				46,931				45,905				46,536
Net income per common share		$	0.23			$	0.23			$	0.66			$	$0.51
Diluted:
Weighted-average common shares outstanding			44,825				46,931				45,905				46,536
Effect of dilutive stock options			857				1,538				1,181				1,167
Weighted-average common and common-equivalent shares outstanding			45,682				48,469				47,086				47,703
Net income per common and common-equivalent share		$	0.22			$	0.22			$	0.64			$	0.50

Stock options to purchase 7,763,085 and 5,521,344 shares of common stock were outstanding during the three-month and nine-month periods ended October 1, 2006, respectively, and 1,586,491 and 4,151,139 for the same periods in 2005, but were not included in the calculation of diluted net income per common share because they were anti-dilutive.

NOTE 12: Segment Information

The Company has two reportable segments: the Modular Vision Systems Division (MVSD) and the Surface Inspections Systems Division (SISD). MVSD designs, develops, manufactures, and markets modular vision systems that are used to control the manufacturing of discrete items by locating, identifying, inspecting, and measuring them during the manufacturing process. SISD designs, develops, manufactures, and markets surface inspection vision systems that are used to inspect surfaces of materials that are processed in a continuous fashion to ensure there are no flaws or defects in the surfaces. Segments are determined based upon the way that management organizes its business for making operating decisions and assessing performance. The Company evaluates segment performance based upon income or loss from operations, excluding unusual items and stock-based compensation expense.

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12: Segment Information (continued)

The following table summarizes information about the Company’s segments (in thousands):

										Reconciling
		MVSD				SISD				Items				Consolidated
Three Months Ended October 1, 2006
Product revenue		$	48,216			$	4,033			$	—			$	52,249
Service revenue			3,087				2,669				—				5,756
Operating income			16,151				720				(5,724	)			11,147
Nine Months Ended October 1, 2006
Product revenue		$	148,564			$	14,686			$	—			$	163,250
Service revenue			9,300				7,569				—				16,869
Operating income			50,043				2,531				(18,171	)			34,403

										Reconciling
		MVSD				SISD				Items				Consolidated
Three Months Ended October 2, 2005
Product revenue		$	45,770			$	6,864			$	—			$	52,634
Service revenue			3,033				2,589				—				5,622
Operating income			14,124				1,902				(2,100	)			13,926
Nine Months Ended October 2, 2005
Product revenue		$	120,363			$	18,325			$	—			$	138,688
Service revenue			10,063				7,306				—				17,369
Operating income			31,565				4,015				(6,210	)			29,370

Reconciling items consist of stock-based compensation expense and unallocated corporate expenses, which primarily include corporate headquarters costs and professional fees. For the nine-month period ended October 1, 2006, corporate expenses also included costs associated with the Company’s 25^th Anniversary party. Asset information by segment is not produced internally for use by the chief operating decision maker, and therefore, is not presented. Asset information is not provided because the cash and investments are commingled and the divisions share assets and resources in a number of locations around the world.

NOTE 13: Acquisitions

Assistware Technology

On May 20, 2006, the Company acquired all of the outstanding shares of Assistware Technology, a privately-held developer of Lane Departure Warning Systems for $2,998,000 in cash paid at closing, with the potential for an additional cash payment of up to $2,000,000 depending upon the achievement of certain performance criteria. The $2,998,000 initial purchase price consisted of $2,848,000 in cash consideration and $150,000 in transaction costs. The acquisition was accounted for under the purchase method of accounting. Accordingly, Assistware’s results of operations have been included in the Company’s consolidated results of operations since the date of acquisition. The historical results of operations of the acquired business were not material compared to the consolidated results of operations of the Company, and therefore, pro forma results are not presented.

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 13: Acquisitions (continued)

With the acquisition of Assistware, the Company has entered the emerging market for machine vision systems in vehicles. These highly-specialized sensors are installed in vehicles, ranging from long-haul trucks to passenger cars, where they provide driver assistance by constantly analyzing the vehicle’s external environment and warning the driver of potentially dangerous situations. Assistware’s Lane Departure Warning System uses machine vision technology to watch the road ahead and alert drivers if they unintentionally leave their lane or if their driving pattern becomes erratic.

The Company adjusted the purchase price allocation during the third quarter of 2006, which resulted in a $33,000 increase in accounts receivable, a $10,000 decrease in goodwill, and a $23,000 increase in accrued expenses. The purchase price was allocated as follows (in thousands):

						Weighted-Average
		Estimated Fair				Amortization Period
		Value				(in years)
Accounts receivable		$	58
Inventories			29
Prepaid expenses and other current assets			320
Property, plant, and equipment			32
Intangible assets
Customer contract			140				3.5
Customer relationships			100				9
Completed technologies			100				5
Goodwill			2,962
Total assets acquired			3,741
Accounts payable			280
Accrued expenses			463
Total liabilities assumed			743
Total purchase price		$	2,998

The contingent payments will be recorded as additional purchase price and allocated to goodwill when and if paid. The goodwill is assigned to the MVSD segment. None of the acquired intangible assets, including goodwill, are deductible for tax purposes. The Company obtained third-party valuations of the acquired intangible assets. The allocation of the purchase price is subject to adjustment through the second quarter of 2007.

DVT Corporation

On May 9, 2005, the Company acquired all of the outstanding shares of DVT Corporation, a provider of low-cost, easy-to-use vision sensors, for approximately $111,607,000, net of $4,702,000 cash acquired. The purchase price consisted of $110,346,000 in cash paid at closing (net of acquired cash) and $1,261,000 in transaction costs.

COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 13: Acquisitions (continued)

The Company adjusted the purchase price allocation during the second quarter of 2006, which resulted in a $281,000 increase in prepaid expenses and other current assets, a $9,000 increase in other assets, a $298,000 decrease in goodwill, and an $8,000 decrease in accrued expenses. The final purchase price was allocated as follows (in thousands):

						Weighted-Average
		Estimated Fair				Amortization Period
		Value				(in years)
Accounts receivable		$	5,785
Inventories			1,995
Prepaid expenses and other current assets			5,531
Property, plant, and equipment			766
Other assets			66
Intangible assets
Distribution networks			38,060				11.6
Customer relationships			4,740				12
Completed technologies			3,680				6
Trade names, trademarks, and non-competition agreement			1,110				4
Goodwill			73,180
Total assets acquired			134,913
Accounts payable			1,388
Accrued expenses			6,102
Net deferred tax liabilities			15,816
Total liabilities assumed			23,306
Total purchase price		$	111,607

Siemens Dematic AG Wafer Identification Business

On March 31, 2003, the Company acquired the wafer identification business of Siemens Dematic AG for 7,000,000 Euros in cash (or approximately $7,630,000) paid at closing, with the potential for an additional cash payment of up to 1,700,000 Euros (or approximately $2,013,000) depending upon the achievement of certain performance criteria. During the second quarter of 2006, the Company determined that a portion of this contingent payment had been earned and made a payment of 149,000 Euros (or approximately $190,000) that was allocated to goodwill.

NOTE 14: Dividends

On July 27, 2006, the Company’s Board of Directors declared a cash dividend of $0.085 per share. The dividend was paid on August 23, 2006 to all shareholders of record at the close of business on August 11, 2006.

NOTE 15: Subsequent Events

On October 26, 2006, the Company’s Board of Directors declared a cash dividend of $0.085 per share. The dividend is payable on November 24, 2006 to all shareholders of record at the close of business on November 10, 2006. Future dividends will be declared at the discretion of the Board of Directors and will depend upon such factors as the Board of Directors deems relevant.

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

Certain statements made in this report, as well as oral statements made by the Company from time to time, constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Readers can identify these forward-looking statements by the Company’s use of the words “expects,” “anticipates,” “estimates,” “believes,” “projects,” “intends,” “plans,” “will,” “may,” “shall,” and similar words and other statements of a similar sense. These statements are based upon the Company’s current estimates and expectations as to prospective events and circumstances, which may or may not be in the Company’s control and as to which there can be no firm assurances given. These forward-looking statements involve known and unknown risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties include: (1) global economic conditions that impact the capital spending trends of manufacturers in a variety of industries; (2) the cyclicality of the semiconductor and electronics industries; (3) the inability to achieve significant international revenue; (4) fluctuations in foreign exchange rates; (5) the loss of, or a significant curtailment of purchases by, any one or more principal customers; (6) the reliance upon certain sole-source suppliers to manufacture and deliver critical components for the Company’s products; (7) the inability to attract and retain skilled employees; (8) the inability to design and manufacture high-quality products; (9) inaccurate forecasts of customer demand; (10) the technological obsolescence of current products and the inability to develop new products; (11) the inability to protect the Company’s proprietary technology and intellectual property; (12) the Company’s involvement in time-consuming and costly litigation; (13) the impact of competitive pressures; (14) the challenges in integrating acquired businesses; and (15) the inability to achieve expected results from acquisitions. The foregoing list should not be construed as exhaustive and the Company encourages readers to refer to the detailed discussion of risk factors included in Part I — Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. The

Company cautions readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. The Company disclaims any obligation to subsequently revise forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date such statements are made.

Executive Overview

Cognex Corporation designs, develops, manufactures, and markets machine vision systems, or computers that can “see,” which are used to automate a wide range of manufacturing processes where vision is required. The Company’s Modular Vision Systems Division (MVSD) specializes in machine vision systems that are used to automate the manufacture of discrete items, while the Company’s Surface Inspection Systems Division (SISD) specializes in machine vision systems that are used to inspect the surfaces of materials processed in a continuous fashion.

In addition to product revenue derived from the sale of machine vision systems, the Company also generates revenue by providing maintenance and support, education, consulting, and installation services to its customers. The Company’s customers can be classified into three categories: semiconductor and electronics capital equipment manufacturers, discrete factory automation, and surface inspection customers. Semiconductor and electronics capital equipment manufacturers purchase Cognex machine vision systems and integrate them into the capital equipment that they manufacture and then sell to their customers in the semiconductor and electronics industries that either make computer chips or make printed circuit boards containing computer chips. Although the Company sells to original equipment manufacturers (OEMs) in a number of industries, these semiconductor and electronics OEMs have historically been large consumers of the Company’s products. Discrete manufacturers in the factory automation area include a wide array of manufacturers who use machine vision for applications in a variety of industries, including the automotive, consumer electronics, food and beverage, healthcare, and pharmaceutical industries. The majority of these customers are end users who purchase Cognex machine vision systems and install them directly on their production lines. The last category, surface inspection customers, includes manufacturers of materials processed in a continuous fashion, such as paper and metals.

On May 20, 2006, the Company acquired all of the outstanding shares of Assistware Technology, a privately-held developer of Lane Departure Warning Systems for $2,998,000 in cash paid at closing, with the potential for an additional cash payment of up to $2,000,000 depending upon the achievement of certain performance criteria. Assistware’s results of operations for the period since the date of acquisition, as well as the amortization of acquired intangible assets, were not material to the Company’s consolidated results of operations.

With the acquisition of Assistware, the Company has entered the emerging market for machine vision systems in vehicles. These highly-specialized sensors are installed in vehicles, ranging from long-haul trucks to passenger cars, where they provide driver assistance by constantly analyzing the vehicle’s external environment and warning the driver of potentially dangerous situations. Assistware’s Lane Departure Warning System uses machine vision technology to watch the road ahead and alert drivers if they unintentionally leave their lane or if their driving pattern becomes erratic. The Company believes that entering this new market for machine visions systems is an important strategic move as the Company seeks to diversify into areas outside of the factory floor.

Stock-Based Compensation Expense

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R requires companies to recognize compensation expense for all share-based payments to employees at fair value.

SFAS No. 123R was adopted by the Company on January 1, 2006 using the modified prospective method in which compensation expense is recognized beginning on the effective date. Under this transition method, compensation expense recognized for the nine-month period ended October 1, 2006 includes: (1) compensation expense for all share-based payments granted prior to but not yet vested as

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