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

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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 July 2, 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                     
Commission File Number 0-17869
COGNEX CORPORATION
 
(Exact name of registrant as specified in its charter)
     
Massachusetts   04-2713778
     
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
One Vision Drive
Natick, Massachusetts 01760-2059
(508) 650-3000

 
(Address, including zip code, and telephone number, including area code, of principal executive offices)
     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 July 30, 2006, there were 45,276,913 shares of Common Stock, $.002 par value, of the registrant outstanding.
 
 

 


 

INDEX
     
PART I
  FINANCIAL INFORMATION
  Financial Statements
 
  Consolidated Statements of Operations for the three-month and six-month periods ended July 2, 2006 and July 3, 2005
 
  Consolidated Balance Sheets at July 2, 2006 and December 31, 2005
 
  Consolidated Statement of Shareholders' Equity for the six-month period ended July 2, 2006
 
  Consolidated Condensed Statements of Cash Flows for the six-month periods ended July 2, 2006 and July 3, 2005
 
  Notes to Consolidated Financial Statements
 
   
  Management's Discussion and Analysis of Financial Condition and Results of Operations
 
   
  Quantitative and Qualitative Disclosures About Market Risk
 
   
  Controls and Procedures
 
   
PART II
  OTHER INFORMATION
 
   
  Legal Proceedings
 
   
  Risk Factors
 
   
  Unregistered Sales of Equity Securities and Use of Proceeds
 
   
  Defaults Upon Senior Securities
 
   
  Submission of Matters to a Vote of Security Holders
 
   
  Other Information
 
   
  Exhibits
 
   
 
  Signatures
 EX-10.3 Second Amendment to the Cognex Corporation 1998 Stock Incentive Plan
 EX-31.1 Section 302 Certification of C.E.O.
 EX-31.2 Section 302 Certification of C.F.O.
 EX-32.1 Section 906 Certification of C.E.O.
 EX-32.2 Section 906 Certification of C.F.O.

 


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PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
COGNEX CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
                                 
    Three Months Ended     Six Months Ended  
    July 2,     July 3,     July 2,     July 3,  
    2006     2005     2006     2005  
    (unaudited)     (unaudited)  
Revenue
                               
Product
  $ 57,352     $ 48,877     $ 111,001     $ 86,054  
Service
    5,722       5,726       11,113       11,747  
 
                       
 
    63,074       54,603       122,114       97,801  
 
                               
Cost of revenue
                               
Product (1)
    12,978       12,529       26,024       22,886  
Service (1)
    3,615       3,536       7,279       6,969  
 
                       
 
    16,593       16,065       33,303       29,855  
 
                               
Gross margin
                               
Product
    44,374       36,348       84,977       63,168  
Service
    2,107       2,190       3,834       4,778  
 
                       
 
    46,481       38,538       88,811       67,946  
 
                               
Research, development, and engineering expenses (1)
    8,582       7,185       16,499       13,500  
Selling, general, and administrative expenses (1)
    25,277       21,494       49,056       39,002  
 
                       
 
                               
Operating income
    12,622       9,859       23,256       15,444  
 
                               
Foreign currency loss
    (280 )     (291 )     (425 )     (192 )
Investment and other income
    1,772       973       3,338       2,443  
 
                       
 
                               
Income before provision for income taxes
    14,114       10,541       26,169       17,695  
 
                               
Income tax provision
    2,680       2,741       5,935       4,601  
 
                       
 
                               
Net income
  $ 11,434     $ 7,800     $ 20,234     $ 13,094  
 
                       
 
                               
Net income per common and common-equivalent share:
                               
Basic
  $ 0.25     $ 0.17     $ 0.44     $ 0.28  
 
                       
Diluted
  $ 0.24     $ 0.17     $ 0.42     $ 0.28  
 
                       
 
                               
Weighted-average common and common-equivalent shares outstanding:
                               
Basic
    46,331       46,286       46,443       46,290  
 
                       
Diluted
    47,517       47,141       47,756       47,269  
 
                       
 
                               
Cash dividends per common share
  $ 0.08     $ 0.08     $ 0.16     $ 0.16  
 
                       
 
                               
(1) Amounts include stock-based compensation expense, as follows:
                               
Product cost of revenue
  $ 197     $     $ 353     $  
Service cost of revenue
    229             428        
Research, development, and engineering
    948             1,730        
Selling, general, and administrative
    2,131             3,950        
 
                       
Total stock-based compensation expense
  $ 3,505     $     $ 6,461     $  
 
                       
The accompanying notes are an integral part of these consolidated financial statements.

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COGNEX CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands)
                 
    July 2,     December 31,  
    2006     2005  
    (unaudited)          
ASSETS
               
 
               
Current assets:
               
Cash and cash equivalents
  $ 79,050     $ 72,856  
Short-term investments
    134,781       169,156  
Accounts receivable, less reserves of $2,673 and $2,370 in 2006 and 2005, respectively
    44,639       42,051  
Inventories, net
    26,039       18,819  
Deferred income taxes
    7,741       7,667  
Prepaid expenses and other current assets
    12,973       16,104  
 
           
 
               
Total current assets
    305,223       326,653  
 
               
Long-term investments
    60,276       70,246  
Property, plant, and equipment, net
    24,220       24,175  
Deferred income taxes
    14,305       10,227  
Intangible assets, net
    47,822       50,049  
Goodwill
    83,060       79,807  
Other assets
    3,443       3,405  
 
           
 
               
 
  $ 538,349     $ 564,562  
 
           
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
 
               
Current liabilities:
               
Accounts payable
  $ 7,276     $ 7,118  
Accrued expenses
    48,798       43,476  
Customer deposits
    1,663       2,142  
Deferred revenue
    6,718       5,305  
 
           
 
               
Total current liabilities
    64,455       58,041  
 
               
Commitments (Notes 3, 7, 8, 9, and 13)
               
 
               
Shareholders’ equity:
               
Common stock, $.002 par value — Authorized: 140,000 shares, issued: 45,257 and 47,171 shares in 2006 and 2005, respectively
    91       94  
Additional paid-in capital
    168,972       216,031  
Retained earnings
    317,227       304,454  
Accumulated other comprehensive loss
    (12,396 )     (14,058 )
 
           
 
               
Total shareholders’ equity
    473,894       506,521  
 
           
 
               
 
  $ 538,349     $ 564,562  
 
           
The accompanying notes are an integral part of these consolidated financial statements.

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COGNEX CORPORATION
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(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
    347       2       7,343                               7,345  
Stock-based compensation expenses
                    6,461                               6,461  
Excess tax benefit from stock option exercises
                    1,015                               1,015  
Payment of dividends
                            (7,461 )                     (7,461 )
Repurchase of Common Stock
    (2,261 )     (5 )     (61,878 )                             (61,883 )
Comprehensive income:
                                                       
Net income
                            20,234             $ 20,234       20,234  
Gains on long-term intercompany loans, net of losses on currency swaps, net of tax of $3
                                    5       5       5  
Net unrealized gain on available-for-sale investments, net of tax of $52
                                    88       88       88  
Foreign currency translation adjustment
                                    1,569       1,569       1,569  
 
                                                     
Comprehensive income
                                          $ 21,896          
 
                                                     
 
                                           
Balance at July 2, 2006 (unaudited)
    45,257     $ 91     $ 168,972     $ 317,227     $ (12,396 )           $ 473,894  
 
                                           
The accompanying notes are an integral part of these consolidated condensed financial
statements.

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COGNEX CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)
                 
    Six Months Ended  
    July 2,     July 3,  
    2006     2005  
    (unaudited)  
Cash flows from operating activities:
               
Net income
  $ 20,234     $ 13,094  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Stock-based compensation expense
    6,461        
Depreciation and amortization
    5,736       5,407  
Excess tax benefit from stock option exercises
    815       503  
Deferred income tax expense (benefit)
    (4,136 )     353  
Change in current assets and current liabilities
    (2,577 )     (4,627 )
Other
    50       270  
 
           
 
               
Net cash provided by operating activities
    26,583       15,000  
 
               
Cash flows from investing activities:
               
Purchase of investments
    (287,552 )     (321,766 )
Maturity and sale of investments
    331,379       435,984  
Purchase of property, plant, and equipment
    (2,023 )     (1,814 )
Cash paid for business acquisition, net of cash acquired
    (2,998 )     (111,427 )
 
           
 
               
Net cash provided by investing activities
    38,806       977  
 
               
Cash flows from financing activities:
               
Payment of dividends
    (7,461 )     (7,405 )
Repurchase of common stock
    (61,883 )      
Issuance of stock under stock option plans
    7,345       4,219  
Excess tax benefit from stock option exercises
    100        
 
           
 
               
Net cash used in financing activities
    (61,899 )     (3,186 )
 
               
Effect of foreign exchange rate changes on cash
    2,704       (2,302 )
 
           
 
               
Net increase in cash and cash equivalents
    6,194       10,489  
Cash and cash equivalents at beginning of period
    72,856       54,270  
 
           
Cash and cash equivalents at end of period
  $ 79,050     $ 64,759  
 
           
The accompanying notes are an integral part of these consolidated financial statements.

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COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 July 2, 2006, and the results of its operations for the three-month and six-month periods ended July 2, 2006 and July 3, 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 six-month periods ended July 2, 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 Interpretation will be effective for public companies no later than the beginning of the first fiscal year after December 15, 2006. 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 consist of the following (in thousands):
                 
    July 2,     December 31,  
    2006     2005  
 
               
Cash
  $ 74,550     $ 72,856  
Cash equivalents
    4,500        
 
           
Total cash and cash equivalents
    79,050       72,856  
 
           
 
               
Municipal bonds
    115,346       140,718  
Commercial paper
    12,953       24,584  
Corporate bonds
    2,500       2,500  
Treasury bills
    3,982       1,354  
 
           
Total short-term investments
    134,781       169,156  
 
           
 
               
Municipal bonds
    49,893       59,863  
Limited partnership interest
    10,383       10,383  
 
           
Total long-term investments
    60,276       70,246  
 
           
 
  $ 274,107     $ 312,258  
 
           

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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 July 2, 2006, the Company had contributed $17,900,000 to the partnership. During the quarter ended April 2, 2006, the Company made a $450,000 contribution to the partnership and also received a distribution of $450,000 from the partnership that was accounted for as a return of capital. No contributions were made to the partnership or distributions received from the partnership during the quarter ended July 2, 2006. At July 2, 2006, the carrying value of this investment was $10,383,000 compared to an estimated fair value, as determined by the General Partner, of $11,438,000.
NOTE 4: Inventories
Inventories consist of the following (in thousands):
                 
    July 2,     December 31,  
    2006     2005  
 
               
Raw materials
  $ 13,105     $ 8,958  
Work-in-process
    1,764       3,406  
Finished goods
    11,170       6,455  
 
           
 
               
 
  $ 26,039     $ 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):
                         
                    Statement of  
    Balance Sheet     Operations  
    Inventories     Accrued Expenses     Benefits  
 
                       
Reserve balance at December 31, 2005
  $ 5,884     $ 1,400          
 
                   
Benefits to cost of product revenue recorded in the six-month period ended July 3, 2005
                  $ 287  
 
                     
Inventory sold to customers
    (604 )         $ 604  
Inventory sold to brokers
    (309 )            
Write-off and scrap of inventory
    (94 )            
 
                 
Reserve balance at July 2, 2006
  $ 4,877     $ 1,400          
Benefits to cost of product revenue recorded in the six-month period ended July 2, 2006
                  $ 604  
 
                     

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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 July 2, 2006.
NOTE 5: Intangible Assets
Amortized intangible assets consist of the following (in thousands):
                         
    Gross             Net  
    Carrying     Accumulated     Carrying  
July 2, 2006   Amount     Amortization     Amount  
 
                       
Distribution networks
  $ 38,060     $ 3,834     $ 34,226  
Customer contracts and relationships
    12,784       3,341       9,443  
Completed technologies
    4,471       1,267       3,204  
Other
    1,365       416       949  
 
                 
 
                       
 
  $ 56,680     $ 8,858     $ 47,822  
 
                 
                         
    Gross             Net  
    Carrying     Accumulated     Carrying  
December 31, 2005   Amount     Amortization     Amount  
 
                       
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 six-month periods ended July 2, 2006 was $1,467,000 and $2,919,000, respectively, and $1,050,000 and $1,450,000 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
  2,990
2007
  5,596
2008
  5,596
2009
  5,407
2010
  5,278
Thereafter
  22,955
 
   
Total
  $47,822
 
   

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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 six-month period ended July 2, 2006 are as follows (in thousands):
                         
    MVSD     SISD     Consolidated  
 
                       
Balance at December 31, 2005
  $ 77,266     $ 2,541     $ 79,807  
Assistware business acquisition (Note 13)
    2,972             2,972  
Siemens contingent payment (Note 13)
    190             190  
DVT purchase price adjustment (Note 13)
    (298 )           (298 )
Foreign exchange rate changes
    185       204       389  
 
                 
 
                       
Balance at July 2, 2006
  $ 80,315     $ 2,745     $ 83,060  
 
                 
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 that would not have been taken into account using historical data become known. Warranty obligations are included in “Accrued expenses” on the Consolidated Balance Sheets.
The changes in the warranty obligation are as follows (in thousands):
         
Balance at December 31, 2005
  $ 1,447  
Provisions for warranties issued during the period
    395  
Fulfillment of warranty obligations
    (510 )
Foreign exchange rate changes
    71  
 
     
 
       
Balance at July 2, 2006
  $ 1,403  
 
     
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.

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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 always 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 $29,361,000 based upon the exchange rate at July 2, 2006) to taxing authorities in Japan that are collateralized by investments on the Consolidated Balance Sheet. The Tokyo Regional Taxation Bureau (TRTB) has asserted that Cognex Corporation has 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. The Company disagrees with this position and believes that this assertion is inconsistent with principles under the U.S. — Japan income tax treaty. The Company has filed a notice of objection and request for deferral of tax payment and intends to contest this assessment vigorously, although no assurances can be made that the Company will prevail in this matter. In September 2003, the Company also filed a request with the Internal Revenue Service Tax Treaty Division for competent authority assistance. Until this matter is resolved, the Company is required to provide collateral for these tax assessments. These letters of credit expire in approximately one year and will be renewed as required. Should the TRTB prevail in its assertion, the income in question would be taxable in Japan and the Company would be required to pay approximately $29,361,000 in taxes, interest and penalties to Japanese taxing authorities. The Company would then be entitled to recoup the majority of this amount from taxing authorities in the U.S. The Company has not provided any additional accrual or reserve related to this matter.
During the quarter ended July 2, 2006, the Company recorded a $869,000 income tax benefit from the reduction of state income tax reserves based on the resolution of a multi-year tax issue in Massachusetts.
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.
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 six-month period ended July 2, 2006 includes:

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COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10: Stock-Based Compensation Expense (continued)
(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 July 2, 2006, the Company had 10,765,799 shares available for grant under three stock option plans: the 1998 Stock Incentive Plan, 3,261,799; 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 1st 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 31st 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 six-month period ended July 2, 2006 is as follows (shares and values in thousands):
                                 
                    Weighted-        
            Weighted-     Average        
            Average     Remaining        
            Exercise     Contractual     Aggregate  
    Shares     Price     Term     Intrinsic Value  
 
                               
Outstanding at December 31, 2005
    10,675     $ 25.36                  
Granted
    1,503       29.28                  
Exercised
    (342 )     21.01                  
Forfeited or Expired
    (248 )     25.99                  
 
                             
Outstanding at July 2, 2006
    11,588     $ 25.99       7.0     $ 27,587  
 
                       
Exercisable at July 2, 2006
    7,004     $ 25.48       5.8     $ 22,897  
 
                       
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.

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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   Six Months Ended
    July 2,   July 3,   July 2,   July 3,
    2006   2005   2006   2005
 
                               
Risk-free rate
    4.5 %     3.6 %     4.5 %     3.4 %
Expected dividend yield
    1.10 %     1.22 %     1.10 %     1.27 %
Expected volatility
    45 %     35 %     45 %     35 %
Expected term (in years)
    4.0       2.8       4.0       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 six-month periods ended July 2, 2006 and July 3, 2005 was $11.13 and $5.96, 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.
The total stock-based compensation expense and the related income tax benefit recognized for the six-month period ended July 2, 2006 was $6,461,000 and $2,268,000, respectively. The total stock-based compensation expense and the related income tax benefit recognized for the three-month period ended

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COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10: Stock-Based Compensation Expense (continued)
July 2, 2006 was $3,505,000 and $1,231,000, respectively. No compensation expense was capitalized at July 2, 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 six-month periods ended July 2, 2006 and July 3, 2005 was $2,908,000 and $1,869,000, respectively.
At July 2, 2006, total unrecognized compensation expense related to non-vested stock options was $17,010,000, which is expected to be recognized over a weighted-average period of 1.5 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 six-month periods ended July 3, 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 six-month periods ended July 2, 2006 are the same since stock-based compensation expense was recorded under the provisions of SFAS No. 123R.
                 
    Three Months     Six Months  
    Ended     Ended  
    July 3,     July 3,  
    2005     2005  
 
               
Net income, as reported
  $ 7,800     $ 13,094  
 
               
Less: Total stock-based compensation expense determined under fair value based method, net of tax
    (2,368 )     (4,678 )
 
           
 
               
Net income, pro forma
    5,432       8,416  
 
           
 
               
Basic net income per share, as reported
  $ 0.17     $ 0.28  
 
           
Basic net income per share, pro forma
  $ 0.12     $ 0.18  
 
           
 
               
Diluted net income per share, as reported
  $ 0.17     $ 0.28  
 
           
Diluted net income per share, pro forma
  $ 0.12     $ 0.18  
 
           

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COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11: Net Income Per Share
Net income per share is calculated as follows (in thousands, except per share amounts) :
                                 
    Three Months Ended     Six Months Ended  
    July 2, 2006     July 3, 2005     July 2, 2006     July 3, 2005  
Net income
  $ 11,434     $ 7,800     $ 20,234     $ 13,094  
 
                       
 
                               
Basic:
                               
Weighted-average common shares outstanding
    46,331       46,286       46,443       46,290  
 
                       
 
                               
Net income per common share
  $ 0.25     $ 0.17     $ 0.44     $ 0.28  
 
                       
 
                               
Diluted:
                               
Weighted-average common shares outstanding
    46,331       46,286       46,443       46,290  
Effect of dilutive stock options
    1,186       855       1,313       979  
 
                       
 
Weighted-average common and common-equivalent shares outstanding
    47,517       47,141       47,756       47,269  
 
                       
 
                               
Net income per common and common-equivalent share
  $ 0.24     $ 0.17     $ 0.42     $ 0.28  
 
                       
Stock options to purchase 5,342,198 and 4,998,936 shares of common stock were outstanding during the three-month and six-month periods ended July 2, 2006, respectively, and 4,481,684 and 4,404,117 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.

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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 July 2, 2006
                               
 
Product revenue
  $ 51,051     $ 6,301     $     $ 57,352  
Service revenue
    3,117       2,605             5,722  
Operating income
    16,994       1,580       (5,952 )     12,622  
 
                               
Six Months Ended July 2, 2006
                               
 
                               
Product revenue
  $ 100,348     $ 10,653     $     $ 111,001  
Service revenue
    6,213       4,900             11,113  
Operating income
    33,892       1,811       (12,447 )     23,256  
                                 
                    Reconciling    
    MVSD   SISD   Items   Consolidated
Three Months Ended July 3, 2005
                               
 
                               
Product revenue
  $ 41,908     $ 6,969     $     $ 48,877  
Service revenue
    3,386       2,340             5,726  
Operating income
    10,402       1,579       (2,122 )     9,859  
 
                               
Six Months Ended July 3, 2005
                               
 
                               
Product revenue
  $ 74,593     $ 11,461     $     $ 86,054  
Service revenue
    7,030       4,717             11,747  
Operating income
    17,441       2,113       (4,110 )     15,444  
Reconciling items consist of stock-based compensation expense and unallocated corporate expenses, which primarily include corporate headquarters costs and professional fees. For the six-month period ended July 2, 2006, corporate expenses also included costs associated with the Company’s 25th 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.

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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 initial purchase price was allocated as follows (in thousands):
                 
            Weighted-Average  
    Estimated Fair     Amortization Period  
    Value     (in years)  
 
 
               
Accounts receivable
  $ 25          
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
    2,972          
 
             
Total assets acquired
    3,718          
 
Accounts payable
    280          
Accrued expenses
    440          
 
             
Total liabilities assumed
    720          
 
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.

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COGNEX CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13: Acquisitions (continued)
The Company adjusted the purchase price 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 April 25, 2006, the Company’s Board of Directors declared a cash dividend of $0.08 per share. The dividend was paid on May 26, 2006 to all shareholders of record at the close of business on May 12, 2006.
NOTE 15: Subsequent Events
On July 27, 2006, the Company’s Board of Directors declared a cash dividend of $0.085 per share. The dividend is payable on August 25, 2006 to all shareholders of record at the close of business on August 11, 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.

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On July 27, 2006, the Company’s Board of Directors authorized a repurchase of up to $100,000,000 of the Company’s Common Stock in open market transactions.

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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

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inspection customers, includes manufacturers of materials processed in a continuous fashion, such as paper and metals.
Revenue amounted to $63,074,000 for the quarter ended July 2, 2006, representing a 16% increase over the same period in 2005. The growth was driven primarily by sales to semiconductor and electronics capital equipment manufacturers, which increased 62% from the prior year. Despite $6,461,000 of stock-based compensation expense recorded in 2006, as well as investments made in the past year to grow the Company’s discrete factory automation business, net income per diluted share increased to $0.24 for the quarter ended July 2, 2006 from $0.17 for the same period in 2005.
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 for the quarter.
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 vision 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 six-month period ended July 2, 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 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. Readers should refer to Note 10: Stock-Based Compensation Expense to the Consolidated Financial Statements for a detailed description of the valuation assumptions.
The total stock-based compensation expense and the related income tax benefit recognized for the six-month period ended July 2, 2006 was $6,461,000 and $2,268,000, respectively. The total stock-based compensation expense and the related income tax benefit recognized for the three-month period ended July 2, 2006 was $3,505,000 and $1,231,000, respectively. No compensation expense was capitalized at July 2, 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.

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At July 2, 2006, total unrecognized compensation expense related to non-vested stock options was $17,010,000, which is expected to be recognized over a weighted-average period of 1.5 years.
Results of Operations
Revenue
Revenue for the three-month and six-month periods ended July 2, 2006 totaled $63,074,000 and $122,114,000, respectively, compared to $54,603,000 and $97,801,000 for the same periods in 2005, representing a 16% increase for the three-month period and a 25% increase for the six-month period. These increases over the prior year were primarily due to a higher volume of modular vision systems sold to customers in the semiconductor and electronics capital equipment market, and to a lesser extent, the discrete factory automation market. Sales to customers who make capital equipment for the semiconductor and electronics industries increased by $7,474,000, or 62%, and $14,853,000, or 61%, in the three-month and six-month periods ended July 2, 2006, respectively. Sales to discrete manufacturing customers in the factory automation area increased by $1,405,000, or 4%, and $10,085,000, or 18%, in the three-month and six-month periods ended July 2, 2006, respectively. In May 2005, the Company acquired DVT Corporation, and as a result, expanded its worldwide distribution network and product offering to the discrete factory automation market. Sales of acquired DVT products contributed to the increase in factory automation revenue. Sales to surface inspection customers declined slightly by $403,000, or 4%, and $625,000, or 4%, from the prior year for the three-month and six-month periods ended July 2, 2006, respectively. Despite the increase in sales to semiconductor and capital equipment manufacturers from the prior year, revenue from customers outside of this sector continued to account for the majority of the Company’s revenue, representing 69% and 68% of total revenue for the three-month and six-month periods in 2006, respectively, compared to 78% and 75% for the same periods in 2005.
Product revenue for the three-month and six-month periods ended July 2, 2006 totaled $57,352,000 and $111,001,000, respectively, compared to $48,877,000 and $86,054,000 for the same periods in 2005, representing a 17% increase for the three-month period and a 29% increase for the six-month period. The increase in product revenue for both periods was primarily due to higher revenues to semiconductor and electronics capital equipment manufacturers, as well as discrete factory automation customers. Service revenue, which is derived from the sale of maintenance and support, education, consulting, and installation services, totaled $5,722,000 and $11,113,000 for the three-month and six-month periods ended July 2, 2006, respectively, compared to $5,726,000 and $11,747,000 for the same periods in 2005, representing relatively flat revenue for the three-month period and a 5% decrease for the six-month period. This decrease was principally due to lower revenue generated by maintenance and support programs. Service revenue represented 9% of total revenue for both the three-month and six-month periods in 2006, compared to 10% and 12% for the same periods in 2005.
MVSD revenue for the three-month and six-month periods ended July 2, 2006 totaled $54,168,000 and $106,561,000, respectively, compared to $45,294,000 and $81,623,000 for the same periods in 2005, representing a 20% increase for the three-month period and a 31% increase for the six-month period. The increase in MVSD revenue for both periods was primarily due to higher revenues from the semiconductor and electronics capital equipment market, and to a lesser extent, the discrete factory automation market. SISD revenue was down slightly from the prior year, amounting to $8,906,000 and $15,553,000 for the three-month and six-month periods ended July 2, 2006, respectively, compared to $9,309,000 and $16,178,000 for the same periods in 2005. SISD revenue decreased as a percentage of total revenue to 14% and 13% for the three-month and six-month periods in 2006, respectively, compared to 17% for both periods in 2005.
Gross Margin
Gross margin as a percentage of revenue was 74% and 73% for the three-month and six-month periods ended July 2, 2006, respectively, compared to 71% and 69% for the same periods in 2005. The increase in gross margin was primarily due to the impact of the higher sales volume, as well as a shift in mix to modular vision systems, which have higher margins than the sale of surface inspection systems and services. Stock-based compensation expense recorded to cost of revenue was $426,000 and $781,000

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for the three-month and six-month periods ended July 2, 2006, respectively, which had a relatively small impact on the total gross margin percentage.
Product gross margin as a percentage of revenue was 77% for the three-month and six-month periods ended July 2, 2006, compared to 74% and 73% for the same periods in 2005. The increase in product margin was primarily due to the impact of the higher sales volume, as well as a shift in mix to higher-margin modular vision systems. Service gross margin as a percentage of revenue was 37% and 35% for the three-month and six-month periods ended July 2, 2006, respectively, compared to 38% and 41% for the same periods in 2005. The decrease in service margin was due principally to lower maintenance and support revenue that is sold bundled with MVSD products, without a corresponding decrease in expenses. In addition, stock-based compensation expense recorded in the three-month and six-month periods ended July 2, 2006 contributed four percentage points and three percentage points to the service margin decline, respectively.
MVSD gross margin as a percentage of revenue was 78% and 77% for the three-month and six-month periods ended July 2, 2006, respectively, compared to 75% and 74% for the same periods in 2005. The increase in MVSD margin was primarily due to the impact of the higher sales volume, as well as a shift in mix to higher-margin product revenue. SISD gross margin as a percentage of revenue was 51% and 47% for the three-month and six-month periods ended July 2, 2006, respectively, compared to 49% for both the three-month and six-month periods ended July 3, 2005.
Operating Expenses
Research, development, and engineering expenses (R,D&E) for the three-month and six-month periods ended July 2, 2006 were $8,582,000 and $16,499,000, respectively, compared to $7,185,000 and $13,500,000 for the same periods in 2005, representing a 19% increase for the three-month period and 22% increase for the six-month period. MVSD R,D&E expenses increased $1,195,000, or 19%, for the three-month period, of which $879,000 represented stock-based compensation expense, and $2,691,000, or 22%, for the six-month period, of which $1,600,000 represented stock-based compensation expense. The remaining increase of $316,000, or 4%, for the three-month period was primarily attributable to an increase in outside service costs related to patent activity and new product initiatives. The remaining increase of $1,091,000, or 9%, for the six-month period was due principally to additional engineering personnel resulting from the acquisition of DVT Corporation in May 2005, as well as an increase in outside service costs related to patent activity and new product initiatives. SISD R,D&E expenses increased $202,000, or 28%, for the three-month period, of which $69,000 represented stock-based compensation expense, and $308,000, or 22%, for the six-month period, of which $130,000 represented stock-based compensation expense. The remaining increase of $133,000, or 18%, and $178,000, or 13%, for the three-month and six-month periods, respectively, was due primarily to increased compensation expenses and higher spending on outside services related to the SmartViewâ product line.
R,D&E expenses as a percentage of revenue were 14% for the six-month periods in 2006 and 2005. The Company believes that a continued commitment to R,D&E activities is essential in order to maintain product leadership with our existing products and to provide innovative new product offerings, and therefore, we expect to continue to make significant R,D&E investments in the future. Although the Company targets its R,D&E spending to be between 10% and 15% of revenue, this percentage is impacted by revenue cyclicality. At any point in time, the Company has numerous research and development projects underway, and the Company believes that none of these projects is material on an individual basis.
Selling, general, and administrative (S,G&A) expenses for the three-month and six-month periods ended July 2, 2006 were $25,277,000 and $49,056,000, respectively, compared to $21,494,000 and $39,002,000 for the same periods in 2005, representing an 18% increase for the three-month period and a 26% increase for the six-month period. MVSD S,G&A expenses increased $2,817,000, or 16%, for the three-month period, of which $1,350,000 represented stock-based compensation expense, and $7,120,000, or 23%, for the six-month period, of which $2,496,000 represented stock-based compensation expense. The remaining increase of $1,467,000, or 7%, and $4,624,000, or 12%, for the three-month and six-month periods, respectively, was due primarily to investments in sales and marketing in the discrete factory automation market, including the acquisition of DVT Corporation in May 2005. This acquisition resulted in additional sales and marketing expenses related to managing a worldwide distribution network, as well as additional amortization expense of $315,000 and $1,259,000 for the three-month and six-month periods,

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respectively, related to acquired intangible assets. In addition to the personnel added as a result of the DVT acquisition, the Company also made investments over the past year in its direct factory automation sales force. SISD S,G&A expenses increased $92,000, or 4%, for the three-month period, and $55,000, or 1%, for the six-month period, despite $231,000 and $450,000 of stock-based compensation expense recorded in the three-month and six-month periods, respectively, primarily due to lower sales commissions.
Corporate expenses that are not allocated to a division for the three-month and six-month periods ended July 2, 2006 were $2,996,000 and $6,989,000, respectively, compared to $2,122,000 and $4,110,000 for the same periods in 2005. Stock-based compensation expense represented $549,000 of the increase for the three-month period, with the remaining increase of $325,000 primarily due to higher company bonus accruals. Stock-based compensation expense represented $1,003,000 of the increase for the six-month period, with the remaining increase of $1,876,000 primarily due to costs associated with the Company’s 25th Anniversary party held in January 2006, as well as higher company bonus accruals.
Nonoperating Income
Investment and other income for the three-month and six-month periods ended July 2, 2006 totaled $1,772,000 and $3,338,000, respectively, compared to $973,000 and $2,443,000 for the same periods in 2005, representing an 82% increase in the three-month period and a 37% increase in the six-month period. Although the average invested balance declined in the past year due to net cash outlays related to the acquisition of DVT Corporation and the Company’s stock repurchase program, investment and other income increased over the prior year because the Company earned higher yields on its portfolio of debt securities.
During the three-month and six-month periods ended July 2, 2006, the Company recorded foreign currency losses of $280,000 and $425,000, respectively, compared to losses of $291,000 and $192,000 for the same periods in 2005. The losses during both periods in 2006 were primarily due to the revaluation of cash balances on the Company’s subsidiaries’ books that are denominated in a currency other than the subsidiaries’ functional currency. The losses during both periods in 2005 were primarily due to the revaluation and settlement of intercompany balances that are reported in one currency and collected or paid in another.
Income Taxes
The Company’s effective tax rate for the three-month and six-month periods ended July 2, 2006 was 19% and 23%, respectively, compared to 26% for both periods in 2005. The second quarter of 2006 included a benefit of $869,000 from the settlement of a multi-year state tax audit during the quarter. The Company’s effective tax rate decreased seven percentage points for the three-month period ended July 2, 2006, of which six percentage points represented the one-time tax benefit, and three percentage points for the six-month period ended July 2, 2006, all of which represented the one-time tax benefit. The remaining decrease of one percentage point for the three-month period was due to more of the Company’s profits being earned in lower tax jurisdictions than had been anticipated.
Liquidity and Capital Resources
The Company has historically been able to generate positive cash flow from operations, which has funded the Company’s operating activities and other cash requirements and has resulted in an accumulated cash, cash equivalent, and investment balance of $274,107,000 at July 2, 2006, representing 58% of shareholders’ equity. The Company has established guidelines relative to credit ratings, diversification, and maturities of its investments that maintain liquidity.
The Company’s cash requirements during the quarter ended July 2, 2006 were met with existing cash, cash equivalent, and investment balances, as well as positive cash flow from operations and the proceeds from stock option exercises. Cash requirements primarily consisted of operating activities, capital expenditures, the Company’s dividend and stock repurchase programs, and the purchase of Assistware Technology. Capital expenditures during the six-month period ended July 2, 2006 totaled $2,023,000 and consisted primarily of expenditures for computer hardware.

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On June 30, 2000, Cognex Corporation became a Limited Partner in Venrock Associates III, L.P. (Venrock), 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 July 2, 2006, the Company had contributed $17,900,000 to the partnership, including $450,000 during the six-month period ended July 2, 2006. The remaining commitment of $4,600,000 can be called by Venrock in any period through 2010.
On December 12, 2000, the Company’s Board of Directors authorized the repurchase of up to $100,000,000 of the Company’s Common Stock. During the six-month period ended July 2, 2006, the Company repurchased 2,260,941 shares at a cost of $61,883,000, which completed the Company’s repurchases under this program. On July 27, 2006, the Company’s Board of Directors authorized a new program for the repurchase of up to $100,000,000 of the Company’s Common Stock in open market transactions. The stock repurchase will be at management’s discretion depending on a variety of factors, including price levels and share availability.
Beginning in the third quarter of 2003, the Company’s Board of Directors has declared and paid a cash dividend in each quarter. During the six-month period ended July 2, 2006, the Company made dividend payments totaling $7,461,000, which amounted to $0.08 per share in each quarter. On July 27, 2006, the Company’s Board of Directors declared a cash dividend of $0.085 per share payable during the third quarter of 2006, representing a 6% increase in the dividend. Future dividends will be declared at the discretion of the Board of Directors and will depend upon such factors as the Board deems relevant.
On May 20, 2006, the Company acquired all of the outstanding shares of Assistware Technology for $2,998,000 in cash paid at closing, with the potential for an additional cash payment of up to $1,500,000 in 2007 and up to $500,000 in 2008 depending upon the achievement of certain performance criteria.
The Company believes that its existing cash, cash equivalent, and investment balance, together with continued positive cash flow from operations, will be sufficient to meet its operating, investing, and financing activities in 2006 and the foreseeable future.
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 Interpretation will be effective for public companies no later than the beginning of the first fiscal year after December 15, 2006. 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.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes to the Company’s exposures to market risk since December 31, 2005.
ITEM 4: CONTROLS AND PROCEDURES
As required by Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934, the Company has evaluated, with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, the effectiveness of its disclosure controls and procedures (as defined in such rules) as of the end of the period covered by this report. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer concluded that such disclosure controls and procedures were effective as of that

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date. From time to time, the Company reviews its disclosure controls and procedures, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that the Company’s systems evolve with its business. There was no change in the Company’s internal control over financial reporting that occurred during the quarter ended July 2, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II: OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None
ITEM 1A. RISK FACTORS
For factors that could affect the Company’s business, results of operations, and financial condition, see the risk factors discussion provided in Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table sets forth information with respect to purchases by the Company of shares of its Common Stock during the periods indicated.
                                 
                    Total Number of     Maximum Number of  
                    Shares Purchased as     Shares that May Yet  
                    Part of Publicly     Be Purchased Under  
    Total Number of     Average Price Paid     Announced Plans or     the Plans or  
Period   Shares Purchased     per Share     Programs     Programs  
April 3 — May 2, 2006
                       
May 3 — June 2, 2006
    1,112,568     $ 26.96       1,112,568        
June 3 — July 2, 2006
    269,696     $ 25.53       269,696        
 
                       
Total
    1,382,264     $ 26.68       1,382,264        
 
                       
 
(1)   On December 12, 2000, the Company’s Board of Directors authorized the repurchase of up to $100,000,000 of the Company’s Common Stock. During the quarter ended July 2, 2006, this repurchase program was completed. On July 27, 2006, the Company’s Board of Directors authorized a new program for the repurchase of up to $100,000,000 of the Company’s Common Stock.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On April 25, 2006, at a Special Meeting of the Shareholders of Cognex Corporation held in lieu of the 2006 Annual Meeting, the Shareholders elected Robert J. Shillman and Reuben Wasserman to serve as Directors for a term of three years. Patrick Alias, Anthony Sun, William Krivsky, and Jerald Fishman continued as Directors after the meeting. The 40,502,410 shares represented at the meeting voted as follows: The election of Robert J. Shillman as Director, 39,390,450 votes for and 1,111,960 withheld; the election of Reuben Wasserman as Director, 38,300,768 votes for and 2,201,642 withheld.

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ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS
         
10.1
    Cognex Corporation 1998 Stock Incentive Plan (incorporated by reference to Exhibit 4.2 to the Registration Statement on Form S-8 [Registration No. 333-60807])
 
       
10.2
    First Amendment to the Cognex Corporation 1998 Stock Incentive Plan (incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-8 [Registration No. 333-60807])
 
       
10.3
    Second Amendment to the Cognex Corporation 1998 Stock Incentive Plan*
 
       
31.1
    Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934*
 
       
31.2
    Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934*
 
       
32.1
    Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
 
       
32.2
    Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
 
*   Filed herewith
 
**   Furnished herewith

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
DATE: August 11, 2006  COGNEX CORPORATION
 
 
  /s/ Robert J. Shillman    
  Robert J. Shillman   
  Chairman of the Board of Directors and Chief Executive Officer (duly authorized officer, principal executive officer)   
 
     
  /s/ Richard A. Morin    
  Richard A. Morin   
  Senior Vice President of Finance and Administration, Chief Financial Officer, and Treasurer (duly authorized officer, principal financial and accounting officer)   
 

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