Thursday, October 26, 2006

Nierenberg Investment Raises Stake in Electro Scientific Industries (ESIO) to 9.4%

In an amended 13D filing on Electro Scientific Industries Inc. (Nasdaq: ESIO), Nierenberg Investment Management disclosed an 9.4% stake (2.74 million shares) in the company. This is up from the 8.3% stake the investment firm disclosed in a past 13D filing.

The firm said they continue to believe that there is a substantial gap between ESIO's current market value and its intrinsic value.

The firm disclosed a recent conversation with the Chairman and a separate conversation with the CEO, CFO, and the company's Director of Corporate Development and Investor Relations.

The firm said they believe that the combination of more proactive communications with the investment community and increased director ownership of ESIO stock could ultimately drive ESIO's share price closer to the company's intrinsic value.

From Item 4 of the Filing: Purpose of Transaction:

The reporting persons acquired the shares because we continue to believe that there is a substantial gap between ESIO's current market value and its intrinsicvalue. We believe this valuation gap persists even though the company has finemanagement, a fine board, a sound business strategy, leading market shares inits major business units, an attractive long term growth rate, and a fortress balance sheet.

In a friendly and constructive spirit, we have recently shared several ideas with the company in the hope that these ideas might, over time, help close the gap between ESIO's market and intrinsic value. This dialogue occurred in two conversations, summarized below, subsequent to ESIO's annual shareholder meetingof October 5, one with the Chairman of the Board of Directors and the other with the CEO, CFO, and the company's Director of Corporate Development and Investor Relations.

In our conversation with the Chairman, we noted that, according to ESIO's most recent proxy statement, none of the company's outside directors owned out rightany shares of the company's stock. We also expressed our belief that the financial community appears to attribute little value to ESIO's approximately$7.50 per share in cash when valuing the company. Finally, we noted how challenging it is for the company to earn a mid teen's return on equity (whichwe consider achievable) when half the company's equity sits on its balance sheet in cash and marketable securities which earn only a 5% pre-tax return.

We suggested to the Chairman that the ESIO board consider mandating that each outside director ultimately, over a period of time, hold a significant personal investment in the company's shares, which could be purchased in the open market or earned through board service in lieu of cash fees. We believe large director shareholding could more closely align the interests of the company's directors and shareholders and perhaps heighten urgency about driving ESIO to attain amid-teens return on equity. We believe that doing this could help close the gap between ESIO's market and intrinsic value.

Our separate conversation with the CEO, CFO and Director of Corporate Development and Investor Relations pertained to several other investors' apparent disappointment with ESIO's recently reported quarterly results. Duringt he company's earnings conference call, several investors expressed surprise and displeasure with the company's revenue guidance, both relative to their expectations and to the company's prospective shipments. This negative reaction was unfortunate because it appears to us that ESIO's several years of investing heavily in Research & Development is beginning to pay off in new products, increased customer penetration, market share gains, improved revenue growth, and widening margins.

The purpose of our conversation, however, was to suggest to management that the shareholders' disappointment with the company's revenue guidance was neither unreasonable nor unforeseeable. After all, investors have two fundamental preferences: they prefer linear growth over lumpy growth and they hate surprises.

Legitimate investor expectations about linear revenue growth create a challengefor ESIO for three reasons: (1) many ESIO products carry seven figure pricetags, which means that small variations in the number of units shipped in aquarter can drive significant near term revenue fluctuations; (2) ESIO sells to a highly concentrated set of customers, which means that small near term variations in ordering by a single customer can drive significant near term revenue fluctuations; and (3) ESIO is introducing many big ticket new products which customers will test thoroughly before accepting and paying for the products.

Therefore we advised ESIO management that they should bend over backwards to remind investors that these innocent factors can cause meaningless near term fluctuations in sequential revenue growth while the company can neverthelessremain on a healthy 15% + long term growth trajectory. In addition, we suggested that ESIO management consider guiding and characterizing financial results lessby individual quarter and more in terms of multi-quarter moving averages which could help smooth over insignificant near term fluctuations. Our belief is that such proactive investor communication could avoid the disappointment which occurred in the most recent earnings call.

In conclusion, we believe that the combination of more proactive communications with the investment community and increased director ownership of ESIO stock could ultimately drive ESIO's share price closer to the company's intrinsic value.

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