VEECO INSTRUMENTS INC.

INDEX

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PART I. FINANCIAL INFORMATIONPart I. Financial Information

Item 1. Financial Statements (Unaudited)

Veeco Instruments Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(In thousands, except per share data)
(Unaudited)

See accompanying notes.

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exercise stock options),three months ended March 31, 2006, the Company did not recognize any amount of consolidated operatingfinancing cash flows for such excess tax deductionsdeductions.

Total stock-based compensation expense is attributable to the remaining requisite service periods of stock options and restricted common stock awards. For the three months ended March 31, 2006, there were no new share-based awards granted. The impact of adopting  SFAS No. 123(R) was a charge of $0.1 million or less than $0.01 per diluted share for the three months ended March 31, 2006. As of March 31, 2006, the total unrecognized compensation cost related to nonvested stock awards and option awards is $0.6 million and $1.1 million, respectively, and the related weighted average period over which it is expected that such unrecognized compensation costs will be recognized is approximately 2.6 years. The impact of future share-based awards will depend on levels of share-based payments granted in the future and, therefore, cannot be predicted at this time.

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Prior to the Company’s adoption of SFAS No. 123(R), SFAS No. 123 required that the Company provide pro forma information regarding net loss and loss per share as if compensation cost for the Company’s stock-based awards had been determined in accordance with the fair value method prescribed therein. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions, under which compensation expense would be recognized as incurred, of SFAS No. 123, to stock-based employee compensation.

Recent Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, Inventory Costs- an amendment to ARB No. 43, Chapter 4. SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal,” as previously stated in ARB No. 43. In addition, this Statement requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company adopted this Statement on January 1, 2006 and such adoption did not result in a significant impact on the Company’s consolidated financial position or results of operations.

Note 2—Share-Based Payments

Option Plans

The Company has four stock option plans. The Veeco Instruments Inc. 2000 Stock Incentive Plan, as amended, (the “2000 Plan”), was approved by the Board of Directors and shareholders in May 2000. The 2000 Plan provides for the grant to officers and key employees of up to 8,530,000 options (2,049,307 options are available for future grants as of March 31, 2006) to purchase shares of common stock of the Company. Stock options granted pursuant to the 2000 Plan expire after seven years and generally become exercisable over a three-year period following the grant date. However, grants made under the 2000 Plan between June 17, 2005 and December 23, 2005 became exercisable on or before December 31, 2005, and are subject to a resale restriction which provides that the shares issuable upon exercise of the option may not be transferred prior to the second anniversary of the option grant date. In addition, the 2000 Plan provides for automatic annual grants of restricted stock to each member of the Board of Directors of the Company who is not an employee of the Company. Up to 1,700,000 of the awards authorized under the 2000 Plan may be issued in the form of restricted stock. In October 2005, the Company granted 45,000 shares of restricted common stock, resulting in stock-based compensation expense of approximately $0.1 million or ($0.0) per common share for the three months ended March 31, 2006. These shares of restricted common stock vest over three years and will result in additional stock-based compensation expense of approximately $0.6 million.

The Veeco Instruments Inc. 2000 Stock Option Plan for Non-Officer Employees (the “Non-Officer Plan”) was approved by the Board of Directors in October 2000. The Non-Officer Plan provides for the grant of stock options to non-officer employees to purchase shares of common stock of the Company. Stock options granted pursuant to the Non-Officer Plan become exercisable over a three-year period following the grant date and expire after seven years.

The Veeco Instruments Inc. Amended and Restated 1992 Employees’ Stock Option Plan (the “1992 Plan”) provides for the grant to officers and key employees of stock options to purchase shares of common stock of the Company. Stock options granted pursuant to the 1992 Plan become exercisable over a three-year period following the grant date and expire after ten years.

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The Veeco Instruments Inc. 1994 Stock Option Plan for Outside Directors, as amended, (the “Directors’ Option Plan”), provides for automatic annual grants of stock options to each member of the Board of Directors of the Company who is not an employee of the Company. Such options are exercisable immediately and expire after ten years.

The Non-Officer Plan, the 1992 Plan and the Directors’ Option Plan have been frozen; and, thus, there are no options available for future grant as of March 31, 2006 under these plans.

In addition to the four plans, the Company assumed certain stock option plans and agreements relating to the merger in September 2001with Applied Epi, Inc. (“Applied Epi”). These stock option plans do not have options available for future grants and expire after ten years from the date of grant. Options granted under two of the plans vested over three years and options granted under one of the plans vested immediately. As of March 31, 2006, there are 208,093 options outstanding under the various Applied Epi plans. In addition, Veeco assumed certain warrants related to Applied Epi, which were in effect prior to the merger with Veeco. These warrants expired in February 2006. In May 2000, the Company assumed certain stock option plans and agreements related to CVC, Inc. and Commonwealth Scientific Corporation, a subsidiary of CVC, Inc., which were in effect prior to the merger with Veeco. These plans do not have options available for future grants, the options granted thereunder generally vested over a three-to-five year period and expire five to ten years from the date of grant. As of March 31, 2006, there are 9,438 options outstanding under the various CVC, Inc. and Commonwealth Scientific Corporation plans.

With the adoption of SFAS No. 123(R) on January 1, 2006, the Company is required to record the fair value of stock-based compensation awards as an expense. In order to determine the fair value of stock options on the date of grant, the Company applies the Black-Scholes option-pricing model. Inherent in the model are assumptions related to expected stock-price volatility, option life, risk-free interest rate and dividend yield. While the risk-free interest rate and dividend yield are less subjective assumptions, typically based on factual data derived from public sources, the expected stock-price volatility and option life assumptions require a level of judgment which make them critical accounting estimates.

For the three months ended March 31, 2006, there were no new options granted. Beginning in the fourth quarter of 2005, the Company used an expected stock-price volatility assumption that is a combination of both historical and implied volatilities of the underlying stock, which are obtained from public data sources. Prior to that time, the Company based this assumption solely on historical volatility.

With regard to the weighted-average option life assumption, the Company considers the exercise behavior of past grants and models the pattern of aggregate exercises.

The fair value of each option grant that was unvested as of January 1, 2006, was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

A summary of the Company’s stock option plans as of and for the three months ended March 31, 2006 is presented below:

The weighted-average grant date fair value of stock options granted for the three months ended March 31, 2005 was $7.39. The total intrinsic value of stock options exercised during the three months ended March 31, 2006 and 2005 was $0.4 million and $0.1 million, respectively.

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The following table summarizes information about stock options outstanding at March 31, 2006:

On April 12, 2005, the Compensation Committee (the “Committee”) of the Company’s Board of Directors approved the acceleration of vesting for unvested, out-of-the-money stock options granted under the Company’s stock option plans prior to September 1, 2004.  An option was considered out-of-the-money if the option exercise price was greater than the closing price of the Company’s common stock on the NASDAQ National Market on April 11, 2005 ($15.26), the last trading day before the Committee approved the acceleration.  As a result of this action, options to purchase approximately 2,522,000 shares of the Company’s common stock became immediately exercisable, including options held by the Company’s executive officers to purchase approximately 852,000 shares of common stock.  The weighted average exercise price of the options for which vesting was accelerated was $21.24.

The purpose of the accelerated vesting was to avoid future compensation expense associated with these options that the Company would otherwise recognize in its Consolidated Statements of Operations upon the adoption of SFAS No. 123(R) (see Note 1). In addition, many of these options had exercise prices significantly in excess of current market values and were not providing an effective means of employee retention and incentive compensation.  Based on the Company’s implementation date for SFAS No. 123(R) of January 1, 2006, the Company will not incur future compensation expense of approximately $7.9 million in 2006 and $3.6 million in 2007.

Employee Stock Purchase Plan

Under the Veeco Instruments Inc. Amended and Restated Employee Stock Purchase Plan (the “ESP Plan”), the Company is authorized to issue up to 2,000,000 shares of common stock to its full-time domestic employees, nearly all of whom are eligible to participate. Under the terms of the ESP Plan, employees can choose to have up to 10% of their annual base earnings withheld to purchase the Company’s common stock. The purchase price of the stock as of December 31, 2005 was 95% of the end-of-offering period market price and qualifies as a noncompensatory employee stock purchase plan under Section 423 of the Internal Revenue Code.

Shares Reserved for Future Issuance

As of March 31, 2006, the Company has reserved the following shares for future issuance related to:

Preferred Stock

The Board of Directors of the Company has authority under the Company’s Certificate of Incorporation to issue shares of preferred stock with voting and economic rights to be determined by the Board or Directors.

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Note 3—Balance Sheet Information

Inventories

Interim inventories have been determined by lower of cost (principally first-in, first-out) or market. Inventories consist of:

Accrued WarrantiesWarranty

The Company estimates the costs that may be incurred under the warranty it provides and recordsrecognizes a liability in the amount of such costs at the time the related revenue is recognized. Factors that affect the Company’s warranty liability include product failure rates, material usage and labor costs incurred in correcting product failures during the warranty period. The Company periodically assesses the adequacy of its recordedrecognized warranty liability and adjusts the amount as necessary. Changes in the Company’s warranty liability during the period are as follows:

Note 4—Segment Information

During the three months ended March 31, 2006, the Company changed its management structure in a manner that caused the composition of its reportable segments to change. The Company currently uses threemanages the business, reviews operating results and assesses performance, as well as allocates resources, based upon two separate reporting segments to managesegments. The Company merged the business, review operating results, assess performanceformer Ion Beam and allocate resources.Mechanical Process Equipment segment and the Epitaxial Process Equipment segment into one reporting segment. The firstnew Process Equipment segment called “ion beam and mechanical process equipment,” combines the etch, deposition, and dicing and slicing products sold mostly to data storage customers. This segment includes production facilities in Plainview, New York, Ft. Collins, Coloradocustomers and Camarillo, California. The second segment, called “epitaxial process equipment,” includes the molecular beam epitaxy and metal organic chemical vapor deposition products primarily sold to high brightness light emitting diode and wireless telecommunications customers. This segment includes production facilities in Plainview, New York, Ft. Collins, Colorado, Camarillo, California, St. Paul, Minnesota and Somerset, New Jersey. The thirdMetrology segment called “metrology,”remains unchanged and represents equipment that is used to provide critical surface measurements on products such as semiconductor devices and thin film magnetic heads and includes Veeco’s broad line of atomic force microscopes, optical interferometers and stylus profilers sold to semiconductor customers, data storage customers and thousands of research facilities and scientific centers. This segment includes production facilities in Santa Barbara, California and Tucson, Arizona. Accordingly, the Company has restated segment information for the prior period presented.

The Company evaluates the performance of its reportable segments based on income or loss from operations before interest, income taxes and amortization (“EBITA”). The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Costs excluded from segment profit primarily consist of interest, amortization, income taxes, corporate expenses, as well as other unusual charges for purchased in-process technology, restructuring and asset impairment charges and merger-related costs. Corporate expenses are comprised primarily of general and administrative expenses.

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The following table outlines the components of net goodwill by business segment at September 30, 2005 and December 31, 2004 (in thousands):

Note 5—Comprehensive Income (Loss)

TheTotal comprehensive income (loss) was $0.5 million and ($6.3) million for the three months ended March 31, 2006 and 2005, respectively. For the three months ended March 31, 2006 and 2005, respectively, the Company’s comprehensive income (loss) is comprised of net income (loss), adjusted forloss and foreign currency translation adjustments. The Company had no other sources affecting comprehensive income (loss).  The Company had total comprehensive income (loss) of $0.9 million and ($7.8) million for the three and nine months ended September 30, 2005, respectively, and ($2.3) million and ($7.0) million for the three and nine months ended September 30, 2004, respectively. during these periods.

Note 6—RestructuringOther Matters

As of March 31, 2006, the Company has outstanding $200.0 million of 4.125% convertible subordinated notes. During the three months ended March 31, 2006, the Company repurchased $20.0 million of its notes, reducing the amount outstanding from $220.0 million to $200.0 million. The repurchase amount was $19.5 million in cash, of which $19.4 million related to principal and $0.1 million related to accrued interest. As a result of the acquisitions of Manufacturing Technology Inc. and Advanced Imaging Inc. and the resulting plan of consolidation of the two facilities in Ventura and Camarillo, California, certain long-lived assets of Advanced Imaging, Inc. were classified as held for sale as of December 31, 2004. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, these long-lived assets were measured at the lower of their carrying amount or fair value less cost to sell.  Fair value was determined byrepurchase, the Company based uponrecorded a gain from the actual sale proceeds, which were received in February 2005 and April 2005. Approximately $2.2 millionearly extinguishment of fixed assets held for sale are included in prepaid expenses and other current assetsdebt in the accompanying Condensed Consolidated Balance Sheets at December 31, 2004.amount of $0.6 million, offset by a $0.3 million proportionate reduction in the related deferred financing costs for a net gain of $0.3 million.

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A reconciliation of the liability for the merger and2005 restructuring charges during 2004 relating tocharge for severance and investigation costs is as follows (in millions):

13Note 7—Subsequent Event and Related Party Transaction

In May 2006, Veeco invested $0.5 million to purchase 19.9% of the common stock of Fluens Corporation (“Fluens”).  Approximately 31% of Fluens is owned by a Vice President and General Manager of Veeco.  Veeco and Fluens plan to jointly develop a next-generation process for high-rate deposition of aluminum oxide for data storage applications.  If this development is successful and upon the satisfaction of certain additional conditions, Veeco will be obligated to buy the balance of the outstanding stock of Fluens for $3.0 million plus an earn-out.  In April 2006, Veeco issued a $0.8 million purchase order to Fluens for a reactive sputtering deposition system.  Veeco had advanced approximately $0.1 million against this purchase order in March 2006.

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•        Net loss of $3.6 million, compared with a net loss of $6.5 million in the first nine months of 2004.

•        Cash and cash equivalents increased $11.4 million, after the effect of making earn-out payments during the first quarter totaling $15.0 million relating to acquisitions, compared with an increase of $4.2 million in the first nine months of 2004, after the effect of making an earn-out payment of $1.0 million.

Current Business Conditions/Outlook:

In the first nine monthsquarter of 2005,2006, Veeco reported sales of $297.3$93.9 million, a 3.4% increase from the $287.5 million reported in the first nine months of 2004. Veeco’s bookings were $302.0 million, down from the $321.3 million reported in the first nine months of 2004.  Third quarter orders were $84.6 million, up 6.4% over theflat compared with prior year butfirst quarter sales. As anticipated, revenues were down 28.7% sequentially from the strong $118.6$112.8 million Veeco booked in the second quarter of this year.  We had forecasted that third quarter bookings would be weak following the strong second quarter, but orders were about 10.0% lower than anticipated.  We expect an improvement in fourth quarter orders, currently forecasted to be between $90-100 million.  During the third quarter we experienced some seasonality due to customer vacation shut downs, and in previous years we have seen that this seasonality effect improves in the fourth quarter.  In particular, we expect orders to improve in the fourth quarter from our data storage, semiconductor and scientific research markets.  As a result of the weak third quarter booking rate, Veeco is reducing its headcount by approximately 5.0% in the fourth quarter, with many actions having already been taken.

For the 2005 year, Veeco had forecasted that its revenues would be flat to modestly higher than the previous year, and that the Company would focus on improving its profitability.  This plan, which is expected to be met for the year, is based upon headcount

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reductions as well as a product mix expectation for 2005 revenues that has led to, and we expect will continue to lead to, increased gross margins.  The Company currently expects higher 2005 revenues in ion beam products, lower 2005 revenues in epitaxial equipment products and growth in its metrology revenues as compared to 2004.  This revenue mix change, as well as other factors such as improved pricing and volume increases in some product lines was expected, and has resulted in higher gross margins in each subsequent quarter of 2005 compared with 2004.  In the third quarter, Veeco reported its fourth consecutive quarter with gross margin improvements of approximately two percentage points per quarter.  Veeco’s third quarter gross margins improved to 44.2%, up about eight percentage points from the third quarter of 2004 and about two percentage points higher than the second quarter of 2005.  Veeco currently expects gross margins to increase again in the fourth quarter of 2005, as compared toa result of the Company’s low order rate of $84.6 million during the third quarter of 2005.

Veeco’s first quarter 2006 bookings were $126.7 million, reflecting double digit market growth in data storage and in HB-LED/wireless. First quarter orders were the highest quarterly level the Company has experienced in five years. Within the  strong order rate, Veeco’s data storage orders increased 55% from the prior year to a record $70.4 million. Another area of strength was in HB-LED/wireless, which reported orders of $24.3 million, up 74% from the prior year. The strong first quarter 2006 order rate reflects market growth in embedded storage for consumer electronic applications, the hard drive industry’s investment in capacity requirements as well as technology changes such as perpendicular recording, and the beginning of HB-LED backlighting for emerging applications such as flat panel televisions.

In 2006, Veeco is continuing its strategy for growth as well as its focus on improving profitability and gross margin performance. For the remainder of 2006, the Company currently anticipates positive market conditions across core markets (data storage, HB-LED/wireless, semiconductor and scientific research), which, combined with significant new product introductions expected from both the Process Equipment and Metrology business units, should provide an opportunity for revenue growth. Veeco has forecasted that revenues will grow 8-10% in 2006 to $440-$450 million. In addition, consumer spending on many types of electronics has increased and various worldwide regions, such as the Asia Pacific region, are experiencing growth. The Company reviews a number of indicators to predict the strength of its markets going forward. These include plant utilization trends, capacity requirements and capital spending trends. At the beginning of 2006, many of these trends appear positive.

Technology changes are continuing in all of Veeco’s markets: the continued ramp upincrease of capacity for 80 GB hard drives and investment in 120 GB hard drives in data storage and investmentsstorage; the increased use of “mini” drives in next generation drives for smaller form factor hard disk drive consumer deviceelectronic applications; the increased use of Veeco’s automated AFMs for 9065 nanometer and below semiconductor applications; the opportunity for Veeco’s MOCVD and MBE products to further penetrate the emerging wireless and HB-LED and wireless market; andmarkets. Veeco believes that these changes, together with the continued funding of nanoscience research, which is one driver of Veeco’s scientific research business.  While Veeco’swill prompt our customers remain cautious regarding capital spending, they are placing orders for certain of Veeco’s process equipmentto seek our next-generation solutions to address their manufacturing and metrology products that enable the production of their next generation products.  Veeco remains well positioned to provide leadership technologies for growth applications in semiconductor, data storage, HB-LED/wireless and scientific research.  While 2005 will be a relatively flat year with significantly improved profitability compared to 2004, we currently forecast that 2006 will be a growth year for the company driven by new Veeco product introductions in Ion Beam, Epitaxial and Metrology, which address the multi-market growth opportunities outlined above.  Veeco currently intends to maintain its focus on gross margin and profitability improvements into 2006.technology challenges.

15The Company’s goal is to continue to increase gross margins in 2006, with improvements in both Process Equipment and Metrology. Veeco has forecasted that gross margins will increase three percentage points from 42% in 2005 to approximately 45% in 2006. Veeco anticipates that progress in this area will continue to come from the introduction of new products with higher gross margins, as well as activities such as better supply chain management, including outsourcing of new products and development of common hardware and software platforms.

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