ORBK Orbotech Ltd. - Ordinary Shares

5.A    Operating Results

(a)    General

Orbotech is an Israeli corporation with three reportable operating segments: (i) Production Solutions for the Electronics Industry; (ii) Recognition Software; and (iii) Medical Imaging. The Company is principally engaged in the design, development, manufacture, marketing and/or service of yield-enhancing and production solutions for specialized applications in the supply chain of the electronics industry. The Company’s products for the electronics industry are primarily AOI and process control systems, and imaging and CAM solutions, principally for application in the production of PCBs and FPDs. Through Orbograph, the Company develops and markets character recognition solutions to banks and other financial institutions and has developed a proprietary technology for web-based, location-independent data entry for check processing and forms processing. Through DDD and OMS, the Company is engaged in the research and development, manufacture and sale of specialized products for application in medical nuclear imaging.

The Company derives revenues from two sources: (i) sales of the Company’s products; and (ii) services provided with respect to the Company’s products. In 2007, 2006 and 2005, revenues derived from sales of products constituted approximately 74%, 80% and 80%, respectively, of the Company’s total revenues, with the remaining revenues being derived from service for product support. During 2007, approximately 92% of revenues from both product sales and service were derived from product lines related to the Company’s yield-enhancement and production solutions for the electronics industry, and the balance from product lines related to recognition software and medical imaging. During each of 2006 and 2005, approximately 97% of revenues from both product sales and service were derived from product lines related to the Company’s production solutions for the electronics industry, and the balance principally from product lines related to recognition software. The Company expects that revenues from its products for the electronics industry will continue to account for a predominant portion of total sales and service revenues in the near future. Most of the Company’s revenues are derived from repeat sales to existing customers, and the Company expects that repeat sales will continue to account for a significant portion of such revenues in the future. See Note 13a to the Financial Statements for a description of each segment and information as to segment revenues, operating income or loss, assets and related data.

The currency of the primary economic environment in which the operations of the Company and its subsidiaries (other than DDD) are conducted is the U.S. Dollar. Virtually all of the Company’s sales are made outside Israel in non-Israeli currencies, mainly the U.S. Dollar, and most of its purchases of materials and components are made, and most marketing and service costs are incurred, outside Israel in non-Israeli currencies, primarily the U.S. Dollar. Thus, the functional currency of the Company and its subsidiaries (other than DDD) is the U.S. Dollar. The functional currency of DDD is the Euro, since virtually all of its revenues are received in Euros.

(b)    U.S. GAAP

The Company’s financial statements are prepared in accordance with U.S. GAAP. Nevertheless, having been advised by the SEC that its staff does not object to the Company’s so doing, the Company accounts for Frontline using the proportionate method of consolidation, including summarized footnote disclosures of the amounts proportionately consolidated, rather than the equity method as is called for under U.S. GAAP pursuant to Accounting Principles Board (“ APB ”) Opinion No. 18.

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(c)    Critical Accounting Policies

To improve understanding of the Company’s financial statements, it is important to obtain some degree of familiarity with the Company’s principal or significant accounting policies. These policies are described in Note 1 to the Financial Statements. The Company reviews its financial reporting, disclosure practices and accounting policies annually to ensure that the Financial Statements, which are developed on the basis of these accounting policies, provide complete, accurate and transparent information concerning the financial condition of the Company. As part of this process, the Company has reviewed the selection and application of its critical accounting policies and financial disclosures as at December 31, 2007, and it believes that the Financial Statements present fairly, in all material respects, the consolidated financial position of the Company as at that date.

In preparing the Financial Statements in accordance with U.S. GAAP, the Company’s management must often make estimates and assumptions, which may affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures as at the date of the financial statements and during the reporting period. Some of those judgments can be subjective and complex, and consequently actual results may differ from those estimates. For any given individual estimate or assumption made by the Company, there may be alternative estimates or assumptions which are also reasonable. However, the Company believes that, given the facts and circumstances before it at the time of making the relevant judgments, estimates or assumptions, it is unlikely that applying any such other reasonable judgment would cause a material adverse effect on the Company’s consolidated results of operations, financial position or liquidity for the periods presented in the Financial Statements.

The Company is also subject to risks and uncertainties that may cause actual results to differ from estimates and assumptions, such as changes in the economic environment, competition, foreign exchange, taxation and governmental programs. Certain of these risks, uncertainties and assumptions are discussed under the heading Cautionary Statement Regarding Forward-Looking Information and in Item 3.D—Risk Factors.

The Company considers its most significant accounting policies to be those discussed below.

(i)    Revenue Recognition

The Company recognizes revenue from sale of products to end users upon delivery, provided that appropriate signed documentation of the arrangement exists, such as a signed contract, purchase order or letter of agreement, the fee is fixed or determinable and collectibility is reasonably assured. If the Company determines that any of these criteria have not been met, revenue recognition is deferred until all of these criteria have been met. The Company does not, in the normal course of business, provide a right of return to its customers.

The Company implements Emerging Issues Task Force (“ EITF ”) Issue 00-21, ‘Revenue Arrangements with Multiple Deliverables’, which deals with the accounting by a vendor for contractual arrangements involving multiple revenue-generating activities to be performed by it, addressing when, and if so how, an arrangement involving multiple deliverables should be divided into separate units of accounting. In such situations, revenue is recognized upon delivery of the separate elements. Multiple element arrangements are treated as follows: (a) the arrangement is divided into ‘delivered’ and ‘undelivered’ elements; (b) revenue is allocated to undelivered elements based on the fair value of each such element; and (c) the residual amounts of revenue are allocated to delivered elements. This accounting treatment is applied if the undelivered elements have value on a stand alone basis, there exists objective and reliable evidence of fair value for the undelivered elements, the arrangement does not include a general right of return with respect to delivered items and delivery or performance of undelivered items is considered probable and is substantially within the Company’s control. The maximum revenue recognized on a delivered element is limited to the amount that is not contingent upon the delivery of additional items.

Installation and training are not considered essential to the product capabilities since they do not require specialized skills and can be performed by other vendors. Accordingly, upon delivery, the Company defers

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revenue in an amount equivalent to the fair value of installation and training and recognizes those deferred revenues once installation and training has been completed.

The Company grants its customers a warranty, usually for a period of six to twelve months, on systems sold. Upon revenue recognition, the Company records as ‘deferred revenue relating to warranty commitments’ a portion of the sale price that relates to the fair value of the work expected to be performed during the warranty period (based on past experience) and recognizes it as service revenue ratably over the warranty period. After the warranty period, service revenue in respect of the Company’s systems is recognized ratably over the contractual period or as services are performed. Annual service fees are generally based on the list price of the Company’s products. It has been the Company’s experience that many of its customers elect to receive maintenance services from the Company on a continuing contractual basis after the conclusion of the warranty period.

In circumstances where the product has been delivered but revenue deferred pending acceptance, principally in the case of newly developed products, the Company records the net proceeds it has received as a current liability under deferred income. The deferred income balance equals the amount of deferred product revenue that has been received less the cost of the delivered products. The cost of the delivered products is offset from deferred revenue, and not presented as inventory—finished products, since title passes to the customer upon delivery. Upon acceptance the related deferred income is recognized.

The Company recognizes revenue from sale of software to end users upon delivery, provided that appropriate signed documentation of the arrangement, such as a signed contract, purchase order or letter of agreement, has been received, the fee is fixed or determinable, and collectibility is probable. When software is made available to customers electronically, it is deemed to have been delivered when the Company has provided the customer with the access codes necessary to enable immediate possession of the software. If collectibility is in question, revenue is recognized when the fee is collected.

Maintenance revenues are comprised of revenue from support arrangements that include technical support and the right to unspecified upgrades on an if-and-when-available basis. Revenues from these services are deferred and recognized on a straight-line basis, over the life of the related agreement, which is typically one year.

(ii)    Inventory Valuation

Inventories are valued at the lower of cost or market value. Cost is determined as follows: components—on the moving average basis; labor and overhead—on the basis of actual manufacturing costs. If actual market conditions prove less favorable than those projected by management, additional inventory write-downs may be required. Inventories are written down for estimated obsolescence based upon assumptions about future demand and market conditions. Likewise, favorable future demand and market conditions could positively impact future operating results if inventory that has been written down is sold.

(iii)    Allowance for Doubtful Accounts

The Company performs ongoing credit evaluations of its customers for the purpose of determining the appropriate allowance for doubtful accounts. In respect of sales to customers in emerging economies, the Company generally requires letters of credit from banks. The allowance for doubtful accounts is determined for specific debts the collection of which is doubtful.

(iv)    Liability for Employee Rights upon Retirement

The Company does not have any obligations to its employees upon retirement which are not fully provided for in the Financial Statements. In accordance with labor laws and agreements in force with respect to its Israeli and Japanese employees, the Company has liability for severance pay upon retirement, and the Company fully

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records such obligations at each balance sheet date on an undiscounted basis, based on salary components which, in management’s opinion, create entitlement to severance pay. The severance pay liability of the Company and its Israeli subsidiaries to their Israeli employees, based upon the number of years of service and the latest monthly salary, is in large part covered by regular deposits with recognized pension funds, deposits with severance pay funds and purchases of insurance policies. See Note 6 to the Financial Statements.

The Company has not undertaken to provide any post-retirement health benefits to its employees.

(v)    Taxes on Income

Taxes on income are calculated based on the Company’s assumptions as to its entitlement to various benefits under the Approved Enterprise Law. The Company’s entitlement to such benefits is conditional upon its compliance with the terms and conditions prescribed in this law. In the event of its failure to do so these benefits may be cancelled and the Company may be required to refund the amount of the benefits already received, in whole or in part, with the addition of Israeli CPI linkage differentials and interest. The Approved Enterprise Law was amended in 2005; however, these amendments do not impact the status or benefits applicable to the Company’s Approved Enterprises that were approved prior to 2005. The termination or curtailment of the Approved Enterprise Law or the loss or reduction of such benefits could increase the Company’s tax rates, thereby reducing its net profits or increasing its net losses, and could have a material adverse effect on the Company’s business, financial condition and results of operations.

Deferred income taxes are determined utilizing the asset and liability method based on the estimated future tax effects of differences between the financial accounting and tax bases of assets and liabilities under the applicable tax laws. Deferred income tax provisions and benefits are based on the changes in the deferred tax asset or tax liability from period to period. Valuation allowance is included in respect of deferred tax assets when it is considered more likely than not that such assets will not be realized. In the event that the tax assets are not realized, income tax expense would increase or, conversely, if the valuation allowance is overestimated, the Company would benefit from a future tax credit.

The Company may incur additional tax liability in the event of intercompany dividend distributions by its subsidiaries. Such additional tax liability in respect of non-Israeli subsidiaries has not been provided for in the Company’s financial statements, as the Company does not expect these subsidiaries to distribute dividends in the foreseeable future.

Taxes that would apply in the event of disposal of investments in subsidiaries have not been taken into account in computing deferred income taxes, as it is the Company’s intention to hold, and not to realize, these investments.

The Company may incur additional tax liability in the event of distribution of tax-exempt income. The Company intends permanently to reinvest the amounts of tax-exempt income of its Approved Enterprises and Benefiting Enterprises and does not intend to cause dividends to be distributed from such income. Therefore, no deferred taxes have been provided in respect of such tax-exempt income as the undistributed tax-exempt income is essentially permanent in duration. In April 2005, substantive amendments to the Approved Enterprise Law came into effect, which revised the criteria for investments qualified to receive tax benefits. These amendments do not apply to investment programs approved prior to January 1, 2005. Under the law as amended, eligible investment programs of the type in which the Company has participated in the past will now qualify for substantially similar benefits as a Benefiting Enterprise, to which the Company will be entitled subject to meeting certain criteria. This replaced the previous terminology of ‘Approved Enterprise’, which required pre-approval from the Investment Center of the Ministry of Industry, Trade and Labor of the State of Israel. As a result of these amendments, future tax-exempt income generated from Benefiting Enterprises under the provisions of the amended law will, if distributed upon liquidation or if paid to a shareholder for the purchase of his or her shares, be deemed distributed as a dividend and will subject the Company to taxes. Therefore, the

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Company may be required to record deferred tax liability with respect to such tax-exempt income, which would have an adverse effect on its results of operations. Since the Company will not be eligible to apply for Benefiting Enterprise status for its production facilities prior to the end of 2008, it has not recorded any such deferred tax liability in its consolidated financial statements for 2007.

(vi)    Amortization of Intangible Assets

Goodwill is not amortized but rather tested for impairment annually. The Company has identified its various reporting units, which consist of its operating segments, and has performed the necessary allocations of its intangible assets between goodwill and other intangible assets, mainly intellectual property. Changes in the fair value of the reporting units following material changes in the assumptions as to the future cash flows and/or discount rates could result in an unexpected impairment charge to goodwill. The Company performs its annual goodwill impairment test on September 30 of each year. On September 30, 2007, an impairment test was conducted on the unamortized goodwill, which led to the conclusion that the carrying value of goodwill allocated to OMS exceeded its fair value, and as a result goodwill in the amount of $3.4 million was written-off.

During 2007 the Company recorded a large increase to goodwill balance due to the acquisition of New System and DDD. As at December 31, 2007, after giving effect to the write-off of the goodwill of OMS, the Company’s goodwill of approximately $37.8 million was allocated as follows: approximately $19.7 million to the Production Solutions for the Electronics Industry segment and the balance of $18.1 million to the Medical Imaging segment, which includes DDD and OMS.

The Company’s acquired intangible assets other than goodwill, comprised primarily of intellectual property, are being amortized on a straight-line basis over a period of five years, based on past experience. If an event or a change in circumstances (such as a significant industry downturn, a significant decline in the market value of the Company or significant reductions in projected future cash flows) indicates that the carrying amount of such intangible assets may not be recoverable through undiscounted future cash flows, the carrying amount of these assets will be reviewed for impairment and, if necessary, written down to their estimated fair values. As a result of such a review, intangible assets of OMS in the amount of $1.3 million were written off during 2007. At December 31, 2007, after giving effect to this write-off, other intangible assets subject to amortization were approximately $29.2 million allocated as follows: approximately $4.2 million to the Production Solutions for the Electronics Industry segment and the balance of $25.0 million to the Medical Imaging segment. The amortization expense for 2007 totaled approximately $4.7 million and is anticipated to total approximately $3.9 million for 2008. For additional information concerning the write-off and the future effect on income of amortization of intangible assets, see Notes 1i, 1j and 5 to Financial Statements.

(vii)    Share-based Compensation

Prior to January 1, 2006, the Company accounted for employees’ share-based payment under the intrinsic value model in accordance with APB Opinion No. 25, ‘Accounting for Stock Issued to Employees’ (“ APB 25 ”), and related interpretations. In accordance with FAS 123, ‘Accounting for Stock-Based Compensation’ (“ FAS 123 ”), as amended by FAS No. 148, ‘Accounting for Stock-Based Compensation—Transition and Disclosure’, the Company disclosed pro forma information, assuming the Company had accounted for employees’ share-based payments using the fair value-based method defined in FAS 123.

Effective January 1, 2006, the Company adopted FAS 123(R), which supersedes APB 25 and related interpretations and amends FAS No. 95, ‘Statement of Cash Flows’. FAS 123(R) requires that awards classified as equity awards be accounted for using the grant-date fair value method. The fair value of share-based payment transactions is recognized as expense over the requisite service period, net of estimated forfeitures. The Company estimates forfeitures based on historical experience and anticipated future conditions.

In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“ SAB 107 ”). SAB 107 provides supplemental implementation guidance on FAS 123(R), including guidance on valuation methods, inventory

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capitalization of share-based compensation cost, income statement effects, disclosures and other issues. SAB 107 requires share-based payment to be classified in the same expense line items as cash compensation. The Company has applied the classification requirements of SAB 107 in its adoption of FAS 123(R).

The Company elected to recognize compensation cost for awards with only service conditions that have a graded vesting schedule using the accelerated multiple-option approach.

The Company elected to adopt the modified prospective transition method, permitted by FAS 123(R). Under such transition method, FAS 123(R) has been implemented as from the first quarter of 2006 with no restatement of prior periods. The valuation provisions of FAS 123(R) apply to new awards and to awards modified, repurchased or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service had not been rendered that were outstanding as of January 1, 2006 are recognized over the remaining service period using the grant-date fair value of those awards as calculated for pro forma disclosure purposes under FAS 123.

As a result of adopting FAS 123(R), income before taxes on income and net income in 2007 were each lower by $4.5 million ($3.4 million in respect of option grants and $1.1 million in respect of restricted share awards) than if the Company had continued to account for compensation for equity awards under APB 25. The corresponding aggregate amount in 2006 was $5.3 million. Compensation expense for equity awards in 2007 was allocated as follows: $0.4 million to cost of revenues: $1.1 million to research and development costs and $3.0 million to selling, general and administrative expenses. As a result of an election under Section 102 of the Israeli Income Tax Ordinance (New Version), 1961 (the “ Tax Ordinance ”), the Company generally will not be allowed to claim an expense for tax purposes. For further information see Item 6.E—Share Ownership—The 2000 Plan.

The unrecorded maximum compensation expense for equity awards outstanding at January 1, 2008 is estimated at approximately $7.9 million at that date (without taking into account forfeiture rates) and will be recorded in the consolidated financial statements for the following periods:

These amounts do not reflect the compensation cost of any awards granted commencing January 1, 2008, which will be reflected in future consolidated financial statements over the applicable vesting period in accordance with FAS 123(R).

Compensation expense relating to future equity awards will depend on a variety of factors including the level and type of future awards and their terms; valuation considerations such as expected option life, volatility of the market price of the Ordinary Shares and applicable interest rates; and future levels of forfeitures of such awards. The Company is not currently able to estimate the additional compensation expense from future grants but will examine carefully this expense and its relation to net income when making such grants.

For a discussion of modifications to the Company’s equity remuneration plans approved by shareholders in July 2005 prior to the adoption of FAS 123(R), see Item 6.E—Share Ownership.

(viii)    Adoption of FIN 48

Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, ‘Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109’ (“ FIN 48 ”). FIN 48 specifies how tax benefits

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for uncertain tax positions are to be recognized, measured and derecognized in financial statements; requires certain disclosures of uncertain tax positions; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim-period guidance, among other provisions. Only tax positions that meet the more likely than not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of FIN 48.

Prior to January 1, 2007, the Company provided for contingent tax liabilities in its financial statements, based on its assessments, on a case-by-case basis, as to whether the relevant tax liabilities were at least more likely than not of being realized, based on technical merits. The Company did not previously provide for interest which may be payable on such liabilities, and classified these provisions among ‘short-term liabilities’.

As a result of adopting FIN 48, as of January 1, 2007, the Company recognized a liability for unrecognized tax benefits in the amount of $896,000, representing mainly interest on contingent tax liabilities. This change was accounted for as a cumulative effect of a change in accounting principle that is reflected in the Financial Statements as a decrease in the balance of retained earnings as of January 1, 2007. In addition, pursuant to the provisions of FIN 48, on January 1, 2007, the Company reclassified its previously existing liability for unrecognized tax benefits, in the amount of $9.3 million, from current to non-current liabilities because payment is not anticipated within one year subsequent to the balance sheet date. This non-current liability is included in the consolidated balance sheet among long-term tax liabilities.

(d)    Newly Issued Accounting Pronouncements

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007), ‘Business Combinations’ (“ SFAS 141(R) ”). SFAS 141(R) changes the accounting for business combinations, including the measurement of acquirer shares issued in consideration for a business combination, the recognition of contingent consideration, the accounting for contingencies, the recognition of capitalized in-process research and development, the accounting for acquisition-related restructuring cost accruals, the treatment of acquisition related transaction costs and the recognition of changes in the acquirer’s income tax valuation allowance and income tax uncertainties. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early application is not permitted. The Company will be required to adopt SFAS 141(R) on January 1, 2009 in respect of business combinations entered into after that date.

In June 2007, the EITF reached a consensus on Issue No. 07-03, ‘Accounting for Nonrefundable Advance Payments for Goods or Services Received to Be Used in Future Research and Development Activities’ (“ EITF 07-03 ”). EITF 07-03 requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and amortized over the period that the goods are delivered or the related services are performed, subject to an assessment of recoverability. The provisions of EITF 07-03 will be effective for financial statements issued for fiscal years beginning after December 15, 2007, and interim periods within those fiscal years (January 1, 2008, for the Company). The provisions of EITF 07-03 are applicable for new contracts entered into on or after the effective date. Earlier application is not permitted. The Company is currently assessing the impact, if any, that EITF 07-03 may have on its results of operations and financial position.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, ‘The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115’ (“ SFAS 159 ”). SFAS 159 is expected to expand the use of fair value accounting but does not affect existing standards which require certain assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may choose, at its initial application or at other specified election dates, to measure eligible items at fair value and report unrealized gains and losses on items for which

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the fair value option has been elected in earnings at each subsequent reporting date. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years (January 1, 2008, for the Company). If the Company elects the fair value option for its existing assets and liabilities, the effect, as of the adoption date, shall be reported as a cumulative-effect adjustment to the opening balance of retained earnings. The Company is currently assessing the impact that SFAS 159 may have on its results of operations and financial position.

In September 2006, the FASB issued FAS No. 157, ‘Fair Value Measurements’ (“ FAS 157 ”). FAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements; however, it does not require any new fair value measurements. FAS 157 is effective for fiscal years beginning after November 15, 2007 (January 1, 2008, for the Company). Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including any interim financial statements for any period of that fiscal year. The Company is currently evaluating the impact, if any, of the provisions of FAS 157 on its financial position and results of operations.

In June 2006, the EITF reached a consensus on Issue No. 06-01, ‘Accounting for Consideration Given by a Service Provider to Manufacturers or Resellers of Equipment Necessary for an End-Customer to Receive Service from the Service Provider’ (“ EITF 06-01 ”). EITF 06-01 provides guidance on the accounting for consideration given to third party manufacturers or resellers of equipment which is required by the end-customer in order to utilize the service from the service provider. EITF 06-01 is effective for fiscal years beginning after June 15, 2007 (January 1, 2008, for the Company). An entity should recognize the effects of applying EITF 06-01 as a change in accounting principle through retrospective application to all prior periods unless it is impracticable to do so. The Company is currently assessing the impact that EITF 06-01 may have on its results of operations and financial position.

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(e)    Geographical Analysis; Worldwide Economic Situation; Cost of Revenues

(i)    Geographical Analysis and Worldwide Economic Situation

The following table sets forth the Company’s sales and service revenues by geographic area for the periods indicated:

Approximately 70% of the Company’s revenues from equipment sales and service during 2007 (compared to 76% during 2006 and 77% during 2005) were derived from the Far East, including approximately 32% from revenues in China, 14% from revenues in Taiwan, 11% from revenues in Japan and 10% from revenues in Korea. Of the Company’s revenues from equipment sales and service which were derived from the Far East in 2006, approximately 27% were from China, 17% were from each of Japan and Taiwan and 13% were from Korea. In addition, virtually all of the Company’s revenues from its gamma camera products during 2007, and from its automatic check reading products during 2007 and 2006, were derived from sales in North America. The Company monitors developments, including banking and currency difficulties, in the financial markets and economies of all countries and regions in which it markets its products and their possible impact upon the Company.

During 2007, the Company recorded significantly reduced revenues from Japan, Korea and Taiwan compared with the previous year, which was principally a function of the reduced demand for the Company’s FPD-AOI systems stemming, in turn, from the substantially lower levels of capital expenditure by FPD manufacturers in those countries. The decrease in revenues from China primarily reflected lower sales of assembled PCB-AOI equipment. The increase in revenues from North America was due primarily to the inclusion, for the first time, of revenues from sales of gamma cameras by DDD, as well as to the higher revenues from Orbograph, all of which were in the United States.

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During 2006, the Company benefited from increased levels of manufacturing activity for more technologically sophisticated PCB products in North America and Europe, as a result of which it recorded higher revenues from these regions. Revenues from China increased significantly compared with the previous year due to the higher levels of capital expenditure associated with the continued migration of PCB fabrication facilities to that country. Revenues from Japan also increased significantly during the year, as both PCB and FPD manufacturers further expanded their high-end manufacturing facilities to meet the demand for new and technologically advanced devices. However, revenues from Korea and Taiwan decreased significantly compared with 2005, reflecting lower capital expenditure by Korean and Taiwanese FPD manufacturers. Aggregate revenues from other Pacific Rim countries remained stable.

While the global electronics industry remains strong, the Company’s ability to foresee future changes in the total volume of orders for its products and services remains limited, particularly with respect to its PCB products. The inherent uncertainties associated with the global economic environment and the financial markets and economies of those countries in which the Company markets its products, together with the related possible changes in demand for its products, means that past operating results may not necessarily be indicative of the future. See Item 5.D—Trend Information.

(ii)    Cost of Revenues

(f)    Effective Corporate Tax Rate

The Company’s income tax obligations consist of those of the Company in Israel and those of each of its subsidiaries in their respective taxing jurisdictions.

Beginning January 1, 2003, the Company elected to exercise the option available to it under Israeli tax laws to calculate its taxable income in Dollars so as to reduce any potential exposure based on the differential between the change in the exchange rate of the Dollar to the New Israeli Sheqel (“ NIS ”) and the change in the Israeli CPI. The Company is now required to notify the Israeli income tax authorities, on an annual basis, if it wishes to renew this election, as it did for each of the subsequent years, up to 2007. For as long as the Company’s taxable income is measured in Dollars, its effective tax rate will be influenced mainly by: (a) the split of taxable income between the various tax jurisdictions; (b) the availability of tax loss carryforwards and the extent to which valuation allowance has been recorded against deferred tax assets; and (c) the portion of the Company’s income which is entitled to tax benefits due to those of its production facilities which are Approved Enterprises or Benefiting Enterprises.

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The combination of the above factors produced effective tax rates of 15.5%, 12.4% and 11.4% for the years 2007, 2006 and 2005, respectively.

See Item 4.B—Business Overview—Additional Considerations Relating to the Company’s Operations in Israel; Note 9 to the Financial Statements; and Taxes on Income.

(g) Impact of Inflation and Currency Fluctuations

The Dollar cost of the Company’s operations in Israel is influenced by the differential between the rate of inflation in Israel and any change in the value of the NIS in relation to the Dollar. The Company’s Dollar costs will increase if this ‘gap’ widens and Israeli currency is revalued or, if devalued, its devaluation rate fails to keep pace with the rate of inflation in Israel, and, conversely, the Company may benefit if Israeli currency devalues against the Dollar at a rate that exceeds the rate of inflation in Israel. In the years ended December 31, 2007, 2006, 2005, 2004 and 2003, the annual inflation rate in Israel as adjusted for the change in the rate of exchange of the Israeli currency in relation to the Dollar was 13.3%, 8.1%, (4.1)%, 2.8% and 5.7%, respectively. The closing representative exchange rate of the Dollar at the end of each such period, as reported by the Bank of Israel, was NIS 3.846, NIS 4.225, NIS 4.603, NIS 4.308 and NIS 4.379, respectively. The Company experienced increases in the Dollar costs of operations in Israel in 2007, 2006, 2004 and 2003, and a decrease in 2005. The changes in the Dollar cost of the Company’s operations in Israel relate primarily to the cost of salaries in Israel, which are paid in, and constitute a substantial portion of, the Company’s expenses in NIS. These NIS related expenses constituted approximately 27%, 25% and 23% of the total expenses of the Company for 2007, 2006 and 2005, respectively. There can be no assurance that the Company will not be materially adversely affected if Israeli currency is revalued in relation to the Dollar or, if devalued, inflation in Israel exceeds the devaluation of the NIS against the Dollar or if the timing of such devaluation lags behind increases in inflation in Israel. The representative exchange rate for converting NIS into Dollars, as published by the Bank of Israel on March 24, 2008, was NIS 3.523 = $1.00, compared with NIS 3.846 on December 31, 2007. See Item 5.D—Trend Information.

In addition, the Company receives most of its European revenues in Euros and its Japanese revenues in Japanese Yen; however, the Company’s expenses in Euros and Japanese Yen are generally less than its respective revenues in these currencies. The management of balances in Euros and Japanese Yen is conducted mainly through hedging agreements in an effort to reduce the effects of fluctuations in the exchange rate. See Item 11—Quantitative and Qualitative Disclosures about Market Risk. The Company’s cash reserves are held almost entirely in Dollars.

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(h)    Results of Operations

The following table sets forth certain financial data as a percentage of revenues for the periods indicated.

(i)    Year Ended December 31, 2007 Compared To Year Ended December 31, 2006

The Company’s financial results for 2007 reflected a very challenging year, as evidenced by the reduction in revenues, gross margins and net income compared to 2006. This resulted primarily from substantially lower demand for the Company’s FPD-AOI equipment which was, in turn, a function of a cyclical downturn, commencing in the latter part of 2006 and continuing through 2007, in the capital investment expenditures of FPD manufacturers. During 2007, the Company took important steps towards implementation of its strategy of expanding its product offerings from yield-enhancement to production solutions, in particular with the significant expansion of its installed base of direct imaging systems, the acquisition of New System, an Italian manufacturer of inkjet legend printers, and through increasing its investments in internal research and development programs oriented towards production solutions. The Company also took a significant step in the implementation of its strategy for diversification into new growth areas for imaging technologies through the acquisition of DDD, a Danish manufacturer of gamma cameras for use in nuclear cardiac imaging.

Revenues in 2007 totaled $360.7 million compared with $416.5 million in 2006. This decrease of approximately 13% was due primarily to a 50% reduction in sales and service revenues from the Company’s FPD-AOI systems; however, this was partially offset by revenues from DDD and by an increase in revenues

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from service activities, to a record $94.1 million from the $83.2 million recorded in 2006. The increase in service income reflects the Company’s continued success in securing service contracts for its steadily increasing global installed base of bare and assembled PCB-AOI systems.

Revenues from the sale and service of PCB-related equipment decreased by 2% to $268.4 million from the $273.7 million recorded in 2006. Of these revenues, $237.0 million, representing approximately 65% of the Company’s total revenues, was attributable to sales and service of equipment for bare PCBs and $31.4 million, representing approximately 9% of the Company’s total revenues, was attributable to sales and service of AOI systems for assembled PCBs. In 2006, $234.0 million of revenues, representing approximately 56% of the Company’s total revenues, was attributable to sales and service of systems for bare PCBs and $39.7million of revenues, representing approximately 10% of the Company’s total revenues, was attributable to sales and service of AOI systems for assembled PCBs.

During 2007, the Company sold approximately 450 Discovery PCB-AOI systems. In the second quarter, the Company introduced the Ultra-Discovery system for high-end applications, which is an important addition to the Discovery series, and which marked the completion of a long-term process of migration to a unified technological system platform for all of the Company’s PCB-AOI systems. This unified platform has resulted in more reliable and easier-to-maintain systems and, in turn, has led to improved cost efficiency for the Company. The Company sold 97 Paragon direct imaging systems, constituting a significant increase from the 75 sold during 2006. The continued industry-wide acceptance of these systems has reinforced the Company’s already strong position of leadership in the provision of AOI, imaging and process control systems for use in the manufacture of bare PCBs. The Company also recorded initial sales of the Maxiprint inkjet legend printers which were developed by New System.

Revenues during the year from sales of AOI systems for assembled PCBs decreased by approximately 21% from 2006. The Company’s revenues in this area continue to be adversely affected by the strongly competitive environment, which remains fragmented and characterized by a large number of relatively small suppliers.

Revenues from the sales and service of FPD-related equipment decreased by 50% to $64.5 million from the $129.1 million recorded in 2006. These revenues were severely impacted by a temporary downturn in the highly cyclical FPD industry and the resulting delay in capital investment by LCD manufacturers, as they rescheduled ‘move in’ dates for their new fabrication facilities to mid-2008 and beyond. However, in the fourth quarter of 2007, as a result of the strong demand for panels, particularly for LCD televisions, and the stabilization of panel prices during the latter part of 2007, the Company’s LCD manufacturing customers have reportedly finalized their plans for new fabrication facilities to be constructed during 2008 and 2009. This is reflected in the Company’s strong FPD bookings for these systems during the fourth quarter of 2007, primarily by way of large orders from first-tier LCD manufacturers. The Company remains at the forefront of development and production of state-of-the-art solutions for FPD manufacturers and, through its in-line and off-line products, continues to provide comprehensive yield-enhancement inspection solutions to meet the critical needs of these customers.

Revenues from the Company’s Recognition Software segment comprising automatic check reading products increased to $16.7 million in 2007 from $13.1 million in 2006, reflecting Orbograph’s continuing successes in diversifying its product portfolio, especially its OrboCAR and Apex Key-Pay technologies, which provide a highly efficient solution to check data entry by using a combination of artificial intelligence and human intervention. Operating income from this segment increased to $4.5 million from $3.0 million in 2006.

Revenues from the Company’s Medical Imaging segment predominantly comprising gamma cameras increased to $11.1 million in 2007 from $0.6 million in 2006. This increase is comprised, almost entirely, of revenues from DDD, which was acquired in August 2007, and develops, manufactures and sells gamma cameras for use in nuclear cardiac imaging, primarily in the United States through major industry suppliers that distribute them under their own brands. The Company believes that DDD is a world leader in the provision of such products.

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The decrease in the cost of products sold in 2007 of $17.3 million, or 5.6%, was principally a result of the $17.5 million decrease in expenditures on materials and components, resulting mainly from the decreased volume of products sold. Labor costs and overhead and other expenses remained stable.

During the second quarter of 2007, in connection with the introduction of the Ultra-Discovery system for high-end applications, the Company wrote-off $4.8 million of inventory primarily related to previous generation, high-end PCB products.

The cost of services rendered in 2007 increased by $1.0 million, or 1.5%, against an increase in revenues from services rendered of $11.0 million, or 13.2%. The cost of materials consumed increased by $3.5 million, reflecting the growing increased installed base of the Company’s direct imaging systems. However, this was offset by a decrease in overhead and other expenses of $2.8 million, which was a function of the more efficient utilization of the Company’s global customer support infrastructure and the increased use of regional response centers and remote diagnostics.

Gross profit for 2007 was $145.2 million, or 40.3% of revenues, compared to $189.6 million, or 45.5% of revenues, in 2006. Gross profit for 2007 from sales of equipment, excluding the inventory write-down, was $124.1 million, or 46.6% of product sales, compared to $173.7 million, or 52.1%, during 2006. The decrease in gross margins arose from the altered product mix (principally the reduced sales of FPD-AOI systems) and from the underutilization of the Company’s manufacturing capacity, as well as the first time inclusion in its results of DDD which, as an OEM, experiences substantially lower product gross margins than the Company’s products for the electronics industry. Gross profit for 2007 from services rendered was $25.9 million, or 27.5% of service revenues, compared to $15.9 million, or 19.1%, during 2006, reflecting the more efficient utilization of the Company’s global customer support infrastructure as noted above.

The increase in gross research and development expenditure, to $71.2 million in 2007 from $62.2 million in 2006, reflects the Company’s significant investment in new products and solutions for both the PCB and FPD industries, which continue to constitute the core of the Company’s business and to hold substantial opportunity. It also reflects the incorporation of the substantial research and development programs of the two companies acquired during the year, New System and DDD, which are expending significant sums on the development of inkjet printing and nuclear cardiac imaging products, respectively. During 2007, the Company received $3.2 million in Israeli Government participations in its research and development expenditures, compared to $1.7 million in 2006.

Selling, general and administrative expenses decreased by 2.8% to $67.0 million in 2007 from the $68.9 million recorded in 2006. This was partly due to a decrease of $1.1 million in the Company’s selling expenses resulting from the lower levels of revenues by the Company, and also included a decrease of $0.9 million in general and administrative expenses including bonuses, reflecting the lower level of activity and net income during 2007.

The amortization of other intangible assets during 2007 increased to $4.7 million from the $0.6 million recorded in 2006. The increase was a result of the $1.1 million amortization attributable to the allocated intangible assets arising from the acquisition of New System in May 2007, and the $3.0 million amortization attributable to the allocated intangible assets arising from the acquisition of DDD in August 2007. For further information concerning amortization expenses for 2007 and 2008, see Amortization of Intangible Assets.

In the fourth quarter of 2007 the Company incurred an impairment charge of $4.7 million relating to the goodwill and intellectual property of OMS associated with its CZT development and production business acquired in March 2005, following a determination that the carrying value of that goodwill and intellectual property exceeded its fair value.

During the fourth quarter of 2007, the Company also recorded a follow-on restructuring charge of $0.5 million in connection with its 2006 program to centralize assembled PCB research and development activities at

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corporate headquarters in Israel (compared to the original restructuring charge of $3.3 million in the fourth quarter of 2006). This charge is comprised of contingent payments due to certain employees who completed their outstanding obligations to the Company in December 2007. The remaining liabilities of $510,000 will be paid through the first quarter of 2008. This restructuring program resulted in an estimated $1.6 million annual cost reduction to the Company.

During 2007, the Company reported an operating loss from its Medical Imaging segment of $13.1 million based on revenues of $11.1 million, compared to an operating loss of $5.6 million in 2006 on revenues of $0.6 million. Excluding the OMS impairment and amortization charges, of $4.7 million and $0.6 million, respectively, and the $3.0 million amortization of intangible assets attributable to DDD, the operating loss for 2007 was $4.8 million, slightly less than the operating loss of $5.0 million for 2006 after excluding amortization of $0.6 million during that year. The majority of this loss was attributable to the research and development expenses of OMS, which continued to focus on improving the yield of its CZT production line.

Net financial income totaled $9.1 million in 2007, compared with $7.4 million in 2006. The increase in interest income, to $9.3 million from $9.0 million in 2006, resulted from higher average interest rates. The Company also recorded $0.9 in interest income from Coreflow Scientific Solutions Ltd. (“ Coreflow ”), in which the Company previously held a 30% equity interest (calculated on a fully diluted basis). The Company received repayment of $750,000 from this investment, and the outstanding loan balance of $1,050,000 at December 31, 2007 is repayable, with interest, through 2009. The Company incurred costs relating to factoring of letters of credit of approximately $1.3 million (compared to $1.1 million in 2006) and had a translation gain of $1.5 million in 2007 (compared to a loss of $0.1 million in 2006). In 2007, the Company concluded that $0.5 million of its marketable securities were other-than-temporarily impaired, and wrote down its marketable securities in that amount.

During the second quarter of 2007, the Company wrote off its $5.0 million investment in Negevtech Ltd. (“ Negevtech ”) a private Israeli company engaged in the development and manufacturing of products for the semiconductor industry, following a further round of financing of Negevtech in which the Company did not participate, and as a result of which the Company’s holding in Negevtech was significantly diluted.

Taxes on income in 2007 were $2.3 million, compared to a charge of $7.9 million in 2006. The Company’s effective tax rates for 2007 and 2006 were 15.5% and 12.4%, respectively. The Company did not realize any tax benefit from its $10.2 million of special charges. Generally, the Company’s effective tax rate varies largely as a function of benefits received from the State of Israel, particularly those relating to Approved Enterprises or Benefiting Enterprises. See Effective Corporate Tax Rate.

The share in losses of an associated company of $0.3 million in 2007, compared with a profit of $0.3 million in 2006, reflected the Company’s share in the losses of Coreflow. At December 31, 2007, the Company’s interest in Coreflow was reduced to below 20%. As a result, in 2008, the Company will account for its investment on Coreflow using the cost method.

The minority share in profits of a consolidated subsidiary of $0.4 million in 2007 reflected the 11% minority interest in Orbograph. This compared to the minority share in profits of $0.3 million in 2006.

Net income for the year ended December 31, 2007 was $1.5 million, or $0.04 per share (diluted), compared with a net income of $55.0 million, or $1.65 per share (diluted), for the year ended December 31, 2006.

(j)    Year Ended December 31, 2006 Compared To Year Ended December 31, 2005

The Company’s financial results for 2006 reflected a strong year, which was marked by record revenues and significantly increased profitability compared to 2005. This was driven principally by solid growth in the Company’s bare PCB business, which was a function of a robust global electronics industry in which new

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product introductions and applications led to increased capital investments. The Company’s increased bare PCB revenues also served to offset a decline during the year in its FPD business.

Revenues in 2006 totaled $416.5 million compared with $379.9 million in 2005. This increase of approximately 10% was traceable primarily to higher demand for the Company’s PCB-AOI and direct imaging systems. Revenues from service activities increased to a record $83.2 million from the $76.6 million recorded in 2005, reflecting the Company’s success in securing additional service contracts for its steadily increasing global installed base of systems in all areas of its business.

Revenues from the sale and service of PCB-related equipment increased to $273.7 million from the $233.2 million recorded in 2005. Of these revenues, $234.0 million, representing approximately 56% of the Company’s total revenues, was attributable to sales and service of equipment for bare PCBs and $39.7 million, representing approximately 10% of the Company’s total revenues, was attributable to sales and service of AOI systems for assembled PCBs. In 2005, $201.1 million of revenues, representing approximately 52% of the Company’s total revenues, was attributable to sales and service of systems for bare PCBs and $32.1 million of revenues, representing approximately 9% of the Company’s total revenues, was attributable to sales and service of AOI systems for assembled PCBs.

During 2006, the Company sold over 400 Discovery PCB-AOI systems, and 75 Paragon direct imaging systems. These systems are designed to respond to the increasingly specialized inspection and imaging needs of PCB manufacturers, who require high throughput and registration accuracy in their manufacturing processes to enable them to meet the challenges they face as part of the ongoing trend of increasingly sophisticated electronic devices. Their industry-wide acceptance reinforced the Company’s position of leadership in the provision of AOI and process control systems and imaging solutions for use in the manufacture of bare PCBs.

Revenues during the year from sales of AOI systems for assembled PCBs increased by approximately 24% from 2005, despite the fact that revenues were slightly lower in the second half of 2006 than the first. The Company’s main offering to the assembled PCB industry, its Symbion series of post-paste and post-reflow systems, were well received by customers since their introduction in the second quarter of 2005. The Company’s revenues in this area of its business were impacted by the strongly competitive environment, which was and remains fragmented and characterized by a large number of relatively small suppliers.

Revenues from the sale and service of FPD-related equipment decreased by 4% to $129.1 million from the $135.0 million recorded in 2005. Although consumer demand for LCD televisions remained very strong, some FPD manufacturers, out of caution and in light of a certain degree of overcapacity, delayed additional investments until industry developments became clearer. The Company maintained its position at the forefront of development and production of state-of-the-art solutions for FPD manufacturers and, through its in-line and off-line products, continued to provide comprehensive yield-enhancement systems to meet the critical needs of these customers.

Revenues from the Company’s automatic check reading products increased to $13.1 million in 2006 from $11.5 million in 2005, reflecting Orbograph’s continued successes in diversifying its product portfolio and achieving increased installations at larger banks and financial institutions.

The increase in the cost of products sold in 2006 of $9.0 million, or 5.6%, arose principally from the 5.9% increase in expenditures on materials and components, resulting mainly from the increased volume of products sold. Labor costs decreased by 5.7%, as a result of the Company’s policy of increased outsourcing of certain subassemblies to third party suppliers. Overhead and other expenses remained stable despite increased production volume.

The cost of services rendered in 2006 increased by $1.2 million, or 1.8%, against an increase in revenues from services rendered of $6.5 million, or 8.5%. This relatively small cost increase, comprised mainly of

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materials consumed, reflected the more efficient utilization of the Company’s global customer support infrastructure and was achieved despite the growth in the Company’s installed base of systems during the year.

Gross profit for 2006 was $189.6 million, or 45.5% of revenues, compared to $163.2 million, or 43.0% of revenues, in 2005. Gross profit for 2006 from sales of equipment was $173.7 million, or 52.1% of product sales, compared to $152.6 million, or 50.3%, during 2005. The increase in gross margins arose principally from the favorable product mix of sales revenues during 2006. Gross profit for 2006 from services rendered was $15.9 million, or 19.1% of service revenues, compared to $13.8 million, or 13.8%, during 2005. This increase also reflected the more efficient utilization during the year of the Company’s global customer support infrastructure.

The increase in gross research and development expenditure, to $62.2 million in 2006 from $56.7 million in 2005, reflected the Company’s ongoing significant investment in research and development and the high priority placed on its efforts to expand into new technologies and product areas. The expenditures during 2006 included a full year of the research and development activities of OMS, which focused on improving the yield of its CZT production line, as well as on independent development of application specific integrated circuits and digital interface electronics for the new version of its CZT detector module for use in nuclear imaging applications. This expense was principally responsible for the operating loss of $5.6 million in the Company’s Medical Imaging segment. During 2006, the Company received $1.7 million in Israeli Government participations in its research and development expenditures, compared to $1.0 million in 2005.

Selling, general and administrative expenses increased by 16% to $68.9 million in 2006 from the $59.4 million recorded in 2005. This was partly due to the higher levels of investment by the Company in its sales and marketing infrastructure in the Far East in light of the continued migration of PCB manufacturing to that region, as reflected in the significant increase in sales to China during 2006. The increase also included $3.3 million expensed as a result of the implementation of FAS 123(R) and costs related to internal control reviews. After giving effect to these expenses, selling, general and administrative expenses as a percentage of revenues was virtually unchanged from 2005. This reflected the Company’s continued efforts to leverage its global infrastructure to offset other increases in general and administrative expenses.

The amortization of other intangible assets during 2006 decreased to $0.6 million from the $2.6 million recorded in 2005.

In the fourth quarter of 2006 the Company initiated a restructuring program related to its assembled PCB product line, consisting primarily of the closure of the Company’s assembled PCB facility in Bad Pyrmont, Germany and the dismissal of 25 persons employed there. This restructuring program was designed to centralize the Company’s assembled PCB research and development activities at Company headquarters in Israel, so as to enable more efficient utilization of core research and development capabilities and, ultimately, develop new and improved solutions for its assembled PCB customers. The program resulted in total restructuring charges of $3.3 million, which were recorded in the fourth quarter of 2006. Liabilities related to the program in the amount of $241,000 were paid during the last quarter of 2006 and the remaining liabilities were paid through the second quarter of 2007. The restructuring resulted in an estimated $1.6 million annual cost reduction to the Company.

Net financial income totaled $7.4 million in 2006, compared with $3.5 million in 2005. The increase in interest income, to $9.2 million from $5.2 million in 2005, resulted from both increased cash balances and the significant increase in prevailing interest rates during 2006. The Company incurred costs relating to factoring of letters of credit of approximately $1.1 million and had small translation losses. The Company incurred no interest expenses in 2006.

Taxes on income in 2006 reflected a charge of $7.9 million, compared to a charge of $5.6 million in 2005. The Company’s effective tax rates for 2006 and 2005 were 12.4% and 11.4%, respectively. Generally, the Company’s effective tax rate varies largely as a function of benefits received from the State of Israel, particularly those relating to Approved Enterprises or Benefiting Enterprises. See Effective Corporate Tax Rate.

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The share in losses of an associated company of $0.3 million in 2006, compared with a profit of $0.1 million in 2005, reflected the Company’s share in the profits of Coreflow, in which the Company previously held a 38% equity interest (calculated on a fully diluted basis). The equity interest was reduced to approximately 30% at year-end after the Company received a repayment of $1.0 million from this investment. The minority share in profits of a consolidated subsidiary of $0.3 million in 2006 reflected the 11% minority interest in Orbograph. This compared to the minority share in profits of $0.2 million in 2005.

Net income for the year ended December 31, 2006 was $55.0 million, or $1.65 per share (diluted), compared with a net income of $43.3 million, or $1.30 per share (diluted), for the year ended December 31, 2005.

5.B    Liquidity and Capital Resources

The Company’s financial position remained strong during 2007. Cash, cash equivalents and marketable securities decreased to $206.0 million at the end of 2007 from the $269.7 million recorded a year earlier. This decrease resulted primarily from cash used in net investing and financing activities totaling $74.6 million, including an aggregate of $53.7 million (including satisfaction of net liabilities) paid in the acquisition of New System and DDD, $10.4 million in capital expenditures and $18.6 million for share repurchases. This was partially offset by the receipt of $7.9 million arising from the exercise of stock options. The Company had cash flow from operating activities of $8.3 million.

Inventories decreased to $77.6 million at December 31, 2007 from $78.3 million at December 31, 2006. Although the level of operations decreased during 2007 and finished goods inventory was $4.3 million lower, inventories used for service of systems to support the increasing global installed base of the Company’s systems increased by $1.4 million and inventories relating to the newly acquired subsidiary DDD were $3.6 million at the end of 2007. Therefore, inventories as a percentage of revenues increased to 21.5% as at December 31, 2007, compared with 18.8% as at December 31, 2006. Net trade accounts receivable rose by $8.2 million at year end, from $143.2 million to $151.4 million. The period trade receivables were outstanding (calculated by dividing trade receivables at year end into latest quarter revenues) increased to 133 days on December 31, 2007 from 126 days on December 31, 2006. The Company did not record any significant bad debts during 2007. Aggregate short-term and long-term accounts payable and accruals of $103.6 million (including a deferred tax liability of $5.2 million recorded in connection with the acquisition of DDD) increased from their December 31, 2006 levels of $102.8 million.

Capital expenditures during 2007 totaled $10.4 million compared with $8.1 million in 2006, as the Company continued to invest in leasehold improvements and in updating its management information systems.

The Company had unutilized credit lines totaling $50.0 million at December 31, 2007.

At December 31, 2007, the Company’s short-term marketable securities included approximately $38 million (currently approximately $33 million) in auction-rate securities, which are variable rate debt instruments having long-term maturity dates (typically 15 to 40 years), but whose interest rates are reset through an auction process, most commonly at intervals of 7, 28 and 35 days. Substantially all of the Company’s auction-rate securities are backed by pools of student loans guaranteed by the United Stated Department of Education, and all are rated AAA. The Company’s intention is not to hold these securities to maturity, but rather to use the periodic auction feature to provide liquidity when available. However, these securities have recently experienced a lack of liquidity, but the Company believes that there is no credit risk attached to these investments. The Company is not aware of any material commitments for capital expenditures in the future and believes that its currently available cash and cash equivalents and funds generated from operations will be sufficient to meet its working capital requirements for the next twelve months.

The Company uses financial instruments and derivatives in order to limit its exposure to risks arising from changes in exchange rates. The use of such instruments does not expose the Company to additional exchange rate

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risks since the derivatives are held against an asset (for example, excess assets in Euros). See Item 11—Quantitative and Qualitative Disclosures About Market Risk. The Company’s policy in utilizing these financial instruments is to protect the Dollar value of its cash and cash equivalent assets rather than to serve as a source of income. For information as to monetary balances in non-Dollar currencies, see Note 11 to the Financial Statements.

5.C    Research and Development, Patents and Licenses, etc.

(a)    Research and Development Policy

The Company places considerable emphasis on research and development projects designed to upgrade its existing product lines and to develop new technologies and additional industrial and service applications of its existing technologies. As of December 31, 2007, 434 employees were engaged primarily in research and development for the Company.

The following table shows the total research and development expenditures of the Company and participation in such expenditures by the Government of Israel for the periods indicated:

The Government participations represent funding by the OCS through a royalty-free program for the development of generic technologies.

Israeli Government consent is required to manufacture products developed with such participations outside of Israel and to transfer to third parties know-how developed through projects in which the Government participates. Such restrictions do not apply to the export from Israel of the Company’s products developed with such know-how.

(b)    Intellectual Property

To safeguard its proprietary product design and technology, the Company relies, in part, on patent, trade secret, trademark and copyright law, as well as technical safeguards. Proprietary software is generally protected under copyright law. Additionally, the Company relies upon trade secrets and regularly enters into non-disclosure agreements with its employees, subcontractors and potential business associates. As of February 29, 2008, the Company held 78 United States patents, and approximately 90 corresponding non-United States patents, and had 47 United States patent applications, and approximately 140 non-United States patent applications, pending.

Notwithstanding the above, there can be no assurance that any patent owned or licensed by the Company will not be invalidated, designed around, challenged or licensed to others, that any of the Company’s pending or future patent applications will be issued with the scope of the claims sought by the Company, if at all, or that non-disclosure agreements will not be breached. In addition, patent coverage may not be extended to all countries, and effective copyright and trade secret protection may be unavailable or limited in certain countries. There can also be no assurance that the steps taken by the Company will prevent misappropriation of its technology. It is also possible that technology developed by the Company may be infringing on patents or other rights held by others. The Company has received in the past, and may in the future receive, communications asserting that the technology used in some of its products requires third-party licenses. Any infringement claims, whether or not meritorious, could result in costly litigation or arbitration and divert the attention of technical and

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management personnel. Any adverse outcome in any litigation alleging infringement could result in the loss of proprietary rights, require the Company to develop non-infringing technology or enter into royalty or licensing agreements (which it may not be successful in achieving) or prevent the Company from manufacturing or selling its products.

The Company has in the past received and may receive in the future notifications from customers with respect to possible indemnification or other action by the Company in connection with intellectual property claims resulting from use of the Company’s products. The Company typically undertakes, subject to various contractual conditions and other limitations, to defend intellectual property claims against customers arising from the purchase and use of its products. The Company’s obligations under these agreements generally provide that the Company may, at its option, either obtain the right to continue using the products or modify them and, in some cases, take back the products with a refund to the customer. To date, no demands have been made by customers seeking indemnification against the Company with respect to intellectual property claims.

Although the Company continues actively to pursue the protection of its intellectual property in the belief that its patents have significant value, it also believes that rapid technological improvement and factors such as the knowledge and experience of the Company’s management personnel and employees and their continued ability to define, develop, enhance and market new products and services afford additional protection which may, in some instances, exceed patent protection.

5.D    Trend Information

The global economy and the world’s financial markets are presently undergoing a period of heightened uncertainty. In particular, there are strong indicators that the United States and other countries are facing the prospect of an economic downturn of unknown duration and severity. It is also unclear what the effects of global imbalances will be on other economies should economic activity and consumer spending in the United States weaken. The short and long term effects of macroeconomic trends such as those currently being experienced can be critical factors in the demand for consumer end-products (in the manufacture of which the Company’s sophisticated yield-enhancing and production products are used) and, consequently, in the capital expenditure decisions taken by electronics manufacturers who purchase the Company’s products.

The global electronics industry remained relatively stable during 2007. This was reflected in the Company’s 2007 revenues from its bare PCB product lines, which were at levels similar to those recorded for 2006. The Company has continued to benefit from the trend in the electronics industry towards technological enhancements and more sophisticated electronic devices, and the resulting desire on the part of PCB manufacturers to seek more advanced inspection and production solutions. The Company’s Discovery PCB-AOI and Paragon direct imaging systems continue to offer high quality yield-enhancing and production solutions to electronics manufacturers. This has reinforced the Company’s position of leadership in the provision of AOI and process control systems and imaging solutions for use in the manufacture of bare PCBs. In addition, during 2007, the Company took further important steps in implementation of its strategy of expanding its product offerings from yield-enhancement to production solutions, in particular with the significant expansion of its installed base of direct imaging systems, the acquisition of New System, an Italian manufacturer of inkjet legend printers, and through increasing its investments in internal research and development programs oriented towards production solutions. The Company continues to experience competition in PCB-related areas, including increased competition for the Company’s direct imaging systems, particularly from suppliers in Japan. This has resulted in ongoing pricing pressure and has had the effect of lengthening the sales cycle in light of extended product evaluations. The Company expects that its first half 2008 PCB-related revenues will be adversely affected by the current economic uncertainty.

The decrease in the Company’s assembled PCB revenues in 2007 reflected the continuing strong competition among suppliers in this industry, leading in turn to strong pricing pressures on all such suppliers, including the Company, a trend which is expected to continue during 2008. The Company believes that the

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recognition on the part of assembly houses of the benefits of AOI, though still limited, continues to increase slowly, and the Company is developing new and improved generations of inspection solutions for PCB assembly houses.

The significant decrease in revenues from FPD-related equipment during 2007 resulted from the downturn in the cyclical FPD industry and the consequent delay in capital investment by LCD manufacturers, which commenced in late 2006 and continued through 2007. However, consumer demand for LCD wall-mounted television sets for home use was strong throughout 2007 and the first quarter of 2008, which is expected to continue at least during the remainder of this year in many major geographic areas. As a result of the strong demand for panels, particularly for LCD televisions, and the stabilization of panel prices during the latter part of 2007, the Company’s customers in the FPD industry have announced a substantial number of new fabrication facilities scheduled for construction during 2008 and 2009, and have placed orders with the Company which have resulted in record bookings for its FPD-AOI systems. However, because of construction cycles, the predominant effect on revenues from this part of the Company’s business is not expected to occur before the second half of 2008. As part of its preparation for the anticipated production required to meet these orders, the Company expects to increase its level of FPD-related inventories and production capabilities and to recruit additional staff. Depending upon the product mix, specific customer requirements (which can vary significantly from customer to customer) and method of inspection used, quarterly gross margins from the Company’s FPD-AOI systems have in the past fluctuated significantly and can be expected to do so in the future. The Company is also experiencing increasing competition for its FPD products which, in addition to potential loss of revenues, can result in pricing pressure from customers. The Company continues to invest in research and development for this important part of its business so as to be able to provide LCD manufacturers with the critical yield-enhancing solutions they are anticipated to require in future generations of fabrication facilities.

During 2007 the Company took a significant step in the implementation of its strategy for diversification into new growth areas for imaging technologies through the acquisition of DDD, a Danish manufacturer of gamma cameras for use in nuclear cardiac imaging. The Company believes that the demand for its gamma cameras should be less subject to the cyclical fluctuations which normally characterize the electronics industry. The Company’s medical imaging activities also include the business of OMS, which is engaged in continuing research and development and improving production processes for solid state gamma radiation detectors for medical nuclear imaging applications, based on its acquired CZT crystal-growth technology. Although the Company expects to reduce substantially its investment in research and development at OMS in 2008, it remains of the view that the CZT crystal growth technology being developed by OMS has the potential to play an important role in the science of medical nuclear imaging. Nevertheless, the activities of OMS represent a long-term undertaking, entailing extended research and development and involving complex operational challenges, and no assurances can be given as to whether, and if so in what time frame, significant revenues can be achieved from this project or as to its profitability.

The Company’s gross profit margins during 2007 were approximately 40%. While the Company anticipates that margins will be lower in the early part of 2008 principally due to the delivery, in the first half of the year, of a large order for eighth generation, in-line FPD-AOI systems to a major Korean FPD manufacturer, margins are expected to improve in the second half as a result of the anticipated increase in the Company’s FPD business.

The Company expects that net income will be adversely affected during 2008 as a result of higher operating costs in Israel (in Dollar terms) principally resulting from the continuing strength of the NIS against the Dollar due to the fact that approximately 25% of the total expenses of the Company are NIS related. If the representative exchange rate for converting NIS into Dollars remains at the current level of approximately NIS 3.5 to the Dollar, this would be expected to increase the cost of the Company’s operations in Israel by approximately $1.5 million per quarter, or approximately 4.5 cents per share. For information regarding historical NIS-Dollar exchange rates and the effect on the Company, see Impact of Inflation and Currency Fluctuations. In addition, during the first quarter of 2008, the Company’s investments in auction-rate securities backed by student loans (totaling approximately $33 million that were purchased in January 2008) experienced a lack of liquidity as evidenced by

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failed auctions which occurred in February and March 2008. This has had the effect, at least temporarily, of reducing the liquidity of a portion of the Company’s marketable securities. However, the Company believes that its currently available cash and cash equivalents and funds generated from operations will be sufficient to meet its working capital requirements for the next twelve months.

The Company remains optimistic as to the long-term demand for its principal products and is confident that its continuing emphasis on research and development, as well as its recent acquisitions, has maintained a solid foundation for future growth. Nevertheless, certain of the Company’s research and development projects are relatively high-risk in nature, and may not ultimately result in the development of products which can contribute to the Company’s revenues and/or profitability. In addition, given unsettled economic conditions worldwide and in particular geographic regions, the Company is not able to predict the duration, extent or stability of the current business and economic environment, and the Company’s ability to foresee future trends in the flow of orders (principally for its bare and assembled PCB-AOI systems) remains generally limited, as is its ability to forecast the extent to which these factors may affect its revenues, profitability and capital resources during 2008 and beyond.

5.E    Off-Balance Sheet Arrangements

The Company does not use off-balance sheet arrangements or transactions with unconsolidated, limited-purpose entities to provide liquidity, financing or credit support or to engage in leasing, hedging or research and development activities or which would expose the Company to liability that is not reflected on the face of its financial statements. The Company is not a party to any ‘off-balance sheet arrangements’ which are required to be disclosed under this Item 5.E of Form 20-F.

5.F    Tabular Disclosure of Contractual Obligations

The following table summarizes the Company’s contractual obligations as at December 31, 2007:

Operating lease obligations represent commitments under various commercial facility and vehicle leases. Purchase obligations mainly represent outstanding purchase commitments for inventory components ordered in the normal course of business. The Company does not have outstanding any short-term or long-term indebtedness and is not a party to any capital leases.

The Company adopted FIN 48 as of January 1, 2007. The total amount of gross unrecognized tax benefits for uncertain tax positions, including positions impacting only the timing of tax benefits, was $11.4 million at December 31, 2007. Payment of these obligations would result from settlements with taxing authorities. Due to the difficulty in determining the timing of settlements, FIN 48 obligations are not included in the table above. The Company does not expect to make a significant tax payment related to these obligations within the next year.

5.G    Safe Harbor

The safe harbor provided in Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act shall apply to forward-looking information provided pursuant to Items 5.E and F.

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