UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

(Mark One)

x                                  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2006

OR

o                                    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM              TO             .

Commission File Number 0-21321

 

CYMER, INC.

(Exact name of registrant as specified in its charter)

Nevada		33-0175463
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)
17075 Thornmint Court, San Diego, CA		92127
(Address of principal executive offices)		(Zip Code)

 

Registrant’s telephone number, including area code: (858) 385-7300

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   ýYes  oNo

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  oYes  ýNo

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ý

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

Large accelerated filerý                             Accelerated filer o                              Non-accelerated filer o  

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

oYes  ýNo

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing price of $46.46 for shares of the registrant’s common stock on June 30, 2006 as reported on the Nasdaq National Market, was $1,819,752,203.  The registrant has no non-voting common stock. In calculating such aggregate market value, shares of common stock owned of record or beneficially by officers or directors, and persons known to the registrant to own more than ten percent of the registrant’s voting securities were excluded because such persons may be deemed to be affiliates.  The registrant disclaims the existence of control or any admission thereof for any other purpose.

Number of shares of common stock outstanding as of  February 23, 2007: 37,278,940.

DOCUMENTS INCORPORATED BY REFERENCE

The following  document is incorporated  by reference in Part II (Item 5) and Part III (Items 10, 11, 12, 13 and 14) of  this  Annual  Report on Form 10-K: portions of registrant’s definitive proxy statement for its annual meeting of stockholders to be held on May 17, 2007 which will be filed with the Securities and Exchange Commission within 120 days of December 31, 2006.

CYMER, INC.

2006 Annual Report on Form 10-K

TABLE OF CONTENTS

PART I
		Item 1.Business
		Item 1A.Risk Factors
		Item 1B.Unresolved Staff Comments
		Item 2.Properties
		Item 3.Legal Proceedings
		Item 4.Submission of Matters to a Vote of Security Holders
PART II
		Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
		Item 6.Selected Financial Data
		Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations
		Item 7A. Quantitative and Qualitative Disclosures About Market Risk
		Item 8.Financial Statements and Supplementary Data
		Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
		Item 9A.Controls and Procedures
		Item 9B.Other Information
PART III
		Item 10. Directors, Executive Officers and Corporate Governance
		Item 11. Executive Compensation
		Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
		Item 13. Certain Relationships and Related Transactions, and Director Independence
		Item 14.Principal Accounting Fees and Services
PART IV
		Item 15. Exhibits and Financial Statement Schedules
		Signatures

 

 

Forward-Looking Statements

Statements in this Annual Report on Form 10-K that are not strictly historical in nature are forward-looking statements. These statements include, but are not limited to, references to the outlook for the semiconductor industry and us; expected domestic and international product sales and development; our research and development activities and expenditures; adequacy of our capital resources and investments; effects of business cycles in the semiconductor business; our competitive position; and our relationships with customers and third-party manufacturers of our products, and may contain words such as “believes,” “anticipates,” “expects,” “plans,” “intends” and words of similar meaning. These statements are predictions based on current information and our expectations and involve a number of risks and uncertainties. The underlying information and our expectations are likely to change over time.  Actual events or results may differ materially from those projected in the forward-looking statements due to various factors, including, but not limited to, those contained under the caption “Risk Factors” and elsewhere in this Annual Report on Form 10-K.  Forward-looking statements herein speak only as of the date of this Annual Report on Form 10-K.  Unless required by law, we undertake no obligation to update or revise any forward-looking statements to reflect new information or future events or developments.  Thus, you should not assume that our silence over time means that actual events are bearing out as expressed or implied in such forward-looking statements.

PART I

Item 1.  Business

Overview

We are the world’s leading supplier of excimer light sources, the essential light source for deep ultraviolet (“DUV”) photolithography systems. DUV photolithography is a key enabling technology that has allowed the semiconductor industry to meet the exacting specifications and manufacturing requirements for volume production of today’s most advanced semiconductor chips. Our light source systems are incorporated into step-and-repeat (“steppers”) and step-and-scan (“scanners”) photolithography systems for use in the manufacture of semiconductors with critical feature sizes below 250 nanometers (“nm”).  One nm equals one billionth of a meter.  Our excimer light source systems constitute a substantial majority of all excimer light sources incorporated in DUV photolithography tools. Our products consist of photolithography light source systems, replacement parts and service.  We maintain a worldwide service organization that supports our installed base of light sources.  As of December 31, 2006, this installed base totaled 3,042 light sources.  Our customers include all three manufacturers of DUV photolithography systems: ASML, Canon and Nikon.  Photolithography systems incorporating our excimer light sources have been purchased by all of the world’s largest semiconductor manufacturers including: AMD, Chartered, Elpida, Fujitsu, Hynix, IBM, Infineon/Qimonda, Intel, Matsushita, Micron, Nanya/Inotera, NEC, Powerchip, Promos, Renesas Technology, Samsung, SMIC, Sony, ST Microelectronics, Texas Instruments, Toshiba, TSMC, and UMC.

In July 2005, we entered into an agreement with Carl Zeiss SMT AG, a German corporation, and Carl Zeiss Laser Optics Beteiligungsgesellschaft mbH, a German limited liability company (which we refer to together with their affiliated entities as “Zeiss”) to establish a joint venture, which we refer to as TCZ (for Team Cymer Zeiss).  In September 2006, we amended and restated this joint venture agreement with Zeiss to move the location of the TCZ joint venture from Switzerland to Singapore and, in connection with the move, formed TCZ Pte Ltd., a company incorporated in Singapore.  TCZ is currently developing, and will integrate, market and sell, and support production tools for the flat panel display manufacturing industry. The joint venture is targeting the growing market for low-temperature poly-silicon (“LTPS”) processing used in the manufacture of liquid crystal displays that are brighter, have higher resolution, and consume less power than displays using today’s predominant amorphous silicon films.  We currently expect that TCZ will ship its first production tool, the TCZ 900X, in late 2007 or early 2008.

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Other Information

We are a Nevada corporation, incorporated on July 12, 1996. We were originally incorporated in California in 1986 and reincorporated in Nevada in 1996.

Our website address is http://www.cymer.com. Our filings with the Securities and Exchange Commission (“SEC”) including our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports are available free of charge through our website as soon as reasonably practicable after we electronically file such reports or furnish them to the SEC.

You may read and copy materials that we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington DC 20549.  Information on the operation of the Public Reference Room is available by calling the SEC at 1-800-SEC-0330.  The SEC maintains an Internet site that contains reports, proxy statements and other information we file.  The address of the SEC website is http://www.sec.gov.

Products and Services

Our products primarily consist of photolithography light source systems, replacement parts, and service.

Photolithography Light Sources

Our excimer light sources for photolithography produce pulsed light of extremely short wavelengths within the DUV spectrum.  The bandwidth of the light is further narrowed through a number of optical techniques.  The DUV wavelengths are measured in nanometers and the light sources are referred to according to either the wavelength or the gases that are mixed to produce the light.  Krypton Fluoride (“KrF”) gases produce light at a 248 nm wavelength, and Argon Fluoride (“ArF”) gases produce light at a 193 nm wavelength. The extremely short wavelengths and highly narrowed bandwidths of light produced by these light sources enable the very fine feature resolution required for patterning or printing the circuitry on silicon wafers. The pulse energy and repetition rate of the light source permit high throughput in wafer processing.  We have designed our light sources to be reliable, easy to install and service and compatible with existing semiconductor manufacturing processes.  Our light sources are used to pattern or print the integrated circuits, which are also called semiconductors or “chips,” that power many of today’s advanced consumer and business electronics.  In 2006, we sold 280 light source systems at an average selling price of $1.0 million.  Revenues generated from sales of light sources were approximately $244.8 million, $207.4 million and $282.4 million for 2004, 2005 and 2006, respectively.

Our product development strategy has been to develop new products in rapid succession to meet continually evolving needs in the marketplace, and to obsolete our own products as quickly as possible, thus rendering our competitors’ products obsolete.  This strategy strengthens our market leadership position since the ongoing reduction of critical dimension (“CD”) on the wafer drives demand for newer, more advanced, higher value-added light sources.

Over the years, we have developed and sold a wide variety of photolithography light source products.  These products can be divided into KrF and ArF product categories and include a number of current products as well as legacy products that we continue to service in our installed base.

Current Products

Our current products include our newest, most advanced, highest value-added ArF and KrF light sources, as well as some mature products that are still experiencing strong chipmaker demand as DUV lithography becomes the prevailing light source technology in wafer fabrication.

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193 nm ArF Light Sources

Chipmakers continue to reduce the feature sizes and shrink the CD on the wafer, which means that the line widths of the circuitry on the wafer become progressively smaller. At this time, chipmakers generally are continuing to expand their manufacturing capacity at 90 nm, a number of chipmakers have begun expanding production capacity at 65 nm, and several chipmakers are in active development of production capabilities at 45 nm. In these circumstances, chipmakers need more leading edge tools, which means they need more of the shorter wavelength ArF photolithography tools in their manufacturing facilities to pattern the critical layers on the wafer.  Growing use of 193 nm ArF light sources at the leading edge, combined with continuing use of 248 nm KrF light sources for the less critical layers, allows chipmakers to meet the rigorous performance and volume demands of high volume manufacturing.  Our light sources are designed to enable chipmakers to achieve their production goals.

XLA Series — The XLA Series of ArF light sources is based on our dual-discharge chamber Master Oscillator Power Amplifier (“MOPA”) light source architecture.  The master oscillator creates a narrow bandwidth beam of light at low power which is referred to as “ultra-narrowed” or “highly line-narrowed”.  The beam then is directed into the power amplifier, where the power is increased significantly while maintaining the narrow bandwidth.  This combination of a narrower bandwidth and higher power enables chipmakers to continue reducing critical circuitry dimensions and increasing processing speeds, capacity and functionality of chips, while giving chipmakers the performance and cost advantages they need.  Each product in the XLA Series is based on the XL common platform, which includes cabling and wiring harnesses, electrical interfaces, power supplies, gas delivery systems, cooling systems, and other various components, all in a common enclosure.  Use of a common platform enables us to develop each new product in the series rapidly and cost-effectively.  Because our customers are accustomed to working with the XLA Series, our direct customers can efficiently integrate a new XLA light source product into their advanced scanners and bring them to market quickly, while our chipmaker customers can quickly begin using these light sources in their existing manufacturing processes and achieve rapid time to yield.

Products Based on the XL Common Platform:

·                   XLR 500i — The XLR 500i is our fifth generation ArF light source based on our MOPA laser architecture, and is built on the production proven universal platform developed for the XLA 300.  Operating at a 6 kHz repetition rate and currently offering up to 60 W of output power, the XLR 500i includes a design which we call our recirculating ring technology. This ring technology comprises a new dual chamber architecture designed to deliver a step-function improvement in energy stability which we expect will lead to both yield and productivity enhancements for the chipmaker.  Additionally, our ring technology is expected to offer a greater than 20% reduction in the average chipmaker’s cost of operation.  Initial shipments of the XLR 500i for installation at chipmakers are expected in 2007.

·                   XLA 300 — The XLA 300 is our fourth generation leading edge ArF light source based on the MOPA design.  It operates at a 6 kHz repetition rate and offers up to 60 W of output power, and is designed for high volume production of semiconductor devices at 45 nm production node using immersion lithography techniques.  Based on the production proven XL platform, the initial shipment of the XLA 300 in the fourth quarter of 2005 marked the fastest product development cycle in our history.

·                   XLA 200 — The XLA 200 is our third generation ArF light source based on the MOPA design and XL platform and offers higher power and a narrower bandwidth than its predecessor.  Operating at a 4 kHz repetition rate, it also offers up to 60 W of output power and an ultra line-narrowed bandwidth to enable production of semiconductor devices at the 65 nm production node in non-immersion applications, and pilot production at the 45 nm node using immersion lithography techniques.  The initial shipment of our XLA 200 occurred in the first quarter of 2005.

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·                   XLA 105 — Now used in volume production in many fabs, the XLA 105 is our second generation XLA Series product, offering a 4 kHz repetition rate and 40 W of output power.  Designed for use at the 65 nm production node, the XLA 105 initially shipped in the first quarter of 2004, and continues to experience strong demand from chipmakers.

·                   XLA 100 — The XLA 100 was our first XLA Series product, and offers a 4 kHz repetition rate and 40 W of output power.  Designed for high volume production at the 90 nm production node and below, the XLA 100 began shipping in the first quarter of 2003.  Though it still ships in small numbers, the XLA 100 has been superseded for the most part by our later models in the XLA Series.

NanoLith 7000 — The NanoLith 7000 is a single-chamber ArF light source offering a 4 kHz repetition rate and 20 W of output power.  Designed  to enable initial ArF process development and production at the 100 nm production node and below, the NanoLith 7000 is the ArF twin of the ELS-7000 KrF light source (see 7000 Series below).  The NanoLith 7000 sold well from its introduction in mid-2001 through 2002, and was replaced by the more advanced XLA 100 when that product was introduced in 2003.  As of the end of 2006, we were shipping this product only sporadically, but continuing to provide consumable modules, spare parts and service for the installed base of NanoLith 7000s in semiconductor fabs throughout the world.

248 nm KrF Light Sources

We have been providing KrF light sources for volume chip production since 1996 when chipmakers reached the 250 nm production node.  Over the years, we have developed and sold a variety of increasingly powerful and productive KrF products.  These light sources have enabled increasing wafer throughput and continually shrinking CD.

7000 Series — The 7000 Series of products offers a complete product line, encompassing both ArF and KrF light sources on a common platform, enabling chipmakers to easily “mix and match” these two different light source wavelengths within the manufacturing environment.  With a 4 kHz repetition rate and high output power, the 7000 Series offers chipmakers high wafer throughput and lower cost of operation by reason of advanced design and materials, thus delivering improved tool availability for increased manufacturing efficiency and flexibility.

Our 7000 Series products:

·                   ELS-7010 — The ELS-7010 is our most advanced KrF light source.  Introduced in the third quarter of 2004 with 40 W of output power to enable chipmakers to achieve high volume production at the 100 nm production node and below, the ELS-7010 is now our best-selling KrF light source.  This light source also offers ultra-narrowed bandwidth and a number of controls to enhance performance.

·                   ELS-7000®  — The ELS-7000 was introduced with 30 W of output power in January 2002 for high volume production of devices at the 130 nm production node and below.  In 2006, there was very limited demand for this light source, since chipmakers now prefer the higher power and narrower bandwidth offered by the ELS-7010.

·                   NanoLith 7000 — See the description of this ArF light source under “NanoLith 7000” above.

6000 Series — The 6000 Series of light sources includes two KrF models and an ArF model.  When originally introduced, 6000 Series light sources were designed for production of semiconductor devices with design rules down to 130 nm.

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Our 6000 Series products:

·                   ELS-6010 — The ELS-6010 offers a 2.5 kHz repetition rate and 20 W of output power.  Originally introduced at the end of 2000, the ELS-6010 has enjoyed strong chipmaker acceptance and demand especially among chipmakers who wish to meet their KrF needs with a highly reliable light source that enables good wafer throughput.

·                   ELS-6000™ — The ELS-6000 operates at a 2 kHz repetition rate, offers 20 W of output power, and was designed for steppers and scanners used in the production of semiconductor devices with CDs of 180 nm and below.  Initial shipments of the ELS-6000 began in the second half of 1998, and this product continued to sell well into 2002, and then again in 2004 when chipmakers were expanding 200 mm fab capacity.  We currently sell only a limited number of these light sources per year.

·                   ELS-6010A — See the description of this light source under “Legacy Products” below.

Legacy Products

In general, we no longer sell our legacy light source products because they have been superseded by our newer, more advanced products.  Our legacy products are still widely used by chipmakers to pattern the circuitry on the less critical layers of the wafer.  They make up a substantial portion of our installed base of light sources, and we still provide consumables, spare parts and service for these light sources.

ELS-6010A — The ELS-6010A is the ArF model in the 6000 Series of products.  It operates at a 2 kHz repetition rate with 10 W of output power and was designed to meet the resolution, image contrast and wafer throughput requirements in semiconductor production at the 130 nm node and below.  It began shipping in the second quarter of 2001, but was superseded later that same year by the NanoLith 7000 with its higher repetition rate and power.  We still provide consumables, spare parts and service for the ELS-6010As installed at chipmakers and other end users.

5000 Series — Our 5000 Series of light sources include several KrF products and one ArF product.  The 5000 Series light sources operate at a 1 kHz repetition rate, and depending on the model, offer 10 W or 15 W of output power for use in the manufacture of semiconductors with CD of 250 nm and below. We last shipped a 5000 Series light source in early 2001, but we continue to provide consumables, spare parts and service to the large installed base of 5000 Series products throughout the world.

Replacement Parts and Refurbishment Activities

Certain components and subassemblies included in our light sources require replacement or refurbishment following extended operation.  We estimate that a light source used in a semiconductor production environment will require one to two replacement chambers per year, depending upon the level of usage. Similarly, certain optical components of the light source deteriorate with continued exposure to DUV light and require periodic replacement.  We provide these and other spare and replacement parts for our photolithography light sources as needed by our customers.

Revenues generated from sales of replacement parts, excluding the receipt of reusable material, were approximately $123.2 million, $130.8 million, and $199.8 million for 2004, 2005, and 2006, respectively.  Revenues from replacement parts are dependent on both the utilization of our light source systems and the size of our installed base of light sources.  The size of our installed base increased from 2,743 light sources as of December 31, 2005 to 3,042 light sources as of December 31, 2006, and the utilization of our light source systems at chipmakers continued to grow throughout 2006. The utilization rate grew 8.1% from the beginning of 2006 and reached a record high level by the end of 2006.

As part of our regular business activities, we conduct significant parts refurbishment and

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material reclaim activities related to some of our core assemblies, in particular our chamber assemblies. These activities involve arrangements with our customers where we sell a new part to the customer at a reduced sales price if the customer returns the consumed core assembly that the new part replaces.  These returned core assemblies contain a certain amount of material, primarily metal components, that may be reused by us in future core assemblies.  Since a portion of the consideration related to the original sale is related to the return of consumed parts, we record revenue when we receive the returned assemblies from our customers.

Revenues generated from the receipt of reusable material contained within consumed assemblies returned from our customers were approximately $28.5 million, $18.0 million and $26.0 million for 2004, 2005 and 2006, respectively.  Revenues from such activities are dependent on the quantity of the core assemblies returned from our customers and the value of the reusable parts that we expect to yield from the core assemblies received.  Our method of accounting for refurbishment activities is explained in greater detail in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the caption “Accounting for Parts Used in Refurbishment Manufacturing Process” and in Note 1 to our consolidated financial statements.

Service

As the life and usage of our installed base of light sources in production at chipmakers exceeds the original warranty periods, some chipmakers request service contracts from us.  Additionally, we provide billable service or service contracts directly to the three semiconductor lithography tool manufacturers, as well as to chipmaker customers. These service agreements require us to maintain and/or service these light sources either on an on-call or regular interval basis or both.  Included in some of the types of service contracts we provide to our customers are the replacement of consumable parts and non-consumable parts.  The pricing for such contracts includes the replacement of these parts.

In addition to service contracts, we offer CymerOnLineTM, a diagnostic and performance software product which delivers critical laser diagnostics and performance information in near real-time directly to authorized users anywhere.  The software simplifies reporting and allows users to efficiently manage consumables usage.  CymerOnLine features a user-friendly browser-based interface, which features a robust design and provides a secure data environment.  Event-initiated messages sent to pagers, e-mail, mobile phones, or other handheld devices enable up-to-the minute communication and proactive management.

Revenues generated from service and service contracts were approximately $20.1 million, $26.4 million and $35.2 million for 2004, 2005 and 2006, respectively.  We expect service and service contract revenues to remain at or exceed these levels as our installed base grows and the warranty period of our light source systems expires.

Customers and End-Users

We sell our photolithography light source products to each of the three manufacturers of DUV photolithography tools:

We believe that maintaining and strengthening customer relationships will play an important role in maintaining our leading position in the photolithography market.  We work closely with our customers to integrate our products into their photolithography tools.  Sales to ASML, Canon, and Nikon accounted for 38%, 6% and 16%, respectively, of total revenue in 2006.

Revenues generated from customers within the U.S. were $75.8 million, $60.3 million and $85.0 million for 2004, 2005 and 2006, respectively.  Revenues generated from customers outside of the U.S. were $342.2 million, $323.4 million and $458.9 million for 2004, 2005 and 2006, respectively.

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Revenues generated from customers located in Japan were $132.8 million, $119.6 million and $120.2 million for 2004, 2005 and 2006, respectively.  Revenues generated from customers located in Europe were $154.7 million, $138.8 million and $223.1 million for 2004, 2005 and 2006, respectively.  These revenues can originate from any of our locations to customers located in these countries.

Long-lived assets located in the U.S. were $114.1 million, $108.9 million and $103.1 million as of December 31, 2004, 2005 and 2006, respectively. Long-lived assets located outside of the U.S. were $9.4 million, $8.4 million and $9.0 million as of December 31, 2004, 2005 and 2006, respectively.

End-users of our light sources include all of the world’s largest semiconductor manufacturers. The following semiconductor manufacturers have purchased one or more DUV photolithography tools incorporating our light sources:

U.S.		Japan		Singapore		Korea
Agere Systems		CASMAT †		1st Silicon		DongbuAnam Semiconductor Inc.
Albany Nanotech		Denso		Chartered Silicon Partners		Hynix Semiconductor Inc.
AMD		Elpida Memory Inc.		Peregrine Semiconductor		Magnachip
Applied Materials		Fuji Film		Silterra		National NanoFab †
Atmel		Fujitsu		SSMC		Samsung
Clariant Corp.		Hitachi		TECH
Cypress		JSR		UMCI Pte Ltd.		Europe
Freescale Semiconductor		Kawasaki Seitetsu				Altis Semiconductor
Headway Technologies		Matsushita		Taiwan/China		C-NET †
Honeywell		NEC		ASMC		CEA-Leti
HP		OKI		ERSO		IHP
IBM		Renesas Semiconductor		GSMC		IMEC v.z.w †
IMFT		Rohm		HeJian		Infineon Technologies AG
Integrated Device Technology		Sanyo		Inotera		NXP Semiconductor
Intel		Seiko		MXIC		Qimonda
Jazz Semiconductor		SELETE †		Nan-ya		ST Microelectronics
LSI Logic Corp.		Sharp		Promos		Tower Semiconductor
Maxim Integrated Products		Sony		PSC
Microchip Technology Inc.		Tokyo Electron Ltd.		SMIC
Micron Technology		Tokyo Ohka Kougyo Co.		TSMC
National Semiconductor		Toshiba		UMC Group
Rohm & Haas				VISC
Sarnoff Corp.				Winbond Group
SEMATECH †
Spansion
Texas Instruments
VLSI
Wafertech

†  A semiconductor industry consortium.

Backlog

We schedule production of light sources based upon order backlog and informal customer forecasts.  We include in backlog only those orders to which a purchase order number has been assigned by the customer and for which delivery has been specified within 12 months.  Because customers may cancel or delay orders with little or no penalty, our backlog as of any particular date may not be a reliable indicator of actual sales for any succeeding period.  At December 31, 2006, we had a backlog of approximately $94.4 million compared with a backlog of $90.8 million at December 31, 2005.

Manufacturing

Our manufacturing activities consist of material management, assembly, integration and testing. These activities are performed in a 265,000 square foot facility in San Diego, California that includes approximately 31,000 square feet of Class 10,000 cleanroom manufacturing and test space.  In order to focus our own resources, capitalize on the expertise of our key suppliers and respond more efficiently to customer demand, we have outsourced the manufacture of many of our subassemblies. Our

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manufacturing outsourcing strategy is exemplified by the modular design of our products.  Substantially all manufacturing of nonproprietary subassemblies has been contracted to third-party suppliers. As a result, we are increasingly dependent upon these contract suppliers to meet our manufacturing schedules.  The failure by one or more of these suppliers to supply us on a timely basis with sufficient quantities of components or subassemblies that perform to our specifications could affect our ability to deliver completed light sources to our customers on schedule. We believe that the highly outsourced content and manufacturable design of our products allows for reduced manufacturing cycle times and increased output per employee. To improve current production efficiencies, control costs, and manage overall manufacturing capacity, we intend to continue to provide additional training to manufacturing personnel, improve our assembly and test processes in order to reduce cycle time, invest in additional manufacturing tooling and further develop our supplier management and engineering capabilities.

In addition to the manufacturing capacity at our facilities in San Diego, California, we have a refurbishment facility in Korea.  This facility refurbishes discharge chambers for light sources in Korea and the Asia-Pacific region.  The refurbishment facility in Korea includes 6,550 square feet of Class 10,000 cleanroom manufacturing space.

A limited number of components and subassemblies included in our products are obtained from a single supplier or a small group of suppliers.  For certain optical, control system and pulse power components and subassemblies used in our light source systems, we currently utilize a single supplier.  Where possible, we work with secondary suppliers to qualify additional sources of supply.  To reduce the risk associated with this single supplier, we carry significant strategic inventories of these components.  Strategic inventories are managed as a percentage of future demand.  We have also negotiated to have vendor-managed inventory of critical components to further reduce the risk of a single supplier.  To date we have been able to obtain adequate supplies of the components and subassemblies used in the production of our light source systems in a timely manner from existing sources.  If in the future we are unable to obtain sufficient quantities of required materials, components or subassemblies, or if such items do not meet our quality standards, delays or reductions in product shipments could occur which could harm our business, financial condition and results of operations.

Sales and Marketing

Our sales and marketing efforts are designed to serve our customer base consisting of both the DUV photolithography tool providers such as ASML, Canon and Nikon as well as many of  the world’s top 23 chipmakers.  We market and sell our products through our own worldwide direct sales and marketing channels and we have developed product and applications engineering teams to support these efforts. We believe that in order for our sales and marketing organization to be successful, we must work closely with and understand the requirements of both the photolithography systems solutions providers and the end-user semiconductor manufacturers.

Service and Support

We believe our success in the semiconductor photolithography market is highly dependent upon after-sales support to both our direct and our end-user customers.  We support our customers with field service, technical service engineers and training programs, and provide on-site support at the customer’s manufacturing facilities.  Prior to shipment, our support personnel typically assist the customer in site preparation and inspection and provide customers with training at our facilities or at the customer’s location.  We also provide direct customers and end-users with a comprehensive set of manuals, including operations, maintenance, service, diagnostic and safety manuals.

Our field engineers and technical support specialists provide field service and front-line technical support capability from our San Diego headquarters, and at our field service offices located throughout the U.S. Support in Europe, Japan, Korea, Singapore, the People’s Republic of China, Taiwan and Southeast Asia is provided by our subsidiaries located within those regions.  As part of our customer service, we maintain an inventory of spare parts at each of our service facilities.  As our installed base grows, replacement parts required to satisfy worldwide support requirements, as well as

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our own logistics support organization, will be subject to the fluctuating demands of the semiconductor industry. In order to meet these demands, we must continue to effectively manage our production of component modules which are required for new systems, as well as for support and warranty requirements for installed systems.

We believe that the need to provide fast and responsive service that meets the level of quality required by semiconductor manufacturers using our light sources is critical and that we cannot depend solely on our customers to provide this service.  Therefore, we believe it is essential to maintain, through our own personnel, a rapid response capability to service our customers and end-users throughout the world.  Accordingly, we seek to continuously develop and enhance our direct support infrastructure in Europe, Japan, Korea, Singapore, the People’s Republic of China, Taiwan and Southeast Asia and the U.S.  This task entails recruiting and training qualified field service personnel or identifying qualified independent firms and maintaining effective and highly trained organizations that can provide service to customers in various countries in their assigned regions.

We generally warrant our new light source products against defects in design, materials, and workmanship.  The warranty period and terms vary by light source model.  We also warrant consumable and spare parts sold to our customers and the coverage period varies by spare part type as some types include time-based warranty periods and others include usage-based warranty periods.

Research and Development

The semiconductor industry is subject to rapid technological change and new product introductions and enhancements.  We believe that continued and timely development and introduction of new and enhanced light source products are essential for us to maintain our competitive position.  We intend to continue to develop our technology and innovative products to meet customer demands. Current projects include enhancements to our KrF and ArF light sources and the recently announced development of a recirculating ring based ArF light source which provides performance enhancements to our MOPA product line.  We have continued to expend significant development efforts to address the technology and products that will be based on the extreme ultraviolet (“EUV”) technology needed for future generation photolithography illumination sources. We may also invest in other product and technology areas in order to expand our portfolio within the semiconductor capital equipment market sector.  In addition there are ongoing efforts to improve existing products, reduce manufacturing costs, lower the cost of light source operation, enhance light source performance, develop new features for existing light sources, and conduct research and development of non-light source products.

We have historically devoted a significant portion of our financial resources to research and development programs and we expect to continue to allocate significant resources to these efforts. Research and development expenses for 2004, 2005 and 2006 were approximately $58.6 million, $64.0 million and $74.0 million, respectively.

In the last three years, we have entered into several research and development agreements related to EUV technology both with customers and government agencies. The largest of these research and development agreements was with Intel Corporation in January 2004. This agreement  provided funding to accelerate the development of production-worthy EUV lithography light sources at Intel’s request. This agreement was terminated in June 2006.  See Note 6 to our consolidated financial statements for additional information. The total funding recorded under this agreement for 2004, 2005 and 2006 was $6.1 million, $1.9 million and $104,000, respectively.

Revenues generated from research and development contracts amounted to approximately $783,000, $1.0 million and $395,000 during 2004, 2005 and 2006, respectively.  For certain of our research and development contracts, our research and development expenses are offset by amounts earned associated with these contracts.  The amounts offset against research and development expenses were $7.6 million, $2.8 million and $154,000 during 2004, 2005 and 2006, respectively.

We have established a joint venture with Zeiss called TCZ which is headquartered in Singapore. 

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The joint venture is owned 60% by us and 40% by Zeiss. TCZ is currently developing, and will integrate, market and sell, and support, production tools for the flat panel display manufacturing industry.  The joint venture is targeting the growing market for low-temperature poly-silicon (“LTPS”) processing used in the manufacture of liquid crystal displays that are brighter, have higher resolution, and consume less power than displays using today’s predominant amorphous silicon films.  We currently expect that TCZ will ship its first production tool, the TCZ 900X, in late 2007 or early 2008.   As a majority owned subsidiary, TCZ’s results, including research and development expenses, are included in our consolidated financial statements.

Intellectual Property Rights

While the success of our business depends more on such factors as the technical expertise of our employees, as well as their innovative skills and marketing and customer relations abilities, the success of our business also relies on our ability to protect our proprietary technology.  Accordingly, we seek to protect our intellectual property rights in a variety of ways, including by obtaining patents.  As of December 31, 2006, we owned 254 U.S. patents covering certain aspects of technology related to light sources and piezo techniques.  These patents will expire at various times during the period from January 2008 to September 2025. As of December 31, 2006, we had applied for 137 additional patents in the U.S.  As of December 31, 2006, we owned 396 foreign patents and had 373 patent applications pending in various foreign countries.

Our pending patent applications and any future applications might not be approved. Our patents might not provide us with a competitive advantage and may be challenged by third parties. In addition, third parties’ patents might have an adverse effect on our ability to do business. Due to cost constraints, we did not begin seeking patent protection in Japan and other countries for our inventions that are covered by U.S. patents and patent applications until 1993.  As a result, we do not have the right to seek foreign patent protection for some of our early inventions.  Additionally, laws of some foreign countries in which our products are or may be developed, manufactured or sold, including various countries in Asia, may not protect our products or intellectual property rights to the same extent as do the laws of the U.S. Thus, the likelihood of piracy of our technology and products is greater in these countries. Further, third parties might independently develop similar products, duplicate our products, or design around patents that are granted to us.

Other companies or persons may have filed or may file in the future patent applications that are similar or identical to ours. We may have to participate in appropriate proceedings in the courts or the patent offices to determine the priority of inventions. These proceedings may determine that these third-party patent applications have priority over our patent applications. Loss of priority in these interference proceedings could result in substantial cost to us.

We also rely on trade secret protection, employee and third-party nondisclosure agreements and other intellectual property protection methods to protect our confidential information and our other intellectual property. However, we may not be successful in protecting our confidential information, particularly our trade secrets, because third parties may independently develop substantially the same proprietary information and techniques, gain access to our trade secrets, or disclose our technology.

In the past, funds from research and development arrangements with third parties have been used to pay for a portion of our own research and development expenses. We receive these funds from government-sponsored programs and customers, in connection with our designing and developing specific products. Periodically, funds from lithography tool manufacturers and chipmakers are used to fund a small portion of our research and development expenses. In providing these research and development services to these manufacturers, we try to make clear who owns the intellectual property that results from the research and development services we perform. However, disputes over the ownership or rights to use or market this intellectual property may arise between the funding organizations and us.

 

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Third parties have notified us in the past, and may notify us in the future, that we are infringing their intellectual property rights. Also, we have notified third parties in the past, and may notify them in the future, that they may be infringing our intellectual property rights.

Specifically, Komatsu notified us in 1996 that we may be infringing some of its Japanese patents. During our subsequent discussions, Komatsu also asserted that our former Japanese manufacturing partner, Seiko, or we may be infringing on some of Komatsu’s U.S. patents and a number of its additional Japanese patents. Komatsu has also notified one of our customers, Nikon, of its belief that our light sources infringe several of Komatsu’s Japanese and U.S. patents. As a result, we started proceedings in the Japanese Patent Office to oppose certain patents and patent applications of Komatsu. The Japanese Patent Office has dismissed our opposition claims. Thus, litigation may result in connection with Komatsu’s Japanese patents or U.S. patents. Also, Komatsu might claim that we infringe other or additional patents. Komatsu notified Seiko that it intends to enforce its rights against Seiko with respect to its Japanese patents if Seiko continued to engage in manufacturing activities for us. In connection with our former manufacturing agreement with Seiko, we agree to pay Seiko under certain conditions for damages associated with these types of claims. Seiko may not prevail in any litigation against Komatsu, and therefore, we may be required to pay Seiko for such damages.

We have notified our competitor and others of our U.S. patent portfolio. Specifically, we have notified Komatsu that it may be infringing some of our U.S. patents. We have discussed with Komatsu our claims against each other.  Komatsu challenged one of our U.S. patents in the United States Patent and Trademark Office (“USPTO”) but our patent was subsequently re-issued by the USPTO.  Also, Komatsu transferred its lithography light source business to our competitor, Gigaphoton.  We also have had discussions with a former competitor, Lambda-Physik (a subsidiary of Coherent, Inc.), regarding allegations by each party against the other for possible patent infringement. Any of these discussions with our competitor or former competitor may not be successful and litigation could result.

In the future, patent litigation may result due to a claim of infringement by our competitor or any other third party or may be necessary to enforce patents issued to us.  Any such litigation could result in substantial cost to us and diversion of our effort, which would have an adverse effect on our business, financial condition and operating results. Furthermore, our customers and the end-users of our products might assert other claims for indemnification that arise from infringement claims against them. If these assertions are successful, our business, financial condition and operating results may be materially affected. Instead of litigation, or as a result thereof, we may seek a license from third parties to use their intellectual property. However, we may not be able to obtain a license. Alternatively, we may design around the third party’s intellectual property rights or we may challenge these claims in legal proceedings.  Any adverse determination in a legal proceeding could result in one or more of the following, any of which could harm our business, financial condition and operating results:

·                   loss of our proprietary rights;

·                   exposure to significant liabilities by other third parties;

·                   requirement that we get a license from third parties on terms that are not favorable; or

·                   restriction from manufacturing or selling our products.

Any of these actions could be costly and would divert the efforts and attention of our management and technical personnel, which would materially adversely affect our business, financial condition and results of operations.

In 1992, we granted Seiko a right of first refusal to fund our development of, and receive a license to, new industrial light source technologies not developed with funding from other parties.  In exchange for these rights, we received up-front license fees of $3.0 million in aggregate during 1992 and 1993. We were also entitled to royalties of 5% on related product sales through September 1999, after which the royalty rate was subject to renegotiation.  To date no renegotiation of the royalty rate has occurred and we have earned no royalties under the agreement.  The license agreement also provides that product sales between us and Seiko will be at a 15% discount from the respective companies’ list prices.  The agreement terminates in August 2012.  There has been no production or sales activity by

 

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Seiko associated with this contract to date and this contract does not apply to our current light source system products.

We have registered the trademarks ‘‘CYMER’’ and “INSIST ON CYMER” and others in the U.S. and in some other countries. We are also trying to register additional trademarks in the U.S. and in other countries. We use these trademarks and many other marks in our advertisements and other business materials, which are distributed throughout the world. We may be subject to trademark infringement actions for using these marks and other marks on a worldwide basis and this would be costly to defend. If a trademark infringement action were successful, we would have to stop using the mark and possibly pay damages.

Competition

We believe that the principal elements of competition in our markets are the technical performance characteristics of the excimer light source products and the operating efficiency of the system, which is based on availability, reliability, performance efficiency, throughput, cost of operation, and rate of quality. We believe that we compete favorably with respect to these factors.

We currently have one significant competitor that sells light sources for DUV photolithography applications. This competitor, Gigaphoton, is a joint venture between two large companies, Komatsu and Ushio, and is headquartered in Japan.  Gigaphoton is aggressively trying to gain larger market penetration in the excimer light source industry. We know that our lithography tool manufacturer customers have purchased products from this competitor and that these customers have approved this competitor’s light sources for use with their products.  Additionally, we know that Gigaphoton has been approved by a number of chipmakers in Japan and other regions in Asia, as well as a few chipmakers in the U.S., and that Gigaphoton has an installed base of light sources at chipmakers in these regions.

In the future, we will likely experience competition from other companies as well, as next generation technologies must be adopted in order to enable critical dimensions to continue to shrink beyond the 32 nm node.  These technologies include EUV, an area in which we have been conducting research and development since 1997 and for which we currently have a very promising light source in development, and possibly nano-imprint lithography or certain types of maskless lithography, such as multiple electron beam direct write lithography.

To remain competitive, we believe that we will need to manufacture and deliver products to customers on a timely basis without significant defects and maintain a high level of investment in research and development and sales and marketing.  We might not have sufficient resources to continue to make the investments necessary to maintain our competitive position.

Larger companies with substantially greater resources, such as other manufacturers of industrial light sources for advanced lithography, may attempt to sell competitive products to our customers. Potential competitors may also be attracted to our growing installed base of light sources and may attempt to supply consumables and spare parts to that installed base.

Employees

On December 31, 2006, we employed 975 persons worldwide. No employees are currently covered by collective bargaining agreements or are members of any labor organization as far as we are aware. We have not experienced any work stoppages and believe that our employee relations are good.

Executive Officers

Set forth below is certain information regarding our executive officers and their ages as of February 23, 2007.

 

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Name		Age		Position
Robert P. Akins		55		Chairman of the Board and Chief Executive Officer
Edward J. Brown		49		President and Chief Operating Officer
Nancy J. Baker		44		Senior Vice President, Chief Financial Officer
Christopher W. Smith		47		Senior Vice President, Worldwide Business Operations
Stephan D. Spiva		58		Senior Vice President, Corporate Operations
Rae Ann Werner		42		Vice President, Controller and Chief Accounting Officer

 

Robert P. Akins, one of our co-founders, has served as our chairman and chief executive officer since our inception in 1986, and served as president of the company as well from our inception until May 2000. He currently serves on the boards of directors of Semiconductor Equipment and Materials International (“SEMI”), and SEMI North America.  He is also a member of the council of advisors to the Irwin and Joan Jacobs School of Engineering at the University of California, San Diego (“UCSD”), and serves on the board of the UC San Diego Foundation.  Mr. Akins received the Ernst & Young Entrepreneur of the Year Award for San Diego County in 1997, and with fellow co-founder Rick Sandstrom, received the outstanding alumnus award from UCSD, and the prestigious SEMI Award for North America, the highest honor conferred by SEMI, in 1996 for contributions to the field of DUV lithography. Mr. Akins received a bachelor’s degree in physics, a bachelor’s degree in literature, and a doctorate in applied physics from the University of California, San Diego.

Edward J. Brown, Jr. has served as president and chief operating officer since September 2005.  Mr. Brown has nearly three decades of experience in the technology sector, including 17 years as an executive and 11 as a corporate officer. Prior to joining us, Mr. Brown held several high-level management positions at Applied Materials Inc., the world’s largest provider of semiconductor equipment and services. At Applied Materials, he was responsible for key business innovations, overseeing global operations, and enabling significant revenue growth. Mr. Brown received a master’s degree in business administration from National University and a bachelor’s degree in industrial studies from San Diego State University.

Nancy J. Baker has served as senior vice president and chief financial officer since January 2002.  Prior to that, she served as our vice president, finance and treasurer from June 1998 to December 2001.  During 2000, she headed the company’s successful effort to implement a new Enterprise Resource Planning system, which was implemented in San Diego in only six months, and globally in only nine months. From October 1996 to June 1998 she served as director, corporate finance and treasurer.  She joined us as corporate controller for worldwide operations in August 1992.  Ms. Baker’s professional career spans more than 21 years, and prior to joining us, she held a variety of financial management positions with an international manufacturer in the San Diego area.  Ms. Baker received a bachelor’s degree in accounting from the University of Texas at Austin and completed the executive advanced management program at Harvard Business School.

Christopher W. Smith has served as senior vice president of worldwide business operations since May 2006.  He has more than 20 years of sales, marketing and senior-level management experience. Prior to joining us, Mr. Smith spent about 12 years at Applied Materials, Inc. where he most recently served as vice president and general manager for the Intel, Micron and all North American regional accounts and was responsible for Applied Materials’ largest customer/technical business relationships from October 2001 to May 2006. Mr. Smith served as vice president and general manager for Applied Materials from October 1998 to October 2001 in the chemical mechanical polishing products business group; and from November 1994 to October 1988 he served as managing director of global business development in the dielectric deposition products business group and the physical vapor deposition products business group of Applied Materials where his responsibilities ranged from marketing and business development to technical and field process support.  Mr. Smith holds a bachelor’s degree in business from San Jose State University, and completed the Executive Program at Stanford University.

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Stephan D. Spiva has served as senior vice president of corporate operations since May 2006.  Mr. Spiva has more than 35 years of management experience, including 20 years with the U.S. Navy.  Prior to joining us, Mr. Spiva was vice president of enterprise solutions at Applied Materials, Inc from June 1998 until his retirement in June 2001. From March 1988 to June 1998, Mr. Spiva served at Applied Materials in various management positions, including as the managing director of global installed base operations, senior director of Intel account operations and director of the advanced manufacturing group and also implemented the Oracle Enterprise Resource Planning system for manufacturing and order fulfillment business processes at Applied Materials. Mr. Spiva received his bachelor’s degree in business administration from the University of Phoenix and is also APICS and CIRM certified.

Rae Ann Werner has served as vice president, controller, and chief accounting officer since January 2003. Prior to that, she served as our controller from February 1999 to January 2003. From 1993 to 1999 she held a variety of finance positions with increasing responsibilities since joining us in November 1993.  Ms. Werner’s professional career spans more than 19 years, and prior to joining us, she held a variety of financial positions with semiconductor and communications companies in the San Diego area.  Ms. Werner received a bachelor’s degree in accounting from San Diego State University.

Executive officers serve at the discretion of the board of directors. There are no family relationships between any of the directors and our executive officers.

 Item 1A.  Risk Factors

The risks described below may not be the only risks we face. Additional risks that we do not currently think are material may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer, and the trading price of our common stock could decline.

Our revenues and operating results from quarter-to-quarter have varied in the past and our future operating results may continue to fluctuate significantly.

Factors that contribute to fluctuations in our revenues and operating results include:

·                  demand for semiconductors in general and, in particular, for leading edge devices with smaller circuit geometries;

·      cyclicality in the market for semiconductor manufacturing equipment;

·                  rates at which chipmakers take delivery of photolithography tools from lithography tool manufacturers;

·                  rates at which lithography tool manufacturer customers take delivery of light source systems from us;

·      timing and size of orders from our customers;

·      changes in market penetration by our competitor;

·                  product lead time demands from our customers;

·                  mix of light source models, consumable and spare parts and service revenues in our total revenues;

·      changes in the price and profitability of our products;

·      our ability to develop and implement new technologies and introduce new products;

·                  utilization rates of light sources and sales of consumable and spare parts and services;

·                  our ability to manage customer satisfaction, product reliability, and direct field service and support effectiveness;

·      our ability to manage our manufacturing requirements;

·                  foreign currency exchange rate fluctuations, principally with respect to the Japanese yen (in which sales by our Japanese subsidiary are denominated);

·      worldwide political instability;

·      changing global economic conditions, including rising energy prices; and

 

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·      intellectual property protection.

We have historically derived a large portion of our quarterly and annual revenues from selling a small number of light source systems. Because we sell a small number of products, the precise time that we recognize revenue from an order may have a significant impact on our total revenue for a particular period. Our customers may cancel or reschedule orders with little or no penalty. Orders expected in one quarter could shift to another period due to changes in the anticipated timing of our customers’ purchase decisions or rescheduled delivery dates requested by our customers. Our operating results for a particular quarter or year may be adversely affected if our customers, particularly our three largest customers, cancel or reschedule orders, or if we cannot fill orders in time due to unexpected delays in manufacturing, testing, shipping, and product acceptance.

We manage our expense levels based, in large part, on expected future revenues. As a result, our expenses are relatively fixed for the short term, and if our actual revenue decreases below the level we expect, our operating results will be adversely affected.  As a result of these or other factors, we could fail to achieve our expectations as to future revenue, gross profit, operating income, net income, earnings per share, and cash flows.  Our failure to meet the performance expectations set and published by external sources could result in a sudden and significant drop in the price of our stock, particularly on a short-term basis, and could negatively affect the value of any investment in our stock.

Our business depends on the semiconductor and the semiconductor capital equipment industries, which are highly volatile and unpredictable.

We derive a substantial portion of our revenues from lithography tool manufacturers who, as original equipment manufacturers (“OEMs”), incorporate our light source systems in photolithography tools that they sell to semiconductor manufacturers, or chipmakers, and from chipmakers who purchase consumables, spare parts, upgrades and service directly from us in support of the light source products. Like us, our OEM customers depend on demand for their products from the chipmakers. The capital equipment and related operating expenditures of chipmakers depend on a number of factors, including the current and anticipated market demand for semiconductors and the many products using semiconductors.  That demand is highly volatile and unpredictable.

As a result of the cyclicality of the semiconductor industry, the semiconductor capital equipment industry historically has experienced periodic ups and downs. The cyclical nature of the semiconductor and the semiconductor capital equipment industries affects our ability to accurately predict future revenue and therefore our ability to manage our future expense levels. When cyclical fluctuations result in lower than expected revenue levels, operating results may be adversely affected and cost reduction measures may be necessary in order for us to remain competitive and financially sound.  During a down cycle or slowdown, we must be in a position to adjust our cost and expense structure to prevailing market conditions while still being able to maintain the longer term strategies of the company as well as motivate and retain our key employees. During periods of rapid growth, we must be able to increase manufacturing capacity and personnel to meet customer demand.  We can provide no assurance that these objectives can be met in a timely manner in response to industry cycles.  We are not able to predict with any certainty the duration of any industry cycle or the timing or order of magnitude of any recovery.

Downturns in the semiconductor industry often result in decreases in demand for semiconductor manufacturing equipment, including the photolithography tools that our OEM customers produce. Downturns in the semiconductor industry have generally had severe effects on the demand for semiconductor manufacturing equipment and the associated parts and support services. Fluctuating levels of investment by chipmakers and resulting pricing volatility will continue to materially affect our aggregate bookings, revenues and operating results. Even during periods of reduced revenues we believe we must continue to invest in research and development and to maintain extensive ongoing worldwide customer service and support capabilities to remain competitive. Continued spending in furtherance of these objectives may temporarily harm our financial results.  Semiconductor industry downturns and slowdowns are likely to continue to adversely affect our business, financial condition and

 

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operating results, and our operating results may fall below the expectations of public market analysts or investors in future quarters. Any failure to meet such expectations could materially adversely affect the price of our common stock.

Our OEM customers try to manage their inventories and production requirements to appropriate levels that reflect their expected sales to chipmakers. Market conditions in the semiconductor industry and our OEM customers’ production efficiency can cause them to expand or reduce their orders for new light source systems as they try to manage their inventories and production requirements. We continue to work with our OEM customers to better understand these issues. However, we cannot guarantee that we will be successful in understanding our OEM customers’ inventory management and production requirements or that our OEM customers will not build up an excess inventory of light source systems. If our OEM customers retain an excess inventory of light source systems, our revenue could be reduced in future periods as the excess inventory is utilized, which could adversely affect our operating results, financial condition and cash flows.  If our OEM customers demand shorter product lead times to improve their inventory and cash positions, our inventory management and cash position may be negatively impacted, which may adversely affect our operating results, financial condition and cash flows.

A significant percentage of our revenue is derived from sales to the three lithography tool manufacturers, and if we are not able to retain these customers, or they reschedule, reduce or cancel orders, or delay or default on payments, our revenues would be reduced and our financial condition and cash flows would suffer.

Three large companies, ASML, Canon and Nikon dominate the photolithography tool business. Collectively, these three companies accounted for the following percentage of our total revenue during the periods indicated:

 

 

Collectively, these three companies accounted for the following percentage of our total accounts receivable at the dates indicated:

 

 

We expect that sales of our light source products to these three customers will continue to account for a substantial portion of our revenue in the foreseeable future. None of our customers are obligated to purchase a minimum number of our products in the aggregate or during any particular period.  We can provide no assurance that any of our customers will continue to purchase our products at past or current levels.  For example, revenue attributable to sales to Canon has declined significantly since 2004.  Sales to Canon or any of these customers may be affected by many factors, some of which are beyond our control. These factors include:

·      a change in a customer’s competitive position in its industry;

·      a customer experiencing lithography tool production problems;

·      a decision to purchase light sources from other suppliers;

 

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·                  changes in economic conditions in the semiconductor or the photolithography tool industries; and

·                  a decline in a customer’s financial condition.

The loss of any significant business from or production problems for any one of these three customers would harm our business and financial condition.

A substantial percentage of our revenue is derived from the sale of a limited number of primary products.

Our only current product line is excimer light source systems, including KrF and ArF systems, and support, including consumable and spare parts and service support.  We expect these light source systems and the related support to continue to account for a substantial majority of our revenues in the near term. Continued market acceptance of our light source system products is, therefore, critical to our future success. The primary market for excimer light sources is in the use of DUV photolithography equipment for manufacturing deep-submicron semiconductor devices using smaller circuit geometries. The demand for our products depends in part on the rate at which chipmakers further adopt excimer light sources as the chosen light source for their photolithography tools.

 The rate with which chipmakers adopt excimer light sources may vary for a variety of reasons, including:

·                  inadequate performance of photoresists used in advanced DUV photolithography, especially new ArF immersion-specific resists;

·                  potential shortages of specialized materials used in DUV optics;

·                  productivity of ArF immersion lithography tools, and in the future, productivity of double-patterning ArF lithography tools; and

·      consolidation of chipmakers.

We cannot guarantee that these factors can or will be overcome or that the demand for our excimer light source products will not be materially reduced. The demand for our light source products, and therefore our operating results, financial condition and cash flows, could be adversely affected by a number of factors, including:

·                  a decline in demand for our customers’ DUV photolithography tools;

·                  a failure to achieve continued market acceptance of our products;

·                  a failure to manage customer satisfaction, product reliability, and direct field service and support effectiveness;

·                  an improved version of products being offered by a competitor in the market in which we participate;

·                  technological change that we are unable to address with our products; and

·      a failure to release new enhanced versions of our products on a timely basis.

We depend on the introduction of new products for our success, and we are subject to risks associated with rapid technological change.

Rapid technological changes in semiconductor manufacturing processes subject us to increased pressure to develop technological advances enabling such processes. We believe that our future success depends in part upon our ability to develop, manufacture, timely introduce and support new light source products with improved capabilities and to continue to enhance our existing light source systems and process capabilities.  Due to the risks inherent in transitioning to new products, we must forecast accurate demand for new products while managing the transition from older products.

Our most significant product introduction in recent years consisted of a technology change from a single-discharge-chamber excimer light source to a dual-discharge-chamber design called MOPA. 

 

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The MOPA design represents a paradigm shift from previously accepted lithography technology and offers chipmakers higher power, tighter bandwidth and lower cost of operation for their current — and we expect for their future — optical lithography applications.  As originally designed, the MOPA architecture was projected to provide its benefits across all three DUV wavelengths — 248 nm, 193 nm, and 157 nm — but at this time, the semiconductor industry has only adopted MOPA at the 193 nm wavelength, due to the successful extension of 248 nm single chamber technology, and the omission of 157 nm lithography from the roadmap.  There are risks inherent in the MOPA technology, including effective execution of our product development roadmap, continuing adoption of the product by lithography tool manufacturers and chipmakers, manufacturability, cost effectiveness, and product performance in the field of the new products and the development of a comparable product by our competitor.

At this time, chipmakers are continuing to expand their manufacturing capacity at 90 nm, and a growing number of chipmakers are ramping up production capability at 65 nm, while manufacturers of certain types of memory chips are in the early stages of ArF immersion production below 65 nm and a significant level of development is underway at 45 nm.  These efforts, along with expanding use of ArF immersion lithography in production among certain memory manufacturers, are driving demand for our most advanced ArF light sources.  At the same time chipmakers also need tools for the less critical layers on wafers, and there remains strong demand for our KrF light source products for DUV photolithography systems as well. After chipmakers have built their capacity to levels appropriate to meet existing demand, their demand for our light source products will depend, in part, on their sales forecasts and their estimates regarding the duration and magnitude of the current industry cycle and whether their projected manufacturing process yields will enable ongoing investments in whatever capacity seems necessary.

Future technologies such as EUV, nano-imprint lithography, and certain maskless lithography techniques may render our excimer light source products obsolete. We must manage product transitions, as introduction of new products could adversely affect our sales of existing products. If new products are not introduced on time, or have reliability or quality problems, our performance may be impacted by reduced orders, higher manufacturing costs, delays in acceptance of and payment for new products, and additional service and warranty expenses. We may not be able to develop and introduce new products or enhancements to our existing products and processes in a timely or cost effective manner that satisfies customer needs or achieves market acceptance. Failure to develop and introduce these new products and enhancements could materially adversely affect our operating results, financial condition and cash flows.

We expect to face significant competition from current and future competitors. We believe that other companies are developing systems and products that are competitive to ours and are planning to introduce new products to this market, which may affect our ability to sell our new products. Furthermore, new products represent significant investments of our resources and their success, or lack thereof, could have a material effect on our financial results.

Failure to maintain effectively our direct field service and support organization could have a material adverse effect on our business.

We believe it is critical for us to provide quick and responsive service directly to the chipmakers throughout the world that use our light source products in their photolithography systems, and that it is essential to maintain our own personnel or trained third-party resources to provide these services.  Accordingly, we have an ongoing effort to develop our direct support system with locations in Europe, Korea, Japan, the People’s Republic of China, Singapore, Taiwan and the U.S. This requires us to do the following:

·                  recruit and train qualified field service personnel;

·                  identify qualified independent firms; and

·                  maintain effective and highly trained organizations that can provide service to our customers in various countries.

 

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We may not be able to attract and train qualified personnel to maintain our direct support operations successfully. We may not be able to find and engage qualified third-party resources to supplement and enhance our direct support operations.  Further, we may incur significant costs in providing these support services. Failure to implement our direct support operation effectively could harm our operating results, financial condition and cash flows.

We must develop and manufacture enhancements to our existing products and introduce new products in order to continue to grow our business. We may not effectively manage our growth and integrate these new enhancements and products, which could materially harm our business.

To continue to grow our business, our existing light source products and their process capabilities must be enhanced, and we must develop and manufacture new products to serve other semiconductor applications. We cannot guarantee that we will be able to manage our business to grow effectively. Nor can we guarantee that we will be able to accelerate the development of new enhancements to our existing products and create new products. Further, we may not be able to effectively integrate new products and applications into our current operations. Any of these risks could materially harm our business, financial condition and results of operations.

We must effectively manage changes in our business.

In order to respond to the business cycles of the semiconductor industry, in the past few years we have sharply expanded and contracted the scope of our operations and the number of employees in many of our locations and departments. As the semiconductor industry cycle moves between growth and contraction we will need to:

·                  improve our product reliability through quality control, and our order fulfillment, field service and customer support capabilities;

·                  closely manage our global operations;

·                  improve our process and other internal management systems;

·                  quickly adapt to changing sales and marketing channels;

·                  effectively manage our inventory levels; and

·      attract, train, retain and manage key personnel.

If we fail to effectively manage changes in our business, our operating results, financial condition and cash flows will be adversely affected.

We depend on a few key suppliers for purchasing components and subassemblies that are included in our products.

We purchase a limited number of components and subassemblies included in our light source products from a single supplier or a small group of suppliers.  For certain optical, control system and pulse power components and subassemblies used in our light source systems, we currently utilize a single supplier.  To reduce the risk associated with this single supplier, we carry a significant strategic inventory of these components.  Strategic inventories are managed as a percentage of future demand.  We have also negotiated to have vendor-managed inventory of critical components to further reduce the risk of a single supplier.  In addition, we contract the manufacture of various subassemblies of our products and depend on our contract manufacturers to deliver to our required specifications, schedule, and quality standards. Further, some of our suppliers have specialized in supplying equipment or manufacturing services to semiconductor equipment manufacturers and therefore are susceptible to industry ups and downs and subject to the same risks and uncertainties regarding their ability to respond to changing market conditions.  Because many of  these suppliers reduce the size of their workforce in an industry downturn and increase it in an upturn, they may not be able to meet our requirements or respond quickly enough as an upturn begins and gains momentum.  Due to the nature of our product development requirements, these key suppliers must rapidly advance their own technologies and production capabilities in order to support the introduction schedule of our new products. These suppliers may not be able to provide new modules and subassemblies when they are

 

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needed to satisfy our product schedule requirements. If we cannot purchase enough of these materials, components or subassemblies, or if these items do not meet our quality standards, there could be delays or reductions in our product shipments, which would harm our operating results, financial condition and cash flows.

We are dependent on our manufacturing facilities and subcontractors to assemble and test our products.

Operations at our primary manufacturing facility and our subcontractors are subject to disruption for a variety of reasons, including work stoppages, terrorism, fire, earthquake, energy shortages, flooding or other natural disasters.  Such disruptions could cause delays in shipments of our products to our customers.  We provide no assurance that alternate production capacity would be available if a major disruption were to occur or that, if it were available, it could be obtained on favorable terms.  Such disruption could result in cancellation of orders or loss of customers, which would have a material adverse effect on our operating results, financial condition and cash flows.

We face competition from one company and may face competition from additional competitors who enter the market.

We currently have one significant competitor that sells light sources for DUV photolithography applications. This competitor, Gigaphoton, is a joint venture between two large companies, Komatsu and Ushio, and is headquartered in Japan.  Gigaphoton is aggressively trying to gain larger market penetration in the excimer light source industry. We know that our customers have purchased products from this competitor and that our customers have approved this competitor’s light sources for use with their products.

Larger companies with substantially greater resources, such as other manufacturers of industrial light sources for advanced lithography, may attempt to sell competitive products to our customers. Potential competitors may also be attracted to our growing installed base of light sources which represents a steady and significant consumable and spare parts revenue stream for us, and they may attempt to supply consumable and spare parts to that installed base. If any existing or future competitors gain market acceptance, we could lose market share and our growth could slow or decline, which could have a material adverse effect on our operating results, financial condition and cash flows.

We depend on key personnel, especially management and technical personnel, who may be difficult to attract and retain.

We are highly dependent on the services of many key employees in various areas, including:

·                  research and development;

·                  engineering;

·                  sales and marketing;

·                  field service and support;

·                  manufacturing; and

·      management.

In particular, there are a limited number of experts in excimer light source technology, and we require highly skilled hardware and software engineers. Competition for qualified personnel is intense and we cannot guarantee that we will be able to continue to attract and retain qualified personnel as needed.  We do not have employment agreements with most of our employees. We believe that our future growth and operating results will depend on:

·                  the continued services of our research and development, engineering, sales and marketing,  field service and support, manufacturing, and management personnel;

·                  our ability to attract, train and retain highly-skilled key personnel; and

 

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·                  the ability of our personnel and key employees to continue to expand, train and manage our employee base.

If we are unable to hire, train and retain key personnel as required, our operating results,  financial condition and cash flows could be adversely affected.

Economic, political, regulatory and other events in geographic areas where we have significant sales or operations could interfere with our business.

We serve an increasingly global market.  A large portion of our total revenues is derived from customers located outside of the U.S.  We expect our international sales to continue to account for a very large portion of our total revenues.  In order to support our foreign customers, we maintain a manufacturing and field service subsidiary in Korea as well as field service and support subsidiaries in Japan, the Netherlands, the People’s Republic of China, Singapore and Taiwan.

We may not be able to manage our operations to address and support our global customers effectively.  Further, our investments in these types of activities may not make us competitive in the global market or we may not be able to meet the service, support, and manufacturing levels required by our global customers.

Additionally, we are subject to the risks inherent in doing business globally, including:

·                  unexpected changes in regulatory requirements;

·                  fluctuations in exchange rates and currency controls;

·                  political and economic conditions and instability;

·                  imposition of trade barriers and restrictions, including changes in tariff and freight rates, foreign customs and duties;

·                  difficulty in coordinating our management and operations in several different countries;

·                  difficulties in staffing and managing foreign subsidiary and branch operations;

·                  limited intellectual property protection in some countries;

·                  potentially adverse tax consequences in some countries;

·                  the possibility of accounts receivable collection difficulties;

·                  in the case of Asia, the risk of business interruption and damage from earthquakes;

·                  the effect of acts of terrorism and war; and

·      the burdens of complying with a variety of foreign laws.

Many of our major customers and many of the chipmakers who use our light source products in their photolithography systems are located in Asia. Economic problems and currency fluctuations affecting these regions in Asia could create a larger risk for us. Further, even though it has not been difficult for us to comply with U.S. export controls, these export rules could change in the future and make it more difficult or impossible for us to export our products to many countries.  Any of these vulnerabilities could have a material adverse effect on our business, financial condition and results of operations.

Our ability to compete could be jeopardized if we are unable to protect our intellectual property rights. These types of claims could seriously harm our business or require us to incur significant costs.

We believe our success and ability to compete depend in large part upon protecting our proprietary technology. We rely on a combination of patent, trade secret, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect our proprietary rights.

As of December 31, 2006, we owned 254 U.S. patents covering certain aspects of technology related to light sources and piezo techniques. These patents will expire at various times during the

 

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period from January 2008 to September 2025.  As of December 31, 2006, we had applied for 137 additional patents in the U.S.  As of December 31, 2006, we owned 396 foreign patents and had 373 patent applications pending in various foreign countries.

Our pending patent applications and any future applications might not be approved. Our patents might not provide us with a competitive advantage and may be challenged by third parties. In addition, third parties’ patents might have an adverse effect on our ability to do business. As a result of cost constraints, we did not begin seeking patent protection in Japan and other countries for our inventions that are covered by U.S. patents and patent applications until 1993.  As a result we do not have the right to seek foreign patent protection for some of our early inventions.  Additionally, laws of some foreign countries in which our products are or may be developed, manufactured or sold, including various countries in Asia, may not protect our products or intellectual property rights to the same extent as do the laws of the U.S. Thus, the likelihood of piracy of our technology and products is greater in these countries. Further, third parties might independently develop similar products, duplicate our products, or design around patents that are granted to us.

Other companies or persons may have filed or may file in the future patent applications that are similar or identical to ours. We may have to participate in appropriate proceedings in the courts or the  patent offices to determine the priority of inventions. These proceedings may determine that these third-party patent applications have priority over our patent applications. Loss of priority in these interference proceedings could result in substantial cost to us.

We also rely on the following to protect our confidential information and our other intellectual property:

·                  trade secret protection;

·                  employee nondisclosure agreements;

·                  third-party nondisclosure agreements; and

·      other intellectual property protection methods.

However, we may not be successful in protecting our confidential information and intellectual property, particularly our trade secrets, because third parties may:

·                  independently develop substantially the same proprietary information and techniques;

·                  gain access to our trade secrets; or

·      disclose our technology.

The parties to whom we provide research and development services may dispute the ownership of the intellectual property that we develop performing these services.

In the past, funds from research and development arrangements with third parties have been used to pay for a portion of our own research and development expenses. We receive these funds from government-sponsored programs and customers, in connection with our designing and developing specific products. Periodically, funds from lithography tool manufacturers and chipmakers are used to fund a small portion of our research and development expenses. In providing these research and development services to these manufacturers, we try to make clear who owns the intellectual property that results from the research and development services we perform. However, disputes over the ownership or rights to use or market this intellectual property may arise between the funding organizations and us. Any dispute over ownership of the intellectual property we develop could restrict our ability to market our products and have a material adverse effect on our business.

 

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In the future, we may be subject to patent litigation to enforce patents issued to us and defend ourselves against claimed infringement by our competitor or any other third party.

Third parties have notified us in the past, and may notify us in the future, that we are infringing their intellectual property rights. Also, we have notified third parties in the past, and may notify them in the future, that they may be infringing our intellectual property rights.

Specifically, Komatsu notified us in 1996 that we may be infringing some of its Japanese patents. During our subsequent discussions, Komatsu also asserted that our former Japanese manufacturing partner, Seiko, or we may be infringing on some of Komatsu’s U.S. patents and a number of its additional Japanese patents. Komatsu has also notified one of our customers, Nikon, of its belief that our light sources infringe several of Komatsu’s Japanese and U.S. patents. As a result, we started proceedings in the Japanese Patent Office to oppose certain patents and patent applications of Komatsu. The Japanese Patent Office has dismissed our opposition claims. Thus, litigation may result in connection with Komatsu’s Japanese patents or U.S. patents. Also, Komatsu might claim that we infringe other or additional patents. Komatsu notified Seiko that it intends to enforce its rights against Seiko with respect to its Japanese patents if Seiko continued to engage in manufacturing activities for us. In connection with our former manufacturing agreement with Seiko, we agreed to pay Seiko under certain conditions for damages associated with these types of claims. Seiko may not prevail in any litigation against Komatsu, and therefore, we may be required to pay Seiko for such damages.

We have notified our competitor and others of our U.S. patent portfolio. Specifically, we have notified Komatsu that it may be infringing some of our U.S. patents. We have discussed with Komatsu our claims against each other.  Komatsu challenged one of our U.S. patents in the United States Patent and Trademark Office (“USPTO”) but our patent was subsequently re-issued by the USPTO.  Also, Komatsu transferred its lithography light source business to our competitor, Gigaphoton.  We also have had discussions with a former competitor, Lambda-Physik (a subsidiary of Coherent, Inc.), regarding allegations by each party against the other for possible patent infringement.  Any of these discussions with our competitor or former competitor may not be successful and litigation could result.

In the future, patent litigation may result due to a claim of infringement by our competitor or any other third party or may be necessary to enforce patents issued to us.  Any such litigation could result in substantial cost to us and diversion of our effort,  which would have an adverse effect on our business, financial condition and operating results. Furthermore, our customers and the end-users of our products might assert other claims for indemnification that arise from infringement claims against them. If these assertions are successful, our business, financial condition and operating results may be materially affected. Instead of litigation, or as a result thereof, we may seek a license from third parties to use their intellectual property. However, we may not be able to obtain a license.  Alternatively, we may design around the third party’s intellectual property rights or we may challenge these claims in legal proceedings.  Any adverse determination in a legal proceeding could result in one or more of the following, any of which could harm our business, financial condition and operating results:

·                  loss of our proprietary rights;

·                  exposure to significant liabilities by other third parties;

·                  requirement that we get a license from third parties on terms that are not favorable to us; or

·      restriction from manufacturing or selling our products.

Any of these actions could be costly and would divert the efforts and attention of our management and technical personnel, which would materially adversely affect our business, financial condition and results of operations.

We may acquire a business or enter a new market that will involve numerous risks.  We may not be able to address these risks successfully without substantial expense, delay or other operational and financial challenges.

The risks involved with acquiring a new company, forming a joint venture, or entering a new market include the following:

 

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·                  diversion of management’s attention and resources to integrate the new company or new business opportunity;

·                  failure to retain key personnel;

·                  client dissatisfaction or performance problems with the acquired company or new product in a new market;

·                  amortization of acquired definite-lived intangible assets and deferred compensation;

·                  costs associated with acquisitions and joint ventures and the integration of acquired  operations;

·                  costs associated with developing, marketing, introducing and supporting a new product in a new market;

·                  failure to commercialize purchased technologies;

·                  ability of the acquired companies, joint ventures or new markets to meet their financial projections;

·                  assumption of unknown liabilities or other unanticipated events or circumstances; and

·                  compliance with the Sarbanes-Oxley Act of 2002, new SEC regulations, NASDAQ Stock Market rules and new accounting pronouncements as they relate to the new company or joint venture.

Mergers, acquisitions and joint ventures, as well as entry into new markets, are inherently subject to multiple significant risks, and the inability to effectively manage these risks could have a material adverse effect on our business.  In July 2005, we formed our TCZ joint venture with Zeiss to produce tools for the manufacture of flat panel displays.  This is a new market for both Cymer and Zeiss and may involve numerous risks. Any of these risks could materially harm our business, financial condition and operating results. Further, any business that we acquire, joint venture that we form or new market we may enter may not achieve anticipated revenues or operating results.

Compliance with changing regulations of corporate governance and public disclosure may result in additional expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations, including accelerated SEC filing timelines and new Proxy rules, new NASDAQ Stock Market rules, and new accounting pronouncements are creating uncertainty and additional complexities for companies such as ours. In particular, the Section 404 internal control evaluation requirements under the Sarbanes-Oxley Act have added and will continue to add complexity and costs to our business and require a significant investment of our time and resources to complete each year.  We take these  requirements seriously and expect to continue to make every effort to ensure that we receive clean attestations on our internal controls each year from our outside auditors. To maintain high standards of corporate governance and public disclosure, we intend to invest all reasonably necessary resources to comply with all other evolving standards. These investments may result in increased general and administrative expenses and a diversion of management time and attention from strategic revenue generating and cost management activities.

Decreased effectiveness of equity compensation could adversely affect our ability to attract and retain employees, and changes in accounting for equity compensation could adversely affect earnings.

We have historically used broad based stock option programs and other forms of equity-related incentives as a key component of our employee compensation packages. We believe that stock options and other long-term equity incentives directly motivate a broader base of employees to maximize long-term stockholder value and, through the use of long-term vesting, encourage employees to remain with us.  In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment — An Amendment to Statement Nos. 123 and 95,” which we adopted on January 1, 2006.  This rule requires us to record an expense to earnings for employee stock option grants and other equity incentives.

 

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Moreover, applicable stock exchange listing standards relating to obtaining stockholder approval of equity compensation plans has made it more difficult and expensive for us to grant options to employees, which has resulted in changes to our equity compensation strategy, including a significant reduction in the number of stock options granted to employees. We have developed alternative cash compensation arrangements for our employees to replace the majority of these stock option programs and may be required to offer additional alternative cash compensation arrangements in the future. These and other developments in the provision of equity compensation to employees could make it more difficult to attract, retain and motivate employees, and such a change in accounting rules and alternative cash compensation programs may adversely impact our future operating results, financial condition and cash flows.

We are dependent on air transport to conduct our business and disruption of domestic and international air transport systems could adversely affect our business.

We depend on regular and reliable air transportation on a worldwide basis for many of our routine business functions. If civil aviation in the U.S. or abroad is disrupted by terrorist activities or security responses to the threat of terrorism or for any other reason, our business could be adversely affected in the following ways:

·                  supplies of raw materials and components for the manufacture of our products or our customers’ products may be disrupted;

·                  we may not be able to deliver our products to our customers in a timely manner;

·                  we may not be able to provide timely service of or support for installed light sources for chipmakers; and

·      our sales and marketing efforts may be disrupted.

We are exposed to risks related to the fluctuations in the currency exchange rates for all foreign currencies in which we do business, but particularly for the Japanese yen.

When we sell products to our Japanese subsidiary, the sale is denominated in U.S. dollars. When our Japanese subsidiary sells our products directly to customers in Japan, the sale is denominated in Japanese yen. Thus, our results of operations may fluctuate based on the changing value of the Japanese yen to the U.S. dollar. We manage the exposure of our Japanese subsidiary to these fluctuations through forward contracts to hedge the subsidiary’s purchase commitments. We will continue to monitor our exposure to these currency fluctuations, and, when appropriate, use hedging transactions to minimize the effect of these currency fluctuations. However, exchange rate fluctuations may still have a material adverse effect on our operating results. In the future, we may need to sell a more significant portion of our products in foreign currencies other than the Japanese yen and the management of more currency fluctuations will be more difficult and expose us to greater risks in this area.

We are subject to many standards and regulations of foreign governments and, even though we intend to comply, we may not always be in compliance with these rules, or we may be unable to design or redesign our products to comply with these rules.

Many foreign government standards and regulations apply to our products.  These standards and regulations are always being amended.  Although we intend to meet all foreign standards and regulations, our products may not comply with these foreign government standards and regulations.  Further, it might not be cost effective for us to redesign our products to comply with these foreign government standards and regulations.  Our inability to design products to comply with foreign standards therefore could have a material adverse effect on our business.

 

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Chipmakers’ prolonged use of our products in high volume production may not produce the results they desire and, as a result, our reputation and that of our customers who supply photolithography tools to the chipmakers could be damaged in the semiconductor industry.

Over time, our light source products may not meet chipmakers’ production specifications or operating cost requirements after the light source has been used for a long period in high volume production. If any chipmaker cannot successfully achieve or sustain their volume production using our light sources, our reputation could be damaged with chipmakers and lithography tool manufacturers. This would harm our business.

Our operations are subject to environmental and other government regulations that may expose us to liabilities for noncompliance.

We are subject to federal, state and local regulations, such as regulations related to the environment, land use, public utility utilization and the fire code, in connection with the storage, handling, discharge and disposal of substances that we use in our manufacturing process and on our facilities.  We believe that our activities comply with current government regulations that are applicable to our operations and current facilities. We may be required to purchase additional capital equipment or other requirements for our processes to comply with these government regulations in the future if they change. Further, these government regulations may restrict us from expanding our operations. Adopting measures to comply with changes in the government regulations, our failure to comply with environmental and land use regulations, or restrictions on our ability to discharge hazardous substances, could subject us to future liability or cause our manufacturing operations to be reduced or stopped.

Our products are subject to potential product liability claims if personal injury or death results from their use.

We are exposed to significant risks for product liability claims if personal injury or death results from the use of our products. We may experience material product liability losses in the future. We maintain insurance against product liability claims. However, our insurance coverage may not continue to be available on terms that we accept. This insurance coverage also may not adequately cover liabilities that we incur. Further, if our products are defective, we may be required to recall or redesign these products. A successful claim against us that exceeds our insurance coverage level, or any claim or product recall that results in adverse publicity against us, could have a material adverse effect on our business, financial condition and results of operations.

Trademark infringement claims against our registered and unregistered trademarks would be expensive and we may have to stop using such trademarks and pay damages.

We registered the trademarks ‘‘CYMER’’ and “INSIST ON CYMER” and others in the U.S. and in some other countries. We are also trying to register additional trademarks in the U.S. and in other countries.  We use these trademarks and many other marks in our advertisements and other business materials, which are distributed throughout the world. We may be subject to trademark infringement actions for using these marks and other marks on a worldwide basis which would be costly to defend. If a trademark infringement action were successful, we would have to stop using one or more of the marks and possibly pay damages.

The price of our common stock has fluctuated and may continue to fluctuate widely.

The price of our common stock has fluctuated in the past. The market price of our common stock will continue to be subject to significant fluctuations in the future in response to a variety of factors, including the risk factors contained in this report.

Various factors may significantly affect the market price of our common stock, including:

·                  the cyclical nature of the semiconductor industry;

·                  actual or anticipated fluctuations in our operating results, including our net income, product gross margins and free cash flow;

·                  conditions and trends in the light source device and other technology industries;

 

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·                  announcements of innovations in technology;

·                  new products offered by us or our competitor;

·                  developments of patents or proprietary rights;

·                  changes in financial estimates by securities analysts;

·                  general worldwide political, economic, and market conditions;

·                  U.S. political, economic, and market conditions; and

·                  failure to properly manage any single or combination of risk factors listed in this section.

In addition, the stock market has experienced extreme price and volume fluctuations that have particularly affected the market price for many high technology companies. Such fluctuations have in some cases been unrelated to the operating performance of these companies. Severe price fluctuations in a company’s stock have frequently been followed by securities litigation.  Any such litigation can result in substantial costs and a diversion of management’s attention and resources and therefore could have a material adverse effect on our business, financial condition and results of operations.

Item 1B.  Unresolved Staff Comments

None.

Item 2.  Properties

Our corporate headquarters is located in San Diego, California and includes our executive and administrative offices, manufacturing, engineering, services, and research and development facilities. In addition, we also have field service offices located throughout the U.S. and internationally, a manufacturing facility located in Korea that we use to refurbish chamber assemblies, and a small office in  Singapore which is the headquarter office for our TCZ joint venture.  We currently have leases for buildings we no longer occupy in San Diego, California and Charlestown, Massachusetts, but we sublease all or a major portion of these facilities.

At December 31, 2006, details on our principal leased and owned properties were as follows:

Location		Lease Expiration		Total Square Footage		Primary Usage / Status
San Diego, California (1)		Owned		135,000		Corporate headquarters, engineering, research and development facilities
San Diego, California (1)		Owned		265,000		Manufacturing and administrative office
San Diego, California		January 2010		108,290		Facility subleased
San Diego, California		January 2010		36,959		Facility subleased
San Diego, California		January 2010		61,300		Facility subleased
Charlestown, Massachusetts		October 2007		21,262		11,262 square feet subleased
						10,000 square feet vacant
Motoyawata, Japan		June 2008		13,831		Field service and sales office
Hsin-Chu, Taiwan		June 2008		4,821		Field service and sales office
Goldenhill Plaza, Singapore		June 2009		3,315		Field service and sales office
Unity Centre, Singapore		January 2008		1,200		Administrative office (TCZ)
Maarssen, Netherlands		May 2009		3,715		Field service and sales office
Veldhoven, Netherlands		December 2008		2,605		Field service and sales office
Pyongtaek-city, Kyonggi, Korea — Land (2)		December 2020
— Building		Owned		26,000		Manufacturing, sales and administrative
Pudong, Shanghai, China		October 2008		4,746		Field service and sales office

 

(1)          Land and building are owned by us.

(2)          Land leased through December 2020.

 

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Item 3.    Legal Proceedings

None.

Item 4.    Submission of Matters to a Vote of Security Holders

None.

PART II

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is publicly traded on the NASDAQ Global Select Market under the symbol “CYMI”. The following table sets forth, for the periods indicated, the high and low prices of our common stock as reported by the NASDAQ Global Select Market.

 

 

The closing sales price of our common stock on the NASDAQ Global Select Market was $44.10 on February 23, 2007 and there were 235 registered holders of record as of that date.

We have never declared or paid cash dividends on our common stock and currently do not anticipate paying cash dividends in the future.

The information required to be disclosed by Item 201(d) of Regulation S-K “Securities Authorized for Issuance Under Equity Compensation Plans” is incorporated herein by reference to our Proxy Statement for our 2007 annual meeting of stockholders.

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Item 6.    Selected Financial Data

The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and notes thereto and with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this report.

		Years ended December 31,
		2002			2003			2004 (2)			2005			2006
		(in thousands, except per share data and footnotes)
Consolidated Statements of Operations Data:
Product sales		$	287,995		$	265,816		$	417,296		$	382,638		$	543,460
Other		871			57			783			1,010			395
Total revenues		288,866			265,873			418,079			383,648			543,855
Costs and expenses:
Cost of product sales		162,095			187,679			243,473			227,290			281,243
Research and development (1)		72,580			56,768			58,612			64,025			73,974
Sales and marketing		17,153			16,966			23,369			25,143			30,618
General and administrative		18,212			39,094			31,630			26,514			38,889
Total costs and expenses		270,040			300,507			357,084			342,972			424,724
Operating income (loss)		18,826			(34,634		)	60,995			40,676			119,131
Other income (expense) — net		(2,077		)	(1,139		)	(421		)	5,112			19,561
Income (loss) before income tax provision (benefit) and minority interest		16,749			(35,773		)	60,574			45,788			138,692
Income tax provision (benefit)		2,706			(21,464		)	15,144			262			46,137
Minority interest		(447		)	(1,091		)	(2,276		)	1,026			3,093
Net income (loss)		$	13,596		$	(15,400	)	$	43,154		$	46,552		$	95,648
Basic earnings (loss) per share		$	0.41		$	(0.44	)	$	1.17		$	1.29		$	2.53
Weighted average common shares outstanding		33,317			35,065			36,758			36,017			37,779
Diluted earnings (loss) per share		$	0.39		$	(0.44	)	$	1.15		$	1.27		$	2.40
Weighted average common and dilutive potential common shares outstanding		34,712			35,065			37,584			36,544			41,397

 

		As of December 31,
		2002			2003			2004 (2)			2005			2006
		(in thousands, except footnotes)
Consolidated Balance Sheet Data:
Cash and cash equivalents		$	92,273		$	110,632		$	114,246		$	233,745		$	302,098
Working capital		351,127			397,790			452,579			499,670			686,702
Total assets		766,887			809,244			818,836			791,376			949,094
Total long-term liabilities		255,154			261,627			208,035			151,304			155,503
Treasury stock		—			—			—			(50,000		)	(150,704		)
Stockholders’ equity		412,334			453,330			517,320			538,454			687,894

(1)          Includes amortization of  intangible assets associated with the acquisition of ACX in February 2001.  These amounts were previously shown as a separate line on the consolidated financial statements. Amortization of intangible assets totaled $160,000 for each of the years ended December 31, 2002, 2003 and 2004 and $20,000 for the year ended December 31, 2005.  As of December 31, 2005 these intangible assets were fully amortized.

(2)          During the fourth quarter of 2004, we corrected our accounting treatment for our parts refurbishment activities and all amounts associated with this correction are included in 2004.  This adjustment resulted in a $2.9 million increase in the inventory balance as of December 31, 2004, a $28.5 million increase in 2004 product revenues, a $25.6 million increase in 2004 cost of product sales, and a $2.0 million increase in 2004 net income.  See Item 7, “Management’s Discussion and Analysis of Financial Position and Results of Operations” under the caption “Critical Accounting Policies and Estimates” for a description of our current accounting treatment for our parts refurbishment activities.

 

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and notes thereto included in this Annual Report on Form 10-K.

Overview

We are the world’s leading supplier of light source solutions for the semiconductor industry.  Our products provide the essential light source for DUV photolithography systems.  Almost all consumer electronic devices manufactured in the last several years contain a semiconductor manufactured using light sources such as ours.  We currently supply light sources to all three lithography tool manufacturers, ASML, Canon, and Nikon, who in turn supply their wafer steppers and scanners to chipmakers.  In addition, we sell replacement parts and services to the lithography tool manufacturers as well as directly to the chipmakers.  Our light source systems currently constitute a substantial majority of all excimer light sources incorporated in lithography stepper and scanner tools. Our headquarters are located in San Diego, California where we develop and manufacture all of our light source systems and the majority of our replacement parts.  As a large portion of our revenue is derived from customers located outside of the U.S., we maintain a spare parts refurbishment facility and field service office in Korea and field service and support offices in Japan, the Netherlands, the People’s Republic of China, Singapore and Taiwan. Japan is currently our only subsidiary office that sells excimer light source systems. We also maintain field service offices in the U.S. to service our installed base of light sources located in the U.S.

Our TCZ joint venture which is headquartered in Singapore, is currently developing, and will integrate, market and sell, and support production tools for the flat panel display manufacturing industry. The joint venture is targeting the growing market for LTPS processing used in the manufacture of liquid crystal displays that are brighter, have higher resolution, and consume less power than displays using today’s predominant amorphous silicon films.  Although TCZ’s product is currently in the development phase, TCZ performed extensive customer demonstrations on its first generation demonstration tool in 2006 and we expect that TCZ will ship its first production tool, the TCZ 900X, in late 2007 or early 2008.

Since we derive a substantial portion of our revenues from lithography tool manufacturers, we are subject to the volatile and unpredictable nature of the semiconductor industry. The semiconductor industry is highly cyclical in nature and historically has experienced periodic ups and downs, and the activities of the last several years illustrate this cyclicality. In 2000, the semiconductor industry experienced strong growth, which was followed by a three year downturn from 2001 through late 2003. Growth resumed in late 2003, but one year later, in late 2004, the industry again declined for several months.  Business activity then leveled off early in 2005 and began to slightly improve quarter-over-quarter thereafter until late 2005, when orders for our light sources increased substantially from the levels seen earlier in the year.  Our chipmaker customers began indicating that increasing demand for chips would require them to expand production capacity, and our lithography tool manufacturing customers began placing orders for a growing number of light sources to meet increasing demand for scanners. By the end of 2005, it appeared that we were again entering  a strong industry growth cycle and upturn.

 

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There were many positive indicators throughout 2006 that reinforced our viewpoint that we had entered an upturn in the semiconductor industry, which included:

·                  Strong continuing demand for our ArF light sources as chipmakers purchased systems to enable production at advanced technology nodes.

·                  Stronger than anticipated demand for our KrF light sources, which chipmakers purchased to expand production capacity and pattern a growing number of less critical layers with DUV light sources.

·                  Substantial ongoing growth in our non-systems revenue which was driven by high light source utilization at chipmakers and high overall fab utilization.

As a result of these strong demand trends, our bookings, revenue and profits grew substantially in 2006 compared to 2005.  In 2006, we achieved record total revenue of $543.9 million, a 42%  increase over total revenue of $383.6 million in 2005.  Utilization of our light source systems at chipmakers also continued to increase in 2006 compared to 2005. This increased utilization when coupled with our growing installed base of light sources systems  drove our non-systems product revenue, which consists of consumables and spare parts, upgrades, and service, to a record $261.0 million for 2006, equal to 48%  of total revenue for the year.  This was a 49% increase over the $175.2 million in non-systems revenue in 2005.  Operating income climbed to a record $119.1 million, yielding an operating margin of 21.9% for the year, compared to 2005 operating income of $40.7 million and operating margin of 10.6%. Net income for 2006 also reached a record high of $95.6 million, equal to $2.40 per share fully diluted, compared to net income of $46.6 million, equal to $1.27 per share fully diluted, in 2005.  Our strong financial performance in 2006 allowed us to continue investing heavily in developing advanced DUV technologies to meet our customers’ next generation requirements.  It also allowed us to make progress on our longer-term growth initiatives such as EUV development and the activities of our TCZ joint venture.

Demand for our most advanced ArF light sources grew more than 20%  in 2006 compared to 2005, and we shipped a total of 122 of our XLA Series light sources during the year.  In 2006, lithography tool manufacturing customers ramped up their first wave of ArF immersion scanner production. Many of the immersion tools delivered earlier in 2006 were used primarily by chipmakers for process development purposes including defect reduction.  As chipmakers experienced success in qualifying their immersion production processes, they moved these tools from qualification into full production, and will augment them with additional immersion tool purchases to increase critical layer capacity.  At this time, immersion lithography is a production reality at a number of chipmakers’ fabs, and our expectation is that a growing number of chipmakers will adopt this advanced production technique over the next several years.

In general, industry trends that affect lithography are positive.  Leading NAND Flash memory manufacturers began using ArF immersion lithography in production near the end of 2006, and we anticipate that demand for immersion tools should grow this year as they continue to drive production with smaller CDs and expand the number of layers they need to pattern with ArF immersion tools.  Demand in the dynamic random access memory (“DRAM”) segment of the market is strong, driven by the transition to more advanced types of memory chips and by the large memory requirements of the Microsoft Vista operating system.  Foundries are primarily making technology buys rather than expanding capacity, but indications from the foundries and lithography tool manufacturers point toward additional capacity-driven growth in equipment orders beginning in the next few quarters.  Demand from integrated device manufacturers (“IDMs”) remains healthy and should be stable over the near and mid-term.  Although fab utilization experienced a slight decline late in 2006, fab utilization at the 90 nm production node and below continues to be strong.  Additionally, the 65 nm production ramp is well underway, and 21 new fabs are expected to be in or entering production at that node by the end of 2007.  Currently, there are significant research and development efforts underway at the 45 nm node, which is driving demand, and the first leading edge chipmakers are expected to begin production at 45 nm by the end of 2007.