**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**ý****                                ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period EndedJune 30, 2006**

 

**OR**

 

**o****                                ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934**

 

**For the Transition Period from                      to                      **

 

**Commissionfile number 0-21321**

 

**CYMER, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Nevada**                                                       | ** ** | **33-0175463**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or  organization) | ** ** | (I.R.S. Employer  Identification No.) |

 

| **17075  Thornmint Court, San Diego, CA** | ** ** | **92127**  |
|-------------------------------------------|------------|------------|
| (Address of  principal executive offices) | ** ** | (Zip Code) |

 

**(858) 385-7300**

(Registrant’stelephone number, including area code)

 

**N/A**

(Former name,former address and former fiscal year, if changed since last report).

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.   ý  Yes   o  No

 

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

 
| ý Large accelerated filer |   | o Accelerated filer |   | o Non-accelerated filer |
|--------------------------------|--------|---------------------|--------|-------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). oYes  ýNo

 

The number of shares ofCommon Stock, with $0.001 par value, outstanding on July 28, 2006 was 39,311,449.

 

 

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**CYMER,INC.**

 

**FORM 10-Q**

 

**For theQuarterly Period Ended June 30, 2006**

 

**INDEX**

 
| **PART I.**    | **FINANCIAL INFORMATION**                                                                        | ** ** |
|----------------|--------------------------------------------------------------------------------------------------|------------|
|           |                                                                                             |       |
| ITEM 1.        | Financial Statements (unaudited)                                                                 |       |
|           |                                                                                             |       |
|           | Consolidated Balance Sheets  as of December 31, 2005 and June 30, 2006                           |       |
|           |                                                                                             |       |
|           | Consolidated Statements of  Operations for the Three and six months ended June 30, 2005 and 2006 |       |
|           |                                                                                             |       |
|           | Consolidated Statements of  Cash Flows for the six months ended June 30, 2005 and 2006           |       |
|           |                                                                                             |       |
|           | Notes to Consolidated  Financial Statements                                                      |       |
|           |                                                                                             |       |
| ITEM  2.       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations      |       |
|           |                                                                                             |       |
| ITEM 3.        | Quantitative  and Qualitative Disclosures About Market Risk                                      |       |
|           |                                                                                             |       |
| ITEM 4.        | Controls and  Procedures                                                                         |       |
|           |                                                                                             |       |
| **PART II.**   | **OTHER INFORMATION**                                                                            | ** ** |
|           |                                                                                             |       |
| ITEM 1.        | Legal Proceedings                                                                                |       |
|           |                                                                                             |       |
| ITEM  1A.      | Risk Factors                                                                                     |       |
|           |                                                                                             |       |
| ITEM 2.        | Unregistered  Sales of Equity Securities and Use of Proceeds                                     |       |
|           |                                                                                             |       |
| ITEM 3.        | Defaults  Upon Senior Securities                                                                 |       |
|           |                                                                                             |       |
| ITEM 4.        | Submission  of Matters to a Vote of Security Holders                                             |       |
|           |                                                                                             |       |
| ITEM 5.        | Other Information                                                                                |       |
|           |                                                                                             |       |
| ITEM  6.       | Exhibits                                                                                         |       |
|           |                                                                                             |       |
| **SIGNATURES** |                                                                                             |

 

2

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**ITEM 1.Financial Statements**

 

**CYMER, INC.**

**CONSOLIDATEDBALANCE SHEETS  (UNAUDITED)**

**(In thousands, except share data)**

 
| ** **                                                                                                                                                                    | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                    | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| **ASSETS**                                                                                                                                                                    |       |                  |       |              |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| CURRENT ASSETS:                                                                                                                                                               |       |                  |       |              |       |
| Cash and cash  equivalents                                                                                                                                                    |       | $                     | 233,745    |              | $          | 312,141 |   |
| Short-term  investments                                                                                                                                                       |       | 130,204               |       | 186,375           |       |
| Accounts  receivable                                                                                                                                                          |       | 89,818                |       | 114,909           |       |
| Accounts  receivable - related party                                                                                                                                          |       | 588                   |       | 3,510             |       |
| Foreign currency  forward exchange contracts                                                                                                                                  |       | 1,776                 |       | 311               |       |
| Inventories                                                                                                                                                                   |       | 89,046                |       | 113,105           |       |
| Deferred income  taxes                                                                                                                                                        |       | 33,338                |       | 33,105            |       |
| Income taxes  receivable                                                                                                                                                      |       | —                |       | 3,028             |       |
| Prepaid expenses  and other assets                                                                                                                                            |       | 6,497                 |       | 7,205             |       |
| Total current  assets                                                                                                                                                         |       | 585,012               |       | 773,689           |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| PROPERTY AND  EQUIPMENT - NET                                                                                                                                                 |       | 117,251               |       | 112,657           |       |
| LONG-TERM INVESTMENTS                                                                                                                                                         |       | 29,395                |       | 9,763             |       |
| DEFERRED INCOME  TAXES                                                                                                                                                        |       | 34,429                |       | 25,680            |       |
| GOODWILL                                                                                                                                                                      |       | 8,358                 |       | 8,833             |       |
| INTANGIBLE  ASSETS - NET                                                                                                                                                      |       | 10,474                |       | 17,403            |       |
| OTHER ASSETS                                                                                                                                                                  |       | 6,457                 |       | 5,910             |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| TOTAL ASSETS                                                                                                                                                                  |       | $                     | 791,376    |              | $          | 953,935 |   |
|                                                                                                                                                                          |       |                  |       |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                |       |                  |       |              |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| CURRENT  LIABILITIES:                                                                                                                                                         |       |                  |       |              |       |
| Accounts payable                                                                                                                                                              |       | $                     | 17,710     |              | $          | 19,935 |   |
| Accounts payable  - related party                                                                                                                                             |       | 4,975                 |       | 4,609             |       |
| Accrued warranty  and installation                                                                                                                                            |       | 30,775                |       | 31,969            |       |
| Accrued payroll  and benefits                                                                                                                                                 |       | 12,461                |       | 16,721            |       |
| Accrued patents,  royalties and other fees                                                                                                                                    |       | 7,180                 |       | 6,114             |       |
| Income taxes  payable                                                                                                                                                         |       | 7,268                 |       | —            |       |
| Unearned income                                                                                                                                                               |       | 1,726                 |       | 2,556             |       |
| Other current  liabilities                                                                                                                                                    |       | 3,247                 |       | 3,301             |       |
| Total current  liabilities                                                                                                                                                    |       | 85,342                |       | 85,205            |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| CONVERTIBLE  SUBORDINATED NOTES                                                                                                                                               |       | 140,722               |       | 140,722           |       |
| OTHER  LIABILITIES                                                                                                                                                            |       | 10,582                |       | 13,712            |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| Total  liabilities                                                                                                                                                            |       | 236,646               |       | 239,639           |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| MINORITY  INTEREST                                                                                                                                                            |       | 16,276                |       | 8,356             |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                |       |                  |       |              |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                   |       |                  |       |              |       |
| Preferred stock  - authorized 5,000,000 shares; $.001 par value, no shares issued or  outstanding                                                                             |       | —                |       | —            |       |
| Common stock -  $.001 par value per share; 100,000,000 shares authorized; 38,036,000 and  41,219,000 shares outstanding at December 31, 2005 and June 30, 2006,  respectively |       | 38                    |       | 41                |       |
| Additional  paid-in capital                                                                                                                                                   |       | 407,549               |       | 528,974           |       |
| Treasury stock  at cost (1,943,000 common shares)                                                                                                                             |       | (50,000               | )          | (50,000           | )          |
| Accumulated  other comprehensive loss                                                                                                                                         |       | (9,025                | )          | (6,172            | )          |
| Retained  earnings                                                                                                                                                            |       | 189,892               |       | 233,097           |       |
| Total  stockholders’ equity                                                                                                                                              |       | 538,454               |       | 705,940           |       |
|                                                                                                                                                                          |       |                  |       |              |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                              |       | $                     | 791,376    |              | $          | 953,935 |   |
|                                                                                                                                                                          |       |                  |       |              |       |
| See Notes to  Unaudited Consolidated Financial Statements.                                                                                                                    |       |                  |       |              |       |

 

3

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**CYMER, INC.**

**CONSOLIDATED STATEMENTS OFOPERATIONS (UNAUDITED)**

**(In thousands, except per share data)**

 
| ** **                                                                | ** ** | **For the three months** | ** ** | **For the six months** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                | ** ** | **ended June 30,**            | ** ** | **ended June 30,**          | ** ** |
| ** **                                                                | ** ** | **2005**                                | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| REVENUES:                                                                 |       |                                    |       |                                  |       |   |   |   |   |
| Product sales                                                             |       | $                                       | 95,797     |                                  | $          | 132,081 |   | $ | 180,406 |   | $ | 256,983 |   |
| Product sales -  related party                                            |       | —                                  |       | 3,209                                 |       | — |   | 5,363 |   |
| Other                                                                     |       | 595                                     |       | 89                                    |       | 796 |   | 150 |   |
| Total revenues                                                            |       | 96,392                                  |       | 135,379                               |       | 181,202 |   | 262,496 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| COSTS AND  EXPENSES:                                                      |       |                                    |       |                                  |       |   |   |   |   |
| Cost of product  sales                                                    |       | 57,731                                  |       | 70,556                                |       | 110,762 |   | 139,247 |   |
| Research and  development                                                 |       | 16,937                                  |       | 18,803                                |       | 31,561 |   | 36,927 |   |
| Sales and  marketing                                                      |       | 6,777                                   |       | 7,367                                 |       | 12,551 |   | 14,216 |   |
| General and  administrative                                               |       | 6,022                                   |       | 9,630                                 |       | 12,326 |   | 18,810 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| Total costs and  expenses                                                 |       | 87,467                                  |       | 106,356                               |       | 167,200 |   | 209,200 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| OPERATING INCOME                                                          |       | 8,925                                   |       | 29,023                                |       | 14,002 |   | 53,296 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                                  |       |                                    |       |                                  |       |   |   |   |   |
| Foreign currency  exchange gain (loss) - net                              |       | (573                                    | )          | 480                                   |       | (767 | ) | 1,099 |   |
| Gain on debt  extinguishment                                              |       | 2,220                                   |       | —                                |       | 2,220 |   | — |   |
| Interest and  other income                                                |       | 2,597                                   |       | 5,493                                 |       | 4,998 |   | 12,479 |   |
| Interest and  other expense                                               |       | (1,776                                  | )          | (1,505                                | )          | (3,903 | ) | (2,907 | ) |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| Total other  income - net                                                 |       | 2,468                                   |       | 4,468                                 |       | 2,548 |   | 10,671 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| INCOME BEFORE  INCOME TAX PROVISION AND MINORITY INTEREST                 |       | 11,393                                  |       | 33,491                                |       | 16,550 |   | 63,967 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| INCOME TAX  PROVISION                                                     |       | 912                                     |       | 11,579                                |       | 912 |   | 22,133 |   |
| MINORITY  INTEREST                                                        |       | 534                                     |       | 690                                   |       | 762 |   | 1,371 |   |
| NET INCOME                                                                |       | $                                       | 11,015     |                                  | $          | 22,602 |   | $ | 16,400 |   | $ | 43,205 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| EARNINGS PER  SHARE:                                                      |       |                                    |       |                                  |       |   |   |   |   |
| Basic earnings  per share                                                 |       | $                                       | 0.31       |                                  | $          | 0.58 |   | $ | 0.45 |   | $ | 1.13 |   |
| Weighted average  common shares outstanding                               |       | 35,841                                  |       | 38,992                                |       | 36,360 |   | 38,084 |   |
|                                                                      |       |                                    |       |                                  |       |   |   |   |   |
| Diluted earnings  per share                                               |       | $                                       | 0.30       |                                  | $          | 0.55 |   | $ | 0.45 |   | $ | 1.07 |   |
| Weighted average  common and dilutive potential common shares outstanding |       | 36,166                                  |       | 42,708                                |       | 36,695 |   | 41,892 |   |

 

See Notes toUnaudited Consolidated Financial Statements.

 

4

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**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

**(In thousands)**

 
| ** **                                                                         | ** ** | **For the six months ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                         | ** ** | **June 30,**                                | ** ** |
| ** **                                                                         | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
|                                                                               |       |                                             |       |   |   |
| OPERATING  ACTIVITIES:                                                             |       |                                             |       |   |   |
| Net income                                                                         |       | $                                                | 16,400     |   | $ | 43,205 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                             |       |   |   |
| Gain on debt  extinguishment                                                       |       | (2,220                                           | )          | — |   |
| Depreciation and  amortization                                                     |       | 14,440                                           |       | 12,727 |   |
| Non-cash  stock-based compensation                                                 |       | 360                                              |       | 4,958 |   |
| Amortization of  unearned compensation                                             |       | 16                                               |       | — |   |
| Minority  interest                                                                 |       | (762                                             | )          | (1,371 | ) |
| Provision for  deferred income taxes                                               |       | 46                                               |       | 8,883 |   |
| Loss on disposal  and impairment of property and equipment                         |       | 35                                               |       | 6 |   |
| Change in assets  and liabilities:                                                 |       |                                             |       |   |   |
| Accounts  receivable – net                                                    |       | 39,648                                           |       | (25,091 | ) |
| Accounts  receivable – related party                                          |       | —                                           |       | (2,922 | ) |
| Income taxes  receivable                                                           |       | —                                           |       | (3,028 | ) |
| Foreign currency  forward exchange contracts                                       |       | (2,677                                           | )          | 1,556 |   |
| Inventories                                                                        |       | 19,672                                           |       | (24,059 | ) |
| Prepaid expenses  and other assets                                                 |       | (277                                             | )          | (551 | ) |
| Accounts payable                                                                   |       | (359                                             | )          | 2,225 |   |
| Accounts payable  - related party                                                  |       | —                                           |       | (366 | ) |
| Accrued expenses  and other liabilities                                            |       | (3,727                                           | )          | 7,572 |   |
| Unearned income                                                                    |       | (1,724                                           | )          | 830 |   |
| Income taxes  payable                                                              |       | 81                                               |       | (7,268 | ) |
|                                                                               |       |                                             |       |   |   |
| Net cash  provided by operating activities                                         |       | 78,952                                           |       | 17,306 |   |
|                                                                               |       |                                             |       |   |   |
| INVESTING  ACTIVITIES:                                                             |       |                                             |       |   |   |
| Acquisition of  property and equipment                                             |       | (7,849                                           | )          | (6,478 | ) |
| Purchases of  investments                                                          |       | (201,673                                         | )          | (98,271 | ) |
| Proceeds from  sold or matured investments                                         |       | 268,200                                          |       | 61,901 |   |
| Acquisition of  patents                                                            |       | —                                           |       | (8,200 | ) |
| Acquisition of  minority interest                                                  |       | —                                           |       | (7,024 | ) |
|                                                                               |       |                                             |       |   |   |
| Net cash  provided by (used in) investing activities                               |       | 58,678                                           |       | (58,072 | ) |
|                                                                               |       |                                             |       |   |   |
| FINANCING  ACTIVITIES:                                                             |       |                                             |       |   |   |
| Proceeds from  issuance of common stock                                            |       | 4,154                                            |       | 98,696 |   |
| Redemption of  convertible subordinated notes                                      |       | (57,336                                          | )          | — |   |
| Excess tax  benefits from stock option exercises                                   |       | —                                           |       | 17,772 |   |
| Payments on  capital lease obligations                                             |       | (20                                              | )          | — |   |
| Repurchase of  common stock into treasury                                          |       | (50,000                                          | )          | — |   |
|                                                                               |       |                                             |       |   |   |
| Net cash  provided by (used in) financing activities                               |       | (103,202                                         | )          | 116,468 |   |
|                                                                               |       |                                             |       |   |   |
| EFFECT OF  EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS                      |       | 375                                              |       | 2,694 |   |
|                                                                               |       |                                             |       |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                         |       | 34,803                                           |       | 78,396 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF THE PERIOD                              |       | 114,246                                          |       | 233,745 |   |
|                                                                               |       |                                             |       |   |   |
| CASH AND CASH  EQUIVALENTS AT END OF THE PERIOD                                    |       | $                                                | 149,049    |   | $ | 312,141 |   |

 

5

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| ** **                                         | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **June 30,**                                | ** ** |
| ** **                                         | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
|                                               |       |                                             |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION: |       |                                             |       |   |   |
| Interest paid                                      |       | $                                                | 4,324      |   | $ | 2,621 |   |
| Income taxes paid,  net                            |       | $                                                | 1,569      |   | $ | 4,831 |   |

 

See Notes toUnaudited Consolidated Financial Statements.

 

6

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**CYMER,INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Three andSix Months Ended June 30, 2006**

**(Unaudited)**

 

**1.****              BASIS OFPRESENTATION**

 

*UnauditedInterim Financial Data* – The accompanying consolidatedfinancial information has been prepared by Cymer, Inc., and its wholly-ownedand majority-owned subsidiaries (collectively, “Cymer”), without audit, inaccordance with the instructions to Form 10-Q. In the opinion of management,the unaudited consolidated financial statements for the interim periodspresented reflect all material adjustments, consisting only of normal recurringadjustments, necessary for a fair presentation of the financial position andresults of operations as of and for such periods indicated. These unaudited consolidatedfinancial statements and notes hereto should be read in conjunction with theconsolidated financial statements and notes thereto included in our AnnualReport on Form 10-K for the year ended December 31, 2005. Results for theinterim periods presented herein are not necessarily indicative of results thatmay be reported for any other interim period or for the entire fiscal year.

 

*Principles of Consolidation* – Theaccompanying consolidated financial statements include our accounts and theaccounts of our wholly owned subsidiaries – Cymer Japan, Inc. (“Cymer Japan”),Cymer Singapore Pte Ltd. (“Cymer Singapore”), Cymer B.V. in the Netherlands (“CymerB.V.”), Cymer Southeast Asia, Ltd, in Taiwan (“Cymer SEA”), Cymer SemiconductorEquipment Shanghai Co., Ltd, in the People’s Republic of China (“Cymer PRC”), CymerKorea, Inc. (“Cymer Korea”), and our majority-owned subsidiary, TCZ GmbH, aSwiss limited liability company (“TCZ”). We formed TCZ in July 2005 inconnection with a joint venture agreement we entered into with (i) Carl ZeissSMT AG, a German corporation (“SMT”); (ii) Carl Zeiss Laser OpticsBeteiligungsgesellschaft mbH, a German limited liability company (“LOB”); and(iii) TCZ. LOB and SMT, together with their affiliated entities, arecollectively referred to as “Zeiss.”  Weown 60% of TCZ and Zeiss owns 40%. On January 2, 2006, we acquired theremaining 19% minority interest in Cymer Korea. We paid a total of $7.0 millionfor this 19% interest. This transaction increased our total interest in CymerKorea from 81% to 100%. Cymer Japan is currently our only subsidiary that sellsexcimer light source systems. Cymer Japan also provides field service to customersin Japan. Cymer Singapore, Cymer B.V., Cymer SEA, and Cymer PRC are fieldservice offices for customers in their respective countries. Cymer Koreaprovides refurbishment manufacturing, field service, and administrativeactivities for Korea and the Asia-Pacific region. TCZ is currently developing,and will integrate, market and sell, and support tools employing an excimerlaser beam to induce crystallization of low-temperature poly-silicon (“LTPS”)processing for the manufacture of flat panel displays. All significantintercompany balances and transactions have been eliminated in consolidation.

 

*Accounting Estimates* – Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires us to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results may differ from those estimates.

 

*Accounting Pronouncements Adopted*

 

In November 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting StandardsNo. 151 (“SFAS No. 151”), ”Inventory Costs, an amendment of ARB43” Chapter 4.  This statement amends Accounting Research BulletinNo. 43 (“ARB No. 43”) Chapter 4, to clarify accounting for abnormalamounts of idle facility expense, freight, handling costs and wastedmaterial.  SFAS No. 151 requires that those items be recognized ascurrent-period charges.  SFAS No. 151 is effective for fiscal yearsbeginning after June 15, 2005.  We adopted SFAS No. 151 on January 1,2006. The adoption of SFAS No. 151 did not have a significant impact on ourconsolidated financial statements.

 

7

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In May 2005, the FASB issued Statement ofFinancial Accounting Standards No. 154 (“SFAS No. 154”), “AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3”. This Statement replaces APB Opinion No. 20, “AccountingChanges” and FASB Statement No. 3, “Reporting Accounting Changes inInterim Financial Statements”, and changes the requirements for the accountingfor and reporting of a change in accounting principle. SFAS No. 154 applies toall voluntary changes in accounting principle. It also applies to changesrequired by an accounting pronouncement in the unusual instance that thepronouncement does not include specific transition provisions. When apronouncement includes specific transition provisions, those provisions shouldbe followed. SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. We adopted SFAS No. 154 on January 1, 2006. The adoption ofSFAS No. 154 did not have a significant impact on our consolidated financialstatements.

 

Effective January 1, 2006, we adopted theprovisions of FASB Statement of Financial Accounting Standards No. 123R (“SFASNo. 123R”) “Share-Based Payment” which replaces Statement of FinancialAccounting Standards No. 123 (“SFAS No.123’), “Accounting for Stock-BasedCompensation” and supersedes APB Opinion No. 25 (“APB 25”), “Accounting forStock Issued to Employees”. Under the fair value recognition provisions of SFASNo. 123R, stock-based compensation cost is measured at the grant date based onthe fair value of the award and is recognized as an expense over the requisiteservice period, or the vesting period. We elected the modified-prospectivemethod in implementing SFAS No. 123R which does not require us to revise priorperiod financial statements for comparative purposes. We elected to use theBlack-Scholes option pricing model to determine the fair value of our stockoptions under SFAS No. 123R. The valuation provisions of SFAS No. 123R apply tonew options granted on or after January 1, 2006. We also elected to attributethe value of share-based compensation to expense using the straight-line methodfor awards granted on or after January 1, 2006. Estimated compensation expensefor grants that were outstanding and unvested as of the effective date will berecognized over the remaining service period using the compensation costestimated for the SFAS No. 123 pro forma disclosures which uses an acceleratedexpense recognition method for those awards with a graded vesting schedule. Theadoption of SFAS No. 123R had a material impact on our consolidated financialstatements. See Footnote 2 for more detailed information on our adoption ofSFAS No. 123R.

 

On November 10, 2005, the FASB issued FASBStaff Position No. FAS 123(R)-3 “TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards”.We have elected to adopt the “short-cut” method provided in the FASB StaffPosition for calculating the tax effects of share-based compensation pursuantto SFAS No. 123R. The “short-cut” method includes simplified methods toestablish the beginning balance of the additional paid-in capital pool (“APICpool”) related to the tax effects of share-based compensation, and to determinethe subsequent impact on the APIC pool, the consolidated statements of cash flows,and earnings per share of the tax effects of share-based compensation awardsthat were outstanding upon adoption of SFAS No. 123R.

 

In accordance with SFAS No. 123R, beginning inthe first quarter of 2006, we have presented excess tax benefits for theexercise of share-based compensation awards as a financing activity in theconsolidated statement of cash flows. Prior to the adoption of SFAS No. 123R,we presented the tax benefits for deductions resulting from the exercise ofstock options as an operating cash flow activity.

 

*Reclassifications*–Certain amounts in the prior year consolidated financial statements have beenreclassified to conform to current period presentation.

 

**2.****             ****STOCKHOLDERS’ EQUITY**

 

**Stock-Based CompensationValuation Assumptions**

 

We estimate the fair value of our stock options using a Black-Scholes optionpricing model, consistent with the provisions of SFAS No. 123R. In addition, weused this same option pricing model to calculate the fair value of our stockoptions included in our prior period pro forma disclosures as required by SFASNo.123.

 

8

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The fair value of stock options granted isrecognized to expense over the requisite service period. For stock optionsgranted after the SFAS No. 123R effective date of January 1, 2006, thestraight-line attribution approach is used. For stock options granted prior toJanuary 1, 2006, which are continuing to vest, we will continue to recordexpense using the Financial Accounting Standards Board Interpretation No. 28 (“FIN28”) accelerated attribution approach.

 

Upon the adoption of SFAS No. 123R, we used acombination of historical and implied volatility (“blended volatility”) tovalue our stock options.  Historical volatility is based on the five-yearexpected term of the options. Implied volatility was derived based on six-monthtraded options of our common stock.  Prior to January 1, 2006, we used onlyhistorical stock price volatility in accordance with SFAS No. 123 for purposesof our pro forma stock compensation calculation. The expected term of our stockoptions represents the period of time options are expected to be outstandingand is based on observed historical exercise patterns for our company which webelieve are indicative of future exercise behavior. For the risk free interestrate, we use the then currently available rate on zero coupon U.S. Governmentissues with a remaining life of five years for valuing options.

 

The following weighted average assumptionswere used for grants issued in the three and six months ended June 30, 2005 underthe SFAS No. 123 requirements and in the three and six months  ended June 30, 2006 under the SFAS No. 123Rrequirements:

 

| ** **                | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** |
|                      |       |                             |       |                           |       |   |   |   |   |
| Dividend yield            |       | None                             |       | None                           |       | None |   | None |   |
| Volatility rate:          |       |                             |       |                           |       |   |   |   |   |
| Options                   |       | 75%                              |       | 56%                            |       | 75% |   | 56% |   |
| ESPP                      |       | 75%                              |       | n/a                            |       | 75% |   | n/a |   |
| Risk free  interest rate: |       |                             |       |                           |       |   |   |   |   |
| Options                   |       | 3.87%                            |       | 5.05%                          |       | 3.89% |   | 4.84% |   |
| ESPP                      |       | 3.33%                            |       | n/a                            |       | 3.33% |   | n/a |   |
| Expected term:            |       |                             |       |                           |       |   |   |   |   |
| Options                   |       | 4.11 years                       |       | 3.16 years                     |       | 4.26 years |   | 3.16 years |   |
| ESPP                      |       | .5 years                         |       | n/a                            |       | .5 years |   | n/a |   |

 

In our pro forma disclosures prior to theadoption of SFAS No. 123R, we accounted for forfeitures as they occurred. SFASNo. 123R requires forfeitures to be estimated at the time of grant and revisedif necessary in subsequent periods if actual forfeiture rates differ from thoseestimates. Forfeitures were estimated based on historical activity for ourcompany. For the three and six months ended June 30, 2006, we estimated a 3% annualforfeiture rate. We amended our ESPP in May 2005, and as a result, our ESPP istreated as a noncompensatory plan.

 

9

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**Impact of SFAS No. 123R**

 

The following table presents the impact to ourconsolidated financial statements as a result of our adoption of SFAS No. 123Rfor the three and six months ended June 30, 2006 (in thousands, except pershare amounts):

 
| ** **                                          | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
|                                                |       |                             |       |                           |       |
| Stock-based  compensation expense by type of award: |       |                             |       |                           |       |
| Employee stock  options                             |       | $                                | 2,209      |                           | $          | 4,490 |   |
| Stock units                                         |       | 175                              |       | 321                            |       |
|                                                |       |                             |       |                           |       |
| Total  stock-based compensation                     |       | 2,384                            |       | 4,811                          |       |
| Tax effect on  stock-based compensation             |       | (824                             | )          | (1,665                         | )          |
| Net effect on  net income                           |       | $                                | 1,560      |                           | $          | 3,146 |   |
|                                                |       |                             |       |                           |       |
| Effect on  earnings per share:                      |       |                             |       |                           |       |
| Basic                                               |       | $                                | 0.04       |                           | $          | 0.08 |   |
| Diluted                                             |       | $                                | 0.04       |                           | $          | 0.08 |   |
|                                                |       |                             |       |                           |       |
| Impact of stock  option deductions on:              |       |                             |       |                           |       |
| Cash flows from  operations                         |       | $                                | (7,618     | )                              | $          | (17,772 | ) |
| Cash flows from  financing activities               |       | $                                | 7,618      |                           | $          | 17,772 |   |

 

As of June 30, 2006, the unamortizedcompensation expense related to outstanding unvested options was approximately$11.2 million with a weighted average remaining vesting period of 1.21 years.We expect to amortize this expense over the remaining vesting period of thesestock options.

 

The amount of stock-based compensation costscapitalized into inventory during the six months ended June 30, 2006 wasimmaterial.

 

We account for options grantedto non-employees under SFAS No. 123 and Emerging Issues Task Force Issue No.96-18, “Accounting for Equity Instruments that are Issued to other thanEmployees for Acquiring or in Conjunction with Selling Goods or Services”. Wemeasure the fair value of such options using the Black-Scholes option pricingmodel at each financial reporting date. We account for changes in fair valuesbetween reporting dates in accordance with FIN 28. Stock-based compensationexpense for options granted to non-employees and for those employees whochanged status during the six months ended June 30, 2005 and 2006 was $356,000and $147,000, respectively.

 

Prior to the adoption ofSFAS No. 123R, for options granted to employees, we applied the intrinsic value-based method of accounting required by AccountingPrinciples Board Opinion No. 25 and provided the pro forma disclosures of SFASNo. 123 as amended by Statement ofFinancial Accounting Standards No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure”.Since the exercise price equaled the market value of the underlying commonstock on the date of grant, the stock options had no intrinsic value upon grantand no compensation expense was recorded prior to the adoption of SFAS No.123R.

 

**Pro forma for 2005 UnderSFAS No. 123**

 

Thefollowing table compares the earnings per share that we reported to the proforma amounts that we would have reported had we recognized compensationexpense for our stock-based compensation plans in accordance with SFAS No. 123(in thousands, except per share amounts):

 

10

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| ** **                                                                                                                                        | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **June 30, 2005**      | ** ** | **June 30, 2005**    | ** ** |
|                                                                                                                                              |       |                             |       |                           |       |
| Net income, as  reported                                                                                                                          |       | $                                | 11,015     |                           | $          | 16,400 |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                                      |       | 188                              |       | 340                            |       |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects |       | (2,053                           | )          | (15,951                        | )          |
|                                                                                                                                              |       |                             |       |                           |       |
| Pro forma net  income                                                                                                                             |       | $                                | 9,150      |                           | $          | 789 |   |
|                                                                                                                                              |       |                             |       |                           |       |
| Earnings per  share:                                                                                                                              |       |                             |       |                           |       |
| Basic - as  reported                                                                                                                              |       | $                                | 0.31       |                           | $          | 0.45 |   |
| Basic - pro  forma                                                                                                                                |       | $                                | 0.26       |                           | $          | 0.02 |   |
|                                                                                                                                              |       |                             |       |                           |       |
| Diluted - as  reported                                                                                                                            |       | $                                | 0.30       |                           | $          | 0.45 |   |
| Diluted - pro  forma                                                                                                                              |       | $                                | 0.25       |                           | $          | 0.02 |   |

 

In February 2005, our board of directorsapproved the acceleration of the vesting of stock options that had exerciseprices of $30.50 per share or higher held by employees. This acceleration ofstock options excluded directors, executive officers and certain vicepresidents. The purpose of this acceleration of vesting was to enable us toeliminate the recognition in our statement of operations of the compensationexpense associated with these “out of the money” stock options in futureperiods, upon our adoption of SFAS No. 123R on January 1, 2006.  Theacceleration of vesting of these stock options in the six months ended June 30,2005 contributed approximately $10.4 million of pro forma stock-basedcompensation expense.

 

**Stock Option Plans**

 

Currently, we grant stockoptions from our 2005 Equity Incentive Plan (the “2005 Plan”), which providesfor the grant or award of various equity instruments to our employees,directors and consultants. Upon approval of the 2005 Plan by stockholders inMay 2005, we discontinued the use of our 1996 Stock Option Plan and 2000 EquityIncentive Plan. Options issued under the 2005 Plan expire ten years after theoptions are granted. It is our practice to generally grant options that vestand become exercisable ratably over a four-year period following the date ofgrant.  A total of 1,000,000 sharesof common stock are reserved for issuance under the 2005 Plan and it providesfor the issuance of incentive stock options, nonstatutory stock options, stockappreciation rights, stock bonus awards, stock purchase awards, stock unitawards and other stock awards. Options to purchase 560,548 shares areoutstanding and 439,316 shares remain available for grant under the 2005 Planas of June 30, 2006.

 

The following describesour other stock option plans from which we no longer issue awards although optionsto purchase shares are still outstanding under these plans and continue to vestand may be exercised:

 

*1996 Stock Option Plan (the “1996Plan”)* – The 1996 Planprovided for the grant of incentive stock options to our employees andnonqualified stock options to our employees, directors and consultants. The exercise prices of stock options granted under the 1996 Plan were at leastequal to the fair market value of our common stock on the dates of grant.Options issued under the 1996 Plan expire five to ten years after the optionswere granted and generally vest and become exercisable ratably over a four-yearperiod following the date of grant. A total of 7,900,000 shares of common stockwere reserved for issuance under the 1996 Plan.  Of these shares, optionsto purchase 1,855,104 million shares are outstanding as of June 30, 2006.

 

11

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*2000 Equity Incentive Plan (the “2000 Plan”)*– In August 2000, our board of directors adopted the 2000 Plan whichprovides for the grant of options to our employees or consultants who areneither directors nor officers. The exercise prices of the options grantedunder the 2000 Plan were equal to the quoted market value of our common stockat the date of grant.  Options issued under the 2000 Plan expire ten yearsafter the options were granted and generally vest and become exercisableratably over a four year period following the date of grant. A total of4,950,000 shares of common stock were reserved for issuance under the 2000Plan. Of these shares, options to purchase 1,600,063 million shares areoutstanding as of June 30, 2006.

 

**Stock Options**

 

The following is asummary of stock option activity under all stock option plans for the sixmonths ended June 30, 2006 (in thousands, except per share data):

 
| ** **                    | ** ** | ** ** | ** ** | **Weighted**       | ** ** | **Weighted**        | ** ** |
|-------------------------------|------------|------------|------------|--------------------|------------|---------------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Average**        | ** ** | **Average**         | ** ** |
| ** **                    | ** ** | **Number** | ** ** | **Exercise**       | ** ** | **Contractual**     | ** ** |
| ** **                    | ** ** | **of**     | ** ** | **Price**          | ** ** | **Term**            | ** ** |
| ** **                    | ** ** | **Shares** | ** ** | **Per Share** | ** ** | **(in years)** | ** ** |
|                          |       |       |       |               |       |                |       |
| Balance at  January 1, 2006   |       | 6,924      |       | $                  | 32.15      |                |       |   |
| Granted                       |       | 207        |       | $                  | 45.65      |                |       |   |
| Exercised                     |       | (2,968     | )          | $                  | 30.90      |                |       |   |
| Forfeited                     |       | (141       | )          | $                  | 30.08      |                |       |   |
| Expired                       |       | (24        | )          | $                  | 49.87      |                |       |   |
|                          |       |       |       |               |       |                |       |
| Balance at June  30, 2006     |       | 3,998      |       | $                  | 33.75      |                | 6.25       |   |
| Exercisable at  June 30, 2006 |       | 2,957      |       | $                  | 33.64      |                | 5.43       |   |

 

The following table summarizes information as ofJune 30, 2006 concerning currently outstanding and exercisable options:

 
| ** **               | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Number**                   | ** ** | **Remaining**                | ** ** | **Average** | ** ** | **Aggregate** | ** ** | **Number** | ** ** | **Average** | ** ** | **Aggregate** | ** ** |
| ** **               | ** ** | **Outstanding**              | ** ** | **Contractual**              | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** | **Exercisable** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** |
| **Range of**        | ** ** | **As of 6/30/06**  | ** ** | **Term**                     | ** ** | **Price** | ** ** | **Value** | ** ** | **As of 6/30/06** | ** ** | **Price** | ** ** | **Value** | ** ** |
| **Exercise Prices** | ** ** | **(in thousands)**      | ** ** | **(in years)**          | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                     | $12.75     | **-**                        | $15.73     |                         | ** ** | 4 |   | 2.17 |   | $ | 12.75 |   | $ | 124 |   | 4 |   | $ | 12.75 |   | $ | 124 |   |
|                     | $16.32     | **-**                        | $19.92     |                         | ** ** | 177 |   | 6.02 |   | $ | 18.96 |   | $ | 4,859 |   | 152 |   | $ | 18.87 |   | $ | 4,178 |   |
|                     | $19.98     | **-**                        | $24.90     |                         | ** ** | 488 |   | 5.35 |   | $ | 22.06 |   | $ | 11,920 |   | 424 |   | $ | 21.90 |   | $ | 10,410 |   |
|                     | $24.96     | **-**                        | $31.12     |                         | ** ** | 764 |   | 7.22 |   | $ | 27.91 |   | $ | 14,169 |   | 469 |   | $ | 27.70 |   | $ | 8,798 |   |
|                     | $31.50     | **-**                        | $38.90     |                         | ** ** | 1,678 |   | 5.76 |   | $ | 35.31 |   | $ | 18,709 |   | 1,286 |   | $ | 35.78 |   | $ | 13,735 |   |
|                     | $39.37     | **-**                        | $48.63     |                         | ** ** | 636 |   | 7.29 |   | $ | 43.36 |   | $ | 1,974 |   | 421 |   | $ | 42.92 |   | $ | 1,493 |   |
|                     | $48.64     | **-**                        | $55.13     |                         | ** ** | 251 |   | 5.99 |   | $ | 50.16 |   | $ | — |   | 201 |   | $ | 50.51 |   | $ | — |   |
|                     | $12.75     | **-**                        | $55.13     |                         | ** ** | 3,998 |   | 6.25 |   | $ | 33.75 |   | $ | 51,755 |   | 2,957 |   | $ | 33.64 |   | $ | 38,738 |   |

 

Theaggregate intrinsic value in the table above represents the total pre-taxintrinsic value, based on a per share price of $46.46, the closing price of ourcommon stock on June 30, 2006 as reported by the Nasdaq National Market, whichwould have been received by the option holders had all option holders

 

12

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exercised their optionsas of that date. The total number of in-the-money stock options exercisable asof June 30, 2006 was 2.7 million.

 

The weighted average per share fair value of theoptions granted was $15.66 and $20.18 during the three months ended June 30,2005 and 2006, respectively, and was $16.24 and $19.23 during the six monthsended June 30, 2005 and 2006, respectively.

 

The total intrinsic value of options exercisedwas $268,000 and $22.9 million during the three months ended June 30, 2005 and2006, respectively, and was $678,000 and $54.1 million during the six monthsended June 30, 2005 and 2006, respectively.

 

The total cash received from employees as aresult of employee stock option exercises during the six months ended June 30,2006 was approximately $91.7 million. In connection with these exercises, thetax benefits recognized by us for the six months ended June 30, 2006 was $17.8million.

 

We settle employee stock option exercises withnewly issued shares of our common stock.

 

**StockUnits**

 

In January 2006,our board of directors approved the use of annual stock unit awards fornon-employee directors pursuant to our 2005 Plan in lieu of quarterly stockoptions grants. The number of shares subject to each stock unit award isdetermined by dividing $100,000 by the closing price per share of our commonstock as of the date of grant. During the six months ended June 30, 2006,17,948 shares subject to such stock units awards were granted to non-employeedirectors with a grant date fair value of $39.00 per share. Each stock unitaward shall vest 100% after one year from the date of grant. Stock basedcompensation expense for stock units for the three and six months ended June30, 2006 was $175,000 and $321,000, respectively.

 

A summary of the change in stock unit awardsoutstanding during the six months ended June 30, 2006 is as follows (inthousands, except life data):

 
| ** **            | ** ** | **Shares** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value as of********June 30, 2006** | ** ** |
|-----------------------|------------|------------|------------|-----------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
|                  |       |       |       |                                                |       |                                                                           |       |
| Beginning Outstanding |       |       |       |                                                |       |                                                                           |       |
| Awarded               |       | 18         |       |                                                |       |                                                                           |       |
| Vested                |       | —     |       |                                                |       |                                                                           |       |
| Forfeited             |       | —     |       |                                                |       |                                                                           |       |
| Ending Outstanding    |       | 18         |       | 0.55                                                |       | $                                                                              | 834        |   |
| Ending Exercisable    |       | —     |       | —                                              |       | —                                                                         |       |
|                       |            |            |            |                                                     |            |                                                                                |            |  |

 

Weighted AverageRemaining Recognition Period - 0.55 years

 

The aggregate intrinsicvalue in the table above represents the total pre-tax intrinsic value based onour closing stock price of $46.46 as of June 30, 2006.

 

**Employee Stock Purchase Plan**

 

*1996 Employee Stock PurchasePlan (the “ESPP”)*– Our ESPP is intendedto qualify for favorable income tax treatment associated with rights grantedunder an employee stock purchase plan which qualifies under Section 423 ofthe Internal Revenue Code.  Under the ESPP, eligible employees maypurchase shares of our common stock through payroll deductions of up to 15% ofhis or her compensation (as defined in the plan), at a price per share equal to95% of the fair market value of our common stock at

 

13

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the end of the purchaseperiod.  Our ESPP was amended in 2005. The amendment: a) changed theduration of offering periods under the plan from two years to six months b)reduced the discount to market price used to determine purchase price forshares of our common stock under the plan from 15% to 5%, and c) eliminated the“lookback” feature that allowed the purchase price to be determined as of thebeginning of an offering period, or enrollment date, if the market price as ofthe enrollment date was lower than the market price at the end of the offeringperiod. As a result of the amendment the plan became non-compensatory.

 

On February 7, 2006, our board of directorsamended our ESPP to extend the expiration date of the plan until July 31, 2016.In addition, on May 18, 2006, our stockholders approved an amendment  to increase the number of shares of commonstock reserved for issuance under the plan by 300,000 shares from 1,200,000shares to 1,500,000 shares.

 

The number of shares issuable under the ESPP asof June 30, 2006 was 380,235, and 1,119,765 shares have been previously issued.Because our ESPP is a non-compensatory plan as defined by SFAS No. 123R, nostock-based compensation expense is recorded for our ESPP.

 

The total cash received from employees as a result of ESPP shares issuedduring the six months ended June 30, 2006 was approximately $711,000.

 

**Common Stock Warrants**

 

* *During2001, we issued warrants to purchase 200,000 shares of our common stock at aweighted average purchase price of $31.43 per share in conjunction with theacquisition of certain patents. In May 2006, these warrants were exercised withrespect to all 200,000 shares for $6.3 million in cash.

 

**3.****              EARNINGS PER SHARE**

 

*EarningsPer Share* – Basicearnings per share (“EPS”) excludes dilution and is computed by dividing netincome or loss attributable to common stockholders by the weighted-average ofcommon shares outstanding for the period. Diluted EPS reflects the potentialdilution that could occur if securities or other contracts to issue commonstock (convertible subordinated notes using the “if-converted” method, warrantsto purchase common stock and common stock options using the treasury stockmethod) were exercised or converted into common stock. Potential dilutivesecurities are excluded from the diluted EPS computation in loss periods astheir effect would be anti-dilutive.

 

Thefollowing table sets forth the basic and diluted EPS for the three and sixmonths ended June 30, 2005 and 2006 (in thousands, except per share information):

 

14

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| ** **                                                                            | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                            | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                            | ** ** | **2005**                         | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                                  |       |                             |       |                           |       |   |   |   |   |
| NET INCOME:                                                                           |       |                             |       |                           |       |   |   |   |   |
| Net income, as  reported (used for basic EPS)                                         |       | $                                | 11,015     |                           | $          | 22,602 |   | $ | 16,400 |   | $ | 43,205 |   |
| Adjustment for  interest expense on 3.5% convertible subordinated notes, net of taxes |       | —                           |       | 918                            |       | — |   | 1,791 |   |
|                                                                                  |       |                             |       |                           |       |   |   |   |   |
| Net income, as  adjusted for assumed conversion (used for diluted EPS)                |       | $                                | 11,015     |                           | $          | 23,520 |   | $ | 16,400 |   | $ | 44,996 |   |
|                                                                                  |       |                             |       |                           |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                                             |       |                             |       |                           |       |   |   |   |   |
| Basic weighted  average common shares outstanding                                     |       | 35,841                           |       | 38,992                         |       | 36,360 |   | 38,084 |   |
| Effect of  dilutive securities:                                                       |       |                             |       |                           |       |   |   |   |   |
| Warrants                                                                              |       | —                           |       | 32                             |       | — |   | 47 |   |
| Options and  stock units                                                              |       | 325                              |       | 870                            |       | 335 |   | 947 |   |
| Convertible  subordinated notes                                                       |       | —                           |       | 2,814                          |       | — |   | 2,814 |   |
|                                                                                  |       |                             |       |                           |       |   |   |   |   |
| Diluted weighted  average common and potential common shares outstanding              |       | 36,166                           |       | 42,708                         |       | 36,695 |   | 41,892 |   |
|                                                                                  |       |                             |       |                           |       |   |   |   |   |
| Earnings per  share:                                                                  |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                 |       | $                                | 0.31       |                           | $          | 0.58 |   | $ | 0.45 |   | $ | 1.13 |   |
| Diluted                                                                               |       | $                                | 0.30       |                           | $          | 0.55 |   | $ | 0.45 |   | $ | 1.07 |   |

 

Forthe three months ended June 30, 2005 and 2006, weighted average options andwarrants to purchase 5,706,000 and 354,000 shares of common stock,respectively, were outstanding but not included in the computation of dilutedearnings per share as their effect was anti-dilutive. In addition, for thethree months ended June 30, 2005, weighted average common shares attributableto convertible subordinated notes of 3,451,000 were not included in thecomputation of diluted earnings per share as their effect was alsoanti-dilutive.

 

For the six months ended June 30, 2005 and 2006,weighted average options and warrants to purchase 5,724,000 and 421,000 sharesof common stock were outstanding but not included in the computation of dilutedearnings per share as their effect was anti-dilutive. In addition, for the sixmonths ended June 30, 2005, weighted average common shares attributable toconvertible subordinated notes of 3,732,000 were not included in thecomputation of diluted earnings per share as their effect was alsoanti-dilutive.

 

**4.****              INVENTORIES**

 

Inventories consisted of thefollowing as of December 31, 2005 and June 30, 2006 (in thousands): 

 
| ** **                                   | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| INVENTORIES:                                 |       |                  |       |              |       |
| Raw materials                                |       | $                     | 42,482     |              | $          | 46,390 |   |
| Work-in-progress                             |       | 18,408                |       | 27,032            |       |
| Finished goods                               |       | 38,601                |       | 50,408            |       |
| Allowance for  excess and obsolete inventory |       | (10,445               | )          | (10,725           | )          |
| Total                                        |       | $                     | 89,046     |              | $          | 113,105 |   |

 

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**5.****              REPORTINGCOMPREHENSIVE INCOME**

 

Comprehensive incomeincludes net income, effective unrealized gains and losses on forwardcontracts, foreign currency translation adjustments, and unrealized gains andlosses on available-for-sale securities, which are recorded as short-term andlong-term investments in the accompanying consolidated balance sheets.

 

The following tablesummarizes the change in each component of accumulated other comprehensive lossfor the six months ended June 30, 2006 (in thousands):

 
| ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | **Total unrealized** | ** ** | **Total unrealized**                | ** ** | ** **        | ** ** |
|--------------------|------------|-------------------|------------|-----------------|------------|---------------------------|------------|------------------------------------------|------------|-------------------|------------|
| ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | **losses on**        | ** ** | **gains (losses) on**          | ** ** | **Accumulated**   | ** ** |
| ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | **available-for-sale**    | ** ** | **foreign currency**                | ** ** | **other**         | ** ** |
| ** **         | ** ** | ** **        | ** ** | **Translation** | ** ** | **investments,**          | ** ** | **forward exchange**                | ** ** | **comprehensive** | ** ** |
| ** **         | ** ** | ** **        | ** ** | **adjustment**  | ** ** | **net of tax**  | ** ** | **contracts, net of tax** | ** ** | **loss**          | ** ** |
|               |       |              |       |            |       |                      |       |                                     |       |              |       |
| December 31,  2005 |       | Balance           |       | $               | (8,157     | )                         | $          | (798                                     | )          | $                 | (70        | ) | $ | (9,025 | ) |
|               |       | Period net change |       | 2,692           |       | 105                       |       | 56                                       |       | 2,853             |       |
| June 30, 2006      |       | Balance           |       | $               | (5,465     | )                         | $          | (693                                     | )          | $                 | (14        | ) | $ | (6,172 | ) |

 

Comprehensive income consistedof the following components (in thousands):

 

| ** **                                                                   | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                   | ** ** | **2005**                         | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                         |       |                             |       |                           |       |   |   |   |   |
| Net income                                                                   |       | $                                | 11,015     |                           | $          | 22,602 |   | $ | 16,400 |   | $ | 43,205 |   |
|                                                                         |       |                             |       |                           |       |   |   |   |   |
| Foreign currency  translation adjustments                                    |       | (64                              | )          | 17                             |       | 221 |   | 2,692 |   |
| Unrealized gains  (losses) on available-for-sale investments, net of tax     |       | 230                              |       | 61                             |       | (364 | ) | 105 |   |
| Unrealized gains  on foreign currency forward exchange contracts, net of tax |       | 82                               |       | (28                            | )          | 758 |   | 56 |   |
| Comprehensive  income                                                        |       | $                                | 11,263     |                           | $          | 22,652 |   | $ | 17,015 |   | $ | 46,058 |   |

 

**6.****              DEVELOPMENT AGREEMENT AND INTELLECTUALPROPERTY LICENSE AGREEMENT**

 

The research anddevelopment agreement we entered into effective as of January 23, 2004 withIntel Corporation (“Intel”) was amended effective on July 17, 2006 (“AmendedDevelopment Agreement”). Under the terms of the original agreement, Intel wasto provide us with up to a total of $20.0 million over a three-year period toaccelerate the development of production-worthy extreme ultraviolet (“EUV”)lithography light sources. The terms of the Amended Development Agreement aredescribed more fully under Footnote 11 – Subsequent Events.

 

The intellectualproperty license agreement we entered into effective as of January 28, 2004with Intel was amended on June 28, 2006 (“Amended Intellectual Property LicenseAgreement”). Under the original intellectual property license agreement,pursuant to which we licensed certain patents and trade secrets from Intelrelated to EUV lithography technology, our obligation to pay license fees toIntel did not commence until our first high volume manufacturing shipment of anEUV lithography light source. The Amended Intellectual Property LicenseAgreement replaces the license fee payments tied to product shipments with anup-front license fee which we paid to Intel in full upon execution of theamendment. The Amended Intellectual Property License Agreement also changes anumber of the EUV patents

 

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covered by the license. Allof the licensed patents under the Amended Intellectual Property License Agreementrelate to EUV technology, and we intend to use them in connection with ourcontinuing research and development efforts related to EUV.

 

We recorded the patentlicense rights acquired from Intel under this Amended Intellectual PropertyLicense Agreement as an intangible asset in our accompanying consolidatedbalance sheets. The total value of these patent license rights are beingamortized over a period of 16.29 years which represents the average remaininglife of all of the patents purchased under this amendment. The amortization ofthese patents is included in research and development expenses on theaccompanying statement of operations since the field of use involvesapplications which are still in the research and development stages.

 

**7.****              GOODWILL ANDINTANGIBLE ASSETS**

 

We account for our goodwill and other intangibleassets in accordance with Statement of Financial Accounting Standards No. 142(“SFAS No. 142”), “Goodwill and Other Intangible Assets”. Under SFAS No. 142,our goodwill is subject to an annual impairment test. During the fourth quarterof 2005, we completed our annual impairment test of goodwill and intangibleassets, and concluded that no impairment of goodwill existed.

 

The following table summarizes the activity in thecarrying amount of goodwill as of December 31, 2005 and June 30, 2006 (inthousands):

 
| Goodwill as of  December 31, 2005                                           |   | $   | 8,358  |   |
|-----------------------------------------------------------------------------|--------|-----|--------|--------|
| Goodwill  acquired with acquisition of 19% minority interest of Cymer Korea |   | 475 |   |
| Goodwill as of  June 30, 2006                                               |   | $   | 8,833  |   |

 

Included in intangible assets – net on theaccompanying balance sheets are amounts associated with patents that wereacquired in 2001, 2003, 2005 and 2006. As of December 31, 2005 and June 30,2006, the net carrying amount of these patents was $10.5 million and $17.4million, respectively. The accumulated amortization for these patents atDecember 31, 2005 and June 30, 2006 was $8.3 million and $9.6 million,respectively. Amortization expense for these patents was $593,000 and $636,000 forthe three months ended June 30, 2005 and 2006, respectively, and $1.2 millionand $1.3 million for the six months ended June 30, 2005 and 2006, respectively.

 

As of June 30, 2006,future estimated amortization expense for these patents is expected to be asfollows for (in thousands):

 

| ** **                           | ** ** | **Future**       | ** ** |
|--------------------------------------|------------|------------------|------------|
| ** **                           | ** ** | **Amortization** | ** ** |
|                                 |       |             |       |
| Six months  ending December 31, 2006 |       | $                | 1,523      |   |
| Year ending  December 31, 2007       |       | $                | 3,046      |   |
| Year ending  December 31, 2008       |       | $                | 3,046      |   |
| Year ending  December 31, 2009       |       | $                | 1,564      |   |
| Year ending  December 31, 2010       |       | $                | 675        |   |
| Thereafter                           |       | $                | 7,549      |   |

 

**8.****              GUARANTEES/WARRANTIES**

 

In the ordinary course of business, we are notsubject to potential obligations under guarantees that fall within the scope ofFinancial Accounting Standards Board Interpretation No. 45 (“FIN 45”), “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others”, except for standard warranty provisionsassociated with product sales and

 

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indemnificationprovisions related to intellectual property that are contained within many ofour lithography tool manufacturer agreements. All of these provisions give riseonly to the disclosure requirements prescribed by FIN 45.

 

(a)               ProductWarranties – Warranty provisions contained within our lithography toolmanufacturer agreements are generally consistent with those prevalent in thesemiconductor equipment industry. The warranty period and terms for lightsource systems and spares and consumable parts varies by light source systemmodel. We record a provision for warranty for all products, which is includedin cost of product sales in the consolidated statements of operations and isrecorded at the time that the related revenue is recognized. We review ourwarranty provision monthly, which is determined using a statistical financialmodel which calculates actual historical expenses, product failure rates, andpotential risks associated with our different product models. We then use thisfinancial model to calculate the future probable expenses related to warrantyand the required level of the warranty provision. Throughout the year we reviewthe risk levels, historical cost information and failure rates used within thismodel and update them as information changes over the product’s life cycle. Ifactual warranty expenditures differ substantially from our estimates, revisionsto the warranty provision would be required. Actual warranty expenditures arerecorded against the warranty provision as they are incurred.

 

The following tablesummarizes information related to our warranty provision for the six monthsended June 30, 2006 (in thousands):

 

| ** **                                                                     | ** ** | **2006** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|
|                                                                           |       |     |       |
| Balance, January  1, 2006                                                      |       | $        | 30,191     |   |
| Liabilities  accrued for warranties issued, net of adjustments and expirations |       | 11,470   |       |
| Warranty  expenditures incurred                                                |       | (10,276  | )          |
| Balance, June  30, 2006                                                        |       | $        | 31,385     |   |

 

(b)              IntellectualProperty Indemnifications – We include intellectual property indemnificationclauses within our general terms and conditions with our customers and thegeneral purchase agreements with our three lithography tool manufacturers, ASMLithography, Canon, and Nikon. In general, these indemnification provisionsprovide that we will defend our customers against any infringement claims thatarise related to our products. Under the indemnification clauses, we will payall costs and damages, including attorney’s fees, associated with suchsettlements or defenses, provided that the lithography tool manufacturerfollows specific procedures for notifying us of such claims and allows us tomanage the settlement proceedings. Due to the nature of these indemnificationprovisions, they are indefinite and extend beyond the term of the actual lithographytool manufacturer agreements.

 

An indemnificationprovision was also included in the contract manufacturing agreement with SeikoInstruments, Inc. (“Seiko”), which was terminated effective March 31, 2003. Aswith our indemnification provisions on intellectual property, we continue tohonor this indemnification clause within the agreement even after itstermination. Seiko and at least one Japanese lithography tool manufacturer havebeen notified that our light source systems in Japan may infringe certainJapanese patents. We believe, based upon the advice of counsel, that ourproducts do not infringe any valid claim of the asserted patents or that we areentitled to prior use claims in Japan. Due to the nature of theseindemnification provisions, they are indefinite and extend beyond the term ofthe actual lithography tool manufacturer agreements.

 

As part of the originalresearch and development agreement signed with Intel in 2004, we also agreed toprovide Intel with indemnity against any infringement of the intellectualproperty rights of any third party arising from Intel’s purchase and/or use ofour EUV source systems. Although this agreement was recently amended, ourobligations to indemnify Intel will be specifically negotiated in any purchaseagreement related to such future products.

 

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As part of the supply agreement signed with TCZin September 2005, we agreed to indemnify TCZ against any infringement of theintellectual property rights of a third party arising from TCZ’s purchase ofour products. We will defend such actions at our own expense and will pay thecost and damage awarded in any such action provided that TCZ grants us solecontrol of the defense and settlement of such action and also provides us withinformation required for the defense and settlement of such action. Due to thenature of these indemnification provisions, they are indefinite and extendbeyond the term of the actual lithography tool manufacturer agreements.

 

**9.****             ****RELATED PARTY TRANSACTIONS**

 

As a result of the TCZ joint venture which was formed in July 2005, Zeissis now a related party. In addition to transactions that occur among us, Zeissand TCZ related to the joint venture, we also purchase certain optical partsdirectly from Zeiss and sell our light source system products to Zeissperiodically. We recorded revenue associated with this related party of $3.2million and $5.4 million for the three and six months ended June 30, 2006,respectively. As of December 31, 2005 and June 30, 2006, we had accountsreceivable balances of $588,000 and $3.5 million, respectively, and accountspayable balances of $5.0 million and $4.6 million, respectively, all of whichwere associated with these related party transactions with Zeiss.

 

**10.****       CONTINGENCIES ANDCOMMITMENTS**

 

We are party to legal actions in the normal course ofbusiness. Based in part on the advice of legal counsel, our management does notexpect the outcome of legal action in the normal course of business to have amaterial impact on our financial position, liquidity, or results of operations.

 

Our former Japanese manufacturing partner, Seiko, andone of our Japanese customers were notified in July 1996 that our light sourcesystems in Japan may infringe certain Japanese patents held by another Japanesecompany. We have agreed to indemnify our former Japanese manufacturing partnerand our customers against patent infringement claims under certaincircumstances, even after the termination date of the contract manufacturingagreement. We believe, based upon the advice of counsel, that our products donot infringe any valid claim of the asserted patents or that we are entitled toprior use claims in Japan.

 

**11.****       SUBSEQUENT EVENTS**

 

The research and development agreement we entered into effective as ofJanuary 23, 2004 with Intel was amended effective July 17, 2006.  Underthe terms of the Amended Development Agreement, most of the mutual obligationsbetween us and Intel have been terminated, including Intel’s obligation toprovide us with up to a total of $20.0 million over a three-year period toaccelerate the development of production-worthy EUV lithography light sources.As of the date of the amendment, we had received a total of $8.5 million fromIntel under the original agreement, which includes an advance payment of $1.3million paid by Intel at the initiation of the agreement in 2004. Under theAmended Development Agreement, Intel has no obligation to provide us withfurther funding beyond that already received and we returned $347,222,which represents the unearned portion of the advance payment made by Intel.Although we will receive no additional funding from Intel under the AmendedDevelopment Agreement, we intend to continue to develop the EUV technology aspart of our existing product roadmap.  In addition, per the terms of theAmended Development Agreement, we will continue meeting with Intel on a regularbasis to review our progress towards developing a production-worthy EUV sourcesystem.

 

On July 28, 2006, we announced that our board of directors had authorizedus to repurchase up to $150 million of our common stock. The purchases will bemade from time to time in the open market or in privately negotiatedtransactions. The program may be discontinued at any time. Total purchasesthrough August 1, 2006 were $22.7 million or 589,515 shares under this program.

 

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**ITEM 2. Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

*The following discussion of our financial condition and results ofoperations should be read in conjunction with our consolidated financialstatements and notes thereto included in this Quarterly Report on Form 10-Q.*

 

**Forward-Looking Statements**

 

Statements in thisQuarterly Report on Form 10-Q that are not strictly historical in nature areforward-looking statements. These statements include, but are not limited to,references to the outlook for the semiconductor industry and us; expecteddomestic and international product sales and development; our research anddevelopment activities and expenditures; adequacy of our capital resources andinvestments; effects of business cycles in the semiconductor business; ourcompetitive position; and our relationships with customers and third-partymanufacturers of our products, and may contain words such as “believes,” “anticipates,”“expects,” “plans,” “intends” and words of similar meaning. These statementsare predictions based on current information and our expectations and involve anumber of risks and uncertainties. The underlying information and ourexpectations are likely to change over time. Actual events or results maydiffer materially from those projected in the forward-looking statements due tovarious factors, including, but not limited to, those contained under thecaption “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Forward-lookingstatements herein speak only as of the date of this Quarterly Report on Form10-Q. Unless required by law, we undertake no obligation to update or reviseany forward-looking statements to reflect new information or future events ordevelopments. Thus, you should not assume that our silence over time means thatactual events are bearing out as expressed or implied in such forward-lookingstatements.

 

#### **Overview**

#### ** **

*General*

 

We are the world’s leading supplier of lightsource solutions for the semiconductor industry. Our products provide theessential light source for deep ultraviolet (“DUV”) photolithography systems. Almostall consumer electronic devices manufactured in the last several years containa semiconductor manufactured using light sources such as ours. We currentlysupply light sources to all three lithography tool manufacturers, ASMLithography, Canon, and Nikon, who in turn supply their wafer steppers andscanners to chipmakers.  In addition, we sell replacement parts andservices to the lithography tool manufacturers as well as directly to thechipmakers. Our light source systems currently constitute a substantialmajority of all excimer light sources incorporated in lithography stepper andscanner tools. Our headquarters are located in San Diego, California where wedevelop and manufacture all of our light source systems. As a large portion ofour revenue is derived from customers located outside of the U.S., we maintaina spare parts refurbishment facility and field service office in Korea andfield service and support offices in Japan, the Netherlands, the People’sRepublic of China, Singapore and Taiwan. Japan is currently our only subsidiaryoffice that sells excimer light source systems. We also maintain field serviceoffices in the U.S. to service our installed base of light sources located inthe U.S.

 

In July 2005, we entered into a joint venture agreement with (i) CarlZeiss SMT AG, a German corporation (“SMT”); (ii) Carl Zeiss Laser OpticsBeteiligungsgesellschaft mbH, a German limited liability company (“LOB”); and(iii) the Swiss liability company that was formed as part of the JV Agreementand named TCZ GmbH (“TCZ”). LOB and SMT, together with their affiliatedentities, are collectively referred to as “Zeiss”. TCZ is currently developing,and will integrate, market and sell, and support, production tools for the flatpanel display manufacturing industry. The joint venture is currentlyheadquartered in San Diego and is owned 60% by us and 40% by Zeiss. The jointventure is targeting the growing market for low-temperature poly-silicon (“LTPS”)processing used in the manufacture of liquid crystal displays that arebrighter, have higher resolution, and consume less power than displays usingtoday’s predominant amorphous silicon films. We currently expect that TCZ willship its first production tool, the TCZ 900X, in the first half of  2007, and we expect that TCZ will break evenfrom a financial standpoint in the 2008 to 2009 timeframe.

 

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***Products***

** **

Our products primarilyconsist of photolithography light source systems, replacement parts, andservice.

 

Our excimer light sourcesfor photolithography produce pulsed light of extremely short wavelengths withinthe DUV spectrum. The bandwidth of the light is further narrowed through anumber of optical techniques. The DUV wavelengths are measured in nanometers(one nanometer is one billionth of a meter), and the light sources are referredto according to either the wavelength or the gases that are mixed to producethe light. Krypton Fluoride (“KrF”) gases produce light at a 248 nm wavelength,and Argon Fluoride (“ArF”) gases produce light at a 193 nm wavelength. Theextremely short wavelengths and highly narrowed bandwidths of light produced bythese light sources enable the very fine feature resolution required forpatterning or printing the circuitry on silicon wafers. The pulse energy andrepetition rate of the light source permit high throughput in wafer processing.We have designed our light sources to be reliable, easy to install and serviceand compatible with existing semiconductor manufacturing processes. Our lightsources are used to pattern or print the integrated circuits, which are alsocalled semiconductors or “chips,” that power many of today’s advanced consumerand business electronics. In the second quarter of 2006, we sold 75 lightsource systems at an average selling price of $968,000.

 

Certain components andsubassemblies included in our light sources require replacement orrefurbishment following extended operation. We estimate that a light sourceused in a semiconductor production environment will require one to tworeplacement chambers per year, depending upon the level of usage. Similarly,certain optical components of the light source deteriorate with continuedexposure to DUV light and require periodic replacement. We provide these andother spare and replacement parts for our photolithography light sources as neededby our customers.

 

As the life and usage ofour installed base of light sources in production at chipmakers exceeds theoriginal warranty periods, some chipmakers request service contracts from us. Additionally,we provide billable service or service contracts directly to the threesemiconductor lithography tool manufacturers. These service agreements requireus to maintain and/or service these light sources either on an on-call orregular interval basis or both. Included in some of the types of servicecontracts we provide to our customers are the replacement of consumable partsand non-consumable parts. The pricing for such contracts includes thereplacement of these parts.

 

Included in some of ourservice contracts and sold separately is CymerOnLineTM,adiagnostic and performance software product which delivers critical laserdiagnostics and performance information in near real-time directly toauthorized users anywhere. The software simplifies reporting and allows usersto efficiently manage consumables usage. CymerOnLine offers a user-friendlybrowser-based interface, which features a robust design and provides a securedata environment. Event-initiated messages sent to pagers, e-mail, mobilephones, or other handheld devices enable up-to-the-minute communication andproactive management.

 

#### ***SemiconductorIndustry Status and Outlook***

#### ** **

Since we derive a substantial portion of our revenuesfrom photolithography tool manufacturers, we are subject to the volatile andunpredictable nature of the semiconductor industry. The semiconductor industryis highly cyclical in nature and historically has experienced periodic ups anddowns, and the activities of the last several years illustrate this cyclicality.In 2000, the semiconductor industry experienced strong growth, which wasfollowed by a three year decline from 2001 through late 2003. Growth resumed inlate 2003, but in late 2004, the industry again declined for several months,then leveled off early in 2005 and began to improve gradually thereafter.

 

In the final quarter of 2005, orders for our lightsources increased substantially from the levels we had experienced earlier inthe year. Our chipmaker customers began indicating that increasing demand forchips would require them to expand production capacity, and our lithographytool manufacturing

 

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customers began placing orders for a growing number of light sources tomeet increasing scanner demand. It began to appear that we were again enteringan industry growth cycle and upturn.

 

There were many positiveindicators in the first quarter of 2006 that reinforced our viewpoint that wewere entering an upturn in the semiconductor industry. In addition to strongcontinuing demand for our ArF light sources in the first quarter of 2006, wealso experienced substantial ongoing growth in our non-systems revenue whichwas driven by high light source utilization at chipmakers and high overall fabutilization. Additionally, there was stronger than anticipated demand for KrFlight sources, as chipmakers ordered tools to expand capacity. Our bookings,revenue and profits grew substantially in the first quarter of 2006 compared tothe fourth quarter of 2005.

 

This growth trendcontinued in the second quarter of 2006, and our revenue grew to a record$135.4 million, up seven percent from our revenue of $127.1 million in thefirst quarter of 2006. Utilization of our light sources at chipmakers continuedto rise in the second quarter of 2006, and grew three percent over the previousquarter’s level. This drove our non-systems product revenue, which consists ofconsumables and spare parts, upgrades, and service, to a record $62.7 millionfor the second quarter of 2006. We shipped 31 of our XLA Series ArF lightsources in the second quarter of 2006, the second highest volume since the XLA Serieswas introduced. Our direct customers are ramping up their ArF immersion scannerproduction to meet growing demand for immersion lithography tools from anexpanding number of chipmakers. We anticipate that this will in turn driveincreasing demand for the XLA 300, which is designed for use in high volumeimmersion production.

 

Industry trends stayedpositive in the second quarter of 2006. Fab utilization continued in the low tomid 90 percent range, and fab managers remained cautious about buying too muchequipment and building excess manufacturing capacity in the fab. NAND Flashmemory manufacturers continued to expand their capacity, and 300mm fabscontinued to be built and populated with equipment.

 

Looking at medium- andlonger-term market conditions, demand for DUV lithography should continue togrow in all segments of the market. We believe we are well positioned as theleader in the most rapidly growing segment of the lithography market – ArFlight sources for both dry and immersion applications. Demand for ArF shouldextend well into the future through the use of both immersion and doublepatterning production techniques. Our most advanced, highest value-addedproducts are experiencing growing demand, our ability to bring more advancedand highly innovative products to market strengthens our leadership, and ouroverall competitive position continues to be strong. However, macro-economicfactors, such as high energy prices and rising interest rates, could have anegative impact on consumer spending, including spending on electronic devices.Additionally, geopolitical turmoil can create a heightened sense of uncertaintythat can cause consumers to become more cautious about their spending. Eitheror both of these factors would have a negative effect on demand for ourproducts.

 

We entered 2006 focusingour efforts on creating shareholder value through improved profitability,overall financial performance and execution. During the second quarter of 2006,our gross margin increased to 48 percent compared to 46 percent in the priorquarter. In the second quarter of 2006, we generated $16.4 million in cash fromoperations, which is a significant improvement from the $869,000 generated fromoperations in the first quarter of 2006. We expect to generate higher levels ofcash from operations through the remainder of 2006 and we will continue toexplore opportunities for the most effective use of our cash.

 

#### **CriticalAccounting Policies and Estimates**

#### ** **

*General*

 

The discussion andanalysis of our financial condition and results of operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States of America. Thepreparation of these financial statements requires us to make estimates and usejudgment that may impact the reported amounts of assets,

 

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liabilities, revenues, expenses, and related disclosure of contingentassets and liabilities. As a part of our ongoing internal processes, weregularly evaluate our estimates and judgments associated with revenuerecognition, valuation of parts used in our refurbishment manufacturingprocess, inventory allowances, warranty provisions, stock-based compensation,income taxes, allowances for bad debts, long-lived assets valuation, intangibleassets valuation, and contingencies and litigation. We base these estimates andjudgments upon historical information and other facts and assumptions that webelieve to be valid and/or reasonable under the circumstances. Theseassumptions and facts form the basis for making judgments and estimates and fordetermining the carrying values of our assets and liabilities that are not apparentfrom other sources. Actual results could vary from our estimates if we were touse different assumptions and conditions.

 

We believe that revenue recognition, valuation ofparts used in our refurbishment manufacturing process, inventory allowances, warrantyprovisions, stock-based compensation, and income taxes require more significantjudgments and estimates in the preparation of our consolidated financialstatements than do other of our accounting estimates and judgments.

 

*RevenueRecognition*

 

Our revenues consist of product sales, which includesales of light source systems, consumable and spare parts, upgrades, service,service contracts and training. Our revenues also consist of certain fundeddevelopment activities performed for our customers and under governmentcontracts and license agreements.

 

The sales of ourlight source systems generally include training and installation services. Wedetermined these elements qualify as one unit of accounting under EmergingIssues Task Force (“EITF”) Bulletin No. 00-21, “Revenue Arrangements withMultiple Deliverables” as we do not have evidence of fair value for theundelivered training and installation elements. Furthermore, we determined thatthe undelivered training and installation elements are perfunctory performanceobligations and are not essential to the functionality of our light sourcesystems. Therefore, in accordance with the provisions of Staff AccountingBulletin No. 104, we recognize revenue when the revenue recognition criteriaare met for the light source system, and accrue the costs of providing thetraining and installation services. We recognize light source system revenue atone of following three points, depending on the terms of our arrangement withour customer – 1) shipment of the light source system 2) delivery of the lightsource system or 3) receipt of an acceptance certificate. For the majority ofour light source system sales, the shipping terms are F.O.B. shipping point andrevenue is recognized upon shipment. For our arrangements which include F.O.B.destination shipping terms, revenue is recognized upon delivery of the lightsource system to our customer. Lastly, one of our arrangements includes anacceptance provision, which is satisfied by the issuance of an acceptancecertificate by the customer. For these transactions, we recognize revenue uponreceipt of the acceptance certificate. In addition, we test our light sourcesystems in environments similar to those used by our customers prior toshipment to ensure that they meet published specifications.

 

Revenue from consumables and spare parts salesis recognized at the point that legal title passes to the customer, which isupon shipment from our facility.  For a significant portion of our spareparts sales, our customers return the consumed assembly to us as part of thesale of the new part.  We reuse some of the material within these coreassemblies, mainly metal components, for the future build of coreassemblies.  As a result, our revenue consists of both cash and the value ofthe reusable parts received from our customers as consideration for these sparepart sales. Revenue associated with our customers’ return of core assemblies isrecognized upon receipt of the returned core assembly.  The amount of therevenue is determined based upon the fair value of the reusable parts that weexpect to yield from the returned core assembly based on historical experience.Service and training revenue is recognized as the services are rendered.

 

For funded development contracts, which areincluded in other revenue, funds received are accounted for on thepercentage-of-completion method based on the relationship of costs incurred tototal estimated costs. Revenues generated from these types of fundeddevelopment contracts are derived from

 

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cost sharing contractsbetween certain customers and us. If milestones on these funded developmentcontracts require that specific results be achieved or reported by us, revenueis not recognized until that milestone is completed.  For some of thefunded development contracts that we enter into with customers and governmentagencies, we evaluate certain criteria to determine whether recording the fundsreceived as revenue is appropriate.  If certain conditions are met, thesefunds are not recorded as revenue but rather are offset against our owninternal research and development expenses in the period that the milestone isachieved.

 

*Valuation of Parts Used in RefurbishmentManufacturing Process and Corrected Accounting Method*

* *

Over the last severalyears as part of our regular business activities, we have conducted significantparts refurbishment and material reclaim activities related to some of our coreassemblies, in particular our chamber assemblies. The volume of this activitysignificantly increased in 2004 and we expect volumes to increase over time aswe become more efficient in these refurbishment activities and  develop capabilities to reclaim material fromand refurbish other core assemblies. These activities involve arrangements withour customers where we sell a new part to the customer at a reduced sales priceif the customer returns the consumed assembly that the new part replaces. Thesereturned core assemblies contain a certain amount of material, primarily metalcomponents, that may be reused by us in future core assemblies. Upon receipt ofthese consumed assemblies from our customers, either we record an entry torecognize the estimated fair value of the reusable components as inventory and revenueor a reduction in cost of product sales sold depending on the reason for thepart replacement. The value of the reusable parts contained within the consumedassembly is determined based upon historical data on the value of the reusableparts that we typically yield from a consumed assembly. As part of our normalexcess and obsolete inventory analysis, these consumed assemblies are alsoreviewed on a quarterly basis and an inventory allowance is recorded asappropriate for these parts. The value that we assign to these core assembliescan be affected by the current demand for the reusable parts in ourmanufacturing operations and the actual yield rate achieved for parts withinthese consumed core assemblies. We believe that our methodology for valuing thereusable parts within these returned core assemblies is reasonable, but anychanges in the demand for the parts or the yield of the parts included in thesecore assemblies could have a material adverse effect on our financial conditionand results of operations.

 

Prior to the fourthquarter of 2004, we recorded the value of this material as a reduction of ourcost of product sales in the period that the returned assembly was disassembledby our manufacturing operations and the value of the reusable parts could bedetermined. Upon further review of U.S. generally accepted accountingprinciples in the fourth quarter of 2004, we determined that we should insteadestimate the value and record these consumed assemblies as inventory at thetime that we receive the returned assembly from our customer and concurrentlyrecord this amount as either revenue or as a reduction to cost of product salesdepending on the reason for the part replacement. During the fourth quarter of 2004, we corrected our accounting treatmentfor these refurbishment activities and recorded the financial impact for all of2004 and prior years in our fourth quarter of 2004 financial statements.

 

***InventoryAllowance***

** **

We perform an analysis ofour inventory allowances on at least a quarterly basis to determine theadequacy of this allowance on our financial statements. The amount of theinventory allowance is determined by taking into consideration certainassumptions related to market conditions and future demands for our products,including changes to product mix, new product introductions, and/or productdiscontinuances, which may result in excess or obsolete inventory. We determinethe level of excess and obsolete inventory associated with our raw materialsand production inventory, which includes all parts on hand from ourrefurbishment activities, by comparing the on hand inventory balances andinventory on order to the next 12 months of forecasted demand. We then adjustthis calculation for inventory that has a high likelihood of use beyond oneyear or can be used in other products that may have lower demands. After thisadjustment, we arrive at our total exposure for excess and obsolete inventorywithin our raw materials and production inventory. As part of this analysis, wealso determine whether there are potential

 

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amounts owed to vendors as a result of cancelled or modified rawmaterial orders. We estimate and record a separate liability, which is includedin accrued and other liabilities in the accompanying balance sheets for suchamounts owed.

 

The inventory allowance totaled $10.4 million and$10.7 million at December 31, 2005 and June 30, 2006, respectively. The slightincrease in the inventory allowance at June 30, 2006 as compared to December31, 2005 is due to higher inventory levels from period to period and increasedexcess and obsolete allowances for both raw materials and parts contained inconsumed assemblies which are received from our customers and are used in our  material reclaim and refurbishment activities.

 

The methodologies used toanalyze excess and obsolete inventory and determine the inventory allowance aresignificantly affected by future demand and usage of our products. There aremany factors that could potentially affect the future demand or usage of ourproducts, including the following:

 

•                  Overallcondition of the semiconductor industry, which is highly cyclical in nature;

•                  Rateat which our lithography tool manufacturers and chipmaker customers takedelivery of our light source systems and our consumable and spare parts;

•                  Lossof any of our three major customers or a significant change in demand from anyof these three customers;

•                  Overallmix of light source system models or consumable and spare parts and any changesto that mix required by our customers; and

•                  Utilizationrates of our light sources at chipmakers.

 

Based upon ourexperience, we believe that the estimates we use in calculating the inventoryallowance are reasonable and properly reflect the risk of excess and obsoleteinventory. If actual demand or the usage periods for our inventory aresubstantially different from our estimates, adjustments to our inventoryallowance may be required, which could have a material adverse effect on ourfinancial condition and results of operations.

 

###### *Warranty Provision*

###### * *

We maintain an accrualfor the estimated cost of product warranties associated with our product sales.Warranty costs include the replacement parts and labor costs to repair ourproducts during the warranty periods. At the time revenue is recognized, werecord a warranty provision, which is included in cost of product sales in theaccompanying consolidated statements of operations. The warranty coverageperiod and terms for light source systems and consumable and spare parts variesby light source system model. The warranty provision for our products isreviewed monthly and determined by using a statistical financial model, whichtakes into consideration actual historical expenses, product failure rates, andpotential risks associated with our different products. This model is then usedto estimate future expenses related to warranty and the required warrantyprovision. The risk levels and historical cost information and failure ratesused within this model are reviewed throughout the year and updated as theseinputs change over the product’s life cycle. Due to the highly technical natureof our light source system products, the newer model light sources and themodules contained within them have higher inherent warranty risks with theirinitial shipments and require higher warranty provisions until the technologybecomes more mature.

 

The total balance in thewarranty provision accrual as of December 31, 2005 and June 30, 2006 was $30.2million and $31.4 million, respectively. This increase is primarily due to thehigher level of consumables and spare parts sales in the first half of 2006 ascompared to the second half of 2005 and the reserve amounts remaining in thewarranty provision on June 30, 2006 related to those sales. The increase in thespares and consumables portion of the warranty provision as of the end of thesecond quarter of 2006 was partially offset by decreases in the warrantyprovision caused by a greater proportion of light source systems requiringlower warranty provisions as calculated by our financial model and an overalldecrease in labor expenses that are expected in future periods to service thelight source systems and spares and consumable parts under warranty as of June30, 2006.

 

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We actively engage inproduct improvement programs and processes to limit our warranty costs, but ourwarranty obligation is affected by the complexity of our product, productfailure rates and costs incurred to correct those product failures at customer sites.The industry in which we operate is subject to rapid technological change, andas a result, we periodically introduce newer, more complex light sources. Althoughwe classify these newly released light source models as having a higher risk inour warranty model resulting in higher warranty provisions, we are more likelyto have differences between the estimated and actual warranty costs for thesenew products. This is due to limited or no historical product performance dataon which to base our future warranty costs. Warranty provisions for our olderand more established light source models are more predictable as we have morehistorical information available on these products. If actual product failurerates or estimated costs to repair those product failures were to differ fromour estimates, revisions to our estimated warranty provision would be required,which could harm our financial condition and results of operations.

 

*Stock-BasedCompensation*

 

We grant options topurchase our common stock to our employees and grant stock unit awards to ournon-employee directors under our current stock plan. The benefits providedunder this plan are share-based payments subject to the provisions of SFAS No.123R. Effective January 1, 2006, we adopted the requirements of SFAS No. 123Rwhich address the accounting for share-based payment transactions in which anenterprise receives employee services in exchange for (a) equityinstruments of the enterprise or (b) liabilities that are based on thefair value of the enterprise’s equity instruments or that may be settled by theissuance of such equity instruments. As a result of this new accountingrequirement, our consolidated financial statements for the six months endedJune 30, 2006 include compensation expense as calculated per the provisions ofSFAS No.123R. In adopting SFAS No. 123R, we elected to use the modifiedprospective transition method, thus our consolidated financial statements forperiods prior to January 1, 2006 do not include any impact of SFAS No.123R. Wealso elected to attribute the value of share-based compensation to expenseusing the straight-line method for awards granted after December 31, 2005 uponour adoption of SFAS No. 123R. Compensation expense for awards outstanding asof December 31, 2005 are being recognized over the remaining service periodusing the compensation expense calculated according to the pro forma disclosureprovisions under SFAS No. 123 which uses an accelerated expense recognitionmethod for those awards with a graded vesting schedule. Share-basedcompensation expense related to stock options and stock units was $2.4 millionand $4.8 million, before taxes for the three and six months ended June 30, 2006,respectively.

 

Upon adoption of SFAS No.123R on January 1, 2006, we elected to value our share-based payment awardsusing the Black-Scholes option pricing model, as we had under the pro formaprovisions of SFAS No. 123. The determination of fair value of stock-basedpayment awards on the date of grant is affected by our stock price as well asassumptions regarding a number of complex and subjective variables. Theseassumptions include our expected stock price volatility over the term of theawards and the expected term of stock options.

 

We determined ourexpected volatility by using a combination of historical and impliedvolatility, or blended volatility, to derive our expected volatility assumptionas allowed under SFAS 123R and SAB 107. Implied volatility was based on oursix-month traded options on our common stock. We determined that the volatilitycalculated using a blend of implied volatility and our historical volatilitywas more reflective of expected volatility than using only historicalvolatility. The expected term of stock options represents the weighted-averageperiod the stock options are expected to remain outstanding. We determined theexpected term of our stock options based on observed historical exercisepatterns for our company, which we believe are indicative of future exercisebehavior.

 

Other assumptions requiredfor estimating fair value under the Black-Scholes option pricing model includethe expected risk-free interest rate and expected dividend yield of our stock. Ourrisk-free interest rate assumption is based upon currently available rates onzero coupon U.S. Government issues for the expected term of our stock options.The expected dividend rate is not applicable to us as we have not historicallydeclared or paid dividends nor do we anticipate paying cash dividends in thefuture.

 

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SFAS No. 123R also requires forfeitures to beestimated at the time of grant and we have estimated our forfeitures based onhistorical experience. We will revise this estimate, if necessary, insubsequent periods if actual forfeiture rates differ from our estimates. In ourpro forma information required under SFAS No. 123 for periods prior to January1, 2006, we accounted for forfeitures as they occurred.

 

If we change any of the key assumptions that we use inthe Black-Scholes option pricing model such as expected volatility or expectedterm or if we decide to use a different valuation model in the future, thecompensation expense that we record under SFAS No. 123R may differsignificantly in the future from what we have recorded in the current period. Inaddition, as the guidance by regulators for SFAS No. 123R is relatively new,the application of these principles may be subject to further interpretationand refinement over time.

 

*Income Taxes*

* *

We account for income taxesin accordance with Statement of Financial Accounting Standards No. 109 (“SFASNo. 109”), “Accounting for Income Taxes.” Pursuant to SFAS No. 109, a deferred tax asset or liability is generallyrecognized for the estimated future tax effects attributable to temporarydifferences, net operating loss (“NOL”) carryforwards and tax creditcarryforwards. Deferred tax assets are to be reduced by a valuation allowanceif, based on the weight of available evidence, it is more likely than not thatsome portion or all of the deferred tax assets will not be realized within thecarryback or carryforward periods. Information about an enterprise’s currentfinancial position and its results of operations for the current and precedingyears, as well as all currently available information about future years shouldbe considered.

 

We have considered ourindustry’s outlook for the future, our historical performance and estimatedfuture taxable income, and ongoing tax planning strategies in assessing theneed for a valuation allowance. Using this information, we have prepared amodel to forecast our expected taxable income in future years and to estimatewhen the benefits of our deferred tax assets are likely to be realized. Basedupon the analysis, with the exception of TCZ GmbH,  we believe that it is more likely than notthat the results of future operations will generate sufficient taxable incometo realize our deferred tax assets within the period covered by our model and,as such, no valuation allowance against deferred tax assets is provided. However,in the case of our joint venture, TCZ, we do not feel that there is sufficientevidence or operating history to conclude that the future operating profits ofTCZ are likely to allow it to utilize its NOL carryforwards and, consequently,a full valuation allowance has been provided against those loss carryforwards.

 

A material adversechange in the outlook for worldwide lithography tool sales, the expectedselling prices or profit margins for our products or our expected share of theglobal market for lithography light sources, could cause us to determine thatadditional valuation allowances are needed for some or all of our deferred taxassets, and would result in an increase to our income tax provision in theperiod in which such determination is made.

 

Our results reflect theimpact of the American Jobs Creation Act of 2004, which repealed theExtraterritorial Income Exclusion (“ETI”) subject to certain transition rules.The ETI benefit is being replaced with a Manufacturing Activity deduction underInternal Revenue Code (“IRC”) Section 199, with a phase out of ETI benefits in2005 and 2006. Our estimated ETI benefit for 2006 reflects the transitionrules.

 

We have not provided forU.S. federal income and foreign withholding taxes on $57.6 million ofundistributed earnings from non-U.S. operations as of June 30, 2006 as it isour intention to reinvest undistributed earnings of our foreign subsidiariesand thereby indefinitely postpone their remittance. Accordingly, no provisionhas been made for foreign withholding taxes or U.S. income taxes which maybecome payable if undistributed earnings of foreign subsidiaries were paid tous as dividends. Currently, we are not considering the repatriation of anyforeign earnings and as such, no impact is reported in the

 

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financialstatements as of June 30, 2006. It is not practicable to estimate the amount ofthe deferred tax liability on such unremitted earnings.

 

**RESULTS OF OPERATIONS**

 

The following table setsforth certain items in our consolidated statements of operations as apercentage of total revenues for the periods indicated:

 

| ** **                                                | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                | ** ** | **2005**                         | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenues:                                                 |       |                             |       |                           |       |   |   |   |   |
| Product sales                                             |       | 99.4                             | %          | 97.5                           | %          | 99.6 | % | 97.9 | % |
| Product sales-related  party                              |       | —                           |       | 2.4                            |       | — |   | 2.0 |   |
| Other                                                     |       | 0.6                              |       | 0.1                            |       | 0.4 |   | 0.1 |   |
| Total revenues                                            |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Cost and  expenses:                                       |       |                             |       |                           |       |   |   |   |   |
| Cost of product  sales                                    |       | 59.9                             |       | 52.1                           |       | 61.1 |   | 53.0 |   |
| Research and  development                                 |       | 17.6                             |       | 13.9                           |       | 17.4 |   | 14.1 |   |
| Sales and  marketing                                      |       | 7.0                              |       | 5.5                            |       | 6.9 |   | 5.4 |   |
| General and  administrative                               |       | 6.2                              |       | 7.1                            |       | 6.8 |   | 7.2 |   |
| Total costs and  expenses                                 |       | 90.7                             |       | 78.6                           |       | 92.2 |   | 79.7 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Operating income                                          |       | 9.3                              |       | 21.4                           |       | 7.8 |   | 20.3 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Total other  income - net                                 |       | 2.5                              |       | 3.3                            |       | 1.4 |   | 4.1 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Income before  income tax provision and minority interest |       | 11.8                             |       | 24.7                           |       | 9.2 |   | 24.4 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Income tax  provision                                     |       | 1.0                              |       | 8.5                            |       | 0.5 |   | 8.4 |   |
| Minority  interest                                        |       | 0.6                              |       | 0.5                            |       | 0.4 |   | 0.5 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Net income                                                |       | 11.4                             | %          | 16.7                           | %          | 9.1 | % | 16.5 | % |
| Gross margin on  product sales                            |       | 39.7                             | %          | 47.9                           | %          | 38.6 | % | 46.9 | % |

 

**THREEMONTHS ENDED JUNE 30, 2005 AND 2006**

 

*Revenues*. Thetypes of revenue that we generate and how we recognize revenue for each isexplained above under the heading “Critical Accounting Policies and Estimates.”

 

The following tablesummarizes the components of our revenue (in thousands, except units sold):

 
| ** **                                       | ** ** | **For the three months ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                       | ** ** | **June 30,**                                  | ** ** |
| ** **                                       | ** ** | **2005**                                           | ** ** | **2006** | ** ** |
|                                             |       |                                               |       |   |   |
| Light source  systems:                           |       |                                               |       |   |   |
| Revenue                                          |       | $                                                  | 54,797     |   | $ | 72,629 |   |
| Units sold                                       |       | 56                                                 |       | 75 |   |
| Average selling  price (1)                       |       | $                                                  | 940        |   | $ | 968 |   |
|                                             |       |                                               |       |   |   |
| Consumable and  spare parts and service products |       | $                                                  | 41,000     |   | $ | 62,661 |   |
| Other revenue                                    |       | $                                                  | 595        |   | $ | 89 |   |
|                                             |       |                                               |       |   |   |
| Total revenue                                    |       | $                                                  | 96,392     |   | $ | 135,379 |   |

 

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(1)    Calculation of average sellingprice excludes $2.2 million of deferred light source revenue during the threemonths ended June 30, 2005. We had one arrangement where a portion of the lightsource system fee was not payable until the system was installed successfullyat the end-user. This arrangement expired in March 2005.

 

Product sales increased 41% from $95.8 million for thethree months ended June 30, 2005 to $135.3 million for the three months endedJune 30, 2006. This increase in product sales was due to higher light sourcesystem revenues and higher consumable and spare parts and service productsrevenues for the three months ended June 30, 2006 compared to the three monthsended June 30, 2005. Light source system revenues increased 33% from $54.8million for the three months ended June 30, 2005 to $72.6 million for the threemonths ended June 30, 2006. A total of 56 light source systems were sold in thethree months ended June 30, 2005 at an average selling price of $940,000,compared to 75 light source systems sold in the three months ended June 30,2006 at an average selling price of $968,000. On a foreign currency adjustedbasis, the average selling price for the three months ended June 30, 2005 was$941,000 compared to $958,000 for the three months ended June 30, 2006. Theslight increase in the average selling price from period to period reflects theshift in the product mix from capacity driven lower priced KrF products in thethree months ended June 30, 2005 to higher priced technology buys of advancedArF products in the three months ended June 30, 2006. The increase inquantities of light source systems sold from period to period was due to theslight slowdown and flattening of the industry in the beginning of 2005compared to the recent upturn in the semiconductor industry in 2006. Chipmakersexpanded capacity needs have impacted the demand for our light source systems,and increased demand for consumables and spare parts and service products. Thisincreased consumable and spare parts demand and rising tool utilizationresulted in an increase in consumables and spare parts and service revenues of53% from $41.0 million for the three months ended June 30, 2005 to $62.7million for the three months ended June 30, 2006. Revenues from fundeddevelopment contracts were $595,000 for three months ended June 30, 2005,compared to $89,000 for the three months ended June 30, 2006. There were norevenues recorded or earned associated with the TCZ joint venture for the threemonths ended June 30, 2006. We expect that our third quarter 2006 revenue willincrease over the second quarter 2006 levels, and current industry forecastssuggest continued growth through the remainder of 2006.

 

Ourbacklog at June 30, 2005 was $75.8 million compared to $92.2 million at June30, 2006. Bookings for the three months ended June 30, 2005 and June 30, 2006were $96.4 million and $128.3 million, respectively. The book-to-bill ratio forthe quarter ended June 30, 2005 was 1.0 compared to 0.95 for the quarter endedJune 30, 2006. The increase in the backlog is due to the changing condition ofthe semiconductor industry from period to period. The backlog as of June 30,2005 reflected the brief slowdown and flattening in the semiconductor industrythat started in late 2004, whereas the backlog as of June 30, 2006 reflects therecent growth phase and upturn in the semiconductor industry. The increase inbookings from period to period was primarily due to increased orders of lightsource systems and consumables and spare parts in the second quarter of 2006 asa result of this recent upturn in the semiconductor industry. The decrease inthe book-to-bill ratio was the result of us shipping a significant number ofthe competitive replacement lasers during the second quarter of 2006 under alaser replacement purchase order which was booked in full during the firstquarter of 2006.

 

Weinstalled 77 light sources at chipmakers and other end-users during the quarterended June 30, 2005 as compared to 80 light sources installed during thequarter ended June 30, 2006.

 

Our sales are generatedprimarily by shipments to customers in Europe, Japan, Korea, Taiwan, and theU.S. Approximately 86% and 85% of our sales for the three months ended June 30,2005 and 2006, respectively, were derived from customers outside the U.S. Wemaintain a wholly owned Japanese subsidiary, which sells to our Japanesecustomers. Revenues from Japanese customers, generated primarily by CymerJapan, accounted for 29% and 21% of total revenues for the three months endedJune 30, 2005 and 2006, respectively. The activities of our Japanese subsidiaryare limited to sales and service of products purchased by them from us as theparent corporation. We anticipate that international sales will continue toaccount for a significant portion of our sales.

 

*Cost of Product Sales*. Cost ofproduct sales includes direct material and labor, warranty expenses, licensefees, and manufacturing and service overhead, and foreign exchange gains andlosses

 

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onforeign currency forward exchange contracts (“forward contracts”) associatedwith purchases of our products by our Japanese subsidiary for resale under firmthird-party sales commitments. Shipping costs associated with our product salesare also included in cost of product sales. We do not charge our customers forshipping fees and such costs are not significant.

 

The cost of product sales increased 22% from $57.7million for the three months ended June 30, 2005 to $70.6 million for the threemonths ended June 30, 2006. This increase in the cost of product sales wasprimarily due to higher light source system sales and sales of consumables andspare parts and service products in the three months ended June 30, 2006compared to the three months ended June 30, 2005 and was partially offset by adecrease in warranty costs from period to period. The gross margin on product sales was40% for the three months ended June 30, 2005 as compared to 48% for the threemonths ended June 30, 2006. This higher gross margin from period to period wasprimarily due to increased factory yield and utilization and reduced lead andcycle times. For the remainder of 2006, we anticipate improved operatingefficiencies, further reductions in lead times and continued benefits from ouron-going product cost control efforts including reductions in warranty andfield costs.

 

*Research and Development*. Research and development expenses include costs of internally-fundedand externally-funded projects as well as continuing product developmentsupport expenses, which consist primarily of employee and material costs,depreciation of equipment and other engineering related costs. Our research anddevelopment expenses are offset by amounts associated with certain of ourexternally funded research and development contracts. Research and developmentexpenses increased 11% from $16.9 million for the three months ended June 30,2005 to $18.8 million for the three months ended June 30, 2006 due primarily tocosts associated with our LTPS product development efforts and EUV light sourcedevelopment. Research and development expenses were offset by amounts related toour externally funded research and development contracts of $204,000 for thethree months ended June 30, 2005 and there were no such offsets recorded forthe three months ended June 30, 2006. In addition to our development of EUV andLTPS technologies, we also continued to focus on next generation ArF and KrFproducts. Included in our ArF product development efforts for 2006 is thedesign of an enhanced universal platform for our XL series light sources. As apercentage of total revenues, research and development expenses decreased from17.6% for the three months ended June 30, 2005 to 13.9% for the three monthsended June 30, 2006 due primarily to revenues increasing at a faster rate thanresearch and development expenses in 2006 as compared to 2005. As a result ofour decision to enter the flat panel display manufacturing tools market withthe formation of the TCZ joint venture, our research and development expensesgoing forward will also include a greater focus on LTPS product developmentefforts. We expect that our investment in research and development expenseswill continue.

 

*Sales and Marketing*. Sales and marketing expenses include theexpenses of the sales, marketing and customer support staff and other marketingexpenses. Sales and marketing expenses increased 9% from $6.8 million for thethree months ended June 30, 2005 to $7.4 million for the three months endedJune 30, 2006. The increase in sales and marketing expenses from period toperiod primarily reflects increases in profit sharing and bonuses, stock-basedcompensation expense associated with the new SFAS 123R requirements which wereadopted in the first quarter of 2006, and increased salary and benefitsassociated with an increase in sales and marketing head count from period toperiod. In addition, sales and marketing expenses were higher in 2006 ascompared to 2005 as a result of expenses associated with our TCZ joint venturewhich was formed in July 2005. As a percentage of total revenues, such salesand marketing expenses decreased from 7.0% for the three months ended June 30,2005 to 5.5% for the three months ended June 30, 2006. We anticipatesales and marketing expenses may increase slightly from the second quarterlevels in the third quarter of 2006.

 

*Generaland Administrative*. General and administrative expensesconsist primarily of management and administrative personnel costs,professional services and administrative operating costs. General andadministrative expenses increased 60% from $6.0 million for the three monthsended June 30, 2005 to $9.6 million for the three months ended June 30, 2006primarily due to stock-based compensation expense recorded in the secondquarter of 2006 as a result of our adoption of SFAS 123R on January 1, 2006.General and administrative expenses in the second quarter of 2006 also include

 

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increased profit sharing and bonus expenses, and increased externalaudit fees as compared to the second quarter of 2005. General andadministrative expenses were also higher in the second quarter of 2006 comparedto the second quarter of 2005 as a result of expenses associated with our TCZjoint venture which was formed in July 2005. As a percentage of total revenues,general and administrative expenses increased slightly from 6.2% for the threemonths ended June 30, 2005 to 7.1% for the three months ended June 30, 2006. Weanticipate general and administrative expenses may remain relatively flat atthe second quarter levels for the third quarter of 2006.

 

*Total Other Income (Expense) -Net.*Net other income (expense) consists primarily ofinterest income and expense, foreign currency exchange gains and lossesassociated with fluctuations in the value of the functional currencies of ourforeign subsidiaries against the U.S. dollar, and gains and losses associatedwith debt extinguishment transactions. Net other income totaled $2.5 millionand $4.5 million for the three months ended June 30, 2005 and 2006,respectively. The increase in net other income was primarily due to an increasein interest income, a decrease in interest expense and a foreign currencyexchange gain recorded in the second quarter of 2006 as compared to a foreigncurrency exchange loss recorded in the second quarter of 2005. The increase ininterest income from 2005 to 2006 reflects higher market interest rate yieldson larger cash and investment balances which resulted from higher earnings andsignificant proceeds from stock option and warrant exercises during the secondquarter of 2006. The decrease in interest expense from period to period was dueto our lower average debt balances as a result of the repurchase of ourconvertible subordinated notes that we made in the second quarter of 2005.Other income was positively impacted in the second quarter of 2005 by a $2.2million gain on debt extinguishment which resulted from the repurchase of theseconvertible subordinated notes. Foreign currency exchange losses totaled$573,000, interest income and other income totaled $2.6 million, interestexpense totaled $1.8 million and gain on debt extinguishment totaled $2.2million for the three months ended June 30, 2005, compared to a foreigncurrency exchange gain of $480,000, interest and other income of $5.5 million,and interest expense of $1.5 million for the three months ended June 30, 2006.

 

*Income Tax Provision.* The tax provision of $912,000 and $11.6 million for the threemonths ended June 30, 2005 and 2006, respectively, reflects an annual effectiverate of 5.5% and 34.6%, respectively. The change in the annual effective taxrate from period to period was primarily attributable to the increase inpre-tax earnings as well as a reduction in tax benefits from U.S. exportincentive programs and the expiration of the federal research credit. Theannual effective tax rate for the three months ended June 30, 2006 was approximatelyequal to the U.S. statutory rate of 35%. The effective tax rate is a functionof current tax law and geographic location of pre-tax income. The federalResearch and Experimentation Credit expired December 31, 2005. The ETI wasrepealed by the American Jobs Creation Act of 2004 subject to certaintransition rules. The ETI exclusion is being replaced with a ManufacturingActivity deduction under IRC Section 199 with a phase out of ETI benefits in2005 and 2006. Our estimated ETI benefit for 2006 reflects the transitionrules.

 

**SIXMONTHS ENDED JUNE 30, 2005 AND 2006**

 

The following tablesummarizes the components of our revenue (in thousands, except units sold):

 

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| ** **                                       | ** ** | **For the six months ended** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                       | ** ** | **June 30,**                                | ** ** |
| ** **                                       | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
|                                             |       |                                             |       |   |   |
| Light source  systems:                           |       |                                             |       |   |   |
| Revenue                                          |       | $                                                | 103,333    |   | $ | 140,664 |   |
| Units sold                                       |       | 104                                              |       | 145 |   |
| Average selling  price (1)                       |       | $                                                | 972        |   | $ | 970 |   |
|                                             |       |                                             |       |   |   |
| Consumable and  spare parts and service products |       | $                                                | 77,073     |   | $ | 121,682 |   |
| Other revenue                                    |       | $                                                | 796        |   | $ | 150 |   |
|                                             |       |                                             |       |   |   |
| Total revenue                                    |       | $                                                | 181,202    |   | $ | 262,496 |   |

 

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(1)    Calculation of average sellingprice excludes $2.2 million of deferred light source revenue during the sixmonths ended June 30, 2005. We had one arrangement where a portion of the lightsource system fee was not payable until the system was installed successfullyat the end-user. This arrangement expired in March 2005.

 

Productsales increased 45% from $180.4****million for thesix months ended June 30, 2005 to $262.3 million for the six months ended June30, 2006. This increase in product sales was due to higher light source systemrevenues and higher consumable and spare parts and service products revenuesfor the six months ended June 30, 2006 compared to the six months ended June30, 2005. Light source system revenues increased 36% from $103.3 million forthe six months ended June 30, 2005 to $140.7 million for the six months endedJune 30, 2006. A total of 104 light source systems were sold in the six monthsended June 30, 2005 at an average selling price of $972,000, compared to 145light source systems sold in the six months ended June 30, 2006 at an averageselling price of $970,000. On a foreign currency adjusted basis, the averageselling price for the six months ended June 30, 2005 was $966,000 compared to$964,000 for the six months ended June 30, 2006. The slight decrease in theaverage selling price from period to period reflects the higher percentage of ourlight source systems sales coming from lower priced capacity driven KrF productsin the six months ended June 30, 2006 as compared to the six months ended June30, 2005. The increase in quantities of light source systems sold from periodto period was due to the slight slowdown and flattening of the industry in thebeginning of 2005 compared to the recent upturn in the semiconductor industryin 2006. Chipmakers expanded capacity needs have impacted the demand for bothour light source systems and our consumables and spare parts and serviceproducts. This increased demand for consumable and spare parts and the risingtool utilization resulted in an increase in consumable and spare parts andservice revenues of 58% from $77.1 million for the six months ended June 30,2005 to $121.7 million for the six months ended June 30, 2006. Revenues fromfunded development contracts were $796,000 for six months ended June 30, 2005,compared to $150,000 for the six months ended June 30, 2006. There were norevenues recorded or earned associated with the TCZ joint venture for the sixmonths ended June 30, 2006.

 

Salesto our three lithography tool manufacturing customers, ASM Lithography, Canon,and Nikon, amounted to 33%, 8% and 26%, respectively, of total revenue for thesix months ended June 30, 2005, and 37%, 6% and 17%, respectively, of totalrevenue for the six months ended June 30, 2006.

 

Approximately 85% and 84%of our sales for the six months ended June 30, 2005 and 2006, respectively,were derived from customers outside the U.S. Revenues from Japanese customers,generated primarily by Cymer Japan, accounted for 33% and 23% of total revenuesfor the six months ended June 30, 2005 and 2006, respectively.

 

*Cost of Product Sales*. The costof product sales increased 26% from $110.8 million for the six months endedJune 30, 2005 to $139.2 million for the six months ended June 30, 2006. Thisincrease in the cost of product sales was primarily due to higher light sourcesystem sales and sales of consumables and spare parts and service products inthe six months ended June 30, 2006 compared to the six months ended June 30,2005. The increased product sales and overallmix of products resulted in improved gross margin on product sales from periodto period. The gross margin on product sales was 39% for the six 

 

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monthsended June 30, 2005 as compared to 47% for the six months ended June 30, 2006.This higher gross margin from period to period was primarily due to increasedfactory yield, improved overall efficiencies and reduced lead and cycle times.

 

*Research and Development*. Research and development expenses increased 17% from $31.6 million forthe six months ended June 30, 2005 to $36.9 million for the six months endedJune 30, 2006 due primarily to costs associated with our LTPS productdevelopment efforts, EUV light source development and ArF product developmentefforts for the design of an enhanced universal platform for our XL serieslight sources. Research and development expenses were offset by amounts relatedto our externally funded research and development contracts of $1.8 million and$154,000 for the six months ended June 30, 2005 and 2006, respectively. Inaddition to our development of EUV and LTPS technologies, we also continued tofocus on next generation ArF and KrF products. As a percentage of totalrevenues, research and development expenses decreased from 17.4% for the sixmonths ended June 30, 2005 to 14.1% for the six months ended June 30, 2006 dueprimarily to increased research and development activities and higher revenuesin 2006 as compared to 2005. As a result of our decision to enter the flatpanel display manufacturing tools market with the formation of the TCZ jointventure, our research and development expenses going forward will also includea greater focus on LTPS product development efforts.

 

*Sales and Marketing*. Sales and marketing expenses increased 13%from $12.6 million for the six months ended June 30, 2005 to $14.2 million forthe six months ended June 30, 2006. The increase in sales and marketingexpenses from period to period primarily reflects increases in profit sharingand bonuses, stock-based compensation expense associated with the new SFAS 123Rrequirements which were adopted in the first quarter of 2006,  increased salary and benefits associated withan increase in sales and marketing head count from period to period andemployer payroll taxes related to stock option exercises which occurred in thefirst six months of 2006. In addition, sales and marketing expenses were higherin the first half of 2006 compared to the first half of 2005 as a result ofexpenses associated with our TCZ joint venture which was formed in July 2005.As a percentage of total revenues, such sales and marketing expenses decreasedfrom 6.9% for the six months ended June 30, 2005 to 5.4% for the six monthsended June 30, 2006.

 

*Generaland Administrative*. General and administrative expensesincreased 53% from $12.3 million for the six months ended June 30, 2005 to$18.8 million for the six months ended June 30, 2006 primarily due tostock-based compensation expense recorded in the first six months of 2006 uponour adoption of SFAS 123R in January 2006. In addition, general andadministrative expenses in 2006 also included increased profit sharing andbonus expenses, employer payroll taxes associated with stock option exercisesthat occurred in the first six months of 2006 and increased external audit feesduring the period. General and administrative expenses were also higher in thefirst half of 2006 compared to the first half of 2005 as a result of expensesassociated with our TCZ joint venture which was formed in July 2005. As apercentage of total revenues, general and administrative expenses increasedslightly from 6.8% for the six months ended June 30, 2005 to 7.2% for the sixmonths ended June 30, 2006.

 

*Total Other Income (Expense) -Net.*Net other income totaled $2.5 million and $10.7 millionfor the six months ended June 30, 2005 and 2006, respectively. The increase innet other income was primarily due to a significant increase in interestincome, the receipt of $3.2 million in life insurance proceeds following thedeath of one of our executive officers in the first quarter of 2006, a decreasein interest expense and a foreign currency exchange gain recorded in the firstsix months of 2006 as compared to a foreign currency exchange loss recorded inthe first six months of 2005. The increase in interest income from 2005 to 2006reflects higher market interest rate yields on larger cash and investmentbalances which resulted from higher earnings and significant proceeds fromstock option and warrant exercises during the first six months of 2006. Thedecrease in interest expense from period to period was due to our lower debtbalances as a result of the repurchase of our convertible subordinated notesthat we made in the second quarter of 2005. Other income was positivelyimpacted in 2005 by a $2.2 million gain on debt extinguishment which resultedfrom the repurchase of these convertible subordinated notes. Foreign currencyexchange loss totaled $767,000, interest income and other income totaled $5.0million, interest expense totaled $3.9 million and the gain on debtextinguishment totaled $2.2

 

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million for the six months ended June 30, 2005, compared to a foreigncurrency exchange gain of $1.1 million, interest and other income of $12.5million, and interest expense of $2.9 million for the six months ended June 30,2006.

 

*Income Tax Provision.* The tax provision of $912,000 and $22.1 million for the sixmonths ended June 30, 2005 and 2006, respectively, reflects an annual effectiverate of 5.5% and 34.6%, respectively. The change in the annual effective taxrate from period to period was primarily attributable to the increase inpre-tax earnings as well as a reduction in tax benefits from U.S. exportincentive programs and the expiration of the federal research credit. Theannual effective tax rate for the six months ended June 30, 2006 wasapproximately equal to the U.S. statutory rate of 35%.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Historicallywe have funded our operations primarily from cash generated from operations,the proceeds of the note offerings, bank borrowings, and the proceeds fromemployee stock option exercises. As of June 30, 2006, we had approximately$312.1 million in cash and cash equivalents, $186.4 million in short-terminvestments, $9.8 million in long-term investments, and $688.5 million inworking capital.

 

In February 2002, we issued $250.0 million in aggregateprincipal amount in a private placement of notes. These notes are due onFebruary 15, 2009 with interest payable semi-annually on February 15 and August15 of each year at 3.50% per annum. The notes are convertible into shares ofour common stock at a conversion rate of 20 shares per $1,000 principal amountor an effective conversion price of $50.00 per share. We used a portion of thenet proceeds from this private placement to redeem the previously issued notesthat were then outstanding. The remaining proceeds are being used for ouroperating, investing and financing activities. With the approval of our boardof directors, we have periodically repurchased these notes in the open market. Werepurchased $60.0 million principal amount of these notes in 2005. As of June30, 2006, there were $140.7 million principal amount of notes outstanding.

 

Net cash provided byoperating activities was approximately $79.0 million and $17.3 million for thesix months ended June 30, 2005 and 2006, respectively. Although net income forthe six months ended June 30,  2006 wassignificantly higher than the same period in 2005, cash provided by operatingactivities was much lower in the first six months of 2006 as compared to thefirst six months of 2005. This is primarily attributable to significantincreases in accounts receivable and inventories for the six months ended June30, 2006 compared to decreases in these same items for the six months endedJune 30, 2005. The increase in accounts receivable is the result of higherrevenues and back-end loaded shipments during the second quarter of 2006. Theincrease in inventory balances for the six months ended June 30, 2006 reflectsfront-end loaded inventory levels to support higher forecasted demand,including expected demand for the XLA 300 light source system and the requiredspare parts for these systems as they are installed in the field. In addition, cashfrom operations was negatively impacted for the six months ended June 30, 2006as a result of classifying excess tax benefits from stock option exercises inthe amount of $17.8 million in financing activities in 2006 rather thanoperating activities in accordance with SFAS 123R which we adopted on January1, 2006.

 

Net cash provided byinvesting activities was approximately $58.7 million for the six months endedJune 30, 2005 compared to $58.1 million used in investing activities for thesix months ended June 30, 2006. Net cash provided by investing activitiesduring the six months ended June 30, 2005 reflects the timing of short-term andlong-term investments that matured and were reinvested during the period, andthe acquisition of $7.8 million of property and equipment. Net cash used ininvesting activities for the six months ended June 30, 2006 was due primarilyto the timing of short-term and long-term investments that matured and werereinvested during the period, a $7.0 million payment to acquire the final 19%minority interest in our Cymer Korea subsidiary, a $8.2 million payment toacquire certain patent license rights and the acquisition of $6.5 million ofproperty and equipment.

 

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Net cash used infinancing activities was approximately $103.2 million for the six months endedJune 30, 2005, compared to net cash provided by financing activities of $116.5million for the six months ended June 30, 2006. Net cash used in financingactivities for the six months ended June 30, 2005 reflects the repurchase oftreasury stock of $50.0 million and the purchase of approximately $60.0 millionprincipal amount of our convertible subordinated notes, at a discount to par,in the second quarter of 2005. These treasury stock and note purchases werepartially offset by proceeds received from the exercise of employee stockoptions totaling $4.2 million during the six months ended June 30, 2005. Netcash provided by financing activities for the six months ended June 30, 2006reflects the proceeds received from the exercise of employee stock options, theproceeds from the exercise of warrants, and proceeds from the employee stockpurchase plan totaling $98.7 million. In addition, cash from financingactivities in 2006 was positively affected by the excess tax benefits for theperiod from stock options exercises which totaled $17.8 million.

 

Werequire substantial working capital to fund our business, particularly tofinance inventories, including purchase orders with our vendors, accountsreceivable, and for capital expenditures. Our future capital requirementsdepend on many factors, including our manufacturing activity, the timing andextent of spending to support product development efforts, expansion of salesand marketing and field service and support, competitive labor market compensationrequirements, the timing of introductions of new products and enhancements toexisting products, and the market acceptance of our products. We believe thatcash generated from operations along with the liquidity provided by ourexisting cash balances and short-term investments will be sufficient to sustainoperations and provide for any potential future expansion of our business forat least the next 12 months.

 

At June 30, 2005 and2006, we did not have any relationship with unconsolidated entities or financialpartnerships, such as entities often referred to as structured finance,variable interest, or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. In addition, we did not engagein trading activities involving non-exchange traded contracts. As a result, weare not exposed to any financing, liquidity, market or credit risk that couldarise if we had engaged in such relationships. We do not have relationships andtransactions with persons and entities that derive benefits from theirnon-independent relationship with us or our related parties except as disclosedherein.

 

**SUBSEQUENT EVENTS**

 

The research and development agreement we entered into effective as ofJanuary 23, 2004 with Intel was amended effective July 17, 2006.  Underthe terms of the Amended Development Agreement, most of the mutual obligationsbetween us and Intel have been terminated, including Intel’s obligation to provideus with up to a total of $20.0 million over a three-year period to acceleratethe development of production-worthy EUV lithography light sources. As of thedate of the amendment, we had received a total of $8.5 million from Intel underthe original agreement, which includes an advance payment of $1.3 million paidby Intel at the initiation of the agreement in 2004. Under the AmendedDevelopment Agreement, Intel has no obligation to provide us with furtherfunding beyond that already received and we returned $347,222, whichrepresents the unearned portion of the advance payment made by Intel. Althoughwe will receive no additional funding from Intel under the Amended DevelopmentAgreement, we intend to continue to develop the EUV technology as part of ourexisting product roadmap.  In addition, per the terms of the AmendedDevelopment Agreement, we will continue meeting with Intel on a regular basisto review our progress towards developing a production-worthy EUV sourcesystem.

 

On July 28, 2006, we announced that our board of directors had authorizedus to repurchase up to $150 million of our common stock. The purchases will bemade from time to time in the open market or in privately negotiatedtransactions. The program may be discontinued at any time. Total purchasesthrough August 1, 2006 were $22.7 million or 589,515 shares under this program.

 

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**RECENT ACCOUNTING PRONOUNCEMENTS**

 

In November 2005, the FASB issued FASB Staff PositionFAS 115-1 and FAS 124-1 (“FSP 115-1 and 124-1”), “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments”.FSP 115-1 and 124-1 applies to debt and equity securities accounted for underStatement of Financial Accounting Standards No. 115, “Accounting for CertainInvestments in Debt and Equity Securities”. The objective of FSP 115-1 and124-1 is to provide guidance for identifying other-than-temporarily impairedinvestments. FSP 115-1 and 124-1 also provide new disclosure requirements forinvestments that are deemed to be temporarily impaired. The disclosure requirements are effective in annual financialstatements for fiscal periods beginning after December 15, 2005. We do notbelieve that the implementation of FSP FAS 115-1 and FAS 124-1 will have amaterial impact on our consolidated financial statements.

 

In July 2006, the FASB issued FASB Interpretation No.48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes”. FIN 48 clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”,**and prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. FIN 48 iseffective for fiscal years beginning after December 15, 2006.  We arecurrently assessing the impact that the adoption of FIN 48 will have on ourconsolidated financial statements.

 

#### **Item3. Quantitative and Qualitative Disclosures About Market Risk**

#### ** **

# **Foreign Currency Risk**

# ** **

Weconduct business in several international currencies through our globaloperations. Due to the large volume of our business that we conduct in Japan,the Japanese operation poses our greatest foreign currency risk. We usefinancial instruments, principally forward contracts, to manage our foreigncurrency exposures. We enter into forward contracts in order to reduce theimpact of currency fluctuations related to purchases of our inventories byCymer Japan in U.S. dollars for resale under firm third-party sales commitmentsdenominated in Japanese yen, as well as other foreign currency exposuresincluding exposures related to intercompany debt. We do not enter into forwardcontracts for speculative purposes.

 

Asof June 30, 2006, we had outstanding forward contracts to buy U.S. $29.1million for 4.5 billion yen under foreign currency exchange facilities withcontract rates ranging from 109.8 yen to 116.4****yenper U.S. dollar. These contracts expire on various dates through December 2006.

 

Our forward contracts generally qualify for hedgeaccounting treatment per the provisions of Statement of Financial AccountingStandards No. 133, “Accounting for Derivative Instruments and HedgingActivities”. As a result, we defer changes in the fair value for the effectiveportion of these hedges and record the amount in other comprehensive income(loss) and subsequently reclassify the gain or loss to cost of product sales inthe same period that the related sale is made to the third party. The fairvalue of all of our forward contracts and the deferred loss (net of tax) forthose that qualify for hedge accounting treatment totaled $311,000 and $14,000,respectively, as of June 30, 2006.

 

The fair value of these forward contracts as of June30, 2006 would have fluctuated by $1.6 million if the foreign currency exchangerate for the Japanese yen to the U.S. dollar on these forward contracts hadchanged by 10%.

 

# **Investment and DebtRisk**

# ** **

Wemaintain an investment portfolio consisting primarily of government andcorporate fixed income securities, certificates of deposit and commercial paper.While it is our general intent to hold such securities until maturity, we willoccasionally sell certain securities for cash flow purposes. Therefore, our

 

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investments are classified as available-for-saleand are carried on the balance sheet at fair value. Due to the conservativenature of the investment portfolio, a sudden change in interest rates would nothave a material effect on the value of the portfolio.

 

In February 2002, weissued $250.0 million principal amount of unsecured fixed rate 3.50%Convertible Subordinated Notes due February 15, 2009. Interest on these notesis payable on February 15 and August 15 of each year. The notes are convertibleinto shares of our common stock at a conversion rate of 20 shares per $1,000principal amount subject to adjustment under certain conditions. We may redeemthe notes after February 20, 2005 at certain redemption prices expressed as apercentage of the principal amount. The notes are subordinated to our existingand future senior indebtedness and effectively subordinated to all indebtednessand other liabilities of our subsidiaries. Because the interest rate is fixed,we believe there is no risk of increased interest expense. These notes arerecorded at face value on the consolidated balance sheets. In the third quarterof 2004 and the second quarter of 2005, we repurchased, at a discount to par,approximately $49.2 million and $60.0 million principal amount, respectively,of these notes. As of June 30, 2006, $140.7 million principal amount of thenotes were outstanding. The fair value of such debt based on quoted marketprices on June 30, 2006 was $144.9 million.

 

**ITEM4. Controls and Procedures**

 

*Evaluationof disclosure controls and procedures*. For the second quarterof 2006, our chief executive officer and our chief financial officer, evaluatedthe effectiveness of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) as of June 30, 2006, and concluded that as ofsuch date, our disclosure controls and procedures were not effective inensuring that information required to be disclosed by us in the reports that wefile under the Exchange Act is recorded, processed, summarized and reportedwithin the time period specified in the rules and forms of the Securities andExchange Commission.

 

This conclusion was basedsolely on our assessment of the company’s processes and controls related to ouraccounting for income taxes described in our 2005 Form 10-K, more specificallythose policies and procedures over the reconciliation of income tax accountswhich were not designed with adequate precision and our policies and proceduresover foreign tax provisions that did not provide for adequate review. Thesedeficiencies resulted in errors in our consolidated tax provision for our yearended December 31, 2005. Such errors were corrected prior to the issuance ofour consolidated financial statements at and for the year ended December 31,2005. These deficiencies also resulted in a more than remote likelihood that amaterial misstatement to our consolidated financial statements would not beprevented or detected. As described in Part II, Item 9A of our Form 10-K forthe year ended December 31, 2005, we have implemented a plan to remediate thismaterial weakness.

 

*Changesin internal control over financial reporting.*There has beenno change in our internal control over financial reporting during the quarterended June 30, 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting other than thesteps taken by us to remediate the material weakness that was first disclosedby us in our 2005 Form 10-K relating to our accounting for income taxes.

 

We have taken the following remediation steps during the six months ended June 30, 2006 to improve our internal controls over our accounting for income taxes:

 

•                  Improvedthe procedures for reviewing our consolidated tax provisions and reconcilingall subsidiary office tax accounts; and

•                  Increasedthe level of communication with our subsidiary office accountants over thepreparation of our foreign quarterly and annual tax provisions.

 

We have been conductingour testing of these new internal controls over the last several months andwill continue to do so for the remainder of this year. We will not be able tocompletely remediate this

 

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material weakness in our accounting for income taxes until we canconduct testing of the 2006 end of year internal controls for income taxes inearly 2007.

 

**PART II. OTHER INFORMATION**

 

**ITEM 1.****                  LegalProceedings**

 

None.

 

**ITEM 1A.****               RiskFactors**

 

*The risks described below may notbe the only risks we face. Additional risks that we do not currently think arematerial may also impair our business operations. If any of the events orcircumstances described in the following risks actually occur, our business,financial condition or results of operations could suffer, and the tradingprice of our common stock could decline.*

 

Our revenues and operating results fromquarter-to-quarter have varied in the past and our future operating results maycontinue to fluctuate significantly.

 

Factors that contribute to fluctuations in our revenuesand operating results include:

 

•                  demand forsemiconductors in general and, in particular, for leading edge devices withsmaller circuit geometries;

•                  cyclicality in themarket for semiconductor manufacturing equipment;

•                  rates at whichchipmakers take delivery of photolithography tools from lithography toolmanufacturers;

•                  rates at which our customerstake delivery of light source systems from us;

•                  timing and size oforders from our customer base;

•                  product lead timedemands from lithography tool manufacturers and chipmakers;

•                  mix of light sourcemodels, consumable and spare parts and service revenues in our total revenues;

•                  changes in the price andprofitability of our products;

•                  our ability to developand implement new technologies and introduce new products;

•                  changes in marketpenetration by our competitor;

•                  utilization rates oflight sources and sales of consumable and spare parts and services;

•                  our ability to manageour manufacturing requirements;

•                  our ability to manage customersatisfaction, product reliability, and direct field service and supporteffectiveness;

•                  foreign currencyexchange rate fluctuations, principally with respect to the Japanese yen (inwhich sales by our Japanese subsidiary are denominated);

•                  worldwide politicalinstability;

•                  changing global economicconditions, including rising energy prices; and

•                  intellectual propertyprotection.

 

We have historically derived a large portion of ourquarterly and annual revenues from selling a small number of light sourcesystems. Because we sell a small number of products, the precise time that werecognize revenue from an order may have a significant impact on our totalrevenue for a particular period. Our customers may cancel or reschedule orderswith little or no penalty. Orders expected in one quarter could shift toanother 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 adverselyaffected if our customers, particularly our three largest customers, 

 

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cancel or rescheduleorders, or if we cannot fill orders in time due to unexpected delays inmanufacturing, testing, shipping, and product acceptance.

 

We manage our expense levels based, in large part, onexpected future revenues. As a result, our expenses are relatively fixed forthe 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 otherfactors, we could fail to achieve our expectations as to future revenue, grossprofit and operating income. Our failure to meet the performance expectationsset and published by external sources could result in a sudden and significantdrop in the price of our stock, particularly on a short-term basis, and couldnegatively affect the value of any investment in our stock.

 

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

 

We derive a substantial portion of our revenues fromphotolithography tool manufacturers, or original equipment manufacturer (“OEM”)customers, who incorporate our light source systems in photolithography toolsthat they sell to semiconductor manufacturers, or chipmakers, and fromchipmakers who purchase consumables, spare parts, upgrades and service directlyfrom us. Like us, our OEM customers depend on demand for their products fromthe chipmakers. The capital equipment and related operating expenditures ofchipmakers depend on a number of factors, including the current and anticipatedmarket demand for semiconductors and the many products using semiconductors. Thatdemand is highly volatile and unpredictable.

 

As a result of the cyclicality of the semiconductorindustry, the semiconductor capital equipment industry historically hasexperienced periodic ups and downs. The cyclical nature of the semiconductorand the semiconductor capital equipment industries affects our ability toaccurately predict future revenue and therefore our ability to manage ourfuture expense levels. When cyclical fluctuations result in lower than expectedrevenue levels, operating results may be adversely affected and cost reductionmeasures may be necessary in order for us to remain competitive and financiallysound. During a down cycle or slowdown, we must be in a position to adjust ourcost and expense structure to prevailing market conditions while still beingable to motivate and retain our key employees. During periods of rapid growth,we must be able to increase manufacturing capacity and personnel to meet customerdemand. We can provide no assurance that these objectives can be met in atimely manner in response to industry cycles. We are not able to predict withany certainty the duration of any industry cycle or the timing or order ofmagnitude of any recovery.

 

Downturnsin the semiconductor industry often result in decreases in demand forsemiconductor manufacturing equipment, including the photolithography toolsthat our OEM customers produce. The most recent downturn in the semiconductorindustry had a severe effect on the demand for semiconductor manufacturingequipment. Fluctuating levels of investment by chipmakers and resulting pricingvolatility will continue to materially affect our aggregate bookings, revenuesand operating results. Even during periods of reduced revenues we believe wemust continue to invest in research and development and to maintain extensiveongoing worldwide customer service and support capabilities to remaincompetitive. Continued spending in furtherance of these objectives maytemporarily harm our financial results. Semiconductor industry downturns andslowdowns are likely to continue to adversely affect our business, financialcondition and operating results, and our operating results may fall below theexpectations of public market analysts or investors in future quarters. Any failureto meet such expectations could materially adversely affect the price of ourcommon stock.

 

Our OEM customers try to manage their inventories andproduction requirements to appropriate levels that reflect their expected salesto chipmakers. Market conditions in the semiconductor industry and our OEMcustomers’ production efficiency can cause them to expand or reduce theirorders for new light source systems as they try to manage their inventories andproduction requirements. We continue to work with our OEM customers to betterunderstand these issues. However, we cannot guarantee that we will besuccessful in understanding our OEM customers’ inventory management andproduction requirements or that our OEM customers will not build up an excessinventory of light source systems. If our OEM

 

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customers retain anexcess inventory of light source systems, our revenue could be reduced infuture periods as the excess inventory is utilized, which could adverselyaffect our operating results, financial condition and cash flows. If our OEMcustomers demand shorter product lead times to improve their inventory and cashpositions, our inventory management and cash position may be negativelyimpacted, which may adversely affect our operating results, financial conditionand cash flows.

 

**A significant percentage of our revenue is derived from sales to thethree 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 wouldsuffer.**

 

Three large companies, ASM Lithography, Canon and Nikondominate the photolithography tool business. Collectively, these threecompanies accounted for the following percentage of our total revenue duringthe periods indicated:

 

| ** **      | ** ** | **Six months ended** | ** ** |
|-----------------|------------|--------------------------------|------------|
| ** **      | ** ** | **June 30,**              | ** ** |
| ** **      | ** ** | **2005**                       | ** ** | **2006** | ** ** |
|            |       |                           |       |   |   |
| ASM Lithography |       | 33                             | %          |   | 37 | % |   |
| Canon           |       | 8                              | %          |   | 6 | % |   |
| Nikon           |       | 26                             | %          |   | 17 | % |   |
|            |       |                           |       |   |   |   |   |
| Total           |       | 67                             | %          |   | 60 | % |   |

 

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

 

| ** **      | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------|------------|-----------------------|------------|-------------------|------------|
| ** **      | ** ** | **2005**              | ** ** | **2006**          | ** ** |
|            |       |                  |       |              |       |
| ASM Lithography |       | 36                    | %          |              | 45         | % |   |
| Canon           |       | 5                     | %          |              | 3          | % |   |
| Nikon           |       | 25                    | %          |              | 20         | % |   |
|            |       |                  |       |              |       |   |   |
| Total           |       | 66                    | %          |              | 68         | % |   |

 

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

 

•                  a change in a customer’scompetitive position in its industry;

•                  a customer experiencinglithography tool production problems;

•                  a decision to purchaselight sources from other suppliers;

•                  changes in economicconditions in the semiconductor or the photolithography tool industries; and

•                  a decline in a customer’sfinancial condition.

 

The loss of any significant business from or productionproblems for any one of these three customers would harm our business andfinancial condition.

 

**A substantial percentage of our revenue is derived fromthe sale of a limited number of primary products.**

** **

Our only current product line is excimer light sourcesystems, including KrF and ArF systems, and support, including consumable andspare parts and service support. We expect these light source

 

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systems and the relatedsupport to continue to account for a substantial majority of our revenues inthe near term. Continued market acceptance of our light source system productsis, therefore, critical to our future success. The primary market for excimerlight sources is in the use of DUV photolithography equipment for manufacturingdeep-submicron semiconductor devices using smaller circuit geometries. Thedemand for our products depends in part on the rate at which chipmakers furtheradopt excimer light sources as the chosen light source for theirphotolithography tools.

 

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

 

•                  inadequate performanceof photoresists used in advanced DUV photolithography;

•                  potential shortages ofspecialized materials used in DUV optics;

•                  productivity of 300 mmphotolithography tools relative to 200 mm tools; and

•                  consolidation ofchipmakers.

 

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

 

•                  a decline in demand forour customers’ DUV photolithography tools;

•                  a failure to achievecontinued market acceptance of our products;

•                  a failure to manage customersatisfaction, product reliability, and direct field service and supporteffectiveness;

•                  an improved version ofproducts being offered by a competitor in the market in which we participate;

•                  technological changethat we are unable to address with our products; and

•                  a failure to release newenhanced versions of our products on a timely basis.

 

**We dependon the introduction of new products for our success, and we are subject torisks associated with rapid technological change.**

 

Rapidtechnological changes in semiconductor manufacturing processes subject us toincreased 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 withimproved capabilities and to continue to enhance our existing light sourcesystems and process capabilities. Due to the risks inherent in transitioning tonew products, we must forecast accurate demand for new products while managingthe transition from older products.

 

Ourmost significant product introduction in recent years consisted of a technologychange from a single-discharge-chamber excimer light source to adual-discharge-chamber design called MOPA. The MOPA design represents aparadigm shift from previously accepted lithography technology and offers chipmakershigher power, tighter bandwidth and lower cost of operation for their current –and we expect for their future – optical lithography applications. Asoriginally designed, the MOPA architecture was projected to provide itsbenefits across all three DUV wavelengths – 248 nm, 193 nm, and 157 nm – but atthis time, the semiconductor industry has only adopted MOPA at the 193 nmwavelength, due to the successful extension of 248 nm single chambertechnology, and the omission of 157 nm lithography from the roadmap. There arerisks inherent in the ongoing transition to the MOPA technology, includingeffective execution of our product development roadmap, continuing adoption ofthe product by lithography tool manufacturers and chipmakers,manufacturability, cost effectiveness, and product performance in the field ofthe new products and the development of a comparable product by our competitor.

 

Atthis time, chipmakers are continuing to expand their manufacturing capacity at90 nm, while manufacturers of certain types of memory chips are in initialproduction at 65 nm and planning for production of chips with even smaller CDs.While these efforts are driving demand for our most advanced

 

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ArF light sources, chipmakers are also expandingproduction capacity overall, driving demand for our KrF light source productsfor DUV photolithography systems as well. After chipmakers have expanded theircapacity to levels appropriate to meet existing demand, their demand for ourlight source products will depend, in part, on whether their sales forecastsgive them confidence in the duration and magnitude of the current growth cycleand their projected manufacturing process yields will enable ongoinginvestments in additional capacity.

 

Futuretechnologies such as EUV, electron projection lithography, and masklesslithography may render our excimer light source products obsolete. We mustmanage product transitions, as introduction of new products could adverselyaffect our sales of existing products. If new products are not introduced ontime, or have reliability or quality problems, our performance may be impactedby reduced orders, higher manufacturing costs, delays in acceptance of andpayment for new products, and additional service and warranty expenses. We maynot be able to develop and introduce new products or enhancements to ourexisting products and processes in a timely or cost effective manner thatsatisfies customer needs or achieves market acceptance. Failure to develop andintroduce these new products and enhancements could materially adversely affectour operating results, financial condition and cash flows.

 

Weexpect to face significant competition from current and future competitors. Webelieve that other companies are developing systems and products that arecompetitive to ours and are planning to introduce new products to this market,which may affect our ability to sell our new products. Furthermore, newproducts 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 supportorganization could have a material adverse effect on our business.**

 

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

 

•                  recruit and trainqualified field service personnel;

•                  identify qualifiedindependent firms; and

•                  maintain effective andhighly trained organizations that can provide service to our customers invarious countries.

 

We may not be able to attract and train qualified personnelto maintain our direct support operations successfully. We may not be able tofind and engage qualified third-party resources to supplement and enhance ourdirect support operations. Further, we may incur significant costs in providingthese support services. Failure to implement our direct support operationeffectively could harm our operating results, financial condition and cashflows.

 

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

** **

To continue to grow our business, our existing lightsource products and their process capabilities must be enhanced, and we mustdevelop and manufacture new products to serve other semiconductor applications.We cannot guarantee that we will be able to manage our business to groweffectively. Nor can we guarantee that we will be able to accelerate thedevelopment of new enhancements to our existing products and create newproducts. Further, we may not be able to effectively integrate new products andapplications into our current operations. Any of these risks could materiallyharm our business, financial condition and results of operations.

 

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**We must effectively manage changes in our business.**

 

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

 

•                  improve our productreliability through quality control, and our order fulfillment, field serviceand customer support capabilities;

•                  closely manage ourglobal operations;

•                  improve our process andother internal management systems;

•                  quickly adapt tochanging sales and marketing channels;

•                  effectively manage ourinventory levels; and

•                  attract, train, retainand manage key personnel.

 

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

 

**We dependon a few key suppliers for purchasing components and subassemblies that areincluded in our products.**

 

We purchase a limited number of components andsubassemblies included in our light source products from a single supplier or asmall group of suppliers. For certain optical, control system and pulse powercomponents and subassemblies used in our light source systems, we currentlyutilize a single supplier. To reduce the risk associated with this singlesupplier, we carry a significant strategic inventory of these components.Strategic inventories are managed as a percentage of future demand. We havealso negotiated to have vendor-managed inventory of critical components tofurther reduce the risk of a single supplier. In addition, we contract the manufactureof various subassemblies of our products and depend on our contractmanufacturers to deliver to our required specifications, schedule, and qualitystandards. Further, some of our suppliers have specialized in supplyingequipment or manufacturing services to semiconductor equipment manufacturersand therefore are susceptible to industry ups and downs and subject to the samerisks and uncertainties regarding their ability to respond to changing marketconditions. Because many of these suppliers reduce the size of their workforcein an industry downturn and increase it in an upturn, they may not be able tomeet our requirements or respond quickly enough as an upturn begins and gainsmomentum. Due to the nature of our product development requirements, these keysuppliers must rapidly advance their own technologies and productioncapabilities in order to support the introduction schedule of our new products.These suppliers may not be able to provide new modules and subassemblies whenthey are needed to satisfy our product schedule requirements. If we cannotpurchase enough of these materials, components or subassemblies, or if theseitems do not meet our quality standards, there could be delays or reductions inour product shipments, which would harm our operating results, financialcondition and cash flows.

 

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

** **

We are currently aware of one significant competitorthat sells light sources for DUV photolithography applications. Thiscompetitor, Gigaphoton, is a joint venture between two large companies, Komatsuand Ushio, and is headquartered in Japan. We believe that Gigaphoton isaggressively trying to gain larger market penetration in the excimer lightsource industry. We know that our customers have purchased products from thiscompetitor and that our customers have approved this competitor’s light sourcesfor use with their products. We know that Gigaphoton has been approved bychipmakers in Japan, the U.S. and elsewhere for producing excimer lightsources.

 

Larger companies with substantially greater resources,such as other manufacturers of industrial light sources for advancedlithography, may attempt to sell competitive products to our customers.Potential competitors may also be attracted to our growing installed base oflight sources which represents

 

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a steady and significantconsumable and spare parts revenue stream for us, and they may attempt tosupply consumable and spare parts to that installed base. If any existing orfuture competitors gain market acceptance we could lose market share and ourgrowth could slow or decline, which could have a material adverse effect on ouroperating results, financial condition and cash flows.

 

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

** **

Over time, our light source products may not meetchipmakers’ production specifications or operating cost requirements after thelight source has been used for a long period in high volume production. If anychipmaker cannot successfully achieve or sustain their volume production usingour light sources, our reputation could be damaged with chipmakers andlithography tool manufacturers. This would harm our business.

 

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

** **

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

 

•                  research anddevelopment;

•                  engineering;

•                  sales and marketing;

•                  field service andsupport;

•                  manufacturing; and

•                  management.

 

In particular, there are a limited number of experts inexcimer light source technology, and we require highly skilled hardware andsoftware engineers. Competition for qualified personnel is intense and we cannotguarantee that we will be able to continue to attract and retain qualifiedpersonnel as needed. We do not have employment agreements with most of ouremployees. We believe that our future growth and operating results will dependon:

 

•                  the continued servicesof our research and development, engineering, sales and marketing,  field service and support, manufacturing andmanagement personnel;

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

•                  the ability of ourpersonnel and key employees to continue to expand, train and manage ouremployee base.

 

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

 

**Economic, political, regulatory and other events ingeographic areas where we have significant sales or operations could interferewith our business.**

** **

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

 

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

 

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

 

•                  unexpected changes inregulatory requirements;

•                  fluctuations in exchangerates and currency controls;

•                  political and economicconditions and instability;

•                  imposition of tradebarriers and restrictions, including changes in tariff and freight rates,foreign customs and duties;

•                  difficulty incoordinating our management and operations in several different countries;

•                  difficulties in staffingand managing foreign subsidiary and branch operations;

•                  limited intellectualproperty protection in some countries;

•                  potentially adverse taxconsequences in some countries;

•                  the possibility ofaccounts receivable collection difficulties;

•                  in the case of Asia, therisk of business interruption and damage from earthquakes;

•                  the effect of acts ofterrorism and war; and

•                  the burdens of complyingwith a variety of foreign laws.

 

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

 

**We may acquire a business or enter a new market thatwill involve numerous risks. We may not be able to address these riskssuccessfully without substantial expense, delay or other operational andfinancial challenges.**

** **

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

 

•                  diversion of management’sattention and resources to integrate the new company or new businessopportunity;

•                  failure to retain keypersonnel;

•                  client dissatisfactionor performance problems with the acquired company or new product in a newmarket;

•                  amortization of acquireddefinite-lived intangible assets and deferred compensation;

•                  the cost associated withacquisitions and joint ventures and the integration of acquired operations;

•                  the cost associated withdeveloping, marketing, introducing and supporting a new product in a newmarket;

•                  failure to commercializepurchased technologies;

•                  ability of the acquiredcompanies, joint ventures or new markets to meet their financial projections;

•                  assumption of unknown liabilitiesor other unanticipated events or circumstances; and

•                  compliance with theSarbanes-Oxley Act of 2002, new SEC regulations, Nasdaq Stock Market rules andnew accounting pronouncements as they relate to the new company or jointventure.

 

Mergers, acquisitions and joint ventures as well asentering new markets are inherently subject to multiple significant risks, andthe inability to effectively manage these risks could have a material adverseeffect on our business. In July 2005, we formed a joint venture with Zeissnamed TCZ GmbH, to produce tools for the manufacture of flat panel displays. Thisis a new market for both Cymer and Zeiss and may involve numerous risks. Any ofthese risks could materially harm our business, financial condition and

 

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operating results.Further, any business that we acquire, joint venture that we form or new marketwe may enter may not achieve anticipated revenues or operating results.

 

**Compliance with changing regulations of corporategovernance and public disclosure may result in additional expenses***.*

 

Changing laws, regulations and standardsrelating to corporate governance and public disclosure, including theSarbanes-Oxley Act of 2002, new SEC regulations, Nasdaq Stock Market rules, andnew accounting pronouncements are creating uncertainty and additionalcomplexities for companies such as ours. In particular, the Section 404internal control requirements under the Sarbanes-Oxley Act have added and willcontinue to add complexity and costs to our business and require a significantinvestment of our time and resources to complete each year. We take theserequirements seriously and expect to continue to make every effort to ensurethat we receive clean attestations on our internal controls each year from ouroutside auditors. To maintain high standards of corporate governance and publicdisclosure, we intend to invest all reasonably necessary resources to complywith all other evolving standards. These investments may result in increasedgeneral and administrative expenses and a diversion of management time andattention from strategic revenue generating and cost management activities.

 

**Decreasedeffectiveness of equity compensation could adversely affect our ability to attractand retain employees, and changes in accounting for equity compensation couldadversely affect earnings.**

 

Wehave historically used broad based stock option programs and other forms ofequity-related incentives as a key component of our employee compensationpackages. We believe that stock options and other long-term equity incentivesdirectly motivate a broader base of employees to maximize long-term stockholdervalue and, through the use of long-term vesting, encourage employees to remainwith us. In December 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-BasedPayment – An Amendment to Statement Nos. 123 and 95,” which we adopted onJanuary 1, 2006. This new rule requires us to record an expense to earnings foremployee stock option grants and other equity incentives. Moreover, applicablestock exchange listing standards relating to obtaining stockholder approval ofequity compensation plans has made it more difficult and expensive for us togrant options to employees, which has resulted in changes to our equitycompensation strategy, including a significant reduction in the number of stockoptions granted to employees. We have already developed alternative cashcompensation arrangements for our employees to replace the majority of thesestock option programs and may be required to offer additional alternative cashcompensation arrangements in the future. These and other developments in theprovision of equity compensation to employees could make it more difficult toattract, retain and motivate employees, and such a change in accounting rulesand alternative cash compensation programs may adversely impact our futureoperating results, financial condition and cash flows.

 

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

 

We believe our success and ability to compete depend inlarge part upon protecting our proprietary technology. We rely on a combinationof patent, trade secret, copyright and trademark laws, nondisclosure and othercontractual agreements and technical measures to protect our proprietary rights.

 

As of June 30, 2006, we owned 239 U.S. patents coveringcertain aspects of technology related to light sources and piezo techniques.These patents will expire at various times during the period from January 2008to March 2025. As of June 30, 2006, we had applied for 127 additional patentsin the U.S. As of June 30, 2006, we owned 359 foreign patents and had 372patent applications pending in various foreign countries.

 

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Our pending patent applications and any futureapplications might not be approved. Our patents might not provide us with acompetitive advantage and may be challenged by third parties. In addition,third parties’ patents might have an adverse effect on our ability to dobusiness. As a result of cost constraints, we did not begin seeking patentprotection in Japan and other countries for our inventions that are covered byU.S. patents and patent applications until 1993. As a result we do not have theright 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 ourproducts or intellectual property rights to the same extent as do the laws ofthe U.S. Thus, the likelihood of piracy of our technology and products isgreater in these countries. Further, third parties might independently developsimilar products, duplicate our products, or design around patents that are grantedto us.

 

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

 

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

 

•                  trade secret protection;

•                  employee nondisclosureagreements;

•                  third-partynondisclosure agreements; and

•                  other intellectualproperty protection methods.

 

However, we may not be successful in protecting ourconfidential information and intellectual property, particularly our tradesecrets, because third parties may:

 

•                  independently developsubstantially the same proprietary information and techniques;

•                  gain access to our tradesecrets; or

•                  disclose our technology.

 

**The partiesto whom we provide research and development services may dispute the ownershipof the intellectual property that we develop performing these services.**

 

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

 

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

** **

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

 

Specifically, Komatsu has notified us that we may beinfringing some of its Japanese patents. During our subsequent discussions,Komatsu also asserted that our former Japanese manufacturing

 

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partner, Seiko, or wemay be infringing on some of Komatsu’s U.S. patents and a number of itsadditional Japanese patents. Komatsu has also notified one of our customers,Nikon, of its belief that our light sources infringe several of Komatsu’sJapanese and U.S. patents. As a result, we started proceedings in the JapanesePatent Office to oppose certain patents and patent applications of Komatsu. TheJapanese Patent Office has dismissed our opposition claims. Thus, litigationmay result in connection with Komatsu’s Japanese patents or U.S. patents. Also,Komatsu might claim that we infringe other or additional patents. Komatsunotified Seiko that it intends to enforce its rights against Seiko with respectto its Japanese patents if Seiko continued to engage in manufacturingactivities for us. In connection with our former manufacturing agreement withSeiko, we agree to pay Seiko under certain conditions for damages associatedwith these types of claims. Seiko may not prevail in any litigation againstKomatsu, 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 beinfringing some of our U.S. patents. We have discussed with Komatsu our claimsagainst each other. Komatsu challenged one of our U.S. patents in the UnitedStates Patent and Trademark Office (“USPTO”) but our patent was subsequentlyre-issued by the USPTO. Also, Komatsu transferred its lithography light sourcebusiness to our competitor, Gigaphoton. We also have had discussions with aformer competitor, Lambda-Physik (a subsidiary of Coherent, Inc.), regardingallegations by each party against the other for possible patent infringement. Anyof these discussions with our competitor or former competitor may not besuccessful and litigation could result.

 

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

 

•                  loss of our proprietaryrights;

•                  exposure to significantliabilities by other third parties;

•                  requirement that we geta license from third parties on terms that are not favorable; or

•                  restriction frommanufacturing or selling our products.

 

Any of these actions could be costly and would divertthe efforts and attention of our management and technical personnel, whichwould materially adversely affect our business, financial condition and resultsof operations.

 

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

 

We registered the trademarks “CYMER” and “INSIST ONCYMER” and others in the U.S. and in some other countries. We are also tryingto register additional trademarks in the U.S. and in other countries. We usethese trademarks and many other marks in our advertisements and other businessmaterials, which are distributed throughout the world. We may be subject totrademark infringement actions for using these marks and other marks on aworldwide basis and this would be costly to defend. If a trademark infringementaction were successful, we would have to stop using the mark and possibly paydamages.

 

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**We are dependent on air transport to conduct our business anddisruption of domestic and international air transport systems could adverselyaffect our business.**

 

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

 

•                  supplies of rawmaterials and components for the manufacture of our products or our customers’products may be disrupted;

•                  we may not be able todeliver our products to our customers in a timely manner;

•                  we may not be able toprovide timely service or support of installed light sources for chipmakers;and

•                  our sales and marketingefforts may be disrupted.

 

**We are exposed to risks related to the fluctuations in the currencyexchange rates for all foreign currencies in which we do business, but particularlyfor the Japanese yen.**

 

**When we sell products to our Japanese subsidiary,the sale is denominated in U.S. dollars. When our Japanese subsidiary sells ourproducts directly to**customers in Japan, the sale isdenominated in Japanese yen. Thus, our results of operations may fluctuatebased on the changing value of the Japanese yen to the U.S. dollar. We managethe exposure of our Japanese subsidiary to these fluctuations through forwardcontracts to hedge the subsidiary’s purchase commitments. We will continue tomonitor our exposure to these currency fluctuations, and, when appropriate, usehedging transactions to minimize the effect of these currency fluctuations.However, exchange rate fluctuations may still have a material adverse effect onour operating results. In the future, we may need to sell a more significantportion of our products in foreign currencies other than the Japanese yen andthe management of more currency fluctuations will be more difficult and exposeus to greater risks in this area.

** **

**We are subject to many standards and regulations offoreign governments and, even though we intend to comply, we may not always bein compliance with these rules, or we may be unable to design or redesign ourproducts to comply with these rules.**

** **

**Many foreign government standards and regulationsapply to our products. These standards and regulations are always being amended.Although we intend to meet all foreign standards and regulations, our productsmay not comply with these foreign government standards and regulations. Further,it might not be cost effective for us to redesign our products to comply withthese foreign government standards and regulations. Our inability to designproducts to comply with foreign standards therefore could have a materialadverse effect on our business.**

** **

## **Weare dependent on our manufacturing facilities and subcontractors to assembleand test our products.**

## ** **

Operations at our primary manufacturing facility and oursubcontractors are subject to disruption for a variety of reasons, includingwork stoppages, terrorism, fire, earthquake, energy shortages, flooding orother natural disasters. Such disruptions could cause delays in shipments ofour products to our customers. We cannot ensure that alternate productioncapacity would be available if a major disruption were to occur or that, if itwere available, it could be obtained on favorable terms. Such disruption couldresult in cancellation of orders or loss of customers, which would have amaterial adverse effect on our operating results, financial condition and cashflows.

 

**Our operations are subject to environmental and other governmentregulations 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 utilityutilization and the fire code, in connection with the storage, handling,discharge and disposal of substances that we use in our manufacturing processand on our facilities. We believe that our activities comply with currentgovernment regulations that are applicable to our operations and currentfacilities. We may be required to purchase additional capital equipment orother requirements

 

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for our processes tocomply 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, ourfailure to comply with environmental and land use regulations, or restrictionson our ability to discharge hazardous substances, could subject us to futureliability or cause our manufacturing operations to be reduced or stopped.

 

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

** **

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

 

**The price of our common stock hasfluctuated and may continue to fluctuate widely.**

 

The price of our common stock has fluctuated in thepast. The market price of our common stock will continue to be subject tosignificant 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 marketprice of our common stock, including:

 

•                  the cyclical nature ofthe semiconductor industry;

•                  actual or anticipatedfluctuations in our operating results;

•                  conditions and trends inthe light source device and other technology industries;

•                  announcements ofinnovations in technology;

•                  new products offered byus or our competitor;

•                  developments of patentsor proprietary rights;

•                  changes in financialestimates by securities analysts;

•                  general worldwidepolitical, economic, and market conditions;

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

•                  failure to properlymanage any single or combination of risk factors listed in this section.

 

**In addition, the stock market has experiencedextreme price and volume fluctuations that have particularly affected themarket price for many high technology companies. Such fluctuations have in somecases been unrelated to the operating performance of these companies. Severeprice fluctuations in a company’s stock have frequently been followed bysecurities litigation. Any such litigation can result in substantial costs anda diversion of management’s attention and resources and therefore could have amaterial adverse effect on our business, financial condition and results ofoperations.**

 

**ITEM 2.****                  UnregisteredSales of Equity Securities and Use of Proceeds**

 

None.

 

**ITEM 3.****                  DefaultsUpon Senior Securities**

 

None.

 

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**ITEM 4.****                  Submissionof Matters to a Vote of Security Holders**

 

Cymer held its AnnualMeeting of Stockholders on May 18, 2006. Out of 37,964,223  shares of common stock entitled to vote atsuch meeting, there were present in person or by proxy 36,250,721 shares. At the Annual Meeting, the stockholders ofCymer approved the following matters:

 

Proposal 1. The electionof the following eight directors to serve for one year. The votes for thenominated directors were as follows:

 
| **Director’s Name** | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|-------------------------------|------------|--------------------|------------|-------------------------|------------|
|                          |       |               |       |                    |       |
| Charles J. Abbe               |       | 35,981,556         |       | 269,165                 |       |
| Robert P. Akins               |       | 34,850,464         |       | 1,400,257               |       |
| Edward H. Braun               |       | 35,973,556         |       | 277,165                 |       |
| Michael R.  Gaulke            |       | 35,926,956         |       | 323,765                 |       |
| William G.  Oldham            |       | 35,981,556         |       | 269,165                 |       |
| Peter J. Simone               |       | 32,887,385         |       | 3,363,336               |       |
| Young K. Sohn                 |       | 35,981,376         |       | 269,345                 |       |
| Jon D. Tompkins               |       | 35,955,056         |       | 295,665                 |       |

 

Proposal 2. Approval of anamendment to our 1996 Employee Stock Purchase Plan to increase the aggregatenumber of shares authorized for issuance under the Plan by 300,000 shares. 31,846,028votes were cast for approval, 274,103 votes were cast against, 7,797 votes wereabstained and there were 4,122,793 broker non-votes.

 

Proposal 3. Ratificationof the selection of KPMG LLP as the independent auditors of Cymer for the yearending December 31, 2006. 35,989,492 votes were cast for approval, 251,452votes were cast against, 9,676 votes were abstained and there were 101 brokernon-votes.

 

**ITEM 5.****                  OtherInformation**

 

None.

 

**ITEM 6.****                  Exhibits**

 
| 10.1   |   | Cymer, Inc. 1996  Employee Stock Purchase Plan, as amended (incorporated herein by reference to  Exhibit 99.1 to our Current Report on form 8-K filed on May 19, 2006). |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                    |
| 10.2*  |   | Amended Intellectual  Property License Agreement, effective June 27, 2006, by and between Intel  Corporation and Cymer, Inc.                                            |
|   |   |                                                                                                                                                                    |
| 31.1   |   | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act.                                                                            |
|   |   |                                                                                                                                                                    |
| 31.2   |   | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act.                                                                            |
|   |   |                                                                                                                                                                    |
| 32.1   |   | Certification of Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act.                                                                            |
|   |   |                                                                                                                                                                    |
| 32.2   |   | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act.                                                                            |

 

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* Confidential treatmenthas been requested with respect to certain portions of this exhibit.

Omittedportions have been filed separately with the Securities and ExchangeCommission.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this quarterly report on Form 10-Q to be signed onits behalf by the undersigned thereunto duly authorized.

 

 
|                 | CYMER, INC.                   |
|----------------------|-------------------------------|
|                 |                          |
|                 |                          |
| Date: August 2, 2006 | By:                           | /s/ Nancy J. Baker |   |
|                 |                          |
|                 | Nancy J. Baker                |
|                 | Senior Vice President  and    |
|                 | Chief Financial Officer       |
|                 | (Duly Authorized  Officer and |
|                 | Principal Financial  Officer) |

 

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