**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

**FORM 10-Q**
| **x**      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                       |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                                                                                                                               |
| ** ** | **For the Quarterly Period Ended September 30,  2006**                                                                                                                                                                                                             |
| ** ** | ** **                                                                                                                                                                                                                                                         |
| **OR**     |
| ** ** | ** **                                                                                                                                                                                                                                                         |
| **o**      | **TRANSITION REPORT 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 |       | (I.R.S. Employer  Identification No.) |
| organization)                                     |       |                                  |
|                                              |       |                                  |
| **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 checkmark whether 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.  xYes                oNo

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

 

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

The total numberof shares of Common Stock, with $0.001 par value, outstanding on November 2,2006 was 37,132,327.

 

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**CYMER,INC.**

**FORM 10-Q**

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

**INDEX**
| **PART I.**    | **FINANCIAL INFORMATION**                                    |
|----------------|--------------------------------------------------------------|
|           |                                                         |
| ITEM 1.        | Financial  Statements (unaudited)                            |
|           |                                                         |
|           | Consolidated  Balance Sheets as of December 31, 2005         |
|           | and September 30, 2006                                       |
|           |                                                         |
|           | Consolidated  Statements of Operations for the               |
|           | three and nine months ended  September 30, 2005 and 2006     |
|           |                                                         |
|           | Consolidated  Statements of Cash Flows for the               |
|           | nine months ended September  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** |

 

 

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**ITEM 1. Financial Statements**

**CYMER, INC.**

**CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

**(In thousands, except share data)**
| ** **                                                                                                                                                                         | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                         | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| **ASSETS**                                                                                                                                                                         |       |                  |       |                   |       |
| ** **                                                                                                                                                                         |       |                  |       |                   |       |
| CURRENT ASSETS:                                                                                                                                                                    |       |                  |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                         |       | $                     | 233,745    |                   | $          | 254,233 |   |
| Short-term  investments                                                                                                                                                            |       | 130,204               |       | 198,112                |       |
| Accounts  receivable                                                                                                                                                               |       | 89,818                |       | 114,998                |       |
| Accounts  receivable - related party                                                                                                                                               |       | 588                   |       | 2,189                  |       |
| Foreign currency  forward exchange contracts                                                                                                                                       |       | 1,776                 |       | 822                    |       |
| Inventories                                                                                                                                                                        |       | 89,046                |       | 104,526                |       |
| Deferred income  taxes                                                                                                                                                             |       | 33,338                |       | 33,362                 |       |
| Prepaid expenses  and other assets                                                                                                                                                 |       | 6,497                 |       | 7,323                  |       |
| Total current  assets                                                                                                                                                              |       | 585,012               |       | 715,565                |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| PROPERTY AND EQUIPMENT  - NET                                                                                                                                                      |       | 117,251               |       | 110,811                |       |
| LONG-TERM INVESTMENTS                                                                                                                                                              |       | 29,395                |       | 9,847                  |       |
| DEFERRED INCOME TAXES                                                                                                                                                              |       | 34,429                |       | 24,557                 |       |
| GOODWILL                                                                                                                                                                           |       | 8,358                 |       | 8,833                  |       |
| INTANGIBLE ASSETS - NET                                                                                                                                                            |       | 10,474                |       | 16,642                 |       |
| OTHER ASSETS                                                                                                                                                                       |       | 6,457                 |       | 6,135                  |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| TOTAL ASSETS                                                                                                                                                                       |       | $                     | 791,376    |                   | $          | 892,390 |   |
|                                                                                                                                                                               |       |                  |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                     | ** ** | ** **            | ** ** | ** **             | ** ** |
|                                                                                                                                                                               |       |                  |       |                   |       |
| CURRENT LIABILITIES:                                                                                                                                                               |       |                  |       |                   |       |
| Accounts payable                                                                                                                                                                   |       | $                     | 17,710     |                   | $          | 14,282 |   |
| Accounts payable  - related party                                                                                                                                                  |       | 4,975                 |       | 4,541                  |       |
| Accrued warranty  and installation                                                                                                                                                 |       | 30,775                |       | 30,519                 |       |
| Accrued payroll  and benefits                                                                                                                                                      |       | 12,461                |       | 20,437                 |       |
| Accrued patents,  royalties and other fees                                                                                                                                         |       | 7,180                 |       | 6,121                  |       |
| Income taxes  payable                                                                                                                                                              |       | 7,268                 |       | 5,592                  |       |
| Unearned income                                                                                                                                                                    |       | 1,726                 |       | 2,489                  |       |
| Other current  liabilities                                                                                                                                                         |       | 3,247                 |       | 2,113                  |       |
| Total current  liabilities                                                                                                                                                         |       | 85,342                |       | 86,094                 |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| CONVERTIBLE  SUBORDINATED NOTES                                                                                                                                                    |       | 140,722               |       | 140,722                |       |
| OTHER LIABILITIES                                                                                                                                                                  |       | 10,582                |       | 15,359                 |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| Total  liabilities                                                                                                                                                                 |       | 236,646               |       | 242,175                |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| MINORITY INTEREST                                                                                                                                                                  |       | 16,276                |       | 7,454                  |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                     |       |                  |       |                   |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                         |       |                  |       |                   |       |
| Preferred stock  - $.001 par value; authorized 5,000,000 shares; no shares issued or outstanding                                                                                   |       | —                |       | —                 |       |
| Common stock -  $.001 par value per share; 100,000,000 shares authorized; 38,036,000 and  41,399,000 shares outstanding at December 31, 2005 and September 30, 2006,  respectively |       | 38                    |       | 41                     |       |
| Additional  paid-in capital                                                                                                                                                        |       | 407,549               |       | 537,716                |       |
| Treasury stock  at cost (1,943,000 and 4,536,000 common shares)                                                                                                                    |       | (50,000               | )          | (150,704               | )          |
| Accumulated  other comprehensive loss                                                                                                                                              |       | (9,025                | )          | (4,421                 | )          |
| Retained  earnings                                                                                                                                                                 |       | 189,892               |       | 260,129                |       |
| Total  stockholders’ equity                                                                                                                                                   |       | 538,454               |       | 642,761                |       |
|                                                                                                                                                                               |       |                  |       |                   |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                    |       | $                     | 791,376    |                   | $          | 892,390 |   |

 

SeeNotes to Unaudited Consolidated Financial Statements.

 

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**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

**(In thousands, except per share data)**
| ** **                                                                | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                | ** ** | **ended September 30,**       | ** ** | **ended September 30,**      | ** ** |
| ** **                                                                | ** ** | **2005**                                | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| REVENUES:                                                                 |       |                                    |       |                                   |       |   |   |   |   |
| Product sales                                                             |       | $                                       | 99,415     |                                   | $          | 142,711 |   | $ | 279,821 |   | $ | 399,694 |   |
| Product sales -  related party                                            |       | 177                                     |       | 1,098                                  |       | 177 |   | 6,461 |   |
| Other                                                                     |       | 61                                      |       | 109                                    |       | 857 |   | 259 |   |
| Total revenues                                                            |       | 99,653                                  |       | 143,918                                |       | 280,855 |   | 406,414 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| COSTS AND EXPENSES:                                                       |       |                                    |       |                                   |       |   |   |   |   |
| Cost of product  sales                                                    |       | 57,480                                  |       | 72,487                                 |       | 168,242 |   | 211,734 |   |
| Research and  development                                                 |       | 15,922                                  |       | 18,940                                 |       | 47,483 |   | 55,867 |   |
| Sales and  marketing                                                      |       | 6,281                                   |       | 8,427                                  |       | 18,832 |   | 22,643 |   |
| General and  administrative                                               |       | 7,789                                   |       | 9,085                                  |       | 20,115 |   | 27,895 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| Total costs and  expenses                                                 |       | 87,472                                  |       | 108,939                                |       | 254,672 |   | 318,139 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| OPERATING INCOME                                                          |       | 12,181                                  |       | 34,979                                 |       | 26,183 |   | 88,275 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                                                   |       |                                    |       |                                   |       |   |   |   |   |
| Foreign currency  exchange gain (loss) - net                              |       | (165                                    | )          | (243                                   | )          | (932 | ) | 856 |   |
| Gain on debt  extinguishment                                              |       | —                                  |       | —                                 |       | 2,220 |   | — |   |
| Interest and  other income                                                |       | 2,693                                   |       | 5,415                                  |       | 7,691 |   | 17,894 |   |
| Interest and  other expense                                               |       | (1,525                                  | )          | (1,474                                 | )          | (5,428 | ) | (4,381 | ) |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| Total other  income - net                                                 |       | 1,003                                   |       | 3,698                                  |       | 3,551 |   | 14,369 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| INCOME BEFORE INCOME  TAX PROVISION AND MINORITY INTEREST                 |       | 13,184                                  |       | 38,677                                 |       | 29,734 |   | 102,644 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| INCOME TAX PROVISION                                                      |       | 1,187                                   |       | 12,547                                 |       | 2,099 |   | 34,680 |   |
| MINORITY INTEREST                                                         |       | 687                                     |       | 902                                    |       | 1,449 |   | 2,273 |   |
| NET INCOME                                                                |       | $                                       | 12,684     |                                   | $          | 27,032 |   | $ | 29,084 |   | $ | 70,237 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| EARNINGS PER SHARE:                                                       |       |                                    |       |                                   |       |   |   |   |   |
| Basic earnings per  share                                                 |       | $                                       | 0.36       |                                   | $          | 0.71 |   | $ | 0.81 |   | $ | 1.85 |   |
| Weighted average  common shares outstanding                               |       | 35,501                                  |       | 37,819                                 |       | 36,070 |   | 37,995 |   |
|                                                                      |       |                                    |       |                                   |       |   |   |   |   |
| Diluted earnings per  share                                               |       | $                                       | 0.35       |                                   | $          | 0.68 |   | $ | 0.80 |   | $ | 1.75 |   |
| Weighted average common  and dilutive potential common shares outstanding |       | 36,131                                  |       | 41,185                                 |       | 36,502 |   | 41,635 |   |

 

SeeNotes to Unaudited Consolidated Financial Statements.

 

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**CYMER, INC.**

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

**(In thousands)**
| ** **                                                                         | ** ** | **For the nine months ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**                            | ** ** |
| ** **                                                                         | ** ** | **2005**                                          | ** ** | **2006** | ** ** |
|                                                                               |       |                                              |       |   |   |
| OPERATING ACTIVITIES:                                                              |       |                                              |       |   |   |
| Net income                                                                         |       | $                                                 | 29,084     |   | $ | 70,237 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                              |       |   |   |
| Gain on debt  extinguishment                                                       |       | (2,220                                            | )          | — |   |
| Depreciation and  amortization                                                     |       | 21,512                                            |       | 18,939 |   |
| Non-cash  stock-based compensation                                                 |       | 953                                               |       | 7,567 |   |
| Amortization of  unearned compensation                                             |       | 16                                                |       | — |   |
| Minority  interest                                                                 |       | (1,449                                            | )          | (2,273 | ) |
| Provision for  deferred income taxes                                               |       | 22                                                |       | 9,410 |   |
| Loss on disposal  and impairment of property and equipment                         |       | 54                                                |       | 94 |   |
| Change in assets  and liabilities:                                                 |       |                                              |       |   |   |
| Accounts  receivable – net                                                    |       | 26,882                                            |       | (25,180 | ) |
| Accounts  receivable – related party                                          |       | (259                                              | )          | (1,601 | ) |
| Foreign currency  forward exchange contracts                                       |       | (2,952                                            | )          | 1,154 |   |
| Inventories                                                                        |       | 23,869                                            |       | (15,480 | ) |
| Prepaid expenses  and other assets                                                 |       | (2,388                                            | )          | (1,089 | ) |
| Accounts payable                                                                   |       | (75                                               | )          | (3,428 | ) |
| Accounts payable  - related party                                                  |       | 4,169                                             |       | (434 | ) |
| Accrued expenses  and other liabilities                                            |       | (2,733                                            | )          | 10,304 |   |
| Unearned income                                                                    |       | (4,152                                            | )          | 763 |   |
| Income taxes  payable                                                              |       | 109                                               |       | (1,676 | ) |
|                                                                               |       |                                              |       |   |   |
| Net cash  provided by operating activities                                         |       | 90,442                                            |       | 67,307 |   |
|                                                                               |       |                                              |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                                              |       |   |   |
| Acquisition of  property and equipment                                             |       | (14,769                                           | )          | (9,976 | ) |
| Purchases of  investments                                                          |       | (276,968                                          | )          | (188,229 | ) |
| Proceeds from  sold or matured investments                                         |       | 323,612                                           |       | 140,823 |   |
| Acquisition of  patents                                                            |       | —                                            |       | (8,200 | ) |
| Acquisition of  minority interest                                                  |       | —                                            |       | (7,024 | ) |
|                                                                               |       |                                              |       |   |   |
| Net cash  provided by (used in) investing activities                               |       | 31,875                                            |       | (72,606 | ) |
|                                                                               |       |                                              |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                                              |       |   |   |
| Proceeds from  issuance of common stock                                            |       | 12,639                                            |       | 103,656 |   |
| Redemption of  convertible subordinated notes                                      |       | (57,336                                           | )          | — |   |
| Cash investment  received from minority shareholder                                |       | 11,120                                            |       | — |   |
| Excess tax  benefits from stock option exercises                                   |       | —                                            |       | 18,947 |   |
| Payments on  capital lease obligations                                             |       | (20                                               | )          | — |   |
| Repurchase of  common stock into treasury                                          |       | (50,000                                           | )          | (100,704 | ) |
|                                                                               |       |                                              |       |   |   |
| Net cash  provided by (used in) financing activities                               |       | (83,597                                           | )          | 21,899 |   |
|                                                                               |       |                                              |       |   |   |
| EFFECT OF EXCHANGE RATE  CHANGES ON CASH AND CASH EQUIVALENTS                      |       | (698                                              | )          | 3,888 |   |
|                                                                               |       |                                              |       |   |   |
| NET INCREASE IN CASH  AND CASH EQUIVALENTS                                         |       | 38,022                                            |       | 20,488 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF THE PERIOD                              |       | 114,246                                           |       | 233,745 |   |
|                                                                               |       |                                              |       |   |   |
| CASH AND CASH EQUIVALENTS AT END OF THE PERIOD                                     |       | $                                                 | 152,268    |   | $ | 254,233 |   |
|                                                                               |       |                                              |       |   |   |
| SUPPLEMENTAL DISCLOSURE  OF CASH FLOW INFORMATION:                                 |       |                                              |       |   |   |
| Interest paid                                                                      |       | $                                                 | 6,850      |   | $ | 5,150 |   |
| Income taxes paid, net                                                             |       | $                                                 | 3,502      |   | $ | 7,860 |   |

 

SeeNotes to Unaudited Consolidated Financial Statements.

 

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**CYMER,INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThree and Nine Months Ended September 30, 2006(Unaudited)**

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

*Unaudited Interim Financial Data* –The accompanying consolidated financial information has been prepared by Cymer,Inc., and its wholly-owned and majority-owned subsidiaries (collectively, “Cymer”),without audit, in accordance with the instructions to Form 10-Q. In the opinionof management, the unaudited consolidated financial statements for the interimperiods presented reflect all material adjustments, consisting only of normalrecurring adjustments, necessary for a fair presentation of the financialposition and results of operations as of and for such periods indicated.  These unaudited consolidated financial statementsand notes hereto should be read in conjunction with the consolidated financialstatements and notes thereto included in our Annual Report on Form 10-K for theyear ended December 31, 2005.  Resultsfor the interim periods presented herein are not necessarily indicative ofresults that may be reported for any other interim period or for the entirefiscal year.

*Principlesof Consolidation* – The accompanying consolidated financialstatements include our accounts and the accounts of our wholly owned subsidiaries– Cymer Japan, Inc. (“Cymer Japan”), Cymer Singapore Pte Ltd. (“Cymer Singapore”),Cymer B.V. in the Netherlands (“Cymer B.V.”), Cymer Southeast Asia, Ltd, inTaiwan (“Cymer SEA”), Cymer Semiconductor Equipment Shanghai Co., Ltd, in thePeople’s Republic of China (“Cymer PRC”), Cymer Korea, Inc. (“Cymer Korea”),and our majority-owned subsidiary, TCZ Pte Ltd., a company incorporated inSingapore (“TCZ Singapore”).  

On January 2,2006, we acquired the remaining 19% minority interest in Cymer Korea.  We paid a total of $7.0 million for this 19%interest.  This transaction increased ourtotal interest in Cymer Korea from 81% to 100%. Cymer Japan is currently our only subsidiary that sells excimer lightsource systems. Cymer Japan also provides field service to customers in Japan.Cymer Singapore, Cymer B.V., Cymer SEA, and Cymer PRC are field service officesfor customers in their respective countries. Cymer Korea provides refurbishment manufacturing, field service, andadministrative activities for Korea and the Asia-Pacific region. 

We formed TCZSingapore in September 2006 in connection with our TCZ joint venture with CarlZeiss SMT AG, a German corporation (“SMT”) and Carl Zeiss Laser OpticsBeteiligungsgesellschaft mbH, a German limited liability company (“LOB”). LOBand SMT, together with their affiliated entities, are collectively referred toas “Zeiss.”  Per the terms of ouroriginal joint venture agreement, TCZ GmbH, a Swiss limited liability company(“TCZ Switzerland”), was formed and Switzerland was designated as the locationfor the TCZ joint venture. In September 2006 we moved the location of the TCZjoint venture from Switzerland to Singapore. See Footnote 4 for moredetails.  We own 60% of TCZ Singapore andZeiss owns 40%.  TCZ is currentlydeveloping, and will integrate, market and sell, and support tools employing anexcimer laser 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.  Actualresults may differ from those estimates.

*Accounting Pronouncements Adopted*

In November 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 151 (“SFAS No. 151”), ”Inventory Costs,an Amendment of ARB 43 Chapter 4”.  This statement amended AccountingResearch Bulletin No. 43 (“ARB No. 43”) Chapter 4, to clarifyaccounting for abnormal amounts of idle facility expense, freight, handlingcosts and wasted

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material.  SFAS No. 151 requires that thoseitems be recognized as current-period charges.  SFAS No. 151 iseffective for fiscal years beginning after June 15, 2005.  We adoptedSFAS No. 151 on January 1, 2006.  Theadoption of SFAS No. 151 did not have an impact on our consolidated financialstatements.

In May 2005, theFASB issued Statement of Financial Accounting Standards No. 154 (“SFASNo. 154”), “Accounting Changes and Error Corrections—a replacement of APBOpinion No. 20 and FASB Statement No. 3”. This Statement replaces APBOpinion No. 20, “Accounting Changes” and FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements”, and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS No. 154 applies to all voluntary changes in accountingprinciple. It also applies to changes required by an accounting pronouncementin the unusual instance that the pronouncement does not include specifictransition provisions. When a pronouncement includes specific transitionprovisions, those provisions should be followed. SFAS No. 154 is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. We adopted SFAS No. 154 on January 1,2006. The adoption of SFAS No. 154 did not have an impact on our consolidatedfinancial statements.

Effective January 1,2006, we adopted the provisions of FASB Statement of Financial AccountingStandards No. 123R (“SFAS No. 123R”) “Share-Based Payment” which replacesStatement of Financial Accounting Standards No. 123 (“SFAS No.123”), “Accountingfor Stock-Based Compensation” and supersedes Accounting Principles BoardOpinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees”.Under the fair value recognition provisions of SFAS No. 123R, stock-basedcompensation cost is measured at the grant date based on the fair value of theaward and is recognized as an expense over the requisite service period, or thevesting period. We elected the modified-prospective method in implementing SFASNo. 123R which does not require us to revise prior period financial statementsfor comparative purposes. We elected to use the Black-Scholes option pricingmodel to determine the fair value of our stock options under SFAS No. 123R. Thevaluation provisions of SFAS No. 123R apply to new options granted on or afterJanuary 1, 2006. We also elected to attribute the value of share-basedcompensation to expense using the straight-line method for awards granted on orafter January 1, 2006.  Estimatedcompensation expense for grants that were outstanding and unvested as of theeffective date will be recognized over the remaining service period using thecompensation cost estimated for the SFAS No. 123 pro forma disclosures whichuses an accelerated expense recognition method for those awards with a gradedvesting schedule. The adoption of SFAS No. 123R had a material impact on ourconsolidated financial statements.  SeeFootnote 2 for more detailed information on our adoption of SFAS No. 123R.

On November 10,2005, the FASB issued FASB Staff Position No. FAS 123(R)-3 “Transition Election Related to Accountingfor Tax Effects of Share-Based Payment Awards”. We have elected to adoptthe “short-cut” method provided in the FASB Staff Position for calculating thetax effects of share-based compensation pursuant to SFAS No. 123R. The “short-cut”method includes simplified methods to establish the beginning balance of theadditional paid-in capital pool (“APIC pool”) related to the tax effects ofshare-based compensation, and to determine the subsequent impact on the APICpool, the consolidated statements of cash flows, and earnings per share of thetax effects of share-based compensation awards that were outstanding uponadoption of SFAS No. 123R.

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

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

7

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

**Stock-Based CompensationValuation Assumptions**

We estimate the fair value of our stockoptions using a Black-Scholes option pricing model, consistent with theprovisions of SFAS No. 123R.  Inaddition, we used this same option pricing model to calculate the fair value ofour stock options included in our prior period pro forma disclosures asrequired by SFAS No.123.

The fair value ofstock options granted is recognized to expense over the requisite serviceperiod.  For stock options granted afterthe SFAS No. 123R effective date of January 1, 2006, the straight-lineattribution approach is used. For stock options granted prior to January 1,2006, which are continuing to vest, we will continue to record expense usingthe FASB Interpretation No. 28 (“FIN 28”) accelerated attribution approach.

Upon the adoption ofSFAS No. 123R, we used a combination of historical and implied volatility (“blendedvolatility”) to value our stock options.  Historical volatility is basedon a period commensurate with the expected term of the options. Impliedvolatility was derived based on six-month traded options of our commonstock.  Prior to January 1, 2006, we used only historical stock pricevolatility in accordance with SFAS No. 123 for purposes of our pro forma stockcompensation calculation. The expected term of our stock options represents theperiod of time options are expected to be outstanding and is based on observedhistorical exercise patterns for our company which we believe are indicative offuture exercise behavior. For the risk free interest rate, we use the thencurrently available rate on zero coupon U.S. Government issues with a remainingperiod commensurate with the expected term for valuing options.

The followingweighted average assumptions were used for grants issued in the three and ninemonths ended September 30, 2005 under the SFAS No. 123 requirements and in thethree and nine months ended September 30, 2006 under the SFAS No. 123Rrequirements:
|                           | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
|                      |       |                             |       |                            |       |   |   |   |   |
| Dividend yield            |       | None                             |       | None                            |       | None |   | None |   |
| Volatility rate:          |       |                             |       |                            |       |   |   |   |   |
| Options                   |       | 75                               | %          | 56                              | %          | 75 | % | 56 | % |
| ESPP                      |       | n/a                              |       | n/a                             |       | 75 | % | n/a |   |
| Risk free  interest rate: |       |                             |       |                            |       |   |   |   |   |
| Options                   |       | 4.04                             | %          | 4.59                            | %          | 3.95 | % | 4.77 | % |
| ESPP                      |       | n/a                              |       | n/a                             |       | 3.33 | % | n/a |   |
| Expected term:            |       |                             |       |                            |       |   |   |   |   |
| Options                   |       | 4.38 years                       |       | 3.14 years                      |       | 4.31 years |   | 3.15 years |   |
| ESPP                      |       | n/a                              |       | n/a                             |       | .5 years |   | n/a |   |

 

In our pro formadisclosures prior to the adoption of SFAS No. 123R, we accounted for forfeituresas they occurred. SFAS No. 123R requires forfeitures to be estimated at thetime of grant and revised if necessary in subsequent periods if actualforfeiture rates differ from those estimates. Forfeitures were estimated basedon historical activity for our company. For the three and nine months endedSeptember 30, 2006, we estimated a 3% annual forfeiture rate.  We amended our Employee Stock Purchase Plan (“ESPP”)in May 2005, and as a result, our ESPP is treated as a noncompensatory plan.

8

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**Impact of SFAS No. 123R**

The following tablepresents the impact to our consolidated financial statements as a result of ouradoption of SFAS No. 123R for the three and nine months ended September 30,2006 (in thousands, except per share amounts):
|                                                     | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** | ** ** |
|                                                |       |                             |       |                             |       |
| Stock-based  compensation expense by type of award: |       |                             |       |                             |       |
| Employee stock  options                             |       | $                                | 2,137      |                             | $          | 6,627 |   |
| Stock units                                         |       | 174                              |       | 495                              |       |
|                                                |       |                             |       |                             |       |
| Total  stock-based compensation                     |       | 2,311                            |       | 7,122                            |       |
| Tax effect on  stock-based compensation             |       | (750                             | )          | (2,407                           | )          |
| Net effect on  net income                           |       | $                                | 1,561      |                             | $          | 4,715 |   |
|                                                |       |                             |       |                             |       |
| Effect on  earnings per share:                      |       |                             |       |                             |       |
| Basic                                               |       | $                                | 0.04       |                             | $          | 0.12 |   |
| Diluted                                             |       | $                                | 0.04       |                             | $          | 0.11 |   |
|                                                |       |                             |       |                             |       |
| Impact of stock  option deductions on:              |       |                             |       |                             |       |
| Cash flows from  operations                         |       | $                                | (1,175     | )                                | $          | (18,947 | ) |
| Cash flows from  financing activities               |       | $                                | 1,175      |                             | $          | 18,947 |   |

 

As of September 30,2006, the unamortized compensation expense related to outstanding unvestedoptions was approximately $10.2 million with a weighted average remainingvesting period of 1.28 years. We expect to amortize this expense over theremaining vesting period of these stock options.

The amount ofstock-based compensation costs capitalized into inventory during the nine monthsended September 30, 2006 was immaterial.

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”.  We measure the fair value of such optionsusing the Black-Scholes option pricing model at each financial reportingdate.  We account for changes in fairvalues between reporting dates in accordance with FIN 28.  Stock-based compensation expense for optionsgranted to non-employees and for those employees who changed status during thenine months ended September 30, 2005 and 2006 was $949,000 and $445,000,respectively.

Prior to the adoption of SFAS No. 123R, we applied the intrinsic value-based method ofaccounting required by APB No. 25 for options granted to employees and providedthe pro forma disclosures of SFAS No. 123 as amended by Statement ofFinancial Accounting Standards No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure”.  During 2005, we recorded no compensationexpense related to the grant of options to employees since the exercise priceof such options equaled or exceeded the market value of the underlying commonstock on the date of grant.

9

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

The following tablecompares the earnings per share that we reported to the pro forma amounts thatwe would have reported had we recognized compensation expense for ourstock-based compensation plans in accordance with SFAS No. 123 (in thousands,except per share amounts):
|                                                                                                                                                   | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
|                                                                                                                                              |       |                             |       |                             |       |
| Net income, as reported                                                                                                                           |       | $                                | 12,684     |                             | $          | 29,084 |   |
| Add: Stock-based employee  compensation expense included in reported net income, net of related tax  effects                                      |       | 546                              |       | 886                              |       |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects |       | (2,889                           | )          | (18,840                          | )          |
|                                                                                                                                              |       |                             |       |                             |       |
| Pro forma net income                                                                                                                              |       | $                                | 10,341     |                             | $          | 11,130 |   |
|                                                                                                                                              |       |                             |       |                             |       |
| Earnings per share:                                                                                                                               |       |                             |       |                             |       |
| Basic - as reported                                                                                                                               |       | $                                | 0.36       |                             | $          | 0.81 |   |
| Basic - pro forma                                                                                                                                 |       | $                                | 0.29       |                             | $          | 0.31 |   |
|                                                                                                                                              |       |                             |       |                             |       |
| Diluted - as reported                                                                                                                             |       | $                                | 0.35       |                             | $          | 0.80 |   |
| Diluted - pro forma                                                                                                                               |       | $                                | 0.29       |                             | $          | 0.30 |   |

 

In February 2005,our board of directors approved the acceleration of the vesting of stockoptions that had exercise prices of $30.50 per share or higher held byemployees. This acceleration of stock options excluded directors, executiveofficers and certain vice presidents. The purpose of this acceleration ofvesting was to enable us to eliminate the recognition in our statement ofoperations of the compensation expense associated with these “out of the money”stock options in future periods, upon our adoption of SFAS No. 123R onJanuary 1, 2006.  The acceleration of vesting of these stock optionsin the nine months ended September 30, 2005 contributed approximately $10.4million of pro forma stock-based compensation expense.

**Stock Option Plans**

Currently,we grant stock options and awards from our 2005 Equity Incentive Plan (the “2005Plan”), which provides for the grant or award of various equity instruments toour employees, directors and consultants. Upon approval of the 2005 Plan bystockholders in May 2005, we discontinued the use of our 1996 Stock Option Planand 2000 Equity Incentive Plan. Options issued under the 2005 Plan expire tenyears after the options are granted. It is our practice to generally grantoptions that vest and become exercisable ratably over a four-year periodfollowing the date of grant.  A total of 1,000,000 shares of common stock are reserved for issuance under the 2005Plan and it provides for the issuance of incentive stock options, nonstatutorystock options, stock appreciation rights, stock bonus awards, stock purchaseawards, stock unit awards and other stock awards. Options and awards topurchase 630,327 shares are outstanding and 369,537 shares remain available forgrant under the 2005 Plan as of September 30, 2006.

Thefollowing describes our other stock option plans from which we no longer issueawards although options to purchase shares are still outstanding under theseplans and continue to vest and may be exercised:

*1996 Stock Option Plan (the “1996 Plan”)*– The 1996 Plan provided for the grant of incentive stock options to ouremployees and nonqualified stock options to our employees, directors andconsultants.  The exercise prices of stock options granted under the 1996Plan were at least equal to the fair market value of our common stock on thedates of grant. Options issued under the 1996 Plan expire five to ten yearsafter the options were granted and generally vest and become exercisableratably over a four-year period following the date of grant. A total of7,900,000 shares of common stock were reserved for issuance under the 1996Plan.  Of these shares, options to purchase 1,819,741 million shares areoutstanding as of September 30, 2006.

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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 1,445,067 million shares areoutstanding as of September 30, 2006.

**StockOptions**

Thefollowing is a summary of stock option activity under all stock option plansfor the nine months ended September 30, 2006 (in thousands, except per sharedata):
|                                    | ** ** | ** ** | ** ** | **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                            |       | 277        |       | $                  | 44.82      |                |       |   |
| Exercised                          |       | (3,149     | )          | $                  | 30.70      |                |       |   |
| Forfeited                          |       | (144       | )          | $                  | 30.02      |                |       |   |
| Expired                            |       | (31        | )          | $                  | 48.52      |                |       |   |
|                               |       |       |       |               |       |                |       |
| Balance at September  30, 2006     |       | 3,877      |       | $                  | 34.19      |                | 6.08       |   |
| Exercisable at  September 30, 2006 |       | 2,952      |       | $                  | 33.76      |                | 5.29       |   |

 

The following tablesummarizes information as of September 30, 2006 concerning currentlyoutstanding and exercisable options:
| ** **                                | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | ** **                   | ** ** | **Average**                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Number**                   | ** ** | **Remaining**                | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** | **Number** | ** ** | **Weighted** | ** ** | **Aggregate** | ** ** |
| ** **                                | ** ** | **Outstanding**              | ** ** | **Contractual**              | ** ** | **Average** | ** ** | **Intrinsic** | ** ** | **Exercisable** | ** ** | **Average** | ** ** | **Intrinsic** | ** ** |
| **Range of**                         | ** ** | **As of 9/30/06**  | ** ** | **Term**                     | ** ** | **Exercise** | ** ** | **Value** | ** ** | **As of 9/30/06** | ** ** | **Exercise** | ** ** | **Value** | ** ** |
| **Exercise Prices**                  | ** ** | **(in thousands)**      | ** ** | **(in years)**          | ** ** | **Price** | ** ** | **(in thousands)** | ** ** | **(in thousands)** | ** ** | **Price** | ** ** | **(in thousands)** | ** ** |
| ** **                                | ** ** | ** **                   | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| $12.75  **-  **$15.73 | ** ** | 4                            |       | 1.92                         |       | $ | 12.75 |   | $ | 114 |   | 4 |   | $ | 12.75 |   | $ | 115 |   |
| $16.32  **-  **$19.98 | ** ** | 237                          |       | 5.84                         |       | $ | 19.23 |   | $ | 5,854 |   | 229 |   | $ | 19.21 |   | $ | 5,655 |   |
| $20.00  **-  **$24.22 | ** ** | 356                          |       | 4.76                         |       | $ | 22.73 |   | $ | 7,528 |   | 319 |   | $ | 22.62 |   | $ | 6,801 |   |
| $24.29  **-  **$31.66 | ** ** | 809                          |       | 6.84                         |       | $ | 28.41 |   | $ | 12,545 |   | 561 |   | $ | 28.51 |   | $ | 8,634 |   |
| $31.69  **-  **$38.66 | ** ** | 1,529                        |       | 5.52                         |       | $ | 35.53 |   | $ | 12,803 |   | 1,220 |   | $ | 35.97 |   | $ | 9,681 |   |
| $39.37  **-  **$48.64 | ** ** | 705                          |       | 7.33                         |       | $ | 43.40 |   | $ | 361 |   | 432 |   | $ | 43.10 |   | $ | 351 |   |
| $48.73  **-  **$55.13 | ** ** | 237                          |       | 5.66                         |       | $ | 50.24 |   | $ | — |   | 187 |   | $ | 50.64 |   | $ |   |   |
| $12.75  **-  **$55.13 | ** ** | 3,877                        |       | 6.08                         |       | $ | 34.19 |   | $ | 39,205 |   | 2,952 |   | $ | 33.76 |   | $ | 31,237 |   |

 

The aggregate intrinsicvalue in the table above represents the total pre-tax intrinsic value, based ona per share price of $43.91, the closing price of our common stock on September30, 2006 as reported

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by The NASDAQ Global Select Market, which would havebeen received by the option holders had all option holders exercised theiroptions as of that date.  The total numberof in-the-money stock options exercisable as of September 30, 2006 was 2.5million.

The weighted average pershare fair value of the options granted was $19.97 and $17.60 during the threemonths ended September 30, 2005 and 2006, respectively, and was $17.70 and$18.82 during the nine months ended September 30, 2005 and 2006, respectively.

The total intrinsicvalue of options exercised was $3.7 million and $2.5 million during the threemonths ended September 30, 2005 and 2006, respectively, and was $4.4 millionand $56.6 million during the nine months ended September 30, 2005 and 2006,respectively.

The total cash receivedfrom employees as a result of employee stock option exercises during the ninemonths ended September 30, 2006 was approximately $96.7 million.  In connection with these exercises, the taxbenefits recognized by us for the nine months ended September 30, 2006 was$18.9 million.

We settle employee stockoption exercises with newly issued shares of our common stock.

**StockUnits**

InJanuary 2006, our board of directors approved the use of annual stock unitawards for non-employee directors pursuant to our 2005 Plan in lieu ofquarterly stock options grants. The number of shares subject to eachstock unit award is determined by dividing $100,000 by the closing price pershare of our common stock as of the date of grant. During thenine months ended September 30, 2006, 17,948 shares subject to such stock unitsawards were granted to non-employee directors with a grant date fair value of$39.00 per share. Each stock unit award shall vest 100% after one year from thedate of grant. Stock based compensation expense for stock units for the threeand nine months ended September 30, 2006 was $174,000 and $495,000,respectively.

A summary of thechange in stock unit awards outstanding during the nine months ended September30, 2006 is as follows (in thousands, except life data):
|                       | ** ** | **Shares** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate**Intrinsic Valueas ofSeptember 30, 2006 | ** ** |
|-----------------------|------------|------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
|                  |       |       |       |                                                |       |                                                                    |       |
| Beginning Outstanding |       | —     |       |                                                |       |                                                                    |       |
| Awarded               |       | 18         |       |                                                |       |                                                                    |       |
| Vested                |       | —     |       |                                                |       |                                                                    |       |
| Forfeited             |       | —     |       |                                                |       |                                                                    |       |
| Ending Outstanding    |       | 18         |       | 0.29                                                |       | $                                                                       | 788        |   |
| Ending Exercisable    |       | —     |       | —                                              |       |                                                                    |       |
|                       |            |            |            |                                                     |            |                                                                         |            |  |

 

WeightedAverage Remaining Recognition Period - 0.29 years

Theaggregate intrinsic value in the table above represents the total pre-taxintrinsic value based on our closing stock price of $43.91 as of September 30,2006.

**Employee Stock Purchase Plan**

*1996 Employee Stock Purchase Plan (the “ESPP”)*–Our ESPP is intended to qualify for favorable income tax treatment associatedwith rights granted under an employee stock purchase plan which qualifies underSection 423 of the Internal Revenue Code.  Under the ESPP, eligibleemployees may

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purchase shares of our common stock through payrolldeductions of up to 15% of his or her compensation (as defined in the plan), ata price per share equal to 95% of the fair market value of our common stock atthe end of the purchase period.  Our ESPP was amended in 2005.  The amendment: a) changed the duration of offeringperiods under the plan from two years to six months, b) reduced the discount tomarket price used to determine the purchase price for shares of our commonstock under the plan from 15% to 5%, and c) eliminated the “lookback” featurethat allowed the purchase price to be determined as of the beginning of anoffering period, or enrollment date, if the market price as of the enrollmentdate was lower than the market price at the end of the offering period.  As a result of the amendment the plan becamenon-compensatory.

On February 7, 2006, ourboard of directors amended our ESPP to extend the expiration date of the planuntil July 31, 2016.  In addition, on May18, 2006, our stockholders approved an amendment to increase the number ofshares of common stock reserved for issuance under the plan by 300,000 sharesfrom 1,200,000 shares to 1,500,000 shares.

The number of sharesissuable under the ESPP as of September 30, 2006 was 380,235, and 1,119,765shares have been previously issued. Because our ESPP is a non-compensatory planas defined by SFAS No. 123R, no stock-based compensation expense is recordedfor our ESPP.

The total cash received from employees asa result of ESPP shares issued during the nine months ended September 30, 2006was approximately $711,000.

**Common Stock Warrants**

During 2001, we issuedwarrants to purchase 200,000 shares of our common stock at a weighted averagepurchase price of $31.43 per share in conjunction with the acquisition ofcertain patents.  In May 2006, these warrantswere exercised with respect to all 200,000 shares for $6.3 million in cash.

**Stock Repurchase Program**

On July 28, 2006, we announced that ourboard of directors had authorized us to repurchase up to $150 million of ourcommon stock.  The purchases will be madefrom time to time in the open market or in privately negotiatedtransactions.  The program may bediscontinued at any time.  Totalpurchases through September 30, 2006 were $100.7 million or 2.6 million sharesunder this program.

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

*Earnings Per Share* – Basic earnings per share (“EPS”) excludesdilution and is computed by dividing net income or loss attributable to commonstockholders by the weighted-average of common shares outstanding for theperiod.  Diluted EPS reflects thepotential dilution that could occur if securities or other contracts to issuecommon stock (convertible subordinated notes using the “if-converted” method,warrants to purchase common stock and common stock options using the treasurystock method) 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.

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The following table sets forth the basic and dilutedEPS for the three and nine months ended September 30, 2005 and 2006 (inthousands, except per share information):
|                                                                                       | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                            | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                                  |       |                             |       |                            |       |   |   |   |   |
| NET INCOME:                                                                           |       |                             |       |                            |       |   |   |   |   |
| Net income, as  reported (used for basic EPS)                                         |       | $                                | 12,684     |                            | $          | 27,032 |   | $ | 29,084 |   | $ | 70,237 |   |
| Adjustment for  interest expense on 3.5% convertible subordinated notes, net of taxes |       | —                           |       | 948                             |       | — |   | 2,742 |   |
|                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Net income, as  adjusted for assumed conversion (used for diluted EPS)                |       | $                                | 12,684     |                            | $          | 27,980 |   | $ | 29,084 |   | $ | 72,979 |   |
|                                                                                  |       |                             |       |                            |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                                             |       |                             |       |                            |       |   |   |   |   |
| Basic weighted  average common shares outstanding                                     |       | 35,501                           |       | 37,819                          |       | 36,070 |   | 37,995 |   |
| Effect of  dilutive securities:                                                       |       |                             |       |                            |       |   |   |   |   |
| Warrants                                                                              |       | 5                                |       | —                          |       | — |   | 29 |   |
| Options and  stock units                                                              |       | 625                              |       | 552                             |       | 432 |   | 797 |   |
| Convertible  subordinated notes                                                       |       | —                           |       | 2,814                           |       | — |   | 2,814 |   |
|                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Diluted weighted  average common and potential common shares outstanding              |       | 36,131                           |       | 41,185                          |       | 36,502 |   | 41,635 |   |
|                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Earnings per  share:                                                                  |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                                 |       | $                                | 0.36       |                            | $          | 0.71 |   | $ | 0.81 |   | $ | 1.85 |   |
| Diluted                                                                               |       | $                                | 0.35       |                            | $          | 0.68 |   | $ | 0.80 |   | $ | 1.75 |   |

 

For the three months ended September 30, 2005and 2006, weighted average options and warrants to purchase 3,601,000 and724,000 shares of common stock, respectively, were outstanding but not includedin the computation of diluted earnings per share as their effect wasanti-dilutive.  In addition, for thethree months ended September 30, 2005, weighted average common sharesattributable to convertible subordinated notes of 2,814,000 were not included inthe computation of diluted earnings per share as their effect was alsoanti-dilutive.

For the nine months ended September 30, 2005 and2006, weighted average options and warrants to purchase 4,927,000 and 642,000shares of common stock were outstanding but not included in the computation ofdiluted earnings per share as their effect was anti-dilutive.  In addition, for the nine months endedSeptember 30, 2005, weighted average common shares attributable to convertiblesubordinated notes of 3,423,000 were not included in the computation of dilutedearnings per share as their effect was also anti-dilutive.

**4.****             ****AMENDED JOINT VENTURE AGREEMENT**

On September 12, 2006, we entered into an Amended and RestatedJoint Venture Agreement (the “Amended JV Agreement”) with (i) TCZSwitzerland,  (ii) SMT, (iii) LOB, and (iv) TCZ Singapore. The purpose ofthis Amended JV Agreement was to move the location of our TCZ joint venturefrom Switzerland to Singapore. The terms and conditions of the original jointventure agreement we entered into with TCZ Switzerland, SMT and LOB on July 15,2005 remain in effect, except for the following: 1)   the change in the businesslocation; 2)  the addition of TCZ Singapore as aparty to the Amended JV Agreement and successor to the rights and obligationsof TCZ Switzerland and 3) t heupdates to the governance provisions to reflect differences in Swiss andSingapore corporate law.

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**5.****              INVENTORIES**

Inventoriesconsisted of the following as of December 31, 2005 and September 30, 2006 (inthousands):
|                                              | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| INVENTORIES:                                 |       |                  |       |                   |       |
| Raw materials                                |       | $                     | 42,482     |                   | $          | 38,200 |   |
| Work-in-progress                             |       | 18,408                |       | 25,488                 |       |
| Finished goods                               |       | 38,601                |       | 52,063                 |       |
| Allowance for excess  and obsolete inventory |       | (10,445               | )          | (11,225                | )          |
| Total                                        |       | $                     | 89,046     |                   | $          | 104,526 |   |

 

**6.****              REPORTINGCOMPREHENSIVE INCOME**

Comprehensive income includes net income, effectiveunrealized gains and losses on forward contracts, foreign currency translationadjustments, and unrealized gains and losses on available-for-sale securities,which are recorded as short-term and long-term investments in the accompanyingconsolidated balance sheets.

The following table summarizes the change ineach component of accumulated other comprehensive loss for the nine months endedSeptember 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 |       | 3,888           |       | 592                       |       | 124                                      |       | 4,604             |       |
| September 30, 2006 |       | Balance            |       | $               | (4,269     | )                         | $          | (206                                     | )          | $                 | 54         |   | $ | (4,421 | ) |

 

Comprehensive income consisted of the followingcomponents (in thousands):
|                                                                                       | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                            | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Net income                                                                            |       | $                                | 12,684     |                            | $          | 27,032 |   | $ | 29,084 |   | $ | 70,237 |   |
|                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Foreign currency  translation adjustments                                             |       | (634                             | )          | 1,196                           |       | (413 | ) | 3,888 |   |
| Unrealized gains  (losses) on available-for-sale investments, net of tax              |       | (243                             | )          | 487                             |       | (607 | ) | 592 |   |
| Unrealized gains  (losses) on foreign currency forward exchange contracts, net of tax |       | (95                              | )          | 68                              |       | 663 |   | 124 |   |
| Comprehensive income                                                                  |       | $                                | 11,712     |                            | $          | 28,783 |   | $ | 28,727 |   | $ | 74,841 |   |

 

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**7.****              DEVELOPMENTAGREEMENT AND INTELLECTUAL PROPERTY LICENSE AGREEMENT**

Theresearch and development agreement we entered into effective as of January 23,2004 with Intel 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. Under the terms of the Amended DevelopmentAgreement, most of the mutual obligations between us and Intel have beenterminated, including Intel’s obligation to provide us with up to a total of$20.0 million.  As of the date of theamendment, we had received a total of $8.5 million from Intel under theoriginal agreement, including an advance payment of $1.3 million paid by Intelat the initiation of the original agreement in 2004. Under the AmendedDevelopment Agreement, Intel has no obligation to provide us with furtherfunding beyond the amount we already received and we returned $347,222,which represents 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.

The intellectual property license agreement weentered into effective as of January 28, 2004 with Intel was amended on June28, 2006 (“Amended Intellectual Property License Agreement”).  Under the original intellectual propertylicense agreement, pursuant to which we licensed certain patents and tradesecrets from Intel related to EUV lithography technology, our obligation to paylicense fees to Intel did not commence until our first high volumemanufacturing shipment of an EUV 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 IntellectualProperty License Agreement also changes a number of the EUV patents covered bythe license.  All of the licensed patentsunder the Amended Intellectual Property License Agreement relate to EUVtechnology, and we intend to use them in connection with our continuingresearch and development efforts related to EUV.

We recorded the patent license rights acquiredfrom Intel valued at $8.2 million under this Amended Intellectual PropertyLicense Agreement as an intangible asset in our accompanying consolidatedbalance sheets.  The total value of thesepatent license rights are being amortized over a period of 16.29 years whichrepresents the average remaining life of all of the patents purchased underthis amendment. The amortization of these patents is included in research anddevelopment expenses on the accompanying statement of operations since thefield of use involves applications which are still in the research anddevelopment stages.

**8.****              GOODWILL ANDINTANGIBLE ASSETS**

We account for our goodwill and other intangible assets in accordance withStatement of Financial Accounting Standards No. 142 (“SFAS No. 142”), “Goodwilland Other Intangible Assets”. Under SFAS No. 142, our goodwill is subject to anannual impairment test. During the fourth quarter of 2005, we completedour annual impairment test of goodwill and intangible assets, and concludedthat no impairment of goodwill existed.

The following table summarizes the activity in thecarrying amount of goodwill as of December 31, 2005 and September 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  September 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

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September 30, 2006, the net carrying amount of thesepatents was $10.5 million and $16.6 million, respectively. The accumulatedamortization for these patents at December 31, 2005 and September 30, 2006 was$8.3 million and $10.4 million, respectively. Amortization expense for these patents was $593,000 and $761,000 for thethree months ended September 30, 2005 and 2006, respectively, and $1.8 millionand $2.0 million for the nine months ended September 30, 2005 and 2006,respectively.

Asof September 30, 2006, future estimated amortization expense for these patentsis expected to be as follows for (in thousands):
|                                        | ** ** | **Future**       | ** ** |
|----------------------------------------|------------|------------------|------------|
| ** **                             | ** ** | **Amortization** | ** ** |
|                                   |       |             |       |
| Three months ending  December 31, 2006 |       | $                | 762        |   |
| 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      |   |

 

**9.****             ****GUARANTEES/WARRANTIES**

In the ordinary courseof business, we are not subject to potential obligations under guarantees thatfall within the scope of Financial Accounting Standards Board InterpretationNo. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others”, exceptfor standard warranty provisions associated with product sales andindemnification provisions related to intellectual property that are containedwithin many of our lithography tool manufacturer agreements. All of theseprovisions give rise only 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 forwarranty for all products, which is included in cost of product sales in theconsolidated statements of operations and is recorded at the time that the relatedrevenue is recognized. We review our warranty provision monthly, which isdetermined using a statistical financial model which calculates actualhistorical expenses, product failure rates, and potential risks associated withour different product models. We then use this financial model to calculate thefuture probable expenses related to warranty and the required level of thewarranty provision. Throughout the year we review the risk levels, historicalcost information and failure rates used within this model and update them asinformation changes over the product’s life cycle. If actual warrantyexpenditures differ substantially from our estimates, revisions to the warrantyprovision would be required. Actual warranty expenditures are recorded againstthe warranty provision as they are incurred.

The following tablesummarizes information related to our warranty provision for the nine monthsended September 30, 2006 (in thousands):
|                                             | ** ** | **2006** | ** ** |
|---------------------------------------------|------------|----------|------------|
|                                        |       |     |       |
| Balance, January 1,  2006                   |       | $        | 30,191     |   |
| Liabilities accrued for  warranties issued, |       |     |       |
|  net of adjustments and expirations    |       | 14,899   |       |
| Warranty expenditures  incurred             |       | (15,015  | )          |
| Balance, September 30,  2006                |       | $        | 30,075     |   |

 

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(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 provisions provide that we will defend our customersagainst any infringement claims directed against our products.  Under the indemnification clauses, we willpay all 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.

An indemnificationprovision was also included in the contract manufacturing agreement with SeikoInstruments, Inc. (“Seiko”), which was terminated effective March 31,2003.  As with our indemnificationprovisions on intellectual property, we continue to honor this indemnificationclause within the agreement even after its termination. Seiko and at least oneJapanese lithography tool manufacturer have been notified that our light sourcesystems in Japan may infringe certain Japanese patents.  We believe, based upon the advice of counsel,that our products do not infringe any valid claim of the asserted patents orthat we are entitled to prior use claims in Japan.

As part of theoriginal research and development agreement signed with Intel in 2004, we alsoagreed to provide Intel with indemnity against any infringement of theintellectual property rights of any third party arising from Intel’s purchaseand/or use of our EUV source systems. Although this agreement was recently amended, our obligations toindemnify Intel will be specifically negotiated in any purchase agreementrelated to such future products.

As part of the supply agreement signed with TCZ in September 2005 andamended in September 2006 in connection with the amendment of the original TCZjoint venture agreement, we agreed to indemnify TCZ Singapore against anyinfringement of the intellectual property rights of a third party arising fromTCZ’s purchase of our products.  We willdefend such actions at our own expense and will pay the cost and damage awardedin any such action provided that TCZ Singapore grants us sole control of thedefense and settlement of such action and also provides us with informationrequired for the defense and settlement of such action.

Due to the nature of the indemnification provisions described above,they are indefinite and extend beyond the term of the actual agreements.

**10.****            ****RELATED PARTY TRANSACTIONS**

As a result of the formation of the TCZ joint venture in July 2005 underthe terms of a joint venture agreement which was amended in September 2006,Zeiss is now a related party.  Inaddition to transactions that occur among us, Zeiss and TCZ Singapore relatedto the joint venture, we also purchase certain optical parts directly fromZeiss and sell our light source system products to Zeiss periodically. Werecorded revenue associated with this related party of $1.1 million and $6.5million for the three and nine months ended September 30, 2006, respectivelyand revenue of $177,000 for the three and nine months ended September 30,2005.  As of December 31, 2005 andSeptember 30, 2006, we had accounts receivable balances of $588,000 and $2.2million, respectively, and accounts payable balances of $5.0 million and $4.5million, respectively, all of which were associated with these related partytransactions with Zeiss.

**11.****             CONTINGENCIES ANDCOMMITMENTS**

We are party to legalactions in the normal course of business. 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

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another Japanese company.  We have agreed to indemnify our formerJapanese manufacturing partner and our customers against patent infringementclaims under certain circumstances, even after the termination date of thecontract manufacturing agreement.  Webelieve, based upon the advice of counsel, that our products do not infringeany valid claim of the asserted patents or that we are entitled to prior useclaims in Japan.

**ITEM2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

*The following discussion of ourfinancial condition and results of operations should be read in conjunctionwith our consolidated financial statements and notes thereto included in thisQuarterly Report on Form 10-Q.*

**Forward-Looking Statements**

Statementsin this Quarterly Report on Form 10-Q that are not strictly historical innature are forward-looking statements. These statements include, but are notlimited to, references to the outlook for the semiconductor industry and us;expected domestic and international product sales and development; our researchand development activities and expenditures; adequacy of our capital resourcesand investments; 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 may differ materially from those projected inthe forward-looking statements due to various factors, including, but notlimited to, those contained under the caption “Risk Factors” and elsewhere inthis Quarterly Report on Form 10-Q. Forward-looking statements herein speak only as of the date of thisQuarterly Report on Form 10-Q.  Unlessrequired by law, we undertake no obligation to update or revise anyforward-looking statements to reflect new information or future events ordevelopments.  Thus, you should notassume that our silence over time means that actual events are bearing out asexpressed or implied in such forward-looking statements.

#### **Overview**

*General*

We are the world’sleading supplier of light source solutions for the semiconductor industry.  Our products provide the essential lightsource for deep ultraviolet (“DUV”) photolithography systems.  Almost all consumer electronic devicesmanufactured in the last several years contain a semiconductor manufacturedusing light sources such as ours.  Wecurrently supply 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 systemscurrently constitute a substantial majority of all excimer light sourcesincorporated in lithography stepper and scanner tools. Our headquarters arelocated in San Diego, California where we develop and manufacture all of ourlight source systems.  As a large portionof our revenue is derived from customers located outside of the U.S., wemaintain a spare parts refurbishment facility and field service office in Koreaand field 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, weentered into a joint venture agreement with (i) Carl Zeiss SMT AG, a Germancorporation (“SMT”); (ii) Carl Zeiss Laser Optics Beteiligungsgesellschaft mbH,a German limited liability company (“LOB”); and (iii) the Swiss liabilitycompany that was formed as part of the JV Agreement and named TCZ GmbH (“TCZSwitzerland”).  LOB and SMT, togetherwith their affiliated entities, are collectively referred to as “Zeiss”. InSeptember 2006, we entered into an amended joint venture

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agreement with Zeiss tomove the location of the TCZ joint venture from Switzerland to Singapore and,in connection with the move, formed TCZ Pte Ltd., a company incorporated inSingapore (“TCZ Singapore”).  TCZSingapore is currently developing, and will integrate, market and sell, andsupport, production tools for the flat panel display manufacturingindustry.  The joint venture is currentlyheadquartered in Singapore 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 Singapore will ship its first productiontool, the TCZ 900X, sometime in 2007.

*Products*

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

Our excimer lightsources for photolithography produce pulsed light of extremely shortwavelengths within the DUV spectrum.  Thebandwidth of the light is further narrowed through a number of opticaltechniques.  The DUV wavelengths aremeasured in nanometers (one nanometer is one billionth of a meter), and thelight sources are referred to according to either the wavelength or the gasesthat are mixed to produce the light. Krypton Fluoride (“KrF”) gases produce light at a 248 nm wavelength, andArgon 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 waferprocessing.  We have designed our lightsources to be reliable, easy to install and service and compatible withexisting semiconductor manufacturing processes. Our light sources are used to pattern or print the integrated circuits,which are also called semiconductors or “chips,” that power many of today’sadvanced consumer and business electronics. In the third quarter of 2006, we sold 67 light source systems at anaverage selling price of $1,065,000.

Certain componentsand subassemblies included in our light sources require replacement or refurbishmentfollowing extended operation.  Weestimate that a light source used in a semiconductor production environmentwill require one to two replacement chambers per year, depending upon the levelof usage. Similarly, certain optical components of the light source deterioratewith continued exposure to DUV light and require periodic replacement.  We provide these and other spare andreplacement parts for our photolithography light sources as needed by ourcustomers.

Asthe life and usage of our installed base of light sources in production atchipmakers exceeds the original warranty periods, some chipmakers requestservice 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.  Includedin some of the types of service contracts we provide to our customers are thereplacement of consumable parts and non-consumable parts.  The pricing for such contracts includes thereplacement of these parts.

#### *Semiconductor Industry Status and Outlook*

Since we derive a substantial portion of our revenuesfrom lithography 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 industryexperienced strong growth, which was followed by a three year decline from 2001through late 2003. Growth resumed in late 2003, but in late 2004, the industryagain declined for several months, then leveled off early in 2005 and began toimprove gradually thereafter.

In late 2005, orders forour light sources increased substantially from the levels we had experiencedearlier in the year.  Our chipmakercustomers began indicating that increasing demand for chips would require themto expand production capacity, and our lithography tool manufacturing

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customers began placing orders for a growing number oflight sources to meet increasing scanner demand.  It began to appear that we were againentering an industry growth cycle and upturn.

Therewere many positive indicators early in 2006 that reinforced our viewpoint thatwe were entering an upturn in the semiconductor industry.  In addition to strong continuing demand forour ArF light sources in the first half of 2006, we also experiencedsubstantial ongoing growth in our non-systems revenue which was driven by highlight source utilization at chipmakers and high overall fab utilization.  Additionally, there was stronger than anticipateddemand for KrF light sources, as chipmakers ordered tools to expandcapacity.  Our bookings, revenue andprofits grew substantially in the first half of 2006 compared to the secondhalf of 2005.

Growthcontinued in the third quarter of 2006. Our revenue increased to a record $143.9 million, up six percent fromour revenue of $135.4 million in the second quarter of 2006.  Utilization of our light sources atchipmakers continued to rise in the third quarter of 2006, and grew two percentover the previous quarter’s level.  Thisdrove our non-systems product revenue, which consists of consumables and spareparts, upgrades, and service, to a record $72.5 million for the third quarterof 2006, equal to 50 percent of total revenue for the quarter.  Demand for our most advanced ArF light sourcesremained robust, and we shipped 32 of our XLA Series light sources in the thirdquarter of 2006, which equaled the highest quarterly shipment volume since theXLA Series was introduced.  Through thefirst nine months of 2006, our lithography tool manufacturing customers rampedup their first wave of ArF immersion scanner production. Many of the immersiontools delivered thus far in 2006 have been used primarily by chipmakers forprocess development purposes including defect reduction.  Some chipmakers recently experienced successin qualifying their immersion production processes. We expect these chipmakerswill continue moving these tools from qualification into full production, andwill augment them with additional immersion tool purchases to increase criticallayer capacity.

Generally,industry trends remained positive in the third quarter of 2006.  However, a number of companies in thesemiconductor equipment industry reported that orders for the fourth quarter ofthis year and early next year had leveled off, indicating flat unit shipmentsin the short term.  Overall fabutilization continued in the low 90 percent range, though some segments of thechip industry have experienced a modest decline in utilization.  However, fab managers continued to orderequipment in line with demand, and avoided building excess manufacturingcapacity in the fab.  NAND Flash memorymanufacturers continued to expand their capacity, and 300mm fabs continued tobe built and populated with equipment.

Inthe near term, we believe light source demand will be affected by a variety offactors, including under- or over-capacity in individual chip sectors, the rateat which chip designs shrink at individual chipmakers, and the lithography toolmanufacturer customers’ manufacturing capacity for their new model lithographytools.  Early in the fourth quarter ofthis year, we received requests from among the lithography tool manufacturercustomers to delay certain XLA 300 light source shipments, as we believe theirfactories reached capacity for their most advanced tools.  As the currently existing inventory of XLA300s is absorbed, and our customers’ new manufacturing capacity is realized, weexpect the shipment rate of XLA 300 light sources to increase.  Looking at medium- and longer-term marketconditions, we expect demand for DUV lithography will continue to grow.  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.  We expect demand for ArF will extend well intothe future through the use of both immersion and double patterning productiontechniques.  However, macro-economicfactors, such as high energy prices and rising interest rates, could have anegative impact on consumer spending, including spending on electronicdevices.  Additionally, geopoliticalturmoil can create a heightened sense of uncertainty that can cause consumersto become more cautious about their spending. Either or both of these factors would have a negative effect on demandfor our products.

Weentered 2006 focusing our efforts on creating shareholder value throughimproved profitability, overall financial performance and execution.  During the third quarter of 2006, our grossmargin increased to 50 percent compared to 48 percent in the priorquarter.  Although our gross margins havebeen steadily improving over the last seven consecutive quarters, we expectthat improvements over the current 50% level will come more slowly and weexpect a slight decrease in gross margin in the fourth quarter of 2006

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due to changes in product mix. In the third quarter of2006, we generated $50.0 million in cash from operations, significantly morethan the $16.4 million in cash from operations generated in the second quarterof 2006.  We expect to continuegenerating substantial levels of cash from operations in the fourth quarter of2006 and we will continue to explore opportunities for the most effective useof our cash including additional buybacks of our common stock under our currentboard approved plan.

#### **Critical Accounting Policies and Estimates**

*General*

Thediscussion and analysis of our financial condition and results of operationsare based upon our consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America.  The preparation ofthese financial statements requires us to make estimates and use judgment thatmay impact the reported amounts of assets, liabilities, revenues, expenses, andrelated disclosure of contingent assets and liabilities.  As a part of our ongoing internal processes,we regularly 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 and judgments uponhistorical information and other facts and assumptions that we believe to bevalid and/or reasonable under the circumstances. These assumptions and factsform the basis for making judgments and estimates and for determining thecarrying values of our assets and liabilities that are not apparent from othersources.  Actual results could vary fromour estimates if we were to use different assumptions and conditions.

We believe that revenue recognition, valuation ofparts used in our refurbishment manufacturing process, inventory allowances,warranty provisions, stock-based compensation, and income taxes require moresignificant judgments and estimates in the preparation of our consolidatedfinancial statements than do other of our accounting estimates and judgments.

*Revenue Recognition*

Our revenues consist of product sales, whichinclude sales of light source systems, consumable and spare parts, upgrades,service, service contracts, training, and limited refurbishments of lightsource systems.  Our revenues alsoconsist of certain funded development activities performed for our customersand under government contracts and license agreements.

The sales of our light source systemsgenerally include training and installation services. We determined these elementsqualify as one unit of accounting under Emerging Issues Task Force (“EITF”)Bulletin No. 00-21, “Revenue Arrangements with Multiple Deliverables” as we donot have evidence of fair value for the undelivered training and installationelements. Furthermore, we determined that the undelivered training andinstallation elements are perfunctory performance obligations and are notessential to the functionality of our light source systems. Therefore, inaccordance with the provisions of Staff Accounting Bulletin No. 104, werecognize revenue when the revenue recognition criteria are met for the lightsource system, and accrue the costs of providing the training and installationservices.  We recognize light source systemrevenue at one of following three points, depending on the terms of ourarrangement with our customer – 1) shipment of the light source system 2)delivery of the light source system or 3) receipt of an acceptance certificate.For the majority of our light source system sales, the shipping terms areF.O.B. shipping point and revenue is recognized upon shipment. For ourarrangements which include F.O.B. destination shipping terms, revenue isrecognized upon delivery of the light source 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 source systems in environments similar tothose used by our customers prior to shipment to ensure that they meetpublished specifications.

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Revenue from consumablesand spare parts sales is recognized at the point that legal title passes to thecustomer, which is upon shipment from our facility.  For a significantportion of our spare parts sales, our customers return the consumed assembly tous as part of the sale of the new part.  We reuse some of the materialwithin these core assemblies, mainly metal components, for the future build ofcore assemblies.  As a result, our revenue consists of both cash and thevalue of the reusable parts received from our customers as consideration forthese spare part sales. Revenue associated with our customers’ return of coreassemblies is recognized upon receipt of the returned core assembly.  Theamount of the revenue is determined based upon the fair value of the reusableparts that we expect to yield from the returned core assembly based onhistorical experience.  Service andtraining revenue is recognized as the services are rendered.

On a very limited basis,we refurbish light source systems owned by our customers to their original ornew condition.  Revenue from refurbishedlight source systems is recognized when the refurbishment process has beencompleted and, depending upon the customer, the proper delivery or acceptanceterms have been met.

For funded developmentcontracts, which are included in other revenue, funds received are accountedfor on the percentage-of-completion method based on the relationship of costsincurred to total estimated costs. Revenues generated from these types offunded development contracts are derived from cost sharing contracts betweencertain customers and us. If milestones on these funded development contractsrequire that specific results be achieved or reported by us, revenue is notrecognized until that milestone is completed.  For some of the fundeddevelopment 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*

Overthe last several years as part of our regular business activities, we haveconducted significant parts refurbishment and material reclaim activitiesrelated to some of our core assemblies, in particular our chamber assemblies.The volume of this activity significantly increased in 2004 and we expectvolumes to increase over time as our installed base of light sources continuesto rise and we become more efficient in these refurbishment activities anddevelop capabilities to reclaim material from and refurbish other coreassemblies. These activities involve arrangements with our customers where wesell a new part to the customer at a reduced sales price if the customerreturns the consumed assembly that the new part replaces.  These returned core assemblies contain acertain amount of material, primarily metal components, that may be reused byus in future core assemblies.  Uponreceipt of these consumed assemblies from our customers, either we record anentry to recognize the estimated fair value of the reusable components asinventory and revenue or a reduction in cost of product sales sold depending onthe reason for the part replacement.  Thevalue of the reusable parts contained within the consumed assembly isdetermined based upon historical data on the value of the reusable parts thatwe typically yield from a consumed assembly. As part of our normal excess and obsolete inventory analysis, theseconsumed assemblies are also reviewed on a monthly basis and an inventoryallowance is recorded as appropriate for these parts.  The value that we assign to these coreassemblies can 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.  Webelieve that our methodology for valuing the reusable parts within thesereturned core assemblies is reasonable, but any changes in the demand for theparts or the yield of the parts included in these core assemblies could have amaterial adverse effect on our financial condition and results of operations.

***InventoryAllowance***

Weperform an analysis of our inventory allowances on at least a quarterly basisto determine the adequacy of this allowance on our financial statements.  The amount of the inventory allowance isdetermined by taking into consideration certain assumptions related to marketconditions and future

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demands for our products, including changes to productmix, new product introductions, and/or product discontinuances, which mayresult in excess or obsolete inventory. We determine the level of excess andobsolete inventory associated with our raw materials and production inventory,which includes all parts on hand from our refurbishment activities, bycomparing the on hand inventory balances and inventory on order to the next 12months of forecasted demand.  We thenadjust this calculation for inventory that has a high likelihood of use beyondone year or can be used in other products that may have lower demands.  After this adjustment, we arrive at our totalexposure for excess and obsolete inventory within our raw materials andproduction inventory.  As part of thisanalysis, we also determine whether there are potential amounts owed to vendorsas a result of cancelled or modified raw material orders.  We estimate and record a separate liability,which is included in accrued and other liabilities in the accompanying balancesheets for such amounts owed.

The inventory allowancetotaled $10.4 million and $11.2 million at December 31, 2005 and September 30,2006, respectively. The increase in the inventory allowance at September30, 2006 as compared to December 31, 2005 was primarily due to increased excessand obsolete allowances for both raw materials and consumable and spare partsfrom period to period offset by decreased excess and obsolete requirements forparts that are used in our material reclaim and refurbishment activities.

Themethodologies used to analyze excess and obsolete inventory and determine theinventory allowance are significantly affected by future demand and usage ofour products.  There are many factorsthat could potentially affect the future demand or usage of our products,including the following:

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

·                  Rate at whichour lithography tool manufacturers and chipmaker customers take delivery of ourlight source systems and our consumable and spare parts;

·                  Loss of any ofour three major customers or a significant change in demand from any of thesethree customers;

·                  Overall mix oflight source system models or consumable and spare parts and any changes tothat mix required by our customers; and

·                  Utilizationrates of our light sources at chipmakers.

Basedupon our experience, we believe that the estimates we use in calculating theinventory allowance are reasonable and properly reflect the risk of excess andobsolete inventory.  If actual demand orthe usage periods for our inventory are substantially different from ourestimates, adjustments to our inventory allowance may be required, which couldhave a material adverse effect on our financial condition and results ofoperations.

###### *Warranty Provision*

Wemaintain an accrual for the estimated cost of product warranties associatedwith our product sales.  Warranty costsinclude the replacement parts and labor costs to repair our products during thewarranty periods.  At the time revenue isrecognized, we record a warranty provision, which is included in cost ofproduct sales in the accompanying consolidated statements of operations. Thewarranty coverage period and terms for light source systems and consumable andspare parts varies by 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 used to estimate futureexpenses related to warranty and the required warranty provision.  The risk levels and historical costinformation and failure rates used within this model are reviewed throughoutthe year and updated as these inputs change over the product’s life cycle. Dueto the highly technical nature of our light source system products, the newermodel light sources and the modules contained within them have higher inherentwarranty risks with their initial shipments and require higher warrantyprovisions until the technology becomes more mature.

Thetotal balance in the warranty provision accrual as of December 31, 2005 andSeptember 30, 2006 was $30.2 million and $30.1 million, respectively.  This slight decrease is primarily due to

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improved warranty performance of both light sourcesystems and consumable and spare parts resulting in lower warranty provisionrequirements as calculated by our financial model and updated in 2006 . Thisimproved overall warranty performance and the resulting decrease in theprovision requirements was almost completely offset by the higher level ofconsumables and spare parts sales in the first nine months of 2006 as comparedto the same time period in 2005.

Weactively engage in product improvement programs and processes to limit ourwarranty costs, but our warranty obligation is affected by the complexity ofour product, product failure rates and costs incurred to correct those productfailures at customer sites. The industry in which we operate is subject torapid technological change, and as a result, we periodically introduce newer,more complex light sources.  Although weclassify these newly released light source models as having a higher risk in ourwarranty model resulting in higher warranty provisions, we are more likely tohave differences between the estimated and actual warranty costs for these newproducts.  This is due to limited or nohistorical product performance data on which to base our future warrantycosts.  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 failure rates or estimatedcosts to repair those product failures were to differ from our estimates,revisions to our estimated warranty provision would be required, which couldharm our financial condition and results of operations.

*Stock-Based Compensation*

Wegrant options to purchase our common stock to our employees and grant stockunit awards to our non-employee directors under our current stock plan.  The benefits provided under this plan areshare-based payments subject to the provisions of SFAS No. 123R.  Effective January 1, 2006, we adopted therequirements of SFAS No. 123R which address the accounting for share-basedpayment transactions in which an enterprise receives employee services inexchange for (a) equity instruments of the enterprise or(b) liabilities that are based on the fair value of the enterprise’sequity instruments or that may be settled by the issuance of such equityinstruments. As a result of this new accounting requirement, our consolidatedfinancial statements for the nine months ended September 30, 2006 includecompensation expense as calculated per the provisions of SFAS No.123R. Inadopting SFAS No. 123R, we elected to use the modified prospective transitionmethod, thus our consolidated financial statements for periods prior to January1, 2006 do not include any impact of SFAS No.123R. We also elected to attributethe value of share-based compensation to expense using the straight-line methodfor awards granted after December 31, 2005 upon our adoption of SFAS No. 123R.Compensation expense for awards outstanding as of December 31, 2005 are beingrecognized over the remaining service period using the compensation expensecalculated according to the pro forma disclosure provisions under SFAS No. 123which uses an accelerated expense recognition method for those awards with agraded vesting schedule. Share-based compensation expense related to stockoptions and stock units was $2.3 million and $7.1 million, before taxes for thethree and nine months ended September 30, 2006, respectively.

Uponadoption of SFAS No. 123R on January 1, 2006, we elected to value ourshare-based payment awards using the Black-Scholes option pricing model, as wehad under the pro forma provisions of SFAS No. 123. The determination of fairvalue of stock-based payment awards on the date of grant is affected by ourstock price as well as assumptions regarding a number of complex and subjectivevariables. These assumptions include our expected stock price volatility overthe term of the awards and the expected term of stock options.

Wedetermined our expected volatility by using a combination of historical andimplied volatility, or blended volatility, to derive our expected volatilityassumption as allowed under SFAS 123R and SAB 107. Implied volatility was basedon our six-month traded options on our common stock. We determined that thevolatility calculated using a blend of implied volatility and our historicalvolatility was more reflective of expected volatility than using onlyhistorical volatility.  The expected termof stock options represents the weighted-average period the stock options areexpected to remain outstanding. We determined the expected term of our stockoptions based on observed historical exercise patterns for our company, whichwe believe are indicative of future exercise behavior.

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Otherassumptions required for estimating fair value under the Black-Scholes optionpricing model include the expected risk-free interest rate and expecteddividend 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.

SFASNo. 123R also requires forfeitures to be estimated at the time of grant and wehave estimated our forfeitures based on historical experience.  We will revise this estimate, if necessary,in subsequent periods if actual forfeiture rates differ from our estimates. Inour pro forma information required under SFAS No. 123 for periods prior toJanuary 1, 2006, we accounted for forfeitures as they occurred.

Ifwe change any of the key assumptions that we use in the Black-Scholes optionpricing model such as expected volatility or expected term or if we decide touse a different valuation model in the future or change our forfeiture rate,the compensation expense that we record under SFAS No. 123R may differsignificantly in the future from what we have recorded in the current period.  In addition, as the guidance by regulatorsfor SFAS No. 123R is relatively new, the application of these principles may besubject to further interpretation and refinement over time.

*Income Taxes*

We account for incometaxes in 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 areto be reduced by a valuation allowance if, based on the weight of availableevidence, it is more likely than not that some portion or all of the deferredtax assets will not be realized within the carryback or carryforwardperiods.  Information about an enterprise’scurrent financial position and its results of operations for the current andpreceding years, as well as all currently available information about futureyears should be considered.

Wehave considered our industry’s outlook for the future, our historicalperformance and estimated future taxable income, and ongoing tax planningstrategies in assessing the need 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.  Based upon the analysis, with the exceptionof TCZ Singapore,  we believe that it ismore likely than not that the results of future operations will generatesufficient taxable income to realize our deferred tax assets within the periodcovered by our model and, as such, no valuation allowance against deferred taxassets is provided.  However, in the caseof our joint venture, TCZ, we do not feel that there is sufficient evidence oroperating history to conclude that the future operating profits of TCZ arelikely to allow it to utilize its NOL carryforwards and, consequently, a fullvaluation allowance has been provided against those loss carryforwards.

Amaterial adverse change in the outlook for worldwide lithography tool sales,the expected selling prices or profit margins for our products or our expectedshare of the global market for lithography light sources, could cause us todetermine that additional valuation allowances are needed for some or all ofour deferred tax assets, and would result in an increase to our income taxprovision in the period in which such determination is made.

We have not provided for U.S. federal income andforeign withholding taxes on $55.4 million of undistributed earnings fromnon-U.S. operations as of September 30, 2006 as it is our intention to reinvestundistributed earnings of our foreign subsidiaries and thereby indefinitelypostpone their remittance.  Accordingly,no provision has been made for foreign withholding taxes or U.S. income taxeswhich may become payable if undistributed earnings of foreign subsidiaries werepaid to us as dividends.

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**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** | ** ** | **Nine months ended** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenues:                                                 |       |                             |       |                            |       |   |   |   |   |
| Product sales                                             |       | 99.7                             | %          | 99.2                            | %          | 99.6 | % | 98.3 | % |
| Product sales -  related party                            |       | 0.2                              |       | 0.7                             |       | 0.1 |   | 1.6 |   |
| Other                                                     |       | 0.1                              |       | 0.1                             |       | 0.3 |   | 0.1 |   |
| Total revenues                                            |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
|                                                      |       |                             |       |                            |       |   |   |   |   |
| Cost and expenses:                                        |       |                             |       |                            |       |   |   |   |   |
| Cost of product  sales                                    |       | 57.7                             |       | 50.4                            |       | 59.9 |   | 52.1 |   |
| Research and  development                                 |       | 16.0                             |       | 13.1                            |       | 16.9 |   | 13.7 |   |
| Sales and  marketing                                      |       | 6.3                              |       | 5.9                             |       | 6.7 |   | 5.6 |   |
| General and  administrative                               |       | 7.8                              |       | 6.3                             |       | 7.2 |   | 6.9 |   |
| Total costs and  expenses                                 |       | 87.8                             |       | 75.7                            |       | 90.7 |   | 78.3 |   |
|                                                      |       |                             |       |                            |       |   |   |   |   |
| Operating income                                          |       | 12.2                             |       | 24.3                            |       | 9.3 |   | 21.7 |   |
|                                                      |       |                             |       |                            |       |   |   |   |   |
| Total other income -  net                                 |       | 1.0                              |       | 2.6                             |       | 1.3 |   | 3.5 |   |
|                                                      |       |                             |       |                            |       |   |   |   |   |
| Income before income  tax provision and minority interest |       | 13.2                             |       | 26.9                            |       | 10.6 |   | 25.2 |   |
|                                                      |       |                             |       |                            |       |   |   |   |   |
| Income tax provision                                      |       | 1.2                              |       | 8.7                             |       | 0.7 |   | 8.5 |   |
| Minority interest                                         |       | 0.7                              |       | 0.6                             |       | 0.5 |   | 0.6 |   |
|                                                      |       |                             |       |                            |       |   |   |   |   |
| Net income                                                |       | 12.7                             | %          | 18.8                            | %          | 10.4 | % | 17.3 | % |
| Gross margin on product sales                             |       | 42.3                             | %          | 49.6                            | %          | 39.9 | % | 47.9 | % |

 

**THREE MONTHS ENDED SEPTEMBER 30,2005 AND 2006**

*Revenues*. The types of revenue that we generateand how we recognize revenue for each is explained above under the heading “CriticalAccounting Policies and Estimates.”

Thefollowing table summarizes the components of our revenue (in thousands,except units sold):
|                                                  | ** ** | **For the three months ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                       | ** ** | **September 30,**                             | ** ** |
| ** **                                       | ** ** | **2005**                                           | ** ** | **2006** | ** ** |
|                                             |       |                                               |       |   |   |
| Light source  systems:                           |       |                                               |       |   |   |
| Revenue                                          |       | $                                                  | 53,848     |   | $ | 71,352 |   |
| Units sold                                       |       | 55                                                 |       | 67 |   |
| Average selling price (1)                        |       | $                                                  | 944        |   | $ | 1,065 |   |
|                                             |       |                                               |       |   |   |
| Consumable and  spare parts and service products |       | $                                                  | 45,744     |   | $ | 72,457 |   |
| Other revenue                                    |       | $                                                  | 61         |   | $ | 109 |   |
|                                             |       |                                               |       |   |   |
| Total revenue                                    |       | $                                                  | 99,653     |   | $ | 143,918 |   |

 

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(1)   Calculationof average selling price excludes $1.9 million of deferred light source revenuethat was recognized for the three months ended September 30, 2005.  We had one arrangement where a portion of thelight source system fee was not payable until the system was installedsuccessfully at the end-user. This arrangement expired in March 2005.

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Product sales increased 44% from $99.6****million for the three months ended September 30, 2005 to$143.8 million for the three months ended September 30, 2006.  This increase in product sales was due tohigher light source system revenues and higher consumable and spare parts andservice products revenues for the three months ended September 30, 2006compared to the three months ended September 30, 2005.  Light source system revenues increased 33%from $53.8 million for the three months ended September 30, 2005 to $71.4million for the three months ended September 30, 2006.  A total of 55 light source systems were soldin the three months ended September 30, 2005 at an average selling price of$944,000, compared to 67 light source systems sold in the three months endedSeptember 30, 2006 at an average selling price of $1.1 million.  On a foreign currency adjusted basis, theaverage selling price for the three months ended September 30, 2005 was$952,000 compared to $1.1 million for the three months ended September 30,2006. The increase in the average selling price from period to period reflectsthe shift in the product mix from capacity driven lower priced KrF products inthe three months ended September 30, 2005 to higher priced technology buys ofadvanced ArF products in the three months ended September 30, 2006. Theincrease in quantities of light source systems sold from period to period wasdue to the slight slowdown and flattening of the industry in the beginning of2005 compared to the upturn in the semiconductor industry in 2006. Chipmakers’expanded capacity needs have impacted the demand for our light source systems,and that combined with our growing installed base of light source systems hasincreased the demand for our consumables and spare parts and service products.This increased consumable and spare parts demand and rising tool utilizationresulted in an increase in consumables and spare parts and service revenues of58% from $45.7 million for the three months ended September 30, 2005 to $72.5 millionfor the three months ended September 30, 2006. Revenues from funded developmentcontracts were $61,000 for three months ended September 30, 2005, compared to$109,000 for the three months ended September 30, 2006. There were no revenuesrecorded or earned associated with the TCZ joint venture for the three monthsended September 30, 2006.  We expect thatour fourth quarter 2006 revenue will decrease slightly compared to the thirdquarter 2006 levels.

Our backlog at September 30, 2005 was $73.8 million comparedto $90.3 million at September 30, 2006. Bookings for the three months ended September 30, 2005 and September 30,2006 were $97.7 million and $142.0 million, respectively.  The book-to-bill ratio for the quarter endedSeptember 30, 2005 was 0.98 compared to 0.99 for the quarter ended September30, 2006.  The increase in the backlog isdue to the changing condition of the semiconductor industry from period toperiod and rising ASPs due to continued adoption of the advanced ArFtools.  The backlog as of September 30,2005 reflected the brief slowdown and flattening in the semiconductor industrythat started in late 2004, whereas the backlog as of September 30, 2006reflects the recent growth phase and upturn in the semiconductor industry. Theincrease in bookings from period to period was primarily due to increasedorders of light source systems and consumables and spare parts in the thirdquarter of 2006 as a result of this recent upturn in the semiconductorindustry. The book-to-bill ratio for the quarter ended September 30, 2006 wasnegatively impacted by us shipping a significant number of the competitivereplacement lasers during the third quarter of 2006 under a laser replacementpurchase order which was booked in full during the first quarter of 2006.

We installed 52 light sources at chipmakers and otherend-users during the quarter ended September 30, 2005 compared to 91 lightsources installed during the quarter ended September 30, 2006.

Oursales are generated primarily by shipments to customers in Europe, Japan,Korea, Taiwan, and the U.S. Approximately 83% and 84% of our sales for the three months endedSeptember 30, 2005 and 2006, respectively, were derived from customers outsidethe U.S.  We maintain a wholly ownedJapanese subsidiary, Cymer Japan, which sells to our Japanese customers.  Revenues from Japanese customers, generatedprimarily by Cymer Japan, accounted for 31% and 19% of total revenues for thethree months ended September 30, 2005 and 2006, respectively. The activities ofCymer Japan are limited to sales and service of products purchased by CymerJapan from us as the parent corporation. We anticipate that international saleswill continue to account 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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on foreign currency forward exchange contracts (“forwardcontracts”) associated with purchases of our products by Cymer Japan for resaleunder firm third-party sales commitments. Shipping costs associated with our product sales are also included incost of product sales.  We do not chargeour customers for shipping fees and such costs are not significant.

The cost of product sales increased 26% from $57.5million for the three months ended September 30, 2005 to $72.5 million for thethree months ended September 30, 2006. This increase in the cost of productsales was primarily due to higher light source system sales and sales ofconsumables and spare parts and service products in the three months endedSeptember 30, 2006 compared to the three months ended September 30, 2005.  This increase in cost of product sales was partiallyoffset by a decrease in warranty costs from period to period. The gross margin on product sales was42.3% for the three months ended September 30, 2005 as compared to 49.6% forthe three months ended September 30, 2006. This higher gross margin from periodto period was primarily due to increased factory yield and utilization, reducedlead and cycle times and improved warranty performance.  We anticipate that our gross margin maydecrease slightly in the fourth quarter of 2006 from the third quarter levelsdue to an expected change in product mix.

*Research and Development*. Research and development expenses include costs of internally-funded andexternally-funded projects as well as continuing product development supportexpenses, which consist primarily of employee and material costs, depreciationof equipment and other engineering related costs.  Our research and development expenses areoffset by amounts associated with certain of our externally funded research anddevelopment contracts.  Research anddevelopment expenses increased 19% from $15.9 million for the three monthsended September 30, 2005 to $18.9 million for the three months ended September30, 2006 due primarily to costs associated with our LTPS product developmentefforts and EUV light source development. Research and development expenseswere offset by amounts related to our externally funded research anddevelopment contracts of $604,000 for the three months ended September 30, 2005and there were no such offsets recorded for the three months ended September30, 2006.  In addition to our developmentof EUV and LTPS technologies, we also continued to focus on next generation ArFand KrF products. Included in our ArF product development efforts for 2006 isthe design of an enhanced universal platform for our XL series light sourcesand associated derivative products based on this platform. As a percentage oftotal revenues, research and development expenses decreased from 16.0% for thethree months ended September 30, 2005 to 13.1% for the three months endedSeptember 30, 2006 due primarily to revenues increasing at a faster rate thanresearch and development expenses in 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.  We expect that our investment in research anddevelopment expenses will continue.

*Salesand Marketing*. Salesand marketing expenses include the expenses of the sales, marketing andcustomer support staff and other marketing expenses.  Sales and marketing expenses increased 34%from $6.3 million for the three months ended September 30, 2005 to $8.4 millionfor the three months ended September 30, 2006. The increase in sales andmarketing expenses from period to period primarily reflects increases in profitsharing and bonuses, stock-based compensation expense associated with the newSFAS 123R requirements which were adopted in the first quarter of 2006, andincreased salary and benefits associated with increased sales and marketinghead count from period to period. As a percentage of total revenues, such salesand marketing expenses decreased from 6.3% for the three months ended September30, 2005 to 5.9% for the three months ended September 30, 2006.  We anticipate that sales and marketingexpenses may remain relatively flat for the fourth quarter of 2006 compared tothe third quarter levels.

*General and Administrative*.General and administrative expenses consist primarily of management andadministrative personnel costs, professional services, including external auditfees, and administrative operating costs. General and administrative expenses increased 17% from $7.8 million forthe three months ended September 30, 2005 to $9.1 million for the three monthsended September 30, 2006 primarily due to stock-based compensation expenserecorded in the third quarter of 2006 as a result of our adoption of SFAS 123Ron January 1, 2006. General and administrative expenses in the third

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quarter of 2006 also included increased profit sharingand bonus expenses, and increased external audit fees as compared to the thirdquarter of 2005.   General andadministrative expenses were also higher in the third quarter of 2006 comparedto the third 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 expensesdecreased from 7.8% for the three months ended September 30, 2005 to 6.3% for the three months ended September30, 2006.  We anticipate that general andadministrative expenses may remain relatively flat for the fourth quarter of2006 compared to the third quarter levels.

*Total Other Income (Expense) - Net.*  Netother income (expense) consists primarily of interest income and expense,foreign currency exchange gains and losses associated with fluctuations in thevalue of the functional currencies of our foreign subsidiaries against the U.S.dollar, and gains and losses associated with debt extinguishmenttransactions.  Net other income totaled$1.0 million and $3.7 million for the three months ended September 30, 2005 and2006, respectively. The increase in net other income was primarily due to anincrease in interest income from period to period. The increase in interestincome from 2005 to 2006 reflects higher market interest rate yields on largercash and investment balances which resulted from higher earnings andsignificant proceeds from stock option and warrant exercises during 2006.Foreign currency exchange losses totaled $165,000, interest income and otherincome totaled $2.7 million and interest expense totaled $1.5 million the threemonths ended September 30, 2005, compared to a foreign currency exchange lossof $243,000, interest and other income of $5.4 million, and interest expense of$1.5 million for the three months ended September 30, 2006.

*Income Tax Provision.* The tax provision of $1.2 million and $12.5 million for the threemonths ended September 30, 2005 and 2006, respectively, reflects an annualeffective rate of 7.06% and 33.8%, respectively.  The change in the annual effective tax ratefrom period to period was primarily attributable to the increase in pre-taxearnings as well as a reduction in tax benefits from U.S. export incentiveprograms and the expiration of the federal research credit. The annualeffective tax rate for the three months ended September 30, 2006 was less thanthe U.S. statutory rate of 35% primarily as a result of permanent book/taxdifferences and tax credits and is a function of current tax law and geographiclocation of pre-tax income. The federal Research and Experimentation Creditexpired December 31, 2005.  The ETI wasrepealed by the American Jobs Creation Act of 2004 subject to certaintransition rules.  The ETI exclusion isbeing replaced with a Manufacturing Activity deduction under IRC Section 199with a phase out of ETI benefits in 2005 and 2006.  Our estimated ETI benefit for 2006 reflectsthe transition rules.

**NINE MONTHS ENDED SEPTEMBER 30,2005 AND 2006**

Thefollowing table summarizes the components of our revenue (in thousands,except units sold):
|                                                  | ** ** | **For the nine months ended** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                       | ** ** | **September 30,**                            | ** ** |
| ** **                                       | ** ** | **2005**                                          | ** ** | **2006** | ** ** |
|                                             |       |                                              |       |   |   |
| Light source  systems:                           |       |                                              |       |   |   |
| Revenue                                          |       | $                                                 | 157,181    |   | $ | 212,016 |   |
| Units sold                                       |       | 159                                               |       | 212 |   |
| Average selling price (1)                        |       | $                                                 | 962        |   | $ | 1,000 |   |
|                                             |       |                                              |       |   |   |
| Consumable and  spare parts and service products |       | $                                                 | 122,817    |   | $ | 194,139 |   |
| Other revenue                                    |       | $                                                 | 857        |   | $ | 259 |   |
|                                             |       |                                              |       |   |   |
| Total revenue                                    |       | $                                                 | 280,855    |   | $ | 406,414 |   |

 

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(1)          Calculation of averageselling price excludes $4.2 million of deferred light source revenue that wasrecognized for the nine months ended September 30, 2005.  We had one arrangement where a portion of thelight source system fee was not payable until the system was installedsuccessfully at the end-user. This arrangement expired in March 2005.

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Product sales increased 45% from $280.0****million for the nine months ended September 30, 2005 to$406.2 million for the nine months ended September 30, 2006.  This increase in product sales was due tohigher light source system revenues and higher consumable and spare parts andservice products revenues for the nine months ended September 30, 2006 comparedto the nine months ended September 30, 2005. Light source system revenues increased 35% from $157.2 million for thenine months ended September 30, 2005 to $212.0 million for the nine monthsended September 30, 2006.  A total of 159light source systems were sold in the nine months ended September 30, 2005 atan average selling price of $962,000, compared to 212 light source systems soldin the nine months ended September 30, 2006 at an average selling price of $1.0million. On a foreign currency adjusted basis, the average selling price forthe nine months ended September 30, 2005 was $961,000 compared to $996,000 forthe nine months ended September 30, 2006. The slight increase in the averageselling price from period to period reflects the higher percentage of our lightsource systems sales coming from higher priced advanced ArF products in thenine months ended September 30, 2006 as compared to the nine months endedSeptember 30, 2005. The increase in quantities of light source systems soldfrom period to period was due to the slight slowdown and flattening of theindustry in the beginning of 2005 compared to the upturn in the semiconductorindustry in 2006. Chipmakers expanded capacity needs have impacted the demandfor our light source systems, and that combined with our growing installed baseof light source systems has increased demand for our consumables and spareparts and service products. This increased demand for consumable and spareparts and the rising tool utilization resulted in an increase in consumable andspare parts and service revenues of 58% from $122.8 million for the nine monthsended September 30, 2005 to $194.1 million for the nine months ended September30, 2006. Consumable and spare parts and service products revenue was alsofavorably impacted by the revenue recorded under a laser replacement agreementwe entered into at the beginning of 2006. Revenues from funded developmentcontracts were $857,000 for nine months ended September 30, 2005, compared to$259,000 for the nine months ended September 30, 2006. There were no revenuesrecorded or earned associated with the TCZ joint venture for the nine monthsended September 30, 2006.

Sales to our three lithography tool manufacturingcustomers, ASM Lithography, Canon, and Nikon, amounted to 32%, 8% and 25%,respectively, of total revenue for the nine months ended September 30, 2005,and 38%, 6% and 15%, respectively, of total revenue for the nine months endedSeptember 30, 2006.

Approximately84% of our sales for both the nine months ended September 30, 2005 and 2006,were derived from customers outside the U.S. Revenues from Japanese customers,generated primarily by Cymer Japan, accounted for 32% and 21% of total revenuesfor the nine months ended September 30, 2005 and 2006, respectively.

*Cost of Product Sales*.  The cost of product sales increased 26% from$168.2 million for the nine months ended September 30, 2005 to $211.7 millionfor the nine months ended September 30, 2006. This increase in the cost ofproduct sales was primarily due to higher light source system sales and salesof consumables and spare parts and service products in the nine months endedSeptember 30, 2006 compared to the nine months ended September 30, 2005.The increased product sales and overall mix of products resulted in improvedgross margin on product sales from period to period.  The gross margin on product sales was39.9% for the nine months ended September 30, 2005 as compared to 47.9% for thenine months ended September 30, 2006. This higher gross margin from period toperiod was primarily due to increased factory yield, improved overallefficiencies, reduced lead and cycle times and improved warranty performance.

*Research and Development*. Research and development expenses increased 18% from $47.5 million forthe nine months ended September 30, 2005 to $55.9 million for the nine monthsended September 30, 2006 due primarily to costs associated with our LTPSproduct development efforts, EUV light source development and ArF productdevelopment efforts for the design of an enhanced universal platform for our XLseries light sources and associated derivative products based on this platform.Research and development expenses were offset by amounts related to ourexternally funded research and development contracts of $2.4 million and $154,000for the nine months ended September 30, 2005 and 2006, respectively.  In addition to our development of EUV andLTPS technologies, we also continued

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to focus on next generation ArF and KrF products.   As a percentage of total revenues, researchand development expenses decreased from 16.9% for the nine months endedSeptember 30, 2005 to 13.7% for the nine months ended September 30, 2006 dueprimarily to increased research and development activities and higher revenuesin 2006 as compared to 2005.  As a resultof our 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.

*Sales andMarketing*. Sales andmarketing expenses increased 20% from $18.8 million for the nine months endedSeptember 30, 2005 to $22.6 million for the nine months ended September 30,2006. The increase in sales and marketing expenses from period to period primarilyreflects increases in profit sharing and bonuses, stock-based compensationexpense associated with the new SFAS 123R requirements which were adopted inthe first quarter of 2006, increased salary and benefits associated with anincrease in sales and marketing head count from period to period, and employerpayroll taxes related to stock option exercises which occurred in the firstnine months of 2006. In addition, sales and marketing expenses were higher inthe first nine months of 2006 compared to the first nine months of 2005 as aresult of expenses associated with our TCZ joint venture which was formed inJuly 2005. Sales and marketing expenses in the nine months ended September 30,2005 also included higher expenses than in the first nine months of 2006associated with our chipmaker customers at our foreign locations. As apercentage of total revenues, such sales and marketing expenses decreased from6.7% for the nine months ended September 30, 2005 to 5.6% for the nine monthsended September 30, 2006.

*General and Administrative*.General and administrative expenses increased 39% from $20.1 million for thenine months ended September 30, 2005 to $27.9 million for the nine months endedSeptember 30, 2006 primarily due to stock-based compensation expense recordedin the first nine months of 2006 upon our adoption of SFAS 123R in January2006. In addition, general and administrative expenses in 2006 also includedincreased profit sharing and bonus expenses, employer payroll taxes associatedwith stock option exercises that occurred in the first nine months of 2006 andincreased external audit fees during the period. General and administrativeexpenses were also higher in the first nine months of 2006 compared to thefirst nine months of 2005 as a result of expenses associated with our TCZ jointventure which was formed in July 2005. As a percentage of total revenues,general and administrative expenses decreased from 7.2% for the nine monthsended September 30, 2005 to 6.9% for the nine months ended September 30, 2006.

*Total Other Income (Expense) - Net.*   Net other income totaled $3.6 million and$14.4 million for the nine months ended September 30, 2005 and 2006,respectively. The increase in net other income was primarily due to asignificant increase in interest income, the receipt of $3.2 million in lifeinsurance proceeds following the death of one of our executive officers in thefirst quarter of 2006, a decrease in interest expense and a foreign currencyexchange gain recorded in the first nine months of 2006 as compared to aforeign currency exchange loss recorded in the first nine months of 2005. Theincrease in interest income from 2005 to 2006 reflects higher market interestrate yields on larger cash and investment balances which resulted from higherearnings and significant proceeds from stock option and warrant exercisesduring the first nine months of 2006. The decrease in interest expense fromperiod to period was due to our lower debt balances as a result of therepurchase of our convertible subordinated notes that we made in the secondquarter of 2005. Other income was positively impacted in 2005 by a $2.2 milliongain on debt extinguishment which resulted from the repurchase of theseconvertible subordinated notes Foreign currency exchange loss totaled $932,000,interest income and other income totaled $7.7 million, interest expense totaled$5.4 million and the gain on debt extinguishment totaled $2.2 million for thenine months ended September 30, 2005, compared to a foreign currency exchange gainof $856,000, interest and other income of $17.9 million, and interest expenseof $4.4 million for the nine months ended September 30, 2006.

*Income Tax Provision.* The tax provision of $2.1 million and $34.7 million for the ninemonths ended September 30, 2005 and 2006, respectively, reflects an annualeffective rate of 7.06% and 33.8%, respectively.  The change in the annual effective tax ratefrom period to period was primarily attributable to the increase in pre-taxearnings as well as a reduction in tax benefits from U.S. export incentiveprograms

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and the expiration of the federal research credit. Theannual effective tax rate for the nine months ended September 30, 2006 was lessthan the U.S. statutory rate of 35% primarily as a result of permanent book/taxdifferences and tax credits.

**LIQUIDITY AND CAPITAL RESOURCES**

Historically we have funded our operations primarilyfrom cash generated from operations, the proceeds of the note offerings, bankborrowings, and the proceeds from employee stock option exercises.  As of September 30, 2006, we hadapproximately $254.2 million in cash and cash equivalents, $198.1 million inshort-term investments, $9.8 million in long-term investments, and $629.5million in working capital.

InFebruary 2002, we issued $250.0 million in aggregate principal amount in aprivate placement of notes.  These notesare due on February 15, 2009 with interest payable semi-annually on February 15and August 15 of each year at 3.50% per annum. The notes are convertible into shares of our common stock at aconversion rate of 20 shares per $1,000 principal amount or an effectiveconversion price of $50.00 per share.  Weused a portion of the net proceeds from this private placement to redeem thepreviously issued notes that were then outstanding. The remaining proceeds arebeing used for our operating, investing and financing activities.  With the approval of our board of directors,we have periodically repurchased these notes in the open market.  We repurchased $60.0 million principal amountof these notes in 2005. As of September 30, 2006, there were $140.7 millionprincipal amount of notes outstanding.

Netcash provided by operating activities was approximately $90.4 million and $67.3million for the nine months ended September 30, 2005 and 2006, respectively.Although net income for the nine months ended September 30, 2006 wassignificantly higher than the same period in 2005, cash provided by operatingactivities was much lower in the first nine months of 2006 as compared to thefirst nine months of 2005. This is primarily attributable to significantincreases in accounts receivable and inventories for the nine months endedSeptember 30, 2006 compared to decreases in these same items for the ninemonths ended September 30, 2005.  The increasein accounts receivable is the result of higher revenues recorded during thethird quarter of 2006 compared to the same period in 2005. The increase ininventory balances for the nine months ended September 30, 2006 is primarilythe result of the increased demand for spares and consumable parts to supportour growing installed base of light source systems, particularly our moreadvanced XLA series systems. In addition, cash from operations was negativelyimpacted for the nine months ended September 30, 2006 as a result ofclassifying excess tax benefits from stock option exercises in the amount of$18.9 million in financing activities in 2006 rather than operating activitiesin accordance with SFAS 123R which we adopted on January 1, 2006.

Netcash provided by investing activities was approximately $31.9 million for thenine months ended September 30, 2005 compared to $72.6 million used ininvesting activities for the nine months ended September 30, 2006.  Net cash provided by investing activitiesduring the nine months ended September 30, 2005 reflects the timing ofshort-term and long-term investments that matured and were reinvested duringthe period, and the acquisition of $14.8 million of property and equipment. Netcash used in investing activities for the nine months ended September 30, 2006was due primarily to the timing of short-term and long-term investments thatmatured and were reinvested during the period, a $7.0 million payment toacquire the final 19% minority interest in our Cymer Korea subsidiary, a $8.2million payment to acquire certain patent license rights and the acquisition of$10.0 million of property and equipment.

Netcash used in financing activities was approximately $83.6 million for the ninemonths ended September 30, 2005, compared to net cash provided by financingactivities of $21.9 million for the nine months ended September 30, 2006. Netcash used in financing activities for the nine months ended September 30, 2005reflects the repurchase of treasury stock of $50.0 million and the purchase ofapproximately $60.0 million principal amount of our convertible subordinatednotes, at a discount to par, in the first and second quarters of 2005. Thetreasury stock and note purchases were offset by proceeds received from theexercise of employee stock options totaling $12.6 million and the minorityinterest

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investment received from Zeiss in the TCZ jointventure of $11.1 million during the nine months ended September 30, 2005.  Net cash provided by financing activities forthe nine months ended September 30, 2006 reflects the proceeds received fromthe exercise of employee stock options, the proceeds from the exercise ofwarrants, and proceeds from the employee stock purchase plan totaling $103.7million.  In addition, cash from financingactivities in 2006 was positively affected by the excess tax benefits for theperiod from stock option exercises which totaled $18.9 million.  This cash provided by financing activitieswas offset by the repurchase of treasury stock totaling $100.7 million duringthe second quarter of 2006.

We require substantial working capital to fund ourbusiness, particularly to finance inventories, including purchase orders withour vendors, accounts receivable, and for capital expenditures.  Our future capital requirements depend onmany factors, including our manufacturing activity, the timing and extent ofspending to support product development efforts, expansion of sales andmarketing 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.

AtSeptember 30, 2005 and 2006, we did not have any relationships withunconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance, variable interest, or special purposeentities, which would have been established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes.  In addition, we did not engagein trading activities involving non-exchange traded contracts.  As a result, we are not exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin such relationships.  We do not haverelationships and transactions with persons and entities that derive benefitsfrom their non-independent relationship with us or our related parties exceptas disclosed herein.

**RECENTACCOUNTING 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 and 124-1 is to provide guidance foridentifying other-than-temporarily impaired investments. FSP 115-1 and 124-1also provides new disclosure requirements for investments that are deemed to betemporarily impaired. Thedisclosure requirements are effective in annual financial statements for fiscalperiods beginning after December 15, 2005. We do not believe that the implementation of FSP FAS 115-1 and FAS 124-1will have a material impact on our consolidated financial statements.

In July 2006, the FASBissued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty inIncome Taxes”.  FIN 48 clarifies theaccounting 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 is effective for fiscal yearsbeginning after December 15, 2006.  We are currently assessing theimpact that the adoption of FIN 48 will have on our consolidated financialstatements.

In September 2006,FASB issued Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”),“Fair Value Measurements”. SFAS No. 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles(“GAAP”), and expands disclosures related to fair value measurements. ThisStatement applies under other accounting pronouncements that require or permitfair value measurements, the FASB having previously concluded in thoseaccounting pronouncements that fair value is the relevant measurementattribute. Accordingly, SFAS No. 157 does

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not require any new fair value measurements. However, for some entities,the application of this Statement will change current practice. This Statementis effective for us on January 1, 2008. We are currently evaluating the impactof this pronouncement on our consolidated financial statements.

In September 2006,the FASB issued Statement of Financial Accounting Standards No. 158 (“SFASNo. 158”), “Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans—an Amendment of FASB Statements No. 87, 88, 106, and132(R)”. SFAS No. 158 requires an employer to recognize the overfunded orunderfunded status of a defined benefit postretirement plan (other than amultiemployer plan) as an asset or liability in its statement of financialposition and to recognize changes in that funded status in the year in whichthe changes occur through other comprehensive income of a business entity orchanges in unrestricted net assets of a not-for-profit organization. SFAS No.158 also requires an employer to measure the funded status of a plan as of thedate of its year-end statement of financial position. We do not believe thatthe adoption of SFAS No. 158 will have a material effect on our consolidatedfinancial statements.

InSeptember 2006, the Securities and Exchange Commission (“SEC”) issuedStaff Accounting Bulletin No. 108 (“SAB No. 108”), “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements”, which provides interpretive guidance on the considerationof the effects of prior year misstatements in quantifying current yearmisstatements for the purpose of a materiality assessment. SAB No. 108 iseffective for fiscal years ending after November 15, 2006. Earlyapplication is encouraged, but not required. We are required to adopt SAB No.108 for our fiscal year ending December 31, 2006. We are currently assessingthe impact, if any, the adoption of SAB No. 108 in the fourth quarter of 2006will have on our consolidated financial statements.

#### **Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

# **Foreign Currency Risk**

We conduct business in severalinternational currencies through our global operations. Due to the large volumeof our business that we conduct in Japan, the Japanese operation poses ourgreatest 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 forward contracts forspeculative purposes.

As of September 30, 2006, we hadoutstanding forward contracts to buy U.S. $30.6 million for 3.8 billion yenunder foreign currency exchange facilities with contract rates ranging from109.76 yen to 117.33****yen per U.S.dollar.  These contracts expire onvarious dates through February 2007.

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 gain (net of tax) forthose that qualify for hedge accounting treatment totaled $822,000 and $54,000respectively, as of September 30, 2006.

The fair value of these forward contracts as ofSeptember 30, 2006 would have fluctuated by $3.1 million if the foreigncurrency exchange rate for the Japanese yen to the U.S. dollar on these forwardcontracts had changed by 10%.

# **Investment and Debt Risk**

We maintain an investment portfolioconsisting primarily of government and corporate fixed income securities,certificates of deposit and commercial paper. While it is our general intent to hold such

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securities until maturity, we will occasionally sellcertain securities for cash flow purposes. Therefore, our investments areclassified as available-for-sale and are carried on the balance sheet at fairvalue.  Due to the conservative nature ofthe investment portfolio, a sudden change in interest rates would not have amaterial effect on the value of the portfolio.

InFebruary 2002, we issued $250.0 million principal amount of unsecured fixedrate 3.50% Convertible Subordinated Notes due February 15, 2009.  Interest on these notes is payable onFebruary 15 and August 15 of each year. The notes are convertible into shares of our common stock at aconversion rate of 20 shares per $1,000 principal amount subject to adjustmentunder certain conditions. We may redeem the notes after February 20, 2005 atcertain redemption prices expressed as a percentage of the principal amount.The notes are subordinated to our existing and future senior indebtedness andeffectively subordinated to all indebtedness and other liabilities of oursubsidiaries.  Because the interest rateis fixed, we believe there is no risk of increased interest expense. Thesenotes are recorded at face value on the consolidated balance sheets. In thethird quarter of 2004 and the second quarter of 2005, we repurchased, at a discountto par, approximately $49.2 million and $60.0 million principal amount,respectively, of these notes.  As ofSeptember 30, 2006, $140.7 million principal amount of the notes wereoutstanding.  The fair value of such debtbased on quoted market prices on September 30, 2006 was $145.3 million.

**ITEM4.  Controls and Procedures**

*Evaluation of disclosure controls and procedures*.  For the third quarter of 2006, our chiefexecutive officer and our chief financial officer, evaluated the effectivenessof our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”))as of September 30, 2006, and concluded that as of such date, our disclosurecontrols and procedures were not effective in ensuring that informationrequired to be disclosed by us in the reports that we file under the ExchangeAct is recorded, processed, summarized and reported within the time periodspecified in the rules and forms of the Securities and Exchange Commission.

Thisconclusion was based solely on our assessment of the company’s processes andcontrols related to our accounting for income taxes described in our 2005 Form10-K, more specifically those policies and procedures over the reconciliation ofincome tax accounts which were not designed with adequate precision and ourpolicies and procedures over foreign tax provisions that did not provide foradequate review.  These deficienciesresulted in errors in our consolidated tax provision for our year endedDecember 31, 2005. Such errors were corrected prior to the issuance of ourconsolidated financial statements at and for the year ended December 31,2005.  These deficiencies also resultedin a more than remote likelihood that a material misstatement to ourconsolidated financial statements would not be prevented or detected.  As described in Part II, Item 9A of our Form10-K for the year ended December 31, 2005, we have implemented a plan toremediate this material weakness.

*Changes in internal control over financial reporting.*Therehas been no change in our internal control over financial reporting during thequarter ended September 30, 2006 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reportingother than the steps taken by us to remediate the material weakness that wasfirst disclosed by us in our 2005 Form 10-K relating to our accounting forincome taxes.

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

·                  Improved theprocedures for reviewing our consolidated tax provisions and reconciling allsubsidiary office tax accounts; and

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

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Wehave been conducting our testing of these new internal controls since early2006 and will continue to do so for the remainder of the year. We will not beable to completely remediate this material weakness in our accounting forincome taxes until we can conduct testing of the 2006 end of year internalcontrols for income taxes in early 2007.

**PART II. OTHER INFORMATION**

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

None.

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

*The risksdescribed below may not be the only risks we face. Additional risks that we donot currently think are material may also impair our business operations.  The risk factors set forth below with anasterisk (*) next to the title contain changes to the description of the riskfactors associated with our business as previously disclosed in Item IA to ourAnnual Report on Form 10-K for the fiscal year ended December 31, 2005 If anyof the events or circumstances described in the following risks actually occur,our business, financial condition or results of operations could suffer, andthe trading price of our common stock could decline.*

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

Factors that contribute tofluctuations in our revenues and operating results include:

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

·      cyclicality in the market for semiconductor manufacturingequipment;

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

·                  rates at which ourcustomers take delivery of light source systems from us;

·      timing and size of orders from our customer base;

·      changes in market penetration by our competitor;

·                  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 and profitability of our products;

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

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

·      our ability to manage our manufacturing requirements;

·                  our ability to managecustomer satisfaction, product reliability, and direct field service andsupport effectiveness;

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

·      worldwide political instability;

·      changing global economic conditions, including rising energyprices; and

·      intellectual property protection.

We have historically derived alarge portion of our quarterly and annual revenues from selling a small numberof light source systems. Because we sell a small number of products, theprecise time that we recognize revenue from an order may have a significantimpact on our total revenue for a particular

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period. Our customers may cancelor reschedule orders with little or no penalty. Orders expected in one quartercould shift to another period due to changes in the anticipated timing of ourcustomers’ purchase decisions or rescheduled delivery dates requested by ourcustomers. Our operating results for a particular quarter or year may beadversely affected if our customers, particularly our three largest customers,cancel or reschedule orders, or if we cannot fill orders in time due tounexpected delays in manufacturing, testing, shipping, and product acceptance.

We manage our expense levelsbased, in large part, on expected future revenues. As a result, our expensesare relatively fixed for the short term, and if our actual revenue decreasesbelow the level we expect, our operating results will be adverselyaffected.  As a result of these or otherfactors, we could fail to achieve our expectations as to future revenue, grossprofit and operating income.  Our failureto meet the performance expectations set and published by external sourcescould result in a sudden and significant drop in the price of our stock,particularly on a short-term basis, and could negatively affect the value ofany investment in our stock.

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

We derive a substantial portionof our revenues from photolithography tool manufacturers, or original equipmentmanufacturer (“OEM”) customers, who incorporate our light source systems inphotolithography tools that they sell to semiconductor manufacturers, orchipmakers, and from chipmakers who purchase consumables, spare parts, upgradesand service directly from us.  Like us,our OEM customers depend on demand for their products from the chipmakers. Thecapital equipment and related operating expenditures of chipmakers depend on anumber of factors, including the current and anticipated market demand forsemiconductors and the many products using semiconductors.  That demand is highly volatile andunpredictable.

As a result of the cyclicalityof the semiconductor industry, the semiconductor capital equipment industryhistorically has experienced periodic ups and downs. The cyclical nature of thesemiconductor and the semiconductor capital equipment industries affects ourability to accurately predict future revenue and therefore our ability tomanage our future expense levels. When cyclical fluctuations result in lowerthan expected revenue levels, operating results may be adversely affected andcost reduction measures may be necessary in order for us to remain competitiveand financially sound.  During a downcycle or slowdown, we must be in a position to adjust our cost and expensestructure to prevailing market conditions while still being able to motivateand retain our key employees. During periods of rapid growth, we must be ableto increase manufacturing capacity and personnel to meet customer demand.  We can provide no assurance that theseobjectives can be met in a timely manner in response to industry cycles.  We are not able to predict with any certaintythe duration of any industry cycle or the timing or order of magnitude of anyrecovery.

Downturns in the semiconductor industry often result indecreases in demand for semiconductor manufacturing equipment, including thephotolithography tools that our OEM customers produce. The most recent downturnin the semiconductor industry had a severe effect on the demand for semiconductormanufacturing equipment. Fluctuating levels of investment by chipmakers andresulting pricing volatility will continue to materially affect our aggregatebookings, revenues and operating results. Even during periods of reducedrevenues we believe we must continue to invest in research and development andto maintain extensive ongoing worldwide customer service and supportcapabilities to remain competitive. Continued spending in furtherance of theseobjectives may temporarily 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. Anyfailure to meet such expectations could materially adversely affect the priceof our common stock.

Our OEM customers try to managetheir inventories and production requirements to appropriate levels thatreflect their expected sales to chipmakers. Market conditions in thesemiconductor industry and our OEM customers’ production efficiency can causethem to expand or reduce their orders for new light

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source systems as they try tomanage their inventories and production requirements. We continue to work withour OEM customers to better understand these issues. However, we cannotguarantee that we will be successful in understanding our OEM customers’inventory management and production requirements or that our OEM customers willnot build up an excess inventory of light source systems. If our OEM customersretain an excess inventory of light source systems, our revenue could bereduced in future periods as the excess inventory is utilized, which couldadversely affect our operating results, financial condition and cashflows.  If our OEM customers demandshorter product lead times to improve their inventory and cash positions, ourinventory management and cash position may be negatively impacted, which mayadversely affect our operating results, financial condition and cash flows.

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

Three large companies, ASMLithography, Canon and Nikon dominate the photolithography tool business.Collectively, these three companies accounted for the following percentage ofour total revenue during the periods indicated:
|                 | ** ** | **Nine months ended** | ** ** |
|-----------------|------------|---------------------------------|------------|
| ** **      | ** ** | **September 30,**          | ** ** |
| ** **      | ** ** | **2005**                        | ** ** | **2006** | ** ** |
|            |       |                            |       |   |   |
| ASM Lithography |       | 32                              | %          | 38 | % |
| Canon           |       | 8                               | %          | 6 | % |
| Nikon           |       | 25                              | %          | 15 | % |
|            |       |                            |       |   |   |
| Total           |       | 65                              | %          | 59 | % |

 

Collectively, these threecompanies accounted for the following percentage of our total accountsreceivable at the dates indicated:
|                 | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------|------------|-----------------------|------------|------------------------|------------|
| ** **      | ** ** | **2005**              | ** ** | **2006**               | ** ** |
|            |       |                  |       |                   |       |
| ASM Lithography |       | 36                    | %          | 47                     | %          |
| Canon           |       | 5                     | %          | 3                      | %          |
| Nikon           |       | 25                    | %          | 21                     | %          |
|            |       |                  |       |                   |       |
| Total           |       | 66                    | %          | 71                     | %          |

 

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

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

·      a customer experiencing lithography tool production problems;

·      a decision to purchase light sources from other suppliers;

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

·                  a decline in a customer’sfinancial condition.

Theloss of any significant business from or production problems for any one ofthese three customers would harm our business and financial condition.

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

Our only current product lineis excimer light source systems, including KrF and ArF systems, and support,including consumable and spare parts and service support.  We expect these light source systems and therelated support to continue to account for a substantial majority of ourrevenues in the near term. Continued market acceptance of our light sourcesystem products is, therefore, critical to our future success. The primarymarket for excimer light sources is in the use of DUV photolithography equipmentfor manufacturing deep-submicron semiconductor devices using smaller circuitgeometries. The demand for our products depends in part on the rate at whichchipmakers further adopt excimer light sources as the chosen light source fortheir photolithography tools.

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

·                  inadequate performanceof photoresists used in advanced DUV photolithography;

·      potential shortages of specialized materials used in DUVoptics;

·      productivity of 300 mm photolithography tools relative to 200mm tools; and

·      consolidation of chipmakers.

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

·      a decline in demand for our customers’ DUV photolithographytools;

·      a failure to achieve continued market acceptance of ourproducts;

·                  a failure to managecustomer satisfaction, product reliability, and direct field service andsupport effectiveness;

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

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

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

**We depend on the introduction ofnew products for our success, and we are subject to risks associated with rapidtechnological change.***

Rapid technological changes in semiconductormanufacturing processes subject us to increased pressure to developtechnological advances enabling such processes. We believe that our futuresuccess depends in part upon our ability to develop, manufacture, timelyintroduce and support new light source products with improved capabilities andto continue to enhance our existing light source systems and processcapabilities.  Due to the risks inherentin transitioning to new products, we must forecast accurate demand for newproducts while managing the transition from older products.

Our most significant product introduction in recentyears consisted of a technology change from a single-discharge-chamber excimerlight source to a dual-discharge-chamber design called MOPA.  The MOPA design represents a paradigm shiftfrom previously accepted lithography technology and offers chipmakers higherpower, tighter bandwidth and lower cost of operation for their current – and weexpect for their future – optical lithography applications.  As originally designed, the MOPA architecturewas projected to provide its benefits across all three DUV wavelengths – 248nm, 193 nm, and 157 nm – but at this time, the semiconductor industry has onlyadopted MOPA at the 193 nm wavelength, due to the successful extension of 248nm single chamber technology, and the omission of 157 nm lithography from theroadmap.  There are risks inherent in theongoing transition to the MOPA technology, including effective execution of ourproduct development roadmap, continuing adoption of the product by lithographytool manufacturers and chipmakers, manufacturability, cost effectiveness, andproduct

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performance in the field of thenew products and the development of a comparable product by our competitor.

At this time, chipmakers are continuing to expand theirmanufacturing capacity at 90 nm, while manufacturers of certain types of memorychips are in the early stages of production at 65 nm and planning forproduction of chips with even smaller CDs. These efforts, along with initial development of ArF immersionlithography capabilities among a number of chipmakers, are driving demand forour most advanced ArF light sources.  Atthe same time chipmakers also need tools for the less critical layers onwafers, and there remains strong demand for our KrF light source products forDUV photolithography systems as well. After chipmakers have built theircapacity to levels appropriate to meet existing demand, their demand for ourlight source products will depend, in part, on their sales forecasts and theirestimates regarding the duration and magnitude of the current industry cycleand whether their projected manufacturing process yields will enable ongoinginvestments in whatever capacity seems necessary.

Future technologies such as EUV, electron projectionlithography, and maskless lithography may render our excimer light sourceproducts obsolete. We must manage product transitions, as introduction of newproducts could adversely affect our sales of existing products. If new productsare not introduced on time, or have reliability or quality problems, ourperformance may be impacted by reduced orders, higher manufacturing costs,delays in acceptance of and payment for new products, and additional serviceand warranty expenses. We may not be able to develop and introduce new productsor enhancements to our existing products and processes in a timely or costeffective manner that satisfies customer needs or achieves market acceptance.Failure to develop and introduce these new products and enhancements couldmaterially adversely affect our operating results, financial condition and cashflows.

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

**Failure to maintain effectivelyour direct field service and support organization could have a material adverseeffect on our business.***

We believe it is critical forus to provide quick and responsive service directly to the chipmakersthroughout the world that use our light source products in theirphotolithography systems, and that it is essential to maintain our ownpersonnel or trained third-party resources to provide these services.  Accordingly, we have an ongoing effort todevelop our direct support system with locations in Europe, Korea, Japan, thePeople’s Republic of China, Singapore, Taiwan and the U.S. This requires us todo the following:

·      recruit and train qualified field service personnel;

·      identify qualified independent firms; and

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

We may not be able to attractand train qualified personnel to maintain our direct support operationssuccessfully. We may not be able to find and engage qualified third-partyresources to supplement and enhance our direct support operations.  Further, we may incur significant costs inproviding these support services. Failure to implement our direct supportoperation effectively could harm our operating results, financial condition andcash flows.

**We must develop andmanufacture enhancements to our existing products and introduce new products inorder to continue to grow our business. We may not effectively manage ourgrowth and integrate these new enhancements and products, which couldmaterially harm our business.**

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To continue to grow ourbusiness, our existing light source products and their process capabilitiesmust be enhanced, and we must develop and manufacture new products to serveother semiconductor applications. We cannot guarantee that we will be able to manageour business to grow effectively. Nor can we guarantee that we will be able toaccelerate the development of new enhancements to our existing products andcreate new products. Further, we may not be able to effectively integrate newproducts and applications into our current operations. Any of these risks couldmaterially harm our business, financial condition and results of operations.

**We must effectively managechanges in our business.***

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

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

·      closely manage our global operations;

·      improve our process and other internal management systems;

·      quickly adapt to changing sales and marketing channels;

·      effectively manage our inventory levels; and

·      attract, train, retain and manage key personnel.

If we fail to effectivelymanage changes in our business, our operating results, financial condition andcash flows will be adversely affected.

**We depend on a few key suppliers for purchasing components andsubassemblies that are included 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.  Forcertain optical, control system and pulse power components and subassembliesused in our light source systems, we currently utilize a single supplier.  To reduce the risk associated with thissingle supplier, we carry a significant strategic inventory of thesecomponents.  Strategic inventories aremanaged as a percentage of future demand. We have also negotiated to have vendor-managed inventory of criticalcomponents to further reduce the risk of a single supplier.  Inaddition, we contract the manufacture of various subassemblies of our productsand depend on our contract manufacturers to deliver to our requiredspecifications, schedule, and quality standards. Further, some of our suppliershave specialized in supplying equipment or manufacturing services tosemiconductor equipment manufacturers and therefore are susceptible to industryups and downs and subject to the same risks and uncertainties regarding theirability to respond to changing market conditions.  Because many of these suppliers reduce thesize of their workforce in an industry downturn and increase it in an upturn,they may not be able to meet our requirements or respond quickly enough as anupturn begins and gains momentum.  Due to the nature of ourproduct development requirements, these key suppliers must rapidly advancetheir own technologies and production capabilities in order to support theintroduction schedule of our new products. These suppliers may not be able toprovide new modules and subassemblies when they are needed to satisfy ourproduct schedule requirements. If we cannot purchase enough of these materials,components or subassemblies, or if these items do not meet our qualitystandards, there could be delays or reductions in our product shipments, whichwould harm our operating results, financial condition and cash flows.

**We face competition fromone company and may face competition from additional competitors who enter themarket.***

We currently have onesignificant competitor that sells light sources for DUV photolithographyapplications. This competitor, Gigaphoton, is a joint venture between two largecompanies, Komatsu and Ushio, and is headquartered in Japan. Gigaphoton isaggressively trying to gain larger market penetration

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in the excimer light sourceindustry. 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 knowthat Gigaphoton has been approved by and has an installed base of services atchipmakers in Japan, the U.S. and elsewhere for producing excimer lightsources.  

Larger companies withsubstantially greater resources, such as other manufacturers of industriallight sources for advanced lithography, may attempt to sell competitiveproducts to our customers. Potential competitors may also be attracted to ourgrowing installed base of light sources which represents a steady andsignificant consumable and spare parts revenue stream for us, and they mayattempt to supply consumable and spare parts to that installed base. If anyexisting or future competitors gain market acceptance we could lose marketshare and our growth could slow or decline, which could have a material adverseeffect on our operating results, financial condition and cash flows.

**Chipmakers’ prolonged useof our products in high volume production may not produce the results theydesire and, as a result, our reputation and that of our customers who supplyphotolithography tools to the chipmakers could be damaged in the semiconductorindustry.***

Over time, our light sourceproducts may not meet chipmakers’ production specifications or operating costrequirements after the light source has been used for a long period in highvolume production. If any chipmaker cannot successfully achieve or sustaintheir volume production using our light sources, our reputation could bedamaged with chipmakers and lithography tool manufacturers. This would harm ourbusiness.

**We depend on keypersonnel, especially management and technical personnel, who may be difficultto attract and retain.**

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

·      research and development;

·      engineering;

·      sales and marketing; 

·      field service and support;

·      manufacturing; and

·      management.

In particular, there are alimited number of experts in excimer light source technology, and we requirehighly skilled hardware and software engineers. Competition for qualifiedpersonnel is intense and we cannot guarantee that we will be able to continueto attract and retain qualified personnel as needed.  We do not have employment agreements withmost of our employees. We believe that our future growth and operating resultswill depend on:

·                  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, trainand retain key personnel as required, our operating results,  financial condition and cash flows could beadversely affected.

**Economic, political, regulatoryand other events in geographic areas where we have significant sales oroperations could interfere with our business.***

We serve an increasingly globalmarket.  A large portion of our totalrevenues is derived from customers located outside of the U.S.  We expect our international sales to continueto account for a very

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large portion of our totalrevenues.  In order to support ourforeign customers, we maintain a manufacturing and field service subsidiary inKorea as well as field service and support subsidiaries in Japan, theNetherlands, the People’s Republic of China, Singapore and Taiwan.

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

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

·      unexpected changes in regulatory requirements;

·      fluctuations in exchange rates and currency controls;

·      political and economic conditions and instability;

·                  imposition of 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 staffing and managing foreign subsidiary andbranch operations;

·      limited intellectual property protection in some countries;

·      potentially adverse tax consequences in some countries;

·      the possibility of accounts receivable collection difficulties;

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

·      the effect of acts of terrorism and war; and

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

Many ofour major customers and many of the chipmakers who use our light sourceproducts in their photolithography systems are located in Asia. Economicproblems and currency fluctuations affecting these regions in Asia could createa larger risk for us. Further, even though it has not been difficult for us tocomply with U.S. export controls, these export rules could change in the futureand make it more difficult or impossible for us to export our products to manycountries.  Any of these vulnerabilitiescould have a material adverse effect on our business, financial condition andresults of operations.

**Our ability to compete could bejeopardized if we are unable to protect our intellectual property rights. Thesetypes of claims could seriously harm our business or require us to incursignificant costs.***

We believe our success andability to compete depend in large part upon protecting our proprietarytechnology. We rely on a combination of patent, trade secret, copyright andtrademark laws, nondisclosure and other contractual agreements and technicalmeasures to protect our proprietary rights.

As of September 30, 2006, weowned 247 U.S. patents covering certain aspects of technology related to light sourcesand piezo techniques. These patents will expire at various times during theperiod from January 2008 to September 2025. As of September 30, 2006, we had applied for 138 additional patents inthe U.S.  As of September 30, 2006, weowned 376 foreign patents and had 377 patent applications pending in variousforeign countries.

Our pending patent applicationsand any future applications might not be approved. Our patents might notprovide us with a competitive advantage and may be challenged by third parties.In addition, third parties’ patents might have an adverse effect on our abilityto do business. As a result of cost constraints, we did not begin seekingpatent protection in Japan and other countries for our inventions that arecovered by U.S. patents and patent applications until 1993.  As a result we do not have the right to seekforeign patent protection for some of our early inventions.  Additionally, laws of some foreign countriesin which our products are or may be developed, manufactured or sold, includingvarious countries in Asia, may not protect our products or intellectualproperty rights to the same extent as do the laws of the U.S. Thus, thelikelihood of piracy of our technology and products is greater in thesecountries.

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Further, third parties mightindependently develop similar products, duplicate our products, or designaround patents that are granted to us.

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

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

·      trade secret protection;

·      employee nondisclosureagreements; 

·      third-party nondisclosureagreements; and

·      other intellectual property protection methods.

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

·      independently developsubstantially the same proprietary information and techniques;

·      gain access to our tradesecrets; or

·      disclose our technology.

**The parties to whom we provideresearch and development services may dispute the ownership of the intellectualproperty that we develop performing these services.***

In the past, funds fromresearch and development arrangements with third parties have been used to payfor a portion of our own research and development expenses. We receive thesefunds from government-sponsored programs and customers, in connection with ourdesigning and developing specific products. Periodically, funds fromlithography tool manufacturers and chipmakers are used to fund a small portionof our research and development expenses. In providing these research anddevelopment services to these manufacturers, we try to make clear who owns theintellectual property that results from the research and development services weperform. However, disputes over the ownership or rights to use or market thisintellectual property may arise between the funding organizations and us. Anydispute over ownership of the intellectual property we develop could restrictour ability to market our products and have a material adverse effect on ourbusiness.

**In the future, we may besubject to patent litigation to enforce patents issued to us and defendourselves against claimed infringement by our competitor or any other thirdparty.***

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

Specifically, Komatsu hasnotified us that we may be infringing some of its Japanese patents. During oursubsequent discussions, Komatsu also asserted that our former Japanesemanufacturing partner, Seiko, or we may be infringing on some of Komatsu’s U.S.patents and a number of its additional Japanese patents. Komatsu has alsonotified one of our customers, Nikon, of its belief that our light sourcesinfringe several of Komatsu’s Japanese and U.S. patents. As a result, westarted proceedings in the Japanese Patent Office to oppose certain patents andpatent applications of Komatsu. The Japanese Patent Office has dismissed ouropposition claims. Thus, litigation may result in connection with Komatsu’sJapanese patents or U.S. patents. Also, Komatsu might claim that we infringeother or additional patents. Komatsu notified Seiko that it intends to enforceits rights against Seiko with respect to its Japanese patents if Seikocontinued to engage in manufacturing activities for us. In connection with ourformer manufacturing agreement with Seiko, we agree to pay Seiko under certainconditions for damages

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associated with these types ofclaims. Seiko may not prevail in any litigation against Komatsu, and therefore,we may be required to pay Seiko for such damages.

We have notified our competitorand others of our U.S. patent portfolio. Specifically, we have notified Komatsuthat it may be infringing some of our U.S. patents. We have discussed withKomatsu our claims against each other. Komatsu challenged one of our U.S. patents in the United States Patentand Trademark Office (“USPTO”) but our patent was subsequently re-issued by theUSPTO.  Also, Komatsu transferred itslithography light source business to our competitor, Gigaphoton.  We also have had discussions with a formercompetitor, Lambda-Physik (a subsidiary of Coherent, Inc.), regardingallegations by each party against the other for possible patentinfringement.  Any of these discussionswith our competitor or former competitor may not be successful and litigationcould result.

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

·      loss of our proprietaryrights;

·      exposure to significantliabilities by other third parties;

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

·      restriction from manufacturing or selling our products.

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

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

The risks involved withacquiring a new company, forming a joint venture, or entering a new marketinclude 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 unknownliabilities or 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.

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Mergers, acquisitions and jointventures as well as entering new markets are inherently subject to multiplesignificant risks, and the inability to effectively manage these risks couldhave a material adverse effect on our business. In July 2005, we formed our TCZ joint venture with Zeiss to producetools for the manufacture of flat panel displays.  This is a new market for both Cymer and Zeissand may involve numerous risks. Any of these risks could materially harm ourbusiness, financial condition and operating results. Further, any business thatwe acquire, joint venture that we form or new market we may enter may notachieve anticipated revenues or operating results.

**Compliancewith changing regulations of corporate governance and public disclosure mayresult in additional expenses****.*

Changinglaws, regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations,including accelerated SEC filing timelines and new Proxy rules, Nasdaq StockMarket rules, and new accounting pronouncements are creating uncertainty andadditional complexities for companies such as ours. In particular, the Section404 internal control requirements under the Sarbanes-Oxley Act have added andwill continue to add complexity and costs to our business and require asignificant investment of our time and resources to complete each year.  We take these requirements seriously andexpect to continue to make every effort to ensure that we receive cleanattestations on our internal controls each year from our outside auditors. Tomaintain high standards of corporate governance and public disclosure, weintend to invest all reasonably necessary resources to comply with all otherevolving standards. These investments may result in increased general andadministrative expenses and a diversion of management time and attention fromstrategic revenue generating and cost management activities.

**Trademark infringement claimsagainst our registered and unregistered trademarks would be expensive and wemay have to stop using such trademarks and pay damages.**

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

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

We have historically used broad based stock optionprograms and other forms of equity-related incentives as a key component of ouremployee compensation packages. We believe that stock options and otherlong-term equity incentives directly motivate a broader base of employees tomaximize long-term stockholder value and, through the use of long-term vesting,encourage employees to remain with us. In December 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-BasedPayment – An Amendment to Statement Nos. 123 and 95,” which we adopted onJanuary 1, 2006.  This new rule requiresus to record an expense to earnings for employee stock option grants and otherequity incentives. Moreover, applicable stock exchange listing standardsrelating to obtaining stockholder approval of equity compensation plans hasmade it more difficult and expensive for us to grant options to employees,which has resulted in changes to our equity compensation strategy, including asignificant reduction in the number of stock options granted to employees. Wehave developed alternative cash compensation arrangements for our employees toreplace the majority of these stock option programs and may be

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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.

**We are dependent on air transportto conduct our business and disruption of domestic and international airtransport systems could adversely affect our business.**

We depend on regular andreliable air transportation on a worldwide basis for many of our routinebusiness functions. If civil aviation in the U.S. or abroad is disrupted byterrorist activities or security responses to the threat of terrorism or forany other reason, our business could be adversely affected in the followingways:

·                  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 marketing efforts may be disrupted.

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

**When we sell products to ourJapanese subsidiary, the sale is denominated in U.S. dollars. When our Japanesesubsidiary sells our products directly to**customers in Japan,the sale is denominated in Japanese yen. Thus, our results of operations mayfluctuate based on the changing value of the Japanese yen to the U.S. dollar.We manage the exposure of our Japanese subsidiary to these fluctuations throughforward contracts to hedge the subsidiary’s purchase commitments. We willcontinue to monitor our exposure to these currency fluctuations, and, whenappropriate, use hedging transactions to minimize the effect of these currencyfluctuations. However, exchange rate fluctuations may still have a materialadverse effect on our operating results. In the future, we may need to sell amore significant portion of our products in foreign currencies other than theJapanese yen and the management of more currency fluctuations will be moredifficult and expose us to greater risks in this area.

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

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

## **We are dependent on our manufacturing facilities andsubcontractors to assemble and test our products.**

Operations at our primarymanufacturing facility and our subcontractors are subject to disruption for avariety of reasons, including work stoppages, terrorism, fire, earthquake,energy shortages, flooding or other natural disasters.  Such disruptions could cause delays inshipments of our products to our customers. We cannot ensure that alternate production capacity would be availableif a major disruption were to occur or that, if it were available, it could beobtained on favorable terms.  Suchdisruption could result in cancellation of orders or loss of customers, whichwould have a material adverse effect on our operating results, financialcondition and cash flows.

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**Our operations are subject toenvironmental and other government regulations that may expose us toliabilities for noncompliance.**

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

**Our products are subjectto potential product liability claims if personal injury or death results fromtheir use. **

We are exposed to significantrisks for product liability claims if personal injury or death results from theuse of our products. We may experience material product liability losses in thefuture. We maintain insurance against product liability claims. However, ourinsurance coverage may not continue to be available on terms that we accept.This insurance coverage also may not adequately cover liabilities that weincur. 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 stockhas fluctuated in the past. The market price of our common stock will continueto be subject to significant fluctuations in the future in response to avariety of factors, including the risk factors contained in this report.

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

·      the cyclical nature of thesemiconductor industry;

·                  actual or anticipatedfluctuations in our operating results, including our net income, product grossmargins and free cash flow;

·      conditions and trends in thelight source device and other technology industries;

·      announcements of innovationsin technology;

·      new products offered by us orour competitor;

·      developments of patents orproprietary rights;

·      changes in financial estimatesby securities analysts; 

·      general worldwide political,economic, and market conditions; 

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

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

**In addition, the stock market hasexperienced extreme price and volume fluctuations that have particularlyaffected the market price for many high technology companies. Such fluctuationshave in some cases been unrelated to the operating performance of thesecompanies. Severe price fluctuations in a company’s stock have frequently beenfollowed by securities litigation.  Anysuch litigation can result in substantial costs and a diversion of management’sattention and resources and therefore could have a material adverse effect onour business, financial condition and results of operations.**

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# **ITEM 2.****              Unregistered Salesof Equity Securities and Use of Proceeds**

(a)                Not applicable

(b)               Not applicable

(c)                On July 28,2006, we announced that our board of directors had authorized us to repurchaseup to $150 million of our common stock. The purchases have been made from time to time in the open market or inprivately negotiated transactions.  Theprogram does not have a fixed expiration date and may be discontinued at anytime. 

The followingtable provides information with respect to the shares of common stockrepurchased by us during the three months ended September 30, 2006:
| **Period**                              | ** ** | **Total number  of shares  purchased** | ** ** | **Average price  paid per share** | ** ** | **Total number  of shares  purchased as  part of publicly  announced  plans or  programs** | ** ** | **Approximate  dollar value of  shares that may  yet be purchased  under the plans  or programs** | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|-----------------------------------|------------|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
|                                    |       |                                   |       |                              |       |                                                                                       |       |                                                                                              |       |
| July 1, 2006 to July 31, 2006           |       | 207,815                                |       | $                                 | 38.95      |                                                                                       | 207,815    |                                                                                              | $          | 141.9 Million |   |
| August 1, 2006 to August 31, 2006       |       | 2,385,057                              |       | $                                 | 38.80      |                                                                                       | 2,385,057  |                                                                                              | $          | 49.3 Million |   |
| September 1, 2006 to September 30, 2006 |       | —                                 |       | $                                 | —     |                                                                                       | —     |                                                                                              | $          | 49.3 Million |   |
| Total                                   |       | 2,592,872                              |       | $                                 | 38.81      |                                                                                       | 2,592,872  |                                                                                              |       |   |

 

# **ITEM 3.      DefaultsUpon Senior Securities**

# None.

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

None.

**ITEM 5.**            **Other Information**

(a)          None.

(b)         There were no materialchanges to the procedures by which security holders may recommend nominees toour board of directors.

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# **ITEM 6.      Exhibits**

| 10.1*  | Amendment of Cymer Corporation and Intel Corporation  Development Agreement, effective July 17, 2006.                                                                                              |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                               |
| 10.2*  | Amended and Restated Joint Venture Agreement, dated  September 12, 2006, among TCZ GmbH, Cymer, Inc., Carl Zeiss SMT AG and Carl  Zeiss Laser Optics Beteiligungsgesellschaft mbH and TCZ Pte Ltd. |
| 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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*       Confidentialtreatment has 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**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused thisquarterly report on Form 10-Q to be signed on its behalf by the undersignedthereunto duly authorized.
|                         | CYMER, INC.                  |               |
|-------------------------|------------------------------|--------------------|
|                    |                         |               |
|                    |                         |               |
| Date: November  7, 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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