**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                               |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                 |
| ** ** | ** ** | **For the Quarterly Period Ended  March 31, 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 check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  ý Yes  o No

 

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

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).   o Yes  ý No

 

The number of shares ofCommon Stock, with $0.001 par value, outstanding on April 28, 2006 was 38,815,124.

 

 

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**CYMER,INC.**

 

**FORM 10-Q**

 

**For theQuarterly Period Ended March 31, 2006**

 

**INDEX**

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

 

2

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**ITEM 1.Financial Statements**

 

**CYMER, INC.**

**CONSOLIDATEDBALANCE SHEETS (UNAUDITED)**

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

 
| ** **                                                                                                                                                                     | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2005**              | ** ** | **2006**           | ** ** |
| **ASSETS**                                                                                                                                                                     |       |                  |       |               |       |
| CURRENT ASSETS:                                                                                                                                                                |       |                  |       |               |       |
| Cash and cash  equivalents                                                                                                                                                     |       | $                     | 233,745    |               | $          | 269,937 |   |
| Short-term  investments                                                                                                                                                        |       | 130,204               |       | 151,213            |       |
| Accounts  receivable                                                                                                                                                           |       | 89,818                |       | 111,571            |       |
| Accounts  receivable - related party                                                                                                                                           |       | 588                   |       | 2,789              |       |
| Foreign currency  forward exchange contracts                                                                                                                                   |       | 1,776                 |       | 276                |       |
| Inventories                                                                                                                                                                    |       | 89,046                |       | 101,252            |       |
| Deferred income  taxes                                                                                                                                                         |       | 33,338                |       | 33,855             |       |
| Prepaid expenses  and other assets                                                                                                                                             |       | 6,497                 |       | 5,963              |       |
| Total current  assets                                                                                                                                                          |       | 585,012               |       | 676,856            |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| PROPERTY AND  EQUIPMENT - NET                                                                                                                                                  |       | 117,251               |       | 115,252            |       |
| LONG-TERM  INVESTMENTS                                                                                                                                                         |       | 29,395                |       | 29,369             |       |
| DEFERRED INCOME  TAXES                                                                                                                                                         |       | 34,429                |       | 29,603             |       |
| GOODWILL                                                                                                                                                                       |       | 8,358                 |       | 8,833              |       |
| INTANGIBLE  ASSETS - NET                                                                                                                                                       |       | 10,474                |       | 9,839              |       |
| OTHER ASSETS                                                                                                                                                                   |       | 6,457                 |       | 6,116              |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| TOTAL ASSETS                                                                                                                                                                   |       | $                     | 791,376    |               | $          | 875,868 |   |
|                                                                                                                                                                           |       |                  |       |               |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                 |       |                  |       |               |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| CURRENT  LIABILITIES:                                                                                                                                                          |       |                  |       |               |       |
| Accounts payable                                                                                                                                                               |       | $                     | 17,710     |               | $          | 23,911 |   |
| Accounts payable  - related party                                                                                                                                              |       | 4,975                 |       | 4,157              |       |
| Accrued warranty  and installation                                                                                                                                             |       | 30,775                |       | 31,666             |       |
| Accrued payroll  and benefits                                                                                                                                                  |       | 12,461                |       | 14,003             |       |
| Accrued patents,  royalties and other fees                                                                                                                                     |       | 7,180                 |       | 6,214              |       |
| Income taxes  payable                                                                                                                                                          |       | 7,268                 |       | 1,135              |       |
| Unearned income                                                                                                                                                                |       | 1,726                 |       | 1,782              |       |
| Other current  liabilities                                                                                                                                                     |       | 3,247                 |       | 2,130              |       |
| Total current  liabilities                                                                                                                                                     |       | 85,342                |       | 84,998             |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| CONVERTIBLE  SUBORDINATED NOTES                                                                                                                                                |       | 140,722               |       | 140,722            |       |
| OTHER LIABILITIES                                                                                                                                                              |       | 10,582                |       | 12,478             |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| Total  liabilities                                                                                                                                                             |       | 236,646               |       | 238,198            |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| MINORITY  INTEREST                                                                                                                                                             |       | 16,276                |       | 9,046              |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                 |       |                  |       |               |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                    |       |                  |       |               |       |
| Preferred stock  - authorized 5,000,000 shares; $.001 par value, no shares issued or  outstanding                                                                              |       | —                |       | —             |       |
| Common stock -  $.001 par value per share; 100,000,000 shares authorized; 38,036,000 and  39,869,000 shares outstanding at December 31, 2005 and March 31, 2006,  respectively |       | 38                    |       | 40                 |       |
| Additional  paid-in capital                                                                                                                                                    |       | 407,549               |       | 474,312            |       |
| Treasury stock  at cost (1,943,000 common shares)                                                                                                                              |       | (50,000               | )          | (50,000            | )          |
| Accumulated  other comprehensive loss                                                                                                                                          |       | (9,025                | )          | (6,223             | )          |
| Retained  earnings                                                                                                                                                             |       | 189,892               |       | 210,495            |       |
| Total  stockholders’ equity                                                                                                                                               |       | 538,454               |       | 628,624            |       |
|                                                                                                                                                                           |       |                  |       |               |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                               |       | $                     | 791,376    |               | $          | 875,868 |   |

 

See Notes toUnaudited Consolidated Financial Statements.

 

3

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**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

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

 
| ** **                                                                | ** ** | **For the three months ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                | ** ** | **March 31,**                                 | ** ** |
| ** **                                                                | ** ** | **2005**                                           | ** ** | **2006** | ** ** |
|                                                                      |       |                                               |       |   |   |
| REVENUES:                                                                 |       |                                               |       |   |   |
| Product sales                                                             |       | $                                                  | 84,609     |   | $ | 124,902 |   |
| Product sales -  related party                                            |       | —                                             |       | 2,154 |   |
| Other                                                                     |       | 201                                                |       | 61 |   |
| Total revenues                                                            |       | 84,810                                             |       | 127,117 |   |
|                                                                      |       |                                               |       |   |   |
| COSTS AND  EXPENSES:                                                      |       |                                               |       |   |   |
| Cost of product  sales                                                    |       | 53,031                                             |       | 68,691 |   |
| Research and  development                                                 |       | 14,624                                             |       | 18,124 |   |
| Sales and  marketing                                                      |       | 5,774                                              |       | 6,849 |   |
| General and  administrative                                               |       | 6,304                                              |       | 9,180 |   |
|                                                                      |       |                                               |       |   |   |
| Total costs and  expenses                                                 |       | 79,733                                             |       | 102,844 |   |
|                                                                      |       |                                               |       |   |   |
| OPERATING INCOME                                                          |       | 5,077                                              |       | 24,273 |   |
|                                                                      |       |                                               |       |   |   |
| OTHER INCOME  (EXPENSE):                                                  |       |                                               |       |   |   |
| Foreign currency  exchange gain (loss) - net                              |       | (194                                               | )          | 619 |   |
| Interest and  other income                                                |       | 2,401                                              |       | 6,986 |   |
| Interest and  other expense                                               |       | (2,127                                             | )          | (1,402 | ) |
|                                                                      |       |                                               |       |   |   |
| Total other  income - net                                                 |       | 80                                                 |       | 6,203 |   |
|                                                                      |       |                                               |       |   |   |
| INCOME BEFORE  INCOME TAX PROVISION AND MINORITY INTEREST                 |       | 5,157                                              |       | 30,476 |   |
|                                                                      |       |                                               |       |   |   |
| INCOME TAX  PROVISION                                                     |       | —                                             |       | 10,554 |   |
| MINORITY  INTEREST                                                        |       | 228                                                |       | 681 |   |
|                                                                      |       |                                               |       |   |   |
| NET INCOME                                                                |       | $                                                  | 5,385      |   | $ | 20,603 |   |
|                                                                      |       |                                               |       |   |   |
| EARNINGS PER  SHARE:                                                      |       |                                               |       |   |   |
| Basic earnings  per share                                                 |       | $                                                  | 0.15       |   | $ | 0.55 |   |
| Weighted average  common shares outstanding                               |       | 36,884                                             |       | 37,278 |   |
|                                                                      |       |                                               |       |   |   |
| Diluted earnings  per share                                               |       | $                                                  | 0.14       |   | $ | 0.52 |   |
| Weighted average  common and dilutive potential common shares outstanding |       | 37,230                                             |       | 41,126 |   |

 

See Notes toUnaudited Consolidated Financial Statements.

 

4

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**CYMER, INC.**

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

**(In thousands)**

 
| ** **                                                                         | ** ** | **For the three months ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **March 31,**                                 | ** ** |
| ** **                                                                         | ** ** | **2005**                                           | ** ** | **2006** | ** ** |
|                                                                               |       |                                               |       |   |   |
| OPERATING  ACTIVITIES:                                                             |       |                                               |       |   |   |
| Net income                                                                         |       | $                                                  | 5,385      |   | $ | 20,603 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                               |       |   |   |
| Depreciation and  amortization                                                     |       | 7,264                                              |       | 6,484 |   |
| Non-cash  stock-based compensation                                                 |       | 152                                                |       | 2,519 |   |
| Amortization of  unearned compensation                                             |       | 16                                                 |       | — |   |
| Minority  interest                                                                 |       | (228                                               | )          | (681 | ) |
| Provision for  deferred income taxes                                               |       | 89                                                 |       | 4,230 |   |
| Loss on disposal  and impairment of property and equipment                         |       | 2                                                  |       | 6 |   |
| Change in assets  and liabilities:                                                 |       |                                               |       |   |   |
| Accounts  receivable – net                                                    |       | 30,988                                             |       | (21,753 | ) |
| Accounts  receivable - related party                                               |       | —                                             |       | (2,201 | ) |
| Foreign currency  forward exchange contracts                                       |       | (1,898                                             | )          | 1,636 |   |
| Inventories                                                                        |       | 7,361                                              |       | (12,206 | ) |
| Prepaid expenses  and other assets                                                 |       | 160                                                |       | 680 |   |
| Accounts payable                                                                   |       | 891                                                |       | 6,201 |   |
| Accounts payable  - related party                                                  |       | —                                             |       | (818 | ) |
| Accrued expenses  and other liabilities                                            |       | (5,194                                             | )          | 2,246 |   |
| Unearned income                                                                    |       | 774                                                |       | 56 |   |
| Income taxes  payable                                                              |       | (1,289                                             | )          | (6,133 | ) |
|                                                                               |       |                                               |       |   |   |
| Net cash  provided by operating activities                                         |       | 44,473                                             |       | 869 |   |
|                                                                               |       |                                               |       |   |   |
| INVESTING  ACTIVITIES:                                                             |       |                                               |       |   |   |
| Acquisition of  property and equipment                                             |       | (5,180                                             | )          | (3,661 | ) |
| Purchases of  investments                                                          |       | (141,521                                           | )          | (54,484 | ) |
| Proceeds from  sold or matured investments                                         |       | 133,719                                            |       | 33,572 |   |
| Acquisition of  minority interest                                                  |       | —                                             |       | (7,024 | ) |
|                                                                               |       |                                               |       |   |   |
| Net cash used in  investing activities                                             |       | (12,982                                            | )          | (31,597 | ) |
|                                                                               |       |                                               |       |   |   |
| FINANCING  ACTIVITIES:                                                             |       |                                               |       |   |   |
| Proceeds from  issuance of common stock                                            |       | 1,557                                              |       | 54,090 |   |
| Excess tax  benefits from stock option exercises                                   |       | —                                             |       | 10,154 |   |
| Payments on  capital lease obligations                                             |       | (12                                                | )          | — |   |
| Repurchase of  common stock into treasury                                          |       | (8,287                                             | )          | — |   |
|                                                                               |       |                                               |       |   |   |
| Net cash  provided by (used in) financing activities                               |       | (6,742                                             | )          | 64,244 |   |
|                                                                               |       |                                               |       |   |   |
| EFFECT OF  EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS                      |       | 484                                                |       | 2,676 |   |
|                                                                               |       |                                               |       |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                         |       | 25,233                                             |       | 36,192 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF THE PERIOD                              |       | 114,246                                            |       | 233,745 |   |
|                                                                               |       |                                               |       |   |   |
| CASH AND CASH  EQUIVALENTS AT END OF THE PERIOD                                    |       | $                                                  | 139,479    |   | $ | 269,937 |   |

 

5

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| ** **                                         | ** ** | **For the three months ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                         | ** ** | **March 31,**                                 | ** ** |
| ** **                                         | ** ** | **2005**                                           | ** ** | **2006** | ** ** |
|                                               |       |                                               |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION: |       |                                               |       |   |   |
| Interest paid                                      |       | $                                                  | 3,627      |   | $ | 2,522 |   |
| Income taxes  paid, net                            |       | $                                                  | 1,356      |   | $ | 1,536 |   |

 

See Notes to UnauditedConsolidated Financial Statements.

 

6

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**CYMER,INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**ThreeMonths Ended March 31, 2006**

**(Unaudited)**

 

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

 

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

 

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

 

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

 

*Accounting Pronouncements Adopted*

 

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

 

7

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

 

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

 

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

 

In accordance with SFAS No. 123R, beginning in thefirst quarter of 2006, we have presented excess tax benefits for the exerciseof share-based compensation awards as a financing activity in the consolidatedstatement of cash flows. Prior to the adoption of SFAS No. 123R, we presentedthe tax benefits for deductions resulting from the exercise of stock options asan operating cash flow activity. 

 

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

 

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

 

**Stock-Based CompensationValuation Assumptions**

 

We estimate the fair value of our stockoptions using a Black-Scholes option pricing model, consistent with theprovisions of SFAS No. 123R, Securities and Exchange Commission StaffAccounting Bulletin No. 107 (“SAB 107”) and our prior period pro formadisclosures of net income (loss), including stock-based compensation asrequired by SFAS No. 123. The fair value of stock options granted is

 

8

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recognized to expense over the requisiteservice period. For stock options granted after the SFAS No. 123R effectivedate of January 1, 2006, the straight-line attribution approach is used. Forstock options granted prior to January 1, 2006, which are continuing to vest,we will continue to record expense using the Financial Accounting StandardsBoard Interpretation No. 28 (“FIN 28”) accelerated attribution approach.

 

Upon the adoption of SFAS No. 123R, we used acombination of historical and implied volatility (“blended volatility”) tovalue our stock options under SFAS No. 123R and SAB 107.  Historicalvolatility is based on the five-year 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 remaininglife of five years for valuing options.

 

The following weighted average assumptionswere used for grants issued in the three months ended March 31, 2005 under theSFAS No. 123 requirements and in the three months ended March 31, 2006 underthe SFAS No. 123R requirements:

 

| ** **                | ** ** | **Three months ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **March 31,**               | ** ** |
| ** **                | ** ** | **2005**                         | ** ** | **2006** | ** ** |
|                      |       |                             |       |   |   |
| Dividend yield            |       | None                             |       | None |   |
| Volatility rate:          |       |                             |       |   |   |
| Options                   |       | 75%                              |       | 56% |   |
| ESPP                      |       | 75%                              |       | NA |   |
| Risk free  interest rate: |       |                             |       |   |   |
| Options                   |       | 3.89%                            |       | 4.53% |   |
| ESPP                      |       | 2.75%                            |       | NA |   |
| Expected term:            |       |                             |       |   |   |
| Options                   |       | 4.29 years                       |       | 3.16 years |   |
| ESPP                      |       | .5 years                         |       | NA |   |

 

In our pro forma disclosures prior to theadoption of SFAS No. 123R, we accounted for forfeitures as they occurred. SFASNo. 123R requires forfeitures to be estimated at the time of grant and revisedif necessary in subsequent periods if actual forfeiture rates differ from thoseestimates. Forfeitures were estimated based on historical activity for ourcompany. For the three months ended March 31, 2006, we estimated a 3% annual forfeiturerate. We amended our ESPP as a result our ESPP is treated as a noncompensatoryplan.

 

9

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**Impact of SFAS No. 123R**

 

The following table presents the impact to ourconsolidated financial statements as a result of our adoption of SFAS No. 123Rfor the three months ended March 31, 2006 (in thousands, except per shareamounts):

 
| ** **                                          | ** ** | **Three months ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **March 31,**               | ** ** |
| ** **                                          | ** ** | **2006**                         | ** ** |
|                                                |       |                             |       |
| Stock-based  compensation expense by type of award: |       |                             |       |
| Employee stock  options                             |       | $                                | 2,281      |   |
| Stock units                                         |       | 146                              |       |
|                                                |       |                             |       |
| Total  stock-based compensation                     |       | $                                | 2,427      |   |
| Tax effect on  stock-based compensation             |       | $                                | (840       | ) |
| Net effect on  net income                           |       | $                                | 1,587      |   |
|                                                |       |                             |       |
| Effect on  earnings per share:                      |       |                             |       |
| Basic                                               |       | $                                | 0.04       |   |
| Diluted                                             |       | $                                | 0.04       |   |
|                                                |       |                             |       |
| Impact of stock  option deductions on:              |       |                             |       |
| Cash flows from  operations                         |       | $                                | (10,154    | ) |
| Cash flows from  financing activities               |       | $                                | 10,154     |   |

 

Asof March 31, 2006, the unamortized compensation expense related to outstandingunvested options was approximately $11.1 million with a weighted average remainingvesting period of 1.20 years. We expect to amortize this expense over theremaining vesting period of these stock options.

 

The amount of stock-based compensation costscapitalized into inventory during the three months ended March 31, 2006 wasimmaterial.

 

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

 

We account for options grantedto non-employees under SFAS No. 123 and Emerging Issues Task Force Issue No.96-18, “Accounting for Equity Instruments that are Issued to other thanEmployees for Acquiring or in Conjunction with Selling Goods or Services”. Wemeasure the fair value of such options using the Black-Scholes option pricingmodel at each financial reporting date. We account for changes in fair valuesbetween reporting dates in accordance with FIN 28. Stock-based compensationexpense for options granted to non-employees and for those employees whochanged status during the three months ended March 31, 2005 and 2006 was$148,000 and $92,000, respectively.

 

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

 

The following tablecompares the earnings (loss) per share that we reported to the pro formaamounts that we would have reported for the three months ended March 31, 2005 hadwe recognized

 

10

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compensationexpense for our stock-based compensation plans in accordance with SFAS No. 123(in thousands, except per share amounts):

 

| ** **                                                                                                                                        | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **March 31,**               | ** ** |
| ** **                                                                                                                                        | ** ** | **2005**                         | ** ** |
|                                                                                                                                              |       |                             |       |
| Net income, as  reported                                                                                                                          |       | $                                | 5,385      |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                                      |       | 152                              |       |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects |       | (13,898                          | )          |
|                                                                                                                                              |       |                             |       |
| Pro forma net loss                                                                                                                                |       | $                                | (8,361     | ) |
|                                                                                                                                              |       |                             |       |
| Earnings (loss) per  share:                                                                                                                       |       |                             |       |
| Basic - as  reported                                                                                                                              |       | $                                | 0.15       |   |
| Basic - pro  forma                                                                                                                                |       | $                                | (0.23      | ) |
|                                                                                                                                              |       |                             |       |
| Diluted - as  reported                                                                                                                            |       | $                                | 0.14       |   |
| Diluted - pro  forma                                                                                                                              |       | $                                | (0.23      | ) |

 

In February 2005, our board of directorsapproved the acceleration of the vesting of stock options that had exerciseprices of $30.50 per share or higher held by employees. This acceleration ofstock options excluded directors, executive officers and certain vicepresidents. The purpose of this acceleration of vesting was to enable us toeliminate the recognition in our statement of operations of the compensationexpense associated with these “out of the money” stock options in futureperiods, upon our adoption of SFAS No. 123R on January 1, 2006.  Theacceleration of vesting of these stock options in the three months ended March31, 2005 contributed approximately $10.4 million of pro forma stock-basedcompensation expense.

 

**Stock Option Plans**

 

Currently, we grant stockoptions from our 2005 Equity Incentive Plan (the “2005 Plan”), which providesfor the grant or award of various equity incentives to our employees, directorsand consultants. Upon approval of the 2005 Plan by stockholders in May 2005, wediscontinued the use of our 1996 Stock Option Plan and 2000 Equity IncentivePlan. Options issued under the 2005 Plan expire ten years after the options aregranted. It is our practice to generally grant options that vest and becomeexercisable ratably over a four-year period following the date of grant. A total of 1,000,000 shares ofcommon stock are reserved for issuance under the 2005 Plan and it provides forthe issuance of incentive stock options, nonstatutory stock options, stockappreciation rights, stock bonus awards, stock purchase awards, stock unitawards and other stock awards. Options to purchase 439,748 shares areoutstanding and 560,116 shares remain available for grant under the 2005 Planas of March 31, 2006.

 

The following describesour other stock option plans from which we no longer issue awards althoughoptions to purchase shares are still outstanding under these plans and theoptions still vest and may be exercised:

 

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

 

11

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forissuance under the 1996 Plan.  Of these shares, options to purchase2,422,217 shares are outstanding as of March 31, 2006.

 

*2000 Equity Incentive Plan(the “2000 Plan”)* – In August 2000,our board of directors adopted the 2000 Plan which provides for the grant ofoptions to our employees or consultants who are neither directors nor officers.The exercise prices of the options granted under the 2000 Plan were equal tothe quoted market value of our common stock at the date of grant.  Optionsissued under the 2000 Plan expire ten years after the options were granted andgenerally vest and become exercisable ratably over a four year period followingthe date of grant. A total of 4,950,000 shares of common stock were reservedfor issuance under the 2000 Plan. Of these shares, options to purchase2,201,440 shares are outstanding as of March 31, 2006.

 

*1996 Director Option Plan (the“Director Option Plan”) –*In1996 we adopted the Director Option Planwhereby 200,000 shares were reserved for option grants to our directors. There were 80,000 options issued under the Director Option Plan in 1997. The Director Option Plan was terminated in October 1997; however, 20,000of these options remain outstanding as of March 31, 2006.

 

**Stock Options**

 

The following is asummary of stock option activity under all stock option plans for the threemonths ended March 31, 2006 (in thousands, except per share data):

 
| ** **                     | ** ** | ** ** | ** ** | **Weighted**       | ** ** | **Weighted**        | ** ** |
|--------------------------------|------------|------------|------------|--------------------|------------|---------------------|------------|
| ** **                     | ** ** | ** ** | ** ** | **Average**        | ** ** | **Average**         | ** ** |
| ** **                     | ** ** | **Number** | ** ** | **Exercise**       | ** ** | **Contractual**     | ** ** |
| ** **                     | ** ** | **of**     | ** ** | **Price**          | ** ** | **Term**            | ** ** |
| ** **                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** | **(in years)** | ** ** |
|                           |       |       |       |               |       |                |       |
| Balance at  January 1, 2006    |       | 6,924      |       | $                  | 32.15      |                |       |   |
| Granted                        |       | 86         |       | $                  | 42.97      |                |       |   |
| Exercised                      |       | (1,833     | )          | $                  | 29.62      |                |       |   |
| Forfeited                      |       | (98        | )          | $                  | 30.42      |                |       |   |
| Expired                        |       | (13        | )          | $                  | 49.64      |                |       |   |
|                           |       |       |       |               |       |                |       |
| Balance at March  31, 2006     |       | 5,066      |       | $                  | 33.24      |                | 6.15       |   |
| Exercisable at  March 31, 2006 |       | 3,968      |       | $                  | 33.69      |                | 5.48       |   |

 

The following table summarizes information as ofMarch 31, 2006 concerning currently outstanding and exercisable options (numberof shares in thousands):

 

12

----

 
| ** **               | ** ** | **Options Outstanding**     | ** ** | **Options Exercisable** | ** ** |
|--------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **               | ** ** | ** **                  | ** ** | **Weighted**            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                  | ** ** | **Average**             | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Number**                  | ** ** | **Remaining**           | ** ** | **Average** | ** ** | **Aggregate** | ** ** | **Number** | ** ** | **Average** | ** ** | **Aggregate** | ** ** |
| **Range of**        | ** ** | **Outstanding**             | ** ** | **Contractual**         | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** | **Exercisable** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** |
| **Exercise Prices** | ** ** | **As of 3/31/06** | ** ** | **Term (in years)**     | ** ** | **Price** | ** ** | **Value** | ** ** | **As of 3/31/06** | ** ** | **Price** | ** ** | **Value** | ** ** |
|                     |       |                        |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| $12.75–$15.73       |       | 10                          |       | 2.63                    |       | $ | 13.91 |   | $ | 305 |   | 10 |   | $ | 13.91 |   | $ | 305 |   |
| $16.32–$19.92       |       | 259                         |       | 6.06                    |       | $ | 18.89 |   | $ | 6,883 |   | 213 |   | $ | 18.74 |   | $ | 5,699 |   |
| $19.98–$24.90       |       | 647                         |       | 5.34                    |       | $ | 21.95 |   | $ | 15,196 |   | 540 |   | $ | 21.75 |   | $ | 12,792 |   |
| $24.96–$31.15       |       | 976                         |       | 7.33                    |       | $ | 27.94 |   | $ | 17,084 |   | 609 |   | $ | 27.75 |   | $ | 10,772 |   |
| $31.38–$38.00       |       | 1,685                       |       | 6.23                    |       | $ | 34.56 |   | $ | 18,315 |   | 1,268 |   | $ | 34.84 |   | $ | 13,436 |   |
| $38.21–$45.44       |       | 1,141                       |       | 5.77                    |       | $ | 40.71 |   | $ | 5,394 |   | 980 |   | $ | 40.37 |   | $ | 4,973 |   |
| $45.49–$55.13       |       | 348                         |       | 5.33                    |       | $ | 49.35 |   | — |   | 348 |   | $ | 49.36 |   | — |   |
| $12.75–$55.13       |       | 5,066                       |       | 6.15                    |       | $ | 33.24 |   | $ | 63,177 |   | 3,968 |   | $ | 33.69 |   | $ | 47,977 |   |

 

The aggregate intrinsic value in the table aboverepresents the total pretax intrinsic value, based on a per share price of$45.44 the closing price of our common stock on March 31, 2006 as reported bythe Nasdaq National Market, which would have been received by the optionholders had all option holders exercised their options as of that date. Thetotal number of in-the-money stock options exercisable as of March 31, 2006 was3.6 million.

 

The weighted average per share fair value of theoptions granted during the three months ended March 31, 2005 and March 31, 2006was $16.33 and $17.90, respectively.

 

The total intrinsic value of options exercisedduring the three months ended March 31, 2005 and 2006 was $410,000 and $31.2million, respectively.

 

The total cash received from employees as aresult of employee stock option exercises during the three months ended March31, 2006 was approximately $54.1 million. In connection with these exercises,the tax benefits realized by us for the three months ended March 31, 2006 was$10.2 million.

 

We settle employee stock option exercises withnewly issued common shares.

 

**StockUnits**

 

In January 2006, our board ofdirectors approved the use of annual stock unit awards for non-employeedirectors pursuant to our 2005 Plan in lieu of quarterly stock options grants.The number of shares subject to each stock unit award is determined by dividing$100,000 by the closing price per share of our common stock as of the date ofgrant. During the three months ended March 31, 2006, 17,948 shares subject to suchstock units awards were granted to non-employee directors with a grant datefair value of $39.00 per share. Each stock unit award shall vest 100% after oneyear from the date of grant. Stock based compensation expense for stock unitsfor the three months ended March 31, 2006 was $146,000.

 

A summary of the change in stock unitawards outstanding during the three months ended March 31, 2006 is as follows(in thousands, except life data):

 
| ** **                       | ** ** | **Shares** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value as of  3/31/06** | ** ** |
|----------------------------------|------------|------------|------------|-----------------------------------------------------|------------|----------------------------------------------------------|------------|
|                             |       |       |       |                                                |       |                                                     |       |
| Beginning Outstanding            |       | —     |       |                                                |       |                                                     |       |
| Awarded                          |       | 18         |       |                                                |       |                                                     |       |
| Vested                           |       | —     |       |                                                |       |                                                     |       |
| Forfeited                        |       | —     |       |                                                |       |                                                     |       |
| Ending Outstanding               |       | 18         |       | 0.79                                                |       | $816                                                     |       |
| Ending Vested + Expected to Vest |       | 18         |       | 0.79                                                |       | $816                                                     |       |
| Ending Exercisable               |       | —     |       | —                                              |       | —                                                   |       |

 

Weighted Average Remaining RecognitionPeriod - 0.79 years

 

13

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The aggregate intrinsicvalue in the table above represents the total pretax intrinsic value based onour closing stock price of $45.44 as of March 31, 2006.

 

**Employee Stock Purchase Plan**

 

*1996 Employee Stock PurchasePlan (the “ESPP”)*– The ESPP is intendedto qualify under Section 423 of the Internal Revenue Code.  Under theESPP, eligible employees may purchase shares of our common stock throughpayroll deductions of up to 15% of his or her compensation (as defined in the plan),at a price per share equal to 95% of the fair market value of our common stockat the end of the purchase period.  Our ESPP was amended in 2005. Theamendment: a) changed the duration of offering periods under the plan from twoyears to six months b) reduced the discount to market price used to determinepurchase price for shares of our common stock under the plan from 15% to 5%,and c) eliminated the “lookback” feature that allowed the purchase price to bedetermined as of the beginning of an offering period, or enrollment date, ifthe market price as of the enrollment date was lower than the market price atthe end of the offering period. The number of shares issuable under the ESPP asof March 31, 2006 was 94,723, and 1,105,277 shares have been previously issued.Because our ESPP is a non-compensatory plan as defined by SFAS No. 123R, nostock-based compensation expense is recorded for our ESPP.

 

On February 7, 2006, our board of directorsamended our ESPP to extend the expiration date of the plan until July 31, 2016.In addition, our board of directors approved an amendment to the plan, subjectto shareholder approval at our annual meeting on May 18, 2006, to increase thenumber of shares of common stock reserved for issuance under the plan by300,000 shares from 1,200,000 shares to 1,500,000 shares.

 

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

 

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

 

The following table setsforth the basic and diluted EPS for the three months ended March 31, 2005 and2006 (in thousands, except per share information):

 

14

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| ** **                                                                            | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **March 31,**               | ** ** |
| ** **                                                                            | ** ** | **2005**                         | ** ** | **2006** | ** ** |
|                                                                                  |       |                             |       |   |   |
| NET INCOME:                                                                           |       |                             |       |   |   |
| Net income, as  reported (used for basic EPS)                                         |       | $                                | 5,385      |   | $ | 20,603 |   |
| Adjustment for  interest expense on 3.5% convertible subordinated notes, net of taxes |       | —                           |       | 873 |   |
|                                                                                  |       |                             |       |   |   |
| Net income, as  adjusted for assumed conversion (used for diluted EPS)                |       | $                                | 5,385      |   | $ | 21,476 |   |
|                                                                                  |       |                             |       |   |   |
| WEIGHTED AVERAGE  SHARES:                                                             |       |                             |       |   |   |
| Basic weighted  average common shares outstanding                                     |       | 36,884                           |       | 37,278 |   |
| Effect of  dilutive securities:                                                       |       |                             |       |   |   |
| Warrants                                                                              |       | —                           |       | 57 |   |
| Options and  stock units                                                              |       | 346                              |       | 977 |   |
| Convertible  subordinated notes                                                       |       | —                           |       | 2,814 |   |
|                                                                                  |       |                             |       |   |   |
| Diluted weighted  average common and potential common shares outstanding              |       | 37,230                           |       | 41,126 |   |
|                                                                                  |       |                             |       |   |   |
| Earnings per  share:                                                                  |       |                             |       |   |   |
| Basic                                                                                 |       | $                                | 0.15       |   | $ | 0.55 |   |
| Diluted                                                                               |       | $                                | 0.14       |   | $ | 0.52 |   |

 

For the three months ended March 31, 2005 and2006, weighted average options and warrants to purchase 5.6 million and 1.0million shares of common stock were outstanding but not included in thecomputation of diluted earnings per share as their effect was anti-dilutive. Inaddition, for the three months ended March 31, 2005, weighted average commonshares attributable to convertible subordinated notes of 4,015,000 were notincluded in the computation of diluted earnings per share as their effect wasalso anti-dilutive.

 

**4.****              INVENTORIES**

 

Inventories consisted of the following as of December31, 2005 and March 31, 2006 (in thousands): 

 
| ** **                                   | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                   | ** ** | **2005**              | ** ** | **2006**           | ** ** |
| INVENTORIES:                                 |       |                  |       |               |       |
| Raw materials                                |       | $                     | 42,482     |               | $          | 41,669 |   |
| Work-in-progress                             |       | 18,408                |       | 22,116             |       |
| Finished goods                               |       | 38,601                |       | 47,892             |       |
| Allowance for  excess and obsolete inventory |       | (10,445               | )          | (10,425            | )          |
| Total                                        |       | $                     | 89,046     |               | $          | 101,252 |   |

 

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

 

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

 

15

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The following tablesummarizes the change in each component of accumulated other comprehensive lossfor the three months ended March 31, 2006 (in thousands):

 
| ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | **Total unrealized** | ** ** | **Total unrealized**                | ** ** | ** **        | ** ** |
|--------------------|------------|-------------------|------------|-----------------|------------|---------------------------|------------|------------------------------------------|------------|-------------------|------------|
| ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | **losses on**        | ** ** | **gains (losses) on**          | ** ** | **Accumulated**   | ** ** |
| ** **         | ** ** | ** **        | ** ** | ** **      | ** ** | **available-for-sale**    | ** ** | **foreign currency**                | ** ** | **other**         | ** ** |
| ** **         | ** ** | ** **        | ** ** | **Translation** | ** ** | **investments,**          | ** ** | **forward exchange**                | ** ** | **comprehensive** | ** ** |
| ** **         | ** ** | ** **        | ** ** | **adjustment**  | ** ** | **net of tax**  | ** ** | **contracts, net of tax** | ** ** | **loss**          | ** ** |
|               |       |              |       |            |       |                      |       |                                     |       |              |       |
| December 31,  2005 |       | Balance           |       | $               | (8,157     | )                         | $          | (798                                     | )          | $                 | (70        | ) | $ | (9,025 | ) |
|               |       | Period net change |       | 2,674           |       | 44                        |       | 84                                       |       | 2,802             |       |
| March 31, 2006     |       | Balance           |       | $               | (5,483     | )                         | $          | (754                                     | )          | $                 | 14         |   | $ | (6,223 | ) |

 

Comprehensive income consistedof the following components (in thousands):

 

| ** **                                                                   | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **March 31,**               | ** ** |
| ** **                                                                   | ** ** | **2005**                         | ** ** | **2006** | ** ** |
|                                                                         |       |                             |       |   |   |
| Net income                                                                   |       | $                                | 5,385      |   | $ | 20,603 |   |
|                                                                         |       |                             |       |   |   |
| Foreign currency  translation adjustments                                    |       | 285                              |       | 2,674 |   |
| Unrealized gains  (losses) on available-for-sale investments, net of tax     |       | (594                             | )          | 44 |   |
| Unrealized gains  on foreign currency forward exchange contracts, net of tax |       | 676                              |       | 84 |   |
|                                                                         |       |                             |       |   |   |
| Comprehensive  income                                                        |       | $                                | 5,752      |   | $ | 23,405 |   |

 

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

 

In January 2004, weentered into a research and development agreement with Intel Corporation (“Intel”).Under this agreement, Intel will provide us a total of $20.0 million over athree-year period to accelerate the development of production-worthy extremeultraviolet (“EUV”) lithography light sources. The funding from Intel underthis agreement is milestone based and is netted against our total research anddevelopment expenses in the period that the milestone is achieved. Due to thecomplexity of the EUV technology, we have regular communications with Intel onthe milestones under the contract and the timing and requirements for theircompletion. As a result of these discussions, only certain milestones wereplanned for and achieved in 2005. We will continue to work with Intel in 2006to further refine the milestones and work to be performed under the contract.The total funded amounts recorded under this agreement for the three monthsended March 31, 2005 and 2006 were $1.6 million and $104,000, respectively.

 

In February 2004, weentered into an intellectual property license agreement with Intel for the useof certain Intel patents and trade secrets related to EUV technology. Under theterms of this agreement, we will pay license fees to Intel if we are successfulin commercializing an EUV lithography light source capable of high volumemanufacturing by the end of the second quarter of 2008. The license paymentsunder this agreement are triggered in the quarter in which we successfully shipthe first complete high volume manufacturing EUV source system. Commencing withshipment of this first unit, we will pay Intel $1.25 million in license feesper quarter for a period of sixteen quarters. The quarterly license amountspaid to Intel, if any, will be related to our sale of EUV light source systemsand, as a result, will be recorded as cost of product sales. The methodologyand amounts that we will record to cost of product sales will be determinedwhen the high volume manufacturing production unit sales or a forecast of salescan be made. No amounts have been earned under this arrangement as of March 31,2006.

 

16

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

 

We account for our goodwill and other intangible assets in accordance with Statementof Financial Accounting Standards No. 142 (“SFAS No. 142”), “Goodwill and OtherIntangible Assets”. Under SFAS No. 142, our goodwill is subject to an annualimpairment test. During the fourth quarter of 2005, we completed ourannual impairment test of goodwill and intangible assets, and concluded that noimpairment of goodwill existed.

 

The following table summarizes the activity in thecarrying amount of goodwill as of December 31, 2005 and March 31, 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  March 31, 2006                                              |   | $   | 8,833  |   |

 

Included in intangible assets – net on theaccompanying balance sheets are amounts associated with patents that wereacquired in 2001, 2003 and 2005. As of December 31, 2005 and March 31, 2006,the net carrying amount of these patents was $10.5 million and $9.8 million,respectively. The accumulated amortization for these patents at December 31,2005 and March 31, 2006 was $8.3 million and $8.9 million, respectively. Amortizationexpense for these patents was $593,000 and $635,000 for the three months ended March31, 2005 and 2006, respectively.

 

As of March 31, 2006,future estimated amortization expense for these patents is expected to be asfollows for (in thousands):

 

| ** **                            | ** ** | **Future**       | ** ** |
|---------------------------------------|------------|------------------|------------|
| ** **                            | ** ** | **Amortization** | ** ** |
|                                  |       |             |       |
| Nine months ending  December 31, 2006 |       | $                | 1,907      |   |
| Year ending  December 31, 2007        |       | $                | 2,542      |   |
| Year ending  December 31, 2008        |       | $                | 2,542      |   |
| Year ending  December 31, 2009        |       | $                | 1,060      |   |
| Year ending  December 31, 2010        |       | $                | 170        |   |
| Thereafter                            |       | $                | 1,619      |   |

 

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

 

In the ordinary course of business, we are notsubject to potential obligations under guarantees that fall within the scope ofFinancial Accounting Standards Board Interpretation No. 45 (“FIN 45”), “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others”, except for standard warranty provisionsassociated with product sales and indemnification provisions related tointellectual property that are contained within many of our lithography toolmanufacturer agreements. All of these provisions give rise only to thedisclosure requirements prescribed by FIN 45.

 

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

 

The following tablesummarizes information related to our warranty provision for the three monthsended March 31, 2006 (in thousands):

 

| ** **                                                                                         | ** ** | **2006** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------|------------|
|                                                                                               |       |     |       |
| Balance, January  1, 2006                                                                          |       | $        | 30,191     |   |
| Liabilities  accrued for warranties issued during the quarter, net of adjustments and  expirations |       | 6,349    |       |
| Warranty  expenditures incurred during the quarter                                                 |       | (5,490   | )          |
| Balance, March  31, 2006                                                                           |       | $        | 31,050     |   |

 

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

 

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

 

As part of theresearch and development agreement signed with Intel in 2004, we also agreed toprovide Intel with indemnity against any infringement of the intellectualproperty rights of any third party arising from Intel’s purchase and/or use ofour EUV source systems. Details of such indemnity will be negotiated as part ofa purchase agreement related to potential future products.

 

As part of the supply agreement signed with TCZin September 2005, we agreed to indemnify TCZ against any infringement of theintellectual property rights of a third party arising from TCZ’s purchase ofour products. We will defend such actions at our own expense and will pay thecost and damage awarded in any such action provided that TCZ grants us solecontrol of the defense

 

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and settlement of such action and also providesus with information required for the defense and settlement of such action. Dueto the nature of these indemnification provisions, they are indefinite andextend beyond the term of the actual lithography tool manufacturer agreements.

 

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

 

As a result of the TCZ joint venture which was formed in July 2005, Zeissis now a related party. In addition to transactions that occur among us, Zeissand TCZ related to the joint venture, we also purchase certain optical partsdirectly from Zeiss and sell our light source system products to Zeissperiodically. We recorded revenue associated with this related party of $2.2million for the three months ended March 31, 2006. As of December 31, 2005 andMarch 31, 2006, we had accounts receivable balances of $588,000 and $2.8million, respectively, and accounts payable balances of $5.0 million and $4.2million, respectively, all of which were associated with these related partytransactions with Zeiss.

 

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

 

We are party to legalactions in the normal course of business. Based in part on the advice of legalcounsel, our management does not expect the outcome of legal action in thenormal course of business to have a material impact on our financial position,liquidity, or results of operations.

 

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

 

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

 

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

 

**Forward-Looking Statements**

 

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

 

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orrevise any forward-looking statements to reflect new information or futureevents or developments. Thus, you should not assume that our silence over timemeans that actual events are bearing out as expressed or implied in suchforward-looking statements.

 

#### **Overview**

 

*General*

 

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

 

In July 2005, we entered into a joint venture agreement with (i) CarlZeiss SMT AG, a German corporation (“SMT”); (ii) Carl Zeiss Laser OpticsBeteiligungsgesellschaft mbH, a German limited liability company (“LOB”); and(iii) the Swiss liability company that was formed as part of the JV Agreementand named TCZ GmbH (“TCZ”). LOB and SMT, together with their affiliatedentities, are collectively referred to as “Zeiss”. TCZ is currently developing,and will integrate, market and sell, and support, production tools for the flatpanel display manufacturing industry. The joint venture is headquartered in SanDiego and is owned 60% by us and 40% by Zeiss. The joint venture is targetingthe growing market for low-temperature poly-silicon (“LTPS”) processing used inthe manufacture of liquid crystal displays that are brighter, have higherresolution, and consume less power than displays using today’s predominantamorphous silicon films. We currently expect that TCZ will ship its firstproduction tool, the TCZ 900X, in late 2006 or early 2007, and we expect thatTCZ will break even from a financial standpoint in 2008.

 

***Products***

** **

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

 

Our excimer light sources for photolithography producepulsed light of extremely short wavelengths within the DUV spectrum. Thebandwidth of the light is further narrowed through a number of opticaltechniques. The DUV wavelengths are measured in nanometers (one nanometer isone billionth of a meter), and the light sources are referred to according toeither the wavelength or the gases that are mixed to produce the light. KryptonFluoride (“KrF”) gases produce light at a 248 nm wavelength, and Argon Fluoride(“ArF”) gases produce light at a 193 nm wavelength. The extremely shortwavelengths and highly narrowed bandwidths of light produced by these lightsources enable the very fine feature resolution required for patterning orprinting the circuitry on silicon wafers. The pulse energy and repetition rateof the light source permit high throughput in wafer processing. We havedesigned our light sources to be reliable, easy to install and service and compatiblewith existing semiconductor manufacturing processes. Our light sources are usedto pattern or print the integrated circuits, which are also calledsemiconductors or “chips,” that power many of today’s advanced consumer andbusiness electronics. In the first quarter of 2006, we sold 70 light sourcesystems at an average selling price of $972,000.

 

Certain components and subassemblies included in ourlight sources require replacement or refurbishment following extended operation.We estimate that a light source used in a semiconductor

 

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production environment will require one to two replacement chambers peryear, depending upon the level of usage. Similarly, certain optical componentsof the light source deteriorate with continued exposure to DUV light andrequire periodic replacement. We provide these and other spare and replacementparts for our photolithography light sources as needed by our customers.

 

As the life and usage ofour installed base of light sources in production at chipmakers exceeds theoriginal warranty periods, some chipmakers request service contracts from us. Additionally,we provide billable service or service contracts directly to the threesemiconductor lithography tool manufacturers. These service agreements requireus to maintain and/or service these light sources either on an on-call orregular interval basis or both. Some of these contracts include replacement ofconsumable parts and non-consumable parts.

 

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

 

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

#### ** **

Since we derive a substantial portion of our revenuesfrom photolithography tool manufacturers, we are subject to the volatile and unpredictablenature of the semiconductor industry. The semiconductor industry is highlycyclical in nature and historically has experienced periodic ups and downs, andthe activities of the last several years illustrate this cyclicality. In 2000,the semiconductor industry experienced strong growth, which was followed by athree year decline from 2001 through late 2003. Growth resumed in the finalquarter of 2003 and continued through the third quarter of 2004. In the fourthquarter of 2004, the industry declined briefly, then leveled off early in 2005,and as a number of industry indicators became more positive, began to improvegradually thereafter. For example, the utilization of our light sources atchipmakers rose steadily throughout 2005 and reached a new record high by yearend. Fab utilization also increased throughout the year, reaching the low tomid-90 percent range by the end of 2005. Our most advanced ArF products werethe main driver of light source demand throughout 2005, and we were able to achievehigher system average selling prices (ASP) as a result.

 

In the final quarter of 2005, orders for our lightsources increased substantially from the levels we had experienced earlier inthe year. Our chipmaker customers began indicating that increasing demand forchips would require them to expand production capacity, and our lithographytool manufacturing customers began placing orders for a growing number of lightsources to meet increasing scanner demand. It began to appear that we wereagain entering an industry growth cycle and upturn.

 

There were many positiveindicators in the first quarter of 2006 that reinforced our viewpoint that wewere entering an upturn in the semiconductor industry. While we continued tosee strong demand for our ArF light sources in the first quarter of 2006, wealso experienced substantial ongoing growth in our non-systems revenue. Inaddition, the utilization of our light sources remained high, and there wasstronger than anticipated demand for KrF light sources, as chipmakers orderedtools to expand capacity. For the first quarter of 2006, our revenue grew to$127.1 million, a 24 percent increase over revenue of $102.8 million in thefourth quarter of 2005. Our bookings in the first quarter of 2006 climbed to$135.6 million, the highest quarterly bookings level in our history. Additionally,our forecast for the second quarter of 2006 calls for revenue to increase overfirst quarter 2006 revenue, and current industry forecasts suggest continuedgrowth through the remainder of 2006.

 

Fab utilization continuedto be in the mid 90 percent range in the first quarter of 2006, while foundryutilization picked up further. Demand has remained strong for certain types ofmemory chips. Additionally, NAND flash manufacturers are spending strategicallyto build long-term positions in the

 

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market, and logicmanufacturers generally are expected to execute to their announced capitalspending plans. A number of chipmakers have recently announced their intentionto increase their capital spending substantially either in 2006, or in both2006 and 2007, and analysts currently estimate that capital spending willincrease by between 11 percent and 14 percent for 2006.

 

The growth opportunities for semiconductor equipmentin general and for lithography in particular are based on strong continuingdemand for consumer electronics.  Themedium-term growth opportunities are promising because of the large number ofmulti-year product cycles that are in early stages of development.  We believe that demand for DUV lithographytools will grow faster than for lithography tools overall as more wafer layerstransition to DUV production.  ArFtechnology is the most rapidly growing segment of DUV lithography. However,macro-economic factors, such as high energy prices and rising interest rates,could have a negative impact on consumer spending, including spending onelectronic devices, which would have a negative effect on demand for ourproducts.

 

As we entered 2006, we continued to focus our effortson creating shareholder value through improved profitability, overall financialperformance and execution.  During thefirst quarter of 2006, our gross margin increased to 46 percent and we achievedimproved execution overall in our business activities.  We continued our efforts to improve assetmanagement with particular emphasis on improving inventory management,increasing inventory turns, and increasing overall cash flows.  In the first quarter of 2006, however, wegenerated much less cash from operations on a quarterly basis than we didthroughout 2005.  Our low cash generationfrom operations so far in 2006 is primarily attributable to high accountsreceivable balances resulting from back-end loaded shipments during the firstquarter, and front-end loaded increased inventory levels to support a ramp inoperations to meet forecasted growing demand. We expect to generate cash from operations through the remainder of 2006and we will continue to explore opportunities for the most effective use of ourcash.

 

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

#### ** **

*General*

 

The discussion andanalysis of our financial condition and results of operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States of America. Thepreparation of these financial statements requires us to make estimates and usejudgment that may impact the reported amounts of assets, liabilities, revenues,expenses, and related disclosure of contingent assets and liabilities. As apart of our ongoing internal processes, we regularly evaluate our estimates andjudgments associated with revenue recognition, valuation of parts used in ourrefurbishment manufacturing process, inventory allowances, warranty provisions,stock-based compensation, income taxes, allowances for bad debts, long-livedassets valuation, intangible assets valuation, and contingencies and litigation.We base these estimates and judgments upon historical information and otherfacts and assumptions that we believe to be valid and/or reasonable under thecircumstances. These assumptions and facts form the basis for making judgmentsand estimates and for determining the carrying values of our assets andliabilities that are not apparent from other sources. Actual results could varyfrom our 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.

 

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*RevenueRecognition*

 

Our revenues consistof product sales, which include sales of light source systems, consumable andspare parts, upgrades, service, service contracts and training. Our revenuesalso consist of certain funded development activities performed for our customersand under government contracts and license agreements.

 

The sales of our light source systems generally include training andinstallation services. We determined these elements qualify as one unit ofaccounting under Emerging Issues Task Force (“EITF”) Bulletin No. 00-21, “RevenueArrangements with Multiple Deliverables” as we do not have evidence of fairvalue for the undelivered training and installation elements. Furthermore, wedetermined that the undelivered training and installation elements areperfunctory performance obligations and are not essential to the functionalityof our light source systems. Therefore, in accordance with the provisions ofStaff Accounting Bulletin No. 104, we recognize revenue when the revenuerecognition criteria are met for the light source system, and accrue the costsof providing the training and installation services. We recognize light sourcesystem revenue 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 an acceptance provision, which is satisfied bythe issuance of an acceptance certificate by the customer. For thesetransactions, we recognize revenue upon receipt of the acceptance certificate. Inaddition, we test our light source systems in environments similar to thoseused by our customers prior to shipment to ensure that they meet publishedspecifications.

 

Revenue from consumables and spare parts salesis recognized at the point that legal title passes to the customer, which isupon shipment from our facility.  For a significant portion of our spareparts sales, our customers return the consumed assembly to us as part of thesale of the new part.  We reuse some of the material within these coreassemblies, mainly metal components, for the future build of coreassemblies.  As a result, our revenue consists of both cash and the valueof the reusable parts received from our customers as consideration for thesespare 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 and training revenue is recognized as theservices are rendered.

 

For funded development contracts, which areincluded in other revenue, funds received are accounted for on thepercentage-of-completion method based on the relationship of costs incurred tototal estimated costs. Revenues generated from these types of fundeddevelopment contracts are derived from cost sharing contracts between certain customersand us. If milestones on these funded development contracts require thatspecific results be achieved or reported by us, revenue is not recognized untilthat milestone is completed.  For some of the funded development contractsthat we enter into with customers and government agencies, we evaluate certaincriteria to determine whether recording the funds received as revenue isappropriate.  If certain conditions are met, these funds are not recordedas revenue but rather are offset against our own internal research anddevelopment expenses in the period that the milestone is achieved.

 

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

* *

Over the last severalyears as part of our regular business activities, we have conducted significantparts refurbishment activities related to some of our core assemblies, inparticular our chamber assemblies. The volume of this activity significantlyincreased in 2004. These activities involve arrangements with our customerswhere we sell a new part to the customer at a reduced sales price if the customerreturns the consumed assembly that the new part replaces. These returned coreassemblies contain a certain amount of material, primarily metal components,that may be reused by us in future core assemblies. Upon receipt of theseconsumed assemblies from our customers, we record an entry to recognize theestimated fair value of the reusable components as inventory and revenue or areduction in

 

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cost of product salessold depending on the reason for the part replacement. The value of thereusable parts contained within the consumed assembly is determined based uponhistorical data on the value of the reusable parts that we typically yield froma consumed assembly. As part of our normal excess and obsolete inventoryanalysis, these consumed assemblies are also reviewed on a quarterly basis andan inventory allowance is recorded as appropriate for these parts. The valuethat we assign to these core assemblies can be affected by the current demandfor the reusable parts in our manufacturing operations and the actual yieldrate achieved for parts within these consumed core assemblies. We believe thatour methodology for valuing the reusable parts within these returned coreassemblies is reasonable, but any changes in the demand for the parts or theyield of the parts included in these core assemblies could have a materialadverse effect on our financial condition and results of operations.

 

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

 

***InventoryAllowance***

** **

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

 

The inventory allowance totaled $10.4 million at bothDecember 31, 2005 and March 31, 2006. Although the inventory allowance remainedconstant from period to period, the inventory allowance at March 31, 2006 ascompared to December 31, 2005 includes increased excess and obsolete allowancesfor raw materials and spares and consumable parts offset by decreased excessand obsolete requirements for parts contained in consumed assemblies which are receivedfrom our customers and are used in our refurbishment activities.

 

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

 

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

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

•                  Lossof any of our three major customers or significant change in demand from any ofthese three customers;

 

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•      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.

 

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

 

###### *Warranty Provision*

###### * *

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

 

The total balance in thewarranty provision accrual as of December 31, 2005 and March 31, 2006 was $30.2million and $31.1 million, respectively. This increase from period to period isprimarily due to the high level of consumables and spare parts sales thatoccurred in the first quarter of 2006 and the reserve amounts remaining in thewarranty provision on March 31, 2006 related to these sales. This increase inthe spares and consumables portion of the warranty provision as of March 31,2006 was offset by decreases in the warranty provision caused by a greaterproportion of systems requiring lower warranty provisions and more systemsbeing at the end of their warranty period.

 

We actively engage inproduct improvement programs and processes to limit our warranty costs, but ourwarranty obligation is affected by the complexity of our product, productfailure rates and costs incurred to correct those product failures at customersites. The industry in which we operate is subject to rapid technologicalchange, and as a result, we periodically introduce newer, more complex lightsources. Although we classify these newly released light source models ashaving a higher risk in our warranty model resulting in higher warrantyprovisions, we are more likely to have differences between the estimated andactual warranty costs for these new products. This is due to limited or nohistorical product performance data on which to base our future warranty costs.Warranty provisions for our older and more established light source models aremore predictable as we have more historical information available on theseproducts. If actual product failure rates or estimated costs to repair thoseproduct failures were to differ from our estimates, revisions to our estimatedwarranty provision would be required, which could harm our financial conditionand results of operations.

 

*Stock-BasedCompensation*

 

We grant options topurchase our common stock to our employees and grant stock unit awards to our non-employeedirectors under our current stock plan. The benefits provided under this planare share-based payments subject to the provisions of SFAS No. 123R. EffectiveJanuary 1, 2006, we adopted the requirements of SFAS No. 123R which address theaccounting for share-based payment transactions in which an enterprise receivesemployee services in exchange for (a) equity instruments of the enterpriseor (b) liabilities that are based on the fair value of the enterprise’sequity instruments or that

 

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may be settled by the issuanceof such equity instruments. As a result of this new accounting requirement, ourconsolidated financial statements for the three months ended March 31, 2006include compensation expense as calculated per the provisions of SFAS No.123R.In adopting SFAS No. 123R, we elected to use the modified prospectivetransition method, thus our consolidated financial statements for periods priorto January 1, 2006 do not include any impact of SFAS No.123R. We also electedto attribute the value of share-based compensation to expense using thestraight-line method for awards granted after December 31, 2005 upon ouradoption of SFAS No. 123R. Compensation expense for awards outstanding as ofDecember 31, 2005 are being recognized over the remaining service period usingthe compensation expense calculated according to the pro forma disclosureprovisions under SFAS No. 123 which uses an accelerated expense recognitionmethod for those awards with a graded vesting schedule. Share-basedcompensation expense related to stock options and stock units was $2.4 million,before taxes for the three months ended March 31, 2006.

 

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

 

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

 

Other assumptionsrequired for estimating fair value under the Black-Scholes option pricing modelare the expected risk-free interest rate and expected dividend yield of ourstock. Our risk-free interest rate assumption is based upon currently availablerates on zero coupon U.S. Government issues for the expected term of our stockoptions. The expected dividend rate is not applicable to us as we have nothistorically declared or paid dividends nor do we anticipate paying cashdividends in the future.

 

SFAS No. 123R alsorequires forfeitures to be estimated at the time of grant and we have estimatedour forfeitures based on historical experience. We will revise this estimate,if necessary, in subsequent periods if actual forfeiture rates differ from ourestimates. In our pro forma information required under SFAS No. 123 for periodsprior to January 1, 2006, we accounted for forfeitures as they occurred.

 

If we change any of thecritical assumptions that we use in the Black-Scholes option pricing model suchas expected volatility or expected term or if we decide to use a differentvaluation model in the future, the compensation expense that we record underSFAS No. 123R may differ significantly in the future from what we have recordedin the current period. In addition, as the guidance by regulators for SFAS No.123R is relatively new, the application of these principles may be subject tofurther 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 are to be reduced by a valuation allowanceif, based on the weight of available evidence, it is more likely than not thatsome portion or all of the deferred tax assets will not be realized within thecarryback or carryforward periods. Information about an enterprise’s current financialposition and its results of

 

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operationsfor the current and preceding years, as well as all currently availableinformation about future years should be considered.

 

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

 

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

 

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

 

We have not provided forU.S. federal income and foreign withholding taxes on $54.2 million ofundistributed earnings from non-U.S. operations as of March 31, 2006 as it isour intention to reinvest undistributed earnings of our foreign subsidiariesand thereby indefinitely postpone their remittance. Accordingly, no provisionhas been made for foreign withholding taxes or U.S. income taxes which maybecome payable if undistributed earnings of foreign subsidiaries were paid tous as dividends. Currently, we are not considering the repatriation of anyforeign earnings and as such, no impact is reported in the financial statementsas of March 31, 2006. It is not practicable to estimate the amount of thedeferred tax liability on such unremitted earnings.

 

 

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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** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                | ** ** | **March 31,**               | ** ** |
| ** **                                                | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| Revenues:                                                 |       |                             |       |   |   |
| Product sales                                             |       | 99.8                             | %          | 99.9 | % |
| Other                                                     |       | 0.2                              |       | 0.1 |   |
| Total revenues                                            |       | 100.0                            | %          | 100.0 | % |
|                                                      |       |                             |       |   |   |
| Cost and  expenses:                                       |       |                             |       |   |   |
| Cost of product  sales                                    |       | 62.5                             |       | 54.0 |   |
| Research and  development                                 |       | 17.2                             |       | 14.3 |   |
| Sales and  marketing                                      |       | 6.8                              |       | 5.4 |   |
| General and  administrative                               |       | 7.5                              |       | 7.2 |   |
| Total costs and  expenses                                 |       | 94.0                             |       | 80.9 |   |
|                                                      |       |                             |       |   |   |
| Operating income                                          |       | 6.0                              |       | 19.1 |   |
|                                                      |       |                             |       |   |   |
| Total other  income - net                                 |       | 0.1                              |       | 4.9 |   |
|                                                      |       |                             |       |   |   |
| Income before  income tax provision and minority interest |       | 6.1                              |       | 24.0 |   |
|                                                      |       |                             |       |   |   |
| Income tax  provision                                     |       | —                           |       | 8.3 |   |
| Minority  interest                                        |       | 0.3                              |       | 0.5 |   |
|                                                      |       |                             |       |   |   |
| Net income                                                |       | 6.4                              | %          | 16.2 | % |
| Gross margin on  product sales                            |       | 37.3                             | %          | 45.9 | % |

 

**THREEMONTHS ENDED MARCH 31, 2005 AND 2006**

 

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

 

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

 
| ** **                                       | ** ** | **For the three months ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                       | ** ** | **March 31,**                                 | ** ** |
| ** **                                       | ** ** | **2005**                                           | ** ** | **2006** | ** ** |
|                                             |       |                                               |       |   |   |
| Light source  systems:                           |       |                                               |       |   |   |
| Revenue                                          |       | $                                                  | 48,536     |   | $ | 68,035 |   |
| Units sold                                       |       | 48                                                 |       | 70 |   |
| Average selling  price (1)                       |       | $                                                  | 1,009      |   | $ | 972 |   |
|                                             |       |                                               |       |   |   |
| Consumable and  spare parts and service products |       | $                                                  | 36,073     |   | $ | 59,021 |   |
| Other revenue                                    |       | $                                                  | 201        |   | $ | 61 |   |
|                                             |       |                                               |       |   |   |
| Total revenue                                    |       | $                                                  | 84,810     |   | $ | 127,117 |   |

 

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(1)Calculationof average selling price excludes $87,000 deferred light source revenue during thethree months ended March 31, 2005. We had one arrangement where a portion ofthe light source system fee was not payable until the system was installedsuccessfully at the end-user. This arrangement expired in March 2005.

 

Productsales increased 50% from $84.6****million forthe three months ended March 31, 2005 to $127.1 million for the three monthsended March 31, 2006. This increase in product sales was due to higher lightsource system revenues and higher consumable and spare parts and serviceproduct revenues for the three months ended March 31, 2006 compared to thethree months ended March 31, 2005. Light source system revenues increased 40%from $48.5 million for the three months ended March

 

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31, 2005 to $68.0 million for the three monthsended March 31, 2006. A total of 48 light source systems were sold in the threemonths ended March 31, 2005 at an average selling price of $1.0 million,compared to 70 light source systems sold in the three months ended March 31,2006 at an average selling price of $972,000. On a foreign currency adjustedbasis, the average selling price for the three months ended March 31, 2005 was$994,000 compared to $970,000 for the three months ended March 31, 2006. Thedecrease in the average selling price from period to period reflects the shiftin the product mix from higher priced technology buys of advanced ArF productsin the three months ended March 31, 2005 to capacity driven lower priced KrFproducts in the three months ended March 31, 2006. The increase in quantitiesof light source systems sold from period to period was due to the slightslowdown and flattening of the industry in the beginning of 2005 compared tothe recent upturn in the semiconductor industry in 2006. Chipmakers expandedcapacity needs have impacted the demand for our light source systems, andincreased demand for consumables and spare parts and service products.Consumable and spare parts and rising tool utilization resulted in service productsincreased 64% from $36.1 million for the three months ended March 31, 2005 to$59.0 million for the three months ended March 31, 2006. Revenues from fundeddevelopment contracts were $201,000 for three months ended March 31, 2005,compared to $61,000 for the three months ended March 31, 2006. There were norevenues recorded or earned associated with the TCZ joint venture for the threemonths ended March 31, 2006. Additionally, our forecast for the secondquarter of 2006 calls for revenue to increase over first quarter 2006 revenue,and current industry forecasts suggest continued growth through the remainderof 2006.

 

Ourbacklog at March 31, 2005 was $75.8 million compared to $99.3 million at March31, 2006. Bookings for the three months ended March 31, 2005 and March 31, 2006were $81.5 million and $135.6 million, respectively. The book-to-bill ratio forthe quarter ended March 31, 2005 was 0.96 compared to 1.07 for the quarterended March 31, 2006. The increase in the backlog is due to the changing conditionof the semiconductor industry from period to period. The backlog as of March31, 2005 reflected the brief slowdown and flattening in the semiconductorindustry that started in late 2004, whereas the backlog as of March 31, 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 firstquarter of 2006 as a result of this recent upturn in the semiconductorindustry.

 

Weinstalled 67 light sources at chipmakers and other end-users during the quarterended March 31, 2005 as compared to 63 light sources installed during thequarter ended March 31, 2006.

 

Salesto our three lithography tool manufacturing customers, ASM Lithography, Canon,and Nikon, amounted to 29%, 7% and 29%, respectively, of total revenue for thethree months ended March 31, 2005, and 35%, 8% and 17%, respectively, of totalrevenue for the three months ended March 31, 2006.

 

Our sales are generatedprimarily by shipments to customers in Europe, Japan, Korea, Taiwan, and theU.S. Approximately 84% and 83% of our sales for the three months ended March31, 2005 and 2006, respectively, were derived from customers outside the U.S. Wemaintain a wholly owned Japanese subsidiary, which sells to our Japanese customers.Revenues from Japanese customers, generated primarily by Cymer Japan, accountedfor 36% and 24% of total revenues for the three months ended March 31, 2005 and2006, respectively. The activities of our Japanese subsidiary are limited tosales and service of products purchased by them from us as the parentcorporation. We anticipate that international sales will continue to accountfor a significant portion of our net 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 on foreign currency forward exchange contracts (“forward contracts”)associated with purchases of our products by our Japanese subsidiary for resaleunder firm third-party sales commitments. Shipping costs associated with ourproduct sales are also included in cost of product sales. We do not charge our customersfor shipping fees and such costs are not significant.

 

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The cost of product sales increased 30% from $53.0million for the three months ended March 31, 2005 to $68.7 million for thethree months ended March 31, 2006. This increase in the cost of product saleswas primarily due to higher light source system sales and sales of consumablesand spare parts and service products in the three months ended March 31, 2006compared to the three months ended March 31, 2005. The increased product sales resulted inimproved gross margin on product sales from period to period. The grossmargin on product sales was 37% for the three months ended March 31, 2005 ascompared to 46% for the three months ended March 31, 2006. This higher grossmargin from period to period was primarily due to increased factory yield andutilization and reduced lead and cycle times. For the remainder of 2006, weanticipate improved operating efficiencies, further reductions in lead times andcontinued benefits from our on-going product cost reduction activities.

 

*Research and Development*. Research and development expenses include costs of internally-fundedand externally-funded projects as well as continuing product developmentsupport expenses, which consist primarily of employee and material costs,depreciation of equipment and other engineering related costs. Our research anddevelopment expenses are offset by amounts associated with certain of ourexternally funded research and development contracts. Research and developmentexpenses increased 24% from $14.6 million for the three months ended March 31,2005 to $18.1 million for the three months ended March 31, 2006 due primarilyto costs associated with our LTPS product development efforts and EUV lightsource development. Research and development expenses were offset by amountsrelated to our externally funded research and development contracts of $1.6million and $154,000 for the three months ended March 31, 2005 and 2006,respectively. In addition to our development of EUV and LTPS technologies, wealso continued to focus on next generation ArF and KrF products. Included inour ArF product development efforts for 2006 is the design of an enhanceduniversal platform for our XL series light sources. As a percentage of totalrevenues, research and development expenses decreased from 17.2% for the threemonths ended March 31, 2005 to 14.3% for the three months ended March 31, 2006due primarily to increased research and development activities and higherrevenues in 2006 as compared to 2005. As a result of our decision to enter theflat panel display manufacturing tools market with the formation of the TCZjoint venture, our research and development expenses going forward will alsoinclude a greater focus on LTPS product development efforts. We expect that ourinvestment in research and development expenses will continue.

 

*Sales and Marketing*. Sales and marketing expenses include the expenses of the sales,marketing and customer support staff and other marketing expenses. Sales andmarketing expenses increased 19% from $5.8 million for the three months endedMarch 31, 2005 to $6.8 million for the three months ended March 31, 2006. Theincrease in sales and marketing expenses from period to period primarily reflectsincreases in profit sharing and bonuses, stock-based compensation expenseassociated with the new SFAS 123R requirements which were adopted in the firstquarter of 2006, and employer payroll taxes related to stock option exercises whichoccurred in the first quarter of 2006. As a percentage of total revenues, suchsales and marketing expenses decreased from 6.8% for the three months endedMarch 31, 2005 to 5.4% for the three months ended March 31, 2006. We anticipatesales and marketing expenses may increase slightly as a result of our expectedrevenue increase in the second quarter of 2006.

 

*Generaland Administrative*. General and administrative expensesconsist primarily of management and administrative personnel costs,professional services and administrative operating costs. General andadministrative expenses increased 46% from $6.3 million for the three monthsended March 31, 2005 to $9.2 million for the three months ended March 31, 2006primarily due to stock-based compensation expense recorded in the first quarterof 2006 upon our adoption of SFAS 123R. General and administrative expenses in2006 also included increased profit sharing and bonus expenses, and employerpayroll taxes associated with stock option exercises that occurred in the firstquarter of 2006 and increased external audit fees during the period. As apercentage of total revenues, general and administrative expenses decreasedslightly from 7.5% for the three months ended March 31, 2005 to 7.2 % for thethree months ended March 31, 2006. We anticipate general and administrativeexpenses may increase slightly as a result of our expected revenue increase inthe second quarter of 2006.

 

*Total Other Income (Expense) -Net.*Net other income (expense) consists primarily of interestincome and expense, foreign currency exchange gains and losses associated withfluctuations in the value of the functional currencies of our foreignsubsidiaries against the U.S. dollar, and gains and losses associated with debtextinguishment transactions. Net other income totaled $80,000 and $6.2 millionfor

 

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the three monthsended March 31, 2005 and 2006, respectively. The increase in net other incomewas primarily due to the receipt of $3.2 million in life insurance proceeds followingthe death of one of our executive officers in the first quarter of 2006, anincrease in interest income, a decrease in interest expense and foreigncurrency exchange gains recorded in the first quarter of 2006 as compared toforeign currency exchange losses recorded in the first quarter of 2005. Theincrease in interest income from 2005 to 2006 reflects higher market interestrate yields on larger cash and investment balances. The decrease in interestexpense from period to period was due to our lower debt balances as a result ofthe repurchase of our convertible subordinated notes that we made in the secondquarter of 2005. Foreign currency exchange losses totaled $194,000, interestincome and other income totaled $2.4 million, and interest expense totaled $2.1million for the three months ended March 31, 2005, compared to a foreigncurrency exchange gain of $619,000, interest and other income of $7.0 million,and interest expense of $1.4 million for the three months ended March 31, 2006.

 

*Income Tax Provision.* The tax provision of $0 and $10.6 million for the three monthsended March 31, 2005 and 2006, respectively, reflects an annual effective rateof 0% and 34.6%, respectively. The change in the annual effective tax rate fromperiod to period was primarily attributable to the increase in pre-tax earningsas well as a reduction in tax benefits from U.S. export incentive programs andthe expiration of the federal research credit. The annual effective tax ratefor the three months ended March 31, 2005 was less than the U.S. statutory rateof 35% primarily as a result of permanent book/tax differences and tax credits.The effective tax rate is a function of current tax law and geographic locationof pre-tax income. The federal Research and Experimentation Credit expiredDecember 31, 2005. The ETI was repealed by the American Jobs Creation Act of2004 subject to certain transition rules. The ETI exclusion is being replacedwith a Manufacturing Activity deduction under IRC Section 199 with a phase outof ETI benefits in 2005 and 2006. Our estimated ETI benefit for 2005 reflectsthe transition rules.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Historicallywe have funded our operations primarily from cash generated from operations,the proceeds of the note offerings, bank borrowings, and the proceeds fromemployee stock option exercises. As of March 31, 2006, we had approximately$269.9 million in cash and cash equivalents, $151.2 million in short-terminvestments, $29.4 million in long-term investments, and $591.9 million inworking capital.

 

In February 2002, we issued $250.0 million in aggregateprincipal amount in a private placement of notes. These notes are due onFebruary 15, 2009 with interest payable semi-annually on February 15 and August15 of each year at 3.50% per annum. The notes are convertible into shares ofour common stock at a conversion rate of 20 shares per $1,000 principal amountor an effective conversion price of $50.00 per share. We used a portion of thenet proceeds from this private placement to redeem the previously issued notesthat were then outstanding. The remaining proceeds are being used for ouroperating, investing and financing activities. With the approval of our boardof directors, we have periodically repurchased these notes in the open market. Werepurchased $60.0 million principal amount of these notes in 2005. As of March31, 2006, there were $140.7 million principal amount of notes outstanding.

 

Net cash provided byoperating activities was approximately $44.5 million and $869,000 for the threemonths ended March 31, 2005 and 2006, respectively. Although net income for thethree months ended March 31, 2006 was significantly higher than the same periodin 2005, cash provided by operating activities was much lower in the firstthree months of 2006 as compared to the first three months of 2005. This is primarilyattributable to significant increases in accounts receivable and inventoriesfor the three months ended March 31, 2006 compared to decreases in these same itemsfor the three months ended March 31, 2005. The increase in accounts receivableis the result of the back-end loaded shipments during the quarter and theincrease in inventory balances reflects front-end loaded inventory levels tosupport forecasted growing demand. In addition, operating cash was impacted forthe three months ended March 31, 2006 as a result of classifying excess taxbenefits from stock option exercises in the amount of $10.2 million in financingactivities rather than operating activities in accordance with SFAS 123R.

 

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Net cash used ininvesting activities was approximately $13.0 and $31.6 million for the threemonths ended March 31, 2005 and 2006, respectively. Net cash used in investingactivities during the three months ended March 31, 2005 reflects the timing ofshort-term and long-term investments that matured and were reinvested duringthe period, and the acquisition of $5.2 million of property and equipment. Netcash used in investing activities for the three months ended March 31, 2006 wasdue 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 and theacquisition of $3.7 million of property and equipment.

 

Net cash used infinancing activities was approximately $6.7 million for the three months endedMarch 31, 2005, compared to net cash provided by financing activities of $64.2million for the three months ended March 31, 2006. Net cash used in financingactivities for the three months ended March 31, 2005 reflects the repurchase oftreasury stock of $8.3 million, partially offset by proceeds received from the exerciseof employee stock options totaling $1.6 million. Net cash provided by financingactivities for the three months ended March 31, 2006 reflects the proceedsreceived from the exercise of employee stock options totaling $54.1 million andthe excess tax benefits for the period from stock option exercises totaling$10.2 million.

 

Werequire substantial working capital to fund our business, particularly tofinance inventories, including purchase orders with our vendors, accountsreceivable, and for capital expenditures. Our future capital requirementsdepend on many factors, including our manufacturing activity, the timing andextent of spending to support product development efforts, expansion of salesand marketing and field service and support, competitive labor marketcompensation requirements, the timing of introductions of new products andenhancements to existing products, and the market acceptance of our products.We believe that cash generated from operations along with the liquidityprovided by our existing cash balances and short-term investments will besufficient to sustain operations and provide for any potential future expansionof our business for at least the next 12 months.

 

At March 31, 2005 and2006, we did not have any relationship with unconsolidated entities orfinancial partnerships, such as entities often referred to as structuredfinance variable interest, or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. In addition, we did not engagein trading activities involving non-exchange traded contracts. As a result, weare not exposed to any financing, liquidity, market or credit risk that couldarise if we had engaged in such relationships. We do not have relationships andtransactions with persons and entities that derive benefits from theirnon-independent relationship with us or our related parties except as disclosedherein.

 

**RECENT ACCOUNTING PRONOUNCEMENT**

 

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

 

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

#### ** **

# **Foreign Currency Risk**

# ** **

Weconduct business in several international currencies through our globaloperations. Due to the large volume of our business that we conduct in Japan,the Japanese operation poses our greatest foreign currency risk. We use financialinstruments, principally forward contracts, to manage our foreign currencyexposures. We enter into forward contracts in order to reduce the impact ofcurrency fluctuations related to purchases of our inventories by Cymer Japan inU.S. dollars for resale under firm third-party sales commitments denominated inJapanese yen, as well as other foreign currency exposures including exposuresrelated to intercompany debt. We do not enter into forward contracts forspeculative purposes.

 

Asof March 31, 2006, we had outstanding forward contracts to buy U.S. $35.6million for 3.9 billion yen under foreign currency exchange facilities withcontract rates ranging from 111.71 yen to 118.27****yenper U.S. dollar. These contracts expire on various dates through November 2006.

 

Our forward contracts generally qualify for hedgeaccounting treatment per the provisions of Statement of Financial AccountingStandards No. 133, “Accounting for Derivative Instruments and HedgingActivities”. As a result, we defer changes in the fair value for the effectiveportion of these hedges and record the amount in other comprehensive income(loss) and subsequently reclassify the gain or loss to cost of product sales inthe same period that the related sale is made to the third party. The fairvalue of all of our forward contracts and the deferred gain (net of tax) forthose that qualify for hedge accounting treatment totaled $276,000 and $14,000,respectively, as of March 31, 2006.

 

The fair value of these forward contracts as of March31, 2006 would have fluctuated by $3.6 million if the foreign currency exchangerate for the Japanese yen to the U.S. dollar on these forward contracts hadchanged by 10%.

 

# **Investment and DebtRisk**

# ** **

Wemaintain an investment portfolio consisting primarily of government andcorporate fixed income securities, certificates of deposit and commercial paper.While it is our general intent to hold such securities until maturity, we willoccasionally sell certain securities for cash flow purposes. Therefore, ourinvestments are classified as available-for-sale and are carried on the balancesheet at fair value. Due to the conservative nature of the investmentportfolio, a sudden change in interest rates would not have a material effecton the value of the portfolio.

 

In February 2002, weissued $250.0 million principal amount of unsecured fixed rate 3.50%Convertible Subordinated Notes due February 15, 2009. Interest on these notesis payable on February 15 and August 15 of each year. The notes are convertibleinto shares of our common stock at a conversion rate of 20 shares per $1,000principal amount subject to adjustment under certain conditions. We may redeemthe notes after February 20, 2005 at certain redemption prices expressed as apercentage of the principal amount. The notes are subordinated to our existingand future senior indebtedness and effectively subordinated to all indebtednessand other liabilities of our subsidiaries. Because the interest rate is fixed,we believe there is no risk of increased interest expense. These notes

 

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are recorded at facevalue on the consolidated balance sheets. In the third quarter of 2004 and thesecond quarter of 2005, we repurchased, at a discount to par, approximately$49.2 million and $60.0 million principal amount, respectively, of these notes.As of March 31, 2006, $140.7 million principal amount of the notes wereoutstanding. The fair value of such debt based on quoted market prices on March31, 2006 was $142.2 million.

 

**ITEM4. Controls and Procedures**

 

*Evaluationof disclosure controls and procedures*. For the first quarterof 2006, our chief executive officer and our chief financial officer, evaluatedthe effectiveness of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) as of March 31, 2006, and concluded that as ofsuch date, our disclosure controls and procedures were not effective in ensuringthat information required to be disclosed by us in the reports that we fileunder the Exchange Act is recorded, processed, summarized and reported withinthe time period specified in the rules and forms of the Securities and ExchangeCommission.

 

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

 

*Changesin internal control over financial reporting.*There has beenno change in our internal control over financial reporting during the quarterended March 31, 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting other than thesteps taken by us to remediate the material weakness that was first disclosedby us in our 2005 Form 10-K relating to our accounting for income taxes.

 

We have taken the following remediation steps during the three months ended March 31, 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

•      Increased thelevel of communication with our subsidiary office accountants over the preparationof our foreign quarterly and annual tax provisions.

 

We plan to conduct ourtesting of these new internal controls during the next several months so thatthis material weakness in our accounting for income taxes is completelyremediated during the second or third quarter of 2006.

 

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**PART II. OTHER INFORMATION**

 

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

 

None.

 

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

 

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

 

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

 

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

 

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

•      cyclicality in themarket for semiconductor manufacturing equipment;

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

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

•      timing and size oforders from our customer base;

•      product lead timedemands from lithography tool manufacturers and chipmakers;

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

•      changes in the price andprofitability of our products;

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

•      changes in marketpenetration by our competitor;

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

•      our ability to manageour manufacturing requirements;

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

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

•      worldwide politicalinstability;

•      changing global economicconditions, including rising energy prices; and

•      intellectual propertyprotection.

 

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

 

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

 

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

 

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

 

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

 

Downturnsin the semiconductor industry often result in decreases in demand forsemiconductor manufacturing equipment, including the photolithography toolsthat our OEM customers produce. The most recent downturn in the semiconductorindustry had a severe effect on the demand for semiconductor manufacturingequipment. Fluctuating levels of investment by chipmakers and resulting pricingvolatility will continue to materially affect our aggregate bookings, revenuesand operating results. Even during periods of reduced revenues we believe wemust continue to invest in research and development and to maintain extensive ongoingworldwide customer service and support capabilities to remain competitive.Continued spending in furtherance of these objectives may temporarily harm ourfinancial results. Semiconductor industry downturns and slowdowns are likely tocontinue to adversely affect our business, financial condition and operatingresults, and our operating results may fall below the expectations of publicmarket analysts or investors in future quarters. Any failure to meet suchexpectations could materially adversely affect the price of our common stock.

 

Our OEM customers try to manage their inventories andproduction requirements to appropriate levels that reflect their expected salesto chipmakers. Market conditions in the semiconductor industry and

 

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our OEM customers’ production efficiency can cause themto expand or reduce their orders for new light 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 cash flows. Ifour OEM customers demand shorter product lead times to improve their inventoryand cash positions, our inventory management and cash position may benegatively impacted, which may adversely affect our operating results,financial condition and cash flows.

 

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

 

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

 

| ** **      | ** ** | **Three months ended** | ** ** |
|-----------------|------------|----------------------------------|------------|
| ** **      | ** ** | **March 31,**               | ** ** |
| ** **      | ** ** | **2005**                         | ** ** | **2006** | ** ** |
|            |       |                             |       |   |   |
| ASM Lithography |       | 29                               | %          | 35 | % |
| Canon           |       | 7                                | %          | 8 | % |
| Nikon           |       | 29                               | %          | 17 | % |
|            |       |                             |       |   |   |
| Total           |       | 65                               | %          | 60 | % |

 

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

 

| ** **      | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-----------------|------------|-----------------------|------------|--------------------|------------|
| ** **      | ** ** | **2005**              | ** ** | **2006**           | ** ** |
|            |       |                  |       |               |       |
| ASM Lithography |       | 36                    | %          | 41                 | %          |
| Canon           |       | 5                     | %          | 5                  | %          |
| Nikon           |       | 25                    | %          | 23                 | %          |
|            |       |                  |       |               |       |
| Total           |       | 66                    | %          | 69                 | %          |

 

We expect that sales of our light source products tothese three customers will continue to account for a substantial portion of ourrevenue in the foreseeable future. None of our customers are obligated topurchase a minimum number of our products in the aggregate or during any particularperiod. We can provide no assurance that any of our customers will continue topurchase our products at past or current levels. For example, revenueattributable to sales to Canon declined by more than 50% from 2004 to 2005. Salesto Canon or any of these customers may be affected by many factors, some ofwhich are beyond our control. These factors include:

 

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

•      a customer experiencinglithography tool production problems;

•      a decision to purchaselight sources from other suppliers;

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

•      a decline in a customer’sfinancial condition.

 

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

 

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

** **

Our only current product line is excimer light sourcesystems, including KrF and ArF systems, and support, including consumable andspare parts and service support. We expect these light source 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 photolithographyequipment for manufacturing deep-submicron semiconductor devices using smallercircuit geometries. The demand for our products depends in part on the rate atwhich chipmakers further adopt excimer light sources as the chosen light sourcefor their photolithography tools.

 

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

 

•      inadequate performanceof photoresists used in advanced DUV photolithography;

•      potential shortages ofspecialized materials used in DUV optics;

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

•      consolidation ofchipmakers.

 

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

 

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

•      a failure to achievecontinued market acceptance of our products;

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

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

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

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

 

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

 

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

 

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

 

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performancein the field of the new products and the development of a comparable product byour competitor.

 

Atthis time, chipmakers are continuing to expand their manufacturing capacity at90 nm, while manufacturers of certain types of memory chips are in initialproduction at 65 nm and planning for production of chips with even smaller CDs.While these efforts are driving demand for our most advanced ArF light sources,chipmakers are also expanding production capacity overall, driving demand forour KrF light source products for DUV photolithography systems as well. Afterchipmakers have expanded their capacity to levels appropriate to meet existingdemand, their demand for our light source products will depend, in part, onwhether their sales forecasts give them confidence in the duration andmagnitude of the current growth cycle and their projected manufacturing processyields will enable ongoing investments in additional capacity.

 

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

 

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

 

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

 

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

 

•      recruit and trainqualified field service personnel;

•      identify qualifiedindependent firms; and

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

 

We may not be able to attract and train qualifiedpersonnel to maintain our direct support operations successfully. We may not beable to find and engage qualified third-party resources to supplement andenhance our direct support operations. Further, we may incur significant costsin providing these support services. Failure to implement our direct supportoperation effectively could harm our operating results, financial condition andcash flows.

 

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

** **

To continue to grow our business, our existing lightsource products and their process capabilities must be enhanced, and we mustdevelop and manufacture new products to serve other semiconductor applications.We cannot guarantee that we will be able to manage our business to groweffectively. Nor

 

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can we guarantee that we will be able to accelerate thedevelopment of new enhancements to our existing products and create newproducts. Further, we may not be able to effectively integrate new products andapplications into our current operations. Any of these risks could materiallyharm our business, financial condition and results of operations.

 

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

 

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

 

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

•      closely manage ourglobal operations;

•      improve our process andother internal management systems;

•      quickly adapt tochanging sales and marketing channels;

•      effectively manage ourinventory levels; and

•      attract, train, retainand manage key personnel.

 

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

 

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

 

Wepurchase a limited number of components and subassemblies included in our lightsource products from a single supplier or a small group of suppliers. Forcertain optical, control system and pulse power components and subassembliesused in our light source systems, we currently utilize a single supplier. Toreduce the risk associated with this single supplier, we carry a significantstrategic inventory of these components. Strategic inventories are managed as apercentage of future demand. We have also negotiated to have vendor-managedinventory of critical components to further reduce the risk of a singlesupplier. In addition, we contract themanufacture of various subassemblies more often than in the past. Further, someof our suppliers have specialized in supplying equipment or manufacturingservices to semiconductor equipment manufacturers and therefore are susceptibleto industry ups and downs and subject to the same risks and uncertaintiesregarding their ability to respond to changing market conditions. Because manyof these suppliers reduce the size of their workforce in an industry downturnand increase it in an upturn, they may not be able to meet our requirements orrespond quickly enough as an upturn 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.

 

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

** **

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

 

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

** **

We are currently aware of one significant competitorthat sells light sources for DUV photolithography applications. Thiscompetitor, Gigaphoton, is a joint venture between two large companies, Komatsuand Ushio, and is headquartered in Japan. Additionally, late in 2004, a former competitor Coherent, Inc., a U.S.company, announced that their Lambda-Physik subsidiary would no longer pursuethe excimer light source systems business for photolithography in thesemiconductor industry.

 

We believe that Gigaphoton is aggressively trying togain larger market penetration in the excimer light source industry. We knowthat our customers have purchased products from this competitor and that our customershave approved this competitor’s light sources for use with their products. Weknow that Gigaphoton has been approved by chipmakers in Japan, the U.S. andelsewhere for producing excimer light sources.

 

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

 

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

** **

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

 

•      research and development;

•      engineering;

•      sales and marketing;

•      field service andsupport;

•      manufacturing; and

•      management.

 

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

 

•      the continued servicesof our research and development, engineering, sales and marketing, fieldservice and support, manufacturing and management personnel;

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

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

 

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

 

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

 

We serve an increasingly global market. A large portionof our total revenues is derived from customers located outside of the U.S.,particularly in Asian countries. We expect our international sales to continueto account for a very large portion of our total revenues. In order to supportour foreign customers, we maintain a manufacturing and field service subsidiaryin Korea 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 manage our operations to addressand support our global customers effectively. Further, our investments in thesetypes of activities may not make us competitive in the global market or we maynot be able to meet the service, support, and manufacturing levels required byour global customers.

 

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

 

•      unexpected changes inregulatory requirements;

•      fluctuations in exchangerates and currency controls;

•      political and economicconditions and instability;

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

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

•      difficulties in staffingand managing foreign subsidiary and branch operations;

•      limited intellectualproperty protection in some countries;

•      potentially adverse taxconsequences in some countries;

•      the possibility ofaccounts receivable collection difficulties;

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

•      the effect of acts ofterrorism and war; and

•      the burdens of complyingwith a variety of foreign laws.

 

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

 

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

** **

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

 

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

•      failure to retain keypersonnel;

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

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

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

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

•      failure to commercializepurchased technologies;

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

•      assumption of unknownliabilities or other unanticipated events or circumstances; and

 

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

 

Mergers, acquisitions and joint ventures as well asentering new markets are inherently subject to multiple significant risks, andthe inability to effectively manage these risks could have a material adverseeffect on our business. In July 2005, we formed a joint venture with Zeissnamed TCZ GmbH, to produce tools for the manufacture of flat panel displays. Thisis a new market for both Cymer and Zeiss and may involve numerous risks. Any ofthese risks could materially harm our business, financial condition andoperating results. Further, any business that we acquire, joint venture that weform or new market we may enter may not achieve anticipated revenues oroperating results.

 

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

 

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

 

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

 

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

 

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

 

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

 

As of March 31, 2006, we owned 234 U.S. patents coveringcertain aspects of technology related to light sources and piezo techniques.These patents will expire at various times during the period from January 2008to January 2024. As of March 31, 2006, we had applied for 117 additionalpatents in the U.S. As of March 31, 2006, we owned 343 foreign patents and had 375patent applications pending in various foreign countries.

 

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

 

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

 

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

 

•      trade secret protection;

•      employee nondisclosureagreements;

•      third-partynondisclosure agreements; and

•      other intellectualproperty protection methods.

 

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

 

•      independently developsubstantially the same proprietary information and techniques;

•      gain access to our tradesecrets; or

•      disclose our technology.

 

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

 

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

 

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

** **

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

 

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

 

We have notified our competitor and others of our U.S.patent portfolio. Specifically, we have notified Komatsu that it may beinfringing some of our U.S. patents. We have discussed with Komatsu our claimsagainst each other. Komatsu challenged one of our U.S. patents in the UnitedStates Patent and Trademark Office (“USPTO”) but our patent was subsequentlyre-issued by the USPTO. Also, Komatsu transferred its lithography light sourcebusiness to our competitor, Gigaphoton. We also have had discussions with Lambda-Physik(a subsidiary of Coherent, Inc.) regarding allegations by each party againstthe other for possible patent infringement. Any of these discussions with ourcompetitor or former competitor may not be successful and litigation couldresult.

 

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

 

•      loss of our proprietaryrights;

•      exposure to significantliabilities by other third parties;

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

•      restriction frommanufacturing or selling our products.

 

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

 

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

 

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

 

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

 

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

 

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

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

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

•      our sales and marketingefforts may be disrupted.

 

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

 

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

** **

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

** **

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

** **

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

## ** **

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

 

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result in cancellation of orders or loss of customers,which would have a material adverse effect on our operating results, financialcondition and cash flows.

 

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

 

We are subject to federal, state and local regulations,such as regulations related to the environment, land use, public utilityutilization and the fire code, in connection with the storage, handling,discharge and disposal of substances that we use in our manufacturing processand on our facilities. We believe that our activities comply with currentgovernment regulations that are applicable to our operations and currentfacilities. We may be required to purchase additional capital equipment orother requirements for our processes to comply with these governmentregulations in the future if they change. Further, these government regulationsmay restrict us from expanding our operations. Adopting measures to comply withchanges in the government regulations, our failure to comply with environmentaland land use regulations, or restrictions on our ability to discharge hazardoussubstances, could subject us to future liability or cause our manufacturingoperations to be reduced or stopped.

 

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

** **

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

 

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

 

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

 

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

 

•      the cyclical nature ofthe semiconductor industry;

•      actual or anticipatedfluctuations in our operating results;

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

•      announcements ofinnovations in technology;

•      new products offered byus or our competitor;

•      developments of patentsor proprietary rights;

•      changes in financialestimates by securities analysts;

•      general worldwidepolitical, economic, and market conditions;

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

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

 

**In addition, the stock market has experiencedextreme price and volume fluctuations that have particularly affected themarket price for many high technology companies. Such fluctuations have in somecases been unrelated to the operating performance of these companies. Severeprice fluctuations in a company’s stock have frequently been followed bysecurities litigation. Any such litigation can result in**

 

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**substantialcosts and a diversion of management’s attention and resources and thereforecould have a material adverse effect on our business, financial condition andresults of operations.**

** **

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

 

None.

 

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

 

None.

 

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

 

None.

 

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

 

None.

 

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

 

10.1        Summarydescription of Cymer, Inc. Incentive Bonus Program as amended (incorporatedherein by reference to Exhibit 99.1 to our Current Report on Form 8-K filed onMarch 31, 2006).

 

31.1        Certificationof Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act.

 

31.2        Certificationof Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act.

 

32.1        Certificationof Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act.

 

32.2        Certificationof Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act.

 

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**SIGNATURES**

 

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

 

 
|              | CYMER, INC.                   |
|-------------------|-------------------------------|
|              |                          |
|              |                          |
| Date: May 3, 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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