**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**ý****                                ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

** **

**For theQuarterly Period Ended March 31, 2005**

 

**OR**

 

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

** **

**For theTransition Period from                          to                          **

 

**Commission file number 0-21321**

 

**CYMER, INC.**

(Exact name of registrant as specified in its charter)

 
| **Nevada**                                                                           | ** ** | **33-0175463**                       |
|--------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or  organization)                      |       | (I.R.S. Employer Identification No.) |
|                                                                                 |       |                                 |
| **17075 Thornmint Court, San Diego, CA**                                             | ** ** | **92127**                            |
| (Address of principal executive offices)                                             |       | (Zip Code)                           |
|                                                                                 |       |                                 |
| **(858) 385-7300**                                                                   |
| (Registrant’s telephone 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 by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.

 

Yes   ý            No   o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act).     Yes   ý            No   o

 

The number of shares ofCommon Stock, with $0.001 par value, outstanding on May 2, 2005 was 36,227,528.

 

 

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**CYMER, INC.**

 

**FORM 10-Q**

 

**For the Quarterly Period Ended March 31, 2005**

 

**INDEX**

 
| **PART I.**    | **FINANCIAL INFORMATION**                                                                       | ** ** |
|----------------|-------------------------------------------------------------------------------------------------|------------|
|           |                                                                                            |       |
| ITEM 1.        | Financial Statements  (unaudited)                                                               |       |
|           |                                                                                            |       |
|           | Consolidated  Balance Sheets as of December 31, 2004 and March 31, 2005               |       |
|           |                                                                                            |       |
|           | Consolidated  Statements of Operations for the three months ended March 31, 2004 and  2005 |       |
|           |                                                                                            |       |
|           | Consolidated  Statements of Cash Flows for the three months ended March 31, 2004 and  2005 |       |
|           |                                                                                            |       |
|           | 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 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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### **PARTI.  FINANCIAL INFORMATION**

 

**ITEM 1. Financial Statements**

 

**CYMER, INC.**

**CONSOLIDATED BALANCE SHEETS  (UNAUDITED)**

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

 
| ** **                                                                                                                                                                                   | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| **ASSETS**                                                                                                                                                                                   | ** ** | ** **                  | ** ** | ** **               | ** ** |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| CURRENT ASSETS:                                                                                                                                                                              |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                                                                                                    |       | $                           | 114,246    |                     | $          | 139,479 |   |
| Short-term investments                                                                                                                                                                       |       | 175,866                     |       | 180,249                  |       |
| Accounts receivable – net                                                                                                                                                               |       | 110,680                     |       | 79,692                   |       |
| Foreign currency forward exchange contracts                                                                                                                                                  |       | —                      |       | 1,142                    |       |
| Inventories                                                                                                                                                                                  |       | 110,022                     |       | 102,661                  |       |
| Deferred income taxes                                                                                                                                                                        |       | 7,470                       |       | 7,468                    |       |
| Prepaid expenses and other assets                                                                                                                                                            |       | 5,726                       |       | 4,971                    |       |
| Total current assets                                                                                                                                                                         |       | 524,010                     |       | 515,662                  |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| PROPERTY AND EQUIPMENT – NET                                                                                                                                                            |       | 123,548                     |       | 122,338                  |       |
| LONG-TERM INVESTMENTS                                                                                                                                                                        |       | 84,561                      |       | 86,974                   |       |
| DEFERRED INCOME TAXES                                                                                                                                                                        |       | 67,722                      |       | 67,379                   |       |
| GOODWILL – NET                                                                                                                                                                          |       | 8,358                       |       | 8,358                    |       |
| INTANGIBLE ASSETS – NET                                                                                                                                                                 |       | 10,394                      |       | 9,781                    |       |
| OTHER ASSETS                                                                                                                                                                                 |       | 7,185                       |       | 7,517                    |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| TOTAL ASSETS                                                                                                                                                                                 |       | $                           | 825,778    |                     | $          | 818,009 |   |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                |       |                        |       |                     |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| CURRENT LIABILITIES:                                                                                                                                                                         |       |                        |       |                     |       |
| Accounts payable                                                                                                                                                                             |       | $                           | 13,949     |                     | $          | 14,840 |   |
| Accrued warranty and installation                                                                                                                                                            |       | 28,546                      |       | 27,903                   |       |
| Accrued payroll and benefits                                                                                                                                                                 |       | 16,284                      |       | 10,372                   |       |
| Accrued patents, royalties and other fees                                                                                                                                                    |       | 6,318                       |       | 6,125                    |       |
| Foreign currency forward exchange contracts                                                                                                                                                  |       | 1,901                       |       | —                   |       |
| Income taxes payable                                                                                                                                                                         |       | 10,397                      |       | 9,108                    |       |
| Unearned income                                                                                                                                                                              |       | 6,152                       |       | 6,926                    |       |
| Accrued and other current liabilities                                                                                                                                                        |       | 4,456                       |       | 5,357                    |       |
| Total current liabilities                                                                                                                                                                    |       | 88,003                      |       | 80,631                   |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| CONVERTIBLE SUBORDINATED NOTES                                                                                                                                                               |       | 200,753                     |       | 200,753                  |       |
| DEFERRED INCOME TAXES                                                                                                                                                                        |       | 6,237                       |       | 6,237                    |       |
| OTHER LIABILITIES                                                                                                                                                                            |       | 7,282                       |       | 7,923                    |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| Total liabilities                                                                                                                                                                            |       | 302,275                     |       | 295,544                  |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| MINORITY INTEREST                                                                                                                                                                            |       | 6,183                       |       | 5,955                    |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| 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; 36,993,000 and 36,772,000 shares outstanding  at December 31, 2004 and March 31, 2005, respectively |       | 37                          |       | 37                       |       |
| Additional paid-in capital                                                                                                                                                                   |       | 378,414                     |       | 380,123                  |       |
| Treasury stock at cost (293,000 common shares)                                                                                                                                               |       | —                      |       | (8,287                   | )          |
| Unearned compensation                                                                                                                                                                        |       | (16                         | )          | —                   |       |
| Accumulated other comprehensive loss                                                                                                                                                         |       | (4,455                      | )          | (4,088                   | )          |
| Retained earnings                                                                                                                                                                            |       | 143,340                     |       | 148,725                  |       |
| Total stockholders’ equity                                                                                                                                                              |       | 517,320                     |       | 516,510                  |       |
|                                                                                                                                                                                         |       |                        |       |                     |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                              |       | $                           | 825,778    |                     | $          | 818,009 |   |

 

See Notes to UnauditedConsolidated Financial Statements.

 

3

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**CYMER, INC.**

**CONSOLIDATED STATEMENTS OFOPERATIONS (UNAUDITED)**

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

 
| ** **                                                                | ** ** | **For the three months ended  March 31,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                                       | ** ** | **2005** | ** ** |
| REVENUES:                                                                 |       |                                           |       |   |   |
| Product sales                                                             |       | $                                              | 87,871     |   | $ | 84,609 |   |
| Other                                                                     |       | 50                                             |       | 201 |   |
| Total revenues                                                            |       | 87,921                                         |       | 84,810 |   |
|                                                                      |       |                                           |       |   |   |
| COSTS AND EXPENSES:                                                       |       |                                           |       |   |   |
| Cost of product sales                                                     |       | 52,168                                         |       | 53,031 |   |
| Research and development                                                  |       | 12,370                                         |       | 14,604 |   |
| Sales and marketing                                                       |       | 5,823                                          |       | 5,774 |   |
| General and administrative                                                |       | 6,615                                          |       | 6,304 |   |
| Amortization of intangible assets                                         |       | 40                                             |       | 20 |   |
|                                                                      |       |                                           |       |   |   |
| Total costs and expenses                                                  |       | 77,016                                         |       | 79,733 |   |
|                                                                      |       |                                           |       |   |   |
| OPERATING INCOME                                                          |       | 10,905                                         |       | 5,077 |   |
|                                                                      |       |                                           |       |   |   |
| OTHER INCOME (EXPENSE):                                                   |       |                                           |       |   |   |
| Foreign currency exchange gain (loss) – net                          |       | 54                                             |       | (194 | ) |
| Interest and other income                                                 |       | 1,896                                          |       | 2,401 |   |
| Interest and other expense                                                |       | (2,556                                         | )          | (2,127 | ) |
|                                                                      |       |                                           |       |   |   |
| Total other income (expense) – net                                   |       | (606                                           | )          | 80 |   |
|                                                                      |       |                                           |       |   |   |
| INCOME BEFORE INCOME TAX PROVISION AND MINORITY  INTEREST                 |       | 10,299                                         |       | 5,157 |   |
|                                                                      |       |                                           |       |   |   |
| INCOME TAX PROVISION                                                      |       | 2,369                                          |       | — |   |
| MINORITY INTEREST                                                         |       | (774                                           | )          | 228 |   |
|                                                                      |       |                                           |       |   |   |
| NET INCOME                                                                |       | $                                              | 7,156      |   | $ | 5,385 |   |
|                                                                      |       |                                           |       |   |   |
| EARNINGS PER SHARE:                                                       |       |                                           |       |   |   |
| Basic earnings per share                                                  |       | $                                              | 0.20       |   | $ | 0.15 |   |
| Weighted average common shares outstanding                                |       | 36,586                                         |       | 36,884 |   |
|                                                                      |       |                                           |       |   |   |
| Diluted earnings per share                                                |       | $                                              | 0.19       |   | $ | 0.14 |   |
| Weighted average common and dilutive potential  common shares outstanding |       | 38,141                                         |       | 37,230 |   |

 

See Notes to UnauditedConsolidated Financial Statements.

 

4

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**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF CASHFLOWS (UNAUDITED)**

**(In thousands)**

 
| ** **                                                                         | ** ** | **For the three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                       | ** ** | **2005** | ** ** |
|                                                                               |       |                                           |       |   |   |
| OPERATING ACTIVITIES:                                                              |       |                                           |       |   |   |
| Net income                                                                         |       | $                                              | 7,156      |   | $ | 5,385 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                           |       |   |   |
| Depreciation and amortization                                                      |       | 6,909                                          |       | 7,264 |   |
| Non-cash stock-based compensation                                                  |       | 104                                            |       | 152 |   |
| Amortization of unearned compensation                                              |       | 35                                             |       | 16 |   |
| Minority interest                                                                  |       | 774                                            |       | (228 | ) |
| Provision for deferred income taxes                                                |       | (32                                            | )          | 89 |   |
| Loss on disposal and impairment of property and  equipment                         |       | 61                                             |       | 2 |   |
| Change in assets and liabilities:                                                  |       |                                           |       |   |   |
| Accounts receivable – net                                                     |       | (16,322                                        | )          | 30,988 |   |
| Foreign currency forward exchange contracts                                        |       | (640                                           | )          | (1,898 | ) |
| Inventories                                                                        |       | (5,197                                         | )          | 7,361 |   |
| Prepaid expenses and other assets                                                  |       | (690                                           | )          | 160 |   |
| Accounts payable                                                                   |       | 362                                            |       | 891 |   |
| Accrued expenses and other liabilities                                             |       | 7,081                                          |       | (4,420 | ) |
| Income taxes payable                                                               |       | 2,090                                          |       | (1,289 | ) |
|                                                                               |       |                                           |       |   |   |
| Net cash provided by operating activities                                          |       | 1,691                                          |       | 44,473 |   |
|                                                                               |       |                                           |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                                           |       |   |   |
| Acquisition of property and equipment                                              |       | (4,435                                         | )          | (5,180 | ) |
| Purchases of investments                                                           |       | (195,233                                       | )          | (141,521 | ) |
| Proceeds from sold or matured investments                                          |       | 190,422                                        |       | 133,719 |   |
| Acquisition of patents                                                             |       | (5,990                                         | )          | — |   |
| Acquisition of minority interest                                                   |       | (2,000                                         | )          | — |   |
|                                                                               |       |                                           |       |   |   |
| Net cash used in investing activities                                              |       | (17,236                                        | )          | (12,982 | ) |
|                                                                               |       |                                           |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                                           |       |   |   |
| Proceeds from issuance of common stock                                             |       | 8,113                                          |       | 1,557 |   |
| Payments on capital lease obligations                                              |       | (12                                            | )          | (12 | ) |
| Purchase of treasury stock                                                         |       | —                                         |       | (8,287 | ) |
|                                                                               |       |                                           |       |   |   |
| Net cash provided by (used in) financing activities                                |       | 8,101                                          |       | (6,742 | ) |
|                                                                               |       |                                           |       |   |   |
| EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH  EQUIVALENTS                      |       | 249                                            |       | 484 |   |
|                                                                               |       |                                           |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                               |       | (7,195                                         | )          | 25,233 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF THE PERIOD                               |       | 110,632                                        |       | 114,246 |   |
|                                                                               |       |                                           |       |   |   |
| CASH AND CASH EQUIVALENTS AT END OF THE PERIOD                                     |       | $                                              | 103,437    |   | $ | 139,479 |   |
|                                                                               |       |                                           |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                  |       |                                           |       |   |   |
| Interest paid                                                                      |       | $                                              | 4,435      |   | $ | 3,627 |   |
| Income taxes paid, net                                                             |       | $                                              | 840        |   | $ | 1,356 |   |

 

See Notes to UnauditedConsolidated Financial Statements.

 

5

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**CYMER, INC.**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS****Three Months Ended March 31, 2005(Unaudited)**

 

**1.****              BASISOF PRESENTATION**

 

*Unaudited Interim Financial Data*– The accompanying consolidated financial information has been prepared byCymer, Inc., and its wholly-owned and majority-owned subsidiaries(collectively, “Cymer”), without audit, in accordance with the instructions toForm 10-Q. In the opinion of management, the unaudited consolidated financialstatements for the interim periods presented reflect all material adjustments,consisting only of normal recurring adjustments, necessary for a fairpresentation of the financial position and results of operations as of and forsuch periods indicated.  These unaudited consolidatedfinancial statements and notes hereto should be read in conjunction with theconsolidated financial statements and notes thereto included in Cymer’s AnnualReport on Form 10-K for the year ended December 31, 2004.  Results for the interim periods presentedherein are not necessarily indicative of results that may be reported for anyother interim period or for the entire fiscal year.

 

*Principles of Consolidation* – Theconsolidated financial statements include the accounts of Cymer, Inc., itswholly owned subsidiaries – Cymer Japan, Inc. (“Cymer Japan”), Cymer SingaporePte Ltd. (“Cymer Singapore”), Cymer B.V. in the Netherlands (“Cymer B.V.”),Cymer Southeast Asia, Ltd, in Taiwan (“Cymer SEA”), Cymer SemiconductorEquipment Shanghai Co., Ltd, in the People’s Republic of China (“Cymer PRC”),and its majority-owned subsidiary, Cymer Korea, Inc. (“Cymer Korea”).  Cymer, Inc. owns 81% of Cymer Korea.  Cymer Japan is currently the only subsidiaryoffice of Cymer that sells excimer light source systems.  In addition, Cymer Japan provides fieldservice to customers in the Japan region. Cymer Singapore, Cymer B.V., CymerSEA, and Cymer PRC are field service offices for customers in those respectiveregions.  Cymer Korea providesrefurbishment manufacturing, field service, and administrative activities forthat region. All significant intercompany balances have been eliminated inconsolidation.

 

*Accounting Estimates*– The preparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America (“GAAP”) requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reporting period.  Actualresults may differ from those estimates.

 

*RecentAccounting Pronouncements.*

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issued Statementof Financial Accounting Standards No. 123R (“SFAS No. 123R”) “Share-BasedPayment - An Amendment to Statement Nos. 123 and 95,” that addresses theaccounting for share-based payment transactions in which an enterprise receivesemployee services in exchange for (a) equity instruments of the enterprise or(b) liabilities that are based on the fair value of the enterprise’s equityinstruments or that may be settled by the issuance of such equity instruments.This statement will eliminate the ability to account for share-basedcompensation transactions using Accounting Principles Board (“APB”) Opinion No.25, “Accounting for Stock Issued to Employees,” and will instead require thatsuch transactions be accounted for using a fair-value-based method.  On April 14,2005, the U.S. Securities and Exchange Commission (“SEC”) announced thedeferral of the effective date of SFAS No. 123R.  The deferral allows companies to adopt theprovisions of SFAS No. 123R beginning on the first annual period beginningafter June 15, 2005.  Based on thenew required adoption date, Cymer plans to adopt SFAS No. 123R as of thebeginning of the first quarter of 2006.

 

6

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*Reclassifications*– Certain amounts in theprior year consolidated financial statements have been reclassified to conformto current period presentation.  As of December 31,2004, $86.8 million of auction rate securities were reclassed from cash andcash equivalents to short-term investments.

 

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

 

*Stock Repurchase Program.*  On January 27, 2005, Cymerannounced that its board of directors had authorized Cymer to repurchase up to$50,000,000 of Cymer’s common stock.  Thepurchases will be made from time to time in the open market or in privatelynegotiated transactions.  The program maybe discontinued at any time. Total purchases through March 31, 2005 were$8.3 million or 292,841 shares under this program.

 

*Employee Stock Purchase Plan.*In February 2005, the board of directorsapproved an amendment to Cymer’s 1996 Employee Stock Purchase Plan (“ESPP”).Effective May 1, 2005, the amendment: a) changes duration of offering periodsunder the plan from 24 months to 6 months, b) reduces the discount to marketprice used to determine purchase price for shares of Cymer’s common stock underthe plan from 15% to 5%, and c) eliminates the “lookback” feature that allowsthe purchase price to be determined as of the beginning of an offering period,or enrollment date, if the market price as of the enrollment date was lowerthan the market price at the end of the offering period.

 

*AcceleratedVesting of Stock Options. *In February 2005,Cymer’s board of directors approved the acceleration of the vesting of stockoptions that have exercise prices of $30.50 per share or higher held byemployees. This acceleration of stock options excludes directors, executiveofficers and certain vice presidents. The purpose of this acceleration ofvesting is to enable Cymer to eliminate recognizing in its statement ofoperations the compensation expense associated with these “out of the money”stock options in future periods, upon adoption of the FASB Statement ofFinancial Accounting Standards No. 123R (“SFAS 123R”), which will be effectivein the first quarter of 2006.

 

*Stock-Based Compensation.*Cymerapplies the intrinsic value-based method of accounting prescribed by AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and relatedinterpretations including FASB Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation aninterpretation of APB Opinion No. 25”**to account forits stock option plans.  Under thismethod, employee-based stock compensation expense is measured on the date ofgrant only if the then current market price of the underlying stock exceededthe exercise price and is recorded on a straight-line basis over the applicablevesting period.  Statement of FinancialAccounting Standards Board No. 123 (“SFASNo. 123”) “Accounting forStock-Based Compensation”, established accounting and disclosurerequirements using a fair value-based method of accounting for stock-basedemployee compensation plans.  As allowed by SFAS No. 123, Cymer has elected tocontinue to apply the intrinsic value-based method of accounting describedabove, and has adopted the disclosure requirements of SFAS No. 123, as amendedby SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”*.*

 

Alloptions granted under the plans had an exercise price equal to the market valueof the underlying common stock on the date of grant.

 

Cymer accounts for options granted to non-employeesunder SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18, “Accountingfor Equity Instruments that are Issued to other than Employees for Acquiring orin Conjunction with Selling Goods or Services”. Cymer measures the fair value of such options using the Black-Scholesoption-pricing model at each financial reporting date.  Cymer accounts for changes in fair valuesbetween reporting dates in accordance with Financial Accounting Interpretation28.  Stock-based compensation expense foroptions granted to non-employees and for those employees who changed status forthe three months ended March 31, 2004 and 2005 was $100,000 and $148,000,  respectively.

 

UnderSFAS No. 123, the weighted average per share fair value of the options grantedfor the three months ended March 31, 2004 and 2005 was $26.81 and $16.33,respectively, on the date of grant.  

 

7

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Fair value under SFAS No.123 is determined using the Black-Scholes option-pricing model with theassumptions noted below.  For the riskfree interest rate, Cymer uses the then currently available rate on zero couponU.S. Government issues with a remaining life of five years for valuing optionsand one year for valuing ESPP shares.

 
| ** **                                | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **2004**                              | ** ** | **2005** | ** ** |
|                                      |       |                                  |       |   |   |
| Dividend yield                            |       | None                                  |       | None |   |
| Volatility rate                           |       | 79                                    | %          | 75 | % |
| Weighted average risk free interest rate: |       |                                  |       |   |   |
| Options                                   |       | 2.98                                  | %          | 3.89 | % |
| ESPP                                      |       | 1.55                                  | %          | 2.75 | % |
| Expected life:                            |       |                                  |       |   |   |
| Options                                   |       | 6 years                               |       | 6 years |   |
| ESPP                                      |       | .5 years                              |       | .5 years |   |

 

Thefollowing table compares earnings (loss) per share as reported by Cymer to thepro forma amounts that would have been reported had compensation expense beenrecognized for Cymer’s stock-based compensation plans in accordance with SFASNo. 123 (in thousands, except per share amounts):

 
| ** **                                                                                                                                        | ** ** | **Three months ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2004**                              | ** ** | **2005** | ** ** |
|                                                                                                                                              |       |                                  |       |   |   |
| Net income, as reported                                                                                                                           |       | $                                     | 7,156      |   | $ | 5,385 |   |
| Add: Stock-based employee compensation expense  included in reported net income, net of related tax effects                                       |       | 80                                    |       | 152 |   |
| Deduct: Total stock-based employee compensation  expense determined under the fair value based method for all awards, net of  related tax effects |       | (4,504                                | )          | (13,898 | ) |
|                                                                                                                                              |       |                                  |       |   |   |
| Pro forma net income (loss)                                                                                                                       |       | $                                     | 2,732      |   | $ | (8,361 | ) |
|                                                                                                                                              |       |                                  |       |   |   |
| Earnings (loss) per share:                                                                                                                        |       |                                  |       |   |   |
| Basic – as reported                                                                                                                          |       | $                                     | 0.20       |   | $ | 0.15 |   |
| Basic – pro forma                                                                                                                            |       | $                                     | 0.07       |   | $ | (0.23 | ) |
|                                                                                                                                              |       |                                  |       |   |   |
| Diluted – as reported                                                                                                                        |       | $                                     | 0.19       |   | $ | 0.14 |   |
| Diluted – pro forma                                                                                                                          |       | $                                     | 0.07       |   | $ | (0.23 | ) |

 

The acceleration ofvesting of “out of the money” stock options in the quarter ended March 31,2005, contributed approximately $10.4 million of pro forma stock-basedcompensation expense during the three months ended March 31, 2005.

 

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**3.****              EARNINGSPER SHARE**

 

*Earnings Per Share* – Basic earnings per share (“EPS”) excludesdilution and is computed by dividing net income or loss attributable to commonstockholders by the weighted-average of common shares outstanding for theperiod.  Diluted EPS reflects thepotential dilution that could occur if securities or other contracts to issuecommon stock (convertible subordinated notes, warrants to purchase common stockand common stock options using the treasury stock method) were exercised orconverted into common stock.  Potentialdilutive securities are excluded from the diluted EPS computation in lossperiods as their effect would be anti-dilutive.

 

The following table sets forth the computation of dilutedweighted average common and potential common shares outstanding for the threemonths ended March 31, 2004 and 2005 (in thousands):

 
| ** **                                                               | ** ** | **Three months ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                               | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| ** **                                                               | ** ** | **(in thousands)**                     | ** ** |
|                                                                     |       |                                   |       |   |   |
| Basic weighted average common shares outstanding                         |       | 36,586                                 |       | 36,884 |   |
|                                                                     |       |                                   |       |   |   |
| Effect of dilutive securities:                                           |       |                                   |       |   |   |
| Warrants                                                                 |       | 50                                     |       | — |   |
| Options                                                                  |       | 1,505                                  |       | 346 |   |
|                                                                     |       |                                   |       |   |   |
| Diluted weighted average common and potential common  shares outstanding |       | 38,141                                 |       | 37,230 |   |

 

For the three months ended March 31,2004 and 2005, weighted average options and warrants to purchase 824,000 and5.6 million shares of common stock, respectively, were outstanding but notincluded in the computation of diluted earnings per share as their effect wasanti-dilutive.  In addition, for thethree months ended March 31, 2004 and 2005, weighted average common sharesattributable to convertible subordinated notes of 5,000,000 and 4,015,000,respectively, were not included in the computation of diluted earnings pershare as their effect was also anti-dilutive.

 

**4.****                 INVENTORIES**

 

Inventoriesconsisted of the following as of December 31, 2004 and March 31, 2005(in thousands):

 
| ** **                                  | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| INVENTORIES:                                |       |                        |       |                     |       |
| Raw materials                               |       | $                           | 48,131     |                     | $          | 47,979 |   |
| Work-in-progress                            |       | 24,344                      |       | 21,253                   |       |
| Finished goods                              |       | 46,093                      |       | 42,138                   |       |
| Allowance for excess and obsolete inventory |       | (8,546                      | )          | (8,709                   | )          |
| Total                                       |       | $                           | 110,022    |                     | $          | 102,661 |   |

 

**5.****              REPORTINGCOMPREHENSIVE INCOME (LOSS)**

 

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

 

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Thefollowing table summarizes the change in each component of accumulated othercomprehensive loss for the three months ended March 31, 2005 (in thousands):

 
| ** **             | ** ** | **Translation  adjustment,  net of tax** | ** ** | **Total unrealized  losses on  available-for-sale  investments,  net of tax** | ** ** | **Total unrealized  gains (losses) on  foreign currency  forward exchange  contracts, net of tax** | ** ** | **Accumulated  other  comprehensive  loss** | ** ** |
|------------------------|------------|------------------------------------------|------------|-------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
|                   |       |                                     |       |                                                                          |       |                                                                                               |       |                                        |       |
| December 31, 2004 |       | Balance                                  |       | $                                                                             | (3,776     | )                                                                                                  | $          | (224                                        | )          | $ | (455 | ) | $ | (4,455 | ) |
|                   |       | Period net  change                       |       | 285                                                                           |       | (594                                                                                               | )          | 676                                         |       | 367 |   |
| March 31, 2005    |       | Balance                                  |       | $                                                                             | (3,491     | )                                                                                                  | $          | (818                                        | )          | $ | 221 |   | $ | (4,088 | ) |

 

Comprehensive incomeconsisted of the following components (in thousands):

 
| ** **                                                                   | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                               | ** ** | **2005** | ** ** |
|                                                                         |       |                                   |       |   |   |
| Net income                                                                   |       | $                                      | 7,156      |   | $ | 5,385 |   |
|                                                                         |       |                                   |       |   |   |
| Foreign currency translation adjustments, net of tax                         |       | 146                                    |       | 285 |   |
| Unrealized losses on available for sale investments,  net of tax             |       | (188                                   | )          | (594 | ) |
| Unrealized gains on foreign currency forward  exchange contracts, net of tax |       | 62                                     |       | 676 |   |
|                                                                         |       |                                   |       |   |   |
| Comprehensive income                                                         |       | $                                      | 7,176      |   | $ | 5,752 |   |

 

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

 

In January 2004,Cymer entered into a research and development agreement with Intel Corporation(“Intel”). Under this agreement Intel will provide Cymer a total of $20.0million over a three-year period to accelerate the development ofproduction-worthy extreme ultraviolet (“EUV”) lithography light sources.  The funding from Intel under this agreementis milestone based and is netted against Cymer’s total research and developmentexpenses in the period that the milestone is achieved.  The total funding amount recorded under thisagreement for the three months ended March 31, 2004 and 2005 was $819,000and $1.6 million, respectively.

 

In February 2004,Cymer entered into an intellectual property license agreement with Intel forthe use of certain Intel patents and trade secrets related to EUV technology.Under the terms of this agreement, Cymer will pay license fees to Intel ifCymer is successful in commercializing an EUV lithography light source capableof high volume manufacturing by the end of the second quarter of 2008. Thelicense payments under this agreement are triggered in the quarter in whichCymer successfully ships the first complete high volume manufacturing EUVsource system.  Commencing with shipment ofthis first unit, Cymer will pay Intel $1.25 million in license fees per quarterfor a period of sixteen quarters.  Thequarterly license amounts paid to Intel, if any, will be related to Cymer’ssale of EUV light source systems and, as a result, will be recorded as cost ofsales.  The methodology and amounts thatwill be recorded to cost of sales will be determined when the high volumemanufacturing production unit sales or a forecast of sales can be made.  No amounts have been earned under thisarrangement as of March 31, 2005.

 

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

 

As ofthe date of adoption of Statement of Financial Accounting Standards No. 142 (“SFASNo. 142”), “Goodwill and Other Intangible Assets”, on January 1, 2002,Cymer had unamortized goodwill in the amount of $9.8 million and unamortizedidentifiable intangible assets, excluding acquired patents, in the amount of$1.1 million, all of which were subject to the transition provisions of SFASNo. 142.

 

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During the fourth quarterof 2004, Cymer completed its annual impairment test of goodwill and intangibleassets, and concluded that no impairment of goodwill existed.

 

Aggregate amortizationexpense for identifiable intangibles, excluding patents, was $40,000 and$20,000 for the three months ended March 31, 2004 and 2005,respectively.  Costs associated withthese identifiable intangibles, excluding patents, were fully amortized as of March 31,2005.

 

The carrying amount ofgoodwill was $8.4 million as of December 31, 2004 and March 31, 2005.

 

Also included inintangible assets – net on the accompanying balance sheets are amountsassociated with patents that were acquired in 2001 and 2003.  As of December 31, 2004 and March 31,2005, the net carrying amount of these patents was $10.4 million and $9.8million, respectively.  Amortizationexpense for these patents was $593,000 for each of the three months ended March 31,2004 and 2005, respectively.

 

As of March 31,2005, future estimated amortization expense for these patents is expected to beas follows (in thousands):

 

| ** **                                | ** ** | **Future  Amortization** | ** ** |
|-------------------------------------------|------------|--------------------------|------------|
|                                      |       |                     |       |
| Nine months ending December 31, 2005 |       | $                        | 1,779      |   |
| Year ending December 31, 2006        |       | $                        | 2,371      |   |
| Year ending December 31, 2007        |       | $                        | 2,371      |   |
| Year ending December 31, 2008        |       | $                        | 2,371      |   |
| Year ending December 31, 2009        |       | $                        | 889        |   |

 

**8.****                ****GUARANTEES**

 

Cymer adopted the disclosure provisions of FinancialAccounting Standards Board Interpretation No. 45 (“FIN 45”), “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness to Others”, during the quarter ended December 31,2002 and adopted the recognition and measurement provisions as required after December 31,2002.  FIN 45 provides expandedaccounting guidance surrounding liability recognition and disclosurerequirements related to guarantees, as defined by this interpretation.

 

In the ordinary courseof business, Cymer is not subject to potential obligations under guaranteesthat fall within the scope of FIN 45, except for standard warranty provisionsassociated with product sales and indemnification provisions related tointellectual property that are contained within many of its customeragreements.  All of these provisions giverise only to the disclosure requirements prescribed by FIN 45.

 

ProductWarranties – Warranty provisions contained within Cymer’s customer agreementsare generally consistent with those prevalent in the semiconductor equipmentindustry. The warranty period and terms vary by light source system model.  In general, the light source system warrantyperiod ranges from 17 to 26 months after shipment. Cymer also warrantsconsumables and spare parts sold to its customers and the coverage periodvaries by spare part type as some types include time-based warranty periods andothers include usage-based warranty periods. On average, the warranty period forconsumables and spare parts is approximately six months from the date ofshipment.  Cymer records a provision forwarranty for all products, which is included in cost of product sales in theconsolidated statements of operations and is recorded at the time that therelated revenue is recognized. The warranty provision for light source systemsis reviewed monthly and determined using a financial statistical model, whichconsiders actual historical expenses, and potential risks associated with Cymer’sdifferent light source system models. This model is then used to calculate thefuture probable expenses related to warranty and the required level of thewarranty provision.  The risk levels andhistorical cost information used within this model are reviewed throughout theyear and updated as 

 

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risklevels change over the light source system’s life cycle. The warranty provisionfor consumables and spares is determined using actual historical data. For bothlight source systems and consumables, if actual warranty expenditures differsubstantially from Cymer’s estimates, revisions to the warranty provision wouldbe required.  Actual warrantyexpenditures are recorded against the warranty provision as they are incurred.

 

The following table summarizes information related to Cymer’s warrantyprovision for the three months ended March 31, 2005 (in thousands):

 

| ** **                                                                                        | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|----------|------------|
|                                                                                              |       |     |       |
| Balance, December 31, 2004                                                                   |       | $        | 28,200     |   |
| Liabilities accrued for warranties issued during the  quarter, net of adjustments and expirations |       | 4,308    |       |
| Warranty expenditures incurred during the quarter                                                 |       | (4,933   | )          |
| Balance, March 31, 2005                                                                      |       | $        | 27,575     |   |

 

Intellectual Property Indemnifications – Cymer includes intellectualproperty indemnification clauses within its general terms and conditions withits customers and the general purchase agreements with its three majorcustomers, ASM Lithography, Canon, and Nikon. In general, these indemnification provisions provide that Cymer willdefend its customers against any infringement claims that arise related toCymer’s products.  Under theindemnification clauses, Cymer will pay all costs and damages, includingattorney’s fees, associated with such settlements or defenses, provided thatthe customer follows specific procedures for notifying Cymer of such claims andallows Cymer to manage the settlement proceedings. Due to the nature of theseindemnification provisions, they are indefinite and extend beyond the term ofthe actual customer agreements.

 

An indemnification provision was also included in the contractmanufacturing agreement with Seiko Instruments, Inc. (“Seiko”), which wasterminated effective March 31, 2003. As with Cymer’s indemnification provisions on intellectual property,Cymer will continue to honor this indemnification clause within the agreementeven after its termination. Seiko and at least one Japanese customer have beennotified that Cymer’s light source systems in Japan may infringe certainJapanese patents.  Cymer believes, basedupon the advice of counsel, that Cymer’s products do not infringe any validclaim of the asserted patents or that Cymer is entitled to prior use claims inJapan.

 

As part of the research and development agreement signed with Intel in2004, Cymer also agreed to provide Intel with indemnity against anyinfringement of the intellectual property rights of any third party arisingfrom Intel’s purchase and/or use of Cymer’s EUV source systems.  Details of such indemnity will be negotiatedas part of a purchase agreement related to potential future products.

 

**9.****              COMMITMENTSAND CONTINGENCIES**

 

Cymer isparty to legal actions in the normal course of business.  Based in part on the advice of legal counsel,management does not expect the outcome of legal action in the normal course ofbusiness to have a material impact on the financial position, liquidity, orresults of operations of Cymer.

 

Cymer’s former Japanesemanufacturing partner, Seiko, and one of Cymer’s Japanese customers have beennotified that Cymer’s light source systems in Japan may infringe certainJapanese patents held by another Japanese company.  Cymer has agreed to indemnify its formerJapanese manufacturing partner and its customers against patent infringementclaims under certain circumstances, even after the termination date of thecontract manufacturing agreement.  Cymerbelieves, based upon the advice of counsel, that Cymer’s products do notinfringe any valid claim of the asserted patents or that Cymer is entitled toprior use claims in Japan.

 

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**10.****             SUBSEQUENT EVENTS**

 

As of March 31,2005 Cymer had $200.8 million principal amount of convertible subordinatednotes outstanding. From April 1, 2005 through May 4, 2005, Cymerpurchased, at a discount to par, $16.9 million principal amount of these notes.

 

From April 1,2005 through May 4, 2005, Cymer purchased $20.2 million or 811,995 shares underits stock repurchase program.

 

**ITEM 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*In this section, references to “we”,“us” or “our” are references to Cymer.**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 andour consolidated financial statements and notes thereto included in our annualreport on Form 10-K for the year ended December 31, 2004.*

 

**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 expected domestic and international product sales anddevelopment; research and development activities and expenditures; adequacy ofcapital resources and investments; effects of business cycles in thesemiconductor business; competitive positioning; and relationships withcustomers and third-party manufacturers for product manufacturing, and maycontain words such as “believes,” “anticipates,” “expects,” and words ofsimilar meaning. These statements are only predictions based on currentinformation and expectations and involve a number of risks and uncertainties.The underlying information and expectations are likely to change overtime.  Actual events or results maydiffer materially from those projected in the forward-looking statements due tovarious factors, including, but not limited to, those set forth under thecaption “Risks and Uncertainties That May Affect Results” and elsewhere in thisQuarterly Report on Form 10-Q. Forward-looking statements herein speak only as of the date of thisQuarterly Report on Form 10-Q.

 

#### **Overview**

 

#### ***General***

 

We are the world’sleading supplier of light source solutions for the semiconductor industry.  Our products provide the essential lightsource for deep ultraviolet (“DUV”) photolithography systems.  Almost all consumer electronic devicesmanufactured in the last several years contain a semiconductor manufacturedusing light sources such as ours.  Wecurrently supply light sources to all three lithography tool manufacturers, ASMLithography, Canon, and Nikon, who in turn supply their wafer steppers andscanners to chipmakers.  In addition, we sell replacement parts andservices to the lithography tool manufacturers as well as directly to thechipmakers.  Our light source systemscurrently constitute a substantial majority of all excimer light sourcesincorporated in lithography stepper and scanner tools.  A large portion of our revenue is derivedfrom customers located outside of the United States.  In order to support our foreign customers andour installed base of light sources in foreign countries, we maintain amanufacturing and field service office in Korea and field service and supportoffices in Japan, Taiwan, Singapore, the People’s Republic of China and theNetherlands. We also maintain field service offices in the United States toservice our installed base of light sources located in the United States.

 

#### ***Products***

 

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

 

Ourphotolithography light sources produce narrow bandwidth pulses of shortwavelength light within the DUV spectrum. The DUV wavelengths are measured innanometers (“nm”). One nanometer 

 

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equals one billionth of ameter.  The light sources are referred toaccording to the gases mixed to produce the light or by the wavelength.  Krypton Fluoride (“KrF”) gases produce 248 nmlight and Argon Fluoride (“ArF”) gases produce 193 nm light. The light sourcespermit very fine feature resolution for imaging the circuitry on the wafer andhigh throughput in wafer processing.  Wehave designed our light sources to be highly reliable, easy to install andcompatible with existing semiconductor manufacturing processes. Our lightsources are used to pattern the integrated circuits, which are also calledsemiconductors or “chips”, that power many of today’s advanced consumer and businesselectronics. In the first quarter of 2005, we sold 48 light source systems atan average selling price of $1.0 million.

 

Certaincomponents and subassemblies included in our light sources require replacementor refurbishment following extended operation. For example, the discharge chamber of our light sources has an expectedlife of approximately three to twenty-four billion pulses, depending on themodel. We estimate that a light source used in a semiconductor productionenvironment will require one to two replacement chambers per year, dependingupon the level of usage. Similarly, certain optical components of the lightsource deteriorate with continued exposure to DUV light and require periodicreplacement.  We provide these and otherspare and replacement parts for our photolithography light sources as needed byour customers.

 

As the life and usage ofour installed base of light sources in production at chipmakers exceeds theoriginal warranty periods (generally 17 to 26 months from date of shipment),some chipmakers request service contracts from us.  Additionally, we provide billable service orservice contracts directly to the three semiconductor lithography toolmanufacturers. These service agreements require us to maintain and/or servicethese light sources either on an on-call or regular interval basis orboth.  Some of these contracts include replacementof consumable parts and non-consumable parts.

 

Inaddition to service contracts, we provide an on-line diagnostic product,CymerOnLineTM. CymerOnline is a diagnostic and performance softwareproduct, which delivers critical laser diagnostics and performance informationin near real-time directly to authorized users anywhere.  The software simplifies reporting and allowsusers to efficiently manage consumables usage. CymerOnLine features a user-friendly browser-based interface, whichfeatures a robust design and provides a secure data environment.  Event-initiated messages sent to pagers,e-mail, mobile phones, or other handheld devices enable up-to-the minutecommunication and proactive management.

 

#### ***Semiconductor Industry Status and Outlook***

#### ** **

Since we derive asubstantial portion of our revenues from lithography tool manufacturers, we aresubject to the volatile and unpredictable nature of the semiconductor industry.The semiconductor industry is highly cyclical in nature and historically hasexperienced periodic ups and downs. Since 2000, the final year of the lastsignificant and prolonged peak in the cycle, the semiconductor industry experiencedone of the longest downturns in its history from 2001 through late 2003.Although this downturn and others like it negatively impact our business andresults of operations, we make every effort to manage our business through thecycles by maintaining our annual profitability and taking the necessary stepsduring the downturns to be strategically positioned for the next upturn.  For example, during this extended downturn,we made several such strategic investments including the completion of our newmanufacturing facilities in San Diego and Korea, the development andintroduction of our new Master Oscillator Power Amplifier (“MOPA”) technologyand XL platform, on which our two-chamber ArF DUV light sources reside, and theongoing work to improve business processes that leverage the overall efficiencyof our workforce.

 

We were once againsubjected to the volatility and swings in the semiconductor industry during theperiod from late 2003 through the end of 2004. In the latter half of 2003, wesaw several indicators that the extended downturn in the semiconductor industrywas coming to an end and that an upturn was in sight.  During the final months of 2003, weexperienced strong order growth, and the chipmakers’ utilization of our DUVlight sources exceeded the levels achieved in 2000, the peak of the lastextended upturn.  As we entered 2004,these positive indicators translated into increased levels of shipments of ourlight source products and increased levels of overall revenue.  We experienced these higher revenue levelsand revenue growth for the first nine months of 2004.  However, during the third quarter of 2004, 

 

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though our businessremained strong and we had received no order push outs, many semiconductor andequipment companies issued warnings about potential shortfalls in revenue andearnings.  Starting in September 2004and continuing through the end of 2004, the utilization rates of our lightsources experienced significant declines and we received notification of lightsource push outs from our direct customers. By the end of 2004, it was clear that the upturn in the semiconductorindustry had been truncated and we had entered what appeared to be a slowdownin the industry.  With this slowdown,there has been an increase in the uncertainty in the semiconductor industry andour visibility and ability to forecast the industry cycle has become extremelylimited.

 

This visibility currentlyremains limited, and the outlook for our industry cannot be predicted withaccuracy.  We will continue to manage ourexpenses effectively while working to increase our operating efficiency duringthis industry slowdown.  The utilizationrates of our light sources at chipmakers was up in February 2005 and March 2005over the January 2005 level, and compared to the fourth quarter 2004 levelwas either flat or up in most regions. Some large chipmakers are engaging in counter-cyclical equipmentpurchasing, and some are making strategic purchases of 300 mm productionequipment.  Based on discussions withchipmakers and the lithography tool manufacturers regarding expected tooldemand, in the near term, we anticipate that technology buys of advanced ArFlight sources will remain strong, and the timing for the resumption of capacitydemand for KrF light sources remains uncertain.

 

In the first quarter of2005, we enhanced our competitiveness and strengthened our market leadershipwith the initial on-schedule shipment of the XLA 200, our third generationMOPA light source.  We also introduced asuite of spectral engineering techniques designed to enable chipmakers tocustomize and optimize their manufacturing processes and increase their yields.Later this year, we expect to introduce the XLA 300. Since we made significantinvestments in facilities and equipment during the last several years, we donot foresee a need for a high level of capital expenditures for some time inthe future.

 

During 2005, we plan tocontinue to focus on improving asset management with particular emphasis onimproving inventory management and increasing operating efficiency. We will alsocontinue our efforts to generate a significant amount of cash and improveshareholder returns by achieving higher returns on assets, which includesincreasing our inventory turns and return on invested capital during the year.

 

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

 

*General*

 

Thediscussion and analysis of our financial condition and results of operationsare based upon our consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America.  The preparation ofthese financial statements requires us to make estimates and use judgment thatmay impact the reported amounts of assets, liabilities, revenues, expenses, andrelated disclosure of contingent assets and liabilities.  As a part of our ongoing internal processes,we regularly evaluate our estimates and judgments associated with revenue recognition,valuation of parts used in our refurbishment manufacturing process, inventoryallowances, warranty provisions, income taxes, allowances for bad debts,long-lived assets valuation, intangible assets valuation, and contingencies andlitigation.  We base these estimates andjudgments upon historical information and other facts and assumptions that webelieve to be valid and/or reasonable under the circumstances.  These assumptions and facts form the basisfor making judgments and estimates and for determining the carrying values ofour assets and liabilities that are not apparent from other sources.  Actual results could vary from our estimatesif we were to use different assumptions and conditions.

 

Webelieve that revenue recognition, valuation of parts used in our refurbishmentmanufacturing process, inventory allowances, warranty provisions, and incometaxes require more significant judgments and estimates in the preparation ofour consolidated financial statements than do other of our accounting estimatesand judgments.

 

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*RevenueRecognition*

 

Our revenues consist of product sales, whichinclude sales of light source systems, consumable and spare parts, upgrades,service, service contracts and training. Our revenues also consist of certain funded development activitiesperformed for our customers and under government contracts and licenseagreements.  We do not recognize anyrevenue for light source systems prior to shipment.  We test the systems in environments similarto those used by our customers prior to shipment to ensure that they meet thecustomers’ specifications and will interface with the customers’ software.  Our installation obligations are perfunctorywithin the framework of Staff Accounting Bulletin No. 104 (“SAB 104”).  The shipping terms vary by customer for lightsource systems shipments.  The majorityof light source shipment terms are F.O.B. shipping point and revenue isrecognized upon shipment.  For thosecustomers with F.O.B. destination shipping terms, revenue is recognized upondelivery of the light source system to the customer.  One of our customers has an acceptanceprovision, which is satisfied by the issuance of an acceptance certificatefollowing a visual inspection of the system by the customer. We do not recognizerevenue on systems shipped to that customer until we receive the acceptancecertificate.  We have one arrangementwhere a portion of the light source system fee is not payable until the systemis successfully installed at the end-user. In accordance with SAB 104, given the installation is not essential tothe functionality of the system, we defer this portion of the fee until thesystem is installed.  Revenue fromconsumables and spare parts sales is recognized at the point that legal titlepasses to the customer, which is generally upon shipment from ourfacility.  For a significant portion ofour spare parts sales, our customers return the consumed assembly to us as partof the sale of a new part.  We reuse someof the material within these core assemblies, mainly metal components, for thefuture build of core assemblies.  As aresult, our revenue consists of both cash and the value of the reusable partsreceived from our customers as consideration for these spare part sales. Revenueassociated with our customers’ return of core assemblies is recognized uponreceipt of the returned core assembly. The amount of the revenue is determined based upon the fair value of thereusable parts that we expect to yield from the returned core assembly.  Service and training revenue is generallyrecognized at the time that the services are rendered or the training class iscompleted.  Service contract revenues aregenerally recorded as revenue ratably over the life of the contract or per thespecific terms of the agreement. 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 certaincustomers and us. If milestones on these funded development contracts requirethat specific results be achieved or reported by us, revenue is not recognizeduntil that milestone is completed.  Forsome of the funded development contracts that we enter into with customers andgovernment agencies, we evaluate certain criteria to determine whetherrecording the funds received as revenue is appropriate.  If certain conditions are met, these fundsare not recorded as revenue but rather are offset against our own internalresearch and development expenses in the period that the milestone is achievedor per the terms of the contract.

 

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

* *

Overthe last several years as part of our regular business activities, we haveconducted significant parts refurbishment activities related to some of ourcore assemblies, in particular our chamber assemblies. The volume of thisactivity significantly increased in 2004. These activities involve arrangementswith our customers where we sell a new part to the customer at a reduced salesprice if the customer returns the consumed assembly that the new partreplaces.  These returned core assembliescontain a certain amount of material, primarily metal components, that may bereused by us in future core assemblies. Upon receipt of these consumed assemblies from our customers, we recordan entry to recognize the estimated fair value of the reusable components asinventory and revenue.  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.  The costs ofrefurbishment are also capitalized as part of ending inventory as incurred.  As part of our normal excess and obsoleteinventory analysis, these consumed assemblies are also reviewed on a quarterlybasis and an inventory allowance is recorded as appropriate for theseparts.  The value that we assign to thesecore assemblies can be affected by the current demand for the reusable parts inour manufacturing operations and the actual yield rate achieved for partswithin these consumed core assemblies. We believe that our methodology for valuing the reusable parts withinthese returned core assemblies is reasonable, but any changes in the 

 

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demand for the parts orthe yield of the parts included in these core assemblies could have a materialadverse effect on our financial condition and results of operations.

 

Priorto the fourth quarter of 2004, we recorded the value of this material as areduction of our cost of product sales in the period that the returned assemblywas disassembled by our manufacturing operations and the value of the reusableparts could be determined.  Upon furtherreview of United States generally accepted accounting principles in the fourthquarter of 2004, we determined that we should instead estimate the value andrecord these consumed assemblies as inventory at the time that we receive thereturned assembly from our customer and concurrently record this amount asrevenue rather than as a reduction of cost of product sales.  Duringthe fourth quarter of 2004, we corrected our accounting treatment for theserefurbishment activities and recorded the financial impact for all of 2004 andprior years in our fourth quarter of 2004 financial statements. 

 

#### ***InventoryAllowance***

 

Weperform an analysis of our inventory allowances on at least a quarterly basisto determine the adequacy of this allowance on our financial statements.  The amount of the inventory allowance isdetermined by taking into consideration certain assumptions related to marketconditions and future demands for our products, including changes to productmix, new product introductions, and/or product discontinuances, which mayresult in excess or obsolete inventory. We determine the level of excess andobsolete inventory associated with our raw materials and production inventoryby comparing the on hand inventory balances and inventory on order to the next12 months of forecasted demand.  We thenadjust this calculation for inventory that has a high likelihood of use beyondone year or can be used in other products that may have lower demands.  After this adjustment, we arrive at our totalexposure for excess and obsolete inventory within our raw materials andproduction inventory.  As part of this analysis,we also determine whether there are potential amounts owed to vendors as aresult of cancelled or modified raw material orders.  We estimate and record a separate liability,which is included in accrued and other liabilities in the accompanying balancesheets for such amounts owed.

 

Theinventory allowance totaled $8.5 million and $8.7 million at December 31,2004 and March 31, 2005, respectively. The slight increase in this allowance from December 31, 2004 to March 31,2005 was primarily due to the mix of parts in inventory and allowances requiredfor parts related to our refurbishment activities.

 

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

 

•                  Overall condition of thesemiconductor industry, which is highly cyclical in nature;

•                  Rate at which our customers takedelivery of our light source systems;

•                  Loss of any of our three majorcustomers or significant change in demand from any of these three customers;

•                  Mix of light source system models andany changes to that mix required by our customers; and

•                  Utilization rates of our lightsources at chipmakers.

 

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

 

###### *WarrantyProvision*

###### * *

Wemaintain an accrual for the estimated cost of product warranties associatedwith our product sales.  Warranty costsinclude the replacement parts and labor costs to repair our products during the

 

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warranty periods.  At the time revenue is recognized, we recorda warranty provision, which is included in cost of product sales in theaccompanying consolidated statements of operations. The warranty coverageperiod and terms vary by light source system model.  In general, the light source system warrantyperiod ranges from 17 to 26 months after shipment.  We also warrant consumables and spare partssold to our customers and the coverage period varies by spare part type as sometypes include time based warranty periods and others include usage basedwarranty periods.  On average, thewarranty period for consumables and spare parts is approximately six monthsfrom the date of shipment. The warranty provision for light source systems isreviewed monthly and determined by using a financial statistical model, whichtakes into consideration actual historical expenses, and potential risksassociated with our different light source systems.  This model is then used to estimate futureexpenses related to warranty and the required warranty provision.  The risk levels and historical costinformation used within this model are reviewed throughout the year and updatedas risk levels change over the light source system’s life cycle. Due to thehighly technical nature of our light source system products, the newer modellight sources and the modules contained within them have higher inherentwarranty risks and require higher warranty provisions. The warranty provisionfor consumables and spare parts is determined by using actual historical data.

 

Thetotal balance in the warranty provision accrual as of December 31, 2004and March 31, 2005 was $28.2 million and $27.6 million, respectively.  This decrease from period to period isprimarily due to a decrease in spares and consumable parts sales and a slightdecrease in the overall installed base of light source systems under warranty.

 

Weactively engage in product improvement programs and processes to limit ourwarranty costs, but our warranty obligation is affected by the complexity ofour product, product failure rates and costs incurred to correct those productfailures at customer sites. The industry in which we operate is subject torapid technological change, and as a result, we periodically introduce newer,more complex light sources.  Although weclassify these newly released light source models as having a higher risk inour warranty model resulting in higher warranty provisions, we are more likelyto have differences between the estimated and actual warranty costs for thesenew products.  This is due to limited orno historical product performance data on which to base our future warrantycosts.  Warranty provisions for our olderand more established light source models are more predictable as we have morehistorical information available on these products.  If actual product failure rates or estimatedcosts to repair those product failures were to differ from our estimates,revisions to our estimated warranty provision would be required, which couldhave a material adverse effect on our financial condition and results ofoperations.

 

*Income Taxes*

* *

We account for incometaxes in accordance with Statement of Financial Accounting Standards No. 109 (“SFAS109”), “Accounting for Income Taxes.” Pursuant to SFAS 109, a deferred tax asset or liability is generallyrecognized for the estimated future tax effects attributable to temporarydifferences, net operating loss carryforwards and tax creditcarryforwards.  Deferred tax assets are tobe reduced by a valuation allowance if, based on the weight of availableevidence, it is more likely than not that some portion or all of the deferredtax assets will not be realized within the carryback or carryforwardperiods.  Information about an enterprise’scurrent financial position and its results of operations for the current andpreceding years, as well as all currently available information about futureyears should be considered.

 

Wehave considered our industry’s outlook for the future, our historicalperformance and estimated future taxable income, and ongoing tax planningstrategies in assessing the need for a valuation allowance.  Using this information, we have prepared amodel to forecast our expected taxable income in future years and to estimatewhen the benefits of our deferred tax assets are likely to be realized.  Based upon the analysis, we believe that itis more likely than not that the results of future operations will generatesufficient taxable income to realize the deferred tax assets within the periodallowed by current applicable tax law and, as such, no valuation allowanceagainst deferred tax assets is provided.

 

Amaterial adverse change in the outlook for worldwide lithography tool sales,the expected selling prices or profit margins for our products, or our expectedshare of the global market for lithography light 

 

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sources could cause us todetermine that a valuation allowance is needed for some or all of our deferredtax assets, and would result in an increase to our income tax provision in theperiod in which such determination is made.

 

Our results reflect the impact of theAmerican Jobs Creation Act of 2004, which repealedthe Extraterritorial Income Exclusion (“ETI”) subject to certain transitionrules.  The ETI benefit is being replacedwith a Manufacturing Activity deduction under Internal Revenue Code (“IRC”) Section 199,with a phase out of ETI benefits in 2005 and 2006.  Our ETI benefit for 2005 reflects the 80%allowable benefit.  The manufacturers benefitis available to us for tax years beginning in 2005, subject to certaintransition rules.  Cymer has not takenbenefit for Section 199 in 2005 due to taxable income limitations. We have not provided for U.S. federal income and foreign withholding taxes on$39 million of undistributed earnings from non-U.S. operations as of March 31,2005 as it is our intention to reinvest undistributed earnings of our foreignsubsidiaries and thereby indefinitely postpone their remittance.  Accordingly, no provision has been made forforeign withholding taxes or United States income taxes which may becomepayable if undistributed earnings of foreign subsidiaries were paid asdividends to us.

 

Currently, we are not considering the repatriation ofany foreign earnings and as such, no impact is reported in the financialstatements as of March 31, 2005. However, we are still evaluating the impact of repatriation of foreignearnings under IRC Section 965. The American Jobs Creation Act of 2004,and IRC Section 965 allow a temporary 85% dividends received deduction onrepatriated foreign earnings if the funds are reinvested in the UnitedStates.  FASB Staff Position No. 109-2 (“FSPNo. 109-2”), allows companies additional time to evaluate whether foreignearnings will be repatriated under the provisions of the new law.  We are awaiting the issuance of furtherregulatory guidance prior to determining what amount, if any, will berepatriated.  As such, at this time, wehave not determined a range of potential repatriated amounts, if any. We expectto complete our analysis and determine what amount, if any, to repatriate by September 30,2005.

 

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**RESULTS OF OPERATIONS**

 

The following table sets forth certain items inour consolidated statements of operations as a percentage of total revenues forthe periods indicated:

 
| ** **                                                | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| Revenues:                                                 |       |                                   |       |   |   |
| Product sales                                             |       | 99.9                                   | %          | 99.8 | % |
| Other                                                     |       | 0.1                                    |       | 0.2 |   |
| Total revenues                                            |       | 100.0                                  | %          | 100.0 | % |
|                                                      |       |                                   |       |   |   |
| Cost and expenses:                                        |       |                                   |       |   |   |
| Cost of product sales                                     |       | 59.3                                   |       | 62.5 |   |
| Research and development                                  |       | 14.1                                   |       | 17.2 |   |
| Sales and marketing                                       |       | 6.6                                    |       | 6.8 |   |
| General and administrative                                |       | 7.5                                    |       | 7.5 |   |
| Amortization of intangible assets                         |       | 0.1                                    |       | — |   |
| Total costs and expenses                                  |       | 87.6                                   |       | 94.0 |   |
|                                                      |       |                                   |       |   |   |
| Operating income                                          |       | 12.4                                   |       | 6.0 |   |
|                                                      |       |                                   |       |   |   |
| Total other income (expense) – net                   |       | (0.7                                   | )          | 0.1 |   |
|                                                      |       |                                   |       |   |   |
| Income before income tax provision and minority  interest |       | 11.7                                   |       | 6.1 |   |
|                                                      |       |                                   |       |   |   |
| Income tax provision                                      |       | 2.7                                    |       | — |   |
| Minority interest                                         |       | (0.9                                   | )          | 0.3 |   |
|                                                      |       |                                   |       |   |   |
| Net income                                                |       | 8.1                                    | %          | 6.4 | % |
| Gross margin on product sales                             |       | 40.6                                   | %          | 37.3 | % |

 

## **THREE MONTHS ENDED MARCH 31,2004 AND 2005**

 

*Revenues*. Thetypes of revenue that we generate and how we recognize revenue for each isexplained in the Revenue Recognition section of Item 2. Management's Discussionand Analysis of Financial Condition and Results of Operations under CriticalAccounting Policies and Estimates.

 

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Thefollowing table summarizes the components of our revenue (in thousands,except units sold):

 
| ** **                                      | ** ** | **For the three months ended  March 31,** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                      | ** ** | **2004**                                       | ** ** | **2005** | ** ** |
|                                            |       |                                           |       |   |   |
| Light source systems:                           |       |                                           |       |   |   |
| Revenue (1)                                     |       | $                                              | 52,661     |   | $ | 48,536 |   |
| Units sold                                      |       | 64                                             |       | 48 |   |
| Average selling price                           |       | $                                              | 827        |   | $ | 1,009 |   |
|                                            |       |                                           |       |   |   |
| Consumable and spare parts and service products |       | $                                              | 35,210     |   | 36,073 |   |
| Other revenue                                   |       | $                                              | 50         |   | $ | 201 |   |
|                                            |       |                                           |       |   |   |
| Total revenue                                   |       | $                                              | 87,921     |   | $ | 84,810 |   |

 

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(1)          Excluding deferred lightsource revenue of $270,000 and $87,000 that was recognized in the three monthsended March 31, 2004 and 2005, respectively.  We have one arrangement where a portion ofthe light source system fee is not payable until the system is installedsuccessfully at the end-user.

 

Product sales decreased 4% from $87.9****million for the three months ended March 31, 2004 to$84.6 million for the three months ended March 31, 2005, primarily due toa 8% decrease in light source system revenue from $52.7 million for the threemonths ended March 31, 2004 to $48.5 million for the three months ended March 31,2005.  A total of 64 light source systemswere sold in the three months ended March 31, 2004 at an average sellingprice of $827,000, compared to 48 systems sold in the three months ended March 31,2005 at an average selling price of $1.0 million.  On a foreign currency adjusted basis, theaverage selling price for the three months ended March 31, 2004 was$805,000 compared to $994,000 for the three months ended March 31, 2005.The increase in the average selling price from period to period reflects the shiftin the product mix from capacity driven lower priced KrF products in the threemonths ended March 31, 2004 to higher priced ArF products in the samethree-month period in 2005.  Thisdecrease in product sales was partially offset by a 3% increase in sales ofconsumable and spare parts and service products from $35.2 million for thethree months ended March 31, 2004 to $36.1 million for the three monthsended March 31, 2005.  Included inthe sales of consumable and spare parts and service revenues for the threemonths ended March 31, 2005 are revenues associated with the receipt ofreusable material contained within consumed core assemblies returned from ourcustomers. These revenues totaled $5.3 million for the three months ended March 31,2005 and there were no such revenues recorded in the three months periodended March 31, 2004 due to the timing in 2004 of our correction in accountingtreatment for these refurbishment activities. See further discussion on change in accounting method for refurbishmentactivities under Item 2. Management’s Discussion and Analysis of 

 

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FinancialCondition and Results of Operations under Critical Accounting Policies.Revenues from funded development contracts were $50,000 for the three monthsended March 31, 2004, compared to $201,000 for the three months ended March 31,2005.

 

Our backlog at March 31, 2004 was $105.5 millioncompared to $75.8 million at March 31, 2005.  Bookings for the three months ended March 31,2004 and March 31, 2005 were $89.6 million and $81.5 million,respectively.  The book-to-bill ratio forthe quarter ended March 31, 2004 was 1.02 compared to 0.96 for the quarterended March 31, 2005.  The decreasein bookings was primarily due to reduced orders of light source systems in thefirst quarter 2005 compared to the first quarter of 2004. The first quarter of2004 bookings reflected the brief upturn in the semiconductor industry thatbegan early in 2004 whereas the first quarter of 2005 orders reflect theindustry slowdown.  The decrease in thebook-to-bill ratio was a result of the industry slowdown at the end of 2004.During the industry cycles, we closely monitor our book-to-bills so that weachieve near unity on this ratio even during such slowdowns.

 

We installed 65 light sources at chipmakers and otherend-users during the quarter ended March 31, 2004 as compared to 67 lightsources installed during the quarter ended March 31, 2005.

 

Sales to our three largest customers, ASMLithography, Canon, and Nikon, amounted to 31%, 20% and 19%, respectively, oftotal revenue for the three months ended March 31, 2004, and 29%, 7% and29%, respectively, of total revenue for the three months ended March 31,2005.

 

Oursales are generated primarily by shipments to customers in Japan, Europe, andthe United States.  Approximately 87% and84% of our sales for the three months ended March 31, 2004 and 2005,respectively, were derived from customers outside the United States.  We maintain a wholly owned Japanesesubsidiary, which sells to our Japanese customers.  Revenues from Japanese customers, generatedprimarily by Cymer Japan, accounted for 38% and 36% of total revenues for thethree months ended March 31, 2004 and 2005, respectively.  The activities of our Japanese subsidiary arelimited to sales and service of products purchased by them from us as theparent corporation. We anticipate that international sales will continue toaccount for a significant portion of our 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 our product sales are also included incost of product sales.  We do not chargeour customers for shipping fees and such costs are not significant.

 

The cost of product salesincreased 2% from $52.2 million for the three months ended March 31, 2004 to$53.0 million for the three months ended March 31, 2005, respectively.This increase in the costs of product sales is primarily due to the change inour accounting treatment for parts used in our refurbishment manufacturingprocesses and theclassification of these transactions as revenue rather than a credit to cost ofproduct sales. This increase in the cost of product sales was offset by theoverall decrease in product sales from period to period.

 

The gross margin onproduct sales was 41% for the three months ended March 31, 2004 ascompared to 37% for the three months ended March 31, 2005.  This lower gross margin for the three monthsended March 31, 2005 was primarily due to reduced factory loading whichwas caused by us reducing our inventory levels, including our field sparesinventories.

 

*Research and Development*.  Research and developmentexpenses include costs of internally-funded and externally-funded projects aswell as continuing product development support expenses, which consistprimarily of employee and material costs, depreciation of equipment and otherengineering related costs.  Our researchand development expenses were offset by amounts associated with certain of ourexternally funded research and development contracts.  Research and development expenses increased18% from $12.4 million for the three months ended March 31, 2004 to $14.6million for the three months ended March 31, 2005, due primarily to costsassociated with our EUV light source development 

 

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and new businessopportunity development. Research and development expenses were offset byamounts related to our externally funded research and development contracts of$1.6 million for each of the three months ended March 31, 2004 and2005.  In addition to our development ofEUV, we also continued to focus on next generation ArF products based on the XLplatform and next generation KrF products. As a percentage of total revenues, research and development expensesincreased from 14.1% for the three months ended March 31, 2004 to 17.2%for the three months ended March 31, 2005 due primarily to increased costsand lower revenues in the first three months of 2005 compared to the sameperiod in 2004.  We expect research anddevelopment expenses to increase slightly in dollar spending next quarter dueto our spending on EUV development and other product development opportunityinvestigations such as flat panel process tools.

 

*Sales and Marketing*. Sales and marketing expenses include the expenses of the sales,marketing and customer support staff and other marketing expenses.  Sales and marketing expenses remained flat at$5.8 million for each of the three months ended March 31, 2004 and2005.  As a percentage of total revenues,such sales and marketing expenses increased from 6.6% for the three monthsended March 31, 2004 to 6.8% for the three months ended March 31,2005.  We anticipate sales and marketingexpenses to remain relatively flat in dollar spending in the second quarter of2005.

 

*Generaland Administrative*. General and administrative expensesconsist primarily of management and administrative personnel costs,professional services and administrative operating costs.  General and administrative expenses decreased5% from $6.6 million for the three months ended March 31, 2004 to $6.3million for the three months ended March 31, 2005 primarily due to thereceipt of rent payments in the first quarter of 2005 from the tenants in twoof our San Diego facilities, which we subleased in the third and fourthquarters of 2004. In addition, in the first quarter of 2005, we reversed $196,000of costs previously accrued for unused lease space associated with oursubleasing activities for one of these San Diego facilities.  This decrease in general and administrationexpenses was partially offset by additional external audit fees associated withour compliance with the internal control requirements under Section 404 ofthe Sarbanes-Oxley Act.  As a percentageof total revenues, such expenses were 7.5% for each of the three months ended March 31,2004 and 2005. We anticipate general and administrative expenses to remainrelatively flat in dollar spending in the second quarter of 2005.

 

*Amortization of IntangibleAssets. *Amortization of intangible assets totaled$40,000 and $20,000 for the three months ended March 31, 2004 and 2005,respectively. This amortization of intangible assets expense relates to theexisting technology associated with the acquisition of Active Control eXperts,Inc., which was completed in early 2001. Costs associated with theseidentifiable intangibles were fully amortized as of March 31, 2005. Amortization expense for patents which is included in research anddevelopment expenses and cost of product sales was $593,000 for each of thethree months ended March 31, 2004 and 2005.

 

*TotalOther Income (Expense) - Net.*  Net other income(expense) consists primarily of interest income and expense and foreigncurrency exchange gains and losses associated with fluctuations in the value ofthe functional currencies of our foreign subsidiaries against the United Statesdollar.  Net other expense totaled$606,000 for the three months ended March 31, 2004, compared to net otherincome of $80,000 for the three months ended March 31, 2005.  The change from net other expense to netother income was primarily due to an increase in interest income and a decreasein interest expense from period to period. The increase in interest income from2004 to 2005 reflects higher market interest rates for our short-term andlong-term investments. The decrease in interest expense from period to periodis due to our lower debt balances as a result of the repurchase of notes thatwe made in the third quarter of 2004. Foreign currency exchange gains totaled$54,000, interest income totaled $1.9 million and interest expense totaled $2.6million for the three months ended March 31, 2004, compared to a foreigncurrency exchange loss of $194,000, interest income of $2.4 million andinterest expense of $2.1 million for the three months ended March 31,2005.

 

*Income Tax Provision*.  The tax provision of $2.4million and $0 million for the three months ended March 31, 2004 and 2005,respectively, reflects an annual effective rate of 23% and 0%, 

 

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respectively. The changein the annual effective tax rate during the three months ended March 31,2005  from a provision rate of 23% to aprovision rate of 0% was primarily attributable to the decrease in pre-taxearnings as well as tax benefits from U.S. export incentive programs andresearch and development and manufacturing investment credits. The annualeffective tax rates for both periods were less than the U.S. statutory rate of35% 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 Research andExperimentation Credit was extended under the Working Families Tax Relief Actfor amounts paid or incurred after June 30, 2004 and before 2006.  The American Jobs Creation Act of 2004repealed the ETI exclusion subject to certain transition rules.  The ETI exclusion is being replaced with aManufacturing Activity deduction under IRC Section 199. The benefit isavailable to us for tax years beginning in 2005, subject to certain transitionrules. We anticipate that the benefit available to us under both regimes iscomparable for years in which we have taxable income.

 

## **LIQUIDITY AND CAPITALRESOURCES**

 

As of March 31, 2005, we had approximately$139.5 million in cash and cash equivalents, $180.2 million in short-terminvestments, $87.0 million in long-term investments, and $435.0 million inworking capital.

 

In February 2002, weissued $250.0 million in aggregate principal amount in a private placement ofnotes.  These 2002 notes are due on February 15,2009 with interest payable semi-annually on February 15 and August 15of each year at 3.50% per annum.  The2002 notes are convertible into shares of our common stock at a conversion rateof 20 shares per $1,000 principal amount or an effective conversion price of$50.00 per share.  We used a portion ofthe net proceeds from this private placement to redeem the previously issuednotes that were outstanding. The remaining proceeds are being used for ouroperating, investing and financing activities. As of March 31, 2005, there were $200.8 million principal amount of2002 notes outstanding.

 

Netcash provided by operating activities was approximately $1.7 million and $44.5million for the first three months ended March 31, 2004 and 2005,respectively. The increase in cash provided by operating activities from periodto period was primarily attributable to significant decreases in accountsreceivable and inventory in the three months ended March 31, 2005 comparedto increases in both for the same three-month period in 2004. The decrease inaccounts receivable reflects collections we made on our receivable balancesthat were outstanding at December 31, 2004. In the fourth quarter of 2004,we recorded a higher number of product shipments than normal in the last monthof the quarter, causing accounts receivable to increase at December 31,2004. The decrease in inventory reflects the reduction in our spares andconsumables inventory as result of our ongoing initiative to reduce inventoryand increase inventory turns.

 

Netcash used in investing activities was approximately $17.2 million and $13.0million for the three months ended March 31, 2004 and 2005, respectively.Net cash used in investing activities for the three months ended March 31,2004 was due primarily to the timing of short-term and long-term investmentsmaturing and being reinvested during the quarter, a $6.0 million payment toacquire certain patents, a $2.0 million payment to acquire an additional 6%minority interest in our Cymer Korea subsidiary, and the acquisition ofproperty and equipment in the amount of $4.4 million. Net cash used ininvesting activities for the three months ended March 31, 2005 reflects thetiming of short-term and long-term investments that matured and were reinvestedduring the period and the acquisition of $5.2 million of property andequipment.

 

Net cash provided byfinancing activities was approximately $8.1 million for the three months ended March 31,2004 compared to cash used in financing activities of $6.7 million for thethree months ended March 31, 2005. Net cash provided by financingactivities for the three months ended March 31, 2004 reflects proceedsreceived from the exercise of employee stock options totaling $8.1 million. Netcash used in financing activities for the three months ended March 31,2005 reflects the purchase of treasury stock of $8.3 million, partially offsetby proceeds received from the exercise of employee stock options totaling $1.6million.

 

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Since our initial****publicoffering and a secondary public offering, both in 1996, we have funded ouroperations primarily from cash generated from operations, the proceeds of thenote offerings in August 1997 and February 2002, bank borrowings, andthe proceeds from employee stock option exercises.

 

We require substantial working capital to fund ourbusiness, particularly to finance inventories, including purchase orders withour vendors, accounts receivable, and for capital expenditures. Our futurecapital requirements depend on many factors, including our manufacturingactivity, the timing and extent of spending to support product developmentefforts, expansion of sales and marketing and field service and support,competitive labor market compensation requirements, the timing of introductionsof new products and enhancements to existing products, and the marketacceptance of our products. We believe that cash generated from operationsalong with the liquidity provided by our existing cash balances and short-terminvestments will be sufficient to sustain operations and provide for anypotential future expansion of our business for at least the next 12 months.

 

At March 31, 2004 and 2005, we did not have anyrelationship with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance variable interest, or specialpurpose entities, which would have been established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes.  In addition, we didnot engage in trading activities involving non-exchange traded contracts.  As a result, we are not exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin such relationships.  We do not haverelationships and transactions with persons and entities that derive benefitsfrom their non-independent relationship with us or our related parties exceptas disclosed herein.

 

**SUBSEQUENTEVENTS**

 

As of March 31,2005 we had $200.8 million principal amount of convertible subordinated notesoutstanding. From April 1, 2005 through May 4, 2005, we repurchased, at a discount to par, $16.9 million principal amountof these notes.

 

*StockRepurchase Program.*  OnJanuary 27, 2005, we announced that our board of directors had authorized us torepurchase up to $50,000,000 of our common stock.  The purchases will be made from time to timein the open market or in privately negotiated transactions. The program may bediscontinued at any time. Total purchases through March 31, 2005 were $8.3million or 292,841 shares under this program. From April 1, 2005 throughMay 4,  2005, we purchased $20.2 millionor 811,995 shares under our stock repurchase program.

 

**RECENTACCOUNTING PRONOUNCEMENTS**

 

In December 2004, FASB issued SFAS No.123R, “Share-Based Payment - An Amendment to Statement Nos. 123 and 95,” thataddresses the accounting for share-based payment transactions in which anenterprise receives employee services in exchange for (a) equity instruments ofthe enterprise or (b) liabilities that are based on the fair value of theenterprise’s equity instruments or that may be settled by the issuance of suchequity instruments. This statement will eliminate the ability to account forshare-based compensation transactions using Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees,” and will requireinstead that such transactions be accounted for using a fair-value-basedmethod.  On April 14, 2005, the SEC announced the deferral of theeffective date of SFAS No. 123R. The deferral allows companies to adopt theprovisions of SFAS No. 123R beginning on the first annual period beginningafter June 15, 2005. Based on the new required adoption date, we plan toadopt SFAS No. 123R as of the beginning of the first quarter of 2006.

 

Weare currently evaluating the impact and implementation of SFAS No.123R and howthis new pronouncement will effect our consolidated financial statements. Ourevaluation includes a determination on how future stock awards will be valuedbased on an appropriate fair value model upon adoption of SFAS No. 123R as wellas the impact of stock compensation expense associated with unvested stockoptions which are outstanding as of December 31, 2005.  In addition, as a result of the amendment toour ESPP, effective May 1, 2005, our ESPP will be a non-compensatory plan, and,therefore, no stock compensation expense will be recorded under the ESPP uponthe adoption of SFAS No. 123R.  We arealso required to elect the transition method that we will use as part of theadoption of SFAS No. 123R. The allowed transition methods include prospectiveand retroactive adoption alternatives. The prospective method requires thatcompensation expense be recorded for all unvested stock options and awards 

 

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prospectively at thebeginning of the first quarter of adoption of SFAS No. 123R, while theretroactive method would require us to record compensation expense for allunvested stock options and awards beginning with the first period restated. We planto elect to use the prospective transition method in our adoption of SFAS No.123R and to adopt effective January 1, 2006.

 

In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151 (“SFAS No. 151),  “Inventory Costs, an amendment of AB 43, Chapter 4”.  This statement amends Accounting Research Bulletin No. 43 (“ARB No. 43”), Chapter 4, to clarify accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material.  SFAS No. 151 requires that those items be recognized as current-period charges in all circumstances.  SFAS No. 151 is effective for fiscal years beginning after June 15, 2005.  We are still assessing the impact that the adoption of SFAS No. 151 will have on our consolidated financial statements.

 

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 153 (“SFAS No. 153), “Exchange ofNonmonetary Assets”, an amendment of APB Opinion No. 29. SFAS No. 153 replacesthe exception from fair value measurement in APB Opinion No. 29, with a generalexception from fair value measurement for exchanges of nonmonetary assets thatdo not have commercial substance.  The statementis to be applied prospectively and is effective for nonmonetary asset exchangesoccurring in fiscal periods beginning after June 15, 2005.  We do not believe that SFAS No. 153 will havea material impact on our results of operations or cash flows.

 

FASB Staff Position No.109-1 (“FSP No. 109-1”), Application of FASB Statement No. 109, Accounting forIncome Taxes, to the Tax Deduction on Qualified Production Activities Providedby the American Jobs Creation Act of 2004, December 21, 2004, clarifiesFASB Statement No. 109’s guidance that applies to the new deduction forqualified domestic production activities. Specifically, FSP No. 109-1 clarifies that the deduction should beaccounted for as a special deduction under FASB Statement No. 109, not as atax-rate reduction.  We will not takeadvantage of the benefit under Section 199 in 2005 due to the taxableincome limitation.  We will comply withthe accounting procedures at such time as it is applicable to the company.

 

FASB Staff Position No.109-2 (“FSP No. 109-2”), Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provision within the American Jobs Creation Act of 2004(the “Act”), December 21, 2004, provides accounting and disclosureguidance for the repatriation provision under the American Jobs CreationAct.  Congress and the TreasuryDepartment have yet to issue clarifying language on key elements of theprovision, which could impact our decision for repatriation of foreignearnings.  FSP No. 109-2 allowscorporations additional time beyond the financial reporting period of enactmentto evaluate the effect of the Act on its plan for reinvestment or repatriationof foreign earnings for purposes of applying FASB Statement No. 109.  As provided for in FSP No. 109-2, we have notmade any adjustments to our tax expense or deferred tax liability related tothe repatriation provisions of the Act.

 

PCAOB Release No.2004-015, Proposed Ethics and Independence Rules Concerning Independence, TaxServices, and Contingent Fees, December 4, 2004, proposes rules to promotethe ethics and independence of registered public accounting firms that auditand review financial statements of U.S. public companies.  The rules would limit the tax servicesindependent auditors could provide to their public company audit clients.  Specifically, the rules would prohibitcontingent fee or commission arrangements; treat the firm as not independent ifthe firm provided assistance in planning or provided tax advice on potentiallyabusive tax transactions or provided tax services to certain senior officers ofthe audit client; and would require accounting firms to provide certaininformation to the audit committee of an audit client in connection with seekingpre-approval to provide non-prohibited tax services to the audit client. Our independentregistered public accountant does not currently provide services to us, whichare considered prohibited under the proposed guidelines. Based on initialanalysis of the above requirements, we are currently in compliance with theproposed guidelines.

 

In March 2005, theFASB issued FASB Interpretation No. 47 (“FIN 47”), “Accounting for Conditional AssetRetirement Obligations and Interpretation of FASB Statement No. 143. FIN 47clarifies that an entity must record a liability for a “conditional” assetretirement obligation if the fair value of the 

 

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obligation can bereasonably estimated. FIN 47 is effective no later than the end of fiscal yearsending after December 15, 2005.  Wedo not expect the adoption of FIN 47 will have a material impact on our resultsof operations or cash flows.

 

#### **RISKS AND UNCERTAINTIESTHAT MAY AFFECT RESULTS**

 

*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 or circumstancesdescribed in the following risks actually occur, our business, financialcondition or results of operations could suffer, and the trading price of ourcommon stock could decline.*

 

Our revenues and operatingresults from quarter-to-quarter have varied in the past and our futureoperating results may continue to fluctuate significantly due to many factorsincluding those listed in this section and throughout this QuarterlyReport on Form 10-Q for the period ended March 31, 2005.

 

These factors include:

 

•                  demand forsemiconductors in general and, in particular, for leading edge devices with smallercircuit geometries;

•                  cyclicality in themarket for semiconductor manufacturing equipment;

•                  rates at whichchipmakers take delivery of photolithography tools from lithography toolmanufacturers (“our customers”);

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

•                  timing and size oforders from our small base of customers;

•                  product lead timedemands from our customers and the 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;

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

•                  worldwide politicalinstability;

•                  changing global economicconditions; and

•                  intellectual propertyprotection.

 

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

 

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

 

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**Our business depends on the semiconductor equipmentindustry, which is highly volatile and unpredictable.**

 

The semiconductor industry ishighly cyclical. We derive a substantial percentage of our revenues fromlithography tool manufacturers within the semiconductor industry. Our customersdepend in turn on the demand for their photolithography tool products fromtheir customers, the chipmakers. The capital equipment expenditures ofchipmakers depend on a number of factors, including the current and anticipatedmarket demand for semiconductors and products using semiconductors.

 

The semiconductor industry iscyclical in nature and historically has experienced periodic ups and downs andcurrently appears to be in a slowing period after a short upturn that followeda significant and prolonged downturn. This cyclical nature of the industry inwhich we operate affects our ability to accurately predict future revenue andthus, future expense levels. When cyclical fluctuations result in lower thanexpected revenue levels, operating results may be adversely affected and costreduction measures may be necessary in order for us to remain competitive andfinancially sound.  During a down cycleor an industry slowdown, we must be in a position to adjust our cost andexpense structure to prevailing market conditions and to continue to motivateand retain our key employees.  Inaddition, during periods of rapid growth, we must be able to increasemanufacturing capacity and personnel to meet customer demand.  We can provide no assurance that theseobjectives can be met in a timely manner in response to industry cycles.

 

We believe the industry has slowed, particularly inregards to purchasing capacity driven semiconductor manufacturingequipment.  Therefore, we are not able topredict with any certainty the depth or duration of the apparent slowdown ofthe semiconductor industry or the timing and order of magnitude of any futurerecovery. The previous downturn had a severe effect on the demand forsemiconductor manufacturing equipment, including photolithography tools thatour customers produce.  If overall marketconditions deteriorate in the near term, our current operating levels maynegatively impact our profitability. We believe that downturns in thesemiconductor industry will occur periodically, and result in periodicdecreases in demand for all semiconductor manufacturing equipment, includingphotolithography tools our customers manufacture. As a result, fluctuatinglevels of investment by chipmakers and pricing volatility will continue tomaterially affect our aggregate bookings, revenues and operating results. Also,even during periods of reduced revenues we believe we must continue to investin research and development and to maintain extensive ongoing worldwidecustomer service and support capabilities to remain competitive, which maytemporarily harm our financial results. Accordingly, these downturns and industry 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 some future quarter or quarters. Such failureto meet operating result expectations would materially adversely affect theprice of our common stock.

 

Our customers try to managetheir inventories and production requirements to appropriate levels that bestreflect their expected sales to chipmakers. Market conditions in the industryand production efficiency of the lithography tool manufacturers can cause ourcustomers to expand or reduce their orders for new light source systems as theytry to manage their inventories and production requirements to these levels. Wecontinue to work with our customers to better understand these issues. However,we cannot guarantee that we will be successful in understanding our customers’inventory management and production requirements or that our customers will notbuild up an excess inventory of light source products. If our customers retainan excess inventory of light source products, our revenue could be reduced infuture periods as the excess inventory is utilized, which could adverselyaffect our operating results, financial condition and cash flows.  In addition, if our customers demand shorterproduct lead times as a solution to improve their inventory and cash positions,our inventory management and cash position may be impacted, which may adverselyaffect our operating results, financial condition and cash flows.

 

**A significant percentage of ourrevenue is derived from sales to a few large customers, and if we are not ableto retain these customers, or they reschedule, reduce or cancel orders, ordelay or**

 

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**default on payments, our revenueswould be reduced and our financial condition and cash flows would suffer.**

 

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

 
| ** **      | ** ** | **Three  months ended  March 31,** | ** ** |
|-----------------|------------|-----------------------------------------|------------|
| ** **      | ** ** | **2004**                                | ** ** | **2005** | ** ** |
|            |       |                                    |       |   |   |
| ASM Lithography |       | 31                                      | %          | 29 | % |
| Canon           |       | 20                                      | %          | 7 | % |
| Nikon           |       | 19                                      | %          | 29 | % |
|            |       |                                    |       |   |   |
| Total           |       | 70                                      | %          | 65 | % |

 

Collectively, these threecompanies account for the following percentage of our total accounts receivableat the dates indicated:

 
| ** **      | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-----------------|------------|-----------------------|------------|--------------------|------------|
| ** **      | ** ** | **2004**              | ** ** | **2005**           | ** ** |
|            |       |                  |       |               |       |
| ASM Lithography |       | 46                    | %          | 36                 | %          |
| Canon           |       | 5                     | %          | 4                  | %          |
| Nikon           |       | 31                    | %          | 33                 | %          |
|            |       |                  |       |               |       |
| Total           |       | 82                    | %          | 73                 | %          |

 

We expect that sales of ourlight source products to these three customers will continue to account for asubstantial majority of our revenue in the foreseeable future. None of ourcustomers are obligated to purchase a minimum number of our products in theaggregate or during any particular period. The loss of any significant businessfrom or production problems for any one of these three customers may have a materialadverse effect on our business and financial condition. Sales to thesecustomers may be affected by many factors, some of which are beyond ourcontrol. 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.

 

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

** **

Our only product line isexcimer light source systems, including KrF and ArF systems, and support,including consumables and service support. We expect these light source systems and support to continue to accountfor a large percentage of our revenues in the near term. Continued marketacceptance of our light source system products is, therefore, critical to ourfuture success. The primary market for excimer light sources is in the use ofDUV photolithography equipment for manufacturing deep-submicron semiconductordevices using smaller circuit geometries. The demand for our products dependsin part on the rate at which chipmakers further adopt excimer light sources asthe chosen light source for 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;

 

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

 

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

•                  a failure to achievecontinued market acceptance of our products;

•                  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 depend on theintroduction of new products for our success, and we are subject to risksassociated with rapid technological change.**

 

Rapid technological changes insemiconductor manufacturing processes subject us to increased pressure todevelop technological advances enabling such processes. We believe that ourfuture success depends in part upon our ability to develop, manufacture andtimely introduce new light source products with improved capabilities and tocontinue to enhance our existing light source systems 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.

 

Our most significant productintroduction in recent years consisted of a technology change from a single-discharge-chamberexcimer light source to a dual-discharge-chamber design called MOPA.  The MOPA design represents a paradigm shiftfrom previously accepted lithography technology and offers chipmakers higherpower, tighter bandwidth and lower cost of operation for their current – and isexpected to offer the same benefits for their future – optical lithographyapplications.  As originally designed,the MOPA architecture was projected to provide its benefits across all threeDUV wavelengths – 248 nm, 193 nm, and 157 nm – but at this time, thesemiconductor industry has only adopted MOPA at the 193 nm wavelength, due tothe successful extension of 248 nm single chamber technology, and the omissionof 157 nm lithography from the roadmap. There are risks inherent in the ongoing transition to the MOPAtechnology, including effective execution of our product development roadmap,continuing adoption of the product by lithography tool manufacturers andchipmakers, manufacturability and cost effectiveness of the new products andthe development of a comparable product by our competitor.

 

We believe that chipmakers arecurrently developing a capability to produce devices that are measured at 90nanometers or less, and these efforts are driving the current demand for ourlight source products for DUV photolithography systems. After chipmakers havethis capability, their demand for our light source products will depend, inpart, on whether they want to expand their capacity to manufacture thesedevices. This will in turn depend on whether their sales forecasts andprojected manufacturing process yields justify the necessary investments.

 

Future technologies such asEUV, electron projection lithography, and maskless lithography may render ourexcimer light source products obsolete. We must manage product transitions, asintroduction of new products could adversely affect our sales of existingproducts. If new products are not introduced on time, or have reliability orquality problems, our performance may be impacted by reduced orders, highermanufacturing costs, delays in acceptance of and payment for new products, andadditional service and warranty expenses. We may not be able to develop andintroduce new products or enhancements to our existing products and processesin a timely or cost effective manner that satisfies customer needs or achievesmarket acceptance. Failure to develop and introduce these new products andenhancements could materially adversely affect our operating results, financialcondition and cash flows.

 

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

 

**We must effectively managechanges 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 departments. As the semiconductor industry grows and contracts we will needto:

 

•                  closely manage ourglobal operations;

•                  improve our process andother internal management systems;

•                  improve our qualitycontrol, order fulfillment, field service and customer support capabilities;

•                  quickly adapt tochanging sales and marketing channels;

•                  effectively manage ourinventory levels; and

•                  attract, train, retainand manage key personnel.

 

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

 

**We depend on a few keysuppliers for purchasing components and subassemblies that are included in ourproducts.**

** **

We purchase a limited number of components andsubassemblies included in our light source products from a single supplier or asmall group of suppliers.  Forcertain optical components used in our light source systems, we currentlyutilize a single supplier.  To reduce therisk associated with this single supplier, we carry a significant strategicinventory of these components.  Strategicinventories are managed as a percentage of future demand.  We have also negotiated to have vendor-managedinventory of critical components to further reduce the risk of a single supplier.  Inaddition, we contract the manufacture of various subassemblies more often thanin the past. Further, some of our suppliers have specialized in supplyingequipment or manufacturing services to semiconductor equipment manufacturersand therefore are susceptible to industry ups and downs and subject to the samerisks and uncertainties regarding their ability to respond to changing marketconditions.  Because many of thesesuppliers reduce the size of their workforce in an industry downturn and increaseit in an upturn, they may not be able to meet our requirements or respondquickly enough as an upturn begins and gains momentum.  Due to the nature of our product developmentrequirements, these key suppliers must rapidly advance their own technologies andproduction capabilities in order to support the introduction schedule ofour new products. These suppliers may not be able to provide new modules andsubassemblies when they are needed to satisfy our product schedule requirements.If we cannot purchase enough of these materials, components or subassemblies,or if these items do not meet our quality standards, there could be delays orreductions in our product shipments, which would have a material adverse effecton our operating results, financial condition and cash flows.

 

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

** **

We are currently aware of onesignificant competitor that sells light sources for DUV photolithographyapplications. This competitor is Gigaphoton, a joint venture between two largecompanies, Komatsu and Ushio, which is headquartered in Japan.  Additionally, late in 2004, a former competitorCoherent, Inc., a U.S. company, announced that their Lambda-Physik subsidiarywould no longer pursue the excimer light source systems business forphotolithography in the semiconductor industry.

 

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We believe that Gigaphoton isaggressively trying to gain larger market penetration in the excimer lightsource industry. We know that our customers have purchased products from thiscompetitor and that our customers have approved this competitor’s light sourcesfor use with their products.  We knowthat Gigaphoton has been approved by chipmakers in Japan, the U.S. andelsewhere for producing excimer light sources.

 

Larger companies withsubstantially greater resources, such as other manufacturers of industriallight sources for advanced lithography, may attempt to sell competitiveproducts to our customers. Potential competitors may also be attracted to ourgrowing installed base of light sources and may attempt to supply consumableproducts and refurbished parts to that installed base. If any existing orfuture competitors gain market acceptance we could lose market share and ourgrowth could slow or decline, which could have a material adverse effect on ouroperating results, financial condition and cash flows.

 

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

** **

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

 

•                  research anddevelopment;

•                  engineering;

•                  sales and marketing;

•                  field service;

•                  manufacturing; and

•                  management.

 

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

 

•                  the continued servicesof our research and development, engineering, sales and marketing,manufacturing and field service, 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, trainand retain key personnel as required, our operating results,  financial condition and cash flows could beadversely affected.

 

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

** **

We serve an increasingly globalmarket.  A large portion of our totalrevenues is derived from customers located outside of the United States,particularly in Asian countries.  Weexpect our international sales to continue to account for a very large portionof our total revenues.  In order tosupport our foreign customers, we maintain a manufacturing and field servicesubsidiary in Korea as well as field service and support subsidiaries in Japan,the Netherlands, the People’s Republic of China, Singapore and Taiwan.

 

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

 

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

 

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•                  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 andmany of the chipmakers who use our light source products in theirphotolithography systems are located in Asia. Economic problems and currencyfluctuations affecting these regions in Asia could create a larger risk for us.Further, even though it has not been difficult for us to comply with UnitedStates export controls, these export rules could change in the future and makeit more difficult or impossible for us to export our products to manycountries.  Any of these vulnerabilitiescould have a material adverse effect on our business, financial condition andresults of operations.

 

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

 

We have historically used broad based stock optionprograms and other forms of equity-related incentives as a key component of ouremployee compensation packages. We believe that stock options and otherlong-term equity incentives directly motivate a broader base of employees tomaximize long-term stockholder value and, through the use of long-term vesting,encourage employees to remain with us. The FASB has issued SFAS No. 123R, of which the date of adoption wasdeferred by the SEC to be effective for annual periods beginning after June 15,2005.  This new rule will require us torecord an expense to earnings for employee stock option grants and other equityincentives. Moreover, applicable stock exchange listing standards relating toobtaining stockholder approval of equity compensation plans could make it moredifficult or expensive for us to grant options to employees in the future,which may result in changes in our equity compensation strategy. These andother developments in the provision of equity compensation to employees couldmake it more difficult to attract, retain and motivate employees, and such achange in accounting rules may adversely impact our future operating results,financial condition and cash flows.

 

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

 

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

 

•                  recruit and trainqualified field service personnel;

•                  identify qualifiedindependent firms; and

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

 

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We might not be able to attractand train qualified personnel to maintain our direct support operationssuccessfully. We may not be able to find and engage qualified third-partyresources to supplement and enhance our direct support operations.  Further, we may incur significant costs inproviding these support services. Failure to implement our direct supportoperation effectively could have a material adverse effect on our operatingresults, financial condition and cash flows.

 

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

 

Changing laws,regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations,Nasdaq Stock Market rules, and new accounting pronouncements are creatinguncertainty and additional complexities for companies such as ours. Inparticular, the Section 404 internal control requirements under theSarbanes-Oxley Act have added and will continue to add complexity and costs toour business and require a significant investment of our time and resources tocomplete each year.  We take these newrequirements 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.

 

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

 

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

 

As of March 31, 2005, weowned 214 United States patents covering certain aspects of technology relatedto light sources and piezo techniques. These patents will expire at varioustimes during the period from January 2008 to June 2023.  As of March 31, 2005, we had applied for89 additional patents in the United States. As of March 31, 2005, we owned 301 foreign patents and had 343patent applications pending in various foreign countries.

 

Our pending patent applicationsand any future applications might not be approved. Our patents might notprovide us with a competitive advantage and may be challenged by third parties.In addition, third parties’ patents might have an adverse effect on our abilityto do business. As a result of cost constraints, we did not begin filing inJapan and other countries our patents for inventions covered by United Statespatents and patent applications until 1993. As a result we do not have the right to seek foreign patent protectionfor some of our early inventions. Additionally, laws of some foreign countries in which our products areor may be developed, manufactured or sold, including various countries in Asia,may not protect our products or intellectual property rights to the same extentas do the laws of the United States. Thus, the possibility of piracy of ourtechnology and products are more likely in these countries. Further, thirdparties might independently develop similar products, duplicate our products,or design around patents that are granted to us.

 

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

 

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

 

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•                  trade secret protection;

•                  employee nondisclosureagreements;

•                  third-partynondisclosure agreements; and

•                  other intellectualproperty protection methods.

 

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

 

•                  independently developsubstantially the same proprietary information and techniques;

•                  gain access to our tradesecrets; or

•                  disclose our technology.

 

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

** **

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

 

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

** **

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

 

Specifically, Komatsu hasnotified us that we may be infringing some of its Japanese patents. During ourdiscussions with Komatsu, they also asserted that our former Japanesemanufacturing partner, Seiko, or we may be infringing on some of Komatsu’sUnited States patents and a number of its additional Japanese patents. Komatsuhas also notified one of our customers, Nikon, of its belief that our lightsources infringe several of Komatsu’s Japanese and U.S. patents. As a result,we started proceedings in the Japanese Patent Office to oppose certain patentsand patent applications of Komatsu. The Japanese Patent Office has dismissedsome of our opposition claims. Thus, litigation may result in connection with Komatsu’sJapanese patents or U.S. patents. Also, Komatsu might claim that we infringeother or additional patents. Komatsu notified Seiko that it intends to enforceits rights against Seiko with respect to its Japanese patents if Seikocontinued to engage in manufacturing activities for us. In connection with ourformer manufacturing agreement with Seiko, we agree to pay Seiko under certainconditions for damages associated with these types of claims. Seiko may notprevail in any litigation against Komatsu, and therefore, we may be required topay Seiko for such damages.

 

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

 

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In the future, patentlitigation may result due to a claim of infringement by our competitor or anyother third party or may be necessary to enforce patents issued to us.  Any such litigation could result insubstantial cost and diversion of effort by us, 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.  In the alternative, we may design around thethird party’s intellectual property rights.  Any adverse determination in a legalproceeding could result in one or more of the following, any of which couldhave a substantial adverse effect on our business, financial condition andoperating 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 becostly and would divert the efforts and attention of our management andtechnical personnel, which would materially adversely affect our business,financial condition and results of operations.

 

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

 

We registered the trademarks “CYMER”and “INSIST ON CYMER” and others in the United States and in some othercountries. We are also trying to register additional trademarks in the UnitedStates 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 have in the past andmay in the future acquire a business or enter a new market that will involvenumerous risks. We may not be able to address these risks successfully withoutsubstantial expense, delay or other operational and financial problems.**

** **

The risks involved withacquiring a new company 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 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 or new markets to meet their financial projections;

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

•                  compliance with theSarbanes-Oxley Act of 2002, new SEC regulations, Nasdaq Stock Market rules andnew accounting pronouncements.

 

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Mergers and acquisitions aswell as entering new markets are inherently subject to multiple significantrisks, and the inability to effectively manage these risks could have amaterial adverse effect on our business. Any of these risks could materially harm our business, financialcondition and operating results. Further, any business that we acquire or newmarket we may enter may not achieve anticipated revenues or operating results.

 

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

 

We depend on regular andreliable air transportation on a worldwide basis for many of our routinebusiness functions. If civil aviation in the United States or abroad isdisrupted by terrorist activities or security responses to the threat ofterrorism or for any other reason, our business could be adversely affected inthe 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 support of installed light sources for chipmakers; and

•                  our sales and marketingefforts may be disrupted.

 

**We are exposed to risks relatedto the fluctuations in the currency exchange rates 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 is denominated in Japaneseyen. Thus, our results of operations may fluctuate based on the changing valueof the Japanese yen to the U.S. dollar. We manage the exposure of our Japanesesubsidiary to these fluctuations through forward contracts to hedge itspurchase commitments. We will continue to monitor our exposure to thesecurrency fluctuations, and, when appropriate, use hedging transactions tominimize the effect of these currency fluctuations. However, exchange ratefluctuations may still have a material adverse effect on our operating results.In the future, we may need to sell our products in foreign currencies otherthan the Japanese yen and the management of more currency fluctuations will bemore difficult and expose us to greater risks in this area.**

 

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

 

**Many foreign government standards and regulationsapply to our products.  These standardsand regulations are always being amended. Although we intend to meet all foreign standards and regulations, ourproducts may not comply with these foreign government standards and regulations.  Further, it might not be cost effective forus to redesign our products to comply with these foreign government standardsand regulations.  Our inability to designproducts to comply with foreign standards therefore could have a material adverseeffect on our business.**

 

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

 

Over time, our light sourceproducts may not meet chipmakers’ production specifications or operating costrequirements after the light source is used for a long period in high volumeproduction. If any chipmaker cannot successfully achieve or sustain theirvolume production using our light sources, our reputation could be damaged withthe chipmakers and our customers who are the limited number of lithography toolmanufacturers. This would have a material adverse effect on our business.

 

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

** **

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

 

## **We are dependent on our manufacturing facilitiesand subcontractors to assemble and test our products.**

## ** **

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

 

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

 

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

 

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

** **

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

 

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

 

The price of our common stockhas fluctuated in the past. The market price of our common stock will continueto be subject to significant fluctuations in the future in response to avariety of factors, including the risk factors contained in this report.

 

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

 

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•                  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;

•                  United States 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 suchlitigation can result in substantial costs and a diversion of management’sattention and resources and therefore could have a material adverse effect onour business, financial condition and results of operations**

 

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

 

# **ForeignCurrency 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 the greatest foreign currency risk.  We use financial instruments, principallyforward contracts, to manage our foreign currency exposures. We enter intoforward contracts in order to reduce the impact of currency fluctuationsrelated to purchases of our inventories by Cymer Japan in U.S. dollars forresale under firm third-party sales commitments denominated in Japanese yen, aswell as other foreign currency exposures including exposures related tointercompany debt.  We do not enter intoforward contracts for speculative purposes.

 

Asof March 31, 2005, we had outstanding forward contracts to buy U.S. $54.5million for 5.7 billion yen under foreign currency exchange facilities withcontract rates ranging from 101.1 yen to 110.0****yenper U.S. dollar.  These contracts expireon various dates through December 2005.

 

Our forward contractsgenerally qualify for hedge accounting treatment per the provisions ofStatement of Financial Accounting Standards No. 133, “Accounting for DerivativeInstruments and Hedging Activities”. As a result, we defer changes in the fairvalue for the effective portion of these hedges and record the amount in othercomprehensive income (loss) and subsequently reclassify the gain or loss tocost of product sales in the same period that the related sale is made to thethird party. The fair value of all of our forward contracts and the deferredgain (net of tax) for those that qualify for hedge accounting treatment totaled$1.1 million and $221,000, respectively, as of March 31, 2005.

 

The fair value of theseforward contracts as of March 31, 2005 would have changed by $5.4 millionif the foreign currency exchange rate for the Japanese yen to the U.S. dollaron these forward contracts had changed by 10%.

 

# **Investmentand Debt Risk**

 

Wemaintain an investment portfolio consisting primarily of government andcorporate fixed income securities, certificates of deposit and commercialpaper.  While it is our general intent tohold such securities until maturity, we will occasionally sell certainsecurities for cash flow purposes. Therefore, our investments are classified asavailable-for-sale and are carried on the balance sheet at fair value.  Due to the conservative nature of theinvestment portfolio, a sudden change in interest rates would not have amaterial effect on the value of the portfolio.

 

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In February 2002,we issued $250.0 million principal amount of unsecured fixed rate 3.50%Convertible Subordinated Notes due February 15, 2009.  Interest on these 2002 notes is payable on February 15and August 15 of each year.  The2002 notes are convertible into shares of our common stock at a conversion rateof 20 shares per $1,000 principal amount subject to adjustment under certainconditions. We may redeem the 2002 notes on or after February 20, 2005, orearlier if the price of our common stock reaches certain levels. The 2002 notesare subordinated to our existing and future senior indebtedness and effectivelysubordinated to all indebtedness and other liabilities of oursubsidiaries.  Because the interest rateis fixed, we believe there is no risk of increased interest expense. These 2002notes are recorded at face value on the consolidated balance sheets. In thethird quarter of 2004, we repurchased, at a discount to par, approximately$49.2 million of these 2002 notes.  As ofMarch 31, 2005, $200.8 million principal amount of the 2002 notes wereoutstanding.  The fair value of such debtbased on quoted market prices on March 31, 2005 was $189.7 million.

 

**ITEM 4****.  Controls andProcedures**

 

*Evaluation of disclosure controls and procedures*.  Our chief executive officer and our chieffinancial officer, after evaluating the effectiveness of our disclosurecontrols and procedures (as defined in Exchange Act Rule 13a-15(e) and15d-15(e)) as of March 31, 2005, have concluded that as of such date, ourdisclosure controls and procedures were adequate and sufficient to ensure thatinformation required to be disclosed by us in the reports that we file underthe Securities Exchange Act of 1934 is recorded, processed, summarized andreported within the time period specified in the Commission’s rules and forms.

 

*Changes in internal controls*. There hasbeen no change in our internal control over financial reporting during thequarter ended March 31, 2005 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

**PART II****.  OTHER INFORMATION**

 
| **ITEM 1.** | ** ** | **Legal  Proceedings**                                                                                                                                                                                                                                                                                                                         |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                                                                           |
|        |       | None.                                                                                                                                                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                                                                                           |
| **ITEM 2.** | ** ** | **Unregistered  Sales of Equity** Securities and Use of Proceeds                                                                                                                                                                                                                                                                               |
|        |       |                                                                                                                                                                                                                                                                                                                                           |
| (c)         |       | On January 27,  2005, we announced that our board of directors had authorized us to  repurchase up to $50,000,000 of our common stock. The purchases will be made  from time to time in the open market or in privately negotiated transactions.  The program does not have a fixed expiration date and may be discontinued at  any time. |

 

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Thefollowing table provides information as of March 31, 2005 with respect tothe shares of common stock repurchased by us during the first quarter of 2005:

 
| **Period**                   | ** ** | **Total  number of  shares  purchased** | ** ** | **Average price  paid per  share** | ** ** | **Total  number of  shares  purchased  as part of  publicly  announced  plans or  programs** | ** ** | **Approximate  dollar value  of shares  that may yet  be purchased  under the  plans or  programs** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
|                         |       |                                    |       |                               |       |                                                                                         |       |                                                                                                |       |
| February 9, 2005 — |       |                                    |       |                               |       |                                                                                         |       |                                                                                                |       |
| February 17, 2005       |       | 292,841                                 |       | $                                  | 28.27      |                                                                                         | 292,841    |                                                                                                | $          | 41,712,856 |   |
|                         |       |                                    |       |                               |       |                                                                                         |       |                                                                                                |       |
| Total                        |       | 292,841                                 |       |                               |       | 292,841                                                                                      |       |                                                                                                |       |
|                              |            |                                         |            |                                    |            |                                                                                              |            |                                                                                                     |            |  |  |

 
| **ITEM 3.** | ** ** | **Defaults  Upon Se**nior Securities                                                                                                                   |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                   |
|        |       | None.                                                                                                                                                  |
|        |       |                                                                                                                                                   |
| **ITEM 4.** | ** ** | **Submission  of Matters**to a Vote of Security Holders                                                                                                |
|        |       |                                                                                                                                                   |
|        |       | None.                                                                                                                                                  |
|        |       |                                                                                                                                                   |
| **ITEM 5.** | ** ** | **Other Infor****mation**                                                                                                                              |
|        |       |                                                                                                                                                   |
|        |       | None.                                                                                                                                                  |
|        |       |                                                                                                                                                   |
| **ITEM 6.** | ** ** | **Exhibit**s                                                                                                                                           |
|        |       |                                                                                                                                                   |
|        |       | 31.1         Certification of Chief Executive  Officer pursuant to Section 302 of the Sarbanes-Oxley Act. |
|        |       |                                                                                                                                                   |
|        |       | 31.2         Certification of Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act. |
|        |       |                                                                                                                                                   |
|        |       | 32.1         Certification of Chief Executive  Officer pursuant to Section 906 of the Sarbanes-Oxley Act. |
|        |       |                                                                                                                                                   |
|        |       | 32.2         Certification of Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act. |

 

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**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 5,  2005 | 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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