**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|------------|------------|----------------------------------------------------------------------------------------------------|
|       |       | **For the Quarterly Period Ended June 30, 2004**                                              |

 

**OR**

 
| **o**  | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934**                                                                                                                |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       | **For the Transition Period from                 to               ** |

 

**Commissionfile number 0-21321**

 

**CYMER, INC.**

(Exact name of registrant as specified in itscharter)

 

| **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 areacode)

 

**N/A**

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

 

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

 

Yes  ý      No  o

 

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

 

The number of shares of Common Stock, with $0.001 par value,outstanding on August 2, 2004 was 36,787,732.

 

 

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**CYMER, INC.**

 

**FORM 10-Q**

 

**For the Quarterly Period Ended June 30,2004**

 

**INDEX**

 
| **PART I.**        | **FINANCIAL INFORMATION**                                                          | ** ** |
|--------------------|------------------------------------------------------------------------------------|------------|
|               |                                                                               |       |
| ITEM 1.            | Consolidated Financial Statements (unaudited)                                      |       |
|               |                                                                               |       |
|               | Consolidated Balance Sheets as of December 31, 2003                           |       |
|               | and June 30, 2004                                                             |       |
|               |                                                                               |       |
|               | Consolidated Statements of Operations for  the                                     |       |
|               | three and six months ended June 30,  2003 and 2004                            |       |
|               |                                                                               |       |
|               | Consolidated Statements of Cash Flows for  the                                     |       |
|               | six months ended June 30, 2003 and  2004                                      |       |
|               |                                                                               |       |
|               | 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.            | Changes in Securities, Use of Proceeds, and  Issuer Purchases of Equity Securities |       |
|               |                                                                               |       |
| ITEM 3.            | Defaults Upon Senior Securities                                                    |       |
|               |                                                                               |       |
| ITEM 4.            | Submission of Matters to a Vote of Security  Holders                               |       |
|               |                                                                               |       |
| ITEM 5.            | Other Information                                                                  |       |
|               |                                                                               |       |
| ITEM 6.            | Exhibits and Reports on Form 8-K                                                   |       |
|               |                                                                               |       |
| **SIGNATURE PAGE** |                                                                               |

 

2

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**PART I. FINANCIAL INFORMATION**

 

 

**ITEM1.  Financial Statements**

 

**CYMER, INC.**

**CONSOLIDATEDBALANCE SHEETS****(UNAUDITED)**

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

 
| ** **                                                                                                                                                                                  | ** ** | **December 31,****2003** | ** ** | **June 30,****2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| **ASSETS**                                                                                                                                                                                  | ** ** | ** **                    | ** ** | ** **                | ** ** |
| ** **                                                                                                                                                                                  | ** ** | ** **                    | ** ** | ** **                | ** ** |
| CURRENT ASSETS:                                                                                                                                                                             |       |                          |       |                      |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                             | 230,657    |                      | $          | 211,056 |   |
| Short-term investments                                                                                                                                                                      |       | 93,474                        |       | 107,544                   |       |
| Accounts receivable – net                                                                                                                                                              |       | 62,819                        |       | 88,828                    |       |
| Inventories                                                                                                                                                                                 |       | 93,012                        |       | 110,788                   |       |
| Deferred income taxes                                                                                                                                                                       |       | 1,407                         |       | 1,692                     |       |
| Prepaid expenses and other assets                                                                                                                                                           |       | 5,513                         |       | 7,378                     |       |
| Total current assets                                                                                                                                                                        |       | 486,882                       |       | 527,286                   |       |
|                                                                                                                                                                                        |       |                          |       |                      |       |
| PROPERTY AND EQUIPMENT – NET                                                                                                                                                           |       | 128,849                       |       | 124,883                   |       |
| LONG-TERM INVESTMENTS                                                                                                                                                                       |       | 77,509                        |       | 80,250                    |       |
| DEFERRED INCOME TAXES                                                                                                                                                                       |       | 80,711                        |       | 81,680                    |       |
| GOODWILL –   NET                                                                                                                                                                  |       | 7,647                         |       | 8,358                     |       |
| INTANGIBLE ASSETS – NET                                                                                                                                                                |       | 12,925                        |       | 11,659                    |       |
| OTHER ASSETS                                                                                                                                                                                |       | 8,698                         |       | 8,324                     |       |
|                                                                                                                                                                                        |       |                          |       |                      |       |
| TOTAL ASSETS                                                                                                                                                                                |       | $                             | 803,221    |                      | $          | 842,440 |   |
|                                                                                                                                                                                        |       |                          |       |                      |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                              | ** ** | ** **                    | ** ** | ** **                | ** ** |
|                                                                                                                                                                                        |       |                          |       |                      |       |
| CURRENT LIABILITIES:                                                                                                                                                                        |       |                          |       |                      |       |
| Accounts payable                                                                                                                                                                            |       | $                             | 19,099     |                      | $          | 22,565 |   |
| Accrued warranty and installation                                                                                                                                                           |       | 26,486                        |       | 27,318                    |       |
| Accrued payroll and benefits                                                                                                                                                                |       | 7,196                         |       | 15,179                    |       |
| Accrued patents, royalties and other fees                                                                                                                                                   |       | 8,436                         |       | 3,824                     |       |
| Foreign currency forward exchange contracts                                                                                                                                                 |       | 6,401                         |       | 2,263                     |       |
| Income taxes payable                                                                                                                                                                        |       | 16,473                        |       | 20,763                    |       |
| Accrued and other current liabilities                                                                                                                                                       |       | 4,945                         |       | 7,785                     |       |
| Total current liabilities                                                                                                                                                                   |       | 89,036                        |       | 99,697                    |       |
|                                                                                                                                                                                        |       |                          |       |                      |       |
| CONVERTIBLE SUBORDINATED NOTES                                                                                                                                                              |       | 250,000                       |       | 250,000                   |       |
| OTHER LIABILITIES                                                                                                                                                                           |       | 5,660                         |       | 6,601                     |       |
| MINORITY INTEREST                                                                                                                                                                           |       | 5,195                         |       | 5,813                     |       |
|                                                                                                                                                                                        |       |                          |       |                      |       |
| 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; 36,345,000 and 36,767,000 shares outstanding  at December 31, 2003 and June 30, 2004, respectively |       | 36                            |       | 37                        |       |
| Additional paid-in capital                                                                                                                                                                  |       | 358,988                       |       | 369,659                   |       |
| Unearned compensation                                                                                                                                                                       |       | (146                          | )          | (79                       | )          |
| Accumulated other comprehensive loss                                                                                                                                                        |       | (5,734                        | )          | (6,831                    | )          |
| Retained earnings                                                                                                                                                                           |       | 100,186                       |       | 117,543                   |       |
| Total stockholders’ equity                                                                                                                                                             |       | 453,330                       |       | 480,329                   |       |
|                                                                                                                                                                                        |       |                          |       |                      |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                             |       | $                             | 803,221    |                      | $          | 842,440 |   |

 

See Notes to Unaudited Consolidated Financial Statements.

 

3

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**CYMER, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS****(UNAUDITED)**

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

 
| ** **                                                                      | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months  ended June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| **2003**                                                                        | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| REVENUES:                                                                       |       |                                          |       |                                        |       |   |   |   |   |
| Product sales                                                                   |       | $                                             | 62,177     |                                        | $          | 94,722 |   | $ | 129,513 |   | $ | 182,593 |   |
| Other                                                                           |       | —                                        |       | 185                                         |       | 57 |   | 235 |   |
| Total revenues                                                                  |       | 62,177                                        |       | 94,907                                      |       | 129,570 |   | 182,828 |   |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| COSTS AND EXPENSES:                                                             |       |                                          |       |                                        |       |   |   |   |   |
| Cost of product sales                                                           |       | 52,031                                        |       | 49,975                                      |       | 94,901 |   | 102,143 |   |
| Research and development                                                        |       | 16,072                                        |       | 14,832                                      |       | 33,390 |   | 27,202 |   |
| Sales and marketing                                                             |       | 4,461                                         |       | 5,879                                       |       | 8,555 |   | 11,702 |   |
| General and administrative                                                      |       | 6,547                                         |       | 8,154                                       |       | 12,320 |   | 14,769 |   |
| Amortization of intangible assets                                               |       | 40                                            |       | 40                                          |       | 80 |   | 80 |   |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| Total costs and expenses                                                        |       | 79,151                                        |       | 78,880                                      |       | 149,246 |   | 155,896 |   |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| OPERATING INCOME (LOSS)                                                         |       | (16,974                                       | )          | 16,027                                      |       | (19,676 | ) | 26,932 |   |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                                                         |       |                                          |       |                                        |       |   |   |   |   |
| Foreign currency exchange loss – net                                       |       | (57                                           | )          | (399                                        | )          | (417 | ) | (345 | ) |
| Interest and other income                                                       |       | 2,397                                         |       | 1,603                                       |       | 4,886 |   | 3,499 |   |
| Interest and other expense                                                      |       | (2,505                                        | )          | (2,511                                      | )          | (4,980 | ) | (5,067 | ) |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| Total other expense – net                                                  |       | (165                                          | )          | (1,307                                      | )          | (511 | ) | (1,913 | ) |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| INCOME (LOSS) BEFORE INCOME TAX  PROVISION (BENEFIT) AND MINORITY INTEREST |       | (17,139                                       | )          | 14,720                                      |       | (20,187 | ) | 25,019 |   |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| INCOME TAX PROVISION (BENEFIT)                                                  |       | (12,112                                       | )          | 3,386                                       |       | (12,112 | ) | 5,754 |   |
| MINORITY INTEREST                                                               |       | (166                                          | )          | (1,133                                      | )          | (480 | ) | (1,908 | ) |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| NET INCOME (LOSS)                                                               |       | $                                             | (5,193     | )                                           | $          | 10,201 |   | $ | (8,555 | ) | $ | 17,357 |   |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| EARNINGS (LOSS) PER SHARE:                                                      |       |                                          |       |                                        |       |   |   |   |   |
| Basic earnings (loss) per share                                                 |       | $                                             | (0.15      | )                                           | $          | 0.28 |   | $ | (0.25 | ) | $ | 0.47 |   |
| Weighted average common shares outstanding                                      |       | 34,577                                        |       | 36,735                                      |       | 34,443 |   | 36,661 |   |
|                                                                            |       |                                          |       |                                        |       |   |   |   |   |
| Diluted earnings (loss) per share                                               |       | $                                             | (0.15      | )                                           | $          | 0.27 |   | $ | (0.25 | ) | $ | 0.46 |   |
| Weighted average common and dilutive  potential common shares outstanding       |       | 34,577                                        |       | 37,673                                      |       | 34,443 |   | 37,846 |   |

 

See Notes to Unaudited Consolidated Financial Statements.

 

4

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**CYMER, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS****(UNAUDITED)**

**(In thousands)**

 
| ** **                                                                                                      | ** ** | **For the six months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** |
|                                                                                                            |       |                                        |       |   |   |
| OPERATING ACTIVITIES:                                                                                           |       |                                        |       |   |   |
| Net income (loss)                                                                                               |       | $                                           | (8,555     | ) | $ | 17,357 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities:             |       |                                        |       |   |   |
| Depreciation and amortization                                                                                   |       | 16,617                                      |       | 13,949 |   |
| Non-cash stock-based compensation                                                                               |       | 804                                         |       | 261 |   |
| Amortization of unearned compensation                                                                           |       | 555                                         |       | 67 |   |
| Minority interest                                                                                               |       | 480                                         |       | 1,908 |   |
| Provision for deferred income taxes                                                                             |       | (21                                         | )          | (490 | ) |
| Loss on disposal and impairment of property  and equipment                                                      |       | 2,036                                       |       | 58 |   |
| Change in assets and liabilities:                                                                               |       |                                        |       |   |   |
| Accounts receivable – net                                                                                  |       | (6,778                                      | )          | (26,009 | ) |
| Income taxes receivable                                                                                         |       | (2,798                                      | )          | — |   |
| Foreign currency forward exchange contracts                                                                     |       | 212                                         |       | (2,127 | ) |
| Inventories                                                                                                     |       | 4,634                                       |       | (17,776 | ) |
| Prepaid expenses and other assets                                                                               |       | 1,216                                       |       | (2,126 | ) |
| Accounts payable                                                                                                |       | (11,243                                     | )          | 3,466 |   |
| Accrued expenses and other liabilities                                                                          |       | (1,965                                      | )          | 13,998 |   |
| Income taxes payable                                                                                            |       | (11,321                                     | )          | 4,290 |   |
|                                                                                                            |       |                                        |       |   |   |
| Net cash provided by (used in) operating  activities                                                            |       | (16,127                                     | )          | 6,826 |   |
|                                                                                                            |       |                                        |       |   |   |
| INVESTING ACTIVITIES:                                                                                           |       |                                        |       |   |   |
| Acquisition of property and equipment                                                                           |       | (42,415                                     | )          | (8,140 | ) |
| Purchases of investments                                                                                        |       | (53,101                                     | )          | (142,560 | ) |
| Proceeds from sold or matured investments                                                                       |       | 70,485                                      |       | 123,724 |   |
| Acquisition of patents  (1)                                                                                |       | —                                      |       | (5,990 | ) |
| Acquisition of minority interest                                                                                |       | (180                                        | )          | (2,000 | ) |
|                                                                                                            |       |                                        |       |   |   |
| Net cash used in investing activities                                                                           |       | (25,211                                     | )          | (34,966 | ) |
|                                                                                                            |       |                                        |       |   |   |
| FINANCING ACTIVITIES:                                                                                           |       |                                        |       |   |   |
| Net borrowings under revolving loan and  security agreements                                                    |       | (6,667                                      | )          | — |   |
| Proceeds from issuance of common stock                                                                          |       | 12,505                                      |       | 10,410 |   |
| Payments on capital lease obligations                                                                           |       | (26                                         | )          | (24 | ) |
|                                                                                                            |       |                                        |       |   |   |
| Net cash provided by financing activities                                                                       |       | 5,812                                       |       | 10,386 |   |
|                                                                                                            |       |                                        |       |   |   |
| EFFECT OF EXCHANGE RATE CHANGES ON CASH AND  CASH EQUIVALENTS                                                   |       | (215                                        | )          | (1,847 | ) |
|                                                                                                            |       |                                        |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                                       |       | (35,741                                     | )          | (19,601 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING  OF THE PERIOD                                                      |       | 196,643                                     |       | 230,657 |   |
|                                                                                                            |       |                                        |       |   |   |
| CASH AND CASH EQUIVALENTS AT END OF THE  PERIOD                                                                 |       | $                                           | 160,902    |   | $ | 211,056 |   |
|                                                                                                            |       |                                        |       |   |   |   |   |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                                                              |       |                                        |       |   |   |   |   |
| Interest paid                                                                                                   |       | $                                           | 4,509      |   | $ | 4,482 |   |
| Income taxes paid, net                                                                                          |       | $                                           | 2,194      |   | $ | 2,159 |   |
|                                                                                                            |       |                                        |       |   |   |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING  AND FINANCING ACTIVITIES:                                        |       |                                        |       |   |   |   |   |
| Reversal of unearned compensation related  to cancelled stock options previously issued for the ACX acquisition |       | $                                           | 1,475      |   | $ | — |   |

 

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(1) These patents were acquired in the fourth quarter of 2003 and thepayment was accrued.  Payment for thesepatents was made in the first quarter of 2004.

 

 

See Notes to Unaudited Consolidated Financial Statements.

 

5

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**CYMER, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****Three and Six Months Ended June 30, 2004**

**(Unaudited)**

 

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

 

*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.  Theseconsolidated financial statements and notes hereto should be read in conjunctionwith the consolidated financial statements and notes thereto included inCymer’s Annual Report on Form 10-K for the year ended December 31,2003.  Results for the interim periodspresented herein are not necessarily indicative of results which may bereported for any other interim period or for the entire fiscal year.

 

*Principles of Consolidation*– The consolidated financial statements include the accounts of Cymer, Inc.,its wholly-owned subsidiaries – Cymer Japan, Inc. (“Cymer Japan”), CymerSingapore Pte Ltd. (“Cymer Singapore”), Cymer B.V. in the Netherlands (“CymerB.V.”), Cymer Southeast Asia, Ltd, in Taiwan (“Cymer SEA”),  Cymer Semiconductor Equipment Shanghai Co.,Ltd, in the People’s Republic of China (“Cymer PRC”), and its majority-ownedsubsidiary, Cymer Korea, Inc. (“Cymer Korea”). Cymer, Inc. owns 81% of Cymer Korea. In February 2004, Cymer acquired 6% of the remaining 25% minorityinterest in its majority-owned subsidiary, Cymer Korea.  Cymer paid a total of $2.0 million for this6% interest and recorded $1.3 million of the $2.0 million as an additionalinvestment in Cymer Korea and the remaining $711,000 as goodwill.  This transaction increased Cymer’s totalinterest in Cymer Korea from 75% to 81%.   Cymer Japan is currently the only subsidiary office of Cymer which sellsexcimer light source systems.  Inaddition, Cymer Japan provides field service to customers in the Japan region.Cymer SEA, Cymer PRC, Cymer Singapore and Cymer B.V. are field service officesfor customers in those respective regions. Cymer Korea provides refurbishment manufacturing, field service, andadministrative activities for that region. All significant intercompanybalances have been eliminated in consolidation.

 

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

 

*Accounting Pronouncements Adopted*–**In January 2003,the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46(“FIN 46”), “Consolidation of Variable Interest Entities”.  FIN 46 provides guidance on how to identify avariable interest entity (“VIE”) and determines when the assets, liabilities,and results of operations of a VIE need to be included in a company’sconsolidated financial statements.  FIN46 also requires additional disclosures by primary beneficiaries and othersignificant variable interest holders in a VIE. The provisions of FIN 46 are effective immediately for all VIEs createdafter January 31, 2003.  For VIEscreated before February 1, 2003, the provisions of FIN 46 must be adoptedat the beginning of the first interim or annual reporting period beginningafter December 15, 2003.  Theadoption of this interpretation did not have a material effect on theconsolidated financial statements of Cymer as it does not have arrangementsthat meet the criteria of a VIE.

 

6

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In December 2003, FASB issued Interpretation No.46R, “Consolidation of Variable Interest Entities”, which supersedes FIN46.  The application of the revisedinterpretation is required in the financial statements of companies that haveinterests in special purpose entities for periods after December 15,2003.  The application of thisinterpretation did not have a material effect on the consolidated financialstatements of Cymer's as it does not have any arrangements that meet thecriteria of a special purpose entity.

 

In March 2004, the Emerging Issues TaskForce (“EITF”) finalized its consensus on EITF Issue 03-6, “ParticipatingSecurities and the Two-Class Method Under FASB Statement No. 128, Earnings PerShare” (“EITF 03-6”). EITF 03-6 clarifies what constitutes a participatingsecurity and requires the use of the two-class method for computing basicearnings per share when participating convertible securities exists. EITF 03-6is effective for fiscal periods beginning after March 31, 2004. Theapplication of EITF 03-6 did not have an effect on Cymer's calculation of earningsper share.

 

In March 2004, the EITF reached aconsensus on EITF Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments”. The EITF’s consensus applies to debt and equitysecurities accounted for under FASB Statement No. 115 (“SFAS 115”),  “Accounting for Certain Investments in Debtand Equity Securities”.  The guidance forevaluating whether an investment is other-than-temporarily impaired should beapplied in other-than-temporary impairment evaluations made in reportingperiods after June 15, 2004. The disclosures are effective in annualfinancial statements for fiscal years ending after June 15, 2004, forinvestments accounted for under SFAS 115. The adoption of  EITF 03-1 did not have a material impact onCymer’s consolidated financial statements.

 

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

 

**2.****             ****STOCK-BASED COMPENSATION**

 

Cymer applies the intrinsic value-based method ofaccounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”,and related interpretations including FASB Interpretation No. 44, “Accounting for Certain Transactionsinvolving Stock Compensation an interpretation of APB Opinion No. 25”**to account for its stock option plans.  Under this method, employee-based stockcompensation expense is measured on the date of grant only if the then currentmarket price of the underlying stock exceeded the exercise price and isrecorded on a straight-line basis over the applicable vesting period.  Statement of Financial Accounting StandardsBoard No. 123 (“SFAS No. 123”)“Accounting for Stock-BasedCompensation”, established accounting and disclosure requirements usinga fair value-based method of accounting for stock-based employee compensationplans.  As allowed by SFAS No. 123, Cymer has elected to continueto apply the intrinsic value-based method of accounting described above, andhas adopted the disclosure requirements of SFAS No. 123, as amended by 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 EITF Issue No. 96-18, “Accounting for Equity Instrumentsthat are Issued to other than Employees for Acquiring or in Conjunction with SellingGoods or Services”.  Cymer measures thefair value of such options using the Black-Scholes option-pricing model at eachfinancial reporting date.  Cymer accountsfor changes in fair values between reporting dates in accordance with FinancialAccounting Interpretation 28. Stock-based compensation expense for options granted to non-employeesand for those employees who changed status for the six months endedJune 30, 2003 and 2004 was $792,000 and $252,000, respectively.

 

7

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Under SFAS No. 123, the weighted average per sharefair value of the options granted for the six months ended June 30, 2003and 2004 was $17.75 and $25.50, respectively, on the date of grant.  Fair value under SFAS No. 123 is determinedusing the Black-Scholes option-pricing model with the assumptions notedbelow.  For risk free interest, Cymeruses the then currently available rate on zero coupon U.S. Government issueswith a remaining life of five years for valuing options and one year forvaluing Employee Stock Purchase Plan (“ESPP”) shares.

 
| ** **                            | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| **2003**                              | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** |
|                                  |       |                                  |       |                                |       |   |   |   |   |
| Dividend yield                        |       | None                                  |       | None                                |       | None |   | None |   |
| Volatility rate                       |       | 83                                    | %          | 79                                  | %          | 83 | % | 79 | % |
| Weighted average risk free interest : |       |                                  |       |                                |       |   |   |   |   |
| Options                               |       | 3.40                                  | %          | 3.72                                | %          | 3.13 | % | 3.31 | % |
| ESPP                                  |       | 1.22                                  | %          | 1.55                                | %          | 1.22 | % | 1.55 | % |
| Assumed forfeiture rate               |       | 5                                     | %          | 5                                   | %          | 5 | % | 5 | % |
| Expected life:                        |       |                                  |       |                                |       |   |   |   |   |
| Options                               |       | 6 years                               |       | 6 years                             |       | 6 years |   | 6 years |   |
| ESPP                                  |       | .5 years                              |       | .5 years                            |       | .5 years |   | .5 years |   |

 

Thefollowing table compares earnings (loss) per share as reported by Cymer to thepro forma amounts that would be 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  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| **2003**                                                                                                                                          | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** |
|                                                                                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss), as reported                                                                                                                    |       | $                                     | (5,193     | )                                   | $          | 10,201 |   | $ | (8,555 | ) | $ | 17,357 |   |
| Add: Stock-based employee compensation expense  included in reported net income (loss), net of related tax effects                                |       | (75                                   | )          | 121                                 |       | 322 |   | 202 |   |
| Deduct: Total stock-based employee compensation  expense determined under the fair value based method for all awards, net of  related tax effects |       | 2,330                                 |       | (4,825                              | )          | (6,320 | ) | (9,008 | ) |
|                                                                                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Pro forma net income (loss)                                                                                                                       |       | $                                     | (2,938     | )                                   | $          | 5,497 |   | $ | (14,553 | ) | $ | 8,551 |   |
|                                                                                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Earnings (loss) per share:                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Basic – as reported                                                                                                                          |       | $                                     | (0.15      | )                                   | $          | 0.28 |   | $ | (0.25 | ) | $ | 0.47 |   |
| Basic – pro forma                                                                                                                            |       | $                                     | (0.08      | )                                   | $          | 0.15 |   | $ | (0.42 | ) | $ | 0.23 |   |
|                                                                                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Diluted – as reported                                                                                                                        |       | $                                     | (0.15      | )                                   | $          | 0.27 |   | $ | (0.25 | ) | $ | 0.46 |   |
| Diluted – pro forma                                                                                                                          |       | $                                     | (0.08      | )                                   | $          | 0.15 |   | $ | (0.42 | ) | $ | 0.23 |   |

 

8

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**3.****              EARNINGS (LOSS) PERSHARE**

 

*Earnings (Loss) Per Share*– Basic earnings (loss) per share(“EPS”) excludes dilution and is computed by dividing net income or lossattributable to common stockholders by the weighted-average of common sharesoutstanding for the period.  Diluted EPSreflects the potential dilution that could occur if securities or othercontracts to issue common stock (convertible subordinated notes, warrants topurchase common stock and common stock options using the treasury stock method)were exercised or converted into common stock. Potential dilutive securities are excluded from the diluted EPScomputation in loss periods as their effect would be anti-dilutive.

 

The following tablesets forth the computation of diluted weighted average common and potentialcommon shares outstanding for the three and six months ended June 30, 2003and 2004 (in thousands):

 
| ** **                                                               | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                               | **2003**   | ** **                            | **2004**   | ** **                          | **2003**   | ** ** | **2004** | ** ** |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Basic weighted average common shares  outstanding                        |       | 34,577                                |       | 36,735                              |       | 34,443 |   | 36,661 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Effect of dilutive securities:                                           |       |                                  |       |                                |       |   |   |   |   |
| Warrants                                                                 |       | —                                |       | 23                                  |       | — |   | 37 |   |
| Options                                                                  |       | —                                |       | 915                                 |       | — |   | 1,148 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Diluted weighted average common and  potential common shares outstanding |       | 34,577                                |       | 37,673                              |       | 34,443 |   | 37,846 |   |

 

Forthe three months ended June 30, 2003 and 2004, weighted average optionsand warrants to purchase 3,893,000 and 2,959,000 shares of common stock,respectively, were outstanding but not included in the computation of dilutedearnings per share as their effect was anti-dilutive.  In addition, for the three months endedJune 30, 2003 and 2004, weighted average common shares attributable toconvertible subordinated notes of 5,000,000 were not included in thecomputation of diluted earnings per share as their effect was alsoanti-dilutive.

 

Forthe six months ended June 30, 2003 and 2004, weighted average options andwarrants to purchase 3,825,000 and 1,425,000 shares of common stock,respectively, were outstanding but not included in the computation of dilutedearnings per share as their effect was anti-dilutive.  In addition, for the six months endedJune 30, 2003 and 2004, weighted average common shares attributable toconvertible subordinated notes of 5,000,000 were not included in thecomputation of diluted earnings per share as their effect was alsoanti-dilutive.

 

9

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**4.****              INVENTORIES**

 

Inventories consist of the following as of December 31,2003 and June 30, 2004 (in thousands):

 
| ** **                                  | ** ** | **December 31,  2003** | ** ** | **June 30,  2004** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| INVENTORIES:                                |       |                        |       |                    |       |
| Raw materials                               |       | $                           | 37,393     |                    | $          | 46,672 |   |
| Work-in-progress                            |       | 26,949                      |       | 32,159                  |       |
| Finished goods                              |       | 40,698                      |       | 42,507                  |       |
| Allowance for excess and obsolete inventory |       | (12,028                     | )          | (10,550                 | )          |
| Total                                       |       | $                           | 93,012     |                    | $          | 110,788 |   |

 

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

 

Comprehensive income (loss) includes netincome (loss), effective unrealized gains and losses on foreign currencyforward exchange contracts, foreign currency translation adjustments, andunrealized gains and losses on available-for-sale securities, which arerecorded as short-term and long-term investments in the accompanyingconsolidated balance sheets.

 

The following table summarizes the change in eachcomponent of accumulated other comprehensive loss for the six months endedJune 30, 2004 (in thousands):

 
| ** **             | ** ** | ** **        | ** ** | **Translation  adjustment,  net of tax** | ** ** | **Total unrealized  gains (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, 2003 |       | Balance           |       | $                                        | (4,473     | )                                                                                     | $          | 1,448                                                                                              |       | $                                           | (2,709     | ) | $ | (5,734 | ) |
|                   |       | Period net change |       | (1,089                                   | )          | (1,194                                                                                | )          | 1,186                                                                                              |       | (1,097                                      | )          |
| June 30, 2004     |       | Balance           |       | $                                        | (5,562     | )                                                                                     | $          | 254                                                                                                |       | $                                           | (1,523     | ) | $ | (6,831 | ) |

 

Comprehensive income (loss) consists of the followingcomponents (in thousands):

 
| ** **                                                                   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| **2003**                                                                     | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss)                                                            |       | $                                     | (5,193     | )                                   | $          | 10,201 |   | $ | (8,555 | ) | $ | 17,357 |   |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Foreign currency translation adjustments,  net of tax                        |       | 491                                   |       | (1,235                              | )          | (127 | ) | (1,089 | ) |
| Unrealized gains (losses) on available for  sale investments, net of tax     |       | (143                                  | )          | (1,006                              | )          | 39 |   | (1,194 | ) |
| Unrealized gains on foreign currency  forward exchange contracts, net of tax |       | 160                                   |       | 1,124                               |       | 324 |   | 1,186 |   |
|                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Comprehensive income (loss)                                                  |       | $                                     | (4,685     | )                                   | $          | 9,084 |   | $ | (8,319 | ) | $ | 16,260 |   |

 

10

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

 

On January 23, 2004, Cymer entered intoa research and development agreement with Intel Corporation (“Intel”).  Total funding under the agreement is $20.0million and will provide Cymer with funding over the next three years toaccelerate the development of production-worthy extreme ultraviolet (“EUV”)lithography light sources.  The fundingto be received from Intel under this agreement is milestone based and will benetted against Cymer’s total research and development expenses in the period thatthe milestone is achieved.  Total fundingamounts recorded under this agreement for the three and six months endedJune 30, 2004 were $1.6 million and $2.4 million, respectively.

 

On February 4, 2004, Cymer entered intoan intellectual property license agreement with Intel for the use of certainIntel patents and trade secrets related to EUV technology.  Under the terms of this agreement, Cymer willpay license fees to Intel if Cymer is successful in commercializing an EUVlithography light source capable of high volume manufacturing by the end of thesecond quarter of 2008.  The licensepayments under this agreement are triggered in the quarter in which Cymersuccessfully ships the first complete high volume manufacturing EUV sourcesystem.  Upon shipment of this firstunit, Cymer is to pay Intel $1.25 million in license fees per quarter for aperiod 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 this arrangementas of June 30, 2004.

 

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

 

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

 

During the fourth quarterof 2003, Cymer completed its annual impairment test of goodwill and intangibleassets, and concluded that no impairment of goodwill existed.

 

Aggregate amortizationexpense was $80,000 for each of the six months ended June 30, 2003 and2004.  As of June 30, 2004, futureestimated amortization expense is expected to be as follows (in thousands):

 
| ** **                               | ** ** | **Future****Amortization** | ** ** |
|------------------------------------------|------------|----------------------------|------------|
|                                     |       |                       |       |
| Six months ending December 31, 2004 |       | $                          | 80         |   |
| Year ending December 31, 2005       |       | $                          | 20         |   |

 

The following tablesummarizes the activity in the carrying amount of goodwill as ofDecember 31, 2003 and June 30, 2004 (in thousands):

 
| Goodwill as of December 31, 2003                                      |   | $   | 7,647  |   |
|----------------------------------------------------------------------------|--------|-----|--------|--------|
| Goodwill acquired with acquisition of 6%  minority interest of Cymer Korea |   | 711 |   |
| Goodwill as of June 30, 2004                                          |   | $   | 8,358  |   |

 

Also included in intangible assets – net on theaccompanying balance sheets are amounts associated with patents which wereacquired in 2001 and 2003.  As ofDecember 31, 2003 and June 30, 2004, the net carrying amount of thesepatents was $12.7 million and $11.6 million, respectively.  Amortization expense for these patents was$323,000 and $593,000 for the three months ended June 30, 2003 and 2004,respectively.  Amortization expense was$645,000 and $1.2 million for the six months ended June 30, 2003 and 2004,respectively.

 

As of June 30,2004, future estimated amortization expense for these patents is expected to beas follows (in thousands):

 

| ** **                          | ** ** | **Future  Amortization** | ** ** |
|-------------------------------------|------------|--------------------------|------------|
|                                |       |                     |       |
| Six months ending December 31, 2004 |       | $                        | 1,186      |   |
| Year ending December 31, 2005       |       | $                        | 2,371      |   |
| 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        |   |

 

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**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 endedDecember 31, 2002 and has adopted the recognition and measurementprovisions as required after December 31, 2002.  FIN 45 provides expanded accounting guidancesurrounding liability recognition and disclosure requirements related to guarantees,as defined by this interpretation.

 

In the ordinary course ofbusiness, Cymer is not subject to potential obligations under guarantees thatfall within the scope of FIN 45, except for standard warranty provisionsassociated with product sales, indemnification provisions related to intellectualproperty that are contained within many of its customer agreements, andthird-party bank guarantees for subsidiary office lines of credit.  All of these provisions give rise only to thedisclosure requirements prescribed by FIN 45.

 

ProductWarranties –Warrantyprovisions contained within Cymer’s customer agreements are generallyconsistent with those prevalent in the semiconductor equipment industry. Thewarranty period andterms vary by light source model.  Ingeneral, the light source system warranty period ranges from 17 to 26 monthsafter 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 periodfor consumables 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 model, which considersactual historical expenses, and potential risks associated with Cymer’sdifferent light source system models. This financial model is then used tocalculate the future probable expenses related to warranty and the requiredlevel of the warranty provision.  Therisk levels used within this model are reviewed and updated as risk levelschange by model over its product life cycle. The warranty provision forconsumables 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 followingtable summarizes information related to Cymer’s warranty provision for the sixmonths ended June 30, 2004 (in thousands):

 
| ** **                                                                                                 | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------|------------|
|                                                                                                       |       |     |       |
| Balance, January 1, 2004                                                                              |       | $        | 26,200     |   |
| Liabilities accrued for warranties issued  during the six month period, net of adjustments and expirations |       | 13,556   |       |
| Warranty expenditures incurred during the  six month period                                                |       | (12,756  | )          |
| Balance, June 30, 2004                                                                                |       | $        | 27,000     |   |

 

Intellectual PropertyIndemnifications – Cymer includes intellectual property indemnification clauseswithin its general terms and conditions with its customers and the generalpurchase agreements with its three major customers, ASM Lithography, Canon, andNikon.  In general, these indemnificationprovisions provide that Cymer will defend its customers against any infringementclaims that arise related to Cymer’s products. Under the indemnification clauses, Cymer will pay all costs and damages,including attorney’s fees, associated with such settlements or defenses,provided that the customer follows specific procedures for notifying Cymer ofsuch claims and allows Cymer to manage the settlement proceedings. Due to thenature of these indemnification provisions, they are indefinite and extendbeyond the term of the actual customer agreements.

 

12

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An indemnification provision was alsoincluded in the contract manufacturing agreement with 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 developmentagreement signed with Intel, Cymer also agreed to provide Intel with indemnityagainst any infringement of the intellectual property rights of any third partyarising from 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.

 

Guarantees on Subsidiary Debt – During the firstquarter of 2003 and part of the second quarter of 2003, Cymer was party to aParent Guarantee associated with a revolving Loan Agreement held by CymerJapan. This guarantee was between a commercial bank in the United States andCymer.  The Parent Guarantee was enteredinto in 2001 in order to establish a banking relationship between thiscommercial bank and Cymer Japan.  Per theterms of the Parent Guarantee, Cymer guaranteed payment of any obligations underthe revolving loan agreement in the event that Cymer Japan could not make suchpayments due or defaults on the loan. Cymer Japan made all payments per the terms of the Loan Agreement andthus, Cymer did not incur any guarantor obligations under the ParentGuarantee.  Since Cymer Japan is awholly-owned subsidiary of Cymer and Cymer Japan recorded the revolving loanoutstanding balance as a liability on its financial statements, the carryingamount of the liability was included in the consolidated balance sheets.  The Loan Agreement expired on June 16,2003 and was paid in full by Cymer Japan. The Loan Agreement was not renewed onthis expiration date and has not since been renewed.

 

**9.****              CONTINGENCIES ANDCOMMITMENTS**

 

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 or results ofoperations 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.

 

13

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**ITEM 2****.  Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

*In this section, references to“we”, “us” or “our” are references to Cymer.**The following discussion of ourfinancial condition and results of operations should be read in conjunctionwith our consolidated financial statements and notes thereto included in thisquarterly report on Form 10-Q and our consolidated financial statements andnotes thereto included in our annual report on Form 10-K for the year endedDecember 31, 2003.*

 

**Forward Looking Statements**

 

Statements in this quarterly report on Form 10-Qthat are not strictly historical in nature are forward-looking statements.These statements include, but are not limited to, references to manufacturingactivities; expected domestic and international product sales and development;service and support; research and development activities and expenditures;adequacy of capital resources and investments; effects of business cycles inthe semiconductor 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 this quarterly report on Form 10-Q.  Forward-looking statements herein speak onlyas of the date of this quarterly 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, ASM Lithography, Canon, and Nikon, whoin turn supply their wafer steppers and scanners to chipmakers.  Inaddition, we sell replacement parts and services to the lithography toolmanufacturers as well as directly to the chipmakers.  Our light source systems currently constitutea substantial majority of all excimer light sources incorporated in lithographystepper and scanner tools.  A largeportion of our revenue is derived from customers located outside of the UnitedStates.  In order to support our foreigncustomers and our installed base of light sources in foreign countries, wemaintain a manufacturing and field service office in Korea and field serviceand support offices in Japan, Taiwan, Singapore, the People’s Republic of Chinaand the Netherlands. We also maintain field service offices in the UnitedStates to service our installed base of light sources located in the UnitedStates.

 

***Products and Services***

 

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

 

Our photolithography light sources producenarrow bandwidth pulses of short wavelength light within the DUV spectrum. Thethree DUV wavelengths are measured in nanometers (“nm”).  One nanometer 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, Argon Fluoride (“ArF”) gases 193 nm light, and Fluorine (“F2”) gas 157nm light. The light sources permit very fine feature resolution for imaging thecircuitry on the wafer and high throughput in wafer processing.  We have designed our light sources to behighly reliable, easy to install and compatible with existing semiconductormanufacturing processes.  Our lightsources are used to pattern the integrated circuits, which are also calledsemiconductors or “chips”, that power many of today’s advanced consumer andbusiness electronics. In the first six months of 2004, we sold 145 light sourcesystems at an average selling price of $777,000.

 

Certain components and subassemblies includedin our light sources require replacement or refurbishment following extendedoperation.  For example, the dischargechamber of our light sources has an expected life of approximately three tosixteen billion pulses, depending on the model. We estimate that a light sourceused in a semiconductor production environment will require one to tworeplacement

 

14

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chambers per year, depending upon the levelof usage.  Similarly, certain opticalcomponents of the light source deteriorate with continued exposure to DUV lightand require periodic replacement.  Weprovide these and other spare and replacement parts for our photolithographylight sources as needed by our customers.

 

As the life and usage of our installed baseof light sources in production at chipmakers exceeds the original warrantyperiods (generally 17 to 26 months from date of shipment), some chipmakersrequest service contracts from us. Additionally, we provide service contracts directly to the threesemiconductor lithography tool manufacturers. These contracts require us tomaintain and/or service these light sources either on an on-call or regularinterval basis or both.  Some of thesecontracts include replacement of consumable parts.

 

In addition to service contracts, we providean on-line diagnostic product, CymerOnLineTM. CymerOnLine is adiagnostic and performance software product which delivers critical laserdiagnostics and performance information in near real-time directly toauthorized users anywhere.  The softwaresimplifies reporting and allows users to efficiently manage consumablesmanagement.  CymerOnLine features auser-friendly browser-based interface which features a robust design andprovides a secure data environment. Event-initiated messages sent to pagers, e-mail, mobile phones, or otherhandheld devices enable up-to-the minute communication and proactivemanagement.

 

# ***SemiconductorIndustry Status and Outlook***

 

Since we derive a substantial portion of our revenues from lithographytool manufacturers, we are subject to the volatile and unpredictable nature ofthe semiconductor industry. The semiconductor industry is highly cyclical innature and historically has experienced periodic ups and downs. Since 2000, thelast peak year in the cycle, the semiconductor industry experienced one of thelongest downturns in its history during the time period from 2001 through late2003. Although this downturn negatively impacted our business and results ofoperations during 2001, 2002 and 2003, we were able to maintain our revenues ata relatively constant level and remain profitable during most of this threeyear period.  We are very conscious ofthe volatile nature of the semiconductor industry and make every effort tomanage our business through the cycles such that we maintain our profitabilityduring the downturn and take the necessary steps during the downturns tostrategically position ourselves for the next upturn.  During this most recent downturn, we madeseveral 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 all of our future DUV light sources are planned toreside, and the ongoing work to improve business processes that leverage theoverall efficiency of our workforce.

 

In the latterhalf of 2003, there were several indicators that the extended downturn in thesemiconductor industry which started in 2001 was coming to an end and that anupturn was in sight.  During the finalmonths of 2003, we experienced strong order growth and our direct customersannounced increasing orders and extended delivery times. In addition, thechipmakers’ utilization of our DUV light sources exceeded the levels achievedin 2000, the peak of the last upturn, and the mix of our light source modelsshipped shifted toward KrF products, reflecting the chipmakers’ need for morecapacity expansion.

 

As we entered 2004, we continued to see many of the same positiveindustry trends that we saw at the end of 2003, and we also experienced revenuegrowth during both the first and second quarters of 2004 that is indicative ofan upturn.  Revenue for the first quarterof 2004 grew 20% over fourth quarter 2003 levels and again by 8% from the firstto second quarters of 2004.  Thiscontinued growth in overall revenue since the beginning of 2004 was due toincreased light source shipments and strong demand for consumables and sparesto support the record light source utilization levels.  In both the first and second quarters of2004, the light source product mix was heavily weighted toward our KrFproducts, reflecting chipmakers’ need to expand capacity to meet currentindustry demands.  Based upon our revenuelevels 

 

15

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and growth thus far in 2004, and the current positive indicators in thesemiconductor industry, we believe that we are currently in the growth periodof the upturn.

 

We believe we are well positioned to take advantage of this most recentupturn in the semiconductor industry due to the key investments that we madeduring the three year downturn and the significant cost reductions andefficiencies we have realized in the first six months of 2004.   As we continue into this latest upturn, weexpect that we will experience sequential quarterly increases in our lightsource unit shipments for the remainder of 2004 and high light source systemutilization levels at our chipmaker customers, which should  continue to drive our consumables and sparesdemand at these current high levels. Based upon our first six month’s 2004 performance and the continuedpositive industry indicators, we expect that 2004 will be a record revenue yearoverall for Cymer.

 

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

 

The discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America.  Thepreparation of these financial statements requires us to make estimates and usejudgment that may impact the reported amounts of assets, liabilities, revenues,expenses, and related disclosure of contingent assets and liabilities.  As a part of our ongoing internal processes,we regularly evaluate our estimates, including those related to inventoryallowances, warranty provision, income taxes, allowances for bad debts,long-lived assets valuation, intangible assets valuation, and contingencies andlitigation.  We base these estimates uponboth historical information and other assumptions that we believe to be validand reasonable under the circumstances. These assumptions form the basis for making judgments and determiningthe carrying values of assets and liabilities that are not apparent from othersources.  Actual results could vary fromour estimates if we were to use different assumptions and conditions.

 

We believe that inventory allowances, warranty provisions, and incometaxes require more significant judgments and estimates in the preparation ofour consolidated financial statements than do other of our accountingestimates.

 

*Inventory Allowance*

 

We perform an analysis of our inventory allowances on at least aquarterly basis to determine the adequacy of this allowance on our financialstatements.  The amount of the inventoryallowance is determined by taking into consideration certain assumptionsrelated to market conditions and future demands for our products, includingchanges to product mix, new product introductions, and/or productdiscontinuances, which may result in excess or obsolete inventory. We determinethe level of excess and obsolete inventory associated with our raw materialsand production inventory by comparing the on hand inventory balances andinventory on order to the next 12 months of forecasted demand.  We then adjust this calculation for inventorythat has a high likelihood of use beyond one year or can be used in otherproducts which may have lower demands. After this adjustment, we arrive at our total exposure for excess andobsolete inventory within our raw materials and production inventory.  As part of this analysis, we also determinewhether there are potential amounts owed to vendors as a result of cancelled ormodified raw material orders.  Weestimate and record a separate liability which is included in accrued and otherliabilities in the accompanying balance sheets for such amounts owed. For spareparts inventory, we calculate the inventory allowance based upon a percentageof total spare parts inventory balances. This percentage is calculated using certain estimates and assumptions,including comparisons of on hand inventory to build forecasts, historicalobsolescence in our spare parts warehouses, and spare parts specificallyidentified as excess or obsolete.

 

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Both methodologies for analyzing excess and obsolete inventory anddetermining the inventory allowance are significantly affected by future demandand usage of our products.  There aremany factors that could potentially affect the future demand or usage of ourproducts, including the following:

 

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

•                  Rateat which our customers take delivery of our light source systems;

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

•                  Mixof light source system models and any changes to that mix required by ourcustomers; and

•                  Utilizationrates of our light sources at chipmakers.

 

Based upon our experience, we believe that the estimates we use incalculating the inventory allowance are reasonable and properly reflect therisk of excess and obsolete inventory. If actual demand or the usage period for our inventory are substantiallydifferent from our estimates, adjustments to our inventory allowance may berequired, which could have a material adverse effect on our financial conditionand results of operations.

 

###### *Warranty Provision*

 

We maintain an accrual for the estimated cost of product warrantiesassociated with our product sales. Warranty costs include the replacement parts and labor costs to repairour products during the warranty periods. At the time revenue is recognized, we record a warranty provision, whichis included in cost of product sales in the accompanying consolidatedstatements of operations. The warranty coverage period and terms vary by lightsource model.  In general, the lightsource system warranty period 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 model, which takes intoconsideration actual historical expenses, and potential risks associated withour different light source system models. This financial model is then used to estimate future expenses related towarranty and the required warranty provision. The risk levels used within this model are reviewed and updated as risklevels change by model over its product life cycle.  Due to the highly technical nature of ourlight source system products, the newer model light sources have higherinherent warranty risks and require higher warranty provisions. The warrantyprovision for consumables and spare parts is determined by using actualhistorical data.

 

We actively engage in product improvement programs and processes tolimit our warranty costs, but our warranty obligation is affected by thecomplexity of our product, product failure rates and costs incurred to correctthose product failures at customer sites. The industry in which we operate issubject to rapid technological change, and as a result, we periodicallyintroduce newer, more complex light sources. Although we classify these newly released light source models as havinga higher risk in our warranty financial model resulting in higher warrantyprovisions, we are more likely to have differences between the estimated andactual warranty costs for these new products. This is due to limited or no historical product performance data onwhich to base our future warranty costs. Warranty provisions for our older and more established light sourcemodels are more predictable as we have more historical information available onthese products.  If actual productfailure rates or estimated costs to repair those product failures were todiffer from our estimates, revisions to our estimated warranty provision wouldbe required, which could have a material adverse effect on our financialcondition and results of operations.

* *

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*Income Taxes*

 

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

 

We have consideredour industry’s outlook for the future, our historical performance and estimatedfuture taxable income, and ongoing tax planning strategies in assessing theneed for a valuation allowance.  Using thisinformation, we have prepared a model to forecast our expected taxable incomein future years in order to estimate when the benefits of our deferred taxassets are likely to be realized.  Basedupon the analysis, we believe that it is more likely than not that the resultsof future operations will generate sufficient taxable income to realize thedeferred tax assets within the period allowed by current applicable tax lawand, as such, no valuation allowance against deferred tax assets is provided.

 

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

 

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**RESULTS OF OPERATIONS**

 

The following table sets forth certain items inCymer’s consolidated statements of operations as a percentage of total revenuesfor the periods indicated:

 
| ** **                                | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| **2003**                                  | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Revenues:                                 |       |                                  |       |                                |       |   |   |   |   |
| Product sales                             |       | 100.0                                 | %          | 99.8                                | %          | 99.9 | % | 99.9 | % |
| Other                                     |       | —                                |       | .2                                  |       | .1 |   | .1 |   |
| Total revenues                            |       | 100.0                                 | %          | 100.0                               | %          | 100.0 | % | 100.0 | % |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Cost and expenses:                        |       |                                  |       |                                |       |   |   |   |   |
| Cost of product sales                     |       | 83.7                                  |       | 52.6                                |       | 73.2 |   | 55.9 |   |
| Research and development                  |       | 25.8                                  |       | 15.6                                |       | 25.8 |   | 14.9 |   |
| Sales and marketing                       |       | 7.2                                   |       | 6.2                                 |       | 6.6 |   | 6.4 |   |
| General and administrative                |       | 10.5                                  |       | 8.6                                 |       | 9.5 |   | 8.0 |   |
| Amortization of intangible assets         |       | .1                                    |       | .1                                  |       | .1 |   | .1 |   |
| Total costs and expenses                  |       | 127.3                                 |       | 83.1                                |       | 115.2 |   | 85.3 |   |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Operating income (loss)                   |       | (27.3                                 | )          | 16.9                                |       | (15.2 | ) | 14.7 |   |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Total other expense – net            |       | (.3                                   | )          | (1.4                                | )          | (.4 | ) | (1.0 | ) |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Income (loss) before income tax           |       |                                  |       |                                |       |   |   |   |   |
| provision (benefit) and minority interest |       | (27.6                                 | )          | 15.5                                |       | (15.6 | ) | 13.7 |   |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Income tax provision (benefit)            |       | (19.5                                 | )          | 3.5                                 |       | (9.4 | ) | 3.2 |   |
| Minority interest                         |       | (.2                                   | )          | (1.2                                | )          | (.4 | ) | (1.0 | ) |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss)                         |       | (8.3                                  | )%         | 10.8                                | %          | (6.6 | )% | 9.5 | % |
| Gross margin on product sales             |       | 16.3                                  | %          | 47.2                                | %          | 26.7 | % | 44.1 | % |

## ** **

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## **THREE MONTHS ENDEDJUNE 30, 2003 AND 2004**

 

*Revenues*. Ourrevenues consist of product sales, which include sales of light source systems,consumable and spare parts, upgrades, service, service contracts and training.Our revenues also consist of other revenues, which include revenue from certainfunded development activities performed for customers and under governmentcontracts and license agreements.  We donot recognize any revenue for light source systems prior to shipment.  The systems are tested by us in environmentssimilar to those used by our customers prior to shipment to ensure that theymeet the customers’ specifications and will interface with the customers’software.  Our installation obligationsare perfunctory within the framework of Staff Accounting Bulletin 104.  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 notrecognize revenue on systems shipped to that customer until we receive theacceptance certificate.  There are nocustomer retentions with the exception of one customer where a small portion ofour light source product revenue is delayed to align with the end-user acceptanceof the integrated scanner containing our light source.  Revenue from consumables and spare partssales is recognized at the point that legal title passes to the customer, whichis generally upon shipment from our facility. Service and training revenue is generally recognized at the time thatthe services are rendered or the training class is completed.  Service contract revenues are generallyrecorded as revenue ratably over the life of the contract or per the specificterms of the agreement. For funded development contracts which are included inother revenue, funds received are accounted for on the percentage-of-completionmethod based on the relationship of costs incurred to total estimatedcosts.  Revenues generated from thesefunded development contracts are derived from cost sharing contracts between usand certain customers.  The costsassociated with these particular contracts are included in research anddevelopment expenses in the period incurred and are not listed separately asother cost or expenses in the consolidated statements of operations.  If milestones on these funded developmentcontracts require that specific results be achieved or reported by us, revenueis not recognized until that milestone is completed.  For some of the funded development contractswhich we enter into with customers and government agencies, we evaluate certaincriteria to determine whether recording the funds received as revenue isappropriate.  If certain conditions aremet, these funds are not recorded as revenue and are rather offset against ourown internal research and development expenses in the period that the milestoneis achieved or per the terms of the contract.

 

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

 
| ** **                                       | ** ** | **Three months ended  June 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | **2003**   | ** **                            | **2004**   | ** ** |
|                                             |       |                                  |       |   |   |
| Light  source systems:                           |       |                                  |       |   |   |
| Revenue                                          |       | $                                     | 35,939     |   | $ | 58,719 | (1) |
| Units sold                                       |       | 31                                    |       | 81 |   |
| Average selling price                            |       | $                                     | 1,159      |   | $ | 737 |   |
|                                             |       |                                  |       |   |   |
| Consumable and spare parts and service  products |       | $                                     | 26,238     |   | $ | 36,003 |   |
| Other revenue                                    |       | $                                     | —     |   | $ | 185 |   |
|                                             |       |                                  |       |   |   |
| Total revenue                                    |       | $                                     | 62,177     |   | $ | 94,907 |   |

 

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(1)  Netof deferred light source revenue of $943,000, which reflects one customer’sretention where light source revenue is delayed to align with the end-user acceptance of the integrated scannercontaining our light source.

 

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Product sales increased 52% from $62.2****million for the three months ended June 30, 2003 to$94.7 million for the three months ended June 30, 2004, primarily due to a63% increase in light source system revenue from $35.9 million in the threemonths ended June 30, 2003 to $58.7 million in the three months endedJune 30, 2004.  A total of 31 lightsource systems were sold in the three months ended June 30, 2003 at anaverage selling price of $1.2 million, compared to 81 systems sold in the threemonths ended June 30, 2004 at an average selling price of $737,000.  On a foreign currency adjusted basis, theaverage selling price for the three months ended June 30, 2003 was $1.1million compared to $736,000 for the three months ended June 30, 2004. Thedecrease in the average selling price from period to period reflects the shiftin the product mix to our lower priced KrF products in the second quarter of2004.  Product sales were furtherincreased from period to period due to a 37% increase in sales of consumableand spare parts and service products from $26.2 million in the three monthsended June 30, 2003 to $36.0 million in the three months endedJune 30, 2004.  The increase in thistype of product sales was due to increased utilization of our DUV light sourceby chipmakers and an increased installed base in the three months endedJune 30, 2004.  There were norevenues from funded development contracts for the three months endedJune 30, 2003, compared to revenues from funded development contracts of$185,000 for the three months ended June 30, 2004.  We anticipate that our total revenues willincrease sequentially for the remainder of 2004 as a result of the upturn inthe semiconductor industry.

 

Ourbacklog at June 30, 2003 was $100.4 million compared to $107.7 million atJune 30, 2004.  Bookings for thethree months ended June 30, 2003 and June 30, 2004 were $65.5 millionand $97.1 million, respectively.  Thebook-to-bill ratio for the three months ended June 30, 2003 was 1.05compared to 1.02 for the three months ended June 30, 2004.  The increase in overall bookings wasprimarily due to the upturn in the semiconductor industry in 2004 which resultedin higher systems bookings and record bookings of consumable and spare parts inthe second quarter of 2004.

 

Weinstalled 50 light sources at chipmakers and other end-users during the quarterended June 30, 2003 as compared to 73 light sources installed during thequarter ended June 30, 2004.

 

Sales to our three largest customers, ASMLithography, Canon, and Nikon, amounted to 15%, 27% and 24%, respectively, oftotal revenue for the three months ended June 30, 2003, and 32%, 18% and19%, respectively, of total revenue for the three months ended June 30,2004.

 

Our sales aregenerated primarily by shipments to customers in Japan, Europe, and the UnitedStates.  Approximately 88% of our salesfor both the three months ended June 30, 2003 and 2004 were derived fromcustomers outside the United States.  Wemaintain a wholly-owned Japanese subsidiary, which sells to our Japanesecustomers.  Revenues from Japanesecustomers, generated primarily by this subsidiary, accounted for 50% and 35% oftotal revenues in the three months ended June 30, 2003 and 2004,respectively.  The activities of ourJapanese subsidiary are limited to sales and service of products purchased bythe subsidiary from the parent corporation. We anticipate that international sales will continue to account for asignificant 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 associated with purchasesof our products by our Japanese subsidiary for resale under firm third-partysales commitments.  Shipping costsassociated with our product sales are also included in cost of product sales.  We do not charge our customers for shippingfees and such costs are not significant.

 

The cost of product sales decreased 4% from$52.0 million for the three months ended June 30, 2003 to $50.0 millionfor the three months ended June 30, 2004. This decrease in the cost ofproduct sales is primarily due to a decrease in the overall costs associatedwith our XL series light source which was initially introduced to manufacturingand started shipping to customers in early 2003.  During its initial months of production in2003, the inefficiencies and costs to manufacture the XL series light sourcewere

 

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veryhigh as is typically the case with new product introductions.  In addition, the cost of product sales werelower in the three months ended June 30, 2004 due to the shift in ourproduct mix to the lower cost KrF products and achievement of our overallmaterial cost reduction targets on a variety of products.

 

The gross margin on productsales was 16% for the three months ended June 30, 2003 as compared to 47%for the same three-month period in 2004. This higher gross margin is primarily due to the improved efficienciesand costs associated with our XL series light source and the shift to our lowercost and higher margin KrF products in 2004 as compared to 2003.  This higher gross margin in 2004 alsoreflects increased factory yield and utilization, increased and improved fieldutilization and efficiency and significant success in our material cost controlefforts.    We anticipate that we canmaintain or achieve improvements in our gross margins over the next couple ofquarters as we continue to reduce spending through ongoing processimprovements, increase manufacturing yields and further reduce materialcosts.  We do not anticipate that systemproduct mix will have a material impact on gross margins going forward.

 

*Research and Development*.  Research and developmentexpenses include costs of internally-funded and externally-funded projects aswell as continuing product development support expenses,  which consist primarily of employee andmaterial costs, depreciation of equipment and other engineering relatedcosts.  Our research and developmentexpenses are offset by amounts associated with certain of our externally fundedresearch and development contracts. These amounts were $239,000 and $2.1 million for the three months endedJune 30, 2003 and 2004, respectively. Research and development expenses decreased 8% from $16.1 million forthe three months ended June 30, 2003 to $14.8 million for the three monthsended June 30, 2004, due primarily to the higher level of developmentefforts associated with the XL series light source product in 2003 compared to2004.  These decreased expenses fromperiod to period were offset by increased costs associated with the profitsharing and bonus plans funded in the second quarter of 2004.  We also continued to invest in EUV, F2 andbeam delivery unit technology and to focus on next generation KrF and ArFproducts based on the XL platform.  As apercentage of total revenues, research and development expenses decreased from25.8% for the three months ended June 30, 2003 to 15.6% for the samethree-month period in 2004 due primarily to lower revenues in 2003 compared to2004.  We expect research and developmentexpenses to remain at this level of dollar spending or increase in the next fewquarters due to increased spending in EUV development and other productdevelopment opportunity investigations.

 

*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 increased 32%from $4.5 million for the three months ended June 30, 2003 to $5.9 millionfor the three months ended June 30, 2004. This increase in sales and marketing expenses from period to periodprimarily reflects the expenses associated with the profit sharing and bonusplans which were funded in the second quarter of 2004.  As a percentage of total revenues, such salesand marketing expenses decreased from 7.2% for the three months endedJune 30, 2003 to 6.2% for the same three-month period in 2004.  We anticipate sales and marketing expenses toremain relatively flat in dollar spending over the next few quarters.

 

*General and Administrative*. General and administrative expenses consist primarily of managementand administrative personnel costs, professional services and administrativeoperating costs.  General andadministrative expenses increased 25% from $6.5 million for the three monthsended June 30, 2003 to $8.2 million for the three months endedJune 30, 2004 due primarily to profit sharing and bonus plans expensesassociated with our increased profitability in the second quarter of 2004 andincreased consulting and advisory fees associated with the implementation ofthe Sarbanes-Oxley section 404 internal controls reportingrequirements.  As a percentage of totalrevenues, such expenses decreased from 10.5% for the three months endedJune 30, 2003 to 8.6% for the same three-month period in 2004.  We anticipate general and administrativeexpenses over the next few quarters to continue to reflect costs for profitsharing and incentive bonuses associated with increased profitability, as wellas continued costs related to the Sarbanes-Oxley section 404 requirements.

 

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*Amortization of Intangible Assets. *Amortization ofintangible assets totaled $40,000 for both three month periods endedJune 30, 2003 and 2004. This amortization of intangible assets expense isconsistent from year to year and relates to the existing technology associatedwith the acquisition of Active Control eXperts, Inc., ("ACX") whichwas completed in early 2001.  With ouradoption of SFAS No. 142 on January 1, 2002, we discontinued theamortization of goodwill with indefinite useful life associated with previouspurchase business combinations. Amortization expense for patents which is included in research anddevelopment expenses and cost of product sales was $323,000 and $593,000 forthe three months ended June 30, 2003 and 2004, respectively.

 

*Total Other 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 subsidiary offices against the UnitedStates dollar.  Net other expense totaled$165,000 and $1.3 million for the three months ended June 30, 2003 and2004, respectively.  The increase in netother expense was primarily due to decreases in interest income from period toperiod.  This decreased interest incomewas primarily due to lower market interest rates for our short-term andlong-term investments in the second quarter of 2004 as compared to the firstquarter of 2003.  Foreign currencyexchange losses totaled $57,000, interest income totaled $2.4 million andinterest expense totaled $2.5 million for the three months ended June 30,2003, compared to foreign currency exchange losses of $399,000, interest incomeof $1.6 million and interest expense of $2.5 million for the three months endedJune 30, 2004.

 

*Income Tax Provision (Benefit)*.  The tax benefit of $12.1million and the tax provision of $3.4 million for the three months endedJune 30, 2003 and 2004, respectively, reflects an annual effective rate of60% and 23%, respectively.  Due to the 0%annual effective tax rate estimated for the first quarter of 2003, ayear-to-date change in the tax provision was made in the second quarter of2003.  This resulted in a quarterly taxbenefit of 71% for the three months ended June 30, 2003.  The change in the annual effective tax rateduring the three months ended June 30, 2003 from 60% to a provision rateof 23% for the three months ended June 30, 2004 is primarily attributableto the increase in pre-tax earnings as well as tax benefits from U.S. exportincentive programs and research and development and manufacturing investmentcredits.  The annual effective tax ratesfor both periods are less than the U.S. statutory rate of 35% primarily as aresult of permanent book/tax differences and tax credits.  The effective tax rate is a function ofcurrent tax law and geographic location of pre-tax income.  There is currently pending legislation torepeal the existing U.S. export incentives. Should these incentives be repealed or allowed to expire with noreplacement benefits, our effective tax rate would likely increase.

 

## **SIX MONTHS ENDED JUNE 30, 2003 AND 2004**

 

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

 
| ** **                                       | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **2003**                            | ** ** | **2004** | ** ** |
|                                             |       |                                |       |   |   |
| Light  source systems:                           |       |                                |       |   |   |
| Revenue                                          |       | $                                   | 79,381     |   | $ | 111,380 | (1) |
| Units sold                                       |       | 87                                  |       | 145 |   |
| Average selling price                            |       | $                                   | 912        |   | $ | 777 |   |
|                                             |       |                                |       |   |   |
| Consumable and spare parts and service  products |       | $                                   | 50,132     |   | $ | 71,213 |   |
| Other revenue                                    |       | $                                   | 57         |   | $ | 235 |   |
|                                             |       |                                |       |   |   |
| Total revenue                                    |       | $                                   | 129,570    |   | $ | 182,828 |   |

 

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(1)          Net ofdeferred light source revenue of $1.2 million, which reflects one customer’sretention where light source revenue is delayed to align with the end-user acceptance of the integrated scanner containingour light source.

 

23

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*Revenues*.  Product sales increased 41% from $129.5****million for the six months ended June 30, 2003 to$182.6****million for the six months endedJune 30, 2004, primarily due to a 40% increase in light source systemsrevenue from $79.4 million in the six months ended June 30, 2003 to $111.4million in the six months ended June 30, 2004.  A total of 87 light source systems were soldin the six months ended June 30, 2003 at an average selling price of$912,000, compared to 145 systems sold in the six months ended June 30,2004 at an average selling price of $777,000. On a foreign currency adjusted basis, the average selling price for thesix months ended June 30, 2003 was $896,000 compared to $767,000 for thesix months ended June 30, 2004. The decrease in the average selling pricefrom year to year reflects the shift in the product mix to our lower priced KrFproducts in the first six months of 2004. Product sales were further increased due to a 42% increase in sales ofconsumable and spare parts and service products from $50.1 million in the sixmonths ended June 30, 2003 to $71.2 million in the six months endedJune 30, 2004.  The increase in thistype of product sales was due to increased utilization of our DUV light sourceby chipmakers and an increased installed base in the six months endedJune 30, 2004.  Revenues from fundeddevelopment contracts were $57,000 and $235,000 for the six months endedJune 30, 2003 and 2004, respectively.

 

Approximately 88% and 87% of our sales for thesix months ended June 30, 2003 and 2004, respectively, were derived fromcustomers outside the United States. Revenues from Japanese customers,generated primarily by our wholly-owned Japanese subsidiary, accounted for 45%and 37% of total revenues in the six months ended June 30, 2003 and 2004,respectively.

 

Sales to our three largest customers, ASMLithography, Canon, and Nikon, amounted to 23%, 25% and 21%, respectively, oftotal revenue for the six months ended June 30, 2003, and 32%, 19% and19%, respectively, of total revenue for the six months ended June 30,2004.

 

*Cost of Product Sales*.   The cost of product sales increased 8% from$94.9 million for the six months ended June 30, 2003 to $102.1 million forthe six months ended June 30, 2004. This increase in the cost of productsales from period to period is primarily due to the overall increase in salesfrom period to period.  Both light sourcesystem sales and sales of consumables and spare parts and service products  were higher in the six months period endedJune 30, 2004 compared to the same six-month period in 2003.  Although our cost of product sales were higherin absolute dollars in the six months ended June 30, 2004 compared to thesame period in 2003, cost of product sales in 2004 included significant costreduction achievements for our XL series products from both a material cost andlabor efficiency standpoint, and lower costs associated with our KrF lightsource systems, which were the majority of our system unit shipments in the sixmonths ended June 30, 2004.

 

The gross margin on product sales was 27% for the six months endedJune 30, 2003 as compared to 44% for the same six-month period in2004.  This higher gross margin in 2004 reflectsimproved efficiencies associated with the XL series product, ongoing overallmanufacturing cost reduction efforts and increased factory yield andutilization.

 

*Research and Development*.  Research and developmentexpenses decreased 19% from $33.4 million for the six months endedJune 30, 2003 to $27.2 million for the six months ended June 30,2004, due primarily to the high costs associated with the final productizationand introduction of the XLA 100 light source which was shipped in the firstquarter of 2003.  Amounts fundedby external research and development contracts totaled $445,000 and $3.6million for the six months ended June 30, 2003 and 2004, respectively. Thedecreased overall research and development expenses from period to period were offsetby increased expenses associated with the profit sharing and bonus plansattributable to research and development personnel, which were funded duringthe six months ended June 30, 2004. We also 

 

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continuedto invest in EUV, F2 and beam delivery unit technology and to focus on nextgeneration KrF and ArF products based on the XL platform.  As a percentage of total revenues, researchand development expenses decreased from 25.8% for the six months endedJune 30, 2003 to 14.9% for the same six-month period in 2004 due to thecombination of higher revenue and lower expenses from period to period.

 

*Sales and Marketing*.  Sales and marketing expensesincreased 37% from $8.6 million for the six months ended June 30, 2003 to$11.7 million for the six months ended June 30, 2004.  This increase in sales and marketing expensesfrom period to period primarily reflects the expenses associated with theprofit sharing and bonus plans which were funded in the first and secondquarters of 2004.  This increase inexpenses also reflects increases in marketing expenses associated with ourinternational subsidiaries recorded in the six months ended June 30, 2004.As a percentage of total revenues, such sales and marketing expenses decreasedslightly from 6.6% for the six months ended June 30, 2003 to 6.4% for  the same six-month period in 2004.

 

*General and Administrative*. General and administrative expenses increased 20% from $12.3 millionfor the six months ended June 30, 2003 to $14.8 million for the six monthsended June 30, 2004 due primarily to expenses associated with the profitsharing and bonus plans which were funded in the first and second quarters of2004 and increased consulting and advisory fees associated with theimplementation of the Sarbanes-Oxley section 404 requirements.  As  apercentage of total revenues, such expenses decreased from 9.5% for the sixmonths ended June 30, 2003 to 8.0% for the same six-month period in 2004due to higher revenues from period to period.

 

*Amortization of Intangible Assets. *Amortization ofintangible assets totaled $80,000 for both six month periods endedJune 30, 2003 and 2004. This amortization of intangible assets expense isconsistent from year to year and relates to the existing technology associatedwith the acquisition of ACX, which was completed in early 2001.  With our adoption of SFAS No. 142 onJanuary 1, 2002, we discontinued the amortization of goodwill withindefinite useful life associated with previous purchase businesscombinations.  Amortization expense forpatents which is included in research and development expenses and cost ofproduct sales was $645,000 and $1.2 million for the six months ended June 30,2003 and 2004, respectively.

 

*Total Other Expense – Net*. Net other expense totaled $511,000 and $1.9 million for the six monthsended June 30, 2003 and 2004, respectively.  The increase in net other expense wasprimarily due to decreases in interest income from period to period.  The decreased interest income from period toperiod was primarily due to lower market interest rates for our short-term andlong-term investments in the first six months of 2004 as compared to the firstsix months of 2003.  Foreign currency exchangelosses totaled $417,000, interest income totaled $4.9 million and interestexpense totaled $5.0 million for the six months ended June 30, 2003,compared to foreign currency exchange losses of $345,000, interest income of$3.5 million and interest expense of $5.1 million for the six months endedJune 30, 2004.

 

*Income Tax Provision (Benefit)*.  The tax benefit of $12.1million and the tax provision of $5.8 million for the six months endedJune 30, 2003 and 2004, respectively, reflect an annual effective rateof  60% and 23%, respectively.  The change in the annual effective tax rateduring the six months ended June 30, 2003 from 60% to a provision rate of23% for the six months ended June 30, 2004 is primarily attributable tothe increase in pre-tax earnings as well as tax benefits from U.S. exportincentive programs and research and development and manufacturing investmentcredits. The annual effective tax rates for both periods are less than the U.S.statutory rate of 35% primarily as a result of permanent book/tax differencesand tax credits.  The effective tax rateis a function of current tax law and geographic location of pre-taxincome.  There is currently pendinglegislation to repeal the existing U.S. export incentives.  Should these incentives be repealed orallowed to expire with no replacement benefits, our effective tax rate wouldlikely increase.

 

## **LIQUIDITY AND CAPITAL RESOURCES**

 

Asof June 30, 2004, we had approximately $211.1 million in cash and cashequivalents, $107.5 million in short-term investments, $80.3 million in long-terminvestments, and $427.6 million in working capital.

 

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In February 2002, we issued $250.0 million inaggregate principal amount in a private placement of notes.  These 2002 Notes are due on February 15,2009 with interest payable semi-annually on February 15 and August 15of each year at 31⁄2% per annum.  The 2002Notes are convertible into shares of our common stock at a conversion rate of20 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 convertiblesubordinated notes then outstanding. The remaining proceeds will be used forour future operating, investing and financing activities.

 

Netcash used in operating activities was approximately $16.1 million for the sixmonths ended June 30, 2003, compared to $6.8 million net cash provided byoperating activities for the six months ended June 30, 2004.  Net cash used in operating activitiesfor the six months ended June 30, 2003 primarily reflects the net loss forthe period, higher accounts receivable balances, primarily due to the timing ofsales and related customer invoicing late in the quarter, and increases ininventories and accrued liabilities for the period.   Net cash provided by operating activitiesfor the six months ended June 30, 2004 primarily reflects net income forthe period, and increases in accounts payable and other liabilities which wereoffset by increases in accounts receivable and inventories.  The increase in accounts receivable reflectsthe increased revenue for the six months ended June 30, 2004.  The increase in inventories was primarily dueto an increase in spares inventories in the field to support the continuing highlight source utilization rates as well as to support overall increasing productdemand.

 

Netcash used in investing activities was approximately $25.2 million and $35.0million for the six months ended June 30, 2003 and June 30, 2004,respectively.  Net cash used ininvesting activities for the six months ended June 30, 2003 was dueprimarily to the construction costs for our new manufacturing and officefacility in San Diego.  This capitalexpenditure during the first six months of 2003 was offset by the timing ofshort-term and long-term investments that matured and were reinvested duringthe period.  Net cash used in investingactivities for the six months ended June 30, 2004 was due primarily to thetiming of short-term and long-term investments maturing and being reinvestedduring the quarter, a $6.0 million payment to acquire certain patents and a$2.0 million payment to acquire an additional 6% minority interest in our CymerKorea subsidiary.

 

Netcash provided by financing activities was approximately $5.8 million and $10.4million for  the six months endedJune 30, 2003 and 2004, respectively. The increase in cash provided by financing activities from periodto period was net of a $6.7 million payoff of our Japanese revolving loan thatwas made in the six months ended June 30, 2003.  The cash was provided during both periodsprimarily from the proceeds received from the exercise of employee stockoptions, but such proceeds were higher during the six months endedJune 30, 2003.  These proceeds totaled$12.5 million and $10.4 million for the six months ended June 30, 2003 and2004, respectively.

 

During the sixmonths ended June 30, 2003, we had certain loan agreements with acommercial bank which provided for unsecured revolving loan facilities allowingfor borrowings of $10.0 million and $20.0 million under a U.S. line of creditand Japanese line of credit, respectively. Under the loan agreements, we were able to borrow in U.S. dollars orJapanese yen, and interest accrued on outstanding borrowings at LIBOR plus1.75% on U.S. dollar-denominated borrowings and at the yen cost of funds rateplus 1.5% on yen-denominated borrowings. The loan agreements required us tomaintain compliance with certain financial and other covenants, includingtangible net worth, quick ratio and profitability requirements.  The loan agreements expired on June 16,2003 and were not renewed.

 

Sinceour initial****public offering and a secondarypublic offering, both in 1996, we have funded our operations primarily fromcash generated from operations, the proceeds of the note offerings inAugust 1997 and February 2002, bank borrowings, and the proceeds fromemployee stock option exercises.

 

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Werequire substantial working capital to fund our business, particularly tofinance inventories, including purchase orders with our vendors, accountsreceivable, and for capital expenditures. Our future capital requirementsdepend on many factors, including our manufacturing activity, the timing andextent of spending to support product development efforts, expansion of salesand marketing and field service and support, competitive labor marketcompensation requirements, the timing of introductions of new products andenhancements to existing products, and the market acceptance of our products.We believe that we have sufficient working capital to sustain operations andprovide for the future expansion of our business for at least the next 12months.

 

At June 30, 2004, we did not have any relationship withunconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance variable interest, or special purposeentities, which would have been established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes.  In addition, we did not engagein trading activities involving non-exchange traded contracts.  As a result, we are not exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin such relationships.  We do not haverelationships and transactions with persons and entities that derive benefitsfrom their non-independent relationship with us or our related parties exceptas disclosed herein.

 

**RECENTACCOUNTING PRONOUNCEMENTS**

 

OnMarch 31, 2004, FASB issued a proposed statement, “Share-Based Payment -An Amendment to Statement Nos. 123 and 95,” that addresses the accounting forshare-based payment transactions in which an enterprise receives employeeservices 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.The proposed statement would eliminate the ability to account for share-basedcompensation transactions using APB Opinion No. 25, “Accounting for StockIssued to Employees,” and generally would require instead that suchtransactions be accounted for using a fair-value-based method.  As proposed, this standard would be appliedprospectively for fiscal years beginning after December 15, 2004, as ifall share-based compensation awards granted, modified or settled afterDecember 15, 1994 had been accounted for using the fair-value-based methodof accounting. We will continue to monitor activity on this subject from theFASB in order to determine the impact on our consolidated financial statements.

 

#### **Risks and Uncertainties ThatMay 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, financial conditionor results of operations could suffer, and the trading price of our commonstock could decline.*

 

Our revenues and operating results fromquarter-to-quarter have varied in the past and our future operating results maycontinue to fluctuate significantly due to many factors including those listedin this section and throughout this quarterly report on Form 10-Q for theperiod ended June 30, 2004. These factors include:

 

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

•                  cyclicality in themarket for semiconductor manufacturing equipment;

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

 

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•                  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 competitors;

•                  utilization rates of lightsources 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 a large portion of ourquarterly and annual revenues from selling a small number of light sourcesystems. Because we sell a small number of products, the precise time that werecognize revenue from an order may have a significant impact on our totalrevenue for a particular period. Our customers may cancel orreschedule 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 levels based, in large part, onexpected future revenues. As a result, our expenses are relatively fixed forthe short term, and if our actual revenue decreases below the level we expect,our operating results will be adversely affected.  As a result of these or other factors, wecould fail to achieve our expectations as to future revenue, gross profit andoperating income.  Our failure to meetthe performance expectations set and published by external sources could resultin a sudden and significant drop in the price of our stock, particularly on ashort-term basis, and could negatively affect the value of any investment inour stock.

 

#### **Our business depends on thesemiconductor equipment industry, which is highly volatile and unpredictable.**

 

The semiconductor industry is highly cyclical. We derivea substantial percentage of our revenues from lithography tool manufacturerswithin the semiconductor industry. Our customers depend in turn on the demandfor their photolithography tool products from their customers, the chipmakers.The capital equipment expenditures of chipmakers depend on a number of factors,including the current and anticipated market demand for semiconductors andproducts using semiconductors.

 

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The semiconductor industry is cyclical in nature andhistorically has experienced periodic ups and downs and currently appears to bein an upturn following a significant and prolonged downturn. This cyclicalnature of the industry in which we operate affects our ability to accuratelypredict future revenue and thus, future expense levels. When cyclicalfluctuations result in lower than expected revenue levels, operating resultsmay be adversely affected and cost reduction measures may be necessary in orderfor us to remain competitive and financially sound.  During a down cycle, we must be in a positionto adjust our cost and expense structure to prevailing market conditions and tocontinue to motivate and retain our key employees.  In addition, during periods of rapid growth,we must be able to increase manufacturing capacity and personnel to meetcustomer demand.  We can provide noassurance that these objectives can be met in a timely manner in response to industrycycles.

 

Although we believe we are currently in an industryupturn,  we are not able to predict withany certainty the recovery of the semiconductor industry or the order ofmagnitude of any recovery.  The recentdownturn had a severe effect on the demand for semiconductor manufacturing equipment,including photolithography tools that our customers produce.  If overall market conditions deteriorate inthe near term, our current operating levels may negatively impact ourprofitability. We believe that downturns in the semiconductor industry willoccur periodically, and result in periodic decreases in demand for allsemiconductor manufacturing equipment, including photolithography tools ourcustomers manufacture. As a result, fluctuating levels of investment bychipmakers and pricing volatility will continue to materially affect ouraggregate bookings, revenues and operating results. Also, even during periodsof reduced revenues we believe we must continue to invest in research anddevelopment and to maintain extensive ongoing worldwide customer service andsupport capabilities to remain competitive, which may temporarily harm ourfinancial results.  Accordingly, thesedownturns are likely to continue to adversely affect our business, financialcondition and operating results and our operating results may fall below theexpectations of public market analysts or investors in some future quarter orquarters. Such failure to meet operating result expectations would materiallyadversely affect the price of our common stock.

 

Our customers try to manage their inventories andproduction requirements to appropriate levels that best reflect their expectedsales to chipmakers. Market conditions in the industry and productionefficiency of the lithography tool manufacturers can cause our customers to expandor reduce their orders for new light source systems as they try to manage theirinventories and production requirements to these levels. We continue to workwith our customers to better understand these issues. However, we cannotguarantee that we will be successful in understanding our customers’ inventorymanagement and production requirements or that our customers will not build upan excess inventory of light source products. If our customers retain an excessinventory of light source products, our revenue could be reduced in futureperiods as the excess inventory is utilized, which could adversely affect ouroperating 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 our revenue is derived from sales to a fewlarge customers, and if we are not able to retain these customers, or theyreschedule, reduce or cancel orders, or delay or default on payments, ourrevenues would be reduced and our financial condition and cash flows wouldsuffer.**

 

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

 
| ** **       | ** ** | **Six months ended  June 30,** | ** ** |
|------------------|------------|-------------------------------------|------------|
| ** **       | ** ** | **2003**                            | ** ** | **2004** | ** ** |
|             |       |                                |       |   |   |
| ASM  Lithography |       | 23                                  | %          | 32 | % |
| Canon            |       | 25                                  | %          | 19 | % |
| Nikon            |       | 21                                  | %          | 19 | % |
|             |       |                                |       |   |   |
| Total            |       | 69                                  | %          | 70 | % |

 

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

 
| ** **       | ** ** | **December 31,  2003** | ** ** | **June 30,  2004** | ** ** |
|------------------|------------|-----------------------------|------------|-------------------------|------------|
|             |       |                        |       |                    |       |
| ASM  Lithography |       | 38                          | %          | 38                      | %          |
| Canon            |       | 14                          | %          | 11                      | %          |
| Nikon            |       | 18                          | %          | 22                      | %          |
|             |       |                        |       |                    |       |
| Total.           |       | 70                          | %          | 71                      | %          |

 

We expect that sales of our light source products tothese three customers will continue to account for a substantial majority ofour revenue in the foreseeable future. None of our customers are obligated topurchase a minimum number of our products in the aggregate or during anyparticular period. The loss of any significant business from or productionproblems for any one of these three customers may have a material adverseeffect on our business and financial condition. Sales to these customers may beaffected by many factors, some of which are beyond our control. These factorsinclude:

 

•                  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 acustomer’s financial condition.

 

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

 

Our only product line is excimer light source systems,which include KrF and ArF systems, and we expect these primary products tocontinue to account for a large percentage of our revenues in the near term.Continued market acceptance of our primary products is, therefore, critical toour future success. The primary market for excimer light sources is in the useof DUV photolithography equipment for manufacturing deep-submicronsemiconductor devices using smaller circuit geometries. The demand for ourproducts depends in part on the rate at which chipmakers further adopt excimerlight sources as the chosen light source for their photolithography tools. Therate with which chipmakers adopt excimer light sources may vary for a varietyof reasons, including:

 

•                  inadequate performanceof photoresists used in advanced DUV photolithography;

•                  potential shortages ofspecialized materials used in DUV optics;

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

•                  consolidation ofchipmakers.

 

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

 

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

•                  a failure to achievecontinued market acceptance of our products;

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

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

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

** **

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** **

**We depend on the introduction of new products for oursuccess, and we are subject to risks associated with rapid technologicalchange.**

** **

Rapid technological changes in semiconductormanufacturing processes subject us to increased pressure to developtechnological advances enabling such processes. We believe that our future successdepends in part upon our ability to develop, manufacture and timely introducenew light source products with improved capabilities and to continue to enhanceour 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 newest product introduction project consists of atechnology change from a single- discharge-chamber designed excimer lightsource to a dual-discharge-chamber design called MOPA.  This MOPA design represents a paradigm shiftfrom current lithography technology and is projected to enable higher power,tighter bandwidth and lower cost of operation for future optical lithographyapplications across all three DUV wavelengths – 248 nm, 193 nm and 157 nm.  There are risks inherent in transitioning tothis new technology.  These risks includeeffective execution of the product development plan, adoption of the product bylithography tool manufacturers and chipmakers, manufacturability and costeffectiveness of the new products and the development of a comparable productby our competitors.

 

We believe that chipmakers are currently developing acapability to produce devices that are measured at 0.13 micron or less, andthese efforts are driving the current demand for our light source products forDUV photolithography systems. After chipmakers have this capability, theirdemand for our light source products will depend, in part, on whether they wantto expand their capacity to manufacture these devices. This will in turn dependon whether their sales forecasts and projected manufacturing process yieldsjustify the necessary investments.

 

Future technologies, such as EUV and EPL, 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.

 

We expect to face significant competition from multiplecurrent and future competitors. We believe that other companies are developingsystems and products that are competitive to ours and are planning to introducenew products to this market, which may affect our ability to sell our newproducts. Furthermore, new products represent significant investments of ourresources and their success, or lack thereof, could have a material effect onour financial results.

 

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

 

In order to respond tothe business cycles of the semiconductor industry, in the past few years wehave sharply expanded and contracted the scope of our operations and the numberof employees in many of our departments. As the semiconductor industry growsand contracts we will need to:

 

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•                  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 effectively manage changes in ourbusiness, our operating results, financial condition and cash flows would beadversely affected.

 

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

 

We serve an increasingly global market.  A large portion of our total revenues isderived from customers located outside of the United States, particularly inAsian countries.  We expect ourinternational sales to continue to account for a very large portion of ourtotal revenues. In order to support our foreign customers, we maintain amanufacturing and field service subsidiary in Korea as well as field serviceand support subsidiaries in Japan, Taiwan, Singapore, the People’s Republic ofChina and the Netherlands.

 

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

 

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

 

•                  unexpected changes inregulatory requirements;

•                  fluctuations in exchangerates and currency controls;

•                  political and economicconditions and instability;

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

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

•                  difficulties in staffingand managing foreign subsidiary and branch operations;

•                  limited intellectualproperty protection in some countries;

•                  potentially adverse taxconsequences in some countries;

•                  the possibility ofaccounts receivable collection difficulties;

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

•                  the effect of acts ofterrorism and war; and

•                  the burdens of complyingwith a variety of foreign laws.

 

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

 

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

 

We purchase a limited number of componentsand subassemblies included in our light source products from a single supplieror a small 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 havevendor-managed inventory of critical components to further reduce the risk of asingle supplier.  In addition, we contract the manufacture of various subassemblies moreoften than in the past. Further, some of our suppliers have specialized insupplying equipment or manufacturing services to semiconductor equipmentmanufacturers and therefore were adversely affected by the industry downturn.Because many of  these suppliers cuttheir work forces or otherwise downsized during the downturn they may not beable to meet our requirements or respond quickly enough as the upturn gainsmomentum.  Due to the nature of ourproduct development requirements, these key suppliers must rapidly advancetheir own technologies and production capabilities in order to support theintroduction schedule of our new products. These suppliers may not be ableto provide new modules and subassemblies when they are needed to satisfy ourproduct schedule requirements. If we cannot purchase enough of thesematerials, components or subassemblies, or if these items do not meet ourquality standards, there could be delays or reductions in our productshipments, which would have a material adverse effect on our operating results,financial condition and cash flows.

 

**We face competition from two companies and may facecompetition from additional competitors who enter the market.**

** **

We are currently aware of two significant competitorsthat sell light sources for DUV photolithography applications. Thesecompetitors are:

 

•                  Gigaphoton, a jointventure between two large companies, Komatsu and Ushio, which is headquarteredin Japan; and

•                  Lambda-Physik, a companyheadquartered in Germany, majority owned by Coherent, Inc., a U.S. company.

 

We believe that Gigaphoton and Lambda-Physik areaggressively trying to gain larger market penetration in the excimer lightsource industry. We know that our customers have purchased products from thesetwo competitors and that our customers have approved these competitors’ lightsources for use with their products.  Weknow that Gigaphoton, in particular, has been approved by chipmakers in Japan,the U.S. and elsewhere for producing excimer light sources.  Also, we believe that Lambda-Physik has beenapproved by chipmakers in the U.S. and Europe for producing excimer lightsource products.

 

The market for excimer light sources is still small andimmature. Larger competitors with substantially greater resources, such asother manufacturers of industrial light sources for advanced lithography, mayattempt to sell competitive products to our customers. Potential competitorsmay also be attracted to our growing installed base of light sources and mayattempt to supply consumable products and refurbished parts to that installedbase. If any existing or future competitors gain market acceptance we couldlose market share and our growth could slow or decline, which could have amaterial adverse effect on our operating results, financial condition and cashflows.

 

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

 

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

 

•                  engineering;

•                  research anddevelopment;

 

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•                  sales and marketing;

•                  field service;

•                  manufacturing; and

•                  management.

 

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

 

•                  the continued servicesof our engineering, research and development, 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, train and retain key personnelas required, our operating results, financial condition and cash flows could be adversely affected.

 

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

 

We have historically used stock options and other forms ofequity-related incentives as a key component of our employee compensationpackages. We believe that stock options and other long-term equity incentivesdirectly motivate our employees to maximize long-term stockholder value and,through the use of long-term vesting, encourage employees to remain withus.  FASB and other agencies haveproposed, and are currently considering, changes to accounting principlesgenerally accepted in the United States of America that would require us torecord a charge 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 effectively our direct field service and supportorganization could have a material adverse effect on our business.**

 

We believe it is critical for us to provide quick andresponsive service directly to the chipmakers throughout the world that use ourlight source products in their photolithography systems, and that it isessential to maintain our own personnel or trained third-party resources toprovide these services.  Accordingly, wehave an ongoing effort to develop our direct support system with locations inthe United States, Japan, Europe, Korea, Singapore, Taiwan and the People’sRepublic of China. This requires 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 attract and train qualifiedpersonnel to maintain our direct support operations successfully. We may not beable to find and engage qualified third-party resources to supplement andenhance our direct support operations. Further, we may incur significant costs in providing these supportservices. Failure to implement our direct support operation effectively couldhave a material adverse effect on our operating results, financial conditionand cash flows.

 

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

 

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

 

As of June 30, 2004, we owned 198 United Statespatents covering certain aspects of technology related to light sources andpiezo techniques. These patents will expire at various times during the periodfrom January 2008 to June 2022. As of June 30, 2004, we had applied for 77 additional patents inthe United States.  As of June 30,2004, we owned 255 foreign patents and had 321 patent applications pending invarious foreign countries.

 

Our pending patent applications and any futureapplications might not be approved. Our patents might not provide us with acompetitive advantage and may be challenged by third parties. In addition,third parties’ patents might have an adverse effect on our ability to dobusiness. As a result of cost constraints, we did not begin filing in Japan andother countries our patents for inventions covered by United States patents andpatent applications until 1993.  As aresult we  do not have the right to seekforeign patent protection for some of our early inventions.  Additionally, laws of some foreign countriesin which our products are or may be developed, manufactured or sold, includingvarious countries in Asia, may not protect our products or intellectualproperty rights to the same extent as do the laws of the United States. Thus,the possibility of piracy of our technology and products are more likely inthese countries. Further, third parties might independently develop similarproducts, duplicate our products or, design around patents that are granted tous.

 

Other companies or persons may have filed or may file inthe future patent applications that are similar or identical to ours. We mayhave to participate in interference proceedings declared by the United StatesPatent and Trademark Office (“USPTO”) in order for the patent office to determinethe priority of inventions. The patent office may determine that thesethird-party patent applications have priority over our patent applications.Loss of priority in these interference proceedings could result in substantialcost to us.

 

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

 

•                  trade secret protection;

•                  employee nondisclosureagreements;

•                  third-partynondisclosure agreements; and

•                  other intellectualproperty protection methods.

 

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

 

•                  independently developsubstantially the same proprietary information and techniques;

•                  gain access to our tradesecrets; or

•                  disclose our technology.

 

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**The parties to whom we provide research and developmentservices may dispute the ownership of the intellectual property that we developperforming these services.**

** **

In the past, funds from research and developmentarrangements with third parties have been used to pay for a portion of our ownresearch and development expenses. We receive these funds fromgovernment-sponsored programs and customers, in connection with our designingand 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 to thesemanufacturers, we try to make clear who owns the intellectual property thatresults from the research and development services we perform. However,disputes over the ownership or rights to use or market this intellectualproperty may arise between us and the manufacturers. Any dispute over ownershipof the intellectual property we develop could restrict our ability to marketour products and have a material adverse effect on our business.

 

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

 

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

 

Specifically, Komatsu has notified us that we may beinfringing some of its Japanese patents. During our discussions with Komatsu,they also asserted that we or our former Japanese manufacturing partner, Seiko,may be infringing on some of Komatsu’s United States patents and a number ofits additional Japanese patents. Komatsu has also notified one of our customers,Nikon, of its belief that our light sources infringe several of Komatsu’sJapanese and U.S. patents. As a result, we started proceedings in the JapanesePatent Office to oppose certain patents and patent applications of Komatsu. TheJapanese Patent Office has dismissed some of our opposition claims. Thus,litigation may result in connection with Komatsu’s Japanese patents or U.S.patents. Also, Komatsu might claim that we infringe other or additionalpatents. Komatsu notified Seiko that it intends to enforce its rights againstSeiko with respect to its Japanese patents if Seiko continued to engage inmanufacturing activities for us. In connection with our former manufacturingagreement with Seiko, we agree to pay Seiko under certain conditions for damagesassociated with these types of claims. Seiko may not prevail in any litigationagainst Komatsu, and therefore, we may be required to pay Seiko for suchdamages.

 

We have notified our competitors and others of ourUnited States patent portfolio. Specifically, we have notified Komatsu thatthey may be infringing on some of our U.S. patents. We have discussed withKomatsu our claims against each other. Komatsu challenged one of our U.S. patents in the USPTO but it was subsequentlyre-issued by the USPTO.  Also, Komatsutransferred its lithography light source business to one of our competitors,Gigaphoton.  We also have had discussionswith Lambda-Physik (a subsidiary of Coherent, Inc.), another competitor,regarding allegations by each party against the other for possible patentinfringement. Any of these discussions with our competitors may not besuccessful and litigation could result.

 

In the future, patent litigation may result due to aclaim of infringement by our competitors or any other third party or may benecessary to enforce patents issued to us. Any such litigation could result in substantial cost and diversion ofeffort by us, which would have an adverse effect on our business, financialcondition and operating results. Furthermore, our customers and the end usersof our products might assert other claims for indemnification that arise frominfringement claims against them. If these assertions are successful, ourbusiness, financial condition and operating results may be materially affected.Instead of litigation, we may seek a license from third parties to use theirintellectual property. However, we may not be able to obtain a license onreasonable terms. In the alternative, we may design

 

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around the third party’s intellectual property rights orwe may challenge these claims in legal proceedings. Any adverse determinationin a legal proceeding could result in one or more of the following, any ofwhich could have a substantial adverse effect on our business, financialcondition and operating results:

 

•                  loss of our proprietaryrights;

•                  exposure to significantliabilities by other third parties;

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

•                  restriction frommanufacturing or selling our products.

 

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

 

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

 

We registered the trademarks ‘‘CYMER’’ and “INSIST ONCYMER” and others in the United States and in some other countries. We are alsotrying to register additional trademarks in the United States and in othercountries.  We use these trademarks andmany other marks in our advertisements and other business materials, which aredistributed throughout the world. We may be subject to trademark infringementactions for using these marks and other marks on a worldwide basis and thiswould be costly to defend. If a trademark infringement action was successful,we would have to stop using the mark and possibly pay damages.

 

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

 

Changing laws,regulations and standards relating to corporate governance and public disclosure,including the Sarbanes-Oxley Act of 2002, new SEC regulations, Nasdaq StockMarket rules, and new accounting pronouncements are creating uncertainty andadditional complexities for companies such as ours. To maintain high standardsof corporate governance and public disclosure, we intend to invest allreasonable necessary resources to comply with evolving standards. Thisinvestment may result in increased general and administrative expenses and adiversion of management time and attention from strategic revenue-generatingand cost management activities.

 

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

 

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

 

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

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

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

•                  our sales and marketingefforts may be disrupted.

 

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**We are exposed to risks related to the fluctuations in the currencyexchange rates for the Japanese yen.**

 

When we sell products to our Japanese subsidiary, thesale 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. Our Japanese subsidiary manages itsexposure to these fluctuations through foreign currency forward exchangecontracts to hedge its purchase commitments. We will continue to monitor ourexposure to these currency fluctuations, and, when appropriate, use hedgingtransactions to minimize the effect of these currency fluctuations. However,exchange rate fluctuations may still have a material adverse effect on ouroperating results. In the future, we may need to sell our products in otherforeign currencies other than the Japanese yen and the management of morecurrency fluctuations will be more difficult and expose us to greater risks inthis area.

 

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

 

Many foreign government standards and regulations applyto our products. These standards and regulations are always being amended.Although we intend to meet all foreign standards and regulations, our productsmay not comply with these foreign government standards and regulations.Further, it might not be cost effective for us to redesign our products tocomply with these foreign government standards and regulations. Our inabilityto design or redesign products to comply with foreign standards therefore couldhave a material adverse effect on our business.

 

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

** **

Over time, our light source products may not meetchipmakers’ production specifications or operating cost requirements after thelight source is used for a long period in high volume production. If anychipmaker cannot successfully achieve or sustain their volume production usingour light sources, our reputation could be damaged with the chipmakers and ourcustomers who are the limited number of lithography tool manufacturers. Thiswould have a material adverse effect on our business.

** **

**We have in the past and may in the future acquire abusiness that will involve numerous risks. We may not be able to address theserisks successfully without substantial expense, delay or other operational andfinancial problems.**

** **

The risks involved with acquiring a new company includethe following:

 

•                  diversion ofmanagement’s attention and resources to integrate the new company;

•                  failure to retain keypersonnel;

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

•                  client dissatisfactionor performance problems with the acquired company;

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

•                  failure to commercializepurchased technologies;

•                  ability of the acquiredcompanies 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.

 

Mergers and acquisitions are inherently subject tomultiple significant risks, and the inability to effectively manage these riskscould have a material adverse effect on our business.  Any of these risks

 

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could materially harm our business, financial conditionand operating results. Further, any business that we acquire may not achieveanticipated revenues or operating results.

 

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

** **

To continue to grow our business, our existing lightsource products and their process capabilities must be enhanced, and we mustdevelop and manufacture new products to serve other semiconductor applications.We cannot guarantee that we will be able to manage our growth effectively. Norcan we guarantee that we will be able to accelerate the development of newenhancements to our existing products and create new products. Further, we maynot be able to effectively integrate new products and applications into ourcurrent operations. Any of these risks could materially harm our business,financial condition and results of operations.

 

## **We are dependent on ourmanufacturing facilities and subcontractors to assemble and test our products.**

 

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

 

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

 

We are subject to federal, state and local regulations,such as regulations related to the environment, land use, public utilityutilization and the fire code, in connection with the storage, handling,discharge and disposal of substances that we use in our manufacturing processand on our facilities.  We believe thatour activities comply with current government regulations that are applicableto our operations and current facilities. We may be required to purchaseadditional capital equipment or other requirements for our processes to complywith these government regulations in the future if they change. Further, thesegovernment regulations may restrict us from expanding our operations. Adoptingmeasures to comply with changes in the government regulations, our failure tocomply with environmental and land use regulations, or restrictions on ourability to discharge hazardous substances, could subject us to future liabilityor cause our manufacturing operations to be reduced or stopped.

 

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

 

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

 

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

 

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

 

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

 

•                  the cyclical nature ofthe semiconductor industry;

•                  actual or anticipatedfluctuations in our operating results;

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

•                  announcements ofinnovations in technology;

•                  new products offered byus or our competitors;

•                  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 experienced extremeprice and volume fluctuations that have particularly affected the market pricefor many high technology companies. Such fluctuations have in some cases beenunrelated to the operating performance of these companies. Severe pricefluctuations in a company’s stock have frequently been followed by securitieslitigation.  Any such litigation canresult in substantial costs and a diversion of management’s attention andresources and therefore could have a material adverse effect on Cymer’s business,financial condition and results of operations.

** **

**We have implemented steps to protect our company fromhostile takeovers.**

 

Nevada law and our articles of incorporation containprovisions that discourage a proxy contest and provisions that make anacquisition of a substantial block of our common stock more difficult. Inaddition, our board of directors is authorized to issue, without stockholderapproval, shares of preferred stock. Such shares of preferred stock may havevoting, conversion and other rights and preferences that may be superior tothose of the common stock and this could adversely affect the voting power orother rights of holders of common stock. Our board can use the issuance of thepreferred stock or rights to purchase the preferred stock to discourage anyunsolicited acquisition proposal or attempt.

 

#### **Item 3.  Quantitative andQualitative Disclosures About Market Risk**

 

# **Foreign Currency Risk**

 

Cymer conducts business in severalinternational currencies through its global operations. Due to the large volumeof Cymer’s business that is conducted in Japan, the Japanese operation posesthe greatest foreign currency risk. Cymer uses financial instruments, principally foreign currency forwardexchange contracts, in Japan to manage its foreign currency exposures. Cymerenters into foreign currency forward exchange contracts in order to reduce theimpact of currency fluctuations related to purchases of Cymer’s inventories byCymer Japan in U.S. dollars for resale under firm third-party sales commitmentsdenominated in Japanese yen.  Cymer doesnot enter into foreign currency forward exchange contracts for tradingpurposes.

 

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As of June 30, 2004, Cymer hadoutstanding foreign currency forward exchange contracts to buy U.S. $78.3million for 8.4 billion yen under foreign currency exchange facilities withcontract rates ranging from 104.3 yen to 118.2****yenper U.S. dollar.  These contracts expireon various dates through June 2005.

 

Cymer’s foreign currency forward exchange contractsqualify for hedge accounting treatment per the provisions of Statement ofFinancial Accounting Standards No. 133, “Accounting for Derivative Instrumentsand Hedging Activities”.  As a result,Cymer defers changes in the fair value of these contracts and records theamount in other comprehensive income (loss) and subsequently reclassifies thegain or loss to cost of product sales in the same period that the related saleis made to the third party. The unrealized loss or fair value of thesecontracts and the deferred loss totaled $2.3 million and $1.5 million,respectively, as of June 30, 2004. The fair value of these foreign currency forward exchange contracts asof June 30, 2004 would have changed by $8.7 million if the foreigncurrency exchange rate for the Japanese yen to the U.S. dollar on these forwardcontracts had changed by 10%.

 

# **Investment and Debt Risk**

 

Cymer maintains an investment portfolioconsisting primarily of government and corporate fixed income securities,certificates of deposit and commercial paper. While it is Cymer’s general intent to hold such securities untilmaturity, Cymer will occasionally sell certain securities for cash flowpurposes. Therefore, Cymer’s investments are classified as available-for-saleand 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.

 

InFebruary 2002, Cymer issued $250.0 million principal amount of unsecuredfixed rate 31⁄2% Convertible Subordinated Notes due February 15, 2009.  Interest on these 2002 Notes is payable onFebruary 15 and August 15 of each year.  The 2002 Notes are convertible into shares ofCymer’s common stock at a conversion rate of 20 shares per $1,000 principalamount subject to adjustment under certain conditions. Cymer may redeem the2002 Notes on or after February 20, 2005, or earlier if the price of itscommon stock reaches certain levels.  The2002 Notes are subordinated to Cymer’s existing and future senior indebtednessand effectively subordinated to all indebtedness and other liabilities ofCymer’s subsidiaries.  Because theinterest rate is fixed, we believe there is no risk of increased interest expense.These 2002 Notes are recorded at face value on the consolidated balancesheets.  The fair value of such debtbased on quoted market prices on June 30, 2004 was $253.6 million.

 

#### **ITEM 4.  Controls and Procedures**

 

*Evaluation of disclosure controls andprocedures*. Cymer’s chief executive officer and its chief financial officer, afterevaluating the effectiveness of Cymer’s disclosure controls and procedures (asdefined in Exchange Act Rule 13a-15(e) and 15d-15(e)) as of June 30, 2004,have concluded that as of such date, Cymer’s disclosure controls and procedureswere adequate and sufficient to ensure that information required to bedisclosed by Cymer in the reports that it files under the Securities ExchangeAct

of 1934 is recorded, processed, summarized and reported within the timeperiod specified in the Commission’s rules and forms.

 

*Changes in internal controls*.There has been no change in Cymer’s internal control over financial reportingduring the fiscal quarter ended June 30, 2004 that has materiallyaffected, or is reasonably likely to materially affect, Cymer’s internalcontrol over financial reporting.

 

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**PARTII.  OTHER INFORMATION**

 

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

 

None.

 

**ITEM 2.****                                                     Changesin Securities, Use of Proceeds, and Issuer Purchases of Equity Securities**

 

None.

 

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

 

None.

 

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

 

Cymer held its Annual Meeting of Stockholders on May 20, 2004. Outof 36,724,104 shares of common stock entitled to vote at such meeting, therewere present in person or by proxy 34,536,168 shares. At the Annual Meeting,the stockholders of Cymer approved the following matters:

 

Proposal 1. The election of the following eight directors to serve forone year. The votes for the nominated directors were as follows:

 
| **Director’s  Name** | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------------------|------------|---------------|------------|--------------------|------------|
|                      |       |          |       |               |       |
| Charles J. Abbe           |       | 22,712,246    |       | 11,823,922         |       |
| Robert P. Akins           |       | 24,462,714    |       | 10,073,454         |       |
| Edward H. Braun           |       | 22,546,899    |       | 11,989,269         |       |
| Michael R. Gaulke         |       | 22,641,546    |       | 11,894,622         |       |
| William G. Oldham         |       | 24,462,714    |       | 10,073,454         |       |
| Peter J. Simone           |       | 23,723,075    |       | 10,813,093         |       |
| Young K. Sohn             |       | 23,525,191    |       | 11,010,977         |       |
| Jon D. Tompkins           |       | 23,454,491    |       | 11,081,677         |       |

 

Proposal 2. Approval of an amendment to Cymer’s 1996 Employee StockPurchase Plan to increase the aggregate number of shares reserved for issuanceunder the plan by 200,000 shares. 28,716,284 votes were cast for approval,884,279 votes were cast against, 32,236 votes were abstained and there were4,903,369 broker non-votes.

 

Proposal 3. Ratification of the selection of KPMG LLP as theindependent auditors of Cymer for the year ending December 31, 2004.21,428,269 votes were cast for approval, 12,974,698 votes were cast against,133,201 votes were abstained and there were no broker non-votes.

 

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

 

None.

 

**ITEM 6.****                                                     Exhibitsand Reports on Form 8-K**

 

**(a)****         **31.1  Certificationof Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act

 

31.2  Certificationof Chief Financial Officer pursuant to Section 302 of the Sarbanes-OxleyAct

 

32.1  Certificationof Chief Executive Officer pursuant to Section 906 of the Sarbanes-OxleyAct

 

32.2  Certificationof Chief Financial Officer pursuant to Section 906 of the Sarbanes-OxleyAct

 

**(b)****          Reports on Form 8-K**

 

On April 20, 2004, Cymer furnished a Form 8-K announcing its firstquarter 2004 financial results.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this quarterlyreport on Form 10-Q to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                            |   | CYMER, INC.                                                                                                    |   |
|---------------------------------|--------|----------------------------------------------------------------------------------------------------------------|--------|
|                            |   |                                                                                                           |   |
|                            |   |                                                                                                           |   |
| Date:  August 4, 2004 | 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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