**UNITEDSTATES 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 September 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                           ** |

 

**Commission file number 0-21321**

 

**CYMER, INC.**

(Exact name of registrant as specified in its charter)

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

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

 

**(858)385-7300**

(Registrant’s telephonenumber, including area code)

 

**N/A**

(Former name, formeraddress and former fiscal 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 Act of1934 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 November 1, 2004 was 36,922,646.

 

** **

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**CYMER, INC.**

 

**FORM 10-Q**

 

**For the Quarterly Period EndedSeptember 30, 2004**

 

**INDEX**

 
| **PART I.**         | **FINANCIAL INFORMATION**                                                                               | ** ** | ** ** |
|---------------------|---------------------------------------------------------------------------------------------------------|------------|------------|
|                |                                                                                                    |       |       |
| ITEM 1.             | Financial Statements  (unaudited)                                                                       |       |       |
|                |                                                                                                    |       |       |
|                | Consolidated  Balance Sheets as of December 31, 2003 and September 30, 2004                             |       |       |
|                |                                                                                                    |       |       |
|                | Consolidated  Statements of Operations for the three and nine months ended September 30,  2003 and 2004 |       |       |
|                |                                                                                                    |       |       |
|                | Consolidated  Statements of Cash Flows for the nine months ended September 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.             | Unregistered Sales of Equity Securities and Use  of Proceeds                                            |       |       |
|                |                                                                                                    |       |       |
| ITEM 3.             | Defaults Upon Senior  Securities                                                                        |       |       |
|                |                                                                                                    |       |       |
| ITEM  4.            | Submission  of Matters to a Vote of Security Holders                                                    |       |       |
|                |                                                                                                    |       |       |
| ITEM 5.             | Other Information                                                                                       |       |       |
|                |                                                                                                    |       |       |
| ITEM 6.             | Exhibits                                                                                                |       |       |
|                |                                                                                                    |       |       |
| **SIGNATURE  PAGE** | ** **                                                                                              | ** ** |

 

2

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**PART I. FINANCIAL INFORMATION**

** **

**ITEM 1.  Financial Statements**

 

**CYMER,INC.**

**CONSOLIDATEDBALANCE SHEETS (UNAUDITED)**

**(Inthousands, except share data)**

 
| ** **                                                                                                                                                                              | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                                              |       |                   |       |                    |       |
| ** **                                                                                                                                                                              |       |                   |       |                    |       |
| CURRENT ASSETS:                                                                                                                                                                         |       |                   |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                              |       | $                      | 230,657    |                    | $          | 217,202 |   |
| Short-term  investments                                                                                                                                                                 |       | 93,474                 |       | 97,133                  |       |
| Accounts  receivable – net                                                                                                                                                         |       | 62,819                 |       | 96,310                  |       |
| Foreign currency  forward exchange contracts                                                                                                                                            |       | —                 |       | 162                     |       |
| Inventories                                                                                                                                                                             |       | 93,012                 |       | 120,625                 |       |
| Deferred income  taxes                                                                                                                                                                  |       | 1,407                  |       | 1,653                   |       |
| Prepaid expenses  and other assets                                                                                                                                                      |       | 5,513                  |       | 7,351                   |       |
| Total current  assets                                                                                                                                                                   |       | 486,882                |       | 540,436                 |       |
|                                                                                                                                                                                    |       |                   |       |                    |       |
| PROPERTY AND  EQUIPMENT – NET                                                                                                                                                      |       | 128,849                |       | 125,184                 |       |
| LONG-TERM  INVESTMENTS                                                                                                                                                                  |       | 77,509                 |       | 43,789                  |       |
| DEFERRED INCOME  TAXES                                                                                                                                                                  |       | 80,711                 |       | 80,888                  |       |
| GOODWILL – NET                                                                                                                                                                     |       | 7,647                  |       | 8,358                   |       |
| INTANGIBLE  ASSETS – NET                                                                                                                                                           |       | 12,925                 |       | 11,026                  |       |
| OTHER ASSETS                                                                                                                                                                            |       | 8,698                  |       | 7,236                   |       |
|                                                                                                                                                                                    |       |                   |       |                    |       |
| TOTAL ASSETS                                                                                                                                                                            |       | $                      | 803,221    |                    | $          | 816,917 |   |
|                                                                                                                                                                                    |       |                   |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                          |       |                   |       |                    |       |
|                                                                                                                                                                                    |       |                   |       |                    |       |
| CURRENT  LIABILITIES:                                                                                                                                                                   |       |                   |       |                    |       |
| Accounts payable                                                                                                                                                                        |       | $                      | 19,099     |                    | $          | 22,934 |   |
| Accrued warranty  and installation                                                                                                                                                      |       | 26,486                 |       | 27,888                  |       |
| Accrued payroll  and benefits                                                                                                                                                           |       | 7,196                  |       | 17,549                  |       |
| Accrued patents,  royalties and other fees                                                                                                                                              |       | 8,436                  |       | 5,143                   |       |
| Foreign currency  forward exchange contracts                                                                                                                                            |       | 6,401                  |       | —                  |       |
| Income taxes  payable                                                                                                                                                                   |       | 16,473                 |       | 25,658                  |       |
| Accrued and  other current liabilities                                                                                                                                                  |       | 4,945                  |       | 6,155                   |       |
| Total current  liabilities                                                                                                                                                              |       | 89,036                 |       | 105,327                 |       |
|                                                                                                                                                                                    |       |                   |       |                    |       |
| CONVERTIBLE  SUBORDINATED NOTES                                                                                                                                                         |       | 250,000                |       | 200,753                 |       |
| OTHER  LIABILITIES                                                                                                                                                                      |       | 5,660                  |       | 6,777                   |       |
| MINORITY  INTEREST                                                                                                                                                                      |       | 5,195                  |       | 5,843                   |       |
|                                                                                                                                                                                    |       |                   |       |                    |       |
| 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  36,822,000 shares outstanding at December 31, 2003 and September 30, 2004,  respectively |       | 36                     |       | 37                      |       |
| Additional  paid-in capital                                                                                                                                                             |       | 358,988                |       | 370,559                 |       |
| Unearned  compensation                                                                                                                                                                  |       | (146                   | )          | (48                     | )          |
| Accumulated  other comprehensive loss                                                                                                                                                   |       | (5,734                 | )          | (5,295                  | )          |
| Retained  earnings                                                                                                                                                                      |       | 100,186                |       | 132,964                 |       |
| Total  stockholders’ equity                                                                                                                                                        |       | 453,330                |       | 498,217                 |       |
|                                                                                                                                                                                    |       |                   |       |                    |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                        |       | $                      | 803,221    |                    | $          | 816,917 |   |

 

See Notes to UnauditedConsolidated Financial Statements.

 

3

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**CYMER, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS (UNAUDITED)**

**(Inthousands, except per share data)**

 
| ** **                                                                 | ** ** | **For the three months  ended September 30,** | ** ** | **For the nine months  ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2003**                                      | ** ** | **2004**                                     | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| REVENUES:                                                                  |       |                                          |       |                                         |       |   |   |   |   |
| Product sales                                                              |       | $                                             | 63,873     |                                         | $          | 106,751 |   | $ | 193,386 |   | $ | 289,344 |   |
| Other                                                                      |       | —                                        |       | 389                                          |       | 57 |   | 624 |   |
| Total revenues                                                             |       | 63,873                                        |       | 107,140                                      |       | 193,443 |   | 289,968 |   |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| COSTS AND  EXPENSES:                                                       |       |                                          |       |                                         |       |   |   |   |   |
| Cost of product  sales                                                     |       | 48,029                                        |       | 56,120                                       |       | 142,930 |   | 158,263 |   |
| Research and  development                                                  |       | 11,470                                        |       | 15,796                                       |       | 44,860 |   | 42,998 |   |
| Sales and  marketing                                                       |       | 3,873                                         |       | 5,784                                        |       | 12,428 |   | 17,486 |   |
| General and  administrative                                                |       | 20,621                                        |       | 8,218                                        |       | 32,941 |   | 22,987 |   |
| Amortization of  intangible assets                                         |       | 40                                            |       | 40                                           |       | 120 |   | 120 |   |
| Gain on debt  extinguishment                                               |       | —                                        |       | (911                                         | )          | — |   | (911 | ) |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| Total costs and  expenses                                                  |       | 84,033                                        |       | 85,047                                       |       | 233,279 |   | 240,943 |   |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| OPERATING INCOME  (LOSS)                                                   |       | (20,160                                       | )          | 22,093                                       |       | (39,836 | ) | 49,025 |   |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                                   |       |                                          |       |                                         |       |   |   |   |   |
| Foreign currency  exchange gain (loss) – net                          |       | 482                                           |       | (928                                         | )          | 65 |   | (1,273 | ) |
| Interest and  other income                                                 |       | 2,078                                         |       | 2,401                                        |       | 6,964 |   | 5,900 |   |
| Interest and  other expense                                                |       | (2,530                                        | )          | (2,299                                       | )          | (7,510 | ) | (7,366 | ) |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| Total other  income (expense) – net                                   |       | 30                                            |       | (826                                         | )          | (481 | ) | (2,739 | ) |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| INCOME (LOSS)  BEFORE INCOME TAX PROVISION (BENEFIT) AND MINORITY INTEREST |       | (20,130                                       | )          | 21,267                                       |       | (40,317 | ) | 46,286 |   |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| INCOME TAX  PROVISION (BENEFIT)                                            |       | (12,078                                       | )          | 5,818                                        |       | (24,190 | ) | 11,572 |   |
| MINORITY  INTEREST                                                         |       | (467                                          | )          | (28                                          | )          | (947 | ) | (1,936 | ) |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| NET INCOME  (LOSS)                                                         |       | $                                             | (8,519     | )                                            | $          | 15,421 |   | $ | (17,074 | ) | $ | 32,778 |   |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| EARNINGS (LOSS)  PER SHARE:                                                |       |                                          |       |                                         |       |   |   |   |   |
| Basic earnings  (loss) per share                                           |       | $                                             | (0.24      | )                                            | $          | 0.42 |   | $ | (0.49 | ) | $ | 0.89 |   |
| Weighted average  common shares outstanding                                |       | 35,302                                        |       | 36,788                                       |       | 34,733 |   | 36,704 |   |
|                                                                       |       |                                          |       |                                         |       |   |   |   |   |
| Diluted earnings  (loss) per share                                         |       | $                                             | (0.24      | )                                            | $          | 0.41 |   | $ | (0.49 | ) | $ | 0.87 |   |
| Weighted average  common and dilutive potential common shares outstanding  |       | 35,302                                        |       | 37,266                                       |       | 34,733 |   | 37,639 |   |

 

See Notes toUnaudited Consolidated Financial Statements.

 

 

4

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**CYMER,INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (UNAUDITED)**

**(Inthousands)**

 
| ** **                                                                                           | ** ** | **For the nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2003**                                     | ** ** | **2004** | ** ** |
|                                                                                                 |       |                                         |       |   |   |
| OPERATING  ACTIVITIES:                                                                               |       |                                         |       |   |   |
| Net income  (loss)                                                                                   |       | $                                            | (17,074    | ) | $ | 32,778 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                         |       |   |   |
| Gain on debt  extinguishment                                                                         |       | —                                       |       | (911 | ) |
| Depreciation and  amortization                                                                       |       | 23,816                                       |       | 21,004 |   |
| Non-cash  stock-based compensation                                                                   |       | 1,115                                        |       | 141 |   |
| Amortization of  unearned compensation                                                               |       | 665                                          |       | 98 |   |
| Minority  interest                                                                                   |       | 947                                          |       | 1,936 |   |
| Provision for  deferred income taxes                                                                 |       | (54                                          | )          | (727 | ) |
| Loss on disposal  and impairment of property and equipment                                           |       | 17,635                                       |       | 61 |   |
| Change in assets  and liabilities: Accounts receivable – net                                    |       | (14,303                                      | )          | (33,491 | ) |
| Income taxes  receivable                                                                             |       | (16,725                                      | )          | — |   |
| Foreign currency  forward exchange contracts                                                         |       | 1,925                                        |       | (2,247 | ) |
| Inventories                                                                                          |       | 11,209                                       |       | (27,613 | ) |
| Prepaid expenses  and other assets                                                                   |       | 786                                          |       | (2,299 | ) |
| Accounts payable                                                                                     |       | (12,094                                      | )          | 3,835 |   |
| Accrued expenses  and other liabilities                                                              |       | (3,627                                       | )          | 16,892 |   |
| Income taxes  payable                                                                                |       | (11,321                                      | )          | 9,185 |   |
|                                                                                                 |       |                                         |       |   |   |
| Net cash  provided by (used in) operating activities                                                 |       | (17,100                                      | )          | 18,642 |   |
|                                                                                                 |       |                                         |       |   |   |
| INVESTING  ACTIVITIES:                                                                               |       |                                         |       |   |   |
| Acquisition of  property and equipment                                                               |       | (55,509                                      | )          | (14,584 | ) |
| Purchases of  investments                                                                            |       | (84,006                                      | )          | (161,549 | ) |
| Proceeds from  sold or matured investments                                                           |       | 121,454                                      |       | 189,384 |   |
| Acquisition of  patents (1)                                                                          |       | —                                       |       | (5,990 | ) |
| Acquisition of  minority interest                                                                    |       | (180                                         | )          | (2,000 | ) |
|                                                                                                 |       |                                         |       |   |   |
| Net cash  provided by (used in) investing activities                                                 |       | (18,241                                      | )          | 5,261 |   |
|                                                                                                 |       |                                         |       |   |   |
| FINANCING  ACTIVITIES:                                                                               |       |                                         |       |   |   |
| Net borrowings  under revolving loan and security agreements                                         |       | (6,667                                       | )          | — |   |
| Proceeds from  issuance of common stock                                                              |       | 31,288                                       |       | 11,430 |   |
| Redemption of  convertible subordinated notes                                                        |       | —                                       |       | (47,407 | ) |
| Payments on  capital lease obligations                                                               |       | (38                                          | )          | (36 | ) |
|                                                                                                 |       |                                         |       |   |   |
| Net cash  provided by (used in) financing activities                                                 |       | 24,583                                       |       | (36,013 | ) |
|                                                                                                 |       |                                         |       |   |   |
| EFFECT OF EXCHANGE  RATE CHANGES ON CASH AND CASH EQUIVALENTS                                        |       | 1,658                                        |       | (1,345 | ) |
|                                                                                                 |       |                                         |       |   |   |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                                           |       | (9,100                                       | )          | (13,455 | ) |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF THE PERIOD                                                |       | 196,643                                      |       | 230,657 |   |
|                                                                                                 |       |                                         |       |   |   |
| CASH AND CASH  EQUIVALENTS AT END OF THE PERIOD                                                      |       | $                                            | 187,543    |   | $ | 217,202 |   |

 

5

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| ** **                                                                                                       | ** ** | **For the nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2003**                                     | ** ** | **2004** | ** ** |
|                                                                                                             |       |                                         |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                                               |       |                                         |       |   |   |
| Interest paid                                                                                                    |       | $                                            | 8,925      |   | $ | 8,949 |   |
| Income taxes  paid, net                                                                                          |       | $                                            | 4,037      |   | $ | 2,650 |   |
|                                                                                                             |       |                                         |       |   |   |
| 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      |   | $ | — |   |

 

----

(1)          Thesepatents were acquired in the fourth quarter of 2003 and the payment wasaccrued.  Payment for these patents was madein the first quarter of 2004.

 

See Notes to Unaudited Consolidated FinancialStatements.  

 

6

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**CYMER, INC.**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**Three and Nine Months EndedSeptember 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 inconjunction with the consolidated financial statements and notes theretoincluded in Cymer’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 that may be reportedfor 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 SemiconductorEquipment Shanghai Co., Ltd, in the People’s Republic of China (“Cymer PRC”),and its majority-owned subsidiary, Cymer Korea, Inc. (“Cymer Korea”).  Cymer, Inc. owns 81% of Cymer Korea.  In February 2004, Cymer acquired 6% of theremaining 25% minority interest in its majority-owned subsidiary, CymerKorea.  Cymer paid a total of $2.0million for this 6% interest and recorded $1.3 million of the $2.0 million asan additional investment in Cymer Korea and the remaining $711,000 asgoodwill.  This transaction increasedCymer’s total interest in Cymer Korea from 75% to 81%.    Cymer Japan is currently the only subsidiaryoffice of Cymer that sells excimer light source systems.  In addition, Cymer Japan provides fieldservice to customers in the Japan region. Cymer SEA, Cymer PRC, Cymer Singaporeand Cymer B.V. are field service offices for customers in those respectiveregions.  Cymer Korea providesrefurbishment manufacturing, field service, and administrative activities forthat region. All significant intercompany balances have been eliminated inconsolidation.

 

*Accounting Estimates* – 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, theFinancial 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 VIEs createdbefore February 1, 2003, the provisions of FIN 46 must be adopted at thebeginning of the first interim or annual reporting period beginning afterDecember 15, 2003.  The adoption of thisinterpretation did not have a material effect on the consolidated financialstatements of Cymer as it does not have arrangements that meet the criteria ofa VIE.

 

InDecember 2003, FASB issued Interpretation No. 46R, “Consolidation of VariableInterest Entities”, which supersedes FIN 46. The application of the revised interpretation is required in thefinancial statements of companies that have interests in special purposeentities for periods after December 15, 2003. The application of this interpretation did not have a material effect onthe 

 

7

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consolidated financialstatements of Cymer as it does not have any arrangements that meet the criteriaof a special purpose entity.

 

In March 2004, the Emerging Issues Task Force (“EITF”)finalized its consensus on EITF Issue 03-6, “Participating Securities and theTwo-Class Method Under FASB Statement No. 128, Earnings Per Share” (“EITF03-6”). EITF 03-6 clarifies what constitutes a participating security andrequires the use of the two-class method for computing basic earnings per sharewhen participating convertible securities exists. EITF 03-6 is effective forfiscal periods beginning after March 31, 2004. The application of EITF 03-6 didnot have an effect on Cymer’s calculation of earnings per share.

 

In March 2004, the EITF reached a consensus on EITFIssue No. 03-1 (“EITF 03-1”),  “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments”. The EITF’s consensus applies to debt and equity securitiesaccounted 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 annual financialstatements for fiscal years ending after June 15, 2004, for investmentsaccounted for under SFAS 115. Cymer does not anticipate that the adoptionof  EITF 03-1 will have a material impacton Cymer’s consolidated financial statements.

 

*Reclassifications–* Certain amounts in the prior year consolidated financialstatements have been reclassified 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 tocontinue to apply the intrinsic value-based method of accounting describedabove, and has adopted the disclosure requirements of SFAS No. 123, as amendedby SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”*.*

 

All options granted under the plans had anexercise price equal to the market value of the underlying common stock on thedate of grant.

 

Cymer accounts foroptions granted to non-employees under SFAS No. 123 and EITF Issue No. 96-18,“Accounting for Equity Instruments that are Issued to other than Employees forAcquiring or in Conjunction with Selling Goods or Services”.  Cymer measures the fair value of such optionsusing the Black-Scholes option-pricing model at each financial reporting date.  Cymer accounts for changes in fair valuesbetween reporting dates in accordance with Financial Accounting Interpretation28.  Stock-based compensation expense foroptions granted to non-employees and for those employees who changed status forthe nine months ended September 30, 2003 and 2004 was $1.1 million and$126,000, respectively.

 

Under SFAS No. 123, theweighted average per share fair value of the options granted for the ninemonths ended September 30, 2003 and 2004 was $18.62 and $24.07, respectively,on the date of grant.  Fair value underSFAS No. 123 is determined using the Black-Scholes option-pricing model withthe assumptions noted below.  For riskfree interest, Cymer uses the then currently available rate on zero coupon U.S.Government issues with a remaining life of five years for valuing options andone year for valuing Employee Stock Purchase Plan (“ESPP”) shares.

 

8

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| ** **                            | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                  |       |                                  |       |                                 |       |   |   |   |   |
| Dividend yield                        |       | None                                  |       | None                                 |       | None |   | None |   |
| Volatility rate                       |       | 83                                    | %          | 79                                   | %          | 83 | % | 79 | % |
| Weighted average  risk free interest: |       |                                  |       |                                 |       |   |   |   |   |
| Options                               |       | 2.91                                  | %          | 3.51                                 | %          | 2.87 | % | 3.38 | % |
| ESPP                                  |       | N/A                                   |       | N/A                                  |       | 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 |   |

 

The following tablecompares earnings (loss) per share as reported by Cymer to the pro formaamounts that would be reported had compensation expense been recognized forCymer’s stock-based compensation plans in accordance with SFAS No. 123 (inthousands, except per share amounts):

 
| ** **                                                                                                                                        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                                                                        | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss), as reported                                                                                                                   |       | $                                     | (8,519     | )                                    | $          | 15,421 |   | $ | (17,074 | ) | $ | 32,778 |   |
| Add: Stock-based  employee compensation expense included in reported net income (loss), net of  related tax effects                               |       | 124                                   |       | (96                                  | )          | 446 |   | 106 |   |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects |       | (2,417                                | )          | (3,818                               | )          | (8,737 | ) | (12,826 | ) |
|                                                                                                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Pro forma net  income (loss)                                                                                                                      |       | $                                     | (10,812    | )                                    | $          | 11,507 |   | $ | (25,365 | ) | $ | 20,058 |   |
|                                                                                                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Earnings (loss)  per share:                                                                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Basic – as  reported                                                                                                                         |       | $                                     | (0.24      | )                                    | $          | 0.42 |   | $ | (0.49 | ) | $ | 0.89 |   |
| Basic – pro  forma                                                                                                                           |       | $                                     | (0.31      | )                                    | $          | 0.31 |   | $ | (0.73 | ) | $ | 0.55 |   |
|                                                                                                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Diluted – as  reported                                                                                                                       |       | $                                     | (0.24      | )                                    | $          | 0.41 |   | $ | (0.49 | ) | $ | 0.87 |   |
| Diluted – pro  forma                                                                                                                         |       | $                                     | (0.31      | )                                    | $          | 0.31 |   | $ | (0.73 | ) | $ | 0.53 |   |

 

**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 table sets forth thecomputation of diluted weighted average common and potential common sharesoutstanding for the three and nine months ended September 30, 2003 and 2004 (inthousands):

 

9

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| ** **                                                               | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                               | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                               | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic weighted  average common shares                                    |       |                                  |       |                                 |       |   |   |   |   |
| outstanding                                                              |       | 35,302                                |       | 36,788                               |       | 34,733 |   | 36,704 |   |
|                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Effect of  dilutive securities:                                          |       |                                  |       |                                 |       |   |   |   |   |
| Warrants                                                                 |       | —                                |       | —                               |       | — |   | 21 |   |
| Options                                                                  |       | —                                |       | 478                                  |       | — |   | 914 |   |
|                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Diluted weighted  average common and potential common shares outstanding |       | 35,302                                |       | 37,266                               |       | 34,733 |   | 37,639 |   |

 

Forthe three months ended September 30, 2003 and 2004, weighted average optionsand warrants to purchase 2,858,000 and 4,922,000 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 endedSeptember 30, 2003 and 2004, weighted average common shares attributable toconvertible subordinated notes of 5,000,000 and 4,572,000, respectively, werenot included in the computation of diluted earnings per share as their effectwas also anti-dilutive.

 

Forthe nine months ended September 30, 2003 and 2004, weighted average options andwarrants to purchase 4,311,000 and 2,978,000 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 nine months endedSeptember 30, 2003 and 2004, weighted average common shares attributable toconvertible subordinated notes of 5,000,000 and 4,856,000, respectively, werenot included in the computation of diluted earnings per share as their effectwas also anti-dilutive.

 

**4.****              INVENTORIES**

 

Inventories consist of the followingas of December 31, 2003 and September 30, 2004 (in thousands):

 
| ** **                                   | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|----------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| INVENTORIES:                                 |       |                   |       |                    |       |
| Raw materials                                |       | $                      | 37,393     |                    | $          | 47,453 |   |
| Work-in-progress                             |       | 26,949                 |       | 34,651                  |       |
| Finished goods                               |       | 40,698                 |       | 49,421                  |       |
| Allowance for  excess and obsolete inventory |       | (12,028                | )          | (10,900                 | )          |
| Total                                        |       | $                      | 93,012     |                    | $          | 120,625 |   |

 

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

 

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

 

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The following table summarizes the change in eachcomponent of accumulated other comprehensive loss for the nine months ended September30, 2004 (in thousands):

 
| ** **          | ** ** | ** **        | ** ** | **Translation  adjustment,  net of tax** | ** ** | **Total unrealized  gains on  available-for-sale  investments,  net of tax** | ** ** | **Total unrealized  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 |       | (793                                     | )          | (1,313                                                                       | )          | 2,545                                                                                      |       | 439                                         |       |
| September 30,  2004 |       | Balance           |       | $                                        | (5,266     | )                                                                            | $          | 135                                                                                        |       | $                                           | (164       | ) | $ | (5,295 | ) |

 

Comprehensive income (loss) consists of the following components (inthousands):

 
| ** **                                                                            | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                            | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                                                                  |       |                                  |       |                                 |       |   |   |   |   |
| Net income  (loss)                                                                    |       | $                                     | (8,519     | )                                    | $          | 15,421 |   | $ | (17,074 | ) | $ | 32,778 |   |
|                                                                                  |       |                                  |       |                                 |       |   |   |   |   |
| Foreign currency  translation adjustments, net of tax                                 |       | 1,104                                 |       | 296                                  |       | 977 |   | (793 | ) |
| Unrealized  losses on available for sale investments, net of tax                      |       | (495                                  | )          | (119                                 | )          | (456 | ) | (1,313 | ) |
| Unrealized gains  (losses) on foreign currency forward exchange contracts, net of tax |       | (1,957                                | )          | 1,359                                |       | (1,633 | ) | 2,545 |   |
|                                                                                  |       |                                  |       |                                 |       |   |   |   |   |
| Comprehensive  income (loss)                                                          |       | $                                     | (9,867     | )                                    | $          | 16,957 |   | $ | (18,186 | ) | $ | 33,217 |   |

** **

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

 

On January 23, 2004, Cymer entered into a research anddevelopment 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 nine months endedSeptember 30, 2004 were $2.1 million and $4.5 million, respectively.

 

On February 4, 2004, Cymer entered into anintellectual property license agreement with Intel for the use of certain Intelpatents 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 thisarrangement as of September 30, 2004.

 

**7.****              GOODWILLAND INTANGIBLE ASSETS**

 

As of the date of adoption of Statement of FinancialAccounting Standards No. 142 (“SFAS No. 142”), “Goodwill and Other IntangibleAssets”, on January 1, 2002, Cymer had unamortized goodwill in the

 

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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 quarter of 2003, Cymer completed its annualimpairment test of goodwill and intangible assets, and concluded that noimpairment of goodwill existed.

 

Aggregate amortization expense for identifiable intangibles, excludingpatents, was $120,000 for each of the nine months ended September 30, 2003 and2004.  As of September 30, 2004, futureestimated amortization expense is expected to be as follows (in thousands):

 

| ** **                             | ** ** | **Future  Amortization** | ** ** |
|----------------------------------------|------------|--------------------------|------------|
|                                   |       |                     |       |
| Three months  ending December 31, 2004 |       | $                        | 40         |   |
| Year ending  December 31, 2005         |       | $                        | 20         |   |

 

The following table summarizes the activity in the carrying amount ofgoodwill as of December 31, 2003 and September 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  September 30, 2004     |   | $      | 8,358  |   |

 

Also included in intangible assets – net on the accompanying balancesheets are amounts associated with patents that were acquired in 2001 and2003.  As of December 31, 2003 andSeptember 30, 2004, the net carrying amount of these patents was $12.7 millionand $11.0 million, respectively. Amortization expense for these patents was $323,000 and $593,000 for thethree months ended September 30, 2003 and 2004, respectively.  Amortization expense was $968,000 and $1.8million for the nine months ended September 30, 2003 and 2004, respectively.

 

As of September 30, 2004, future estimatedamortization expense for these patents is expected to be as follows (inthousands):

 

| ** **                             | ** ** | **Future  Amortization** | ** ** |
|----------------------------------------|------------|--------------------------|------------|
|                                   |       |                     |       |
| Three months  ending December 31, 2004 |       | $                        | 593        |   |
| 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        |   |

 

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

 

Cymer adopted the disclosureprovisions of Financial Accounting Standards Board Interpretation No. 45 (“FIN45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness to Others”, during the quarterended December 31, 2002 and has adopted the recognition and measurementprovisions as required after December 31, 2002. FIN 45 provides expanded accounting guidance surrounding liabilityrecognition and disclosure requirements related to guarantees, as defined bythis interpretation.

 

In the ordinary course of business, Cymer is notsubject to potential obligations under guarantees that fall within the scope ofFIN 45, except for standard warranty provisions associated with product sales,indemnification provisions related to intellectual property that are containedwithin many of its customer 

 

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agreements, and third-party bank guarantees forsubsidiary office lines of credit.  Allof these provisions give rise only to the disclosure requirements prescribed byFIN 45.

 

Product Warranties –Warranty provisions contained within Cymer’s customer agreements are generallyconsistent with those prevalent in the semiconductor equipment industry. Thewarranty period and terms vary by light source model.  In general, the light source system warrantyperiod ranges from 17 to 26 months after shipment.  Cymer also warrants consumables and spareparts sold to its customers and the coverage period varies by spare part typeas some types include time-based warranty periods and others includeusage-based warranty periods. On average, the warranty period for consumablesand spare parts is approximately six months from the date of shipment.  Cymer records a provision for warranty forall products, which is included in cost of product sales in the consolidatedstatements of operations and is recorded at the time that the related revenueis recognized. The warranty provision for light source systems is reviewedmonthly and determined using a financial model, which considers actualhistorical expenses, and potential risks associated with Cymer’s differentlight source system models. This financial model is then used to calculate thefuture probable expenses related to warranty and the required level of thewarranty provision.  The risk levels usedwithin this model are reviewed and updated as risk levels change over the lightsource system’s life cycle. The warranty provision for consumables and sparesis determined using actual historical data. For both light source systems andconsumables, if actual warranty expenditures differ substantially from Cymer’sestimates, revisions to the warranty provision would be required.  Actual warranty expenditures are recordedagainst the warranty provision as they are incurred.

 

Thefollowing table summarizes information related to Cymer’s warranty provisionfor the nine months ended September 30, 2004 (in thousands):

 
| ** **                                                               | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|
|                                                                     |       |     |       |
| Balance, January  1, 2004                                                |       | $        | 26,200     |   |
| Liabilities  accrued for warranties issued during the nine month period, |       |     |       |
| net of  adjustments and expirations                                      |       | 18,687   |       |
| Warranty  expenditures incurred during the nine month period             |       | (17,337  | )          |
| Balance,  September 30, 2004                                             |       | $        | 27,550     |   |

 

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 anyinfringement claims that arise related to Cymer’s products.  Under the indemnification clauses, Cymer willpay all costs and damages, including attorney’s fees, associated with suchsettlements or defenses, provided that the customer follows specific proceduresfor notifying Cymer of such claims and allows Cymer to manage the settlementproceedings. Due to the nature of these indemnification provisions, they areindefinite and extend beyond the term of the actual customer agreements.

 

An indemnificationprovision was also included in the contract manufacturing agreement with Seiko,which was terminated 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 theresearch and development agreement signed with Intel, Cymer also agreed toprovide Intel with indemnity against any infringement of the intellectualproperty rights of any third party arising from Intel’s purchase and/or use ofCymer’s EUV source systems.  Details ofsuch indemnity will be negotiated as part of a purchase agreement related topotential future products.

 

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Guarantees on SubsidiaryDebt – During the first quarter of 2003 and part of the second quarter of 2003,Cymer was party to a Parent Guarantee associated with a revolving LoanAgreement held by Cymer Japan. This guarantee was between a commercial bank inthe United States and Cymer.  The ParentGuarantee was entered into in 2001 in order to establish a banking relationshipbetween this commercial bank and Cymer Japan. Per the terms of the Parent Guarantee, Cymer guaranteed payment of anyobligations under the revolving loan agreement in the event that Cymer Japancould not make such payments due or defaulted on the loan.  Cymer Japan made all payments per the termsof the Loan Agreement and thus, Cymer did not incur any guarantor obligationsunder the Parent Guarantee.  Since CymerJapan is a wholly-owned subsidiary of Cymer and Cymer Japan recorded therevolving loan outstanding balance as a liability on its financial statements,the carrying amount of the liability was included in the consolidated balancesheets.  The Loan Agreement expired onJune 16, 2003 and was paid in full by Cymer Japan. The Loan Agreement was notrenewed on this expiration date and has not since been renewed.

 

**9.****                  ****CONVERTIBLE SUBORDINATED NOTES**

 

In February 2002, Cymerissued $250.0 million principal amount of unsecured fixed rate 3.50%convertible subordinated notes due February 15, 2009 with interest payable onFebruary 15 and August 15 of each year. These notes are convertible into sharesof Cymer common stock at a conversion rate of 20 shares per $1,000 principalamount or an effective conversion price of $50.00 per share. Cymer may redeemthe 2002 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. In the third quarter of 2004, Cymer repurchased, at adiscount to par, $49.2 million of these notes. As a result of this repurchase,Cymer recognized a gain on debt extinguishment of $911,000. As of September 30,2004, Cymer had $200.8 million convertible subordinated notes outstanding.

 

**10****.****           ****STOCKHOLDERS’ EQUITY**

 

*StockholderRights Plan*. On August 23, 2004, Cymer announced itsamendment to its Preferred Shares Rights Agreement (the “Agreement”) changingthe Agreement’s Final Expiration Date from February 13, 2008 to September 1,2004.  As a result of this amendment, theAgreement terminated on September 1, 2004. On September 2, 2004, Cymer filed with the Nevada Secretary of State towithdraw the Certificate of Designations of Rights, Preferences and Privilegesof Series A Participating Preferred Stock and the elimination from Cymer’sArticles of Incorporation of the Series A Participating Preferred Stock thathad been created in connection with the Agreement.

 

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

 

Cymer is party to legal actions inthe normal course of business.  Based inpart on the advice of legal counsel, management does not expect the outcome oflegal action in the normal course of business to have a material impact on thefinancial position or results of operations of Cymer.

 

Cymer’s former Japanese manufacturing partner, Seiko,and one of Cymer’s Japanese customers have been notified that Cymer’s lightsource systems in Japan may infringe certain Japanese patents held by anotherJapanese company.  Cymer has agreed toindemnify its former Japanese manufacturing partner and its customers againstpatent infringement claims under certain circumstances, even after thetermination date of the contract manufacturing agreement.  Cymer believes, based upon the advice ofcounsel, that Cymer’s products do not infringe any valid claim of the assertedpatents or that Cymer is entitled to prior use claims in Japan.

 

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

 

*In this section, references to “we”, “us” or “our” are references toCymer. The following discussion of our financial condition and resultsof operations should be read in conjunction with our consolidated financialstatements and notes thereto included in this quarterly report on Form 10-Q andour consolidated financial statements and notes thereto included in our annualreport on Form 10-K for the year ended December 31, 2003.*

 

**Forward Looking Statements**

 

Statementsin this quarterly report on Form 10-Q that are not strictly historical innature are forward-looking statements. These statements include, but are notlimited to, references to manufacturing activities; expected domestic andinternational product sales and development; service and support; research anddevelopment activities and expenditures; adequacy of capital resources andinvestments; effects of business cycles in the semiconductor business;competitive positioning; and relationships with customers and third-partymanufacturers for product manufacturing, and may contain words such as“believes,” “anticipates,” “expects,” and words of similar meaning. Thesestatements are only predictions based on current information and expectationsand involve a number of risks and uncertainties. The underlying information andexpectations are likely to change over time. Actual events or results may differ materially from those projected inthe forward-looking statements due to various factors, including, but notlimited to, those set forth under the caption “Risks and Uncertainties That MayAffect Results” and  elsewhere in thisquarterly report on Form 10-Q. Forward-looking statements herein speak only as of the date of thisquarterly report on Form 10-Q.

 

#### **Overview**

#### ** **

*General*

 

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

 

*Products and Services*

** **

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

 

Our photolithographylight sources produce narrow bandwidth pulses of short wavelength light withinthe DUV spectrum. The three DUV wavelengths are measured in nanometers(“nm”).  One nanometer equals onebillionth of a meter.  The light sourcesare referred to according to the gases mixed to produce the light or by thewavelength.  Krypton Fluoride (“KrF”)gases produce 248 nm light and Argon Fluoride (“ArF”) gases 193 nm light. Thelight sources permit very fine feature resolution for imaging the circuitry onthe 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,

 

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which are also called semiconductors or “chips”, that power many oftoday’s advanced consumer and business electronics. In the first nine months of2004, we sold 231 light source systems at an average selling price of $785,000.

 

Certain components andsubassemblies included in our light sources require replacement orrefurbishment following extended operation. For example, the discharge chamber of our light sources has an expectedlife of approximately three to sixteen billion pulses, depending on the model.We estimate that a light source used in a semiconductor production environmentwill require one to two replacement chambers per year, depending upon the levelof usage.  Similarly, certain 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 ofour installed base of light sources in production at chipmakers exceeds theoriginal warranty periods (generally 17 to 26 months from date of shipment),some chipmakers request service contracts from us.  Additionally, we provide service contractsdirectly to the three semiconductor lithography tool manufacturers. Thesecontracts require us to maintain and/or service these light sources either onan on-call or regular interval basis or both. Some of these contracts include replacement of consumable parts.

 

In addition to servicecontracts, we provide an on-line diagnostic product, CymerOnLineTM. CymerOnLineis a diagnostic 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 consumablesusage.  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.

 

# ***Semiconductor Industry Status andOutlook***

# ** **

Since we derive asubstantial portion of our revenues from lithography tool manufacturers, we aresubject to the volatile and unpredictable nature of the semiconductor industry.The semiconductor industry is highly cyclical in nature and historically hasexperienced periodic ups and downs. Since 2000, the last significant peak yearin the cycle, the semiconductor industry experienced one of the longestdownturns in its history during the time period from 2001 through late 2003.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 thisthree-year period.  We are very consciousof the 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 us for the next upturn. During the downturn which occurred during 2001 through 2003, we made severalsuch strategic investments including the completion of our new manufacturingfacilities in San Diego and Korea, the development and introduction of our newMaster Oscillator Power Amplifier (“MOPA”) technology and XL platform on whichall of our future DUV light sources are planned to reside, and the ongoing workto improve business processes that leverage the overall efficiency of ourworkforce.

 

In the latter half of 2003, there were severalindicators that the extended downturn in the semiconductor industry, whichstarted in 2001, was coming to an end and that an upturn was in sight.  During the final months of 2003, weexperienced strong order growth and our direct customers announced increasingorders and extended delivery times. In addition, the chipmakers’ utilization ofour DUV light sources exceeded the levels achieved in 2000, the peak of thelast upturn, and the mix of our light source models shipped shifted toward KrFproducts, reflecting the chipmakers’ need for more capacity expansion.  In addition to the positive industryindicators, which we saw at the end of 2003, we have experienced much higherrevenue levels and revenue growth from quarter to quarter during the first ninemonths of 2004.  From the end of 2003 tothe end of the third quarter of 2004, our sequential quarter over 

 

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quarter revenuegrowth ranged from 8% to 20%.  As aresult of these positive activities and industry indicators over the last year,we concluded that we were an upturn.

 

As soon as this most recent upturn became apparent,there was controversy over its potential duration and magnitude.  During the course of the third quarter of2004, though our business remained strong and we had received no net order pushouts, many semiconductor and equipment companies issued warnings aboutpotential shortfalls in revenue and earnings. Starting in October 2004, the reported decline in chip fab utilizationcaused some chipmakers to begin holding off on equipment purchases, includingthe purchase of lithography tools. Recently, we also received notification oflight source push outs from two of our direct customers and have begun to see areduction in light source system utilizations at chipmakers.  As a result of this uncertainty in thesemiconductor industry, our visibility as to the forecastability of theindustry cycle has become limited to less than one quarter.  Under these circumstances, we have decided totake actions that will prepare Cymer to deal effectively with what, at thistime, appears to be an industry slowdown that could persist potentially for afew quarters.

 

Since we cannot predict with any certainty the depthor duration of this apparent slowdown of the semiconductor industry, we havetaken actions to align our cost structure accordingly with these uncertainconditions.  In addition to taking anumber of steps to reduce our overall expenses, early in the fourth quarter of2004 we implemented a reduction in our workforce of approximately 14% onOctober 21, 2004.  Since we were able tokeep our headcount in line with the volume of our business during this mostrecent and brief upturn in 2004, this headcount adjustment primarily reflectsthe change in any volume production activities. In addition, since approximatelyone-third of the employees affected by this workforce reduction were temporaryemployees, we are preserving our ability to ramp up production again quickly inresponse to any potential re-acceleration of orders that may occur as we enter2005.

 

#### **Critical AccountingPolicies and Estimates**

#### ** **

The discussion andanalysis of our financial condition and results of operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States ofAmerica.  The preparation of thesefinancial statements requires us to make estimates and use judgment that mayimpact the reported amounts of assets, liabilities, revenues, expenses, and relateddisclosure of contingent assets and liabilities.  As a part of our ongoing internal processes,we regularly evaluate our estimates and judgments associated with revenuerecognition, inventory allowances, warranty provisions, income taxes,allowances for bad debts, long-lived assets valuation, intangible assetsvaluation, and contingencies and litigation. We base these estimates and judgments upon historical information andother facts and assumptions that we believe to be valid and/or reasonable underthe circumstances.  These assumptions andfacts form the basis for making judgments and estimates and for determining thecarrying values of our assets and liabilities that are not apparent from othersources.  Actual results could vary fromour estimates if we were to use different assumptions and conditions.

 

We believe that revenuerecognition, inventory allowances, warranty provisions, and income taxesrequire more significant judgments and estimates in the preparation of ourconsolidated financial statements than do other of our accounting estimates andjudgments.

 

*RevenueRecognition*

 

Our revenues consist ofproduct sales, which include sales of light source systems, consumable andspare parts, upgrades, service, service contracts and training. Our revenuesalso consist of other revenues, which include revenue from certain fundeddevelopment activities performed for customers and under government contractsand license agreements.  We do notrecognize any revenue for light source systems prior to shipment.  We test the systems in environments similarto those used by our customers prior to shipment to ensure that they meet thecustomers’ specifications and will interface with the customers’ software.  Our installation obligations are perfunctorywithin the framework of Staff Accounting Bulletin 104.  The shipping terms vary by customer for lightsource systems shipments.  The majorityof light source shipment terms are F.O.B. shipping point and revenue isrecognized upon shipment.  For thosecustomers with F.O.B. destination shipping terms, revenue is recognized upondelivery of the light source system to the customer.  One of our customers has an acceptanceprovision, which is satisfied by the issuance of an acceptance certificatefollowing a visual inspection of the system by the customer. We do notrecognize

 

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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-useracceptance of 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 estimated costs.Revenues generated from these types of funded development contracts are derivedfrom cost sharing contracts between certain customers and us. If milestones onthese funded development contracts require that specific results be achieved orreported by us, revenue is not recognized until that milestone iscompleted.  For some of the fundeddevelopment contracts that we enter into with customers and governmentagencies, we evaluate certain criteria to determine whether recording the fundsreceived as revenue is appropriate.  Ifcertain conditions are met, these funds are not recorded as revenue but  rather offset against our own internalresearch and development expenses in the period that the milestone is achievedor per the terms of the contract.

 

*InventoryAllowance*

 

We perform an analysis ofour inventory allowances on at least a quarterly basis to determine theadequacy of this allowance on our financial statements.  The amount of the inventory allowance isdetermined by taking into consideration certain assumptions related to marketconditions and future demands for our products, including changes to productmix, new product introductions, and/or product discontinuances, which mayresult in excess or obsolete inventory. We determine the level of excess andobsolete inventory associated with our raw materials and production inventoryby comparing the on hand inventory balances and inventory on order to the next12 months of forecasted demand.  We thenadjust this calculation for inventory that has a high likelihood of use beyondone year or can be used in other products that may have lower demands.  After this adjustment, we arrive at our totalexposure for excess and obsolete inventory within our raw materials andproduction inventory.  As part of thisanalysis, we also determine whether there are potential amounts owed to vendorsas a result of cancelled or modified raw material orders.  We estimate and record a separate liability,which is included in accrued, and other liabilities in the accompanying balancesheets for such amounts owed. For spare parts inventory, we calculate theinventory allowance based upon the level of information and analysis availablefor the particular spare parts warehouse location.  For certain of our spare parts warehouses,the inventory reserve is calculated using a detailed analysis which compares onhand balances and parts on order to the 12 month forecasted demand.  For the remaining spare parts warehouses, theinventory reserve is calculated using a percentage of the spare parts inventorybalances in those warehouses.  Thispercentage is calculated using certain estimates and assumptions and historicalinformation on the obsolescence of parts in these spare parts warehouses.

 

Both methodologies foranalyzing excess and obsolete inventory and determining the inventory allowanceare significantly affected by future demand and usage of our products.  There are many factors that could potentiallyaffect the future demand or usage of our products, 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 ourexperience, we believe that the estimates we use in calculating the inventoryallowance are reasonable and properly reflect the risk of excess and obsoleteinventory.  If actual demand or the usageperiods for our inventory are substantially different from our estimates,adjustments to our

 

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inventory allowance may be required, which could have a materialadverse effect on our financial condition and results of operations.

 

###### *WarrantyProvision*

###### * *

We maintain an accrualfor the estimated cost of product warranties associated with our productsales.  Warranty costs include thereplacement parts and labor costs to repair our products during the warrantyperiods.  At the time revenue isrecognized, we record a warranty provision, which is included in cost ofproduct sales in the accompanying consolidated statements of operations. Thewarranty coverage period and terms vary by light source model.  In general, the light source system warrantyperiod ranges from 17 to 26 months after shipment.  We also warrant consumables and spare partssold to our customers and the coverage period varies by spare part type as sometypes include time based warranty periods and others include usage basedwarranty periods.  On average, thewarranty period for consumables and spare parts is approximately six monthsfrom the date of shipment. The warranty provision for light source systems isreviewed monthly and determined by using a financial model, which takes intoconsideration actual historical expenses, and potential risks associated withour different light source systems.  Thisfinancial model is then used to estimate future expenses related to warrantyand the required warranty provision.  Therisk levels used within this model are reviewed and updated as risk levelschange over the light source system’s life cycle.  Due to the highly technical nature of ourlight source system products, the newer model light sources and the modulescontained within them have higher inherent warranty risks and require higherwarranty provisions. The warranty provision for consumables and spare parts isdetermined by using actual historical data.

 

We actively engage inproduct improvement programs and processes to limit our warranty costs, but ourwarranty obligation is affected by the complexity of our product, productfailure rates and costs incurred to correct those product failures at customersites. The industry in which we operate is subject to rapid technologicalchange, and as a result, we periodically introduce newer, more complex lightsources.  Although we classify thesenewly released light source models as having a higher risk in our warrantyfinancial model resulting in higher warranty provisions, we are more likely tohave differences between the estimated and actual warranty costs for these newproducts.  This is due to limited or nohistorical product performance data on which to base our future warrantycosts.  Warranty provisions for our olderand more established light source models are more predictable as we have morehistorical information available on these products.  If actual product failure rates or estimatedcosts to repair those product failures were to differ from our estimates,revisions to our estimated warranty provision would be required, which couldhave a material adverse effect on our financial condition and results ofoperations.

 

*Income Taxes*

* *

We account for income taxes in accordance withStatement of Financial Accounting Standards No. 109 (“SFAS 109”), “Accountingfor Income Taxes.”  Pursuant to SFAS 109, a deferred tax asset orliability is generally recognized for the estimated future tax effectsattributable to temporary differences, net operating loss carryforwards and taxcredit carryforwards.  Deferred tax assets are to be reduced by avaluation allowance if, based on the weight of available evidence, it is morelikely than not that some portion or all of the deferred tax assets will not berealized within the carryback or carryforward periods.  Information aboutan enterprise’s current financial position and its results of operations forthe current and preceding years, as well as all currently available informationabout future years should be considered.

 

We have considered our industry’s outlook for thefuture, our historical performance and estimated future taxable income, andongoing tax planning strategies in assessing the need for a valuationallowance.  Using this information, we have prepared a model to forecastour expected taxable income in future years in order to estimate when thebenefits of our deferred tax assets are likely to be realized.  Based uponthe analysis, we believe that it is more likely than not that the results offuture 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.

 

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A material adverse change in the outlook for worldwidelithography tool sales, in the expected selling prices or profit margins forour products, or in our expected share of the global market for lithographylight sources could cause us to determine that a valuation allowance is neededfor some or all of our deferred tax assets, and would result in an increase to ourincome tax provision in the period in which such determination is made.

 

**RESULTS OF OPERATIONS**

 

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

 
| ** **                                                                 | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                 | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Revenues:                                                                  |       |                                  |       |                                 |       |   |   |   |   |
| Product sales                                                              |       | 100.0                                 | %          | 99.6                                 | %          | 99.9 | % | 99.8 | % |
| Other                                                                      |       | —                                |       | .4                                   |       | .1 |   | .2 |   |
| Total revenues                                                             |       | 100.0                                 | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Cost and  expenses:                                                        |       |                                  |       |                                 |       |   |   |   |   |
| Cost of product  sales                                                     |       | 75.2                                  |       | 52.4                                 |       | 73.9 |   | 54.6 |   |
| Research and  development                                                  |       | 18.0                                  |       | 14.7                                 |       | 23.2 |   | 14.8 |   |
| Sales and  marketing                                                       |       | 6.0                                   |       | 5.4                                  |       | 6.4 |   | 6.0 |   |
| General and  administrative                                                |       | 32.3                                  |       | 7.7                                  |       | 17.0 |   | 7.9 |   |
| Amortization of  intangible assets                                         |       | .1                                    |       | .1                                   |       | .1 |   | .1 |   |
| Gain on debt  extinguishment                                               |       | —                                |       | (0.9                                 | )          | — |   | (0.3 | ) |
| Total costs and  expenses                                                  |       | 131.6                                 |       | 79.4                                 |       | 120.6 |   | 83.1 |   |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Operating income  (loss)                                                   |       | (31.6                                 | )          | 20.6                                 |       | (20.6 | ) | 16.9 |   |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Total other  income (expense) – net                                   |       | .1                                    |       | (0.8                                 | )          | (.2 | ) | (0.9 | ) |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Income (loss)  before income tax provision (benefit) and minority interest |       | (31.5                                 | )          | 19.8                                 |       | (20.8 | ) | 16.0 |   |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Income tax  provision (benefit)                                            |       | (18.9                                 | )          | 5.4                                  |       | (12.5 | ) | 4.0 |   |
| Minority  interest                                                         |       | (0.7                                  | )          | —                               |       | (.5 | ) | (0.7 | ) |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Net income  (loss)                                                         |       | (13.3                                 | )%         | 14.4                                 | %          | (8.8 | )% | 11.3 | % |
| Gross margin on  product sales                                             |       | 24.8                                  | %          | 47.4                                 | %          | 26.1 | % | 45.3 | % |

 

## **THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2004**

## ** **

*Revenues*.Our revenues consist of product sales, which include sales of light sourcesystems, consumable and spare parts, upgrades, service, service contracts andtraining. Our revenues also consist of other revenues, which include revenuefrom certain funded development activities performed for customers and undergovernment contracts and license agreements. We do not recognize any revenue for light source systems prior toshipment.  We test the systems inenvironments similar to those used by our customers prior to shipment to ensurethat they meet the customers’ specifications and will interface with thecustomers’ software.  Our installationobligations are perfunctory within the framework of Staff Accounting Bulletin104.  One of our customers has anacceptance provision, which is satisfied by the issuance of an acceptancecertificate following a visual inspection of the system by the customer. We donot recognize 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

 

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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 that are included inother revenue, funds received are accounted for on the percentage-of-completionmethod based on the relationship of costs incurred to total estimated costs.Revenues generated from these funded development contracts are derived fromcost sharing contracts between certain customers and us.  The costs associated with these particularcontracts are included in research and development expenses in the periodincurred and are not listed separately as other cost or expenses in theconsolidated statements of operations. If milestones on these funded development contracts require thatspecific results be achieved or reported by us, revenue is not recognized untilthat milestone is completed.  For some ofthe funded development contracts that we enter into with customers andgovernment agencies, we evaluate certain criteria to determine whetherrecording the funds received as revenue is appropriate.  If certain conditions are met, these fundsare not recorded as revenue and are rather offset against our own internalresearch and development expenses in the period that the milestone is achievedor per the terms of the contract.

 

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

 
| ** **                                       | ** ** | **Three months ended  September 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2003**                              | ** ** | **2004** | ** ** |
|                                             |       |                                  |       |   |   |
| Light source  systems:                           |       |                                  |       |   |   |
| Revenue                                          |       | $                                     | 39,163     |   | $ | 67,717 | (1) |
| Units sold                                       |       | 34                                    |       | 86 |   |
| Average selling  price                           |       | $                                     | 1,152      |   | $ | 798 |   |
|                                             |       |                                  |       |   |   |
| Consumable and  spare parts and service products |       | $                                     | 24,710     |   | $ | 39,034 |   |
| Other revenue                                    |       | $                                     | —     |   | $ | 389 |   |
|                                             |       |                                  |       |   |   |
| Total revenue                                    |       | $                                     | 63,873     |   | $ | 107,140 |   |

 

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(1)     Net of deferred light source revenue of$943,000, which reflects one customer’s retention where light source revenue isdelayed  to align with the end-useracceptance of the integrated scanner containing our light source.

 

Product sales increased67% from $63.9****million for the three monthsended September 30, 2003 to $106.8 million for the three months ended September30, 2004, primarily due to a 73% increase in light source system revenue from$39.2 million in the three months ended September 30, 2003 to $67.7 million inthe three months ended September 30, 2004. A total of 34 light source systems were sold in the three months endedSeptember 30, 2003 at an average selling price of $1.2 million, compared to 86systems sold in the three months ended September 30, 2004 at an average sellingprice of $798,000.  On a foreign currencyadjusted basis, the average selling price for the three months ended September30, 2003 was $1.1 million compared to $798,000 for the three months endedSeptember 30, 2004. The decrease in the average selling price from period toperiod reflects the shift in the product mix to our lower priced KrF productsin the third quarter of 2004.  Productsales were further increased from period to period due to a 58% increase insales of consumable and spare parts and service products from $24.7 million inthe three months ended September 30, 2003 to $39.0 million in the three monthsended September 30, 2004.  The increasein this type of product sales was due to increased utilization of our DUV lightsource by chipmakers and an increased installed base in the three months endedSeptember 30, 2004.  There were

 

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no revenues from funded development contracts for the three monthsended September 30, 2003, compared to revenues from funded developmentcontracts of $389,000 for the three months ended September 30, 2004.  As a result of the current market conditions,we expect our revenue to decrease approximately 10% in the fourth quarter of2004 compared to the third quarter 2004 levels.

 

Our backlog at September30, 2003 was $109.5 million compared to $104.6 million at September 30,2004.  Bookings for the three monthsended September 30, 2003 and September 30, 2004 were $72.0 million and $104.0million, respectively.  The book-to-billratio for the three months ended September 30, 2003 was 1.14 compared to 0.97for the three months ended September 30, 2004. The increase in overall bookings was primarily due to the short threequarter upturn in the semiconductor industry in 2004 that resulted in highersystems bookings and record bookings of consumable and spare parts in the thirdquarter of 2004.

 

 We installed 48 light sources at chipmakersand other end-users during the quarter ended September 30, 2003 as compared to76 light sources installed during the quarter ended September 30, 2004.

 

Sales to our threelargest customers, ASM Lithography, Canon, and Nikon, amounted to 21%, 27% and22%, respectively, of total revenue for the three months ended September 30,2003, and 39%, 7% and 25%, respectively, of total revenue for the three monthsended September 30, 2004.

 

Our sales are generatedprimarily by shipments to customers in Japan, Europe, and the UnitedStates.  Approximately 90% and 87% of oursales for the three months ended September 30, 2003 and 2004, respectively,were derived from customers outside the United States.  We maintain a wholly-owned Japanesesubsidiary, which sells to our Japanese customers.  Revenues from Japanese customers, generatedprimarily by this subsidiary, accounted for 48% and 31% of total revenues in thethree months ended September 30, 2003 and 2004, respectively.  The activities of our Japanese subsidiary arelimited to sales and service of products purchased by the subsidiary from theparent corporation.  We anticipate thatinternational sales will continue to account for a significant portion of ournet 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 productsales.  We do not charge our customersfor shipping fees and such costs are not significant.

 

The cost of product sales increased 17% from $48.0million for the three months ended September 30, 2003 to $56.1 million for thethree months ended September 30, 2004. This increase in the cost of productsales from period to period is primarily due to the overall increase in productsales from period to period. Both light source system sales and sales ofconsumables and spare parts and service products were higher in the threemonths ended September 30, 2004 compared to the same three-month period in2003. This increase in the cost of product sales was partially offset by theproduct costs associated with the shift in the product mix to the lower costsKrf products and our overall material cost reduction targets on a variety ofproducts.

 

The gross margin on product sales was 24.8% for thethree months ended September 30, 2003 as compared to 47.4% for the samethree-month period in 2004.  This highergross margin is primarily due to the improved efficiencies and costs associatedwith our XL series light source and the shift to our lower cost and highermargin 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.  As a result of the apparentslowdown in the semiconductor industry and the related uncertainties, we do notanticipate being able to sustain the high level of gross margin that weexperienced during the third quarter of 2004. In response to the current industry conditions, we have decided toreduce our inventory levels which will have a negative effect on our gross marginby several points due to reduced factory loading.

 

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*Researchand Development*. Research and development expenses include costs of internally-funded andexternally-funded projects as well as continuing product development supportexpenses, which consist primarily of employee and material costs, depreciationof equipment and other engineering related costs.  Our research and development expenses areoffset by amounts associated with certain of our externally funded research anddevelopment contracts.  Research anddevelopment expenses increased 38% from $11.5 million for the three monthsended September 30, 2003 to $15.8 million for the three months ended September30, 2004, due primarily to costs associated with our EUV light sourcedevelopment, new business opportunity development and costs associated with theprofit sharing and bonus plans, which were earned by employees in the thirdquarter of 2004. In addition to our development of EUV, we also continued tofocus on next generation KrF and ArF products based on the XL platform.  Total amounts recorded as offsets to ourresearch and development costs from externally funded research and developmentcontracts were $563,000 and $2.4 million for the three months ended September30, 2003 and 2004, respectively.  As apercentage of total revenues, research and development expenses decreased from18.0% for the three months ended September 30, 2003 to 14.7% for the same three-monthperiod in 2004 due primarily to lower revenues in 2003 compared to 2004.  We expect research and development expensesto remain at about this dollar level during the next few quarters due to ourspending on EUV development and other product development opportunityinvestigations.

 

*Sales andMarketing*. Sales and marketing expenses include the expensesof the sales, marketing and customer support staff and other marketingexpenses.  Sales and marketing expensesincreased 49% from $3.9 million for the three months ended September 30, 2003to $5.8 million for the three months ended September 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 earned by employees in the thirdquarter of 2004 and increased marketing expenses associated with ourinternational subsidiaries recorded in the three months ended September 30,2004.  As a percentage of total revenues,such sales and marketing expenses decreased from 6.0% for the three monthsended September 30, 2003 to 5.4% for the same three-month period in 2004.  We anticipate sales and marketing expenses toremain relatively flat in dollar spending with the third quarter levels for theremainder of 2004.

 

*Generaland Administrative*. General and administrative expensesconsist primarily of management and administrative personnel costs,professional services and administrative operating costs.  General and administrative expenses decreased60% from $20.6 million for the three months ended September 30, 2003 to $8.2million for the three months ended September 30, 2004 due primarily to a $15.6million tenant improvement write-off associated with the facilities which wevacated during the third quarter of 2003. General and administrative expenses in the three months ended September30, 2004 included $1.4 million in costs associated with revisions of ourestimates related to the timing and market rates for subleasing our San Diegoand Boston facilities, which we exited in 2003, as well as expenses associatedwith our bonus and profit sharing plans, which were earned by employees in thethird quarter of 2004.   As a percentageof total revenues, such expenses decreased from 32% for the three months endedSeptember 30, 2003 to 8% for the same three-month period in 2004.  We anticipate general and administrativeexpenses in dollars to remain relatively flat in dollar spending with the thirdquarter levels for the remainder of 2004.

 

*Amortizationof Intangible Assets. *Amortizationof intangible assets totaled $40,000 for both three-month periods endedSeptember 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”) which wascompleted in early 2001.  With ouradoption of SFAS No. 142 on January 1, 2002, we discontinued the amortizationof goodwill with indefinite useful life associated with previous purchasebusiness combinations.  Amortizationexpense for patents which is included in research and development expenses andcost of product sales was $323,000 and $593,000 for the three months endedSeptember 30, 2003 and 2004, respectively.

 

*Gainon Debt Extinguishment.*In February 2002, we issued $250.0million principal amount of unsecured fixed rate 3.50% convertible subordinatedto fund our operations. These notes are due February 15, 2009 with interestpayable on February 15 and August 15 of each year. In the third quarter of2004, we repurchased, at a discount to par, $49.2 million of these notes. As aresult of this repurchase, we recognized a gain on debt extinguishment of$911,000 for the three months ended September 30, 2004.

 

*TotalOther Income (Expense) - Net.* Net other income (expense) consists primarily of interest income andexpense and foreign currency exchange gains and losses associated withfluctuations in the value of the functional currencies of our foreignsubsidiary offices against the United States dollar.  Net

 

23

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other income totaled $30,000 for the three months ended September 30,2003 compared to net other expense of $826,000 million for the three monthsended September 30, 2004.  The changefrom net other income to net other expense was primarily due to foreigncurrency exchange losses recorded in the third quarter of 2004 compared toforeign currency exchange gains recorded in the third quarter of 2003.  The foreign currency loss in the thirdquarter of 2004 reflects the loss of $1.1 million from our discontinuance ofcertain cash flow hedges.  These otherexpenses in the third quarter of 2004 were offset by a $281,000 gain recordedfor a sale of investments during the quarter and slightly reduced interestexpense associated with our lower bond balances at the end of the third quarterof 2004.  Foreign currency exchange gainstotaled $482,000, interest income totaled $2.1 million and interest expensetotaled $2.5 million for the three months ended September 30, 2003, compared toforeign currency exchange losses of $928,000, interest income and other incomeof $2.4 million and interest expense of $2.3 million for the three months endedSeptember 30, 2004.

 

*Income Tax Provision (Benefit)*.  The tax benefit of $12.1 million and the taxprovision of $5.8 million for the three months ended September 30, 2003and 2004, respectively, reflect an annual effective rate of 60% and 25%,respectively.  The change in the annual effective tax rate from abenefiting rate of 60% during the three months ended September 30, 2003 toa provision rate of 25% for the three months ended September 30, 2004 isprimarily attributable to the increase in pre-tax earnings as well as taxbenefits from U.S. export incentive programs and research and development andmanufacturing investment credits.  The annual effective tax rates for bothperiods are less than the U.S. statutory rate of 35% primarily as a result ofpermanent book/tax differences and tax credits.  The effective tax rate isa function of current tax law and geographic location of pre-tax income. OnOctober 22, 2004, the American Jobs Creation Act of 2004 was enacted in theUnited States. We are currently evaluating the impact of this new law on ouroperations and effective tax rate. At this time, we are unable to determine theeffects of this new law and will continue to analyze its potential impact asguidance is made available.

 

## **NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2004**

## ** **

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

 
| ** **                                       | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2003**                             | ** ** | **2004** | ** ** |
|                                             |       |                                 |       |   |   |
| Light source  systems:                           |       |                                 |       |   |   |
| Revenue                                          |       | $                                    | 118,544    |   | $ | 179,097 | (1) |
| Units sold                                       |       | 121                                  |       | 231 |   |
| Average selling  price                           |       | $                                    | 980        |   | $ | 785 |   |
|                                             |       |                                 |       |   |   |
| Consumable and  spare parts and service products |       | $                                    | 74,842     |   | $ | 110,247 |   |
| Other revenue                                    |       | $                                    | 57         |   | $ | 624 |   |
|                                             |       |                                 |       |   |   |
| Total revenue                                    |       | $                                    | 193,443    |   | $ | 289,968 |   |

 

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(1)          Net of deferred lightsource revenue of $2.2 million, which reflects one customer’s retention wherelight source revenue is delayed  to alignwith the end-user acceptance of the integrated scanner containing our lightsource.

 

*Revenues*.  Product sales increased 50% from $193.4****million for the nine months ended September 30, 2003 to$289.3****million for the nine months endedSeptember 30, 2004, primarily due to a 51% increase in light source systemsrevenue from $118.5 million in the nine months ended September 30, 2003 to$179.1 million in the nine months ended September 30, 2004.  A total of 121 light source systems were soldin the nine months ended September 30, 2003 at an average selling price of$980,000, compared to 231 systems sold in the nine months ended September 30,2004 at an average selling price of $785,000. On a foreign currency adjusted basis, the average selling price for thenine months ended 

 

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September 30, 2003 was $966,000 compared to $776,000for the nine months ended September 30, 2004. The decrease in the averageselling price from period to period reflects the shift in the product mix toour lower priced KrF products in the first nine months of 2004.  Product sales were further increased due to a47% increase in sales of consumable and spare parts and service products from$74.8 million in the nine months ended September 30, 2003 to $110.2 million inthe nine months ended September 30, 2004. The increase in this type of product sales was due to increasedutilization of our DUV light sources by chipmakers and an increased installedbase in the nine months ended September 30, 2004. Revenues from fundeddevelopment contracts were $57,000 and $624,000 for the nine months endedSeptember 30, 2003 and 2004, respectively.

 

Approximately 90% and87% of our sales for the nine months ended September 30, 2003 and 2004, respectively,were derived from customers outside the United States. Revenues from Japanesecustomers, generated primarily by our wholly-owned Japanese subsidiary,accounted for 46% and 35% of total revenues in the nine months ended September30, 2003 and 2004, respectively.

 

Sales to our threelargest customers, ASM Lithography, Canon, and Nikon, amounted to 22%, 26% and22%, respectively, of total revenue for the nine months ended September 30,2003, and 35%, 14% and 21%, respectively, of total revenue for the nine monthsended September 30, 2004.

 

*Cost of Product Sales*.  The cost of product sales increased 11% from$142.9 million for the nine months ended September 30, 2003 to $158.3 millionfor the nine months ended September 30, 2004. This increase in the cost ofproduct sales from period to period is primarily due to the overall increase insales from period to period.  Both lightsource system sales and sales of consumables and spare parts and serviceproducts were higher in the nine months period ended September 30, 2004compared to the same nine-month period in 2003. Although our cost of product sales were higher in absolute dollars inthe nine months ended September 30, 2004 compared to the same period in 2003,cost of product sales in 2004 included significant cost reduction achievementsfor our XL series products, from both a material cost and labor efficiencystandpoint, and lower costs associated with our KrF light source systems, whichwere the majority of our system unit shipments in the nine months endedSeptember 30, 2004.

 

The gross margin on product sales was 26.1% for thenine months ended September 30, 2003 as compared to 45.3% for the samenine-month period in 2004.  This highergross margin in 2004 reflects improved efficiencies associated with the XLseries product, ongoing overall manufacturing cost reduction efforts andincreased factory yield and utilization. As a result of the current slowdown in the semiconductor industry andour plans to reduce inventory levels, we do not anticipate that we will be ableto sustain the high level of gross margin that we experienced during 2004. 

 

*Researchand Development*. Research and development expenses decreased 4% from $44.9 million forthe nine months ended September 30, 2003 to $43.0 million for the nine monthsended September 30, 2004. During the nine months of 2003, research anddevelopment spending was due primarily to the high costs associated with thefinal productization and introduction of the XLA 100 light source, which wasshipped in the first quarter of 2003. For the nine months ended September 30,2004, research and development spending represented costs associated with theprofit sharing and bonus plans attributable to research and developmentpersonnel, which were earned by employees during the nine months endedSeptember 30, 2004, and costs associated with our EUV light source developmentefforts and new business development investigations.   We also continued to invest in nextgeneration KrF and ArF products based on the XL platform. Amounts funded byexternal research and development contracts totaled $1.0 million and $6.0million for the nine months ended September 30, 2003 and 2004, respectively. Asa percentage of total revenues, research and development expenses decreased from23.2% for the nine months ended September 30, 2003 to 14.8% for the samenine-month period in 2004 due to the combination of higher revenue and lowerexpenses from period to period.

 

*Sales andMarketing*.  Sales andmarketing expenses increased 41% from $12.4 million for the nine months endedSeptember 30, 2003 to $17.5 million for the nine months ended September 30,2004.

 

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This increase in sales and marketing expenses from period to periodprimarily reflects the expenses associated with the profit sharing and bonusplans, which were earned by employees in all three quarters of 2004. Thisincrease in expenses also reflects increases in marketing expenses associatedwith our international subsidiaries recorded in the nine months ended September30, 2004. As a percentage of total revenues, such sales and marketing expensesdecreased slightly from 6.4% for the nine months ended September 30, 2003 to6.0% for the same nine-month period in 2004.

 

*Generaland Administrative*. General and administrative expensesdecreased 30% from $32.9 million for the nine months ended September 30, 2003to $23.0 million for the nine months ended September 30, 2004 due primarily tothe $15.6 million tenant improvement write-off associated with the facilitiesvacated in the third quarter of 2003. This decrease in expenses from period to period was partially offset byexpenses associated with the profit sharing and bonus plans, which were earnedby employees in the nine months ended September 30, 2004 as well as increasedconsulting and advisory fees associated with the implementation of theSarbanes-Oxley section 404 requirements. As a percentage of total revenues, such expenses decreased from 17.0%for the nine months ended September 30, 2003 to 7.9% for the same nine-monthperiod in 2004 due to both higher revenues and lower expenses from period toperiod.

 

*Amortizationof Intangible Assets. *Amortizationof intangible assets totaled $120,000 for both nine-month periods ended September30, 2003 and 2004. This amortization of intangible assets expense is consistentfrom year to year and relates to the existing technology associated with theacquisition of ACX, which was completed in early 2001.  With our adoption of SFAS No. 142 on January1, 2002, we discontinued the amortization of goodwill with indefinite usefullife associated with previous purchase business combinations.  Amortization expense for patents which isincluded in research and development expenses and cost of product sales was$968,000 and $1.8 million for the nine months ended September 30, 2003 and2004, respectively.

 

*Gain onDebt Extinguishment.*In February 2002, we issued $250.0million principal amount of unsecured fixed rate 3.50% convertible subordinatedto fund our operations. These notes are due February 15, 2009 with interestpayable on February 15 and August 15 of each year. In the third quarter of2004, we repurchased, at a discount to par, $49.2 million of these notes. As aresult of this repurchase, we recognized a gain on debt extinguishment of$911,000 for the nine months ended September 30, 2004.

 

*TotalOther Expense – Net*.  Net other expense totaled $481,000 and $2.7million for the nine months ended September 30, 2003 and 2004,respectively.  The increase in net otherexpense was primarily due to foreign currency exchange losses recorded in thenine months ended September 30, 2004 and decreases in interest income fromperiod to period. The foreign currency loss in 2004 reflects the loss of $1.1million from our discontinuance of certain cash flow hedges. The decreasedinterest income from period to period was primarily due to lower marketinterest rates for our short-term and long-term investments in the first ninemonths of 2004 as compared to the first nine months of 2003.  This increase in expense from period toperiod was partially offset by a $281,000 gain on sale of investment recordedin the third quarter of 2004 and reduced interest expense associated with ourlower bond balances at the end of the third quarter of 2004. Foreign currencyexchange gains totaled $65,000, interest income totaled $7.0 million andinterest expense totaled $7.5 million for the nine months ended September 30,2003, compared to foreign currency exchange losses of $1.3 million, interestincome of $5.9 million and interest expense of $7.4 million for the nine monthsended September 30, 2004.

 

*Income Tax Provision (Benefit)*.  The tax benefit of $24.2 million and the taxprovision of $11.6 million for the nine months ended September 30, 2003and 2004, respectively, reflect an annual effective rate of 60% and 25%,respectively.  The change in the annual effective tax rate from abenefiting rate of 60% during the nine months ended September 30, 2003 toa provision rate of 25% for the nine months ended June 30, 2004 isprimarily attributable to the increase in pre-tax earnings as well as taxbenefits from U.S. export incentive programs and research and development andmanufacturing investment credits. The annual effective tax rates for bothperiods are less than the U.S. statutory rate of 35% primarily as a result ofpermanent book/tax differences and tax credits.  The effective tax rate isa function of current tax law and geographic location of pre-tax income. OnOctober 22, 2004, the American Jobs Creation Act of 2004 was enacted in theUnited States. We are currently evaluating the impact of this new law on ouroperations and effective tax rate. At this time, we are unable to determine theeffects of this new law and will continue to analyze its potential impact asguidance is made available.

 

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## **LIQUIDITY AND CAPITAL RESOURCES**

## ** **

As of September 30, 2004,we had approximately $217.2 million in cash and cash equivalents, $97.1 millionin short-term investments, $43.8 million in long-term investments, and $435.1million in working capital.

 

InFebruary 2002, we issued $250.0 million in aggregate principal amount in aprivate placement of notes.  These 2002Notes are due on February 15, 2009 with interest payable semi-annually onFebruary 15 and August 15 of each year at 31⁄2% per annum.  The 2002 Notes are convertible into shares ofour common stock at a conversion rate of 20 shares per $1,000 principal amountor an effective conversion price of $50.00 per share.  We used a portion of the net proceeds fromthis private placement to redeem the convertible subordinated notes thenoutstanding. The remaining proceeds will be used for our future operating, investingand financing activities.

 

Net cash used inoperating activities was approximately $17.1 million for the nine months endedSeptember 30, 2003, compared to $18.6 million net cash provided by operatingactivities for the nine months ended September 30, 2004.  Net cash used in operating activities for thenine months ended September 30, 2003 reflects the net loss for the period,higher accounts receivable balances, primarily due to the timing of sales andrelated customer invoicing late in the quarter, and decreases in accountspayable, accrued liabilities and income taxes for the period.  This use of cash in the first nine months of2003 was partially offset by a decrease in inventories.  Net cash provided by operating activities forthe nine months ended September 30, 2004 primarily reflects net income for theperiod and increases in accounts payable and other liabilities offset byincreases in accounts receivable and inventories.  The increase in accounts receivable is theresult of an unusually large portion of product shipments being made in thefinal month of the quarter ended September 30, 2004.  The increase in inventories was primarily dueto our response to the growing light source utilizations that we saw throughout2004 and our preparation from a spare parts standpoint for what we thought wasa continued upturn in the semiconductor industry.

 

Net cash used ininvesting activities was approximately $18.2 million for the nine months endedSeptember 30, 2003 compared to $5.3 million in cash provided by investingactivities for the nine months ended September 30, 2004.  Net cash used in investing activities for thenine months ended September 30, 2003 was due primarily to the constructioncosts associated with our new manufacturing and office facility in San Diegoand purchases of required manufacturing equipment for the new facility.  This capital expenditure during the firstnine months of 2003 was offset by the timing of short-term and long-terminvestments that matured and were reinvested during the period.  Net cash provided by investing activities forthe nine months ended September 30, 2004 was due primarily to the timing ofshort-term and long-term investments maturing and being reinvested during thequarter, offset by a $6.0 million payment to acquire certain patents and a $2.0million payment to acquire an additional 6% minority interest in our CymerKorea subsidiary.

 

Net cash provided byfinancing activities was approximately $24.6 million for the nine months endedSeptember 30, 2003 as compared to net cash used in financing activities of$36.0 million for the nine months ended September 30, 2004.  Net cash provided by financing activities forthe nine months ended September 30, 2003 was due primarily to proceeds receivedfrom the exercise of employee stock options totaling $31.3 million, offset by a$6.7 million payoff of our Japanese revolving loan that was made during thenine months ended September 30, 2003. Net cash used in financing activities for the nine months endedSeptember 30, 2004 reflects the repurchase of approximately $49.2 million ofour convertible subordinated notes during September 2004.  This was offset by proceeds received from theexercise of stock options totaling $11.4 million during the first nine monthsof 2004.

 

During the nine months ended September 30, 2003, wehad certain loan agreements with a commercial bank, which provided forunsecured revolving loan facilities allowing for borrowings of $10.0 millionand $20.0 million under a U.S. line of credit and Japanese line of credit,respectively.  Under the

 

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loan agreements,we were able to borrow in U.S. dollars or Japanese yen, and interest accrued onoutstanding borrowings at LIBOR plus 1.75% on U.S. dollar-denominatedborrowings and at the yen cost of funds rate plus 1.5% on yen-denominatedborrowings. The loan agreements required us to maintain compliance with certainfinancial and other covenants, including tangible net worth, quick ratio andprofitability requirements.  The loanagreements expired on June 16, 2003 and were not renewed.

 

Since our initial****public offering and a secondary public offering, both in1996, we have funded our operations primarily from cash generated fromoperations, the proceeds of the note offerings in August 1997 and February2002, bank borrowings, and the proceeds from employee stock option exercises.

 

We require substantialworking capital to fund our business, particularly to finance inventories,including purchase orders with our vendors, accounts receivable, and for capitalexpenditures. Our future capital requirements depend on many factors, includingour manufacturing activity, the timing and extent of spending to supportproduct development efforts, expansion of sales and marketing and field serviceand support, competitive labor market compensation requirements, the timing ofintroductions of new products and enhancements to existing products, and themarket acceptance of our products. We believe that we have sufficient workingcapital to sustain operations and provide for the future expansion of ourbusiness for at least the next 12 months.

 

                   AtSeptember 30, 2004, we did not have any relationship with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance variable interest, or special purpose entities, which wouldhave been established for the purpose of facilitating off-balance sheetarrangements or other contractually narrow or limited purposes.  In addition, we did not engage in tradingactivities 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.

 

**RECENT ACCOUNTING PRONOUNCEMENTS**

 

On March 31, 2004, FASB issued a proposed statement,“Share-Based Payment - An Amendment to Statement Nos. 123 and 95,” thataddresses the accounting for share-based payment transactions in which anenterprise receives employee services in exchange for (a) equity instruments ofthe enterprise or (b) liabilities that are based on the fair value of the enterprise’sequity instruments or that may be settled by the issuance of such equityinstruments. The proposed statement would eliminate the ability to account forshare-based compensation transactions using APB Opinion No. 25, “Accounting forStock Issued to Employees,” and generally would require instead that suchtransactions be accounted for using a fair-value-based method.  While the final statement is subject tochange, it is currently expected that it will become effective for periodsbeginning after June 15, 2005, which would be our third quarter in 2005.  We will continue to monitor activity on thissubject from the FASB in order to determine the impact on our consolidatedfinancial statements.

 

#### **Risksand Uncertainties That May Affect Results**

#### ** **

*The risks described below may not be the only risks we face. Additionalrisks that we do not currently think are material may also impair our businessoperations.  If any of the events orcircumstances described in the following risks actually occur, our business, financialcondition or results of operations could suffer, and the trading price of ourcommon stock could decline.*

 

Ourrevenues and operating results from quarter-to-quarter have varied in the pastand our future operating results may continue to fluctuate significantly due tomany factors including those listed in this section and throughout thisquarterly report on Form 10-Q. These factors include:

 

•                       demand for semiconductors in general and, inparticular, for leading edge devices with smaller circuit geometries;

•                       cyclicality in the market for semiconductormanufacturing equipment;

 

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•                       rates at which chipmakers take delivery ofphotolithography tools from lithography tool manufacturers (“our customers”);

•                       rates at which our customers take delivery oflight source systems from us;

•                       timing and size of orders from our small base ofcustomers;

•                       product lead time demands from our customers andthe chipmakers;

•                       mix of light source models, consumable and spareparts and service revenues in our total revenues;

•                       changes in the price and profitability of ourproducts;

•                       our ability to develop and implement newtechnologies and introduce new products;

•                       changes in market penetration by our competitors;

•                       utilization rates of light sources and sales ofconsumable and spare parts and services;

•                       our ability to manage our manufacturingrequirements;

•                       foreign currency exchange rate fluctuations,principally with respect to the Japanese yen (in which sales by our Japanesesubsidiary are denominated);

•                       worldwide political instability;

•                       changing global economic conditions; and

•                       intellectual property protection.

 

Wehave historically derived a large portion of our quarterly and annual revenuesfrom selling a small number of light source systems. Because we sell a smallnumber of products, the precise time that we recognize revenue from an ordermay have a significant impact on our total revenue for a particular period. Ourcustomers may cancel or reschedule orders with little or no penalty. Ordersexpected in one quarter could shift to another period due to changes in theanticipated timing of customers’ purchase decisions or rescheduled deliverydates requested by our customers. Our operating results for a particular quarteror year may be adversely affected if our customers, particularly our threelargest customers, cancel or reschedule orders, or if we cannot fill orders intime due to unexpected delays in manufacturing, testing, shipping, and productacceptance.

 

We manageour expense levels based, in large part, on expected future revenues. As aresult, our expenses are relatively fixed for the short term, and if our actualrevenue decreases below the level we expect, our operating results will beadversely affected.  As a result of theseor other factors, we could fail to achieve our expectations as to futurerevenue, gross profit and operating income. Our failure to meet the performance expectations set and published byexternal sources could result in a sudden and significant drop in the price ofour stock, particularly on a short-term basis, and could negatively affect thevalue of any investment in our stock.

 

**Ourbusiness depends on the semiconductor equipment industry, which is highlyvolatile and unpredictable.**

** **

Thesemiconductor industry is highly cyclical. We derive a substantial percentageof our revenues from lithography tool manufacturers within the semiconductorindustry. Our customers depend in turn on the demand for their photolithographytool products from their customers, the chipmakers. The capital equipmentexpenditures of chipmakers depend on a number of factors, including the currentand anticipated market demand for semiconductors and products usingsemiconductors.

 

Thesemiconductor industry is cyclical in nature and historically has experiencedperiodic ups and downs and currently appears to be slowing after a short threequarter upturn that followed a significant and prolonged three-year downturn.This cyclical nature of the industry in which we operate affects our ability toaccurately predict future revenue and thus, future expense levels. Whencyclical fluctuations result in lower than expected revenue levels, operatingresults may be adversely affected and cost reduction measures may be necessaryin order for 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 toindustry cycles.

 

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Webelieve the industry has paused, particularly in regards to purchasing capacitydriven semiconductor manufacturing equipment. Therefore, we are not able to predict with any certainty the depth orduration of the apparent slowdown of the semiconductor industry or the timingand order of magnitude of any future recovery. The previous downturn had a severe effect on the demand forsemiconductor manufacturing equipment, including photolithography tools thatour customers produce.  If overall marketconditions deteriorate in the near term, our current operating levels maynegatively impact our profitability. We believe that downturns in thesemiconductor industry will occur periodically, and result in periodicdecreases in demand for all semiconductor manufacturing equipment, includingphotolithography tools our customers manufacture. As a result, fluctuatinglevels of investment by chipmakers and pricing volatility will continue tomaterially affect our aggregate bookings, revenues and operating results. Also,even during periods of reduced revenues we believe we must continue to investin research and development and to maintain extensive ongoing worldwidecustomer service and support capabilities to remain competitive, which maytemporarily harm our financial results. Accordingly, these downturns are likely to continue to adversely affectour business, financial condition and operating results and our operatingresults may fall below the expectations of public market analysts or investorsin some future quarter or quarters. Such failure to meet operating resultexpectations would materially adversely affect the price of our common stock.

 

Ourcustomers try to manage their inventories and production requirements toappropriate levels that best reflect their expected sales to chipmakers. Marketconditions in the industry and production efficiency of the lithography toolmanufacturers can cause our customers to expand or reduce their orders for newlight source systems as they try to manage their inventories and productionrequirements to these levels. We continue to work with our customers to betterunderstand these issues. However, we cannot guarantee that we will besuccessful in understanding our customers’ inventory management and productionrequirements or that our customers will not build up an excess inventory oflight source products. If our customers retain an excess inventory of lightsource products, our revenue could be reduced in future periods as the excessinventory is utilized, which could adversely affect our operating results,financial condition and cash flows.  Inaddition, if our customers demand shorter product lead times as a solution toimprove their inventory and cash positions, our inventory management and cashposition may be impacted, which may adversely affect our operating results,financial condition and cash flows.

 

**Asignificant percentage of our revenue is derived from sales to a few largecustomers, 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.**

 

Threelarge companies, ASM Lithography, Canon and Nikon dominate the photolithographytool business. Collectively, these three companies accounted for the followingpercentage of our total revenue during the periods indicated:

 
| ** **      | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------|------------|--------------------------------------|------------|
| ** **      | ** ** | **2003**                             | ** ** | **2004** | ** ** |
|            |       |                                 |       |   |   |
| ASM Lithography |       | 22                                   | %          | 35 | % |
| Canon           |       | 26                                   | %          | 14 | % |
| Nikon           |       | 22                                   | %          | 21 | % |
|            |       |                                 |       |   |   |
| Total           |       | 70                                   | %          | 70 | % |

 

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Collectively,these three companies account for the following percentage of our totalaccounts receivable at the dates indicated:

 
| ** **      | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|-----------------|------------|------------------------|------------|-------------------------|------------|
|            |       |                   |       |                    |       |
| ASM Lithography |       | 38                     | %          | 45                      | %          |
| Canon           |       | 14                     | %          | 3                       | %          |
| Nikon           |       | 18                     | %          | 28                      | %          |
|            |       |                   |       |                    |       |
| Total           |       | 70                     | %          | 76                      | %          |

 

Weexpect that sales of our light source products to these three customers willcontinue to account for a substantial majority of our revenue in the foreseeablefuture. None of our customers are obligated to purchase a minimum number of ourproducts in the aggregate or during any particular period. The loss of anysignificant business from or production problems for any one of these threecustomers may have a material adverse effect on our business and financialcondition. Sales to these customers may be affected by many factors, some ofwhich are beyond our control. These factors include:

 

•                       a change in a customer’s competitive position inits industry;

•                       a customer experiencing lithography toolproduction problems;

•                       a decision to purchase light sources from othersuppliers;

•                       changes in economic conditions in thesemiconductor or the photolithography tool industries; and

•                       a decline in a customer’s financial condition.

 

**Asubstantial percentage of our revenue is derived from the sale of a limitednumber of primary products.**

** **

Ouronly product line is excimer light source systems, which include KrF and ArFsystems, and we expect these primary products to continue to account for alarge percentage of our revenues in the near term. Continued market acceptanceof our primary products is, therefore, critical to our future success. Theprimary market for excimer light sources is in the use of DUV photolithographyequipment for manufacturing deep-submicron semiconductor devices using smallercircuit geometries. The demand for our products depends in part on the rate atwhich chipmakers further adopt excimer light sources as the chosen light sourcefor their photolithography tools. The rate with which chipmakers adopt excimerlight sources may vary for a variety of reasons, including:

 

•                       inadequate performance of photoresists used inadvanced DUV photolithography;

•                       potential shortages of specialized materials usedin DUV optics;

•                       productivity of 300 mm photolithography toolsrelative to 200 mm tools; and

•                       consolidation of chipmakers.

 

Wecannot guarantee that these factors can or will be overcome or that the demandfor our excimer light source products will not be materially reduced. Thedemand for our light source products, and therefore our operating results,financial condition and cash flows, could be adversely affected by a number offactors, including:

 

•                       a decline in demand for our customers’ DUVphotolithography tools;

•                       a failure to achieve continued market acceptanceof our products;

•                       an improved version of products being offered bya competitor in the market in which we participate;

•                       technological change that we are unable toaddress with our products; and

•                       a failure to release new enhanced versions of ourproducts on a timely basis.

 

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**Wedepend on the introduction of new products for our success, and we are subjectto risks associated with rapid technological change.**

** **

Rapidtechnological changes in semiconductor manufacturing processes subject us toincreased pressure to develop technological advances enabling such processes.We believe that our future success depends in part upon our ability to develop,manufacture and timely introduce new light source products with improvedcapabilities and to continue to enhance our existing light source systems andprocess capabilities.  Due to the risksinherent in transitioning to new products, we must forecast accurate demand fornew products while managing the transition from older products.

 

Ournewest product introduction project consists of a technology change from asingle-discharge-chamber designed excimer light source to adual-discharge-chamber design called MOPA. This MOPA design represents a paradigm shift from current lithographytechnology and is projected to enable higher power, tighter bandwidth and lowercost of operation for future optical lithography applications across all threeDUV wavelengths — 248 nm, 193 nm and 157 nm. There are risks inherent in transitioning to this new technology.  These risks include effective execution ofthe product development plan, adoption of the product by lithography toolmanufacturers and chipmakers, manufacturability and cost effectiveness of thenew products and the development of a comparable product by our competitors.

 

Webelieve that chipmakers are currently developing a capability to producedevices that are measured at 90 nanometers or less, and these efforts aredriving the current demand for our light source products for DUVphotolithography systems. After chipmakers have this capability, their demandfor our light source products will depend, in part, on whether they want toexpand their capacity to manufacture these devices. This will in turn depend onwhether their sales forecasts and projected manufacturing process yieldsjustify the necessary investments.

 

Futuretechnologies such as EUV, EPL, and maskless lithography may render our excimerlight 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.

 

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

 

**We musteffectively manage changes in our business.**

 

Inorder to respond to the business cycles of the semiconductor industry, in thepast few years we have sharply expanded and contracted the scope of ouroperations and the number of employees in many of our departments. As thesemiconductor industry grows and contracts we will need to:

 

•                       closely manage our global operations;

•                       improve our process and other internal managementsystems;

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

•                       quickly adapt to changing sales and marketingchannels;

•                       effectively manage our inventory levels; and

•                       attract, train, retain and manage key personnel.

 

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Ifwe fail to effectively manage changes in our business, our operating results,financial condition and cash flows would be adversely affected.

 

**Economic,political, regulatory and other events in geographic areas where we havesignificant sales or operations could interfere with our business.**

** **

Weserve an increasingly global market.  Alarge portion of our total revenues is derived from customers located outsideof the United States, particularly in Asian countries.  We expect our international sales to continueto account for a very large portion of our total revenues.  In order to support our foreign customers, wemaintain a manufacturing and field service subsidiary in Korea as well as fieldservice and support subsidiaries in Japan, Taiwan, Singapore, the People’sRepublic of China and the Netherlands.

 

Wemay not be able to manage our operations to address and support our globalcustomers effectively.  Further, ourinvestments in these types of activities may not make us competitive in theglobal market or we may not be able to meet the service, support, andmanufacturing levels required by our global customers.

 

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

 

•                       unexpected changes in regulatory requirements;

•                       fluctuations in exchange rates and currencycontrols;

•                       political and economic conditions andinstability;

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

•                       difficulty in coordinating our management andoperations in several different countries;

•                       difficulties in staffing and managing foreignsubsidiary and branch operations;

•                       limited intellectual property protection in somecountries;

•                       potentially adverse tax consequences in somecountries;

•                       the possibility of accounts receivable collectiondifficulties;

•                       in the case of Asia, the risk of businessinterruption and damage from earthquakes;

•                       the effect of acts of terrorism and war; and

•                       the burdens of complying with a variety offoreign laws.

 

Manyof our major customers and many of the chipmakers who use our light sourceproducts in their photolithography systems are located in Asia. Economicproblems and currency fluctuations affecting these regions in Asia could createa larger risk for us. Further, even though it has not been difficult for us tocomply with United States export controls, these export rules could change inthe future and make it more difficult or impossible for us to export ourproducts to many countries.  Any of thesevulnerabilities could have a material adverse effect on our business, financialcondition and results of operations.

 

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

 

Wepurchase a limited number of components and subassemblies included in our lightsource products from a single supplier or a small group of suppliers.  For certain optical components used inour light source systems, we currently utilize a single supplier.  To reduce the risk associated with thissingle supplier, we carry a significant strategic inventory of thesecomponents.  Strategic inventories aremanaged as a percentage of future demand. We have also negotiated to have vendor-managed inventory of criticalcomponents to further reduce the risk of a single supplier.  Inaddition, we contract the manufacture of various subassemblies more often thanin the past. Further, some of our suppliers have specialized in supplyingequipment or manufacturing services to semiconductor equipment manufacturersand therefore are susceptible to industry ups and downs and subject to the samerisks and uncertainties regarding their ability to respond to changing marketconditions.  Because many of  these suppliers reduce the size of theirworkforce in an industry downturn and increase it in an upturn, they may not beable to meet our

 

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requirements or respond quickly enough as an upturnbegins and gains momentum.  Due to thenature of our product development requirements, these key suppliers mustrapidly advance their own technologies and production capabilities in order tosupport the introduction schedule of our new products. These suppliers may notbe able to provide new modules and subassemblies when they are needed tosatisfy our product schedule requirements. If we cannot purchase enough ofthese materials, 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.

 

**Weface competition from two companies and may face competition from additionalcompetitors who enter the market.**

** **

Weare currently aware of two significant competitors that sell light sources forDUV photolithography applications. These competitors are:

 

•                  Gigaphoton, a joint venture between two largecompanies, Komatsu and Ushio, which is headquartered in Japan; and

 

•                  Lambda-Physik, a company headquartered inGermany, owned by Coherent, Inc., a U.S. company.

 

Webelieve that Gigaphoton and Lambda-Physik are aggressively trying to gainlarger market penetration in the excimer light source industry. We know thatour customers have purchased products from these two competitors and that ourcustomers have approved these competitors’ light sources for use with theirproducts.  We know that Gigaphoton, inparticular, has been approved by chipmakers in Japan, the U.S. and elsewherefor producing excimer light sources. Also, we believe that Lambda-Physik has been approved by chipmakers inthe U.S. and Europe for producing excimer light source products.

 

Themarket for excimer light sources is still small and immature. Largercompetitors with substantially greater resources, such as other manufacturersof industrial light sources for advanced lithography, may attempt to sellcompetitive products to our customers. Potential competitors may also beattracted to our growing installed base of light sources and may attempt tosupply consumable products and refurbished parts to that installed base. If anyexisting or future competitors gain market acceptance we could lose marketshare and our growth could slow or decline, which could have a material adverseeffect on our operating results, financial condition and cash flows.

 

**Wedepend on key personnel, especially management and technical personnel, who maybe difficult to attract and retain.**

** **

Weare highly dependent on the services of many key employees in various areas,including:

 

•                       engineering;

•                       research and development;

•                       sales and marketing;

•                       field service;

•                       manufacturing; and

•                       management.

 

Inparticular, there are a limited number of experts in excimer light sourcetechnology, and we require highly skilled hardware and software engineers.Competition for qualified personnel is intense and we cannot guarantee that wewill be able to continue to attract and retain qualified personnel asneeded.  We do not have employmentagreements with most of our employees. We believe that our future growth and operatingresults will depend on:

 

•                  the continued services of our engineering,research and development, sales and marketing, manufacturing and field service,and management personnel;

 

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

•                  the ability of our personnel and key employees tocontinue to expand, train and manage our employee base.

 

Ifwe are unable to hire, train and retain key personnel as required, ouroperating results,  financial conditionand cash flows could be adversely affected.

 

**Decreased effectiveness of equitycompensation could adversely affect our ability to attract and retainemployees, and proposed changes in accounting for equity compensation could adverselyaffect earnings.**

 

We have historically usedstock options and other forms of equity-related incentives as a key componentof our employee compensation packages. We believe that stock options and otherlong-term equity incentives directly motivate our employees to maximizelong-term stockholder value and, through the use of long-term vesting,encourage employees to remain with us. FASB has issued a proposed statement, which is expected to be effectivefor periods after June 15, 2005, that would require us to record an expense toearnings for employee stock option grants and other equity incentives.Moreover, applicable stock exchange listing standards relating to obtainingstockholder approval of equity compensation plans could make it more difficult orexpensive for us to grant options to employees in the future, which may resultin changes in our equity compensation strategy. These and other developments inthe provision of equity compensation to employees could make it more difficultto attract, retain and motivate employees, and such a change in accountingrules may adversely impact our future operating results, financial conditionand cash flows.

 

**Failure tomaintain effectively our direct field service and support organization couldhave a material adverse effect on our business.**

 

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

 

•                       recruit and train qualified field servicepersonnel;

•                       identify qualified independent firms; and

•                       maintain effective and highly trainedorganizations that can provide service to our customers in various countries.

 

Wemight not be able to attract and train qualified personnel to maintain ourdirect support operations successfully. We may not be able to find and engagequalified third-party resources to supplement and enhance our direct supportoperations.  Further, we may incursignificant costs in providing these support services. Failure to implement ourdirect support operation effectively could have a material adverse effect onour operating results, financial condition and cash flows.

 

**Our abilityto compete could be jeopardized if we are unable to protect our intellectualproperty rights. These types of claims could seriously harm our business orrequire us to incur significant costs.**

 

Webelieve our success and ability to compete depend in large part upon protectingour proprietary technology. We rely on a combination of patent, trade secret,copyright and trademark laws, nondisclosure and other contractual agreementsand technical measures to protect our proprietary rights.

 

Asof September 30, 2004, we owned 207 United States patents covering certainaspects of technology related to light sources and piezo techniques. Thesepatents will expire at various times during the period from January 2008 toJune 2022.  As of September 30, 2004, wehad applied for 78 additional

 

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patents in the United States.  As of September 30, 2004, we owned 280foreign patents and had 323 patent applications pending in various foreigncountries.

 

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

 

Othercompanies or persons may have filed or may file in the future patentapplications that are similar or identical to ours. We may have to participatein interference proceedings declared by the United States Patent and TrademarkOffice (“USPTO”) in order for the patent office to determine the priority ofinventions. The patent office may determine that these third-party patentapplications have priority over our patent applications. Loss of priority inthese interference proceedings could result in substantial cost to us.

 

Wealso rely on the following to protect our confidential information and ourother intellectual property:

 

•                       trade secret protection;

•                       employee nondisclosure agreements;

•                       third-party nondisclosure agreements; and

•                       other intellectual property protection methods.

 

However,we may not be successful in protecting our confidential information andintellectual property, particularly our trade secrets, because third partiesmay:

 

•                       independently develop substantially the sameproprietary information and techniques;

•                       gain access to our trade secrets; or

•                       disclose our technology.

 

**Theparties to whom we provide research and development services may dispute theownership of the intellectual property that we develop performing theseservices.**

** **

Inthe past, funds from research and development arrangements with third partieshave been used to pay for a portion of our own research and developmentexpenses. We receive these funds from government-sponsored programs andcustomers, in connection with our designing and developing specific products.Currently, funds from lithography tool manufacturers and chipmakers are used tofund a small portion of our development expenses. In providing these researchand development services to these manufacturers, we try to make clear who ownsthe intellectual property that results from the research and developmentservices we perform. However, disputes over the ownership or rights to use ormarket this intellectual property may arise between the manufacturers and us.Any dispute over ownership of the intellectual property we develop couldrestrict our ability to market our products and have a material adverse effecton our business.

 

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**Inthe future, we may be subject to patent litigation to enforce patents issued tous and defend ourselves against claimed infringement by our competitors or anyother third party.**

** **

Thirdparties have notified us in the past, and may notify us in the future, that weare infringing their intellectual property rights. Also, we have notified thirdparties in the past, and may notify them in the future, that they may beinfringing our intellectual property rights.

 

Specifically,Komatsu has notified us that we may be infringing some of its Japanese patents.During our discussions with Komatsu, they also asserted that our formerJapanese manufacturing partner, Seiko, or we may be infringing on some ofKomatsu’s United States patents and a number of its additional Japanesepatents. Komatsu has also notified one of our customers, Nikon, of its beliefthat our light sources infringe several of Komatsu’s Japanese and U.S. patents.As a result, we started proceedings in the Japanese Patent Office to oppose certainpatents and patent applications of Komatsu. The Japanese Patent Office hasdismissed some of our opposition claims. Thus, litigation may result inconnection with Komatsu’s Japanese patents or U.S. patents. Also, Komatsu mightclaim that we infringe other or additional patents. Komatsu notified Seiko thatit intends to enforce its rights against Seiko with respect to its Japanesepatents if Seiko continued to engage in manufacturing activities for us. Inconnection with our former manufacturing agreement with Seiko, we agree to paySeiko under certain conditions for damages associated with these types ofclaims. Seiko may not prevail in any litigation against Komatsu, and therefore,we may be required to pay Seiko for such damages.

 

Wehave notified our competitors and others of our United States patent portfolio.Specifically, we have notified Komatsu that they may be infringing on some ofour U.S. patents. We have discussed with Komatsu our claims against eachother.  Komatsu challenged one of ourU.S. patents in the USPTO but it was subsequently re-issued by the USPTO.  Also, Komatsu transferred its lithographylight source business to one of our competitors, Gigaphoton.  We also have had discussions withLambda-Physik (a subsidiary of Coherent, Inc.), another competitor, regardingallegations by each party against the other for possible patent infringement.Any of these discussions with our competitors may not be successful andlitigation could result.

 

Inthe future, patent litigation may result due to a claim of infringement by ourcompetitors or any other third party or may be necessary to enforce patentsissued to us.  Any such litigation couldresult in substantial cost and diversion of effort by us, which would have anadverse effect on our business, financial condition and operating results.Furthermore, our customers and the end users of our products might assert otherclaims for indemnification that arise from infringement claims against them. Ifthese assertions are successful, our business, financial condition andoperating results may be materially affected. Instead of litigation, we mayseek a license from third parties to use their intellectual property. However,we may not be able to obtain a license on reasonable terms. In the alternative,we may design around the third party’s intellectual property rights or we maychallenge these claims in legal proceedings. Any adverse determination in alegal proceeding could result in one or more of the following, any of whichcould have a substantial adverse effect on our business, financial conditionand operating results:

 

•                       loss of our proprietary rights;

•                       exposure to significant liabilities by otherthird parties;

•                       requirement that we get a license from thirdparties on terms that are not favorable; or

•                       restriction from manufacturing or selling ourproducts.

 

Anyof these actions could be costly and would divert the efforts and attention ofCymer’s management and technical personnel, which would materially adverselyaffect Cymer’s business, financial condition and results of operations.

 

**Trademarkinfringement claims against our registered and unregistered trademarks would beexpensive and we may have to stop using such trademarks and pay damages.**

 

Weregistered the trademarks ‘‘CYMER’’ and “INSIST ON CYMER” and others in theUnited States and in some other countries. We are also trying to registeradditional trademarks in the United

 

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States and in other countries.  We use these trademarks and many other marksin our advertisements and other business materials, which are distributedthroughout the world. We may be subject to trademark infringement actions forusing these marks and other marks on a worldwide basis and this would be costlyto defend. If a trademark infringement action were successful, we would have tostop 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 standardsrelating to corporate governance and public disclosure, including theSarbanes-Oxley Act of 2002, new SEC regulations, Nasdaq Stock Market rules, andnew accounting pronouncements are creating uncertainty and additionalcomplexities for companies such as ours. In particular, the Section 404internal control requirements under the Sarbanes-Oxley Act have added and willcontinue to add complexity and costs to our business and require a significantinvestment of our time to complete its initial implementation in 2004 andmaintain going forward. We are taking this new requirement very seriously andmaking every effort to ensure that we receive a clean attestation on ourinternal controls from our outside auditors for 2004 and in the future, but weare unsure as to the final outcome of this effort at this time. To maintainhigh standards of corporate governance and public disclosure, we intend toinvest all reasonably necessary resources to comply with all other evolvingstandards. These investments may result in increased general and administrativeexpenses and a diversion of management time and attention from strategicrevenue generating and cost management activities.

 

**We aredependent on air transport to conduct our business and disruption of domesticand international air transport systems could adversely affect our business.**

 

Wedepend on regular and reliable air transportation on a worldwide basis for manyof our routine business functions. If civil aviation in the United States orabroad is disrupted by terrorist activities or security responses to the threatof terrorism or for any other reason, our business could be adversely affectedin the following ways:

 

•                       supplies of raw materials and components for themanufacture of our products or our customers’ products may be disrupted;

•                       we may not be able to deliver our products to ourcustomers in a timely manner;

•                       we may not be able to provide timely support ofinstalled light sources for chipmakers; and

•                       our sales and marketing efforts may be disrupted.

 

**We areexposed to risks related to the fluctuations in the currency exchange rates forthe Japanese yen.**

 

Whenwe sell products to our Japanese subsidiary, the sale is denominated in U.S.dollars. When our Japanese subsidiary sells our products directly to customersin Japan, the sale is denominated in Japanese yen. Thus, our results ofoperations may fluctuate based on the changing value of the Japanese yen to theU.S. dollar. Our Japanese subsidiary manages its exposure to these fluctuationsthrough foreign currency forward exchange contracts to hedge its purchasecommitments. We will continue to monitor our exposure to these currencyfluctuations, and, when appropriate, use hedging transactions to minimize theeffect of these currency fluctuations. However, exchange rate fluctuations maystill have a material adverse effect on our operating results. In the future,we may need to sell our products in other foreign currencies other than theJapanese yen and the management of more currency fluctuations will be moredifficult and expose us to greater risks in this area.

 

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**Weare subject to many standards and regulations of foreign governments and, eventhough we intend to comply, we may not always be in compliance with theserules, or we may be unable to design or redesign our products to comply withthese rules.**

** **

Manyforeign government standards and regulations apply to our products. Thesestandards and regulations are always being amended. Although we intend to meetall foreign standards and regulations, our products may not comply with theseforeign government standards and regulations. Further, it might not be costeffective for us to redesign our products to comply with these foreign governmentstandards and regulations. Our inability to design or redesign products tocomply with foreign standards therefore could have a material adverse effect onour business.

 

**Chipmakers’prolonged use of our products in high volume production may not produce theresults they desire and, as a result, our reputation and that of our customerswho supply photolithography tools to the chipmakers could be damaged in thesemiconductor industry.**

** **

Overtime, our light source products may not meet chipmakers’ productionspecifications or operating cost requirements after the light source is usedfor a long period in high volume production. If any chipmaker cannotsuccessfully achieve or sustain their volume production using our lightsources, our reputation could be damaged with the chipmakers and our customerswho are the limited number of lithography tool manufacturers. This would have amaterial adverse effect on our business.

 

**Wehave in the past and may in the future acquire a business that will involvenumerous risks. We may not be able to address these risks successfully withoutsubstantial expense, delay or other operational and financial problems.**

** **

Therisks involved with acquiring a new company include the following:

 

•                       diversion of management’s attention and resourcesto integrate the new company;

•                       failure to retain key personnel;

•                       amortization of acquired definite-livedintangible assets and deferred compensation;

•                       client dissatisfaction or performance problemswith the acquired company;

•                       the cost associated with acquisitions and theintegration of acquired operations;

•                       failure to commercialize purchased technologies;

•                       ability of the acquired companies to meet theirfinancial projections;

•                       assumption of unknown liabilities or otherunanticipated events or circumstances; and

•                       compliance with the Sarbanes-Oxley Act of 2002,new SEC regulations, Nasdaq Stock Market rules and new accountingpronouncements.

 

Mergersand acquisitions are inherently subject to multiple significant risks, and theinability to effectively manage these risks could have a material adverseeffect on our business.  Any of theserisks could materially harm our business, financial condition and operatingresults. Further, any business that we acquire may not achieve anticipatedrevenues or operating results.

 

**Wemust develop and manufacture enhancements to our existing products andintroduce new products in order to continue to grow our business. We may noteffectively manage our growth and integrate these new enhancements andproducts, which could materially harm our business.**

** **

Tocontinue to grow our business, our existing light source products and theirprocess capabilities must be enhanced, and we must develop and manufacture newproducts to serve other semiconductor applications. We cannot guarantee that wewill be able to manage our growth effectively. Nor can we guarantee that wewill be able to accelerate the development of new enhancements to our existingproducts and create new products. Further, we may not be able to effectivelyintegrate new products and applications into our current operations. Any ofthese risks could materially harm our business, financial condition and resultsof operations.

 

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

## ** **

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

 

**Ouroperations are subject to environmental and other government regulations thatmay expose us to liabilities for noncompliance.**

 

Weare subject to federal, state and local regulations, such as regulationsrelated to the environment, land use, public utility utilization and the firecode, in connection with the storage, handling, discharge and disposal ofsubstances that we use in our manufacturing process and on our facilities.  We believe that our activities comply withcurrent government regulations that are applicable to our operations andcurrent facilities. We may be required to purchase additional capital equipmentor other requirements for our processes to comply with these governmentregulations in the future if they change. Further, these government regulationsmay restrict us from expanding our operations. Adopting measures to comply withchanges in the government regulations, our failure to comply with environmentaland land use regulations, or restrictions on our ability to discharge hazardoussubstances, could subject us to future liability or cause our manufacturingoperations to be reduced or stopped.

 

**Ourproducts are subject to potential product liability claims if personal injuryor death results from their use.**

** **

Weare exposed to significant risks for product liability claims if personalinjury or death results from the use of our products. We may experiencematerial product liability losses in the future. We maintain insurance againstproduct liability claims. However, our insurance coverage may not continue tobe available on terms that we accept. This insurance coverage also may notadequately cover liabilities that we incur. Further, if our products aredefective, we may be required to recall or redesign these products. Asuccessful claim against us that exceeds our insurance coverage level, or anyclaim or product recall that results in adverse publicity against us, couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

**The price of our common stock has fluctuated and may continueto fluctuate widely.**

 

Theprice of our common stock has fluctuated in the past. The market price of ourcommon stock will continue to be subject to significant fluctuations in thefuture in response to a variety of factors, including the risk factorscontained in this report.

 

Variousfactors may significantly affect the market price of our common stock,including:

 

•                       the cyclical nature of the semiconductorindustry;

•                       actual or anticipated fluctuations in ouroperating results;

•                       conditions and trends in the light source deviceand other technology industries;

•                       announcements of innovations in technology;

•                       new products offered by us or our competitors;

•                       developments of patents or proprietary rights;

•                       changes in financial estimates by securitiesanalysts;

•                       general worldwide political, economic, and marketconditions;

•                       United States political, economic, and marketconditions; and

•                       failure to properly manage any single orcombination of risk factors listed in this section.

 

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Inaddition, the stock market has experienced extreme price and volumefluctuations that have particularly affected the market price for many hightechnology companies. Such fluctuations have in some cases been unrelated tothe operating performance of these companies. Severe price fluctuations in acompany’s stock have frequently been followed by securities litigation.  Any such litigation can result in substantialcosts and a diversion of management’s attention and resources and thereforecould have a material adverse effect on our business, financial condition andresults of operations.

 

#### **Item 3. Quantitative and Qualitative Disclosures About Market Risk**

#### ** **

# **Foreign Currency Risk**

# ** **

Cymer conducts businessin several international currencies through its global operations. Due to thelarge volume of Cymer’s business that is conducted in Japan, the Japaneseoperation poses the greatest foreign currency risk.  Cymer uses financial instruments, principallyforeign currency forward exchange contracts, in Japan to manage its foreigncurrency exposures. Cymer enters into foreign currency forward exchangecontracts in order to reduce the impact of currency fluctuations related topurchases of Cymer’s inventories by Cymer Japan in U.S. dollars for resaleunder firm third-party sales commitments denominated in Japanese yen.  Cymer does not enter into foreign currencyforward exchange contracts for trading purposes.

 

As of September 30,2004, Cymer had outstanding foreign currency forward exchange contracts to buyU.S. $67.4 million for 7.4 billion yen under foreign currency exchangefacilities with contract rates ranging from 104.3 yen to 116.2****yen per U.S. dollar. These contracts expire on 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 for the effective portion of thesehedges and records the amount in other comprehensive income (loss) andsubsequently reclassifies the gain or loss to cost of product sales in the sameperiod that the related sale is made to the third party. The fair value ofthese contracts and the deferred loss totaled $162,000 and $164,000,respectively, as of September 30, 2004. In the third quarter of 2004, Cymer recorded a loss of $1.1 million as aresult of the discontinuance of certain cash flow hedges.  This loss is included in foreign currencyexchange gain (loss) on the accompanying statements of operations.

 

The fair value of these foreign currency forwardexchange contracts as of September 30, 2004 would have changed by $6.8 millionif the foreign currency exchange rate for the Japanese yen to the U.S. dollaron these forward contracts had changed by 10%.

 

# **Investment and Debt Risk**

# ** **

Cymer maintains aninvestment portfolio consisting primarily of government and corporate fixedincome securities, certificates of deposit and commercial paper.  While it is Cymer’s general intent to holdsuch securities until maturity, Cymer will occasionally sell certain securitiesfor cash flow purposes. Therefore, Cymer’s investments are classified as available-for-saleand are carried on the balance sheet at fair value. In September 2004 Cymersold approximately $20.3 million of corporate debt securities that resulted ina $281,000 gain on the sale.  Due to theconservative nature of the investment portfolio, a sudden change in interestrates would not have a material effect on the value of the portfolio.

 

In February 2002, Cymerissued $250.0 million principal amount of unsecured fixed rate 31⁄2% ConvertibleSubordinated Notes due February 15, 2009. Interest on these 2002 Notes is payable on February 15 and August 15 ofeach year.  The 2002 Notes areconvertible into shares of Cymer’s common stock at a conversion rate of 20shares per $1,000 principal amount subject to adjustment under certainconditions. Cymer may redeem the 2002 Notes on or after February 20, 2005, orearlier if the price of its 

 

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commonstock reaches certain levels. The 2002 Notes are subordinated to Cymer’sexisting and future senior indebtedness and effectively subordinated to allindebtedness and other liabilities of Cymer’s subsidiaries.  Because the interest rate is fixed, webelieve there is no risk of increased interest expense. These 2002 Notes arerecorded at face value on the consolidated balance sheets. In the third quarterof 2004, Cymer repurchased, at a discount to par, approximately $49.2 millionof these 2002 notes.  As of September 30,2004, $200.8 million principal amount of the 2002 Notes were outstanding.  The fair value of such debt based on quotedmarket prices on September 30, 2004 was $194.3 million.

 

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

 

*Evaluationof disclosure controls and procedures*.  Cymer’s chief executive officer and its chieffinancial officer, after evaluating the effectiveness of Cymer’s disclosurecontrols and procedures (as defined in Exchange Act Rule 13a-15(e) and15d-15(e)) as of September 30, 2004, have concluded that as of such date,Cymer’s disclosure controls and procedures were adequate and sufficient toensure that information required to be disclosed by Cymer in the reports thatit files under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time period specified in the Commission’srules and forms.

 

*Changesin internal controls*. There has been no change in Cymer’sinternal control over financial reporting during the fiscal quarter endedSeptember 30, 2004 that has materially affected, or is reasonably likely tomaterially affect, Cymer’s internal control over financial reporting.

 

**PARTII.  OTHER INFORMATION**

 
| **ITEM  1.**    | ** ** | **Legal  Proceedings**                                           |
|-----------------|------------|------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                       |
|            |       | None.                                                            |
|            |       |                                                             |
| **ITEM  2.**    | ** ** | **Unregistered  Sales of Equity Securities and Use of Proceeds** |
| ** **      | ** ** | ** **                                                       |
|            |       | None.                                                            |
|            |       |                                                             |
| **ITEM 3.**     | ** ** | **Defaults  Upon Senior Securities**                             |
| ** **      | ** ** | ** **                                                       |
|            |       | None.                                                            |
|            |       |                                                             |
| **ITEM 4.**     | ** ** | **Submission  of Matters to a Vote of Security Holders**         |
| ** **      | ** ** | ** **                                                       |
|            |       | None.                                                            |
|            |       |                                                             |
| **ITEM 5****.** | ** ** | **Other Information**                                            |
|            |       |                                                             |
|            |       | None.                                                            |
|            |       |                                                             |
| **ITEM 6.**     | ** ** | **Exhibits**                                                     |
| ** **      | ** ** | ** **                                                       |
|            |       | **(a)**                                                          | 31.1   Certification of Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act |
|            |       |                                                             |   |
|            |       |                                                             | 31.2   Certification of Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act |
|            |       |                                                             |   |
|            |       |                                                             | 32.1   Certification of Chief Executive Officer  pursuant to Section 906 of the Sarbanes-Oxley Act |
|            |       |                                                             |   |
|            |       |                                                             | 32.2   Certification of Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act |

 

42

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this quarterly report on Form 10-Q to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                   |   | CYMER, INC.                   |
|------------------------|--------|-------------------------------|
|                   |   |                          |
|                   |   |                          |
| Date: November 5, 2004 | By:    | /s/ NANCY J. BAKER            |   |
|                   |   |                          |
|                   |   | Nancy J. Baker                |
|                   |   | Senior Vice President  and    |
|                   |   | Chief Financial Officer       |
|                   |   | (Duly Authorized  Officer and |
|                   |   | Principal Financial  Officer) |

 

43

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