**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

**(Mark One)**

x                                  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934

**For the Fiscal Year Ended December 31, 2006**

**OR**

o                                    TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM             TO             .

**Commission File Number0-21321**

** **

**CYMER, INC.**

(Exact name of registrant as specified in its charter)
| **Nevada**                                | ** ** | **33-0175463**       |
|-------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer     |
| incorporation or  organization)           |       | Identification  No.) |
|                                      |       |                 |
| **17075  Thornmint Court, San Diego, CA** | ** ** | **92127**            |
| (Address of  principal executive offices) |       | (Zip Code)           |

 
| Registrant’s telephone  number, including area code: **(858) 385-7300** |
|------------------------------------------------------------------------------|
|                                                                         |
| Securities registered pursuant to Section 12(b) of  the Act:                 |
|                                                                         |

 

| Title of Each Class             |   | Name of Each  Exchange on Which Registered |
|---------------------------------|--------|--------------------------------------------|
|                            |   |                                       |
| Common stock,  $0.001 par value |   | The NASDAQ Stock  Market LLC               |
|                            |   |                                       |

 
| Securities registered pursuant to Section 12(g) of the Act: |
|-------------------------------------------------------------|
| None                                                        |

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act.   ýYes  oNo

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) of theAct.  oYes  ýNo

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. ýYes  oNo

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K (§229.405 of this chapter) is not contained herein,and will not be contained to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. ý

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

Large accelerated filerý                             Accelerated filer o                              Non-acceleratedfiler o   

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

oYes  ýNo

The aggregate market value of the voting stockheld by non-affiliates of the registrant, based upon the closing price of$46.46 for shares of the registrant’s common stock on June 30, 2006 as reportedon the Nasdaq National Market, was $1,819,752,203.  The registrant has no non-voting commonstock. In calculating such aggregate market value, shares of common stock ownedof record or beneficially by officers or directors, and persons known to theregistrant to own more than ten percent of the registrant’s voting securitieswere excluded because such persons may be deemed to be affiliates.  The registrant disclaims the existence ofcontrol or any admission thereof for any other purpose.

Number of shares of common stock outstanding as of  February 23, 2007: 37,278,940.

DOCUMENTS INCORPORATED BY REFERENCE

The following  document isincorporated  by reference in Part II(Item 5) and Part III (Items 10, 11, 12, 13 and 14) of  this Annual  Report on Form 10-K:portions of registrant’s definitive proxy statement for its annual meeting ofstockholders to be held on May 17, 2007 which will be filed with the Securitiesand Exchange Commission within 120 days of December 31, 2006.

 

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CYMER, INC.

2006 Annual Report on Form 10-K

TABLE OF CONTENTS
| PART I   |   |                                                                                                                      |   |   |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------|--------|--------|
|     |   | Item 1.Business                                                                                                           |   |   |
|     |   | Item  1A.Risk Factors                                                                                                     |   |   |
|     |   | Item 1B.Unresolved Staff Comments                                                                                         |   |   |
|     |   | Item  2.Properties                                                                                                        |   |   |
|     |   | Item  3.Legal Proceedings                                                                                                 |   |   |
|     |   | Item 4.Submission of Matters to a Vote of Security  Holders                                                               |   |   |
| PART II  |   |                                                                                                                      |   |   |
|     |   | Item 5.Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   |   |
|     |   | Item  6.Selected Financial Data                                                                                           |   |   |
|     |   | Item 7.Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        |   |   |
|     |   | Item 7A. Quantitative and Qualitative Disclosures  About Market Risk                                                      |   |   |
|     |   | Item 8.Financial Statements and Supplementary Data                                                                        |   |   |
|     |   | Item 9.Changes in and Disagreements with Accountants  on Accounting and Financial Disclosure                              |   |   |
|     |   | Item 9A.Controls and Procedures                                                                                           |   |   |
|     |   | Item  9B.Other Information                                                                                                |   |   |
| PART III |   |                                                                                                                      |   |   |
|     |   | Item 10. Directors, Executive Officers and Corporate  Governance                                                          |   |   |
|     |   | Item 11. Executive Compensation                                                                                           |   |   |
|     |   | Item 12. Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                  |   |   |
|     |   | Item 13. Certain Relationships and Related  Transactions, and Director Independence                                       |   |   |
|     |   | Item 14.Principal Accounting Fees and Services                                                                            |   |   |
| PART IV  |   |                                                                                                                      |   |   |
|     |   | Item 15. Exhibits and Financial Statement Schedules                                                                       |   |   |
|     |   | Signatures                                                                                                                |   |   |
|     |   |                                                                                                                      |   |   |

 

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#### **Forward-LookingStatements**

Statementsin this Annual Report on Form 10-K that are not strictly historical in natureare forward-looking statements. These statements include, but are not limitedto, references to the outlook for the semiconductor industry and us; expecteddomestic and international product sales and development; our research anddevelopment activities and expenditures; adequacy of our capital resources andinvestments; effects of business cycles in the semiconductor business; ourcompetitive position; and our relationships with customers and third-partymanufacturers of our products, and may contain words such as “believes,” “anticipates,”“expects,” “plans,” “intends” and words of similar meaning. These statementsare predictions based on current information and our expectations and involve anumber of risks and uncertainties. The underlying information and ourexpectations are likely to change over time. Actual events or results may differ materially from those projected inthe forward-looking statements due to various factors, including, but notlimited to, those contained under the caption “Risk Factors” and elsewhere inthis Annual Report on Form 10-K. Forward-looking statements herein speak only as of the date of thisAnnual Report on Form 10-K.  Unlessrequired by law, we undertake no obligation to update or revise anyforward-looking statements to reflect new information or future events ordevelopments.  Thus, you should notassume that our silence over time means that actual events are bearing out asexpressed or implied in such forward-looking statements.

PART I

### **Item 1.  Business**

#### **Overview**

We are the world’s leadingsupplier of excimer light sources, the essential light source for deepultraviolet (“DUV”) photolithography systems. DUV photolithography is a keyenabling technology that has allowed the semiconductor industry to meet theexacting specifications and manufacturing requirements for volume production oftoday’s most advanced semiconductor chips. Our light source systems are incorporatedinto step-and-repeat (“steppers”) and step-and-scan (“scanners”)photolithography systems for use in the manufacture of semiconductors withcritical feature sizes below 250 nanometers (“nm”).  One nm equals one billionth of a meter.  Our excimer light source systems constitute asubstantial majority of all excimer light sources incorporated in DUVphotolithography tools. Our products consist of photolithography light sourcesystems, replacement parts and service. We maintain a worldwide service organization that supports our installedbase of light sources.  As of December31, 2006, this installed base totaled 3,042 light sources.  Our customers include all three manufacturersof DUV photolithography systems: ASML, Canon and Nikon.  Photolithography systems incorporating ourexcimer light sources have been purchased by all of the world’s largestsemiconductor manufacturers including: AMD, Chartered, Elpida, Fujitsu, Hynix,IBM, Infineon/Qimonda, Intel, Matsushita, Micron, Nanya/Inotera, NEC, Powerchip,Promos, Renesas Technology, Samsung, SMIC, Sony, ST Microelectronics, TexasInstruments, Toshiba, TSMC, and UMC.

InJuly 2005, we entered into an agreement with Carl Zeiss SMT AG, a Germancorporation, and Carl Zeiss Laser Optics Beteiligungsgesellschaft mbH, a Germanlimited liability company (which we refer to together with their affiliatedentities as “Zeiss”) to establish a joint venture, which we refer to as TCZ (forTeam Cymer Zeiss).  In September 2006, weamended and restated this joint venture agreement with Zeiss to move thelocation of the TCZ joint venture from Switzerland to Singapore and, inconnection with the move, formed TCZ Pte Ltd., a company incorporated inSingapore.  TCZ is currently developing,and will integrate, market and sell, and support production tools for the flatpanel display manufacturing industry. The joint venture is targeting thegrowing market for low-temperature poly-silicon (“LTPS”) processing used in themanufacture of liquid crystal displays that are brighter, have higherresolution, and consume less power than displays using today’s predominantamorphous silicon films.  We currentlyexpect that TCZ will ship its first production tool, the TCZ 900X, in late 2007or early 2008.

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#### **OtherInformation**

We are a Nevada corporation,incorporated on July 12, 1996. We were originally incorporated in California in1986 and reincorporated in Nevada in 1996.

Our website address ishttp://www.cymer.com. Our filings with the Securities and Exchange Commission (“SEC”) including our AnnualReport on Form 10-K, quarterly reports on Form 10-Q, current reports onForm 8-K and any amendments to those reports are available free of chargethrough our website as soon as reasonably practicable after we electronicallyfile such reports or furnish them to the SEC.

You may read and copy materialsthat we file with the SEC at the SEC’s Public Reference Room at 450 FifthStreet, NW, Washington DC 20549. Information on the operation of the Public Reference Room is availableby calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxystatements and other information we file. The address of the SEC website is http://www.sec.gov.

**Products and Services**

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

*Photolithography Light Sources*

Ourexcimer light sources for photolithography produce pulsed light of extremelyshort wavelengths within the DUV spectrum. The bandwidth of the light is further narrowed through a number ofoptical techniques.  The DUV wavelengthsare measured in nanometers and the light sources are referred to according toeither the wavelength or the gases that are mixed to produce the light.  Krypton Fluoride (“KrF”) gases produce lightat a 248 nm wavelength, and Argon Fluoride (“ArF”) gases produce light at a 193nm wavelength. The extremely short wavelengths and highly narrowed bandwidthsof light produced by these light sources enable the very fine featureresolution required for patterning or printing the circuitry on silicon wafers.The pulse energy and repetition rate of the light source permit high throughputin wafer processing.  We have designedour light sources to be reliable, easy to install and service and compatiblewith existing semiconductor manufacturing processes.  Our light sources are used to pattern orprint the integrated circuits, which are also called semiconductors or “chips,”that power many of today’s advanced consumer and business electronics.  In 2006, we sold 280 light source systems atan average selling price of $1.0 million. Revenues generated from sales of light sources were approximately $244.8million, $207.4 million and $282.4 million for 2004, 2005 and 2006,respectively.

Ourproduct development strategy has been to develop new products in rapidsuccession to meet continually evolving needs in the marketplace, and toobsolete our own products as quickly as possible, thus rendering ourcompetitors’ products obsolete.  Thisstrategy strengthens our market leadership position since the ongoing reductionof critical dimension (“CD”) on the wafer drives demand for newer, moreadvanced, higher value-added light sources.

Overthe years, we have developed and sold a wide variety of photolithography lightsource products.  These products can bedivided into KrF and ArF product categories and include a number of currentproducts as well as legacy products that we continue to service in ourinstalled base.

***CurrentProducts***

Ourcurrent products include our newest, most advanced, highest value-added ArF andKrF light sources, as well as some mature products that are still experiencingstrong chipmaker demand as DUV lithography becomes the prevailing light sourcetechnology in wafer fabrication.

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***193nm ArF Light Sources***

Chipmakerscontinue to reduce the feature sizes and shrink the CD on the wafer, whichmeans that the line widths of the circuitry on the wafer become progressivelysmaller. At this time, chipmakers generally are continuing to expand theirmanufacturing capacity at 90 nm, a number of chipmakers have begun expandingproduction capacity at 65 nm, and several chipmakers are in active developmentof production capabilities at 45 nm. In these circumstances, chipmakers needmore leading edge tools, which means they need more of the shorter wavelengthArF photolithography tools in their manufacturing facilities to pattern thecritical layers on the wafer.  Growinguse of 193 nm ArF light sources at the leading edge, combined with continuinguse of 248 nm KrF light sources for the less critical layers, allows chipmakersto meet the rigorous performance and volume demands of high volumemanufacturing.  Our light sources aredesigned to enable chipmakers to achieve their production goals.

**XLASeries** — The XLA Series of ArF light sources is based onour dual-discharge chamber Master Oscillator Power Amplifier (“MOPA”) lightsource architecture.  The masteroscillator creates a narrow bandwidth beam of light at low power which isreferred to as “ultra-narrowed” or “highly line-narrowed”.  The beam then is directed into the poweramplifier, where the power is increased significantly while maintaining thenarrow bandwidth.  This combination of anarrower bandwidth and higher power enables chipmakers to continue reducingcritical circuitry dimensions and increasing processing speeds, capacity andfunctionality of chips, while giving chipmakers the performance and costadvantages they need.  Each product inthe XLA Series is based on the XL common platform, which includes cabling andwiring harnesses, electrical interfaces, power supplies, gas delivery systems,cooling systems, and other various components, all in a common enclosure.  Use of a common platform enables us to developeach new product in the series rapidly and cost-effectively.  Because our customers are accustomed toworking with the XLA Series, our direct customers can efficiently integrate anew XLA light source product into their advanced scanners and bring them tomarket quickly, while our chipmaker customers can quickly begin using theselight sources in their existing manufacturing processes and achieve rapid timeto yield.

**ProductsBased on the XL Common Platform**:

·                   **XLR 500i**— The XLR 500i is our fifth generation ArF lightsource based on our MOPA laser architecture, and is built on the productionproven universal platform developed for the XLA 300.  Operating at a 6 kHz repetition rate andcurrently offering up to 60 W of output power, the XLR 500i includes a designwhich we call our recirculating ring technology. This ring technology comprisesa new dual chamber architecture designed to deliver a step-function improvementin energy stability which we expect will lead to both yield and productivityenhancements for the chipmaker. Additionally, our ring technology is expected to offer a greater than20% reduction in the average chipmaker’s cost of operation.  Initial shipments of the XLR 500i forinstallation at chipmakers are expected in 2007.

·                   **XLA 300** — The XLA 300 is our fourth generation leading edgeArF light source based on the MOPA design. It operates at a 6 kHz repetition rate and offers up to 60 W of outputpower, and is designed for high volume production of semiconductor devices at45 nm production node using immersion lithography techniques.  Based on the production proven XL platform,the initial shipment of the XLA 300 in the fourth quarter of 2005 marked thefastest product development cycle in our history.

·                   **XLA 200** — The XLA 200 is our third generation ArF lightsource based on the MOPA design and XL platform and offers higher power and anarrower bandwidth than its predecessor. Operating at a 4 kHz repetition rate, it also offers up to 60 W ofoutput power and an ultra line-narrowed bandwidth to enable production ofsemiconductor devices at the 65 nm production node in non-immersionapplications, and pilot production at the 45 nm node using immersionlithography techniques.  The initialshipment of our XLA 200 occurred in the first quarter of 2005.

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·                   **XLA 105** — Now used in volume production in many fabs, theXLA 105 is our second generation XLA Series product, offering a 4 kHzrepetition rate and 40 W of output power. Designed for use at the 65 nm production node, the XLA 105 initiallyshipped in the first quarter of 2004, and continues to experience strong demandfrom chipmakers.

·                   **XLA 100** — The XLA 100 was our first XLA Series product, andoffers a 4 kHz repetition rate and 40 W of output power.  Designed for high volume production at the 90nm production node and below, the XLA 100 began shipping in the first quarterof 2003.  Though it still ships in smallnumbers, the XLA 100 has been superseded for the most part by our later modelsin the XLA Series.

**NanoLith7000**— The NanoLith 7000 is a single-chamber ArF lightsource offering a 4 kHz repetition rate and 20 W of output power.  Designed to enable initial ArF process development and production at the 100 nmproduction node and below, the NanoLith 7000 is the ArF twin of the ELS-7000KrF light source (see 7000 Series below). The NanoLith 7000 sold well from its introduction in mid-2001 through2002, and was replaced by the more advanced XLA 100 when that product wasintroduced in 2003.  As of the end of2006, we were shipping this product only sporadically, but continuing to provideconsumable modules, spare parts and service for the installed base of NanoLith7000s in semiconductor fabs throughout the world.

***248nm KrF Light Sources***

We have beenproviding KrF light sources for volume chip production since 1996 whenchipmakers reached the 250 nm production node. Over the years, we have developed and sold a variety of increasinglypowerful and productive KrF products. These light sources have enabled increasing wafer throughput andcontinually shrinking CD.

**7000Series** — The 7000 Series of products offers a completeproduct line, encompassing both ArF and KrF light sources on a common platform,enabling chipmakers to easily “mix and match” these two different light sourcewavelengths within the manufacturing environment.  With a 4 kHz repetition rate and high outputpower, the 7000 Series offers chipmakers high wafer throughput and lower costof operation by reason of advanced design and materials, thus deliveringimproved tool availability for increased manufacturing efficiency and flexibility.

**Our 7000Series products**:

·                   **ELS-7010** — The ELS-7010 is our most advanced KrF lightsource.  Introduced in the third quarterof 2004 with 40 W of output power to enable chipmakers to achieve high volumeproduction at the 100 nm production node and below, the ELS-7010 is now ourbest-selling KrF light source.  Thislight source also offers ultra-narrowed bandwidth and a number of controls toenhance performance.

·                   **ELS-7000®**  — TheELS-7000 was introduced with 30 W of output power in January 2002 for highvolume production of devices at the 130 nm production node and below.  In 2006, there was very limited demand forthis light source, since chipmakers now prefer the higher power and narrowerbandwidth offered by the ELS-7010.

·                   **NanoLith 7000**— See the description of this ArF light sourceunder “NanoLith 7000” above.

**6000Series** — The 6000 Series of light sources includes twoKrF models and an ArF model.  Whenoriginally introduced, 6000 Series light sources were designed for productionof semiconductor devices with design rules down to 130 nm.

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**Our 6000Series products**:

·                   **ELS-6010** — The ELS-6010 offers a 2.5 kHz repetition rate and20 W of output power.  Originallyintroduced at the end of 2000, the ELS-6010 has enjoyed strong chipmakeracceptance and demand especially among chipmakers who wish to meet their KrFneeds with a highly reliable light source that enables good wafer throughput.

·                   **ELS**-**6000TM** — TheELS-6000 operates at a 2 kHz repetition rate, offers 20 W of output power, andwas designed for steppers and scanners used in the production of semiconductordevices with CDs of 180 nm and below. Initial shipments of the ELS-6000 began in the second half of 1998, andthis product continued to sell well into 2002, and then again in 2004 whenchipmakers were expanding 200 mm fab capacity. We currently sell only a limited number of these light sources per year.

·                   **ELS-6010A** — See the description of this light source under “LegacyProducts” below.

***LegacyProducts***

Ingeneral, we no longer sell our legacy light source products because they havebeen superseded by our newer, more advanced products.  Our legacy products are still widely used bychipmakers to pattern the circuitry on the less critical layers of the wafer.  They make up a substantial portion of ourinstalled base of light sources, and we still provide consumables, spare partsand service for these light sources.

**ELS-6010A**— The ELS-6010A is the ArF model in the 6000 Series of products.  It operates at a 2 kHz repetition rate with10 W of output power and was designed to meet the resolution, image contrastand wafer throughput requirements in semiconductor production at the 130 nmnode and below.  It began shipping in thesecond quarter of 2001, but was superseded later that same year by the NanoLith7000 with its higher repetition rate and power. We still provide consumables, spare parts and service for the ELS-6010Asinstalled at chipmakers and other end users.

**5000Series** — Our 5000 Series of light sources include several KrFproducts and one ArF product.  The 5000Series light sources operate at a 1 kHz repetition rate, and depending on themodel, offer 10 W or 15 W of output power for use in the manufacture ofsemiconductors with CD of 250 nm and below. We last shipped a 5000 Series lightsource in early 2001, but we continue to provide consumables, spare parts andservice to the large installed base of 5000 Series products throughout theworld.

*Replacement Parts and Refurbishment Activities*

Certain componentsand subassemblies included in our light sources require replacement orrefurbishment following extended operation. We estimate that a light source used in a semiconductor productionenvironment will require one to two replacement chambers per year, dependingupon the level of usage. Similarly, certain optical components of the lightsource deteriorate with continued exposure to DUV light and require periodicreplacement.  We provide these and otherspare and replacement parts for our photolithography light sources as needed byour customers.

Revenuesgenerated from sales of replacement parts, excluding the receipt of reusablematerial, were approximately $123.2 million, $130.8 million, and $199.8 millionfor 2004, 2005, and 2006, respectively. Revenues from replacement parts are dependent on both the utilization ofour light source systems and the size of our installed base of lightsources.  The size of our installed baseincreased from 2,743 light sources as of December 31, 2005 to 3,042 lightsources as of December 31, 2006, and the utilization of our light sourcesystems at chipmakers continued to grow throughout 2006. The utilization rategrew 8.1% from the beginning of 2006 and reached a record high level by the endof 2006.

As part of ourregular business activities, we conduct significant parts refurbishment and 

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material reclaimactivities related to some of our core assemblies, in particular our chamberassemblies. These activities involve arrangements with our customers where wesell a new part to the customer at a reduced sales price if the customerreturns the consumed core assembly that the new part replaces.  These returned core assemblies contain acertain amount of material, primarily metal components, that may be reused byus in future core assemblies.  Since aportion of the consideration related to the original sale is related to thereturn of consumed parts, we record revenue when we receive the returnedassemblies from our customers.

Revenues generated from the receipt of reusablematerial contained within consumed assemblies returned from our customers wereapproximately $28.5 million, $18.0 million and $26.0 million for 2004, 2005 and2006, respectively.  Revenues from suchactivities are dependent on the quantity of the core assemblies returned fromour customers and the value of the reusable parts that we expect to yield fromthe core assemblies received.  Our methodof accounting for refurbishment activities is explained in greater detail inItem 7, “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations” under the caption “Accounting for Parts Used in RefurbishmentManufacturing Process” and in Note 1 to our consolidated financial statements.

*Service*

Asthe life and usage of our installed base of light sources in production atchipmakers exceeds the original warranty periods, some chipmakers requestservice contracts from us.  Additionally,we provide billable service or service contracts directly to the threesemiconductor lithography tool manufacturers, as well as to chipmakercustomers. These service agreements require us to maintain and/or service theselight sources either on an on-call or regular interval basis or both.  Included in some of the types of servicecontracts we provide to our customers are the replacement of consumable partsand non-consumable parts.  The pricingfor such contracts includes the replacement of these parts.

Inaddition to service contracts, we offer CymerOnLineTM,a diagnostic and performance software product whichdelivers critical laser diagnostics and performance information in nearreal-time directly to authorized users anywhere.  The software simplifies reporting and allowsusers to efficiently manage consumables usage. CymerOnLine features a user-friendly browser-based interface, which featuresa robust design and provides a secure data environment.  Event-initiated messages sent to pagers,e-mail, mobile phones, or other handheld devices enable up-to-the minutecommunication and proactive management.

Revenues generated from service and service contractswere approximately $20.1 million, $26.4 million and $35.2 million for 2004,2005 and 2006, respectively.  We expectservice and service contract revenues to remain at or exceed these levels asour installed base grows and the warranty period of our light source systemsexpires.

**Customers and End-Users**

We sell our photolithography light source products to each of the threemanufacturers of DUV photolithography tools:

| ASML |   | Canon |   | Nikon |
|------|--------|-------|--------|-------|

We believe that maintaining and strengthening customer relationshipswill play an important role in maintaining our leading position in thephotolithography market.  We work closelywith our customers to integrate our products into their photolithographytools.  Sales to ASML, Canon, and Nikonaccounted for 38%, 6% and 16%, respectively, of total revenue in 2006.

Revenues generated from customers within the U.S. were $75.8 million,$60.3 million and $85.0 million for 2004, 2005 and 2006, respectively.  Revenues generated from customers outside ofthe U.S. were $342.2 million, $323.4 million and $458.9 million for 2004, 2005and 2006, respectively.

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Revenues generated from customers locatedin Japan were $132.8 million, $119.6 million and $120.2 million for 2004, 2005and 2006, respectively.  Revenuesgenerated from customers located in Europe were $154.7 million, $138.8 millionand $223.1 million for 2004, 2005 and 2006, respectively.  These revenues can originate from any of ourlocations to customers located in these countries.

Long-lived assetslocated in the U.S. were $114.1 million, $108.9 million and $103.1 million asof December 31, 2004, 2005 and 2006, respectively. Long-lived assets locatedoutside of the U.S. were $9.4 million, $8.4 million and $9.0 million as ofDecember 31, 2004, 2005 and 2006, respectively.

End-users of our light sources include all of the world’s largestsemiconductor manufacturers. The following semiconductor manufacturers havepurchased one or more DUV photolithography tools incorporating our lightsources:
| **U.S.**                     | ** ** | **Japan**             | ** ** | **Singapore**              | ** ** | **Korea**                     |
|------------------------------|------------|-----------------------|------------|----------------------------|------------|-------------------------------|
| Agere Systems                |       | CASMAT †         |       | 1st Silicon           |       | DongbuAnam Semiconductor Inc. |
| Albany Nanotech              |       | Denso                 |       | Chartered Silicon Partners |       | Hynix Semiconductor Inc.      |
| AMD                          |       | Elpida Memory Inc.    |       | Peregrine Semiconductor    |       | Magnachip                     |
| Applied Materials            |       | Fuji Film             |       | Silterra                   |       | National NanoFab †       |
| Atmel                        |       | Fujitsu               |       | SSMC                       |       | Samsung                       |
| Clariant Corp.               |       | Hitachi               |       | TECH                       |       |                          |
| Cypress                      |       | JSR                   |       | UMCI Pte Ltd.              | ** ** | **Europe**                    |
| Freescale Semiconductor      |       | Kawasaki Seitetsu     |       |                       |       | Altis Semiconductor           |
| Headway Technologies         |       | Matsushita            | ** ** | **Taiwan/China**           |       | C-NET †                  |
| Honeywell                    |       | NEC                   |       | ASMC                       |       | CEA-Leti                      |
| HP                           |       | OKI                   |       | ERSO                       |       | IHP                           |
| IBM                          |       | Renesas Semiconductor |       | GSMC                       |       | IMEC v.z.w †             |
| IMFT                         |       | Rohm                  |       | HeJian                     |       | Infineon Technologies AG      |
| Integrated Device Technology |       | Sanyo                 |       | Inotera                    |       | NXP Semiconductor             |
| Intel                        |       | Seiko                 |       | MXIC                       |       | Qimonda                       |
| Jazz Semiconductor           |       | SELETE †         |       | Nan-ya                     |       | ST Microelectronics           |
| LSI Logic Corp.              |       | Sharp                 |       | Promos                     |       | Tower Semiconductor           |
| Maxim Integrated Products    |       | Sony                  |       | PSC                        |       |                          |
| Microchip Technology Inc.    |       | Tokyo Electron Ltd.   |       | SMIC                       |       |                          |
| Micron Technology            |       | Tokyo Ohka Kougyo Co. |       | TSMC                       |       |                          |
| National Semiconductor       |       | Toshiba               |       | UMC Group                  |       |                          |
| Rohm & Haas              |       |                  |       | VISC                       |       |                          |
| Sarnoff Corp.                |       |                  |       | Winbond Group              |       |                          |
| SEMATECH †              |       |                  |       |                       |       |                          |
| Spansion                     |       |                  |       |                       |       |                          |
| Texas Instruments            |       |                  |       |                       |       |                          |
| VLSI                         |       |                  |       |                       |       |                          |
| Wafertech                    |       |                  |       |                       |       |                          |

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†  A semiconductorindustry consortium.

**Backlog**

We schedule production of light sources based upon order backlog andinformal customer forecasts.  We includein backlog only those orders to which a purchase order number has been assignedby the customer and for which delivery has been specified within 12months.  Because customers may cancel ordelay orders with little or no penalty, our backlog as of any particular datemay not be a reliable indicator of actual sales for any succeeding period.  At December 31, 2006, we had a backlogof approximately $94.4 million compared with a backlog of $90.8 million atDecember 31, 2005.

**Manufacturing**

Our manufacturing activities consist of material management, assembly,integration and testing. These activities are performed in a 265,000 squarefoot facility in San Diego, California that includes approximately 31,000square feet of Class 10,000 cleanroom manufacturing and test space.  In order to focus our own resources,capitalize on the expertise of our key suppliers and respond more efficientlyto customer demand, we have outsourced the manufacture of many of oursubassemblies. Our 

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manufacturing outsourcing strategy is exemplified by the modular designof our products.  Substantially allmanufacturing of nonproprietary subassemblies has been contracted to third-partysuppliers. As a result, we are increasingly dependent upon these contractsuppliers to meet our manufacturing schedules. The failure by one or more of these suppliers to supply us on a timelybasis with sufficient quantities of components or subassemblies that perform toour specifications could affect our ability to deliver completed light sourcesto our customers on schedule. We believe that the highly outsourced content andmanufacturable design of our products allows for reduced manufacturing cycletimes and increased output per employee. To improve current productionefficiencies, control costs, and manage overall manufacturing capacity, weintend to continue to provide additional training to manufacturing personnel,improve our assembly and test processes in order to reduce cycle time, investin additional manufacturing tooling and further develop our supplier managementand engineering capabilities.

In addition to the manufacturing capacity at our facilities in SanDiego, California, we have a refurbishment facility in Korea.  This facility refurbishes discharge chambersfor light sources in Korea and the Asia-Pacific region.  The refurbishment facility in Korea includes6,550 square feet of Class 10,000 cleanroom manufacturing space.

A limited number ofcomponents and subassemblies included in our products are obtained from asingle supplier or a small group of suppliers. For certain optical, control system and pulse power components andsubassemblies used in our light source systems, we currently utilize a singlesupplier.  Where possible, we work withsecondary suppliers to qualify additional sources of supply.  To reduce the risk associated with thissingle supplier, we carry significant strategic inventories 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.  To date we have been able to obtain adequatesupplies of the components and subassemblies used in the production of ourlight source systems in a timely manner from existing sources.  If in the future we are unable to obtainsufficient quantities of required materials, components or subassemblies, or ifsuch items do not meet our quality standards, delays or reductions in productshipments could occur which could harm our business, financial condition andresults of operations.

**Sales and Marketing**

Oursales and marketing efforts are designed to serve our customer base consistingof both the DUV photolithography tool providers such as ASML, Canon and Nikonas well as many of  the world’s top 23chipmakers.  We market and sell ourproducts through our own worldwide direct sales and marketing channels and wehave developed product and applications engineering teams to support theseefforts. We believe that in order for our sales and marketing organization tobe successful, we must work closely with and understand the requirements ofboth the photolithography systems solutions providers and the end-usersemiconductor manufacturers.

**Service and Support**

We believe our success in the semiconductor photolithography market ishighly dependent upon after-sales support to both our direct and our end-usercustomers.  We support our customers withfield service, technical service engineers and training programs, and provideon-site support at the customer’s manufacturing facilities.  Prior to shipment, our support personneltypically assist the customer in site preparation and inspection and providecustomers with training at our facilities or at the customer’s location.  We also provide direct customers andend-users with a comprehensive set of manuals, including operations,maintenance, service, diagnostic and safety manuals.

Our field engineers and technical support specialists provide fieldservice and front-line technical support capability from our San Diegoheadquarters, and at our field service offices located throughout the U.S.Support in Europe, Japan, Korea, Singapore, the People’s Republic of China,Taiwan and Southeast Asia is provided by our subsidiaries located within thoseregions.  As part of our customerservice, we maintain an inventory of spare parts at each of our servicefacilities.  As our installed base grows,replacement parts required to satisfy worldwide support requirements, as wellas 

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our own logistics support organization, will be subject to thefluctuating demands of the semiconductor industry. In order to meet thesedemands, we must continue to effectively manage our production of componentmodules which are required for new systems, as well as for support and warrantyrequirements for installed systems.

We believe that the need to provide fast and responsive service thatmeets the level of quality required by semiconductor manufacturers using ourlight sources is critical and that we cannot depend solely on our customers toprovide this service.  Therefore, webelieve it is essential to maintain, through our own personnel, a rapidresponse capability to service our customers and end-users throughout theworld.  Accordingly, we seek tocontinuously develop and enhance our direct support infrastructure in Europe,Japan, Korea, Singapore, the People’s Republic of China, Taiwan and SoutheastAsia and the U.S.  This task entailsrecruiting and training qualified field service personnel or identifyingqualified independent firms and maintaining effective and highly trainedorganizations that can provide service to customers in various countries intheir assigned regions.

We generally warrant our new light source products against defects indesign, materials, and workmanship.  Thewarranty period and terms vary by light source model.  We also warrant consumable 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.

#### **Research and Development**

The semiconductor industry is subject to rapid technological change andnew product introductions and enhancements. We believe that continued and timely development and introduction of newand enhanced light source products are essential for us to maintain ourcompetitive position.  We intend tocontinue to develop our technology and innovative products to meet customerdemands. Current projects include enhancements to our KrF and ArF light sourcesand the recently announced development of a recirculating ring based ArF lightsource which provides performance enhancements to our MOPA product line.  We have continued to expend significantdevelopment efforts to address the technology and products that will be basedon the extreme ultraviolet (“EUV”) technology needed for future generationphotolithography illumination sources. We may also invest in other product and technology areas in orderto expand our portfolio within the semiconductor capital equipment marketsector. In addition there are ongoing efforts to improve existing products,reduce manufacturing costs, lower the cost of light source operation, enhancelight source performance, develop new features for existing light sources, andconduct research and development of non-light source products.

We have historically devoted a significant portion of our financialresources to research and development programs and we expect to continue toallocate significant resources to these efforts. Research and developmentexpenses for 2004, 2005 and 2006 were approximately $58.6 million, $64.0million and $74.0 million, respectively.

Inthe last three years, we have entered into several research and developmentagreements related to EUV technology both with customers and governmentagencies. The largest of these research and development agreements was withIntel Corporation in January 2004. This agreement  provided funding to accelerate thedevelopment of production-worthy EUV lithography light sources at Intel’srequest. This agreement was terminated in June 2006.  See Note 6 to our consolidated financialstatements for additional information. The total funding recorded under thisagreement for 2004, 2005 and 2006 was $6.1 million, $1.9 million and $104,000,respectively.

Revenuesgenerated from research and development contracts amounted to approximately$783,000, $1.0 million and $395,000 during 2004, 2005 and 2006,respectively.  For certain of ourresearch and development contracts, our research and development expenses areoffset by amounts earned associated with these contracts.  The amounts offset against research anddevelopment expenses were $7.6 million, $2.8 million and $154,000 during 2004,2005 and 2006, respectively.

Wehave established a joint venture with Zeiss called TCZ which is headquarteredin Singapore.  

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The joint ventureis owned 60% by us and 40% by Zeiss. TCZ is currently developing, and willintegrate, market and sell, and support, production tools for the flat paneldisplay manufacturing industry.  Thejoint venture is targeting the growing market for low-temperature poly-silicon(“LTPS”) processing used in the manufacture of liquid crystal displays that arebrighter, have higher resolution, and consume less power than displays usingtoday’s predominant amorphous silicon films. We currently expect that TCZ will ship its first production tool, theTCZ 900X, in late 2007 or early 2008.  As a majority owned subsidiary, TCZ’s results, including research anddevelopment expenses, are included in our consolidated financial statements.

#### **Intellectual Property Rights**

While the success of our business depends more onsuch factors as the technical expertise of our employees, as well as theirinnovative skills and marketing and customer relations abilities, the successof our business also relies on our ability to protect our proprietarytechnology.  Accordingly, we seek toprotect our intellectual property rights in a variety of ways, including byobtaining patents.  As of December 31,2006, we owned 254 U.S. patents covering certain aspects of technology relatedto light sources and piezo techniques. These patents will expire at various times during the period fromJanuary 2008 to September 2025. As of December 31, 2006, we had applied for 137additional patents in the U.S.  As ofDecember 31, 2006, we owned 396 foreign patents and had 373 patent applicationspending in various foreign countries.

Our pending patent applications and any futureapplications might not be approved. Our patents might not provide us with acompetitive advantage and may be challenged by third parties. In addition,third parties’ patents might have an adverse effect on our ability to dobusiness. Due to cost constraints, we did not begin seeking patent protectionin Japan and other countries for our inventions that are covered by U.S.patents and patent applications until 1993. As a result, we do not have the right to seek foreign patent protectionfor some of our early inventions. Additionally, laws of some foreign countries in which our products areor may be developed, manufactured or sold, including various countries in Asia,may not protect our products or intellectual property rights to the same extentas do the laws of the U.S. Thus, the likelihood of piracy of our technology andproducts is greater in these countries. Further, third parties mightindependently develop similar products, duplicate our products, or design aroundpatents that are granted to us.

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

We also rely on trade secret protection, employee and third-partynondisclosure agreements and other intellectual property protection methods toprotect our confidential information and our other intellectual property.However, we may not be successful in protecting our confidential information,particularly our trade secrets, because third parties may independently developsubstantially the same proprietary information and techniques, gain access toour trade secrets, or disclose our technology.

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

 

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

Specifically, Komatsu notified us in 1996 that wemay be infringing some of its Japanese patents. During our subsequentdiscussions, Komatsu also asserted that our former Japanese manufacturingpartner, Seiko, or we may be infringing on some of Komatsu’s U.S. patents and anumber of its additional Japanese patents. Komatsu has also notified one of ourcustomers, Nikon, of its belief that our light sources infringe several ofKomatsu’s Japanese and U.S. patents. As a result, we started proceedings in theJapanese Patent Office to oppose certain patents and patent applications ofKomatsu. The Japanese Patent Office has dismissed our opposition claims. Thus,litigation may result in connection with Komatsu’s Japanese patents or U.S. patents.Also, Komatsu might claim that we infringe other or additional patents. Komatsunotified Seiko that it intends to enforce its rights against Seiko with respectto its Japanese patents if Seiko continued to engage in manufacturingactivities for us. In connection with our former manufacturing agreement withSeiko, we agree to pay Seiko under certain conditions for damages associatedwith these types of claims. Seiko may not prevail in any litigation againstKomatsu, and therefore, we may be required to pay Seiko for such damages.

We have notified our competitor and others of ourU.S. patent portfolio. Specifically, we have notified Komatsu that it may beinfringing some of our U.S. patents. We have discussed with Komatsu our claimsagainst each other.  Komatsu challengedone of our U.S. patents in the United States Patent and Trademark Office (“USPTO”)but our patent was subsequently re-issued by the USPTO.  Also, Komatsu transferred its lithographylight source business to our competitor, Gigaphoton.  We also have had discussions with a formercompetitor, Lambda-Physik (a subsidiary of Coherent, Inc.), regardingallegations by each party against the other for possible patent infringement.Any of these discussions with our competitor or former competitor may not besuccessful and litigation could result.

Inthe future, patent litigation may result due to a claim of infringement by ourcompetitor or any other third party or may be necessary to enforce patentsissued to us.  Any such litigation couldresult in substantial cost to us and diversion of our effort, which would havean adverse 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, or as aresult thereof, we may seek a license from third parties to use theirintellectual property. However, we may not be able to obtain a license.Alternatively, we may design around the third party’s intellectual propertyrights or we may challenge these claims in legal proceedings.  Any adverse determination in a legalproceeding could result in one or more of the following, any of which could harm our business,financial condition and operating results:

·                   loss of our proprietary rights;

·                   exposure to significant liabilities by other thirdparties;

·                   requirement that we get a license from third parties onterms that are not favorable; or

·                   restriction from manufacturing or selling our products.

Any of these actions could be costly and would divert the efforts andattention of our management and technical personnel, which would materiallyadversely affect our business, financial condition and results of operations.

In 1992, we grantedSeiko a right of first refusal to fund our development of, and receive alicense to, new industrial light source technologies not developed with fundingfrom other parties.  In exchange forthese rights, we received up-front license fees of $3.0 million in aggregateduring 1992 and 1993. We were also entitled to royalties of 5% on related productsales through September 1999, after which the royalty rate was subject torenegotiation.  To date no renegotiationof the royalty rate has occurred and we have earned no royalties under theagreement.  The license agreement alsoprovides that product sales between us and Seiko will be at a 15% discount fromthe respective companies’ list prices. The agreement terminates in August 2012. There has been no production or sales activity by 

 

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Seiko associated withthis contract to date and this contract does not apply to our current lightsource system products.

We have registered the trademarks ‘‘CYMER’’ and “INSISTON CYMER” and others in the U.S. and in some other countries. We are alsotrying to register additional trademarks in the U.S. and in other countries. Weuse these trademarks and many other marks in our advertisements and otherbusiness materials, which are distributed throughout the world. We may besubject to trademark infringement actions for using these marks and other markson a worldwide basis and this would be costly to defend. If a trademarkinfringement action were successful, we would have to stop using the mark andpossibly pay damages.

**Competition**

We believe that the principal elements of competition in our markets arethe technical performance characteristics of the excimer light source productsand the operating efficiency of the system, which is based on availability,reliability, performance efficiency, throughput, cost of operation, and rate ofquality. We believe that we compete favorably with respect to these factors.

We currently have one significant competitor thatsells light sources for DUV photolithography applications. This competitor,Gigaphoton, is a joint venture between two large companies, Komatsu and Ushio,and is headquartered in Japan. Gigaphoton is aggressively trying to gain larger market penetration inthe excimer light source industry. We know that our lithography toolmanufacturer customers have purchased products from this competitor and thatthese customers have approved this competitor’s light sources for use withtheir products.  Additionally, we knowthat Gigaphoton has been approved by a number of chipmakers in Japan and otherregions in Asia, as well as a few chipmakers in the U.S., and that Gigaphotonhas an installed base of light sources at chipmakers in these regions.

In the future, we will likely experiencecompetition from other companies as well, as next generation technologies mustbe adopted in order to enable critical dimensions to continue to shrink beyondthe 32 nm node.  These technologiesinclude EUV, an area in which we have been conducting research and developmentsince 1997 and for which we currently have a very promising light source indevelopment, and possibly nano-imprint lithography or certain types of masklesslithography, such as multiple electron beam direct write lithography.

To remain competitive, we believe that we willneed to manufacture and deliver products to customers on a timely basis withoutsignificant defects and maintain a high level of investment in research anddevelopment and sales and marketing.  Wemight not have sufficient resources to continue to make the investmentsnecessary to maintain our competitive position.

Larger companies with substantially greaterresources, such as other manufacturers of industrial light sources for advancedlithography, may attempt to sell competitive products to our customers.Potential competitors may also be attracted to our growing installed base oflight sources and may attempt to supply consumables and spare parts to thatinstalled base.

**Employees**

On December 31, 2006, we employed 975 persons worldwide. No employeesare currently covered by collective bargaining agreements or are members of anylabor organization as far as we are aware. We have not experienced any work stoppagesand believe that our employee relations are good.

### **Executive Officers**

Set forth below is certain information regarding our executive officersand their ages as of February 23, 2007.

 

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| Name                  | ** ** | **Age** | ** ** | **Position**                                             |
|-----------------------|------------|---------|------------|----------------------------------------------------------|
| Robert P. Akins       |       | 55      |       | Chairman of the Board and Chief Executive Officer        |
| Edward J. Brown       |       | 49      |       | President and Chief Operating Officer                    |
| Nancy J. Baker        |       | 44      |       | Senior Vice President, Chief Financial Officer           |
| Christopher W.  Smith |       | 47      |       | Senior Vice President, Worldwide Business Operations     |
| Stephan D. Spiva      |       | 58      |       | Senior Vice President, Corporate Operations              |
| Rae Ann Werner        |       | 42      |       | Vice President, Controller and Chief Accounting  Officer |

 

**Robert P. Akins**,****one of our co-founders, has served as our chairmanand chief executive officer since our inception in 1986, and served aspresident of the company as well from our inception until May 2000. Hecurrently serves on the boards of directors of Semiconductor Equipment andMaterials International (“SEMI”), and SEMI North America.  He is also a member of the council ofadvisors to the Irwin and Joan Jacobs School of Engineering at the Universityof California, San Diego (“UCSD”), and serves on the board of the UC San DiegoFoundation.  Mr. Akins received the Ernst& Young Entrepreneur of the Year Award for San Diego County in 1997, andwith fellow co-founder Rick Sandstrom, received the outstanding alumnus awardfrom UCSD, and the prestigious SEMI Award for North America, the highest honorconferred by SEMI, in 1996 for contributions to the field of DUV lithography.Mr. Akins received a bachelor’s degree in physics, a bachelor’s degree inliterature, and a doctorate in applied physics from the University ofCalifornia, San Diego.

**EdwardJ. Brown, Jr.** has served as president and chief operatingofficer since September 2005.  Mr. Brownhas nearly three decades of experience in the technology sector, including 17years as an executive and 11 as a corporate officer. Prior to joining us, Mr.Brown held several high-level management positions at Applied Materials Inc.,the world’s largest provider of semiconductor equipment and services. AtApplied Materials, he was responsible for key business innovations, overseeingglobal operations, and enabling significant revenue growth. Mr. Brown receiveda master’s degree in business administration from National University and abachelor’s degree in industrial studies from San Diego State University.

**Nancy J. Baker**has served as senior vice president and chief financial officer since January2002.  Prior to that, she served as ourvice president, finance and treasurer from June 1998 to December 2001.  During 2000, she headed the company’ssuccessful effort to implement a new Enterprise Resource Planning system, whichwas implemented in San Diego in only six months, and globally in only ninemonths. From October 1996 to June 1998 she served as director, corporatefinance and treasurer.  She joined us ascorporate controller for worldwide operations in August 1992.  Ms. Baker’s professional career spans morethan 21 years, and prior to joining us, she held a variety of financialmanagement positions with an international manufacturer in the San Diegoarea.  Ms. Baker received a bachelor’sdegree in accounting from the University of Texas at Austin and completed theexecutive advanced management program at Harvard Business School.

**Christopher W. Smith** has served as senior vice president of worldwide business operationssince May 2006.  He has more than 20years of sales, marketing and senior-level management experience. Prior tojoining us, Mr. Smith spent about 12 years at Applied Materials, Inc. where hemost recently served as vice president and general manager for the Intel,Micron and all North American regional accounts and was responsible for AppliedMaterials’ largest customer/technical business relationships from October 2001to May 2006. Mr. Smith served as vice president and general manager for AppliedMaterials from October 1998 to October 2001 in the chemical mechanicalpolishing products business group; and from November 1994 to October 1988 heserved as managing director of global business development in the dielectricdeposition products business group and the physical vapor deposition productsbusiness group of Applied Materials where his responsibilities ranged frommarketing and business development to technical and field process support.  Mr. Smith holds a bachelor’s degree inbusiness from San Jose State University, and completed the Executive Program atStanford University.

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**StephanD. Spiva**has servedas senior vice president of corporate operations since May 2006.  Mr. Spiva has more than 35 years ofmanagement experience, including 20 years with the U.S. Navy.  Prior to joining us, Mr. Spiva was vicepresident of enterprise solutions at Applied Materials, Inc from June 1998until his retirement in June 2001. From March 1988 to June 1998, Mr. Spivaserved at Applied Materials in various management positions, including as themanaging director of global installed base operations, senior director of Intelaccount operations and director of the advanced manufacturing group and alsoimplemented the Oracle Enterprise Resource Planning system for manufacturingand order fulfillment business processes at Applied Materials. Mr. Spivareceived his bachelor’s degree in business administration from the Universityof Phoenix and is also APICS and CIRM certified.

**RaeAnn Werner**has served as vice president, controller, andchief accounting officer since January 2003. Prior to that, she served as ourcontroller from February 1999 to January 2003. From 1993 to 1999 she held avariety of finance positions with increasing responsibilities since joining usin November 1993.  Ms. Werner’s professional career spans more than 19years, and prior to joining us, she held a variety of financial positions withsemiconductor and communications companies in the San Diego area.  Ms.Werner received a bachelor’s degree in accounting from San Diego StateUniversity.

Executive officers serve at the discretion of the board of directors.There are no family relationships between any of the directors and our executiveofficers.

** Item 1A.**  **Risk Factors**

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

**Our revenues and operating results from quarter-to-quarter have variedin the past and our future operating results may continue to fluctuatesignificantly.**

Factors that contribute to fluctuations in ourrevenues and operating results include:

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

·      cyclicality in the market for semiconductor manufacturingequipment;

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

·                  rates at whichlithography tool manufacturer customers take delivery of light source systemsfrom us;

·      timing and size of orders from our customers;

·      changes in market penetration by our competitor;

·                  product lead timedemands from our customers;

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

·      changes in the price and profitability of our products;

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

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

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

·      our ability to manage our manufacturing requirements;

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

·      worldwide political instability;

·      changing global economic conditions, including rising energyprices; and

 

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·      intellectualproperty protection.

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

We manage our expense levels based, in large part,on expected future revenues. As a result, our expenses are relatively fixed forthe short term, and if our actual revenue decreases below the level we expect,our operating results will be adversely affected.  As a result of these or other factors, wecould fail to achieve our expectations as to future revenue, gross profit,operating income, net income, earnings per share, and cash flows.  Our failure to meet the performanceexpectations set and published by external sources could result in a sudden andsignificant drop in the price of our stock, particularly on a short-term basis,and could negatively affect the value of any investment in our stock.

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

We derive a substantial portion of our revenuesfrom lithography tool manufacturers who, as original equipment manufacturers (“OEMs”),incorporate our light source systems in photolithography tools that they sellto semiconductor manufacturers, or chipmakers, and from chipmakers who purchaseconsumables, spare parts, upgrades and service directly from us in support ofthe light source products. Like us, our OEM customers depend on demand fortheir products from the chipmakers. The capital equipment and related operatingexpenditures of chipmakers depend on a number of factors, including the currentand anticipated market demand for semiconductors and the many products usingsemiconductors.  That demand is highlyvolatile and unpredictable.

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

Downturns in the semiconductor industry often result in decreases indemand for semiconductor manufacturing equipment, including thephotolithography tools that our OEM customers produce. Downturns in thesemiconductor industry have generally had severe effects on the demand forsemiconductor manufacturing equipment and the associated parts and supportservices. Fluctuating levels of investment by chipmakers and resulting pricingvolatility will continue to materially affect our aggregate bookings, revenuesand operating results. Even during periods of reduced revenues we believe wemust continue to invest in research and development and to maintain extensiveongoing worldwide customer service and support capabilities to remaincompetitive. Continued spending in furtherance of these objectives maytemporarily harm our financial results. Semiconductor industry downturns and slowdowns are likely to continue toadversely affect our business, financial condition and

 

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operatingresults, and our operating results may fall below the expectations of publicmarket analysts or investors in future quarters. Any failure to meet suchexpectations could materially adversely affect the price of our common stock.

Our OEM customers try to manage their inventoriesand production requirements to appropriate levels that reflect their expectedsales to chipmakers. Market conditions in the semiconductor industry and ourOEM customers’ production efficiency can cause them to expand or reduce theirorders for new light source systems as they try to manage their inventories andproduction requirements. We continue to work with our OEM customers to betterunderstand these issues. However, we cannot guarantee that we will besuccessful in understanding our OEM customers’ inventory management andproduction requirements or that our OEM customers will not build up an excessinventory of light source systems. If our OEM customers retain an excessinventory of light source systems, our revenue could be reduced in futureperiods as the excess inventory is utilized, which could adversely affect ouroperating results, financial condition and cash flows.  If our OEM customers demand shorter productlead times to improve their inventory and cash positions, our inventorymanagement and cash position may be negatively impacted, which may adverselyaffect our operating results, financial condition and cash flows.

**A significant percentage of our revenue is derived from sales to thethree lithography tool manufacturers, and if we are not able to retain thesecustomers, or they reschedule, reduce or cancel orders, or delay or default onpayments, our revenues would be reduced and our financial condition and cashflows would suffer.**

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

 

|            | ** ** | **Years ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| ASML       |       | 34                                          | %          | 32 | % | 38 | % |
| Canon      |       | 11                                          | %          | 8 | % | 6 | % |
| Nikon      |       | 22                                          | %          | 24 | % | 16 | % |
| Total      |       | 67                                          | %          | 64 | % | 60 | % |

 

Collectively, these three companies accounted forthe following percentage of our total accounts receivable at the datesindicated:

 

|   | ** ** | **December 31,  2005 ** | ** ** | **December 31,  2006 ** | ** ** |
|--------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ASML   |       | 36                                | %          | 48                                | %          |
| Canon  |       | 5                                 | %          | 3                                 | %          |
| Nikon  |       | 25                                | %          | 19                                | %          |
| Total  |       | 66                                | %          | 70                                | %          |

 

We expect that sales of our light source productsto these three customers will continue to account for a substantial portion ofour revenue in the foreseeable future. None of our customers are obligated topurchase a minimum number of our products in the aggregate or during anyparticular period.  We can provide noassurance that any of our customers will continue to purchase our products atpast or current levels.  For example,revenue attributable to sales to Canon has declined significantly since2004.  Sales to Canon or any of thesecustomers may be affected by many factors, some of which are beyond ourcontrol. These factors include:

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

·      a customer experiencing lithography tool production problems;

·      a decision to purchase light sources from other suppliers;

 

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·                  changes in economic conditionsin the semiconductor or the photolithography tool industries; and

·                  a decline in a customer’sfinancial condition.

The loss of any significantbusiness from or production problems for any one of these three customers wouldharm our business and financial condition.

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

Our only current product line is excimer lightsource systems, including KrF and ArF systems, and support, includingconsumable and spare parts and service support. We expect these light source systems and the related support to continueto account for a substantial majority of our revenues in the near term.Continued market acceptance of our light source system products is, therefore,critical to our future success. The primary market for excimer light sources isin the use of DUV photolithography equipment for manufacturing deep-submicronsemiconductor devices using smaller circuit geometries. The demand for ourproducts depends in part on the rate at which chipmakers further adopt excimerlight sources as the chosen light source for their photolithography tools.

 The ratewith which chipmakers adopt excimer light sources may vary for a variety ofreasons, including:

·                  inadequate performanceof photoresists used in advanced DUV photolithography, especially new ArFimmersion-specific resists;

·                  potential shortages ofspecialized materials used in DUV optics;

·                  productivity of ArFimmersion lithography tools, and in the future, productivity ofdouble-patterning ArF lithography tools; and

·      consolidation of chipmakers.

We cannot guarantee that these factors can or willbe overcome or that the demand for our excimer light source products will notbe materially reduced. The demand for our light source products, and thereforeour operating results, financial condition and cash flows, could be adverselyaffected by a number of factors, including:

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

·                  a failure to achievecontinued market acceptance of our products;

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

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

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

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

**We depend on the introduction of new products for our success, and weare subject to risks associated with rapid technological change.**

Rapid technological changes in semiconductor manufacturing processessubject us to increased pressure to develop technological advances enablingsuch processes. We believe that our future success depends in part upon ourability to develop, manufacture, timely introduce and support new light sourceproducts with improved capabilities and to continue to enhance our existinglight source systems and process capabilities. Due to the risks inherent in transitioning to new products, we mustforecast accurate demand for new products while managing the transition fromolder products.

Our most significant product introduction in recent years consisted of atechnology change from a single-discharge-chamber excimer light source to adual-discharge-chamber design called MOPA. 

 

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TheMOPA design represents a paradigm shift from previously accepted lithographytechnology and offers chipmakers higher power, tighter bandwidth and lower costof operation for their current — and we expect for their future — opticallithography applications.  As originallydesigned, the MOPA architecture was projected to provide its benefits acrossall three DUV wavelengths — 248 nm, 193 nm, and 157 nm — but at this time, thesemiconductor industry has only adopted MOPA at the 193 nm wavelength, due tothe successful extension of 248 nm single chamber technology, and the omissionof 157 nm lithography from the roadmap. There are risks inherent in the MOPA technology, including effectiveexecution of our product development roadmap, continuing adoption of theproduct by lithography tool manufacturers and chipmakers, manufacturability,cost effectiveness, and product performance in the field of the new productsand the development of a comparable product by our competitor.

At this time, chipmakers are continuing to expand their manufacturingcapacity at 90 nm, and a growing number of chipmakers are ramping up productioncapability at 65 nm, while manufacturers of certain types of memory chips arein the early stages of ArF immersion production below 65 nm and a significantlevel of development is underway at 45 nm. These efforts, along with expanding use of ArF immersion lithography inproduction among certain memory manufacturers, are driving demand for our mostadvanced ArF light sources.  At the sametime chipmakers also need tools for the less critical layers on wafers, andthere remains strong demand for our KrF light source products for DUVphotolithography systems as well. After chipmakers have built their capacity tolevels appropriate to meet existing demand, their demand for our light sourceproducts will depend, in part, on their sales forecasts and their estimatesregarding the duration and magnitude of the current industry cycle and whethertheir projected manufacturing process yields will enable ongoing investments inwhatever capacity seems necessary.

Future technologies such as EUV, nano-imprint lithography, and certainmaskless lithography techniques may render our excimer light source productsobsolete. We must manage product transitions, as introduction of new productscould adversely affect our sales of existing products. If new products are notintroduced on time, or have reliability or quality problems, our performancemay be impacted by reduced orders, higher manufacturing costs, delays inacceptance of and payment for new products, and additional service and warrantyexpenses. We may not be able to develop and introduce new products orenhancements to our existing products and processes in a timely or costeffective manner that satisfies customer needs or achieves market acceptance.Failure to develop and introduce these new products and enhancements couldmaterially adversely affect our operating results, financial condition and cashflows.

We expect to face significant competition from 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.

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

We believe it is critical for us to provide quickand responsive service directly to the chipmakers throughout the world that useour light source products in their photolithography systems, and that it isessential to maintain our own personnel or trained third-party resources toprovide these services.  Accordingly, wehave an ongoing effort to develop our direct support system with locations inEurope, Korea, Japan, the People’s Republic of China, Singapore, Taiwan and theU.S. This requires us to do the following:

·                  recruit and trainqualified field service personnel;

·                  identify qualifiedindependent firms; and

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

 

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We may not be able to attract and train qualifiedpersonnel to maintain our direct support operations successfully. We may not beable to find and engage qualified third-party resources to supplement andenhance our direct support operations. Further, we may incur significant costs in providing these supportservices. Failure to implement our direct support operation effectively couldharm our operating results, financial condition and cash flows.

**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.**

To continue to grow our business, our existinglight source products and their process capabilities must be enhanced, and wemust develop and manufacture new products to serve other semiconductorapplications. We cannot guarantee that we will be able to manage our businessto grow effectively. Nor can we guarantee that we will be able to acceleratethe development of new enhancements to our existing products and create newproducts. Further, we may not be able to effectively integrate new products andapplications into our current operations. Any of these risks could materiallyharm our business, financial condition and results of operations.

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

In order to respond to the business cycles of the semiconductor industry,in the past few years we have sharply expanded and contracted the scope of ouroperations and the number of employees in many of our locations anddepartments. As the semiconductor industry cycle moves between growth and contractionwe will need to:

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

·                  closely manage ourglobal operations;

·                  improve our process andother internal management systems;

·                  quickly adapt tochanging sales and marketing channels;

·                  effectively manage ourinventory levels; and

·      attract, train, retain and manage key personnel.

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

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

We purchase a limited number of components and subassemblies included inour light source products from a single supplier or a small group ofsuppliers.  For certain optical,control system and pulse power components and subassemblies used in our lightsource systems, we currently utilize a single supplier.  To reduce the risk associated with this singlesupplier, we carry a significant strategic inventory of these components.  Strategic inventories are managed as apercentage of future demand.  We havealso negotiated to have vendor-managed inventory of critical components tofurther reduce the risk of a single supplier. In addition, we contract themanufacture of various subassemblies of our products and depend on our contractmanufacturers to deliver to our required specifications, schedule, and qualitystandards. 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 requirements or respond quickly enough as an upturn begins andgains momentum.  Due to the nature of ourproduct development requirements, these key suppliers must rapidly advancetheir own technologies and production capabilities in order to support theintroduction schedule of our new products. These suppliers may not be able toprovide new modules and subassemblies when they are 

 

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needed to satisfy our product schedule requirements. Ifwe cannot purchase enough of these materials, components or subassemblies, orif these items do not meet our quality standards, there could be delays orreductions in our product shipments, which would harm our operating results,financial condition and cash flows.

## **We aredependent on our manufacturing facilities and subcontractors to assemble andtest our products.**

Operations at our primary manufacturing facilityand our subcontractors are subject to disruption for a variety of reasons,including work stoppages, terrorism, fire, earthquake, energy shortages,flooding or other natural disasters. Such disruptions could cause delays in shipments of our products to ourcustomers.  We provide no assurance thatalternate production capacity would be available if a major disruption were tooccur or that, if it were available, it could be obtained on favorable terms.  Such disruption could result in cancellationof orders or loss of customers, which would have a material adverse effect onour operating results, financial condition and cash flows.

**Weface competition from one company and may face competition from additionalcompetitors who enter the market.**

We currently have one significant competitor thatsells light sources for DUV photolithography applications. This competitor,Gigaphoton, is a joint venture between two large companies, Komatsu and Ushio,and is headquartered in Japan.  Gigaphoton is aggressively trying to gain larger market penetration inthe excimer light source industry. We know that our customers have purchasedproducts from this competitor and that our customers have approved thiscompetitor’s light sources for use with their products.

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

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

We are highly dependent on the services of many key employees in variousareas, including:

·                  research anddevelopment;

·                  engineering;

·                  sales and marketing;

·                  field service andsupport;

·                  manufacturing; and

·      management.

In particular, there are a limited number ofexperts in excimer light source technology, and we require highly skilledhardware and software engineers. Competition for qualified personnel is intenseand we cannot guarantee that we will be able to continue to attract and retainqualified personnel as needed.  We do nothave employment agreements with most of our employees. We believe that ourfuture growth and operating results will depend on:

·                  the continued servicesof our research and development, engineering, sales and marketing,  field service and support, manufacturing, andmanagement personnel;

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

 

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

If we are unable to hire, train and retain keypersonnel as required, our operating results, financial condition and cash flows could be adversely affected.

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

We serve an increasingly global market.  A large portion of our total revenues isderived from customers located outside of the U.S.  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, the Netherlands, the People’sRepublic of China, Singapore and Taiwan.

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

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

·                  unexpected changes inregulatory requirements;

·                  fluctuations in exchangerates and currency controls;

·                  political and economicconditions and instability;

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

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

·                  difficulties in staffingand managing foreign subsidiary and branch operations;

·                  limited intellectualproperty protection in some countries;

·                  potentially adverse taxconsequences in some countries;

·                  the possibility ofaccounts receivable collection difficulties;

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

·                  the effect of acts ofterrorism and war; and

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

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

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

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

As of December 31, 2006, we owned 254 U.S. patentscovering certain aspects of technology related to light sources and piezotechniques. These patents will expire at various times during the 

 

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period from January 2008 to September 2025.  As of December 31, 2006, we had applied for137 additional patents in the U.S.  As ofDecember 31, 2006, we owned 396 foreign patents and had 373 patent applicationspending in various foreign countries.

Our pending patent applications and any futureapplications might not be approved. Our patents might not provide us with acompetitive advantage and may be challenged by third parties. In addition,third parties’ patents might have an adverse effect on our ability to dobusiness. As a result of cost constraints, we did not begin seeking patentprotection in Japan and other countries for our inventions that are covered byU.S. patents and patent applications until 1993.  As a result we do not have the right to seekforeign patent protection for some of our early inventions.  Additionally, laws of some foreign countriesin which our products are or may be developed, manufactured or sold, includingvarious countries in Asia, may not protect our products or intellectualproperty rights to the same extent as do the laws of the U.S. Thus, thelikelihood of piracy of our technology and products is greater in thesecountries. Further, third parties might independently develop similar products,duplicate our products, or design around patents that are granted to us.

Other companies or persons may have filed or mayfile in the future patent applications that are similar or identical to ours.We may have to participate in appropriate proceedings in the courts or the  patent offices to determine the priority ofinventions. These proceedings 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.

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

·                  trade secret protection;

·                  employee nondisclosureagreements;

·                  third-partynondisclosure agreements; and

·      other intellectual property protection methods.

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

·                  independently developsubstantially the same proprietary information and techniques;

·                  gain access to our tradesecrets; or

·      disclose our technology.

**The parties to whom we provide research and development services may disputethe ownership of the intellectual property that we develop performing theseservices.**

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

 

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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 competitor or anyother third party.**

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

Specifically, Komatsu notified us in 1996 that wemay be infringing some of its Japanese patents. During our subsequentdiscussions, Komatsu also asserted that our former Japanese manufacturingpartner, Seiko, or we may be infringing on some of Komatsu’s U.S. patents and anumber of its additional Japanese patents. Komatsu has also notified one of ourcustomers, Nikon, of its belief that our light sources infringe several ofKomatsu’s Japanese and U.S. patents. As a result, we started proceedings in theJapanese Patent Office to oppose certain patents and patent applications ofKomatsu. The Japanese Patent Office has dismissed our opposition claims. Thus,litigation may result in connection with Komatsu’s Japanese patents or U.S.patents. Also, Komatsu might claim that we infringe other or additionalpatents. Komatsu notified Seiko that it intends to enforce its rights againstSeiko with respect to its Japanese patents if Seiko continued to engage inmanufacturing activities for us. In connection with our former manufacturingagreement with Seiko, we agreed to pay Seiko under certain conditions fordamages associated with these types of claims. Seiko may not prevail in anylitigation against Komatsu, and therefore, we may be required to pay Seiko forsuch damages.

We have notified our competitor and others of ourU.S. patent portfolio. Specifically, we have notified Komatsu that it may beinfringing some of our U.S. patents. We have discussed with Komatsu our claimsagainst each other.  Komatsu challengedone of our U.S. patents in the United States Patent and Trademark Office (“USPTO”)but our patent was subsequently re-issued by the USPTO.  Also, Komatsu transferred its lithographylight source business to our competitor, Gigaphoton.  We also have had discussions with a formercompetitor, Lambda-Physik (a subsidiary of Coherent, Inc.), regardingallegations by each party against the other for possible patentinfringement.  Any of these discussionswith our competitor or former competitor may not be successful and litigationcould result.

In the future, patent litigation may result due toa claim of infringement by our competitor or any other third party or may benecessary to enforce patents issued to us. Any such litigation could result in substantial cost to us and diversionof our effort,  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, or as aresult thereof, we may seek a license from third parties to use theirintellectual property. However, we may not be able to obtain a license.  Alternatively, we may design around the thirdparty’s intellectual property rights or we may challenge these claims in legalproceedings.  Any adverse determinationin a legal proceeding could result in one or more of the following, any ofwhich could harm our business, financial condition and operating results:

·                  loss of our proprietaryrights;

·                  exposure to significantliabilities by other third parties;

·                  requirement that we geta license from third parties on terms that are not favorable to us; or

·      restriction from manufacturing or selling our products.

Any of these actions could be costly and woulddivert the efforts and attention of our management and technical personnel,which would materially adversely affect our business, financial condition andresults of operations.

**Wemay acquire a business or enter a new market that will involve numerousrisks.  We may not be able to addressthese risks successfully without substantial expense, delay or other operationaland financial challenges.**

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

 

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

·                  failure to retain keypersonnel;

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

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

·                  costs associated withacquisitions and joint ventures and the integration of acquired  operations;

·                  costs associated withdeveloping, marketing, introducing and supporting a new product in a newmarket;

·                  failure to commercializepurchased technologies;

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

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

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

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

**Compliance with changing regulations of corporate governance and publicdisclosure may result in additional expenses***.*

Changing laws, regulations and standards relating tocorporate governance and public disclosure, including the Sarbanes-Oxley Act of2002, new SEC regulations, including accelerated SEC filing timelines and newProxy rules, new NASDAQ Stock Market rules, and new accounting pronouncementsare creating uncertainty and additional complexities for companies such as ours.In particular, the Section 404 internal control evaluation requirements underthe Sarbanes-Oxley Act have added and will continue to add complexity and coststo our business and require a significant investment of our time and resourcesto complete each year.  We takethese  requirements seriously and expectto continue to make every effort to ensure that we receive clean attestationson our internal controls each year from our outside auditors. To maintain highstandards of corporate governance and public disclosure, we intend to investall reasonably necessary resources to comply with all other evolving standards.These investments may result in increased general and administrative expensesand a diversion of management time and attention from strategic revenuegenerating and cost management activities.

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

We have historically used broad based stock option programs and otherforms of equity-related incentives as a key component of our employeecompensation packages. We believe that stock options and other long-term equityincentives directly motivate a broader base of employees to maximize long-termstockholder value and, through the use of long-term vesting, encourageemployees to remain with us.  In December2004, the Financial Accounting Standards Board (“FASB”) issued Statement ofFinancial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment— An Amendment to Statement Nos. 123 and 95,” which we adopted on January 1,2006.  This rule requires us to record anexpense to earnings for employee stock option grants and other equityincentives. 

 

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Moreover,applicable stock exchange listing standards relating to obtaining stockholderapproval of equity compensation plans has made it more difficult and expensivefor us to grant options to employees, which has resulted in changes to ourequity compensation strategy, including a significant reduction in the numberof stock options granted to employees. We have developed alternative cashcompensation arrangements for our employees to replace the majority of thesestock option programs and may be required to offer additional alternative cashcompensation arrangements in the future. These and other developments in theprovision of equity compensation to employees could make it more difficult toattract, retain and motivate employees, and such a change in accounting rulesand alternative cash compensation programs may adversely impact our futureoperating results, financial condition and cash flows.

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

We depend on regular and reliable airtransportation on a worldwide basis for many of our routine business functions.If civil aviation in the U.S. or abroad is disrupted by terrorist activities orsecurity responses to the threat of terrorism or for any other reason, ourbusiness could be adversely affected in the following ways:

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

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

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

·      our sales and marketing efforts may be disrupted.

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

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

**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.  These standards and regulations are alwaysbeing amended.  Although we intend tomeet all foreign standards and regulations, our products may not comply withthese foreign government standards and regulations.  Further, it might not be cost effective forus to redesign our products to comply with these foreign government standardsand regulations.  Our inability to designproducts to comply with foreign standards therefore could have a materialadverse effect on our business.**

** **

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**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.**

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

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

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

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

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

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

We registered the trademarks ‘‘CYMER’’ and “INSISTON CYMER” and others in the U.S. and in some other countries. We are alsotrying to register additional trademarks in the U.S. and in othercountries.  We use these trademarks andmany other marks in our advertisements and other business materials, which aredistributed throughout the world. We may be subject to trademark infringementactions for using these marks and other marks on a worldwide basis which wouldbe costly to defend. If a trademark infringement action were successful, wewould have to stop using one or more of the marks and possibly pay damages.

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

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

Various factors may significantly affect themarket price of our common stock, including:

·                  the cyclical nature ofthe semiconductor industry;

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

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

 

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·                  announcements ofinnovations in technology;

·                  new products offered byus or our competitor;

·                  developments of patentsor proprietary rights;

·                  changes in financialestimates by securities analysts;

·                  general worldwidepolitical, economic, and market conditions;

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

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

**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 1B.**** UnresolvedStaff Comments**

None.

#### **Item 2. Properties**

Our corporateheadquarters is located in San Diego, California and includes our executive andadministrative offices, manufacturing, engineering, services, and research anddevelopment facilities. In addition, we also have field service offices locatedthroughout the U.S. and internationally, a manufacturing facility located inKorea that we use to refurbish chamber assemblies, and a small office in  Singapore which is the headquarter office forour TCZ joint venture.  We currently haveleases for buildings we no longer occupy in San Diego, California andCharlestown, Massachusetts, but we sublease all or a major portion of thesefacilities.

At December 31,2006, details on our principal leased and owned properties were as follows:
| Location                                       | ** ** | **Lease  Expiration** | ** ** | **Total  Square  Footage** | ** ** | **Primary Usage / Status**                                                |
|------------------------------------------------|------------|-----------------------|------------|----------------------------|------------|---------------------------------------------------------------------------|
| San Diego,  California (1)                     |       | Owned                 |       | 135,000                    |       | Corporate headquarters, engineering, research and  development facilities |
| San Diego,  California (1)                     |       | Owned                 |       | 265,000                    |       | Manufacturing and administrative office                                   |
| San Diego,  California                         |       | January 2010          |       | 108,290                    |       | Facility subleased                                                        |
| San Diego,  California                         |       | January 2010          |       | 36,959                     |       | Facility subleased                                                        |
| San Diego,  California                         |       | January 2010          |       | 61,300                     |       | Facility subleased                                                        |
| Charlestown,  Massachusetts                    |       | October 2007          |       | 21,262                     |       | 11,262 square feet subleased                                              |
|                                           |       |                  |       |                       |       | 10,000 square feet vacant                                                 |
| Motoyawata,  Japan                             |       | June 2008             |       | 13,831                     |       | Field service and sales office                                            |
| Hsin-Chu, Taiwan                               |       | June 2008             |       | 4,821                      |       | Field service and sales office                                            |
| Goldenhill  Plaza, Singapore                   |       | June 2009             |       | 3,315                      |       | Field service and sales office                                            |
| Unity Centre,  Singapore                       |       | January 2008          |       | 1,200                      |       | Administrative office (TCZ)                                               |
| Maarssen,  Netherlands                         |       | May 2009              |       | 3,715                      |       | Field service and sales office                                            |
| Veldhoven,  Netherlands                        |       | December 2008         |       | 2,605                      |       | Field service and sales office                                            |
| Pyongtaek-city, Kyonggi, Korea — Land (2) |       | December 2020         |       |                       |       |                                                                      |
|  — Building                          |       | Owned                 |       | 26,000                     |       | Manufacturing, sales and administrative                                   |
| Pudong,  Shanghai, China                       |       | October 2008          |       | 4,746                      |       | Field service and sales office                                            |

 

#### (1)          Land and building are owned by us.

(2)          Land leased throughDecember 2020.

 

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####  

**Item 3.    Legal Proceedings**

None.

**Item 4.    Submission of Mattersto a Vote of Security Holders**

None.

##### **PART II**

**Item 5.    Market for Registrant’sCommon Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities.**

Our common stock is publicly traded on the NASDAQ Global Select Marketunder the symbol “CYMI”. The following table sets forth, for the periodsindicated, the high and low prices of our common stock as reported by theNASDAQ Global Select Market.

| Year ended December 31, 2005 | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------------------------------|------------|----------|------------|---------|------------|
| First quarter                                    |       | $        | 30.00      |    | $          | 22.65 |   |
| Second quarter                                   |       | $        | 29.13      |    | $          | 22.96 |   |
| Third quarter                                    |       | $        | 36.43      |    | $          | 26.07 |   |
| Fourth quarter                                   |       | $        | 40.43      |    | $          | 30.46 |   |

 

| Year ended December 31, 2006 | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
| First quarter                                    |       | $          | 50.38      |       | $          | 35.13 |   |
| Second quarter                                   |       | $          | 56.69      |       | $          | 42.24 |   |
| Third quarter                                    |       | $          | 47.20      |       | $          | 33.75 |   |
| Fourth quarter                                   |       | $          | 50.03      |       | $          | 42.22 |   |

 

Theclosing sales price of our common stock on the NASDAQ Global Select Market was $44.10on February 23, 2007 and there were 235 registered holders of record as of thatdate.

We have never declared or paid cash dividends on our common stock andcurrently do not anticipate paying cash dividends in the future.

The informationrequired to be disclosed by Item 201(d) of Regulation S-K *“Securities Authorized for Issuance Under EquityCompensation Plans”* is incorporated herein by reference to our ProxyStatement for our 2007 annual meeting of stockholders.

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**Item6.    Selected Financial Data**

The following selected consolidated financial data should be read inconjunction with our consolidated financial statements and notes thereto andwith Item 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” which are included elsewhere in this report.
| ** **                                                                 | ** ** | **Years ended December 31,**                                                | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2002**                                                                                   | ** ** | **2003** | ** ** | **2004 (2)** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                 | ** ** | **(in thousands, except per share data and footnotes)** | ** ** |
| **Consolidated Statements of  Operations Data:**                           |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Product sales                                                              |       | $                                                                                          | 287,995    |   | $ | 265,816 |   | $ | 417,296 |   | $ | 382,638 |   | $ | 543,460 |   |
| Other                                                                      |       | 871                                                                                        |       | 57 |   | 783 |   | 1,010 |   | 395 |   |
| Total revenues                                                             |       | 288,866                                                                                    |       | 265,873 |   | 418,079 |   | 383,648 |   | 543,855 |   |
|                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Costs and expenses:                                                        |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Cost of product  sales                                                     |       | 162,095                                                                                    |       | 187,679 |   | 243,473 |   | 227,290 |   | 281,243 |   |
| Research and  development (1)                                              |       | 72,580                                                                                     |       | 56,768 |   | 58,612 |   | 64,025 |   | 73,974 |   |
| Sales and  marketing                                                       |       | 17,153                                                                                     |       | 16,966 |   | 23,369 |   | 25,143 |   | 30,618 |   |
| General and  administrative                                                |       | 18,212                                                                                     |       | 39,094 |   | 31,630 |   | 26,514 |   | 38,889 |   |
| Total costs and  expenses                                                  |       | 270,040                                                                                    |       | 300,507 |   | 357,084 |   | 342,972 |   | 424,724 |   |
| Operating income (loss)                                                    |       | 18,826                                                                                     |       | (34,634 | ) | 60,995 |   | 40,676 |   | 119,131 |   |
|                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Other income (expense)  — net                                         |       | (2,077                                                                                     | )          | (1,139 | ) | (421 | ) | 5,112 |   | 19,561 |   |
| Income (loss) before  income tax provision (benefit) and minority interest |       | 16,749                                                                                     |       | (35,773 | ) | 60,574 |   | 45,788 |   | 138,692 |   |
| Income tax provision  (benefit)                                            |       | 2,706                                                                                      |       | (21,464 | ) | 15,144 |   | 262 |   | 46,137 |   |
| Minority interest                                                          |       | (447                                                                                       | )          | (1,091 | ) | (2,276 | ) | 1,026 |   | 3,093 |   |
|                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Net income (loss)                                                          |       | $                                                                                          | 13,596     |   | $ | (15,400 | ) | $ | 43,154 |   | $ | 46,552 |   | $ | 95,648 |   |
|                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Basic earnings (loss)  per share                                           |       | $                                                                                          | 0.41       |   | $ | (0.44 | ) | $ | 1.17 |   | $ | 1.29 |   | $ | 2.53 |   |
| Weighted average common  shares outstanding                                |       | 33,317                                                                                     |       | 35,065 |   | 36,758 |   | 36,017 |   | 37,779 |   |
|                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Diluted earnings (loss)  per share                                         |       | $                                                                                          | 0.39       |   | $ | (0.44 | ) | $ | 1.15 |   | $ | 1.27 |   | $ | 2.40 |   |
| Weighted average common and dilutive potential common shares  outstanding  |       | 34,712                                                                                     |       | 35,065 |   | 37,584 |   | 36,544 |   | 41,397 |   |

 
| ** **                            | ** ** | **As of December 31,**               | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                            | ** ** | **2002**                                            | ** ** | **2003** | ** ** | **2004 (2)** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | **(in thousands, except footnotes)** | ** ** |
| **Consolidated  Balance Sheet Data:** | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents            |       | $                                                   | 92,273     |   | $ | 110,632 |   | $ | 114,246 |   | $ | 233,745 |   | $ | 302,098 |   |
| Working capital                       |       | 351,127                                             |       | 397,790 |   | 452,579 |   | 499,670 |   | 686,702 |   |
| Total assets                          |       | 766,887                                             |       | 809,244 |   | 818,836 |   | 791,376 |   | 949,094 |   |
| Total long-term  liabilities          |       | 255,154                                             |       | 261,627 |   | 208,035 |   | 151,304 |   | 155,503 |   |
| Treasury stock                        |       | —                                              |       | — |   | — |   | (50,000 | ) | (150,704 | ) |
| Stockholders’ equity             |       | 412,334                                             |       | 453,330 |   | 517,320 |   | 538,454 |   | 687,894 |   |
|                                       |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Includes amortizationof  intangible assets associated with theacquisition of ACX in February 2001. These amounts were previously shown as a separate line on theconsolidated financial statements. Amortization of intangible assets totaled$160,000 for each of the years ended December 31, 2002, 2003 and 2004 and$20,000 for the year ended December 31, 2005. As of December 31, 2005 these intangible assets were fully amortized.

(2)          During the****fourth****quarterof 2004, we corrected our accounting treatment for our parts refurbishmentactivities and all amounts associated with this correction are included in2004.  This adjustment resulted in a $2.9million increase in the inventory balance as of December 31, 2004, a $28.5million increase in 2004 product revenues, a $25.6 million increase in 2004cost of product sales, and a $2.0 million increase in 2004 net income.  See Item 7, “Management’s Discussion andAnalysis of Financial Position and Results of Operations” under the caption “CriticalAccounting Policies and Estimates” for a description of our current accountingtreatment for our parts refurbishment activities.

 

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### **Item 7.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

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

### **Overview**

We arethe world’s leading supplier of light source solutions for the semiconductorindustry.  Our products provide theessential light source for 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,ASML, Canon, and Nikon, who in turn supply their wafer steppers and scanners tochipmakers.  In addition, we sell replacement parts and services to thelithography tool manufacturers as well as directly to the chipmakers.  Our light source systems currently constitutea substantial majority of all excimer light sources incorporated in lithographystepper and scanner tools. Our headquarters are located in San Diego,California where we develop and manufacture all of our light source systems andthe majority of our replacement parts. As a large portion of our revenue is derived from customers locatedoutside of the U.S., we maintain a spare parts refurbishment facility and fieldservice office in Korea and field service and support offices in Japan, theNetherlands, the People’s Republic of China, Singapore and Taiwan. Japan iscurrently our only subsidiary office that sells excimer light source systems.We also maintain field service offices in the U.S. to service our installedbase of light sources located in the U.S.

Our TCZjoint venture which is headquartered in Singapore, is currently developing, andwill integrate, market and sell, and support production tools for the flatpanel display manufacturing industry. The joint venture is targeting thegrowing market for LTPS processing used in the manufacture of liquid crystaldisplays that are brighter, have higher resolution, and consume less power thandisplays using today’s predominant amorphous silicon films.  Although TCZ’s product is currently in thedevelopment phase, TCZ performed extensive customer demonstrations on its firstgeneration demonstration tool in 2006 and we expect that TCZ will ship itsfirst production tool, the TCZ 900X, in late 2007 or early 2008.

Since we derive a substantial portion of our revenuesfrom lithography tool manufacturers, we are subject to the volatile andunpredictable nature of the semiconductor industry. The semiconductor industryis highly cyclical in nature and historically has experienced periodic ups anddowns, and the activities of the last several years illustrate thiscyclicality. In 2000, the semiconductor industry experienced strong growth,which was followed by a three year downturn from 2001 through late 2003. Growthresumed in late 2003, but one year later, in late 2004, the industry againdeclined for several months.  Businessactivity then leveled off early in 2005 and began to slightly improvequarter-over-quarter thereafter until late 2005, when orders for our lightsources increased substantially from the levels seen earlier in the year.  Our chipmaker customers began indicating thatincreasing demand for chips would require them to expand production capacity,and our lithography tool manufacturing customers began placing orders for agrowing number of light sources to meet increasing demand for scanners. By theend of 2005, it appeared that we were again entering  a strong industry growth cycle and upturn.

 

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There were manypositive indicators throughout 2006 that reinforced our viewpoint that we hadentered an upturn in the semiconductor industry, which included:

·                  Strong continuing demand for our ArFlight sources as chipmakers purchased systems to enable production at advancedtechnology nodes.

·                  Stronger than anticipated demand forour KrF light sources, which chipmakers purchased to expand production capacityand pattern a growing number of less critical layers with DUV light sources.

·                  Substantialongoing growth in our non-systems revenue which was driven by high light sourceutilization at chipmakers and high overall fab utilization.

As a result ofthese strong demand trends, our bookings, revenue and profits grewsubstantially in 2006 compared to 2005. In 2006, we achieved record total revenue of $543.9 million, a 42%  increase over total revenue of $383.6 millionin 2005.  Utilization of our light sourcesystems at chipmakers also continued to increase in 2006 compared to 2005. Thisincreased utilization when coupled with our growing installed base of lightsources systems  drove our non-systemsproduct revenue, which consists of consumables and spare parts, upgrades, andservice, to a record $261.0 million for 2006, equal to 48%  of total revenue for the year.  This was a 49% increase over the $175.2million in non-systems revenue in 2005. Operating income climbed to a record $119.1 million, yielding anoperating margin of 21.9% for the year, compared to 2005 operating income of$40.7 million and operating margin of 10.6%. Net income for 2006 also reached arecord high of $95.6 million, equal to $2.40 per share fully diluted, comparedto net income of $46.6 million, equal to $1.27 per share fully diluted, in2005.  Our strong financial performancein 2006 allowed us to continue investing heavily in developing advanced DUVtechnologies to meet our customers’ next generation requirements.  It also allowed us to make progress on ourlonger-term growth initiatives such as EUV development and the activities ofour TCZ joint venture.

Demand for ourmost advanced ArF light sources grew more than 20%  in 2006 compared to 2005, and we shipped atotal of 122 of our XLA Series light sources during the year.  In 2006, lithography tool manufacturingcustomers ramped up their first wave of ArF immersion scanner production. Manyof the immersion tools delivered earlier in 2006 were used primarily bychipmakers for process development purposes including defect reduction.  As chipmakers experienced success inqualifying their immersion production processes, they moved these tools fromqualification into full production, and will augment them with additionalimmersion tool purchases to increase critical layer capacity.  At this time, immersion lithography is aproduction reality at a number of chipmakers’ fabs, and our expectation is thata growing number of chipmakers will adopt this advanced production techniqueover the next several years.

In general, industry trends that affect lithographyare positive.  Leading NAND Flash memorymanufacturers began using ArF immersion lithography in production near the endof 2006, and we anticipate that demand for immersion tools should grow thisyear as they continue to drive production with smaller CDs and expand thenumber of layers they need to pattern with ArF immersion tools.  Demand in the dynamic random access memory (“DRAM”)segment of the market is strong, driven by the transition to more advancedtypes of memory chips and by the large memory requirements of the MicrosoftVista operating system.  Foundries areprimarily making technology buys rather than expanding capacity, butindications from the foundries and lithography tool manufacturers point towardadditional capacity-driven growth in equipment orders beginning in the next fewquarters.  Demand from integrated devicemanufacturers (“IDMs”) remains healthy and should be stable over the near andmid-term.  Although fab utilizationexperienced a slight decline late in 2006, fab utilization at the 90 nmproduction node and below continues to be strong.  Additionally, the 65 nm production ramp iswell underway, and 21 new fabs are expected to be in or entering production atthat node by the end of 2007.  Currently,there are significant research and development efforts underway at the 45 nmnode, which is driving demand, and the first leading edge chipmakers areexpected to begin production at 45 nm by the end of 2007.

 

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Based on current market trends, we believe thatintegrated circuit (“IC”) unit growth in 2007 will be in the high single digitto low double digit range.  We expectthat chipmakers’ capital spending in 2007 will be down slightly from the 2006level as they continue to work down chip inventories and attempt to matchcapacity expansion to market demand.  Ifthis scenario is realized, we expect that demand for DUV lithography tools in2007 will be relatively flat to slightly down in units compared with 2006, butthat growth in demand for higher priced ArF tools, and particularly for ArFimmersion will drive overall revenue growth in lithography.  In addition we also expect our KrF and non-systemsrevenue streams to, at a minimum, remain stable.  We therefore anticipate that 2007 revenue maygrow slightly above the 2006 levels. However, macro-economic factors, such as high energy prices and interestrates, could have a negative impact on consumer spending, including spending onelectronic devices.  Additionally,geopolitical turmoil can create a heightened sense of uncertainty that cancause consumers to become more cautious in their spending.  Either or both of these factors would have anegative effect on the demand for our products.

During the course of2006, we focused on better serving our customers, building a better company,and creating shareholder value. We introduced an innovative new light source,we enhanced overall operating efficiencies, and achieved record earnings andcash generation. In 2006, we generated a record $115.8 million in cash fromoperations and in the third quarter of 2006, we used $100.7 million in cash torepurchase 2.6 million shares of our common stock in the open market.  We expect to continue generating substantiallevels of cash from operations in 2007 and we will continue to exploreopportunities for the most effective use of our cash including additionalbuybacks of our common stock.

**CRITICAL ACCOUNTING POLICIES AND ESTIMATES**

*General*

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

We believe thatrevenue recognition, valuation of parts used in our refurbishment manufacturingprocess, inventory allowances, warranty provisions, stock-based compensation,and income taxes require more significant judgments and estimates in thepreparation of our consolidated financial statements than do other of ouraccounting estimates and judgments.

*RevenueRecognition*

Our revenues consist of product sales, which include sales oflight source systems, consumable and spare parts, upgrades, service, servicecontracts, training, and limited refurbishments of light source systems.  Our revenues also consist of certain fundeddevelopment activities performed for our customers and under governmentcontracts and license agreements.

The sales of our lightsource systems generally include training and installation services. Wedetermined these elements qualify as one unit of accounting under EmergingIssues Task Force 

 

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(“EITF”) Bulletin No. 00-21, “RevenueArrangements with Multiple Deliverables” as we do not have evidence of fairvalue for the undelivered training and installation elements. Furthermore, wedetermined that the undelivered training and installation elements areperfunctory performance obligations and are not essential to the functionalityof our light source systems. Therefore, in accordance with the provisions ofStaff Accounting Bulletin No. 104, we recognize revenue when the revenuerecognition criteria are met for the light source system, and accrue the costsof providing the training and installation services.  We recognize light source system revenue atone of following three points, depending on the terms of our arrangement withour customer — 1) shipment of the light source system, 2) delivery of the lightsource system or 3) receipt of an acceptance certificate. For the majority ofour light source system sales, the shipping terms are F.O.B. shipping point andrevenue is recognized upon shipment. For our arrangements which include F.O.B.destination shipping terms, revenue is recognized upon delivery of the lightsource system to our customer.  Lastly,one of our arrangements includes an acceptance provision, which is satisfied bythe issuance of an acceptance certificate by the customer. For thesetransactions, we recognize revenue upon receipt of the acceptancecertificate.  In addition, we test ourlight source systems in environments similar to those used by our customersprior to shipment to ensure that they meet published specifications.

Revenuefrom consumables and spare parts sales is recognized at the point that legaltitle passes to the customer, which is upon shipment from our facility. For a significant portion of our spare parts sales, our customers return theconsumed assembly to us as part of the sale of the new part.  We reusesome of the material within these core assemblies, mainly metal components, forthe future build of core assemblies.  As a result, our revenue consists ofboth cash and the value of the reusable parts received from our customers asconsideration for these spare part sales. Revenue associated with our customers’return of core assemblies is recognized upon receipt of the returned coreassembly.  The amount of the revenue is determined based upon the fairvalue of the reusable parts that we expect to yield from the returned coreassembly based on historical experience. Service and training revenue is recognized as the services are rendered.

On avery limited basis, we refurbish light source systems owned by our customers totheir original or new condition.  Revenuefrom refurbished light source systems is recognized when the refurbishmentprocess has been completed and, depending upon the customer, the proper deliveryor acceptance terms have been met.

Forfunded development contracts, funds received are accounted for on thepercentage-of-completion method based on the relationship of costs incurred tototal estimated costs. Revenues generated from these types of fundeddevelopment contracts are, except as noted below, included in other revenue andare derived from cost sharing contracts between certain customers and us. Ifmilestones on these funded development contracts require that specific resultsbe achieved or reported by us, revenue is not recognized until that milestoneis completed.  For some of the funded development contracts that we enterinto with customers and government agencies, we evaluate certain criteria todetermine whether recording the funds received as revenue is appropriate. If certain conditions are met, these funds are not recorded as revenue butrather are offset against our own internal research and development expenses inthe period that the milestone is achieved.

*Accountingfor Parts Used in Refurbishment Manufacturing Process*

Over the lastseveral years as part of our regular business activities, we have conductedsignificant parts refurbishment and material reclaim activities related to someof our core assemblies, in particular our chamber assemblies. The volume ofthis activity significantly increased in 2004 and we expect volumes to increaseover time as our installed base of light sources continues to rise and webecome more efficient in these refurbishment activities and  develop capabilities to reclaim material fromand refurbish other core assemblies. These activities involve arrangements withour customers where we sell a new part to the customer at a reduced sales priceif the customer returns the consumed assembly that the new part replaces.  These returned core assemblies contain acertain amount of material, primarily metal components, that may be reused byus in future core assemblies.  Uponreceipt of these consumed core assemblies from our customers, we record anentry to recognize the estimated 

 

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fair value of thereusable components either 1) as revenue if the return of the core assemblyrelates to a spare part replacement sale or 2) as a reduction in cost ofproduct sales if the return of the core assembly is related to a part beingreplaced under our warranty or per the terms of an active service contract withthe customer.  The value of the reusableparts contained within the consumed assembly is determined based uponhistorical data on the value of the reusable parts that we typically yield froma consumed assembly.  As part of ournormal excess and obsolete inventory analysis, these consumed assemblies are alsoreviewed on a monthly basis and an inventory allowance is recorded asappropriate for these parts.  The valuethat we assign to these core assemblies can be affected by the current demandfor the reusable parts in our manufacturing operations and the actual yieldrate achieved for parts within these consumed core assemblies.  We believe that our methodology for valuingthe reusable parts within these returned core assemblies is reasonable, but anydecreases in the demand for the parts or any changes in the yield of thereusable parts included in these core assemblies could have a material adverseeffect on our financial condition and results of operations. In 2005 and 2006,the amount by which the value of these core assemblies was affected bydecreases in demand and changes in yield was immaterial.

***Inventory Allowance***

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

The inventory allowance totaled $10.4 million and$15.1 million at December 31, 2005 and December 31, 2006, respectively. Theincrease in the inventory allowance at December 31, 2006 as compared toDecember 31, 2005 was primarily due to changes in the 12 month forecasteddemand from period to period for both raw materials and consumable and spareparts, engineering change orders which impacted excess and obsolete levels andthe updated assessment of on-hand inventory with no requirements beyond the 12month forecasted demand by our senior manufacturing management.

The methodologiesused to analyze excess and obsolete inventory and determine the inventoryallowance are significantly affected by future demand and usage of ourproducts. There are many factors that could potentially affect the futuredemand or usage of our products, including the following:

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

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

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

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

·                  Utilizationrates of our light sources at chipmakers; and

·                  Engineeringchange orders.

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, 

 

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adjustments to ourinventory allowance may be required, which could have a material adverse effecton our financial condition and results of operations.

*WarrantyProvision*

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

The total balancein the warranty provision accrual as of December 31, 2005 and December 31, 2006was $30.2 million and $29.5 million, respectively.  This slight decrease is primarily due toimproved warranty performance of both light source systems and consumable andspare parts resulting in lower warranty provision requirements as calculated byour financial model and updated throughout 2006. The improved warrantyperformance in 2006 is the result of proven extended lives of our consumablemodules and an increase in the level of expertise and training of our fieldservice engineers who perform warranty service on our light source systems andconsumable and spare parts.  Thisimproved overall warranty performance and the resulting decrease in theprovision requirements was almost completely offset by the higher level ofconsumables and spare parts sales in 2006 as compared to 2005 and the resultinghigher level of warranty provisions to support those sales.

We actively engagein product improvement programs and processes to limit our warranty costs, butour warranty 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 warrantymodel resulting in higher warranty provisions, we are more likely to havedifferences between the estimated and actual warranty costs for these newproducts.  This is due to limited or nohistorical product performance data on which to base our future warrantycosts.  Warranty provisions for our olderand more established light source models are more predictable as we have morehistorical information available on these products.  If actual product failure rates or estimatedcosts to repair those product failures were to differ from our estimates,revisions to our estimated warranty provision would be required, which couldharm our financial condition and results of operations.

*Stock-BasedCompensation*

We grant optionsto purchase our common stock to our employees and grant stock unit awards toour non-employee directors under our current stock plan.  The benefits provided under this plan areshare-based payments subject to the provisions of SFAS No. 123R.  Effective January 1, 2006, we adopted the requirementsof SFAS No. 123R which address the accounting for share-based paymenttransactions in which an enterprise receives employee services in exchange for(a) equity instruments of the enterprise or (b) liabilities that arebased on the fair value of the enterprise’s equity instruments or that may besettled by the issuance of such equity instruments. As a result of this newaccounting requirement, our consolidated financial statements includecompensation expense as calculated per the provisions of  SFAS No.123R. In adopting SFAS No. 123R, weelected to use the modified prospective transition method, thus ourconsolidated financial statements for periods prior to January 1, 2006 do not 

 

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include any impact ofSFAS No.123R. We also elected to attribute the value of share-basedcompensation to expense using the straight-line method for awards granted afterDecember 31, 2005 upon our adoption of SFAS No. 123R. Compensation expense forawards outstanding and unvested as of December 31, 2005 are being recognizedover the remaining service period using the compensation expense calculatedaccording to the pro forma disclosure provisions under SFAS No. 123 which usesan accelerated expense recognition method for those awards with a gradedvesting schedule. Share-based compensation expense related to stock options andstock units was $12.5 million before taxes for the year ended December 31,2006.  Included in this stock-basedcompensation expense for 2006 is $4.2 million related to a small number ofstock options that were granted primarily in 1999 for which we used theincorrect measurement date to calculate our compensation expense, and as aresult failed to record the related compensation expense in the correctperiods. We recorded the charge in 2006 as the charge was neither material to2006 or any prior period.

Upon adoption ofSFAS No. 123R on January 1, 2006, we elected to value our share-based paymentawards using the Black-Scholes option pricing model, as we had under the proforma provisions of SFAS No. 123. The determination of fair value ofstock-based payment awards on the date of grant is affected by our stock priceas well as assumptions regarding a number of complex and subjective variables.These assumptions include the expected term of stock options and our expectedstock price volatility over the expected term of the awards.

We determine ourexpected volatility by using a combination of historical and impliedvolatility, or blended volatility, to derive our expected volatility assumptionas allowed under SFAS No. 123R and Staff Accounting Bulletin No. 107. Impliedvolatility is based on our six-month traded options on our common stock. Wedetermined that the volatility calculated using a blend of implied volatilityand our historical volatility is more reflective of expected volatility thanusing only historical volatility.  Theexpected term of stock options represents the weighted-average period the stockoptions are expected to remain outstanding. We determine the expected term ofour stock options based on observed historical exercise patterns for ourcompany, which we believe are indicative of future exercise behavior.

Other assumptionsrequired for estimating fair value under the Black-Scholes option pricing modelinclude the expected risk-free interest rate and expected dividend yield of ourstock.  Our risk-free interest rateassumption is based upon currently available rates on zero coupon U.S.Government issues for the expected term of our stock options. The expecteddividend rate is not applicable to us as we have not historically declared orpaid dividends nor do we anticipate paying cash dividends in the future.

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

If we change anyof the key assumptions that we use in the Black-Scholes option pricing modelsuch as expected volatility or expected term or if we decide to use a differentvaluation model in the future or change our forfeiture rate, the compensationexpense that we record under SFAS No. 123R may differ significantly in thefuture from what we have recorded in the current period.

*IncomeTaxes*

Weaccount for income taxes in accordance with Statement of Financial AccountingStandards No. 109 (“SFAS No. 109”), “Accounting for Income Taxes.”  Pursuant to SFAS No. 109, a deferred taxasset or liability is generally recognized for the estimated future tax effectsattributable to temporary differences, net operating loss (“NOL”) carryforwardsand tax credit carryforwards.  Deferredtax assets are to be reduced by a valuation allowance if, based on the weightof available evidence, it is more likely than not that some portion or all ofthe deferred tax assets will not be realized within the carryback orcarryforward periods.  Information aboutan enterprise’s current financial position and its results of 

 

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

We have considered ourindustry’s outlook for the future, our historical performance and estimatedfuture taxable income, and ongoing tax planning strategies in assessing theneed for a valuation allowance.  Usingthis information, we have prepared a model to forecast our expected taxableincome in future years and to estimate when the benefits of our deferred taxassets are likely to be realized.  Basedupon the analysis, with the exceptions noted below, we believe that it is morelikely than not that the results of future operations will generate sufficienttaxable income to realize all of our deferred tax assets within the periodcovered by our model and, as such, no valuation allowance has been providedagainst these deferred tax assets. However, a valuation allowance has been provided against certain deferredtax assets related to TCZ’s business and our French branch operations in thetotal amount of $1.2 million, as these businesses have not yet developedsufficiently to allow us to assert that these assets will ultimately berealized.

At December 31, 2006, wehad federal tax credit carryforwards of $11.7 million which begin to expire in2018.  At December 31, 2006, we had statetax credit carryforwards of $14.2 million, which  may be carried forward indefinitely.  At December 31, 2006 we had foreign NOLcarryforwards of $2.6 million which may be carried forward indefinitely.

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

Our accounting for incometaxes give effect to the phase out of the Extraterritorial Income Exclusion (“ETI”)benefit in 2005 and 2006, and its concurrent replacement with a phased inManufacturing Activity deduction under Internal Revenue Code Section 199.

It is ourintention to reinvest undistributed earnings of our foreign subsidiaries andthereby indefinitely postpone their remittance, with the exception of our TCZjoint venture. Accordingly, we have not provided U.S. federal income andforeign withholding taxes on $58 million of undistributed earnings fromnon-U.S. operations as of December 31, 2006.  It is not practicable to estimate the amountof the deferred tax liability on such unremitted earnings.

 

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### **RESULTS OFOPERATIONS**

Thefollowing table sets forth certain items in our consolidated statements ofoperations as a percentage of total revenues for the periods indicated:
| ** **                                                | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenues:                                                 |       |                                        |       |   |   |   |   |
| Product sales                                             |       | 99.8                                        | %          | 99.6 | % | 98.6 | % |
| Product sales —  related party                       |       | —                                      |       | 0.1 |   | 1.3 |   |
| Other                                                     |       | 0.2                                         |       | 0.3 |   | 0.1 |   |
| Total revenues                                            |       | 100.0                                       | %          | 100.0 | % | 100 | % |
|                                                      |       |                                        |       |   |   |   |   |
| Cost and expenses:                                        |       |                                        |       |   |   |   |   |
| Cost of product  sales                                    |       | 58.2                                        |       | 59.2 |   | 51.7 |   |
| Research and  development                                 |       | 14.0                                        |       | 16.7 |   | 13.6 |   |
| Sales and  marketing                                      |       | 5.6                                         |       | 6.6 |   | 5.6 |   |
| General and  administrative                               |       | 7.6                                         |       | 6.9 |   | 7.2 |   |
| Total costs and  expenses                                 |       | 85.4                                        |       | 89.4 |   | 78.1 |   |
|                                                      |       |                                        |       |   |   |   |   |
| Operating income                                          |       | 14.6                                        |       | 10.6 |   | 21.9 |   |
|                                                      |       |                                        |       |   |   |   |   |
| Other income (expense)  — net                        |       | (0.1                                        | )          | 1.3 |   | 3.6 |   |
|                                                      |       |                                        |       |   |   |   |   |
| Income before income  tax provision and minority interest |       | 14.5                                        |       | 11.9 |   | 25.5 |   |
|                                                      |       |                                        |       |   |   |   |   |
| Income tax provision                                      |       | 3.6                                         |       | 0.1 |   | 8.5 |   |
| Minority interest                                         |       | (0.6                                        | )          | 0.3 |   | 0.6 |   |
|                                                      |       |                                        |       |   |   |   |   |
| Net income                                                |       | 10.3                                        | %          | 12.1 | % | 17.6 | % |
| Gross margin on product sales                             |       | 41.7                                        | %          | 40.6 | % | 48.3 | % |

 

### **YEARS ENDEDDECEMBER 31, 2005 AND 2006**

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

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

|                                                  | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Light source  systems:                           |       |                                        |       |   |   |   |   |
| Revenue                                          |       | $                                           | 244,840    |   | $ | 207,402 |   | $ | 282,449 |   |
| Units sold                                       |       | 301                                         |       | 207 |   | 280 |   |
| Average selling price (1)                        |       | $                                           | 827        |   | $ | 982 |   | $ | 1,009 |   |
|                                             |       |                                        |       |   |   |   |   |
| Consumable and  spare parts and service products |       | $                                           | 172,456    |   | $ | 175,236 |   | $ | 261,011 |   |
| Other revenue                                    |       | $                                           | 783        |   | $ | 1,010 |   | $ | 395 |   |
|                                             |       |                                        |       |   |   |   |   |
| Total revenue                                    |       | $                                           | 418,079    |   | $ | 383,648 |   | $ | 543,855 |   |

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(1)                                  Calculationof average selling price includes $4.2 million deferred light source revenueduring 2004 and excludes $4.2 million deferred light source revenue that wasrecognized in 2005.  We had onearrangement where a portion of the light source system fee was not payable untilthe system was installed successfully at the end-user. This arrangement expiredin March 2005.

 

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Product sales increased 42% from $382.6****millionfor 2005 to $543.5 million for 2006. The increase in product sales was due tohigher light source system revenues and continued growth in consumable andspare parts and service product revenues for 2006 compared to 2005.  Light source system revenues increased 36%from $207.4 million for 2005 to $282.4 million for 2006.  A total of 207 light source systems were soldin 2005 at an average selling price of $982,000, compared to 280 light sourcesystems sold in 2006 at an average selling price of $1.0 million.  On a foreign currency adjusted basis, theaverage selling price for 2005 was $984,000 compared to $1.0 million for 2006.The slight increase in the average selling price year over year reflects ashift in the product mix from capacity driven lower priced KrF products in 2005to higher priced technology buys of advanced ArF products in 2006. The increasein quantities of light source systems sold from 2005 to 2006 reflects theslight slowdown of the industry in the beginning of 2005 compared to the upturnin the semiconductor industry in 2006. Chipmakers’ expanded capacity needs haveimpacted the demand for our light source systems, which, combined with ourgrowing installed base of light source systems, has increased the demand forour consumables and spare parts and service products. This growth in consumableand spare parts demand and rising tool utilization resulted in an increase inconsumables and spare parts and service revenues of 49% from $175.2 million for2005 to $261.0 million for 2006. Consumable and spare parts and serviceproducts revenue was also favorably impacted by the revenue recorded under a laserreplacement agreement we entered into in 2006. Revenues from funded developmentcontracts were $1.0 million for 2005 compared to $395,000 for 2006. There wereno revenues recorded or earned associated with the TCZ joint venture for2006.  We expect that our first quarter2007 revenue will be flat or increase slightly from the fourth quarter 2006levels.

Our backlog at December 31, 2005 was $90.8 million compared to $94.4million at December 31, 2006. Bookings for the year ended December 31, 2005 and2006 were $395.4 million and $547.4 million, respectively.  The book-to-bill ratio for the quarter endedDecember 31, 2005 was 1.17 compared to 1.03 for the quarter ended December 31,2006. The increase in the backlog is due to the changing condition of thesemiconductor industry from 2005 to 2006 and the increase in our averageselling prices from year to year due to the continued adoption of our advancedArF products.  The backlog as of December31, 2005 reflected the brief slowdown and flattening in the semiconductorindustry that started in late 2004 and continued into 2005, whereas the backlogas of December 31, 2006 reflects the recent growth phase and upturn in thesemiconductor industry. The 38% increase in bookings year over year wasprimarily due to increased orders of light source systems and consumables andspare parts in 2006 as a result of the upturn in the semiconductor industry in2006.

We installed 248 light sources at chipmakers and other end-users during2005 compared to 299 light sources installed during 2006.

Sales to our three lithography tool manufacturing customers, ASML,Canon, and Nikon, amounted to 32%, 8% and 24%, respectively, of total revenuefor 2005, and 38%, 6% and 16%, respectively, of total revenue for 2006.

Our sales aregenerated primarily by shipments to customers in Europe, Japan, Korea, Taiwan,and the U.S.  Approximately 84% of oursales for both 2005 and 2006 were derived from customers outside the U.S.  We maintain a wholly owned Japanesesubsidiary, Cymer Japan, which sells to our Japanese customers.  Revenues from Japanese customers, generatedprimarily by Cymer Japan, accounted for 31% and 22% of total revenues for 2005and 2006, respectively. The activities of Cymer Japan are limited to sales andservice of products purchased by Cymer Japan from us as the parent corporation.We anticipate that international sales will continue to account for asignificant portion of our sales.

*Cost ofProduct Sales*.Cost of product sales includes direct material and labor, warranty expenses,license fees, manufacturing and service overhead, and foreign exchange gainsand losses on foreign currency forward exchange contracts (“forward contracts”)associated with purchases of our products by Cymer Japan for resale under firmthird-party sales commitments.  Shippingcosts associated with our product sales are also included in cost of productsales.  We do not charge our customersfor shipping fees.

 

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The cost of productsales increased 24% from $227.3 million for 2005 to $281.2 million for 2006.This increase in the cost of product sales was primarily due to higher lightsource system sales and sales of consumables and spare parts and serviceproducts in 2006 compared to 2005.  Thisincrease in cost of product sales was partially offset by a decrease inwarranty costs year over year.  Thisdecrease in warranty costs in 2006 is primarily due to the proven extendedlives of our consumable modules and efficiencies gained through an increase inthe level of expertise and training of our field service engineers who performwarranty service on our light source systems and consumable and spare parts.  Gross profit increased 69% from $155.3million for 2005 to $262.2 million for 2006. The gross margin on product sales was 40.6% for 2005 compared to 48.3% for2006. This higher gross margin in 2006 as compared to 2005 was primarily due tooperating efficiency improvements, cost reductions, reduced lead and cycletimes and reduced warranty costs which resulted from product reliabilityimprovements which were made throughout 2006. The higher gross margin year overyear was also caused by the overall increase in product sales in 2006 and themix of those product sales being higher margin products. Going forward, weanticipate that gross margin will remain strong but stay at the current levelin the high 40% range.

*Research and Development*.  Research and developmentexpenses include costs of internally-funded and externally-funded projects aswell as continuing product development support expenses, which consistprimarily of employee and material costs, depreciation of equipment and otherengineering related costs.  Our researchand development expenses are offset by amounts associated with certain of ourexternally funded research and development contracts.  Research and development expenses increased16% from $64.0 million for 2005 to $74.0 million for 2006 due primarily tocosts associated with our LTPS product development efforts, EUV light sourcedevelopment efforts and ArF product development efforts for the design of anenhanced universal platform for our XL Series light sources, and associatedderivative products based on this platform. Research and development expenseswere offset by amounts related to our externally funded research anddevelopment contracts of $2.8 million and $154,000 for 2005 and 2006,respectively.  In addition to ourdevelopment of EUV and LTPS technologies, we also continued to focus on nextgeneration ArF and KrF products. As a percentage of total revenues, researchand development expenses decreased 3.1 percentage points from 16.7% for 2005 to13.6% for 2006 due primarily to revenues increasing at a faster rate thanresearch and development expenses in 2006 as compared to 2005.  As a result of our decision to enter the flatpanel display manufacturing tools market with the formation of the TCZ jointventure, our research and development expenses going forward will also includea greater focus on LTPS product development efforts.  We expect that our investment in research anddevelopment expenses overall will continue and that our research anddevelopment expenses associated with TCZ will remain relatively flat in 2007compared to the 2006 levels.

*Sales and Marketing*. Sales andmarketing expenses include sales, marketing and customer support staff expensesand other marketing expenses.  Sales andmarketing expenses increased 22% from $25.1 million for 2005 to $30.6 millionfor 2006. The sales and marketing expenses increase primarily reflects $2.9million in profit sharing and bonuses due to our improved financial performanceand $1.6 million of stock-based compensation expense associated with the SFASNo. 123R requirements which we adopted in January 2006. In addition, sales and marketingexpenses were higher in 2006 compared to 2005 as a result of expensesassociated with our TCZ joint venture which was formed in July 2005.  As a percentage of total revenues,such sales and marketing expenses decreased from 6.6% for 2005 to 5.6% for2006.  We anticipate that sales andmarketing expenses may remain relatively flat in the first quarter of 2007.

*Generaland Administrative*. General and administrative expensesconsist primarily of management and administrative personnel costs,professional services, including external audit fees, and administrativeoperating costs.  General and administrativeexpenses increased 47% from $26.5 million for 2005 to $38.9 million for 2006.The increase is primarily due to a $5.0 million increase in stock-basedcompensation expense recorded in 2006 as a result of our adoption of SFAS No.123R on January 1, 2006. In addition to stock-based compensation expenserecorded as a result of SFAS No. 123R, we recorded $4.2 million of stock-basedcompensation expense in the fourth quarter of 2006 related to a small number ofstock options granted primarily in 1999. This additional stock-based compensationexpense resulted from us using the incorrect measurement date to calculate ourcompensation expense for those stock options. 

 

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Additional increases ingeneral and administrative expenses from 2005 to 2006 include $2.1 million inprofit sharing and bonus expenses and a $1.1 million increase in external auditand advisory fees. In addition, general and administrative expenses in 2006reflect increased expenses associated with the TCZ joint venture formed in July2005.  As a percentage of total revenues,general and administrative expenses increased from 6.9% for 2005 to 7.2% for 2006.  We anticipate that general and administrativeexpenses will decrease in the first quarter of 2007 compared to the fourthquarter 2006 levels as a result of recording the $4.2 million in stock-basedcompensation expense related to the 1999 stock options in the fourth quarter of2006.

*Total Other Income - Net.*  Netother income consists primarily of interest income and expense, foreigncurrency exchange gains and losses associated with fluctuations in the value ofthe functional currencies of our foreign subsidiaries against the U.S. dollar,and gains and losses associated with debt extinguishment transactions. Netother income was $5.1 million and $19.6 million for 2005 and 2006,respectively. This significant increase in net other income from year to year wasprimarily due to a significant increase in interest income, the receipt of $3.2million in life insurance proceeds following the death of one of our executiveofficers in the first quarter of 2006, a decrease in interest expense and aforeign currency exchange gain recorded in 2006 as compared to a foreigncurrency exchange loss recorded in 2005. The increase in interest incomereflects higher market interest rate yields on larger cash and investmentbalances which resulted from higher earnings and significant proceeds fromstock option and warrant exercises during 2006. The decrease in interest expense from yearto year was due to our lower debt balances as a result of the repurchase of ourconvertible subordinated notes that we made in the second quarter of 2005.Other income was positively impacted in 2005 by a $2.2 million gain on debtextinguishment which resulted from the repurchase of these convertiblesubordinated notes.  Foreigncurrency exchange losses totaled $1.1 million, interest income and other incometotaled $10.9 million, interest expense totaled $6.9 million and gain on debtextinguishment totaled $2.2 million for 2005, compared to a foreign currencyexchange gain of $1.7 million, interest and other income of $23.9 million, andinterest expense of $6.0 million for 2006.

*Income Tax Provision.* The tax provision of $262,000 and $46.1million for 2005 and 2006, respectively, reflects an annual effective rate of1% and 33%, respectively.  The change inthe annual effective tax rate from year to year was primarily attributable tothe significant increase in pre-tax earnings, changes in the geographicaldistribution of income, a reduction in tax benefits from the ETI, and therelease of certain tax reserves in 2005 as a result of the expiration ofstatutes of limitations. The annual effective tax rate for 2006 was less thanthe U.S. statutory rate of 35% primarily as a result of permanent book/taxdifferences and tax credits and is a function of current tax law and geographiclocation of pre-tax income. The ETI was repealed by the American Jobs CreationAct of 2004 subject to certain transition rules.  The ETI exclusion is being replaced with aManufacturing Activity deduction under IRC Section 199 with a phase out of ETIbenefits in 2005 and 2006.  Our estimatedETI benefit for 2006 reflects the transition rules.

### **YEARS ENDEDDECEMBER 31, 2004 AND 2005**

*Revenues*. Product sales decreased 8% from $417.3****millionfor 2004 to $382.6 million for 2005. This decrease in product sales was due tolower light source system revenues partially offset by higher consumable andspare parts and service product revenues during 2005 as compared to 2004. Lightsource system revenues decreased 15% from $244.8 million for 2004 to $207.4million for 2005.  A total of 301 lightsource systems were sold in 2004 at an average selling price of $827,000,compared to 207 systems sold in 2005 at an average selling price of$982,000.  On a foreign currency adjustedbasis, the average selling price for 2004 was $816,000 compared to $984,000 for2005. The increase in the average selling price from year to year reflected theshift in the product mix from capacity driven lower priced KrF products in 2004to higher priced technology buys of advanced ArF products in 2005. The decreasein quantities of light source systems sold from year to year was due to thebrief upturn in the semiconductor industry in 2004, when chipmakers expandedcapacity, compared to the slight slowdown and flattening of the industry in2005 which impacted the demand for our light source systems, particularly KrFlight sources for capacity expansion. This decrease in light source systemrevenues from year to year was partially offset by a 2% increase in revenuesassociated with our 

 

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consumableand spare parts and service products from $172.5 million for 2004 to $175.2million for 2005.  Revenues from fundeddevelopment contracts were $783,000 for 2004, compared to $1.0 million for2005.  There were no revenues recorded orearned associated with the TCZ joint venture for 2005.

Sales to our three lithography tool manufacturing customers, ASML,Canon, and Nikon, amounted to 34%, 11% and 22%, respectively, of total revenuefor 2004, and 32%, 8% and 24%, respectively, of total revenue for 2005.

Approximately 82%and 84% of our sales for 2004 and 2005, respectively, were derived fromcustomers outside the U.S.  Revenues fromJapanese customers, generated primarily by Cymer Japan, accounted for 32% and31% of total revenues for 2004 and 2005, respectively.

*Cost ofProduct Sales*.   The cost of product sales decreased 7% from$243.5 million for 2004 to $227.3 million for 2005. This decrease in the costof product sales was primarily due to lower light source system sales in 2005compared to 2004.  In addition, thedecrease in the cost of product sales from year to year also reflects loweroverall product costs as a result of our material costs reduction efforts.  Gross profit decreased 11% from $173.8million for 2004 to $155.3 million for 2005.

The gross margin onproduct sales was 41.7% for 2004 as compared to 40.6% for 2005. This lowergross margin from year to year was primarily due to the increase in consumablesand service revenues which have lower gross margins. In addition, the grossmargin for 2004 was favorably impacted by approximately two percentage pointsdue to a customs refund that was received by our Korea office and credited tocost of product sales. Gross margin in the second half of 2005 was improvedfrom the first half of the year due to increased factory yield and utilizationand decreased cycle times and overall material costs.

*Research and Development*.  Research and developmentexpenses increased 9% from $58.6 million for 2004 to $64.0 million for 2005 dueprimarily to costs associated with our LTPS product development efforts and EUVlight source development. Research and development expenses were offset byamounts related to our externally funded research and development contracts of$7.6 million and $2.8 million for 2004 and 2005, respectively.  In addition to our development of EUV andLTPS technologies during 2005, we also continued to focus on next generationArF products based on the XL platform and next generation KrF products. As apercentage of total revenues, research and development expenses increased from14.0% for 2004 to 16.7% for 2005 due primarily to increased research anddevelopment efforts and lower revenues in 2005 as compared to 2004.

*Sales and Marketing*.  Sales and marketing expensesincreased 8% from $23.4 million for 2004 to $25.1 million for 2005. Thisincrease in sales and marketing expenses from year to year primarily reflectsincreased sales expenses associated with our chipmaker customers at our foreignlocations and market development costs associated with the TCZ joint venture.These expenses were offset by decreased profit sharing and bonus expensesincurred in 2005 compared to 2004.  As apercentage of total revenues, such sales and marketing expenses increased from5.6% for 2004 to 6.6% for 2005.

*Generaland Administrative*. General and administrative expenses decreased 16% from $31.6 million for2004 to $26.5 million for 2005 primarily due to the receipt of rent payments in2005 from the tenants in two of our San Diego facilities, which we subleased inthe third and fourth quarters of 2004. General and administrative expenses in2004 also included $3.0 million in costs associated with revisions of ourestimates related to the timing and market rates for subleasing the San Diegoand Charlestown facilities, which we exited in 2003 compared to $384,000 ofsuch expenses recorded in 2005. The lower general and administrative expensesin 2005 were offset by increased stock-based compensation expense associatedwith non-employees and initial expenses associated with the TCZ joint ventureduring the year.  As a percentage oftotal revenues, general and administrative expenses decreased slightly from7.6% for 2004 to 6.9% for 2005.

*Total Other Income (Expense) - Net.*   Net other expense totaled $421,000 for 2004,compared to net other income of $5.1 million for 2005. The change from netother expense to net other income 

 

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was primarily due to anincrease in interest income, a decrease in interest expense and a higher gainon debt extinguishment related to our notes repurchase activities from year toyear. This was offset by a foreign currency exchange loss recorded in 2005compared to a small foreign currency gain recorded in 2004. The increase ininterest income from 2004 to 2005 reflected higher market interest rates forour short-term and long-term investments on higher cash and investmentbalances. The decrease in interest expense from year to year was due to ourlower debt balances as a result of the repurchase of our convertiblesubordinated notes that we made in the third quarter of 2004 and the secondquarter of 2005.  Foreign currency exchangegains totaled $82,000, interest income totaled $8.1 million, interest expensetotaled $9.5 million and gain on debt extinguishment totaled $911,000 for 2004,compared to a foreign currency exchange loss of $1.1 million, interest incomeof $10.9 million, interest expense of $6.9 million and gain on debtextinguishment totaling $2.2 million for 2005.

*                Income Tax Provision.* The tax provision of $15.1 million and$262,000 for 2004 and 2005, respectively, reflects an annual effective rate of25% and less than 1%, respectively.  Thechange in the annual effective tax rate from period to period was primarilyattributable to the decrease in pre-tax earnings as well as tax benefits fromU.S. export incentive programs and research credits. The annual effective taxrates for both periods were less than the U.S. statutory rate of 35% primarilyas a result of permanent book/tax differences and tax credits. The effectivetax rate is a function of current tax law and geographic location of pre-taxincome. During the fourth quarter of 2005, the expiration of certain statutesof limitations related primarily to U.S. federal tax credits and deductionsallowed us to release tax reserves in the amount of $4.2 million.  As a result, our fourth quarter of 2005annualized effective tax rate was a benefit rate of 11% resulting in an annualeffective tax rate of less than 1%.  Thedecision to release tax reserves is made each quarter based on all relevantfacts and circumstances.

                The ETI was repealed by the American Jobs CreationAct of 2004 subject to certain transition rules.  The ETI exclusion is being replaced with aManufacturing Activity deduction under IRC Section 199 with a phase out of ETIbenefits in 2005 and 2006.  Our estimatedETI benefit for 2005 reflects the transition rules.  We did not benefit from the Section 199deduction in 2005 due to the taxable income limitation. The benefit isavailable to us for future tax years subject to certain transition rules. Weanticipate that the benefit available to us under both regimes will becomparable for years in which we have taxable income.

#### **LIQUIDITYAND CAPITAL RESOURCES**

Historically we have funded our operations primarily from cash generatedfrom operations, the proceeds of the note offerings, bank borrowings, and theproceeds from employee stock option exercises. As of December 31, 2006, we had approximately $302.1 million in cash andcash equivalents, $207.9 million in short-term investments, $8.4 million inlong-term investments, and $686.7 million in working capital.

In February 2002, we issued$250.0 million in aggregate principal amount in a private placement ofnotes.  These notes are due on February15, 2009 with interest payable semi-annually on February 15 and August 15 ofeach year at 3.50% per annum.  The notesare convertible into shares of our common stock at a conversion rate of 20shares per $1,000 principal amount or an effective conversion price of $50.00per share.  We used a portion of the netproceeds from this private placement to redeem the previously issued notes thatwere then outstanding. The remaining proceeds are being used for our operating,investing and financing activities.  Withthe approval of our board of directors, we have periodically repurchased thesenotes in the open market.  We repurchased$49.2 

 

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million and $60.0 million principal amount of thesenotes in 2004 and 2005, respectively. As of December 31, 2006, there were$140.7 million principal amount of notes outstanding.

Net cash provided byoperating activities was approximately $34.2 million,  $114.0 million and $115.8 million for 2004,2005 and 2006, respectively. Net cash provided by operating activities during2004 reflects net income for the year and increases in accrued and otherliabilities and income taxes offset by increases in accounts receivable,inventories, and accounts payable. The increase in accounts receivable wassignificant for 2004 and resulted from a higher number of product shipmentsthan normal taking place in the last month of the year. The increase ininventories was primarily due to our response to the growing light sourceutilizations and higher spares inventories to support what we thought would bea continued upturn in the semiconductor industry. When the industry started toslow down in the later half of 2004, we took action to reduce our spares andconsumables inventory. As a result of these actions, our inventory decreased by$10.6 million in the fourth quarter of 2004. Net cash provided by operatingactivities during 2005 reflects net income for the year, significant decreasesin accounts receivable and inventory and increases in accounts payable. Thedecrease in accounts receivable primarily reflects collections made in ourreceivable balances that were outstanding at December 31, 2004 and a decreasein sales compared to 2004. The decrease in inventory reflects the reduction inour field and factory inventory as a result of our ongoing initiative during2005 to improve asset management by reducing inventory and increasing inventoryturns.  Net cash provided by operatingactivities during 2006 reflects significant net income for the year andincreases in accrued expenses and other liabilities offset by increases inaccounts receivable and inventories. The increase in accounts receivable is theresult of higher revenues recorded during 2006 as compared to 2005. Theincrease in inventory balances for 2006 is primarily the result of an increaseddemand for spares and consumable parts to support our growing installed base oflight source systems, particularly our more advanced XLA series systems and theincrease in sales of our light source systems. In addition, cash fromoperations was negatively impacted in 2006 as a result of classifying excesstax benefits from stock option exercises in the amount of $20.2 million infinancing activities in 2006 rather than operating activities in accordancewith SFAS No. 123R which was adopted on January 1, 2006.

Net cash provided byinvesting activities was approximately $272,000 and $78.6 million for 2004 and2005, respectively, compared to $87.2 million in cash used in investingactivities in 2006. Net cash provided by investing activities during 2004reflects the timing of short-term and long-term investments that matured andwere reinvested during the year, the acquisition of $19.5 million of  property and equipment, a $6.0 millionpayment to acquire certain patents and a $2.0 million payment to acquire anadditional 6% minority interest in our Cymer Korea subsidiary. Net cashprovided by investing activities during 2005 reflects the timing of short-termand long-term investments that matured and were reinvested during the period,the acquisition of $18.8 million of property and equipment and a $2.5 millionpayment to acquire certain patents. Net cash used in investing activities for2006 was due primarily to the timing of short-term and long-term investmentsthat matured and were reinvested during the period, a $7.0 million payment toacquire the final 19% minority interest in our Cymer Korea subsidiary, a $8.2million payment to acquire certain patent license rights and the acquisition of$16.4 million of property and equipment.

Net cash used infinancing activities was approximately $32.0 million and $71.0 million for 2004and 2005, compared to net cash provided by financing activities of $35.6million in 2006. In 2004, net cash used in financing activities reflects therepurchase of $49.2 million in principal amount of our convertible subordinatednotes in the third quarter of 2004, at a discount to par. This was offset byproceeds received from the exercise of stock options in 2004 totaling $15.4million. Net cash used in financing activities for 2005 reflects the repurchaseof treasury stock of $50.0 million and the purchase of approximately $60.0million principal amount of our convertible subordinated notes, at a discountto par, during 2005. The treasury stock and note purchases were offsetpartially by proceeds received from the exercise of employee stock optionstotaling $25.2 million and the minority interest investment received from Zeissin the TCZ joint venture of $11.1 million during 2005.  Net cash provided by financing activities for2006 primarily reflects the proceeds received from the exercise of employeestock options as well as the exercise of warrants and proceeds from theemployee stock purchase plan totaling $116.1 million.  In addition, cash from financing activitiesin 2006 was positively affected by the 

 

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excess tax benefits forthe period from stock option exercises which totaled $20.2 million.  This cash provided by financing activities wasoffset by the repurchase of treasury stock totaling $100.7 million during 2006.

We requiresubstantial working capital to fund our business, particularly to financeinventories, including purchase orders with our vendors, accounts receivable,and for capital expenditures.  Our futurecapital requirements depend on many factors, including our manufacturingactivity, the timing and extent of spending to support product developmentefforts, expansion of sales and marketing and field service and support, competitivelabor market compensation requirements, the timing of introductions of newproducts and enhancements to existing products, and the market acceptance ofour products. We believe that cash generated from operations along with theliquidity provided by our existing cash balances and short-term investmentswill be sufficient to sustain operations and provide for any potential futureexpansion of our business for at least the next 12 months.

**TABULARDISCLOSURE OF CONTRACTUAL OBLIGATIONS**

The following summarizes ourcontractual obligations and other commitments as of December 31, 2006, and theimpact such obligations could have on our liquidity and cash flow in futureperiods (in thousands):
| ** **                                  | ** ** | **Amount of Commitment Expiring by Period** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Total**                                                            | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **More  than  5 years** | ** ** |
| Operating lease  obligations (1)            |       | $                                                                    | 12,681     |   | $ | 5,095 |   | $ | 4,088 |   | $ | 3,393 |   | $ | 89 |   | $ | 16 |   | $ | 2 |   |
| Convertible  subordinated notes             |       | 140,722                                                              |       | — |   | — |   | 140,722 |   | — |   | — |   | — |   |
| Interest on  convertible subordinated notes |       | 12,313                                                               |       | 4,925 |   | 4,925 |   | 2,463 |   | — |   | — |   | — |   |
| Purchase orders                             |       | 50,123                                                               |       | 50,123 |   | — |   | — |   | — |   | — |   | — |   |
| Total commitments                           |       | $                                                                    | 215,839    |   | $ | 60,143 |   | $ | 9,013 |   | $ | 146,578 |   | $ | 89 |   | $ | 16 |   | $ | 2 |   |

----

(1)                                  Wecurrently sublease all or a portion of our leased facilities, and the paymentsreceived under these are direct offsets to our operating lease obligations. Theamounts in the table above represent the gross lease amounts and the followingtable summarizes amounts to be received under these non-cancelable subleaseagreements (in thousands):

 
| ** **                | ** ** | **Future Sublease Payments** | ** ** |
|---------------------------|------------|----------------------------------------|------------|
| ** **                | ** ** | **Total**                              | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **More  than  5 years** | ** ** |
| Total sublease agreements |       | $                                      | 6,254      |   | $ | 3,604 |   | $ | 1,526 |   | $ | 1,124 |   | $ | — |   | $ | — |   | $ | — |   |
|                           |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31,2005 and 2006, we did not have any relationships with unconsolidated entitiesor financial partnerships, such as entities often referred to as structuredfinance, variable interest, or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. In addition, we did not engage in trading activities involvingnon-exchange traded contracts.  As aresult, we are not exposed to any financing, liquidity, market or credit riskthat could arise if we had engaged in such relationships.  We do not have relationships and transactionswith persons and entities that derive benefits from their non-independentrelationship with us or our related parties except as disclosed herein.

 

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# **RECENT ACCOUNTING PRONOUNCEMENTS**

In July 2006, the FASB issued Financial AccountingStandard Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty inIncome Taxes”. FIN 48 clarifies the accounting for income taxes by prescribinga minimum probability threshold that a tax position must meet before afinancial statement benefit is recognized. The minimum threshold is defined inFIN 48 as a tax position that is more likely than not to be sustained uponexamination by the applicable taxing authority, including resolution of anyrelated appeals or litigation processes, based on the technical merits of theposition. The tax benefit to be recognized is measured as the largest amount ofbenefit that has a greater than fifty percent chance of being realized uponultimate settlement. FIN 48 must be applied to all existing tax positions uponinitial adoption. The cumulative effect of applying FIN 48 at adoption, if any,is to be reported as an adjustment to opening retained earnings for the year ofadoption. FIN 48 is effective for fiscal years beginning after December 15,2006.

We have adopted a FIN 48 implementation strategy.  This strategy is aimed at identifying,evaluating and measuring all of our uncertain tax positions.  This will be done for all open tax years, byunits of account and for all of our legal entities. We are currently in theprocess of identifying and evaluating uncertain tax positions for all of ourlegal entities according to their units of account.  Once this stage is completed, we will beginthe measurement stage and determine the cumulative effect adjustment, ifany.  Since we are still in the processof implementing FIN 48, we are not currently in a position where we canquantify or disclose the potential effect of FIN 48 on our 2007 consolidatedfinancial statements.

In September 2006, the FASB issuedStatement of Financial Accounting Standards No. 157 (“SFAS No. 157”), “FairValue Measurements”. SFAS No. 157 defines fair value, establishes a frameworkfor measuring fair value using generally accepted accounting principles, andexpands disclosures related to fair value measurements. This Statement appliesunder other accounting pronouncements that require or permit fair valuemeasurements, the FASB having previously concluded in those accountingpronouncements that fair value is the relevant measurement attribute.Accordingly, SFAS No. 157 does not require any new fair value measurements.However, for some entities, the application of this Statement will changecurrent practice. This Statement is effective for us on January 1, 2008. We arecurrently evaluating the impact of this pronouncement on our consolidatedfinancial statements.

In September 2006, FASB issued SFAS No.158 (“SFAS No. 158”), “Employers’ Accounting for Defined Benefit Pension andOther Postretirement Plans—an Amendment of FASB Statements No. 87, 88,106, and 132(R)”.  We adopted allprovisions of SFAS No. 158 in December 2006 except for the provision which willrequire us to measure the funded status of our pension plans as of the date ofour year-end statement of financial position. This provision will be effective for us for the fiscal year endingDecember 31, 2008, and we do not expect its adoption to have a material impacton our consolidated financial statements. See Note 1 under Accounting Pronouncements Adopted and Note 12 underRetirement Plans to our consolidated financial statements for information onthe provisions of SFAS No. 158 which we adopted effective with our fiscal yearended December 31, 2006.

#### **Item 7A.  Quantitative and Qualitative Disclosures AboutMarket Risk**

# **Foreign Currency Risk**

We conductbusiness in several international currencies through our global operations. Dueto the large volume of our business that we conduct in Japan, the Japaneseoperation poses our greatest foreign currency risk.  We use financial instruments, principallyforward contracts, to manage our foreign currency exposures. We enter intoforward contracts in order to reduce the impact of currency fluctuationsrelated to purchases of our inventories by Cymer Japan in U.S. dollars forresale under firm third-party sales commitments denominated in Japanese yen, aswell as other foreign currency 

 

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exposures including exposures related tointercompany debt.  We do not enter intoforward contracts for speculative purposes.

As of December31, 2006, we had outstanding forward contracts to buy U.S. $42.0 million for5.3 billion yen under foreign currency exchange facilities with contract ratesranging from 113.23 yen to 117.32****yen per U.S.dollar.  These contracts expire onvarious dates through December 2007.

Our forward contractsgenerally qualify for hedge accounting treatment per the provisions ofStatement of Financial Accounting Standards No. 133, “Accounting for DerivativeInstruments and Hedging Activities”. As a result, we defer changes in the fairvalue for the effective portion of these hedges and record the amount in othercomprehensive income and subsequently reclassify the gain or loss to cost ofproduct sales in the same period that the related sale is made to the thirdparty. The fair value of all of our forward contracts and the deferred gain(net of tax) for those that qualify for hedge accounting treatment totaled$652,000 and $17,000 respectively, as of December 31, 2006.

The fair value of theseforward contracts as of December 31, 2006 would have fluctuated by $4.2 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**

We maintain aninvestment portfolio consisting primarily of government and corporate fixedincome securities, certificates of deposit and commercial paper.  While it is our general intent to hold suchsecurities until maturity, we will occasionally sell certain securities forcash flow purposes. Therefore, our investments are classified asavailable-for-sale and are carried on the balance sheet at fair value.  A change in market interest rates of 1% wouldhave impacted our net income from these investments by approximately $2.3million in 2006.

In February 2002,we issued $250.0 million principal amount of unsecured fixed rate 3.50%Convertible Subordinated Notes due February 15, 2009.  Interest on these notes is payable onFebruary 15 and August 15 of each year. The notes are convertible into sharesof our common stock at a conversion rate of 20 shares per $1,000 principalamount subject to adjustment under certain conditions. We may redeem the notesafter February 20, 2005 at certain redemption prices expressed as a percentageof the principal amount. The notes are subordinated to our existing and future seniorindebtedness and effectively subordinated to all indebtedness and otherliabilities of our subsidiaries.  Becausethe interest rate is fixed, we believe there is no risk of increased interestexpense. These notes are recorded at face value on the consolidated balancesheets. In the third quarter of 2004 and the second quarter of 2005, werepurchased, at a discount to par, $49.2 million and $60.0 million principalamount, respectively, of these notes.  Asof December 31, 2005 and 2006, $140.7 million principal amount of the noteswere outstanding.  The fair value of suchdebt based on quoted market prices on December 31, 2005 and 2006 was $136.5million and $147.6 million, respectively.

#### **Item 8. Financial Statements and Supplementary Data**

The information required bythis Item is included in Part IV Items 15(a)(1) and (2) of this AnnualReport on Form 10-K.

**Item 9.  Changes in and Disagreements with Accountantson Accounting and Financial Disclosure**

None.

**Item9A.  Controls and Procedures**

1.                                       Evaluationof Disclosure Controls and Procedures. Our chief executive officer and our chief financial officer, afterevaluating the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934,as amended (the “Exchange Act”)) as of December 31, 2006, have concluded thatour disclosure controls and procedures were not effective as of such datebecause of the existence of a material weaknessin our internal control over financial reporting related to our accounting forincome taxes, as describedbelow. 

** **

2.                                       Management'sReport on Internal Control Over Financial Reporting. Our management isresponsible for establishing and maintaining adequate internal control over ourfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of theExchange Act).  

 

We assessed theeffectiveness of our internal control over financial reporting as of December31, 2006, using the criteria established in Internal Control – IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO).  Based upon thisassessment, we have concluded that, as of December 31, 2006, our internalcontrol over financial reporting was not effective due to the material weaknessrelated to our accounting for income taxes, described below. A material weakness in internal controlover financial reporting is a significant deficiency, or combination ofsignificant deficiencies, that results in more than a remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected.

 

Management’s assessmentidentified the following material weakness in our internal control overfinancial reporting as of December 31, 2006:

 

Our policies and proceduresdid not provide for effective oversight and review of our accounting for incometaxes. Specifically, our policies and procedures did not include adequatemanagement review of various income tax calculations, reconciliations andrelated supporting documentation to ensure that our accounting for income taxeswas in accordance  with generallyaccepted accounting principles.  Thismaterial weakness resulted in material errors in our consolidated income taxprovision that were corrected prior to the issuance of our 2006 consolidatedfinancial statements.

 

Management's assessmentof the effectiveness of our internal control over financial reporting as ofDecember 31, 2006, has been audited by KPMG LLP, an independent registeredpublic accounting firm.  Their reportappears on page F-2 of this Annual Report on Form 10-K.

** **

3.                                     Changesin Internal Control Over Financial Reporting. There were no changes in ourinternal control over financial reporting that occurred during the last fiscalquarter that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting other than the following stepstaken by us during the fourth quarter of 2006 in response to the materialweakness that we disclosed in our 2005 Form 10-K related to our accounting forincome taxes:

 

·     Improvedthe procedures for reviewing and reconciling all subsidiary office taxaccounts; and

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

 

4.                                       Management’sRemediation Plans.   Because 2006 is thesecond year in which we have identified and reported a material weakness in internalcontrol over financial reporting associated with our accounting for incometaxes, we plan to conduct significant remediation efforts throughout 2007 withthe goal to remediate this material weakness prior to December 

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31, 2007.  Although we are still discussing andfinalizing the specifics of these plans, they currently include the following:

 

·              Hiringadditional tax personnel and providing additional regulatory training forselect tax personnel;

·              Redesigningand implementing new review and approval procedures and processes associatedwith all income tax provision workpapers and the consolidated income taxreconciliation schedules;

·              Restructuringof the income tax department to allow for the proper review and approvalprocesses;

·              Identifyingand implementing an automated tax provision software tool that will reduce thenumber of manual spreadsheets that we use to calculate and reconcile all incometax accounts on a quarterly and annual basis; and

·              Improvingthe communications between our tax department and our accounting department,and increasing the involvement of our accounting department in the reviews ofincome tax reconciliations.

 

We will monitor theeffectiveness of these new processes, procedures and controls as they areimplemented in 2007 and will make changes management determines to be appropriate.

 

5.                                       InherentLimitations on the Effectiveness of Internal Control. There are inherentlimitations in the effectiveness of any internal control, including thepossibility of human error and the circumvention or overriding of controls.  Accordingly, even effective internal controlscan provide only reasonable assurances with respect to financial statementpreparation. Further, because of changes in conditions, the effectiveness ofinternal controls may vary over time.

 

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#### **Item 9B.  Other Information**

None.

##### **PART III**

**Item 10.  Directors, Executive Officers and CorporateGovernance.**

The information regarding theidentification and business experience of our directors under the caption “Proposal1 - Election of Directors” in our Proxy Statement for the annual meeting ofstockholders to be held on May 17, 2007 to be filed with the SEC within 120days after the end of our fiscal year ended December 31, 2006, is incorporatedherein by reference. For information regarding the identification and businessexperience of our executive officers, see “Executive Officers” at the end ofItem 1 in Part I of this Annual Report on Form 10-K. Information concerningfiling requirements applicable to our executive officers and directors underthe caption “Section 16(a) Beneficial Ownership Reporting Compliance” in ourProxy Statement is incorporated herein by reference.

In 2003, we adopted a code of ethics that appliesto our principal executive officer, principal financial officer, principalaccounting officer or controller, or persons performing similar functions.  We have posted the text of the code of ethicson our website which can be accessed at http://www.cymer.com under “InvestorRelations.”  In addition, we willpromptly disclose on our website (1) the nature of any amendment to the code ofethics that applies to our principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions and (2) the nature of any waiver, including an implicitwaiver, from a provision of the code of ethics that is granted to one of thesespecified officers, and the name of such person who is granted the waiver onour website in the future.

**Item 11.  Executive Compensation**

The information under thecaptions “Compensation of Executive Officers” and “Report of the CompensationCommittee” in our Proxy Statement is incorporated herein by reference.

**Item 12. Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

The information under thecaptions “Security Ownership of Certain Beneficial Owners and Management” and “EquityCompensation Plan Information” in our Proxy Statement is incorporated herein byreference.

### **Item 13.  CertainRelationships and Related Transactions, and Director Independence**

The information under thecaption “Certain Transactions” in our Proxy Statement is incorporated herein byreference.

With the exception of theinformation specifically incorporated by reference from our Proxy Statement inthis Annual Report on Form 10-K, our Proxy Statement shall not be deemed to befiled as part of this Report.  Withoutlimiting the foregoing, the information under the captions “Report of the AuditCommittee of the Board of Directors in our Proxy Statement is not incorporatedby reference in this Annual Report on Form 10-K.

#### **Item 14.  Principal AccountingFees and Services**

The information under the caption “Independent Registered PublicAccounting Firm Fees” in our Proxy Statement is incorporated herein byreference.

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**PART IV**

### **Item 15.  Exhibits,Financial Statement Schedules**

(a)           The following documents are filed as part of, orincorporated by reference into, this Annual Report on Form 10-K:

(1)(2)       FinancialStatements and Financial Statement Schedule. The following ConsolidatedFinancial Statements of Cymer, Inc., Financial Statement Schedule and Reportsof Independent Registered Public Accounting Firm are included in a separatesection of this Annual Report on Form 10-K beginning on page F-1:

| Description                                                                                                                            | ** ** | **Page Number** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
|                                                                                                                                   |       |            |
| Report of Independent Registered Public Accounting  Firm                                                                               |       |            |
| Report of Independent Registered Public Accounting  Firm                                                                               |       |            |
| Consolidated Balance Sheets as of  December 31, 2005 and 2006                                                                          |       |            |
| Consolidated Statements of Operations  for the Years Ended 

December 31, 2004, 2005 and 2006                                          |       |            |
| Consolidated Statements of  Stockholders’ Equity and Comprehensive Income 

For the Years Ended December 31, 2004,  2005 and 2006 |       |            |
| Consolidated Statements of Cash Flows  for the Years Ended 

December 31, 2004, 2005 and 2006                                          |       |            |
| Notes to  Consolidated Financial Statements                                                                                            |       |            |
| Financial  Statement Schedule:                                                                                                         |       |            |
| Schedule II — Valuation and Qualifying  Accounts and Reserves                                                                     |       |            |

 

All other financial statement schedules have been omitted because therequired information is not applicable or not present in amounts sufficient torequire submission of the schedule, or because the information required isincluded in our consolidated financial statements or the notes thereto.

(3)           Exhibits.  The exhibits listed under Item 15(c) hereofare filed with, or incorporated by reference into, this Annual Report on Form10-K.  Each management contract orcompensatory plan or arrangement is identified separately in item 15(c) hereof.

(b)                           Exhibits.  The following exhibits are filed as part of,or incorporated by reference into, this Annual Report on Form 10-K:
| 3.1    |   | Amended and Restated Articles of Incorporation of  Cymer, Inc. (incorporated herein by reference to Exhibit 3.1 to Cymer’s  Registration Statement on Form S-1, Reg. No. 333-08383).                                                                                                                         |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                              |
| 3.2    |   | Amendment of Articles of Incorporation of Cymer,  Inc. (incorporated herein by reference to Exhibit 3.1 to Cymer’s Quarterly  Report on Form 10-Q for the quarter ended June 30, 2002).                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 3.3    |   | Amended and restated Bylaws of Cymer, as amended and  restated (incorporated herein by reference to Exhibit 3.1 to Cymer’s Form 8-K  filed on November 21, 2006).                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 4.1    |   | Purchase Agreement, dated as of February 12,  2002, among Cymer, Credit Suisse First Boston Corporation and Merrill Lynch  Pierce Fenner and Smith Incorporated (incorporated herein by reference to  Exhibit 4.1 to Cymer’s Quarterly Report on Form 10-Q for the quarter ended  March 31, 2002). |
|   |   |                                                                                                                                                                                                                                                                                                              |

 

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| 4.2    |   | Indenture, dated as of February 15, 2002,  between Cymer and State Street Bank and Trust Company of California, N.A., as  Trustee (incorporated herein by reference to Exhibit 4.2 to Cymer’s Quarterly  Report on Form 10-Q for the quarter ended March 31, 2002).                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 4.3    |   | Registration Rights Agreement, dated as of  February 15, 2002, among Cymer, Credit Suisse First Boston Corporation  and Merrill Lynch Pierce Fenner and Smith Incorporated (incorporated herein  by reference to Exhibit 4.3 to Cymer’s Quarterly Report on Form 10-Q for the  quarter ended March 31, 2002). |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.1   | #      | Form of Indemnification Agreement with Directors and  Officers (incorporated herein by reference to Exhibit 10.1 to Cymer’s Annual  Report on Form 10-K for the year ended December 31, 2003).                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.2   |   | Single-Tenant Industrial Lease, dated  December 19, 1996, by and between Arden Realty Finance III, LLC  (originally AEW/LBA Acquisition Co. II, LLC) and Cymer, as amended  (incorporated herein by reference to Exhibit 10.3 to Cymer’s Annual Report on  Form 10-K for the year ended December 31, 2004).        |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.3   |   | Sublease Agreement, dated December 22, 2004, by  and between Northrop Grumman Systems Corporation and Cymer (incorporated  herein by reference to Exhibit 10.4 to Cymer’s Annual Report on Form 10-K for  the year ended December 31, 2004).                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.4   | #      | 1996 Stock Option Plan, as amended (incorporated  herein by reference to Exhibit 99.1 to Cymer’s Registration Statement on Form  S-8, Registration No. 333-69736).                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.5   | #      | Form of Stock Option Agreement used in connection  with the 1996 Stock Option Plan, as amended (incorporated herein by reference  to Exhibit 4.1 to Cymer’s Registration Statement on Form S-8, Registration  No. 333-48242).                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.6   | #      | 1996 Employee Stock Purchase Plan, as amended  (incorporated herein by reference to Exhibit 99.2 to Cymer’s Current Report  on Form 8-K filed on May 19, 2006).                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                         |

 

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| 10.7#  |   | 2000 Equity Incentive Plan (formerly known as the  2000 Nonstatutory Stock Option Plan and incorporated herein by reference to  Exhibit 99.4 to Cymer’s Registration Statement on Form S-8, Registration No.  333-69736).                          |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                    |
| 10.8#  |   | Form of Stock Option Agreement used in connection  with the 2000 Equity Incentive Plan (incorporated herein by reference to  Exhibit 99.5 to Cymer’s Registration Statement on Form S-8, Registration No.  333-69736).                             |
|   |   |                                                                                                                                                                                                                                                    |
| 10.9#  |   | 2005 Equity Incentive Plan (incorporated herein by  reference to Exhibit 99.1 to Cymer’s Current Report on Form 8-K filed on May  20, 2005).                                                                                                       |
|   |   |                                                                                                                                                                                                                                                    |
| 10.10# |   | Form of Stock Option Agreement used in connection  with the 2005 Equity Incentive Plan (incorporated herein by reference to  Exhibit 99.2 to Cymer’s Current Report on Form 8-K filed on May 20, 2005).                                            |
|   |   |                                                                                                                                                                                                                                                    |
| 10.11# |   | Form of Stock Unit Grant Notice and Stock Unit  Agreement used in connection with the 2005 Equity Incentive Plan  (incorporated herein by reference to Exhibit 99.1 to Cymer’s Current Report  8-K filed on February 10, 2006).                    |
|   |   |                                                                                                                                                                                                                                                    |
| 10.12# |   | Amended and Restated Employment Agreement, effective  as of January 2, 2007, by and between Robert P. Akins and Cymer.                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                    |
| 10.13# |   | Amended and Restated Employment Agreement, effective  as of January 2, 2007, by and between Nancy J. Baker and Cymer.                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                    |
| 10.14# |   | Employment Agreement, effective as of June 1, 2003,  by and between Pascal Didier and Cymer (incorporated herein by reference to  Exhibit 10.1 to Cymer’s Quarterly Report on Form 10-Q for the quarter ended  June 30, 2003).                     |
|   |   |                                                                                                                                                                                                                                                    |
| 10.15# |   | Employment Agreement, effective as of May 1, 2003,  by and between Edward P. Holtaway and Cymer (incorporated herein by reference  to Exhibit 10.4 to Cymer’s Quarterly Report on Form 10-Q for the quarter  ended June 30, 2003).                 |
|   |   |                                                                                                                                                                                                                                                    |
| 10.16# |   | Employment Agreement, effective as of May 1, 2003,  by and between Brian C. Klene and Cymer (incorporated herein by reference to  Exhibit 10.5 to Cymer’s Quarterly Report on Form 10-Q for the quarter ended  June 30, 2003).                     |
|   |   |                                                                                                                                                                                                                                                    |
| 10.17# |   | Employment Agreement, effective as of May 1,  2003, by and between Rae Ann Werner and Cymer (incorporated herein by  reference to Exhibit 10.7 to Cymer’s Quarterly Report on Form 10-Q  for the quarter ended June 30, 2003). |
|   |   |                                                                                                                                                                                                                                                    |
| 10.18# |   | Employment Agreement, effective as of January 2,  2007, by and between Edward Brown, Jr. and Cymer.                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                    |
| 10.19# |   | Employment Agreement, effective as of October 21,  2004, by and between Bill N. Alexander and Cymer (incorporated herein by  reference to Exhibit 10.21 to Cymer’s Annual Report on Form 10-K for the year  ended December 31, 2005).              |
|   |   |                                                                                                                                                                                                                                                    |
| 10.20# |   | Summary description of Cymer, Inc. Incentive Bonus  Program as amended (incorporated herein by reference to Exhibit 99.2 to  Cymer’s Current Report on Form 8-K filed on March 31, 2006).                                                          |
|   |   |                                                                                                                                                                                                                                                    |

 

52

----

 
| 10.21# |   | Summary description of Cymer, Inc. 3-Year Bonus Program  (incorporated herein by reference to Exhibit 99.1 to Cymer’s Current Report  on Form 8-K filed April 1, 2005).                                                                                                                                                                    |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.22# |   | Executive Nonqualified Excess Plan, as amended and  restated as of January 1, 2007.                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.23* |   | Amended and Restated Joint Venture Agreement, dated  September 12, 2006, among TCZ GmbH, Cymer, Inc., Carl Zeiss SMT AG and Carl  Zeiss Laser Optics Beteiligungsgesellschaft mbH and TCZ Pte Ltd (incorporated  herein by reference to Exhibit 10.2* to Cymer’s Quarterly Report on Form 10-Q  for the quarter ended September 30, 2006). |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.24* |   | Patent License Agreement, dated May 14, 2001, by and  among Cymer, Inc., Linda B. Jacob, Joseph A. Mangano, and Science Research  Laboratory, Inc. (incorporated herein by reference to Exhibit 10.2 to Cymer’s  Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
|   |   | Patent Sublicense Agreement, dated May 14, 2001, by  and between Science Research Laboratory, Inc. and Cymer, Inc. (incorporated  herein by reference to Exhibit 10.2 to Cymer’s Quarterly Report on Form 10-Q  for the quarter ended June 30, 2001).                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.25* |   | Patent Sublicense Agreement, dated November 7,  2003, by and between SRL-EUV, LLC and Cymer, Inc. (incorporated herein by  reference to Exhibit 10.27 to Cymer’s Annual Report on Form 10-K for the year  ended December 31, 2003).                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.26* |   | Patent Sublicense Agreement, dated November 7,  2003, by and between Science Research Laboratory, Inc. and Cymer, Inc.  (incorporated herein by reference to Exhibit 10.28 to Cymer’s Annual Report  on Form 10-K for the year ended December 31, 2003).                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.27# |   | Reduction in Force Benefits Plan, as amended  (incorporated herein by reference to Exhibit 10.1 to Cymer’s Quarterly Report  on Form 10-Q for the quarter ended March 31, 2003).                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.28# |   | Executive Option and Group Health Coverage Extension  Program (incorporated herein by reference to Exhibit 10.22 to Cymer’s Annual  Report on Form 10-K for the year ended December 31, 2001).                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.29* |   | Development Agreement dated January 23, 2004,  by and between Cymer, Inc. and Intel Corporation (incorporated herein by  reference to Exhibit 10.1 to Cymer’s Quarterly Report on Form 10-Q for the  quarter ended March 31, 2004).                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
|   |   | Amendment of Cymer Corporation and Intel Corporation  Development Agreement, effective July 17, 2006 (incorporated herein by  reference to Exhibit 10.1* to Cymer’s Quarterly Report on Form 10-Q for the  quarter ended September 30, 2006).                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.30* |   | Intellectual Property License Agreement dated  February 4, 2004, by and between Cymer, Inc. and Intel Corporation  (incorporated herein by reference to Exhibit 10.2 to Cymer’s Quarterly Report  on Form 10-Q for the quarter ended March 31, 2004).                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                            |

 

53

----

 
|        |   | Amendment Intellectual Property License Agreement,  effective June 27, 2006, by and between Intel Corporation and Cymer, Inc  (incorporated herein by reference to Exhibit 10.2* to Cymer’s Quarterly  Report on Form 10-Q for the quarter ended June 30, 2006). |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                  |
| 14.1   |   | Code of Ethics for Chief Executive, Chief Financial  and Chief Accounting Officers (incorporated herein by reference to Exhibit  14.1 to Cymer’s Annual Report on Form 10-K for the year ended  December 31, 2003).                                         |
|   |   |                                                                                                                                                                                                                                                                  |
| 21.1   |   | Subsidiaries of Cymer.                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                  |
| 23.1   |   | Consent of KPMG LLP, Independent Registered Public Accounting  Firm.                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                  |
| 24.1   |   | Power of Attorney (reference is made to the  signature page).                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                  |
| 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.                                                                                                                                                                |

----

#       Indicatesmanagement contract or compensatory plan or arrangement.

*       Confidentialtreatment was requested with respect to certain portions of this exhibit.Omitted portions were filed separately with the SEC.

(d)           Financial Statement Schedules.  See item 15, paragraph (a) (2), above.

 

54

----

 

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|        |   |                      |       CYMER, INC.               |
|--------|--------|---------------------------|-----------------------------------------------------|
|   |   |                      |                                                |
|   |   |                      |                                                |
|   |   | By:                       | /s/ ROBERT P. AKINS                                 |
|   |   |                      | Robert P. Akins,                                    |
|   |   |                      | Chief Executive  Officer, and Chairman of the Board |
|   |   |                      |                                                |
|   |   | Dated: February  27, 2007 |

 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signatureappears below constitutes and appoints Nancy J. Baker and Rae Ann Werner, andeach of them, as his true and lawful attorneys-in-fact and agents, with fullpower of substitution and resubstitution, for him and in his name, place, andstead, in any and all capacities, to sign any and all amendments to this AnnualReport on Form 10-K, and to file the same, with all exhibits thereto, and otherdocuments in connection therewith, with the Securities and Exchange Commission,granting unto said attorneys-in-fact and agents, and each of them, full powerand authority to do and perform each and every act and thing requisite andnecessary to be done in connection therewith, as fully to all intents andpurposes as he might or could do in person, hereby ratifying and confirmingthat all said attorneys-in-fact and agents, or any of them or their or hissubstitute or substituted, may lawfully do or cause to be done by virtuehereof.

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the dateindicated.
| /s/ ROBERT P. AKINS   |   | Chief Executive Officer, and Chairman of the Board       |   | February 27, 2007 |
|-----------------------|--------|----------------------------------------------------------|--------|-------------------|
| Robert P. Akins       |   | *(Principal Executive Officer)*                          |   |              |
|                  |   | * *                                                 |   |              |
| /s/ NANCY J. BAKER    |   | Senior Vice President and Chief Financial Officer        |   | February 27, 2007 |
| Nancy J. Baker        |   | *(Principal Financial Officer)*                          |   |              |
|                  |   | * *                                                 |   |              |
| /s/ RAE ANN WERNER    |   | Vice President, Controller and Chief Accounting  Officer |   | February 27, 2007 |
| Rae Ann Werner        |   | *(Principal Accounting Officer)*                         |   |              |
|                  |   | * *                                                 |   |              |
| /s/ CHARLES J. ABBE   |   | Director                                                 |   | February 27, 2007 |
| Charles J. Abbe       |   |                                                     |   |              |
|                  |   |                                                     |   |              |
| /s/ EDWARD H. BRAUN   |   | Director                                                 |   | February 27, 2007 |
| Edward H. Braun       |   |                                                     |   |              |
|                  |   |                                                     |   |              |
| /s/ MICHAEL R. GAULKE |   | Director                                                 |   | February 27, 2007 |
| Michael R. Gaulke     |   |                                                     |   |              |
|                  |   |                                                     |   |              |
| /s/ WILLIAM G. OLDHAM |   | Director                                                 |   | February 27, 2007 |
| William G. Oldham     |   |                                                     |   |              |
|                  |   |                                                     |   |              |
| /s/ PETER J. SIMONE   |   | Director                                                 |   | February 27, 2007 |
| Peter J. Simone       |   |                                                     |   |              |
|                  |   |                                                     |   |              |
| /s/ YOUNG K. SOHN     |   | Director                                                 |   | February 27, 2007 |
| Young K. Sohn         |   |                                                     |   |              |
|                  |   |                                                     |   |              |
| /s/ JON D. TOMPKINS   |   | Director                                                 |   | February 27, 2007 |
| Jon D. Tompkins       |   |                                                     |   |              |

 

55

----

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and StockholdersCymer, Inc.:

We have audited the accompanying consolidated balancesheets of Cymer, Inc. and subsidiaries (the Company) as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity and comprehensive income (loss), and cash flows for eachof the years in the three-year period ended December 31, 2006. Inconnection with our audits of the consolidated financial statements, we alsohave audited financial statement Schedule II. These consolidated financialstatements and financial statement schedule are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Cymer, Inc. and subsidiaries as of December 31, 2006 and 2005,and the results of their operations and their cash flows for each of the yearsin the three-year period ended December 31, 2006, in conformity withU.S. generally accepted accounting principles. Also, in our opinion, therelated financial statement Schedule II, when considered in relation tothe basic consolidated financial statements taken as a whole, presents fairly,in all material respects, the information set forth therein.

As discussed in note 1 to the consolidatedfinancial statements, effective January 1, 2006, the Company adoptedStatement of Financial Accounting Standards No. 123(R), *Share-Based Payment*.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of the Company’s internal control over financial reporting as ofDecember 31, 2006, based on criteria established in Internal Control —Integrated Framework issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), and our report dated February 26, 2007expressed an unqualified opinion on management’s assessment of, and an adverseopinion on the effective operation of, internal control over financialreporting.

/s/ KPMG LLP

San Diego, CaliforniaFebruary 26, 2007

 

 

F-1

----

 

**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors and StockholdersCymer, Inc.:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting (Item 9A.2), that Cymer, Inc. and subsidiaries(the Company) did not maintain effective internal control over financialreporting as of December 31, 2006, because of the effect of the materialweakness identified in management’s assessment, based on criteria establishedin *Internal Control — Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). The Company’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accounting principles,and that receipts and expenditures of the company are being made only inaccordance with authorizations of management and directors of the company; and(3) provide reasonable assurance regarding prevention or timely detectionof unauthorized acquisition, use, or disposition of the company’s assets thatcould have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialinformation will not be prevented or detected.

F-2

----

The following material weakness has been identified andincluded in management’s assessment:

The Company’s policies and procedures did not providefor effective oversight and review of its accounting for income taxes.Specifically, the Company’s policies and procedures did not include adequatemanagement review of various income tax calculations, reconciliations, andsupporting documentation to ensure that its accounting for income taxes was inaccordance with U.S. generally accepted accounting principles. This deficiencyresulted in material errors in the Company’s consolidated income tax provision.

In our opinion, management’s assessment that theCompany did not maintain effective internal control over financial reporting asof December 31, 2006, is fairly stated, in all material respects, based oncriteria established in *Internal Control —Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also, in our opinion, becauseof the effect of the material weakness described above on the achievement ofthe objectives of the control criteria, the Company has not maintainedeffective internal control over financial reporting as of December 31,2006, based on criteria established in *Internal Control —Integrated Framework* issued by the Committee of Sponsoring Organizationsof the Treadway Commission (COSO).

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheets of the Company as of December 31, 2006 and2005, and the related consolidated statements of operations, stockholders’equity and comprehensive income (loss), and cash flows for each of the years inthe three-year period ended December 31, 2006.  This material weakness was considered indetermining the nature, timing, and extent of audit tests applied in our auditof the 2006 consolidated financial statements, and this report does not affectour report dated February 26, 2007 which expressed an unqualified opinionon those consolidated financial statements.

/s/ KPMG LLP

San Diego, CaliforniaFebruary 26, 2007

 

F-3

----

 

 

CYMER, INC.

**CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **ASSETS**                                                                                                                                                                            | ** ** | **2005**              | ** ** | **2006** | ** ** |
|                                                                                                                                                                                  |       |                  |       |   |   |
| CURRENT ASSETS:                                                                                                                                                                       |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                             |       | $                     | 233,745    |   | $ | 302,098 |   |
| Short-term investments                                                                                                                                                                |       | 130,204               |       | 207,943 |   |
| Accounts receivable — net                                                                                                                                                        |       | 89,818                |       | 115,857 |   |
| Accounts receivable — related party                                                                                                                                              |       | 588                   |       | 834 |   |
| Foreign currency forward exchange contracts                                                                                                                                           |       | 1,776                 |       | 652 |   |
| Inventories                                                                                                                                                                           |       | 89,046                |       | 104,296 |   |
| Deferred income taxes                                                                                                                                                                 |       | 33,338                |       | 46,943 |   |
| Prepaid expenses and other assets                                                                                                                                                     |       | 6,497                 |       | 7,143 |   |
| Total current assets                                                                                                                                                                  |       | 585,012               |       | 785,766 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| PROPERTY AND  EQUIPMENT — NET                                                                                                                                                    |       | 117,251               |       | 112,074 |   |
| LONG-TERM  INVESTMENTS                                                                                                                                                                |       | 29,395                |       | 8,384 |   |
| DEFERRED INCOME  TAXES                                                                                                                                                                |       | 34,429                |       | 12,766 |   |
| GOODWILL                                                                                                                                                                              |       | 8,358                 |       | 8,833 |   |
| INTANGIBLE  ASSETS — NET                                                                                                                                                         |       | 10,474                |       | 15,880 |   |
| OTHER ASSETS                                                                                                                                                                          |       | 6,457                 |       | 5,391 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| TOTAL ASSETS                                                                                                                                                                          |       | $                     | 791,376    |   | $ | 949,094 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                        |       |                  |       |   |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| CURRENT  LIABILITIES:                                                                                                                                                                 |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                      |       | $                     | 17,710     |   | $ | 18,711 |   |
| Accounts payable — related party                                                                                                                                                 |       | 4,975                 |       | 4,858 |   |
| Accrued warranty and installation                                                                                                                                                     |       | 30,775                |       | 29,974 |   |
| Accrued payroll and benefits                                                                                                                                                          |       | 12,461                |       | 21,707 |   |
| Accrued patents, royalties and other fees                                                                                                                                             |       | 7,180                 |       | 4,262 |   |
| Income taxes payable                                                                                                                                                                  |       | 7,268                 |       | 13,293 |   |
| Unearned income                                                                                                                                                                       |       | 1,726                 |       | 2,544 |   |
| Other current liabilities                                                                                                                                                             |       | 3,247                 |       | 3,715 |   |
| Total current liabilities                                                                                                                                                             |       | 85,342                |       | 99,064 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| CONVERTIBLE  SUBORDINATED NOTES                                                                                                                                                       |       | 140,722               |       | 140,722 |   |
| OTHER  LIABILITIES                                                                                                                                                                    |       | 10,582                |       | 14,781 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| Total liabilities                                                                                                                                                                     |       | 236,646               |       | 254,567 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| MINORITY  INTEREST                                                                                                                                                                    |       | 16,276                |       | 6,633 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                        |       |                  |       |   |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                           |       |                  |       |   |   |
| Preferred stock — $.001 par value, authorized  5,000,000 shares; no shares issued or outstanding                                                                                 |       | —                |       | — |   |
| Common stock — $.001 par value per share;  100,000,000 shares authorized; 38,036,000 and 41,774,000 shares outstanding  at December 31, 2005 and December 31, 2006, respectively |       | 38                    |       | 42 |   |
| Additional paid-in capital                                                                                                                                                            |       | 407,549               |       | 557,082 |   |
| Treasury stock at cost (1,943,000 and 4,536,000  common shares) at December 31, 2005 and 2006, respectively                                                                           |       | (50,000               | )          | (150,704 | ) |
| Accumulated other comprehensive loss                                                                                                                                                  |       | (9,025                | )          | (4,066 | ) |
| Retained earnings                                                                                                                                                                     |       | 189,892               |       | 285,540 |   |
| Total stockholders’ equity                                                                                                                                                       |       | 538,454               |       | 687,894 |   |
|                                                                                                                                                                                  |       |                  |       |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                      |       | $                     | 791,376    |   | $ | 949,094 |   |

 

See Notes toConsolidated Financial Statements.

F-4

----

 

**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
| ** **                                                                | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                      |       |                                        |       |   |   |   |   |
| REVENUES:                                                                 |       |                                        |       |   |   |   |   |
| Product sales                                                             |       | $                                           | 417,296    |   | $ | 382,238 |   | $ | 536,098 |   |
| Product sales — related party                                        |       | —                                      |       | 400 |   | 7,362 |   |
| Other                                                                     |       | 783                                         |       | 1,010 |   | 395 |   |
| Total revenues                                                            |       | 418,079                                     |       | 383,648 |   | 543,855 |   |
|                                                                      |       |                                        |       |   |   |   |   |
| COSTS AND  EXPENSES:                                                      |       |                                        |       |   |   |   |   |
| Cost of product sales                                                     |       | 243,473                                     |       | 227,290 |   | 281,243 |   |
| Research and development                                                  |       | 58,612                                      |       | 64,025 |   | 73,974 |   |
| Sales and marketing                                                       |       | 23,369                                      |       | 25,143 |   | 30,618 |   |
| General and administrative                                                |       | 31,630                                      |       | 26,514 |   | 38,889 |   |
|                                                                      |       |                                        |       |   |   |   |   |
| Total costs and expenses                                                  |       | 357,084                                     |       | 342,972 |   | 424,724 |   |
|                                                                      |       |                                        |       |   |   |   |   |
| OPERATING INCOME                                                          |       | 60,995                                      |       | 40,676 |   | 119,131 |   |
|                                                                      |       |                                        |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                                  |       |                                        |       |   |   |   |   |
| Foreign currency exchange gain (loss) — net                          |       | 82                                          |       | (1,115 | ) | 1,674 |   |
| Gain on debt extinguishment                                               |       | 911                                         |       | 2,220 |   | — |   |
| Interest and other income                                                 |       | 8,079                                       |       | 10,943 |   | 23,852 |   |
| Interest and other expense                                                |       | (9,493                                      | )          | (6,936 | ) | (5,965 | ) |
|                                                                      |       |                                        |       |   |   |   |   |
| Total other income (expense) — net                                   |       | (421                                        | )          | 5,112 |   | 19,561 |   |
|                                                                      |       |                                        |       |   |   |   |   |
| INCOME BEFORE  INCOME TAX PROVISION AND MINORITY INTEREST                 |       | 60,574                                      |       | 45,788 |   | 138,692 |   |
|                                                                      |       |                                        |       |   |   |   |   |
| INCOME TAX  PROVISION                                                     |       | 15,144                                      |       | 262 |   | 46,137 |   |
| MINORITY  INTEREST                                                        |       | (2,276                                      | )          | 1,026 |   | 3,093 |   |
| NET INCOME                                                                |       | $                                           | 43,154     |   | $ | 46,552 |   | $ | 95,648 |   |
|                                                                      |       |                                        |       |   |   |   |   |
|                                                                      |       |                                        |       |   |   |   |   |
| EARNINGS PER  SHARE:                                                      |       |                                        |       |   |   |   |   |
| Basic earnings  per share                                                 |       | $                                           | 1.17       |   | $ | 1.29 |   | $ | 2.53 |   |
| Weighted average common shares outstanding                                |       | 36,758                                      |       | 36,017 |   | 37,779 |   |
|                                                                      |       |                                        |       |   |   |   |   |
|                                                                      |       |                                        |       |   |   |   |   |
| Diluted earnings  per share                                               |       | $                                           | 1.15       |   | $ | 1.27 |   | $ | 2.40 |   |
| Weighted average common and dilutive potential  common shares outstanding |       | 37,584                                      |       | 36,544 |   | 41,397 |   |

 

See Notes toConsolidated Financial Statements.

F-5

----

**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (LOSS)**

**(In thousands)**

 
| ** **                                                         | ** ** | ** **                    | ** ** | ** **                                                          | ** ** | ** **                                 | ** ** | ** **               | ** ** | ** **                                                              | ** ** | ** **                                                                                                              | ** ** | **Accumulated**                                                                                 | ** ** | ** **                           | ** ** | ** **                                                         | ** ** | ** **                                                                                | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------|------------|-------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | ** **                    | ** ** | ** **                                                          | ** ** | **Additional**                             | ** ** | ** **               | ** ** | ** **                                                              | ** ** | ** **                                                                                                              | ** ** | **Other**                                                                                       | ** ** | ** **                           | ** ** | **Total**                                                          | ** ** | **Total**                                                                                 | ** ** |
| ** **                                                         | ** ** | **Common Stock**         | ** ** | **Paid-in**                                                         | ** ** | **Treasury Stock**                    | ** ** | **Unearned**             | ** ** | **Comprehensive**                                                       | ** ** | **Retained**                                                                                                            | ** ** | **Stockholders’**                                                                          | ** ** | **Comprehensive**                    | ** ** |
| ** **                                                         | ** ** | **Shares**                    | ** ** | **Amount**                                                          | ** ** | **Capital**                                | ** ** | **Shares**               | ** ** | **Amount**                                                              | ** ** | **Compensation**                                                                                                        | ** ** | **Loss**                                                                                        | ** ** | **Earnings**                         | ** ** | **Equity**                                                         | ** ** | **Income**                                                                                | ** ** |
| **BALANCE, JANUARY 1, 2004**                                       | ** ** | **36,345**                    |       | **$          36** |       | **$     358,988** |       | **—**               |       | **$          —** | ** ** | **$               (146**                     | **)**      | **$              (5,734** | **)**      | **$    100,186** |       | **$         453,330** |       | ** **                                                                                | ** ** |
|                                                               |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       |                                                               |       |                                                                                      |       |
| Exercise of common stock  options and warrants                     |       | 502                           |       | 1                                                                   |       | 11,721                                     |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 11,722                                                             |       |                                                                                      |       |
| Issuance of employee  stock purchase plan shares                   |       | 145                           |       |                                                                |       | 3,724                                      |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 3,724                                                              |       |                                                                                      |       |
| Amortization of unearned  compensation                             |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       | 130                                                                                                                     |       |                                                                                            |       |                                 |       | 130                                                                |       |                                                                                      |       |
| Non-employee stock options  granted                                |       |                          |       |                                                                |       | 29                                         |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 29                                                                 |       |                                                                                      |       |
| Employee stock options —  change in status                    |       |                          |       |                                                                |       | 297                                        |       |                     |       |                                                                    |       | ** **                                                                                                              |       | ** **                                                                                      |       | ** **                           |       | 297                                                                |       | ** **                                                                                | ** ** |
| Employee stock awards                                              |       | 1                             |       |                                                                |       | 19                                         |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 19                                                                 |       |                                                                                      |       |
| Income tax benefit from  stock options exercises                   |       |                          |       |                                                                |       | 3,636                                      |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 3,636                                                              |       |                                                                                      |       |
| Net loss                                                           |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       | 43,154                               |       | 43,154                                                             |       | $             43,154     |       |
| Other comprehensive  loss:                                         | ** ** | ** **                    |       | ** **                                                          |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       |                                                               |       |                                                                                      |       |
| Translation  adjustment                                            |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       | 697                                                                                             |       |                                 |       | 697                                                                |       | 697                                                                                       |       |
| Net  unrealized loss on available-for-sale investments, net of tax |       |           |       |                                                 |       |                        |       |      |       |                                                                    |       |                                                                                                     |       | (1,672                                                                                          | )          |                  |       | (1,672                                                             | )          | (1,672                                                                                    | )          |
| Net  unrealized gain on derivatives, net of tax                    | ** ** | ** **                    |       | ** **                                                          |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       | 2,254                                                                                           |       |                                 |       | 2,254                                                              |       | 2,254                                                                                     |       |
| Total comprehensive  income                                        |       |                          |       |                                                                |       |                                       |       | ** **               |       | ** **                                                              | ** ** | ** **                                                                                                              |       | ** **                                                                                      |       | ** **                           |       | ** **                                                         |       | **$             44,433** | ** ** |
|                                                               |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       |                                                               |       |                                                                                      |       |
| **BALANCE, DECEMBER 31, 2004**                                     | ** ** | **36,993**                    |       | **$          37** |       | **$     378,414** |       | **—**               |       | **$          —** | ** ** | **$                 (16**          | **)**      | **$              (4,455** | **)**      | **$    143,340** |       | **$         517,320** |       |                                                                                      |       |
|                                                               |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       |                                                               |       |                                                                                      |       |
|  Exercise of common stock options and warrants                |       | 928                           |       | 1                                                                   |       | 22,527                                     |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 22,528                                                             |       |                                                                                      |       |
| Issuance of employee  stock purchase plan shares                   |       | 115                           |       |                                                                |       | 2,690                                      |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 2,690                                                              |       |                                                                                      |       |
| Amortization of unearned  compensation                             |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       | 16                                                                                                                      |       |                                                                                            |       |                                 |       | 16                                                                 |       |                                                                                      |       |
| Repurchase of common  stock into treasury                          |       |                          |       |                                                                |       |                                       |       | (1,943                   | )          | (50,000                                                                 | )          |                                                                                                                    |       |                                                                                            |       |                                 |       | (50,000                                                            | )          |                                                                                      |       |
| Non-employee stock  options granted                                |       |                          |       |                                                                |       | 83                                         |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 83                                                                 |       |                                                                                      |       |
| Employee stock options —  change in status                    |       |                          |       |                                                                |       | 932                                        |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 932                                                                |       |                                                                                      |       |
| Employee stock awards                                              |       |                          |       |                                                                |       | 4                                          |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 4                                                                  |       |                                                                                      |       |
| Income tax benefit from  stock options exercises                   | ** ** |                          |       | ** **                                                          |       | 2,899                                      |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 2,899                                                              |       |                                                                                      |       |
| Net income                                                         |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       | 46,552                               |       | 46,552                                                             |       | $             46,552     |       |
| Other comprehensive  income:                                       |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       |                                                               |       |                                                                                      |       |
| Translation  adjustment                                            |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       | (4,381                                                                                          | )          |                                 |       | (4,381                                                             | )          | (4,381                                                                                    | )          |
| Net  unrealized loss on available-for-sale investments, net of tax | ** ** |   **   ** |       |   **   **                                       |       |   **  **               |       |      |       |                                                                    |       |                                                                                                     |       | (574                                                                                            | )          |                  |       | (574                                                               | )          | (574                                                                                      | )          |
| Net  unrealized gain on derivatives, net of tax                    |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       | 385                                                                                             |       |                                 |       | 385                                                                |       | 385                                                                                       |       |
| Total comprehensive  income                                        |       |                          |       |                                                                |       |                                       |       | ** **               |       | ** **                                                              | ** ** | ** **                                                                                                              |       | ** **                                                                                      |       | ** **                           |       | ** **                                                         |       | **$             41,982** | ** ** |
|                                                               |       |                          |       |                                                                |       |                                       |       | ** **               |       | ** **                                                              | ** ** | ** **                                                                                                              |       | ** **                                                                                      |       | ** **                           |       | ** **                                                         |       | ** **                                                                                | ** ** |
| **BALANCE, DECEMBER 31, 2005**                                     | ** ** | **38,036**                    |       | **$          38** |       | **$     407,549** |       | **(1,943**               | **)**      | **$  (50,000**                                                | **)**      | **$                  —** |       | **$              (9,025** | **)**      | **$    189,892** |       | **$         538,454** |       |                                                                                      |       |
| ** **                                                         |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       |                                                               |       |                                                                                      |       |
| Exercise of common stock  options and warrants                     |       | 3,709                         |       | 4                                                                   |       | 114,730                                    |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 114,734                                                            |       |                                                                                      |       |
| Issuance of employee  stock purchase plan shares                   |       | 29                            |       |                                                                |       | 1,325                                      |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 1,325                                                              |       |                                                                                      |       |
| Employee stock-based  compensation                                 |       |                          |       |                                                                |       | 12,512                                     |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 12,512                                                             |       |                                                                                      |       |
| Employee stock options —  change in status                    |       |                          |       |                                                                |       | 665                                        |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 665                                                                |       |                                                                                      |       |
| Non-employee stock  options granted                                |       |                          |       |                                                                |       | 58                                         |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 58                                                                 |       |                                                                                      |       |
| Income tax benefit from  stock options exercised                   |       |                          |       |                                                                |       | 20,243                                     |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       | 20,243                                                             |       |                                                                                      |       |
| Repurchase of common  stock into treasury                          |       |                          |       |                                                                |       |                                       |       | (2,593                   | )          | (100,704                                                                | )          |                                                                                                                    |       |                                                                                            |       |                                 |       | (100,704                                                           | )          |                                                                                      |       |
| Net income                                                         |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       | 95,648                               |       | 95,648                                                             |       | $             95,648     |       |
| Other comprehensive  income:                                       |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       |                                                                                            |       |                                 |       |                                                               |       |                                                                                      |       |
| Translation  adjustment                                            |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       | 4,173                                                                                           |       |                                 |       | 4,173                                                              |       | 4,173                                                                                     |       |
| Net  unrealized gain on available-for-sale investments, net of tax |       |           |       |                                                 |       |                        |       |      |       |                                                                    |       |                                                                                                     |       | 706                                                                                             |       |                  |       | 706                                                                |       | 706                                                                                       |       |
| Net  unrealized gain on derivatives, net of tax                    |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       | 87                                                                                              |       |                                 |       | 87                                                                 |       | 87                                                                                        |       |
| Net  unrealized pension loss                                       |       |                          |       |                                                                |       |                                       |       |                     |       |                                                                    |       |                                                                                                                    |       | (7                                                                                              | )          |                                 |       | (7                                                                 | )          | (7                                                                                        | )          |
| Total comprehensive  income                                        |       |                          |       |                                                                |       |                                       |       | ** **               |       | ** **                                                              | ** ** | ** **                                                                                                              |       | ** **                                                                                      |       | ** **                           |       | ** **                                                         |       | **$           100,607**            | ** ** |
| **BALANCE, DECEMBER 31, 2006**                                     | ** ** | **41,774**                    |       | **$          42** |       | **$     557,082** |       | **(4,536**               | **)**      | **$ (150,704**                                                     | **)**      | **$                  —** |       | **$           (4,066 )**                 |       | **$    285,540** |       | **$         687,894** |       |                                                                                      |       |

 

See Notes to Consolidated Financial Statements.

F-6

----

 

**CYMER, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                 | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| OPERATING  ACTIVITIES:                                     |       |                                        |       |   |   |   |   |
| Net income                                                 |       | $   43,154                   |       | $   46,552 |   | $   95,648 |   |
| Adjustments to reconcile net income to net cash            |       |                                        |       |   |   |   |   |
| provided by operating activities:                          |       |                                        |       |   |   |   |   |
| Gain on debt extinguishment                                |       | (911                                        | )          | (2,220 | ) | — |   |
| Depreciation and amortization                              |       | 28,364                                      |       | 28,280 |   | 25,127 |   |
| Non-cash stock-based compensation                          |       | 345                                         |       | 1,019 |   | 13,235 |   |
| Amortization of unearned compensation                      |       | 130                                         |       | 16 |   | — |   |
| Minority interest                                          |       | 2,276                                       |       | (1,026 | ) | (3,093 | ) |
| Provision for deferred income taxes                        |       | 13,035                                      |       | (1,680 | ) | 8,558 |   |
| Loss on disposal and impairment of property and  equipment |       | 131                                         |       | 55 |   | 27 |   |
| Change in assets and liabilities:                          |       |                                        |       |   |   |   |   |
| Accounts receivable — net                             |       | (47,861                                     | )          | 20,862 |   | (26,039 | ) |
| Accounts receivable — related party                   | ** ** | **—**                                  | ** ** | (588 | ) | (246 | ) |
| Foreign currency forward exchange contracts                |       | (679                                        | )          | (3,002 | ) | 1,264 |   |
| Inventories                                                |       | (17,010                                     | )          | 20,976 |   | (15,250 | ) |
| Prepaid expenses and other assets                          |       | (884                                        | )          | (1,936 | ) | (359 | ) |
| Accounts payable                                           |       | (5,150                                      | )          | 3,761 |   | 1,001 |   |
| Accounts payable — related party                      | ** ** | **—**                                  | ** ** | 4,975 | ** ** | (117 | ) |
| Accrued expenses and other liabilities                     |       | 16,270                                      |       | 2,634 |   | 9,686 |   |
| Unearned income                                            |       | 5,399                                       |       | (4,426 | ) | 818 |   |
| Income taxes payable                                       |       | (2,439                                      | )          | (230 | ) | 5,541 |   |
|                                                       |       |                                        |       |   |   |   |   |
| Net cash provided by operating activities                  |       | 34,170                                      |       | 114,022 |   | 115,801 |   |
|                                                       |       |                                        |       |   |   |   |   |
| INVESTING  ACTIVITIES:                                     |       |                                        |       |   |   |   |   |
| Acquisition of property and equipment                      |       | (19,485                                     | )          | (18,750 | ) | (16,404 | ) |
| Purchases of investments                                   |       | (641,674                                    | )          | (290,728 | ) | (278,594 | ) |
| Proceeds from sold or matured investments                  |       | 669,421                                     |       | 390,580 |   | 223,004 |   |
| Acquisition of patents                                     |       | (5,990                                      | )          | (2,500 | ) | (8,200 | ) |
| Acquisition of minority interest                           |       | (2,000                                      | )          | — |   | (7,024 | ) |
|                                                       |       |                                        |       |   |   |   |   |
| Net cash provided by (used in) investing activities        |       | 272                                         |       | 78,602 |   | (87,218 | ) |
|                                                       |       |                                        |       |   |   |   |   |
| FINANCING  ACTIVITIES:                                     |       |                                        |       |   |   |   |   |
| Proceeds from issuance of common stock                     |       | 15,446                                      |       | 25,218 |   | 116,059 |   |
| Redemption of convertible subordinated notes               |       | (47,407                                     | )          | (57,336 | ) | — |   |
| Cash investment received from minority shareholder         |       | —                                      |       | 11,120 |   | — |   |
| Excess tax benefits from stock option exercises            |       | —                                      |       | — |   | 20,243 |   |
| Payments on capital lease obligations                      |       | (48                                         | )          | (20 | ) | — |   |
| Repurchase of common stock into treasury                   |       | —                                      |       | (50,000 | ) | (100,704 | ) |
|                                                       |       |                                        |       |   |   |   |   |
| Net cash provided by (used in) financing activities        |       | (32,009                                     | )          | (71,018 | ) | 35,598 |   |
|                                                       |       |                                        |       |   |   |   |   |
| EFFECT OF  EXCHANGE RATE CHANGES ON CASH AND               |       |                                        |       |   |   |   |   |
|  CASH EQUIVALENTS                                     |       | 1,181                                       |       | (2,107 | ) | 4,172 |   |
|                                                       |       |                                        |       |   |   |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                 |       | 3,614                                       |       | 119,499 |   | 68,353 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF THE YEAR        |       | 110,632                                     |       | 114,246 |   | 233,745 |   |
|                                                       |       |                                        |       |   |   |   |   |
| CASH AND CASH  EQUIVALENTS AT END OF THE YEAR              |       | $ 114,246                              |       | $ 233,745 |   | $ 302,098 |   |
|                                                       |       |                                        |       |   |   |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:         |       |                                        |       |   |   |   |   |
| Interest paid                                              |       | $     9,033        |       | $     6,914 |   | $     5,301 |   |
| Income taxes  paid, net                                    |       | $     3,515        |       | $     2,613 |   | $   12,111 |   |

 

SeeNotes to Consolidated Financial Statements.

F-7

----

 

**1.**                      SUMMARY OF SIGNIFICANTACCOUNTING POLICIES

***Nature of Operations***— Cymer, Inc. and its wholly owned and majority-owned subsidiaries, are engagedprimarily in the development, manufacturing and marketing of excimer lightsources for sale to manufacturers of photolithography tools in thesemiconductor equipment industry.  Wesell our product to customers primarily in Japan, Asia, Europe and the U.S.  In addition, we entered into an agreement inJuly 2005 with Carl Zeiss SMT AG, a German corporation, and Carl Zeiss LaserOptics Beteiligungsgesellschaft mbH, a German limited liability company (whichwe refer to with their affiliated entities as “Zeiss”) to establish a jointventure which we call TCZ (for Team Cymer Zeiss). In September 2006 we amendedand restated this joint venture agreement with Zeiss to move the location ofthe TCZ joint venture from Switzerland to Singapore, and in connection with themove, formed TCZ Pte Ltd. TCZ is developing a process tool for the flat paneldisplay manufacturing industry.

***Principles ofConsolidation*****— The accompanying consolidatedfinancial statements include our accounts and the accounts of our wholly ownedsubsidiaries — Cymer Japan, Inc. (“Cymer Japan”), Cymer Singapore Pte Ltd. (“CymerSingapore”), Cymer B.V. in the Netherlands (“Cymer B.V.”), Cymer SoutheastAsia, Ltd, in Taiwan (“Cymer SEA”), Cymer Semiconductor Equipment Shanghai Co.,Ltd, in the People’s Republic of China (“Cymer PRC”), Cymer Korea, Inc. (“CymerKorea”), and our majority-owned subsidiary, TCZ Pte Ltd., a companyincorporated in Singapore (“TCZ Singapore”).

OnJanuary 2, 2006, we acquired the remaining 19% minority interest in CymerKorea.  We paid a total of $7.0 millionfor this 19% interest.  This transactionincreased our total interest in Cymer Korea from 81% to 100%.  Cymer Japan is currently our only subsidiarythat sells excimer light source systems. Cymer Japan also provides fieldservice to customers in Japan. Cymer Korea provides refurbishmentmanufacturing, field service, and administrative activities for Korea and theAsia-Pacific region.  Cymer Singapore,Cymer B.V., Cymer SEA, and Cymer PRC are field service offices for customers intheir respective countries.

Weformed the TCZ joint venture in July 2005 with Zeiss.  Per the terms of our original joint ventureagreement, TCZ was originally formed as TCZ GmbH, a Swiss limited liabilitycompany (“TCZ Switzerland”), and Switzerland was designated as the location forthe TCZ joint venture. In September 2006, we moved the location of the TCZjoint venture from Switzerland to Singapore and changed our joint ventureentity into a Singapore corporation. See Note 2 for more details.  We own 60% of TCZ and Zeiss owns 40%. TCZ iscurrently developing, and will integrate, market and sell, and support toolsemploying an excimer laser beam to induce crystallization of low-temperaturepoly-silicon (“LTPS”) processing for the manufacture of flat panel displays.

Allsignificant intercompany balances and transactions have been eliminated inconsolidation.

***Accounting Estimates —***The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results may differ from thoseestimates.

***Cash Equivalents***— Cash equivalents consist ofmoney market instruments, commercial paper and other highly liquid investmentspurchased with an original maturity of three months or less.  As of December 31, 2005 and 2006 we had$143.0 million and $227.3 million of cash equivalents, respectively.

***Investments***—  We maintain an investment portfolioconsisting primarily of government and corporate fixed income securities,auction rate securities, certificates of deposit, and commercial paper.  While it is our general intent to hold suchsecurities until maturity, we will occasionally sell

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certain securities for cash flow purposes.Therefore, our investments are classified as available-for-sale and are carriedon the balance sheet at fair value. In September 2004, we soldapproximately $20.3 million of corporate debt securities that resulted in a$281,000 gain on the sale.  The cost of securities sold is determined by aspecific identification method. We had no saleof investments which resulted in a gain or loss in 2005 or 2006.

***Inventories***— Inventoriesare carried at the lower of cost, which approximates the first-in, first-outmethod, or market.  Cost includesmaterial, labor and manufacturing overhead costs.Our inventories include reusable parts that we receive from our customers aspart of consumed assemblies. We refurbish these returned core assemblies, whichconsist primarily of metal components, and reuse them in future coreassemblies.  Refurbishment costs arecapitalized as incurred.   We review the components of our inventory on aregular basis for excess or obsolete inventory and make appropriate allowancesand dispositions in the period that such inventory is identified.

***Parts Refurbishment***— Over the last several years as part of our regular businessactivities, we have conducted parts refurbishment and material reclaimactivities related to some of our core assemblies, in particular our chamberassemblies. The volume of this activity significantly increased in 2004 fromprior periods and we expect volumes to increase over time as our installed baseof light sources continues to rise and we become more efficient in theserefurbishment activities and  developcapabilities to reclaim material from and refurbish other core assemblies.These activities involve arrangements with our customers where we sell a newpart to the customer at a reduced sales price if the customer returns theconsumed core assembly that the new part replaces.  These returned core assemblies contain acertain amount of material, primarily metal components, that may be reused byus in future core assemblies.  Uponreceipt of these consumed core assemblies from our customers, we record anentry to recognize the estimated fair value of the reusable components either1) as revenue if the return of the core assembly relates to a spare partreplacement sale or 2) as a reduction in cost of product sales if the return ofthe core assembly is related to a part being replaced under our warranty or perthe terms of an active service contract with the customer.  The value of the reusable parts containedwithin the consumed  assembly isdetermined based upon historical data on the value of the reusable parts thatwe typically yield from a consumed core assembly. As part of our normal excessand obsolete inventory analysis, these consumed core assemblies are alsoreviewed on a monthly basis and an inventory allowance is recorded asappropriate for these parts. The value that we assign to these core assembliescan be affected by the current demand for the reusable parts in ourmanufacturing operations and the actual yield rate achieved for parts withinthese consumed core assemblies.

***Property and Equipment*** — Property and equipment are stated at costless accumulated depreciation. Additions and improvements arecapitalized and maintenance and repairs are expensed as incurred.  Depreciationis computed using the straight-line method over the estimated useful lives ofthe assets (generally one to five years). The buildings that we own are depreciated over a useful life of twentyyears. Leasehold improvements and equipment held under capital leases areamortized using the straight-line method over the shorter of the life of theasset or the remaining lease term. Equipment acquired under capitalleases is stated at the present value of the future minimum leasepayments.  Amortization of equipment obtained under capital leases is included indepreciation expense in the accompanying consolidated financialstatements.  Light source systems builtfor internal use are capitalized and depreciated using the straight-line methodover three years.

***Goodwill****/**IntangibleAssets** —*We account for our goodwill and other intangibleassets in accordance with Statement of Financial Accounting Standards No. 142 (“SFASNo. 142”), “Goodwill and Other Intangible Assets”. SFAS No. 142 includes provisions thatdiscontinued the amortization of goodwill and intangible assets with indefiniteuseful lives associated with purchase business combinations. Under SFAS No.142, our goodwill is subject to an annual impairment test. We conduct this testin the fourth quarter of each fiscal year or whenever events or circumstancesoccur indicating potential impairment.

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Intangible assets consist primarily of acquiredpatents. Intangible assets with finite lives are recorded at cost and areamortized using the straight-line method over their expected useful lives.  The expected useful life can vary dependingupon the nature of the technology and the remaining useful life of the patent,but currently, it ranges from four to seventeen years. We review the carryingvalue and remaining useful life of intangibles for impairment whenever eventsor circumstances indicate that the carrying amount may not be recoverable. The amountof impairment, if any, is measured based on the projected discounted futureoperating cash flows using a discount rate reflecting our average cost offunds.  The assessment of therecoverability of intangible assets will be impacted if estimated futureoperating cash flows are not achieved.

***Impairment of Long-Lived Assetsand Long-Lived Assets to Be Disposed Of***—Long-lived assets and certain identifiable intangibles are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. Recoverability of assets tobe held and used is measured by a comparison of the carrying amount of theassets to future net cash flows (undiscounted and without interest) expected tobe generated by the asset.  If suchassets are considered to be impaired, the impairment to be recognized ismeasured by the amount by which the carrying amount of the assets exceeds thefair value of the assets.  Assets to bedisposed of are reported at the lower of the carrying amount or fair value lesscosts to sell. Impairment losses for 2004, 2005 and 2006 were immaterial.

***AssetRetirement Obligation*** — We currently account for our asset retirement obligationsin accordance with Statement of Financial Accounting Standards No. 143 (“SFASNo. 143”), “Accounting for Asset Retirement Obligations.” SFAS No. 143establishes accounting requirements for retirement obligations associated withtangible long-lived assets, including (1) the timing of the liabilityrecognition (2) the initial measurement of the liability (3) theallocation of the asset retirement cost to expense (4) the subsequentmeasurement of the liability and (5) financial statement disclosures.SFAS No. 143 requires that the cost for the asset retirement obligation becapitalized as part of the cost of the related long-lived asset andsubsequently allocated to expense using a systematic and rational method.

We currently have alease agreement for our facility in Japan which includes an obligation for usto restore the facility to its original condition when we vacate it.  We have estimated the fair value of thisasset retirement obligation to be approximately $657,000 at December 31, 2006and have recorded it in other liabilities on the accompanying consolidatedbalance sheets.  The total accretionexpense that we recorded related to this obligation for the years endedDecember 31, 2005 and 2006 was $200,000 and $67,000, respectively.

***Fair Value of FinancialInstruments*** — We used thefollowing methods and assumptions to estimate the fair value of each class offinancial instruments for which it is suitable to estimate that value:

Cash and cash equivalents, accounts receivable,accounts receivable — related party, accounts payable, accounts payable —related party, accrued warranty and installation, accrued payroll and benefits,accrued patents, royalties and other fees, income tax payable, unearned income,and other current liabilities — the carrying amount reported in theconsolidated balance sheets for these balances approximates fair value due tothe short maturities of these instruments.

Investments — Investments are recorded at fairvalue, which is based on quoted market prices for such securities.

Forward Contracts — Forward contracts arerecorded at fair value which is based on the quoted exchange rates for suchinstruments (see “Derivative Instruments” below).

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Convertible Subordinated Notes — ConvertibleSubordinated Notes are recorded at their face value of $140.7 million at bothDecember 31, 2005 and December 31, 2006. The fair value of such debt, based onquoted market prices at December 31, 2005 and 2006, was $136.5 million and$147.6  million, respectively.

***LeaseLoss Accrual*****—**Inaccordance with Statement of Financial Accounting Standards No. 146 (“SFAS No.146”), “Accounting for Costs Associated with Exit or Disposal Activities”, ourcosts associated with exit or disposal activities are recognized when they areincurred or when we cease using a property. To date, our exit or disposal activities have consisted of leaseobligations net of expected sublease income for our San Diego, California andCharlestown, Massachusetts facilities which were vacated by us prior to the endof their leases. The total liability is included within Other CurrentLiabilities on the accompanying consolidated balance sheets.

The followingtable summarizes information related to our accrued lease loss liability forthe years ended December 31, 2005 and 2006 (in thousands):

 

|                       | ** ** | **2005**               | ** ** | **2006**               | ** ** |
|-----------------------|------------|------------------------|------------|------------------------|------------|
|                  |       |                   |       |                   |       |
| Balance, January  1   |       | $ 2,230           |       | $   634 |       |
| Lease loss  accruals  |       | 384                    |       | —                 |       |
| Rent payments         |       | (1,980                 | )          | (359                   | )          |
| Balance,  December 31 |       | $   634 |       | $   275 |       |
|                  |       |                   |       |                   |       |

 

***Guarantees/Warranties***— In the ordinary course ofbusiness, we are not subject to potential obligations under guarantees thatfall within the scope of Financial Accounting Standards Board (“FASB”)Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers”, except for standard warranty provisions associated with product salesand indemnification provisions related to intellectual property that arecontained within many of our lithography tool manufacturer agreements. All ofthese provisions give rise only to the disclosure requirements prescribed byFIN 45 except for product warranties.

(a) Product Warranties — Warrantyprovisions contained within our lithography tool manufacturer agreements aregenerally consistent with those prevalent in the semiconductor equipmentindustry. The warranty period and terms for light source systems and spares andconsumable parts varies by light source system model.  We record a provision for warranty for allproducts, which is included in cost of product sales in the consolidatedstatements of operations and is recorded at the time that the related revenueis recognized. We review our warranty provision monthly, which is determinedusing a statistical financial model which calculates actual historical expenses,product failure rates, and potential risks associated with our differentproduct models. We then use this financial model to calculate the futureprobable expenses related to warranty and the required level of the warrantyprovision. Throughout the year we review the risk levels, historical costinformation and failure rates used within this model and update them asinformation changes over the product’s life cycle. If actual warrantyexpenditures differ substantially from our estimates, revisions to the warrantyprovision would be required. Actual warranty expenditures are recorded againstthe warranty provision as they are incurred.

 

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The following tablesummarizes information related to our warranty provision for the years endedDecember 31, 2004, 2005 and 2006 (in thousands):

|                                                                                                       | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                                  |       |     |       |     |       |     |       |
| Balance, January 1                                                                                    |       | $        | 26,200     |     | $          | 28,200   |       | $ | 30,191 |   |
| Liabilities accrued for  warranties issued during  the year, net  of adjustments and expirations |       | 23,595   |       | 26,331   |       | 18,209   |       |
| Warranty expenditures  incurred during the year                                                       |       | (21,595  | )          | (24,340  | )          | (18,950  | )          |
| Balance, December 31                                                                                  |       | $        | 28,200     |     | $          | 30,191   |       | $ | 29,450 |   |
|                                                                                                  |       |     |       |     |       |     |       |

 

(b)         IntellectualProperty Indemnifications — We include intellectual property indemnificationclauses within our general terms and conditions with our customers and thegeneral purchase agreements with our three lithography tool manufacturers, ASML,Canon, and Nikon.  In general, theseindemnification provisions provide that we defend our customers against anyinfringement claims directed against our products.  Under the indemnification clauses, we pay allcosts and damages, including attorney’s fees, associated with such settlementsor defenses, provided that the lithography tool manufacturer follows specificprocedures for notifying us of such claims and allows us to manage thesettlement proceedings.

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

As part of the originalresearch and development agreement signed with Intel Corporation (“Intel”) in2004, we also agreed to provide Intel with indemnity against any infringementof the intellectual property rights of any third party arising from Intel’spurchase and/or use of our EUV source systems. Under the terms of this agreement, as recently amended, our obligationsto indemnify Intel will be specifically negotiated in any purchase agreementrelated to such future products.

As part of the supplyagreement signed with TCZ in September 2005 and amended in September 2006 inconnection with the amendment and restatement of the original TCZ joint ventureagreement, we agreed to indemnify TCZ against any infringement of theintellectual property rights of a third party arising from TCZ’s purchase ofour products.  We will defend suchactions at our own expense and will pay the cost and damage awarded in any suchaction provided that TCZ grants us sole control of the defense and settlementof such action and also provides us with information required for the defenseand settlement of such action.

Due to the nature ofthe indemnification provisions described above, these provisions are indefiniteand extend beyond the term of the actual agreements.

***Comprehensive Income*****—** Comprehensiveincome includes net income, unrealized gains and losses on effective forwardcontracts, foreign currency translation adjustments, net unrealized pensiongains and losses, and unrealized gains and losses on available-for-salesecurities, which are recorded as short-term and long-term investments in theaccompanying consolidated balance sheets.

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***RevenueRecognition***— We recognize revenue inaccordance with Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition”.  We recognize revenue when persuasive evidenceof an arrangement exists, delivery has occurred or services have been rendered,our price is fixed or determinable, and collectibility is reasonably assured.Our revenues consist of product sales, which include sales of light sourcesystems, consumable and spare parts, upgrades, service, service contracts,training, and limited refurbishments of light source systems.  Ourrevenues also consist of certain funded development activities performed forour customers and under government contracts and license agreements.

The sales of our light source systemsgenerally include training and installation services. We determined theseelements qualify as one unit of accounting under Emerging Issues Task Force (“EITF”)Bulletin No. 00-21, “Revenue Arrangements with Multiple Deliverables” as we donot have evidence of fair value for the undelivered training and installationelements. Furthermore, we determined that the undelivered training andinstallation elements are perfunctory performance obligations and are notessential to the functionality of our light source systems. Therefore, inaccordance with the provisions of SAB No. 104, we recognize revenue when therevenue recognition criteria are met for the light source system, and accruethe costs of providing the training and installation services.  We recognize light source system revenue atone of following three points, depending on the terms of our arrangement withour customer — 1) shipment of the light source system, 2) delivery of the lightsource system or 3) receipt of an acceptance certificate. For the majority ofour light source system sales, the shipping terms are F.O.B. shipping point andrevenue is recognized upon shipment. For our arrangements which include F.O.B.destination shipping terms, revenue is recognized upon delivery of the lightsource system to our customer.  Lastly,one of our arrangements includes an acceptance provision, which is satisfied bythe issuance of an acceptance certificate by the customer. For thesetransactions, we recognize revenue upon receipt of the acceptancecertificate.  In addition, we test ourlight source systems in environments similar to those used by our customersprior to shipment to ensure that they meet published specifications.

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

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

For funded developmentcontracts, 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, exceptas noted below, included in other revenue and are derived from cost sharingcontracts between certain customers and us. If milestones on these fundeddevelopment contracts require that specific results be achieved or reported byus, revenue is not recognized until that milestone is completed.  For someof the funded development contracts that we enter into with customers andgovernment agencies, we evaluate certain criteria to determine whetherrecording the funds received as revenue is appropriate.  If certainconditions are met, these funds are not recorded as revenue but rather areoffset against our own internal research and development expenses in the periodthat the milestone is achieved.

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***Research and Development*****— We expense research and development costs, which includecosts associated with funded development contracts, in the period incurred.Funded development contracts are generally cost sharing contracts between usand a customer where each party pays near equivalent portions of the totaldevelopment costs.  As a result, costsfor the funded development contracts approximate the revenue we record forthese contracts in other revenue in the accompanying statements of operations.The services performed under the funded development contracts are provided on abest efforts basis.  Our research and developmentexpenses also include offsets for amounts we receive from certain of ourexternally funded research and development contracts.

***Income Taxes*** — Income taxes are accounted for under the asset andliability method.  Deferred tax assetsand liabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax ratesthat are expected to apply in the periods in which the deferred tax asset orliability is expected to be realized or settled.  The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date.

***Stock-Based Compensation*** — We estimate the fair value of our stockoptions using a Black-Scholes option pricing model, consistent with theprovisions of SFAS No. 123R which we adopted on January 1, 2006.  See Accounting Pronouncements Adopted sectionof Note 1 for more details on the adoption of SFAS No. 123R.  In addition, we used this same option pricingmodel to calculate the fair value of our stock options included in our priorperiod pro forma disclosures as required by SFAS No.123.

The fairvalue of stock options granted is recognized to expense over the requisiteservice period.  For stock optionsgranted after the SFAS No. 123R effective date of January 1, 2006, thestraight-line attribution approach is used. For stock options granted prior toJanuary 1, 2006, and which are continuing to vest, we will continue to recordexpense using the FASB Interpretation No. 28 (“FIN 28”) accelerated attributionapproach.

Upon the adoption ofSFAS No. 123R, we used a combination of historical and implied volatility (“blendedvolatility”) to value our stock options.  Historical volatility is basedon a period commensurate with the expected term of the options. Impliedvolatility was derived based on six-month traded options of our common stock. Prior to January 1, 2006, we used only historical stock price volatility inaccordance with SFAS No. 123 for purposes of our pro forma stock compensationcalculation. The expected term of our stock options represents the period oftime options are expected to be outstanding and is based on observed historicalexercise patterns for our company which we believe are indicative of futureexercise behavior. For the risk free interest rate, we use the then currentlyavailable rate on zero coupon U.S. Government issues with a remaining periodcommensurate with the expected term for valuing options.

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**(a) Stock-BasedCompensation Valuation Assumptions**

Thefollowing weighted average assumptions were used for grants issued in the yearsended December 31, 2004 and 2005 under the SFAS No. 123 requirements and in theyear ended December 31, 2006 under the SFAS No. 123R requirements:

 
|                           | ** ** | **Years ended December 31,** | ** ** |
|---------------------------|------------|---------------------------------------------|------------|
| ** **                | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Dividend yield            |       | None                                        |       | None |   | None |   |
| Volatility rate:          |       |                                        |       |   |   |   |   |
| Options                   |       | 75%                                         |       | 74% |   | 56% |   |
| ESPP                      |       | 75%                                         |       | 75% |   | N/A |   |
| Risk free interest  rate: |       |                                        |       |   |   |   |   |
| Options                   |       | 3.40%                                       |       | 3.97% |   | 4.75% |   |
| ESPP                      |       | 2.30%                                       |       | 3.33% |   | N/A |   |
| Expected life:            |       |                                        |       |   |   |   |   |
| Options                   |       | 4.36 years                                  |       | 4.19 years |   | 3.15 years |   |
| ESPP                      |       | .5 years                                    |       | .5 years |   | N/A |   |

 

In our pro formadisclosures prior to the adoption of SFAS No. 123R, we accounted forforfeitures as they occurred. SFAS No. 123R requires forfeitures to beestimated at the time of grant and revised if necessary in subsequent periodsif actual forfeiture rates differ from those estimates. Forfeitures wereestimated based on historical activity for our company. We amended our 1996Employee Stock Purchase Plan (“ESPP”) in May 2005, and as a result, our ESPP istreated as a noncompensatory plan.

**(b)Impact of SFAS No. 123R**

The following tablepresents the impact to our consolidated financial statements as a result of ouradoption of SFAS No. 123R for the year December 31, 2006 (in thousands, exceptper share amounts):
|                                                     | ** ** | **Year ended**             | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **December 31, 2006** | ** ** |
|                                                |       |                            |       |
| Stock-based  compensation expense by type of award: |       |                            |       |
| Employee stock options                              |       | $                               | 7,637      |   |
| Stock units                                         |       | 671                             |       |
|                                                |       |                            |       |
| Total  stock-based compensation                     |       | 8,308                           |       |
| Tax effect on  stock-based compensation             |       | (2,767                          | )          |
| Net effect on  net income                           |       | $                               | 5,541      |   |
|                                                |       |                            |       |
| Effect on  earnings per share:                      |       |                            |       |
| Basic                                               |       | $                               | 0.15       |   |
| Diluted                                             |       | $                               | 0.13       |   |
|                                                |       |                            |       |
| Impact of stock  option deductions on:              |       |                            |       |
| Cash flows from operations                          |       | $                               | (20,243    | ) |
| Cash flows from  financing activities               |       | $                               | 20,243     |   |

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As of December 31, 2006,the unamortized compensation expense related to outstanding unvested optionswas approximately $8.0 million with a weighted average remaining vesting periodof 2.04 years. We expect to amortize this expense over the remaining vestingperiod of these stock options.

The amount ofstock-based compensation costs capitalized into inventory during the year endedDecember 31, 2006 was immaterial.

We account for options granted to non-employees underSFAS No. 123 and EITF Issue No. 96-18, “Accounting for Equity Instruments thatare Issued to other than Employees for Acquiring or in Conjunction with SellingGoods or Services”.  We measure the fairvalue of such options using the Black-Scholes option pricing model at eachfinancial reporting date.  We account forchanges in fair values between reporting dates in accordance with FIN 28.  Stock-based compensation expense for optionsgranted to non-employees and for those employees who changed status fromemployee to a non-employee during the years ended December 31, 2004, 2005 and2006 was $326,000, $1.0 million and $723,000, respectively.

Prior to the adoption of SFAS No. 123R, we applied the intrinsic value-based method ofaccounting required by Accounting Principles Board Opinion (“APB”) No. 25, “Accountingfor Stock Issued to Employees” for options granted to employees and providedthe pro forma disclosures of SFAS No. 123 as amended by SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure”. During 2004 and 2005, we recorded no compensation expenserelated to the grant of options to employees since the exercise price of suchoptions equaled or exceeded the market value of the underlying common stock onthe date of grant.

In the fourth quarter of2006, we recorded $4.2 million of stock-based compensation expense related to asmall number of stock options that were granted primarily in 1999.  This additional stock-based compensationexpense resulted from us using the incorrect measurement date to calculate thecompensation expense and as a result, we failed to record the relatedcompensation expense for these 1999 stock options. We recorded the charge in2006 as the charge was not material to 2006 or any prior periods. In connectionwith this $4.2 million of stock-based compensation expense, we recorded a $1.2million tax benefit.

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**(c)Pro Forma for 2004 and 2005 Under SFAS No. 123**

Thefollowing table compares the earnings per share that we reported to the proforma amounts that we would have reported had we recognized compensationexpense for our stock-based compensation plans in accordance with SFAS No. 123(in thousands, except per share amounts):

 

|                                                                                                                                                   | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                        | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
|                                                                                                                                              |       |                                        |       |   |   |
| Net income, as reported                                                                                                                           |       | $                                           | 43,154     |   | $ | 46,552 |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                                      |       | 259                                         |       | 1,013 |   |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of related tax effects |       | (17,112                                     | )          | (22,911 | ) |
|                                                                                                                                              |       |                                        |       |   |   |
| Pro forma net income                                                                                                                              |       | $                                           | 26,301     |   | $ | 24,654 |   |
|                                                                                                                                              |       |                                        |       |   |   |
| Earnings per share:                                                                                                                               |       |                                        |       |   |   |
| Basic — as  reported                                                                                                                         |       | $                                           | 1.17       |   | $ | 1.29 |   |
| Basic — pro  forma                                                                                                                           |       | $                                           | 0.72       |   | $ | 0.68 |   |
|                                                                                                                                              |       |                                        |       |   |   |
| Diluted — as  reported                                                                                                                       |       | $                                           | 1.15       |   | $ | 1.27 |   |
| Diluted — pro  forma                                                                                                                         |       | $                                           | 0.70       |   | $ | 0.67 |   |
|                                                                                                                                              |       |                                        |       |   |   |

 

In February 2005,our board of directors approved the acceleration of the vesting of stockoptions that had exercise prices of $30.50 per share or higher held byemployees. This acceleration of stock options excluded directors, executiveofficers and certain vice presidents. The purpose of this acceleration ofvesting was to enable us to eliminate the recognition in our statement ofoperations of the compensation expense associated with these “out of the money”stock options in future periods, upon our adoption of SFAS No. 123R onJanuary 1, 2006.  The acceleration of vesting of these stock optionsin the year ended December 31, 2005 contributed approximately $10.4 million ofpro forma stock-based compensation expense.

***Foreign Currency Translation*** — Thefinancial statements of our foreign subsidiaries where the functional currencyis the local currency are translated into U.S. dollars using current rates ofexchange for assets and liabilities and rates of exchange that approximate therates in effect at the transaction date for revenues, expenses, gains andlosses. Gains and losses resulting from foreign currency translation areaccumulated as a separate component of consolidated stockholders’ equity asaccumulated other comprehensive loss. Gains and losses resulting from foreigncurrency transactions are included in the consolidated statements ofoperations. Net losses from foreign currency transactions totaled $1.1million for the year ended December 31, 2005 and net gains from foreigncurrency transactions totaled $82,000 and $1.7 million for the years endedDecember 31, 2004 and 2006, respectively. Such amounts are recorded in otherincome (expense) in the accompanying consolidated statements of operations.

***Derivative Instruments*****— We conduct business in several internationalcurrencies through our global operations. We maintain a foreign exchange riskmanagement policy with the goals of protecting product margins and minimizingthe volatility of reported earnings due to foreign currency exposure.  In accordance with our policy, we usefinancial instruments, principally foreign currency forward exchange contracts(“forward contracts”), to manage our foreign currency exposures. We

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enterinto forward contracts in order to reduce the impact of currency fluctuations relatedto purchases of our inventories by Cymer Japan in U.S. dollars for resale underfirm third-party sales commitments denominated in Japanese yen, as well asother foreign currency exposures including exposures related to intercompanydebt.  We do not enter into forwardcontracts for speculative purposes.

Our forward contractsgenerally qualify for hedge accounting treatment as “cash flow hedges” per theprovisions of Statement of Financial Accounting Standards No. 133 (“SFASNo. 133”), “Accounting for Derivative Instruments and Hedging Activities”.  Pursuant to SFAS No. 133, designated hedginginstruments and hedged items or transactions qualify for cash flow hedgeaccounting treatment if certain criteria are met.  For example, at the inception of the hedge,we must have formal documentation of the hedging relationship and our riskmanagement objective and strategy for undertaking the hedge, includingidentification of the hedging instrument, the hedged transaction, the nature ofthe risk being hedged, and how the hedging instrument’s effectiveness will beassessed.  Furthermore, the hedgingrelationship must be highly effective in achieving offsetting cash flowsattributable to the hedged risk during the term of the hedge.

Inaccordance with the provisions of SFAS No. 133, we defer changes in the fairvalue for the effective portion of these hedges and record the amount in othercomprehensive loss, and subsequently reclassify the gain or loss to cost ofproduct sales in the same period that the related sale is made to the thirdparty.  For forward contracts enteredinto after May 1, 2004, interest charges or “forward points” on our forwardcontracts are excluded from the assessment of hedge effectiveness, and arerecorded currently in foreign currency exchange gain (loss) in the consolidatedstatements of operations. In the event that an anticipated, hedged transactionis no longer likely to occur within a certain time period, the derivative gainor loss reported in accumulated other comprehensive loss is immediatelyreclassified into foreign currency exchange gain (loss).

The fair value of allforward contracts and the associated deferred gain in other comprehensive losstotaled $652,000 and $17,000, respectively, as of December 31, 2006. It isexpected that 100% of the deferred gain will be reclassified into earningswithin the next 12 months. The excluded component of our forward contractsamounted to a gain of $809,000 and $721,000 for the years ended December 31,2005 and 2006, respectively.  In the thirdquarter of 2004, we recorded a loss of $1.1 million as a result of thediscontinuance of certain cash flow hedges. This loss is included in foreign currency exchange gain (loss) on ourconsolidated statements of operations.

Asof December 31, 2006, we had outstanding forward contracts to buy U.S. $42.0million for 5.3 billion yen under foreign currency exchange facilities withcontract rates ranging from 113.23 yen to 117.32****yenper U.S. dollar. These contracts expire on various dates through December 2007.We recognized a net loss through cost of product sales from forward contractsof $2.3 million for the year ended December 31, 2004, and a net gain throughcost of product sales of $1.4 million and $254,000 for the years ended December31, 2005 and 2006, respectively.

***Concentration of Credit Risk***— Financial instruments, which potentiallysubject us to concentrations of credit risk, consist principally of cash andaccounts receivable.

*Cash and cash equivalents*— We invest our excess cash in an effort to preserve capital, provideliquidity, maintain diversification and generate returns relative to ourcorporate investment policy and prevailing market conditions.  We have not experienced any material lossesin our cash and investment accounts.  The cash balances that we hold in financialinstitutions are in excess of federally insured limits. We perform periodicevaluations of the relative credit standing of financial institutions and limitthe amount of risk by selecting financial institutions with a strong relativecredit standing.  At December 31, 2005and 2006, we had $233.3 million and $301.9 million respectively, in depositswith major financial institutions that exceeded the federally insured limit of$100,000.

 

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*Accountsreceivable* — We maintainan allowance for doubtful accounts for estimated losses due to the inability ofour customers to make required payments, which results in bad debtexpense.  Our management periodicallydetermines the adequacy of this allowance by continually evaluating individualcustomer receivables considering our customer’s financial condition, theirpayment history, security deposits, and current economic conditions.   We have minimal credit losses to date.

***Concentrationof Supplier Risk*** — We obtain a limitednumber of components and subassemblies included in our products from a singlesupplier or a small group of suppliers. We currently utilize a single supplierfor certain optical, control systems and pulse power components and subassembliesused in our light source systems. Where possible, we work with secondarysuppliers to qualify additional supply sources. We carry significant strategicinventories of these components to reduce the risk associated with this singlesupplier. Strategic inventories are managed as a percentage of futuredemand.  We have also negotiated to havevendor-managed inventory of critical components to further reduce the risk of asingle supplier.  To date we have beenable to obtain adequate supplies of the components and subassemblies used inthe production of our light source systems in a timely manner from existingsources.

***Major Customers*** — Revenues from our major customers aredetailed as follows (in thousands):
|              | ** ** | **Years ended December 31,** | ** ** |
|--------------|------------|---------------------------------------------|------------|
| ** **   | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Customer** |       |                                        |       |   |   |   |   |
| ASML         |       | $                                           | 140,828    |   | $ | 121,156 |   | $ | 204,931 |   |
| Canon        |       | 45,597                                      |       | 29,957 |   | 33,503 |   |
| Nikon        |       | 90,972                                      |       | 93,203 |   | 88,405 |   |
|              |            |                                             |            |  |  |  |  |  |  |  |

 

Accountsreceivable balances for these same major customers are detailed as follows (inthousands):
|              | ** ** | **December 31,** | ** ** |
|--------------|------------|-----------------------|------------|
| ** **   | ** ** | **2005**              | ** ** | **2006** | ** ** |
| **Customer** |       |                  |       |   |   |
| ASML         |       | $                     | 31,846     |   | $ | 55,091 |   |
| Canon        |       | 4,079                 |       | 2,875 |   |
| Nikon        |       | 22,303                |       | 22,080 |   |
|              |            |                       |            |  |  |  |  |

 

Revenues from Japanese customers,generated primarily by Cymer Japan, accounted for 32%, 31% and 22% of totalrevenue for the years ended December 31, 2004, 2005, and 2006,respectively. Revenues from ASML in the Netherlands accounted for 34%, 32% and38% of revenues for the years ended December 31, 2004, 2005, and 2006,respectively.  The loss of business ofany of these major customers would have a material adverse effect on ouroperating results, financial condition, and cash flows.

***Earnings Per Share*****— Basic earnings pershare (“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 using the “if-converted”method, warrants to purchase common stock and common stock options using the

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treasurystock method) were exercised or converted into common stock. Potential dilutivesecurities are excluded from the diluted EPS computation in loss periods astheir effect would be anti-dilutive.

The following table setsforth the basic and diluted EPS for the years ended December 31, 2004, 2005,and 2006 (in thousands, except per share information):
|                                                                                         | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                                    |       |                                        |       |   |   |   |   |
| NET INCOME:                                                                             |       |                                        |       |   |   |   |   |
| Net income, as  reported (used for basic EPS)                                           |       | $                                           | 43,154     |   | $ | 46,552 |   | $ | 95,648 |   |
| Adjustment for  interest expense on 3.5% convertible

subordinated notes, net  of taxes |       | —                                      |       | — |   | 3,709 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| Net income, as  adjusted for assumed conversion

(used for diluted EPS)                 |       | $                                           | 43,154     |   | $ | 46,552 |   | $ | 99,357 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                                               |       |                                        |       |   |   |   |   |
| Basic weighted  average common

shares outstanding                                      |       | 36,758                                      |       | 36,017 |   | 37,779 |   |
| Effect of  dilutive securities:                                                         |       |                                        |       |   |   |   |   |
| Warrants                                                                                |       | 14                                          |       | — |   | 22 |   |
| Options and stock units                                                                 |       | 812                                         |       | 527 |   | 782 |   |
| Convertible subordinated notes                                                          |       | —                                      |       | — |   | 2,814 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| Diluted weighted  average common and

potential common shares  outstanding              |       | 37,584                                      |       | 36,544 |   | 41,397 |   |
|                                                                                    |       |                                        |       |   |   |   |   |
| Earnings per  share:                                                                    |       |                                        |       |   |   |   |   |
| Basic                                                                                   |       | $                                           | 1.17       |   | $ | 1.29 |   | $ | 2.53 |   |
| Diluted                                                                                 |       | $                                           | 1.15       |   | $ | 1.27 |   | $ | 2.40 |   |

 

For the years ended December 31, 2004, 2005 and2006, weighted average options and warrants to purchase shares of common stockwere 3,326,000, 4,500,000 and 622,000, respectively, and were outstanding butnot included in the computation of diluted earnings per share as their effectwas anti-dilutive.  In addition, for theyears ended December 31, 2004 and 2005, weighted average common sharesattributable to convertible subordinated notes consisting of 4,645,000 and3,820,000 shares, respectively, were not included in the computation of dilutedearnings per share as their effect was also anti-dilutive.

***Accounting Pronouncements Adopted***

InNovember 2004, the FASB issued Statement of Financial Accounting StandardsNo. 151 (“SFAS No. 151”), ”Inventory Costs, an Amendment of ARB43 Chapter 4”.  This statement amended Accounting Research BulletinNo. 43 (“ARB No. 43”) Chapter 4, to clarify accounting for abnormalamounts of idle facility expense, freight, handling costs and wasted material. SFAS No. 151 requires that those items be recognized as current-periodcharges.  SFAS No. 151 is effective for fiscal years beginning afterJune 15, 2005.  We adopted SFAS No. 151 on January 1, 2006.  The adoption of SFAS No. 151 has not had animpact on our consolidated financial statements.

InMay 2005, the FASB issued Statement of Financial Accounting StandardsNo. 154 (“SFAS No. 154”), “Accounting Changes and Error Corrections—areplacement of APB Opinion No. 20 and FASB Statement No. 3”. This Statementreplaces APB Opinion No. 20, “Accounting Changes” and FASB StatementNo. 3, “Reporting Accounting Changes in Interim Financial Statements”, andchanges the requirements for the accounting for and reporting of a change inaccounting principle. SFAS No. 154 applies to all voluntary changes inaccounting principle. It also applies to changes

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requiredby an accounting pronouncement in the unusual instance that the pronouncementdoes not include specific transition provisions. When a pronouncement includesspecific transition provisions, those provisions should be followed. SFASNo. 154 is effective for accounting changes and corrections of errors madein fiscal years beginning after December 15, 2005. We adopted SFASNo. 154 on January 1, 2006. The adoption of SFAS No. 154 did not havean impact on our consolidated financial statements.

EffectiveJanuary 1, 2006, we adopted the provisions of FASB Statement of FinancialAccounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment”which replaces Statement of Financial Accounting Standards No. 123 (“SFAS No.123”), “Accounting for Stock-Based Compensation” and supersedes AccountingPrinciples Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued toEmployees”. Under the fair value recognition provisions of SFAS No. 123R,stock-based compensation cost is measured at the grant date based on the fairvalue of the award and is recognized as an expense over the requisite serviceperiod, or the vesting period. We elected the modified-prospective method inimplementing SFAS No. 123R which does not require us to revise prior periodfinancial statements for comparative purposes. We elected to use theBlack-Scholes option pricing model to determine the fair value of our stockoptions under SFAS No. 123R. The valuation provisions of SFAS No. 123R apply tonew options granted on or after January 1, 2006. We also elected to attributethe value of share-based compensation to expense using the straight-line methodfor awards granted on or after January 1, 2006. Estimated compensation expense for grants that were outstanding andunvested as of the effective date will be recognized over the remaining serviceperiod using the compensation cost estimated for the SFAS No. 123 pro formadisclosures which uses an accelerated expense recognition method for thoseawards with a graded vesting schedule. The adoption of SFAS No. 123R had amaterial impact on our consolidated financial statements.  For more detailed information on our adoptionof SFAS No. 123R, see Note 1 under Stock-Based Compensation.

On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3,“Transition Election Related toAccounting for Tax Effects of Share-Based Payment Awards”. We haveelected to adopt the “short-cut” method provided in the FASB Staff Position forcalculating the tax effects of share-based compensation pursuant to SFAS No.123R. The “short-cut” method includes simplified methods to establish thebeginning balance of the additional paid-in capital pool (“APIC pool”) relatedto the tax effects of share-based compensation, and to determine the subsequentimpact on the APIC pool, the consolidated statements of cash flows, andearnings per share of the tax effects of share-based compensation awards thatwere outstanding upon adoption of SFAS No. 123R.

Inaccordance with SFAS No. 123R, beginning in the first quarter of 2006, we havepresented excess tax benefits for the exercise of share-based compensationawards as a financing activity in the consolidated statement of cash flows.Prior to the adoption of SFAS No. 123R, we presented the tax benefits for deductionsresulting from the exercise of stock options as an operating cash flowactivity.

In September 2006, the FASB issued Statement of Financial AccountingStandards No. 158 (“SFAS No. 158”), “Employers’ Accounting for DefinedBenefit Pension and Other Postretirement Plans—an Amendment of FASB StatementsNo. 87, 88, 106, and 132(R)”. SFAS No. 158 requires an employer torecognize the overfunded or underfunded status of a defined benefitpostretirement plan (other than a multiemployer plan) as an asset or liabilityin its statement of financial position and to recognize changes in that fundedstatus in the year in which the changes occur through other comprehensive incomeof a business entity or changes in unrestricted net assets of a not-for-profitorganization. We adopted SFAS No. 158 for our fiscal year ended December 31,2006, and its adoption did not have a material effect on our consolidatedfinancial statements.  For more detailedinformation on our adoption of SFAS No. 158, see Note 12 under RetirementPlans.

In November 2005,the FASB issued FASB Staff Position FAS 115-1 and FAS 124-1 (“FSP 115-1 and124-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application toCertain

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Investments”. FSP115-1 and 124-1 applies to debt and equity securities accounted for underStatement of Financial Accounting Standards No. 115, “Accounting for CertainInvestments in Debt and Equity Securities”. The objective of FSP 115-1 and 124-1 is to provide guidance foridentifying other-than-temporarily impaired investments. FSP 115-1 and 124-1also provides new disclosure requirements for investments that are deemed to betemporarily impaired. The disclosure requirements were effective in annualfinancial statements for fiscal periods beginning after December 15, 2005.  We adopted FSP FAS 115-1 and FAS 124-1 onJanuary 1, 2006.  The adoption of FSP FAS115-1 and FAS 124-1 did not have a material impact on our consolidated financialstatements.

InSeptember 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB No. 108”),“Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements”.  The intent of SAB No. 108 is to reducediversity in practice for the method companies use to quantify financialstatement misstatements, including the effect of prior year uncorrectederrors.  SAB No. 108 establishes anapproach that requires quantification of financial statement errors using bothan income statement and a cumulative balance sheet approach.  SAB No. 108 is effective for fiscal yearsending after November 15, 2006.  Theadoption of SAB No. 108 did not have a significant impact on our consolidatedfinancial statements.

**2.****                      ****JOINT VENTURE AGREEMENT**

In July 2005, Cymer entered into a Joint Venture Agreement (the “JVAgreement”) with Zeiss to establish TCZ, which was originally formed as TCZGmbH, a Swiss limited liability company (“TCZ Switzerland”). TCZ is currentlydeveloping and will integrate, market and sell, and support tools employing anexcimer laser beam to induce crystallization of LTPS processing for themanufacture of flat panel displays.

TCZ is owned 60% by us and 40% by Zeiss and earnings and losses aredistributed according to the same percentages.  As an initial capitalcontribution to TCZ, we contributed certain intellectual property andapproximately $14.2 million in cash in the third quarter of 2005.  Weconsolidate the financial position and results of operations of TCZ and reflectZeiss’ interest in TCZ as minority interest in our consolidated financialstatements.  If TCZ is dissolved, the intellectual property owned by TCZwill be distributed to the members as joint owners, and the remaining assets,net of liabilities, will be distributed to the members in accordance with theirpercentage interests.

As a result of the formation of TCZ, we entered into various agreementswith TCZ.  Included in these agreements was a long-term supply agreementwhich requires us to provide TCZ with components for TCZ’s products and anintellectual property agreement which controls the use of any intellectualproperty developed by us for the joint venture (“JV”).

On September 12, 2006, we amended and restatedthe JV Agreement to move the location of our TCZ joint venture from Switzerlandto Singapore and to change our joint venture entity to a Singapore corporation.The terms and conditions of the original joint venture agreement we enteredinto with Zeiss remain in effect, except for the following: 1)   the change in the businesslocation; 2) the addition of TCZ Pte. Ltd. as a party to the amended and restated JV Agreement and successor to therights and obligations of TCZ Switzerland and 3) the updates to the governanceprovisions to reflect differences in Swiss and Singapore corporate law.

Basedupon our analysis of the TCZ operations and Cymer as a consolidated entity, wehave determined that TCZ qualifies as a separate operating segment.  See Note 15.

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**3.****                      ****BALANCE SHEET DETAILS**

The consolidatedbalance sheets detail is as follows as of December 31, 2005 and 2006(in  thousands):

 
|                                                | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2005**              | ** ** | **2006** | ** ** |
| ACCOUNTS  RECEIVABLE:                          |       |                  |       |   |   |
| Trade                                          |       | $                     | 88,404     |   | $ | 113,599 |   |
| Other                                          |       | 2,170                 |       | 3,201 |   |
|                                           |       | 90,574                |       | $ | 116,800 |   |
| Less allowance for doubtful accounts           |       | (756                  | )          | (943 | ) |
| Total                                          |       | $                     | 89,818     |   | $ | 115,857 |   |
|                                           |       |                  |       |   |   |
| INVENTORIES:                                   |       |                  |       |   |   |
| Raw materials                                  |       | $                     | 42,482     |   | $ | 39,512 |   |
| Work-in-progress                               |       | 18,408                |       | 24,082 |   |
| Finished goods                                 |       | 38,601                |       | 55,812 |   |
| Allowance for excess and obsolete inventory    |       | (10,445               | )          | (15,110 | ) |
| Total                                          |       | $                     | 89,046     |   | $ | 104,296 |   |
|                                           |       |                  |       |   |   |
| UNEARNED INCOME:                               |       |                  |       |   |   |
| Funded development contracts                   |       | $                     | 796        |   | $ | 145 |   |
| Service contracts                              |       | 880                   |       | 2,349 |   |
| License agreement                              |       | 50                    |       | 50 |   |
|                                           |       | $                     | 1,726      |   | $ | 2,544 |   |
| PROPERTY AND  EQUIPMENT:                       |       |                  |       |   |   |
| Land                                           |       | $                     | 9,080      |   | $ | 9,080 |   |
| Building                                       |       | 89,852                |       | 90,349 |   |
| Building improvements                          |       | 6,687                 |       | 7,538 |   |
| Furniture and equipment                        |       | 85,804                |       | 89,054 |   |
| Capitalized light sources                      |       | 41,739                |       | 46,294 |   |
| Leasehold improvements                         |       | 3,473                 |       | 3,447 |   |
| Construction in process                        |       | 1,552                 |       | 2,675 |   |
|                                           |       | 238,187               |       | 248,437 |   |
| Less accumulated depreciation and amortization |       | (120,936              | )          | (136,363 | ) |
| Total                                          |       | $                     | 117,251    |   | $ | 112,074 |   |

**Depreciation expense totaled $24.7 million, $25.0 million and $21.6million for the years ended December 31, 2004, 2005 and 2006, respectively.**

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**4.**            INVESTMENTS

Investmentsat December 31, 2005 consist of the following (in thousands):

|                                       | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|---------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                            | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Market** | ** ** |
| ** **                            | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
| Short-term:                           |       |          |       |           |       |           |       |       |       |
| Corporate debt  securities            |       | $             | 17,079     |           | $          | —         |       | $          | (179       | ) | $ | 16,900 |   |
| Commercial paper                      |       | 4,611         |       | —         |       | (2             | )          | 4,609      |       |
| U.S. government  agencies             |       | 77,868        |       | —         |       | (768           | )          | 77,100     |       |
| Auction rate  securities              |       | 31,575        |       | —         |       | —         |       | 31,575     |       |
| Other                                 |       | 20            |       | —         |       | —         |       | 20         |       |
| Total                                 |       | $             | 131,153    |           | $          | —         |       | $          | (949       | ) | $ | 130,204 |   |
|                                  |       |          |       |           |       |           |       |       |       |
| Long-term - U.S.  government agencies |       | $             | 30,000     |           | $          | —         |       | $          | (605       | ) | $ | 29,395 |   |

 

Investmentsat December 31, 2006 consist of the following (in thousands):

|                            | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|----------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                 | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Market** | ** ** |
| ** **                 | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
| Short-term:                |       |          |       |           |       |           |       |       |       |
| U.S. government  agencies  |       | $             | 93,256     |           | $          | 5              |       | $          | (393       | ) | $ | 92,868 |   |
| Auction rate  securities   |       | 115,075       |       | —         |       | —         |       | 115,075    |       |
| Total                      |       | $             | 208,331    |           | $          | 5              |       | $          | (393       | ) | $ | 207,943 |   |
|                       |       |          |       |           |       |           |       |       |       |
| Long-term:                 |       |          |       |           |       |           |       |       |       |
| Corporate debt  securities |       | 5,414         |       | —         |       | (24            | )          | 5,390      |       |
| U.S. government  agencies  |       | 3,000         |       | —         |       | (6             | )          | 2,994      |       |
| Total                      |       | $             | 8,414      |           | $          | —         |       | $          | (30        | ) | $ | 8,384 |   |

 

Asof December 31, 2006, the contractual maturities of debt securities were asfollows (in thousands):
|             | ** ** | **Less than** | ** ** | **One to**      | ** ** | ** ** | ** ** |
|-------------|------------|--------------------|------------|----------------------|------------|------------|------------|
| ** **  | ** ** | **One Year**  | ** ** | **Three Years** | ** ** | **Total**  | ** ** |
| Short-term: |       | $                  | 207,943    |                 | $          | —     |       | $ | 207,943 |   |
| Long-term:  |       | —             |       | 8,384                |       | 8,384      |       |
|        |       |               |       |                 |       |       |       |
| Total       |       | $                  | 207,943    |                 | $          | 8,384      |       | $ | 216,327 |   |

 

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The following table shows the fair value of ourinvestments with gross unrealized losses that are not deemed to beother-than-temporarily impaired grouped by investment category at December 31,2006:
|                            | ** ** | ** ** | ** ** | **Gross**      | ** ** |
|----------------------------|------------|------------|------------|----------------|------------|
| ** **                 | ** ** | **Market** | ** ** | **Unrealized** | ** ** |
|                            | ** ** | **Value**  | ** ** | **Loss**       | ** ** |
|                       | ** ** | ** ** | ** ** | ** **     | ** ** |
| Corporate debt  securities |       | $          | 5,390      |           | $          | (24 | ) |
| U.S. government  agencies  |       | 82,322     |       | (399           | )          |
| Total                      |       | $          | 87,712     |           | $          | (423 | ) |

 

At December 31, 2006, wedid not have any investments in individual securities that have been in acontinuous unrealized loss position deemed to be temporary for more than 12months. The unrealized losses are the result of market conditions affectingfixed-income securities. Because our general intent is to hold our investmentsecurities to maturity, and considering the high quality of the investmentsecurities, we are confident that the unrealized losses at December 31, 2006represent a temporary condition and will not result in realized losses on saleor maturity of the securities. We review our investment portfolio to identifyand evaluate investments that have indications of possible impairment. Factorsconsidered in determining whether a loss is temporary include the length oftime and extent to which fair value has been less than the cost basis, thefinancial condition and near-term prospects of the investee, credit quality andour ability to hold the investment for a period of time sufficient to allow forany anticipated recovery in market value.

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

Comprehensive incomeincludes net income, effective unrealized gains and losses on forwardcontracts, foreign currency translation adjustments, net unrealized pensiongains and losses, and unrealized gains and losses on available-for-salesecurities, which are recorded as short-term and long-term investments in theaccompanying consolidated balance sheets.

See the ConsolidatedStatements of Stockholders’ Equity for the impact of the components ofcomprehensive loss to our net income.

Thefollowing table summarizes the change in each component of accumulated othercomprehensive loss for the years ended December 31, 2004, 2005 and 2006 (inthousands):
|                   | ** ** | ** **         | ** ** | **Translation   adjustment** | ** ** | **Total unrealized   loss on   available-for-sale   investments,   net of tax** | ** ** | **Total unrealized   gain (loss) on  derivatives,   net of tax** | ** ** | **Net unrealized   pension loss (1)** | ** ** | **Accumulated   other   comprehensive   loss** | ** ** |
|-------------------|------------|--------------------|------------|-----------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| January 1, 2004   |       | Balance            |       | $                                 | (4,473     | )                                                                                                                       | $          | 1,448                                                                                               |       | $                                                         | (2,709     | )                                                             | $          | — |   | $ | (5,734 | ) |
|              |       | Period  net change |       | 697                               |       | (1,672                                                                                                                  | )          | 2,254                                                                                               |       |                                                      |       | 1,279                                                         |       |
| December 31, 2004 |       | Balance            |       | $                                 | (3,776     | )                                                                                                                       | $          | (224                                                                                                | )          | $                                                         | (455       | )                                                             | $          | — |   | $ | (4,455 | ) |
|              |       | Period  net change |       | (4,381                            | )          | (574                                                                                                                    | )          | 385                                                                                                 |       | —                                                    |       | (4,570                                                        | )          |
| December 31, 2005 |       | Balance            |       | $                                 | (8,157     | )                                                                                                                       | (798       | )                                                                                                   | $          | (70                                                       | )          | $                                                             | —     |   | $ | (9,025 | ) |
|              |       | Period  net change |       | 4,173                             |       | 706                                                                                                                     |       | 87                                                                                                  |       | (7                                                        | )          | 4,959                                                         |       |
| December 31, 2006 |       | Balance            |       | $                                 | (3,984     | )                                                                                                                       | $          | (92                                                                                                 | )          | $                                                         | 17         |                                                          | $          | (7 | ) | $ | (4,066 | ) |

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(1)See Note 12 under Retirement Plans for additional information.

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

The research and development agreement we entered intoeffective January 23, 2004 with Intel was amended on July 17, 2006 (“AmendedDevelopment Agreement”). Under the terms of the original agreement, Intel wasto provide us with up to a total of $20.0 million over a three-year period toaccelerate the development of production-worthy extreme ultraviolet (“EUV”)lithography light sources. Under the terms of the Amended DevelopmentAgreement, most of the mutual obligations between us and Intel have beenterminated, including Intel’s obligation to provide us with up to a total of$20.0 million. As of the date of the amendment, we had received a total of $8.5million from Intel under the original agreement, including an advance paymentof $1.3 million paid by Intel at the initiation of the original agreement in2004. Under the Amended Development Agreement, Intel has no obligation toprovide us with further funding beyond the amount we already received andwe returned $347,222, which represented the unearned portion of the advancepayment made by Intel. Although we will receive no additional funding fromIntel under the Amended Development Agreement, we intend to continue to developthe EUV technology as part of our existing product roadmap.  In addition,per the terms of the Amended Development Agreement, we will continue meetingwith Intel on a regular basis to review our progress towards developing aproduction-worthy EUV source system. The total funded amounts recorded underthis agreement for the years ended December 31, 2004, 2005 and 2006 were $6.1million, $1.9 million and $104,000, respectively.

Theintellectual property license agreement we entered into effective as of January28, 2004 with Intel was amended on June 28, 2006 (“Amended Intellectual PropertyLicense Agreement”). Under the original intellectual property licenseagreement, pursuant to which we licensed certain patents and trade secrets fromIntel related to EUV lithography technology, our obligation to pay license feesto Intel did not commence until our first high volume manufacturing shipment ofan EUV lithography light source. The Amended Intellectual Property LicenseAgreement replaces the license fee payments tied to product shipments with anup-front license fee which we paid to Intel in full upon execution of theamendment. The Amended Intellectual Property License Agreement also changes anumber of the EUV patents covered by the license. All of the licensed patentsunder the Amended Intellectual Property License Agreement relate to EUVtechnology, and we intend to use them in connection with our continuingresearch and development efforts related to EUV.

We recorded the patentlicense rights acquired from Intel valued at $8.2 million under this AmendedIntellectual Property License Agreement as an intangible asset in ouraccompanying consolidated balance sheets. These amounts have been capitalizedas we expect to use the technology in future research and development projects.See Note 13, Patent License Agreements for more information.

**7.****             ****GOODWILL AND INTANGIBLE ASSETS**

We account for our goodwill and other indefinite lifeintangible assets in accordance with SFAS No. 142. Under SFAS No. 142, ourgoodwill is subject to an annual impairment test. In addition, SFAS No. 142requires us to test for goodwill impairment at the reporting unit level. Forthe year ended December 31, 2006, we concluded that we have two separate reportingunits, our primarybusiness to design, manufacture and sell excimer light source systems,replacement parts, and support services for use in photolithography systemsused in the manufacture of semiconductors and our TCZ joint venture with Zeissthat is currently developing a process tool for use in the manufactureof flat panel displays. During the fourth quarter of 2006 we completed ourannual impairment test of goodwill and intangibles and concluded that noimpairment of goodwill or intangibles existed. As a result, no impairment losswas recorded during the year ended December 31, 2006. Since all of our recordedgoodwill was acquired prior to the formation of TCZ, none of the goodwill wasallocated to the TCZ reporting unit.

F-26

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Changes in goodwill from the year ended December 31,2005 to the year ended December 31, 2006 consisted of approximately $475,000 asa result of our acquisition of the final 19% minority interest in Cymer Koreain January 2006. The carrying amount of goodwill was $8.4 million and $8.8million as of December 31, 2005 and 2006, respectively.

Intangible assets — net,within the accompanying balance sheets represents amounts associated withpatents that were acquired in 2001, 2003, 2005 and 2006. As of December 31,2005 and December 31, 2006, the net carrying amount of these patents was $10.5million and $15.9 million, respectively. The accumulated amortization of thesepatents at December 31, 2005 and December 31, 2006 was $8.3 million and $11.1million, respectively. Amortization expense of our patents was $2.4 million,$2.4 million and $2.8 million for the years ended December 31, 2004, 2005 and2006, respectively.

As of December 31, 2006,future estimated amortization expense for these patents for the next five yearsand beyond is expected to be as follows (in thousands):

 

|                                | ** ** | **Future**       | ** ** |
|--------------------------------|------------|------------------|------------|
| ** **                     | ** ** | **Amortization** | ** ** |
| Year ending December  31, 2007 |       | $                | 3,046      |   |
| Year ending December  31, 2008 |       | 3,046            |       |
| Year ending December  31, 2009 |       | 1,564            |       |
| Year ending December  31, 2010 |       | 675              |       |
| Year ending December  31, 2011 |       | 675              |       |
| Thereafter                     |       | 6,873            |       |
|                                |            |                  |            |  |

 

**8.**               CREDIT FACILITIES

***Margin Facility —***During 2005 and 2006, we maintained a revolvingcredit facility referred to as a “margin facility” with a large U.S. financialinstitution. The facility carries a preferred interest rate which is tied tothe U.S. Federal Funds rate, and is secured by certain investment securitieswhich we hold at the same financial institution. The applicable rate ofinterest on this facility at December 31, 2005 and 2006 was approximately 4.95%and 6.0%, respectively. No amounts were outstanding under this facility during2005 or 2006.

***Foreign Currency Exchange Facilities*** —During 2005 and 2006, we maintained foreign currency exchange facilities withfive financial institutions in the U.S. See also “Derivative Instruments” inNote 1. The foreign currency exchange facilities provided up to $100.0 millionin 2005 and 2006 to be utilized for spot and futures foreign currency exchangecontracts for periods of up to one year. As of the years ended December 31,2005 and 2006, $46.2 million and $42.0 million was utilized under the foreigncurrency exchange facilities, respectively.

**9.**               CONVERTIBLE SUBORDINATEDNOTES

In February 2002, weissued $250.0 million principal amount of unsecured fixed rate 3.50%Convertible Subordinated Notes due February 15, 2009. Interest on these notesis payable on February 15 and August 15 of each year. The notes are convertibleinto shares of our common stock at a conversion rate of 20 shares per $1,000principal amount subject to adjustment under certain conditions. We may redeemthe notes after February 20, 2005 at certain redemption prices expressed as apercentage of the principal amount. The notes are subordinated to our existingand future senior indebtedness and effectively subordinated to all indebtednessand other liabilities of our subsidiaries. In the third quarter of 2004 and thesecond quarter of 2005, we repurchased, at a

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discount to par, $49.2million and $60.0 million principal amount of these notes, respectively. As aresult of these repurchases we recognized a gain on debt extinguishment of$911,000 in 2004 and $2.2 million in 2005. As of December 31, 2005 and 2006, wehad $140.7 million principal amount of the notes outstanding.

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

***Common Stock Warrants*** — During 2001, we issued warrants topurchase 200,000 shares of our common stock at a weighted average purchaseprice of $31.43 per share in conjunction with the acquisition of certainpatents (See Note 13). During 2005 and2006, no warrants were granted. In May 2006, all 200,000 warrants wereexercised for total proceeds of $6.3 million in cash.

***Stock Repurchase Program****—*InJanuary 2005, our board of directors authorized us to repurchase up to $50million**of our common stock inthe open market or in privately negotiated transactions.  We executedstock repurchases under this program until the full $50 million was repurchasedat the end of May 2005. As a result of this program, we repurchased 1.9 millionshares of our common stock.

On July 28, 2006,our board of directors authorized us to repurchase up to $150 million of ourcommon stock under a second repurchase program. The purchases will be made fromtime to time in the open market or in privately negotiated transactions and theprogram may be discontinued at any time. Total purchases through December 31,2006 were $100.7 million or 2.6 million shares under this 2006 approvedprogram.

***Stock Option Plans***— We have thefollowing stock option plans:

*2005Equity Incentive Plan (the “2005 Plan”)*****— In May2005, at our annual meeting of stockholders, our stockholders approved the 2005Plan. The 2005 Plan provides for the grant or award of various equityincentives to our employees, directors and consultants. Upon approval of the2005 Plan by the stockholders, we discontinued the use of our 1996 Stock OptionPlan and 2000 Equity Incentive Plan for future equity awards. Options issuedunder the 2005 Plan expire ten years after the options are granted andgenerally vest and become exercisable ratably over a four-year period followingthe date of grant. Stock unit awards issued under the 2005 Plan generally vestone year from the date granted. A total of 1,000,000 shares of common stock arereserved for issuance under the 2005 Plan and it provides for the issuance ofincentive stock options, nonstatutory stock options, stock appreciation rights,stock bonus awards, stock purchase awards, stock unit awards and other stockawards. Options to purchase 635,948 shares are outstanding and 344,154 sharesremain available for grant under this plan as of December 31, 2006.

*1996 Stock Option Plan (the“1996 Plan”)* — The 1996 Plan provided for the grant of incentive stock options to ouremployees and nonqualified stock options to our employees, directors andconsultants.  The exercise prices of stock options granted under the 1996Plan were at least equal to the fair market value of our common stock on thedates of grant. Options issued under the 1996 Plan expire five to ten yearsafter the options were granted and generally vest and become exercisableratably over a four-year period following the date of grant. The 1996 Plan was terminatedin May 2005 with the approval of the 2005 Plan. A total of 7,900,000 shares ofcommon stock were reserved for issuance under the 1996 Plan.  Of theseshares, options to purchase 1,607,671 shares are outstanding as of December 31,2006.

*2000 Equity Incentive Plan (the “2000 Plan”)* — In August 2000, our board ofdirectors adopted the 2000 Plan which provides for the grant of options to ouremployees or consultants who were neither directors nor officers. The exerciseprices of the options granted under the 2000 Plan were equal to the quotedmarket value of our common stock at the date of grant.  Options issuedunder the 2000 Plan expire ten years after the options were granted andgenerally vest and become

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exercisable ratably over a four year period followingthe date of grant. The 2000 Plan was amended in 2002 to increase the sharesreserved for issuance under the plan from 1,850,000 to 4,950,000. The plan wasterminated in May 2005 with the approval of the 2005 Plan. Of these shares,options to purchase 1,232,520 shares are outstanding as of December 31, 2006.

*ACX 1993 Stock Option Plan**(the “ACX Plan”)*— We assumed the ACX Stock Option Planupon completion of the acquisition of ACX in February 2001. Outstanding optionsmay be exercised solely for shares of our common stock, according to theconversion ratio established in the terms of the acquisition. The outstandingACX options were converted to options to purchase 336,109 of our shares, atexercise prices ranging from $2.08 to $38.71 per share. The ACX Plan providedfor the grant of incentive and nonstatutory options to purchase shares ofcommon stock to employees, directors and consultants at exercise prices notless than 100% of the fair market value of common stock on the dates theoptions were granted. Options issued under the ACX Plan expire five to tenyears after the options were granted and generally vest and become exercisableratably over a four-year period following the date of grant. No further optionswill be issued under the ACX Plan. As of December 31, 2006, no options topurchase shares are outstanding under the ACX Plan.

In 1996, weadopted a *1996 Director Option Plan (the “Director OptionPlan”)* whereby 200,000 shares were reserved for option grants to ourdirectors. There were 80,000 options issued under the Director Option Plan in1997. The Director Option Plan was terminated in October 1997 and none of theseoptions remain outstanding as of December 31, 2006.

**Stock Options**

A summary of the stockoption activity under all stock option plans is as follows (in thousands,except per share data):

|                                  | ** ** | ** **                                              | ** ** | **Options Outstanding**     | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | **Stock Options   Available  for Grant** | ** ** | **Number of   Shares** | ** ** | **Weighted Average   Exercise Price   Per Share** | ** ** |
| Balance at January 1,  2004      |       | 1,594                                                   |       | 7,226                            |       | $ | 30.36 |   |
| Granted                          |       | (1,053                                                  | )          | 1,053                            |       | 36.73 |   |
| Exercised                        |       | —                                                  |       | (502                             | )          | 23.34 |   |
| Cancelled                        |       | 315                                                     |       | (248                             | )          | 29.98 |   |
| Expired                          |       | (4                                                      | )          | (67                              | )          | 44.16 |   |
|                             |       |                                                    |       |                             |       |   |   |
| Balance at December 31,  2004    |       | 852                                                     |       | 7,462                            |       | 31.62 |   |
| Reserved for 2005 Plan           |       | 1,000                                                   |       | —                           |       |   |   |
| Granted                          |       | (732                                                    | )          | 732                              |       | 29.90 |   |
| Exercised                        |       | —                                                  |       | (928                             | )          | 24.27 |   |
| Cancelled                        |       | 342                                                     |       | (131                             | )          | 30.97 |   |
| Expired                          |       | (799                                                    | )          | (211                             | )          | 40.67 |   |
|                             |       |                                                    |       |                             |       |   |   |
| Balance at December 31,  2005    |       | 663                                                     |       | 6,924                            |       | 32.15 |   |
| Granted                          |       | (331                                                    | )          | 313                              |       | 44.94 |   |
| Exercised                        |       | —                                                  |       | (3,509                           | )          | 30.91 |   |
| Cancelled                        |       | 270                                                     |       | (213                             | )          | 30.90 |   |
| Expired                          |       | (258                                                    | )          | (57                              | )          | 48.73 |   |
|                             |       |                                                    |       |                             |       |   |   |
| Balance at December 31,  2006    |       | 344                                                     |       | 3,458                            |       | $ | 34.38 |   |
|                             |       |                                                    |       |                             |       |   |   |
| Exercisable at December 31, 2006 |       |                                                    |       | 2,696                            |       | $ | 33.60 |   |

 

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Thefollowing table summarizes information as of December 31, 2006 concerningcurrently outstanding and exercisable options:
| ** **                              | ** ** | **Options Outstanding**                                                 | ** ** | **Options Exercisable**                                         | ** ** |
|-----------------------------------------|------------|------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding  As of 12/31/06   (in thousands)** | ** ** | **Weighted  Average  Remaining  Contractual  Term  (in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value  (in thousands)** | ** ** | **Number  Exercisable  As of 12/31/06  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic  Value   (in thousands)** | ** ** |
| $12.75-$15.73                           |       | 4                                                                            |       | 1.67                                                                 |       | $ | 12.75 |   | $ | 115 |   | 4 |   | $ | 12.75 |   | $ | 115 |   |
| $16.32-$19.98                           |       | 193                                                                          |       | 5.22                                                                 |       | 19.19 |   | 4,784 |   | 193 |   | 19.19 |   | 4,784 |   |
| $20.00-$25.76                           |       | 405                                                                          |       | 4.36                                                                 |       | 23.24 |   | 8,382 |   | 384 |   | 23.21 |   | 7,963 |   |
| $25.79-$31.66                           |       | 644                                                                          |       | 6.02                                                                 |       | 28.66 |   | 9,844 |   | 463 |   | 28.88 |   | 6,974 |   |
| $31.69-$39.81                           |       | 1,457                                                                        |       | 5.12                                                                 |       | 35.82 |   | 11,848 |   | 1,207 |   | 36.11 |   | 9,466 |   |
| $39.85-$48.64                           |       | 534                                                                          |       | 7.20                                                                 |       | 44.83 |   | — |   | 275 |   | 44.87 |   | — |   |
| $48.73-$55.13                           |       | 221                                                                          |       | 5.34                                                                 |       | 50.25 |   | — |   | 170 |   | 50.71 |   | — |   |
| $12.75-$55.13                           |       | 3,458                                                                        |       | 5.54                                                                 |       | $ | 34.38 |   | $ | 34,973 |   | $ | 2,696 |   | $ | 33.60 |   | $ | 29,302 |   |
|                                         |            |                                                                              |            |                                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue in the table above represents the total pre-tax intrinsic value, based ona per share price of $43.95, the closing price of our common stock on December31, 2006 as reported by The NASDAQ Global Select Market, which would have beenreceived by the option holders had all option holders exercised their optionsas of that date. The total number of in-the-money stock options exercisable asof December 31, 2006 was 2.3 million.

Theweighted average per share fair value of the options granted was $21.76,$17.39, and $18.85 during the years ended December 2004, 2005 and 2006,respectively.

Thetotal intrinsic value of options exercised was $8.9 million, $10.2 million and$62.0 million during the years ended December 2004, 2005 and 2006,respectively.

Thetotal cash received from employees as a result of employee stock optionexercises during the year ended December 31, 2006 was approximately $108.4million. In connection with these exercises, the tax benefits recognized by usfor the year ended December 31, 2006 was $21.5 million.

We settle employee stock option exercises with newly issuedshares of our common stock.

**Stock Units**

In January 2006, our board of directors approved the use of annual stockunit awards for non-employee directors pursuant to our 2005 Plan in lieu ofquarterly stock options grants. The number of shares subject to eachstock unit award is determined by dividing $100,000 by the closing price pershare of our common stock as of the date of grant. During theyear ended December 31, 2006, 17,948 shares subject to such stock units awardswere granted to non-employee directors with a grant date fair value of $39.00per share. Each stock unit award shall vest 100% after one year from the dateof grant. Stock based compensation expense for stock units for the year endedDecember 31, 2006 was $671,000.

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A summary of the change in stock unit awards outstanding during the yearended December 31, 2006 is as follows (in thousands, except life data):

|                       | ** ** | **Shares** (in thousands) | ** ** | **Weighted   Average   Remaining   Contractual   Life** | ** ** | **Aggregate**  Intrinsic Value as of December 31, 2006 (in thousands) | ** ** |
|-----------------------|------------|--------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| Beginning Outstanding |       | —                         |       | —                                                                      |       | —                                                                                              |       |
| Awarded               |       | 18                             |       | —                                                                      |       | —                                                                                              |       |
| Vested                |       | —                         |       | —                                                                      |       | —                                                                                              |       |
| Forfeited             |       | —                         |       | —                                                                      |       | —                                                                                              |       |
| Ending Outstanding    |       | 18                             |       | 0.04                                                                        |       | $                                                                                                   | 789        |   |
| Ending  Exercisable   |       | —                         |       | —                                                                      |       |                                                                                                |       |
|                       |            |                                |            |                                                                             |            |                                                                                                     |            |  |

 

WeightedAverage Remaining Recognition Period - 0.04 years

The aggregate intrinsic value in the table aboverepresents the total pre-tax intrinsic value based on our closing stock priceof $43.95 as of December 31, 2006.

**Employee Stock Purchase Plan**

*1996 Employee Stock Purchase Plan (the “ESPP”)*— Our ESPP is intended toqualify for favorable income tax treatment associated with rights granted underan employee stock purchase plan which qualifies under Section 423 of theInternal Revenue Code.  Under the ESPP, eligible employees may purchaseshares of our common stock through payroll deductions of up to 15% of his orher compensation (as defined in the plan), at a price per share equal to 95% ofthe fair market value of our common stock at the end of the purchaseperiod.  Our ESPP was amended in 2005. The amendment: a) changed theduration of offering periods under the plan from two years to six months, b)reduced the discount to market price used to determine the purchase price forshares of our common stock under the plan from 15% to 5%, and c) eliminated the“lookback” feature that allowed the purchase price to be determined as of thebeginning of an offering period, or enrollment date, if the market price as ofthe enrollment date was lower than the market price at the end of the offeringperiod. As a result of the amendment the plan became non-compensatory.

OnFebruary 7, 2006, our board of directors amended our ESPP to extend theexpiration date of the plan until July 31, 2016. In addition, on May 18, 2006,our stockholders approved an amendment to increase the number of shares ofcommon stock reserved for issuance under the plan by 300,000 shares from1,200,000 shares to 1,500,000 shares.

Thenumber of shares issuable under the ESPP as of December 31, 2006 was 366,295,and 1,133,715 shares have been previously issued. Because our ESPP is anon-compensatory plan as defined by SFAS No. 123R, no stock-based compensationexpense is recorded for our ESPP.

The total cashreceived from employees as a result of ESPP shares issued during the year endedDecember 31, 2006 was approximately $1.3 million.

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**11.**         INCOME TAXES

Totalincome taxes for the years ended December 31, 2004, 2005 and 2006 wereallocated as follows (in thousands):

|                                            | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                       |       |                                        |       |   |   |   |   |
| To income from  continuing operations      |       | $                                           | 15,144     |   | $ | 262 |   | $ | 46,137 |   |
| To stockholders’ equity  and goodwill |       | (2,748                                      | )          | (736 | ) | (19,759 | ) |
| Total income taxes                         |       | $                                           | 12,396     |   | $ | (474 | ) | $ | 26,378 |   |

 

Thebreakdown of income before income tax provision and minority interest and thecomponents of the provision for income taxes on continuing operations on U.S.and foreign pre-tax income are summarized as follows (in thousands):

|                        | ** ** | **Years ended December 31,** | ** ** |
|------------------------|------------|---------------------------------------------|------------|
| ** **             | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
|                   |       |                                        |       |   |   |   |   |
| U.S. pre-tax income    |       | $                                           | 48,369     |   | $ | 43,002 |   | $ | 137,961 |   |
| Foreign pre-tax income |       | 12,205                                      |       | 2,786 |   | 731 |   |
| Total                  |       | $                                           | 60,574     |   | $ | 45,788 |   | $ | 138,692 |   |
|                   |       |                                        |       |   |   |   |   |
| Current income taxes:  |       |                                        |       |   |   |   |   |
| Federal                |       | $                                           | (794       | ) | $ | 1,576 |   | $ | 24,541 |   |
| State                  |       | 78                                          |       | (11 | ) | 665 |   |
| Foreign                |       | 1,838                                       |       | 1,032 |   | 3,813 |   |
| Total                  |       | 1,122                                       |       | 2,597 |   | 29,019 |   |
|                   |       |                                        |       |   |   |   |   |
| Deferred income taxes: |       |                                        |       |   |   |   |   |
| Federal                |       | 16,455                                      |       | 328 |   | 15,641 |   |
| State                  |       | (1,226                                      | )          | (2,338 | ) | 964 |   |
| Foreign                |       | (1,207                                      | )          | (325 | ) | 513 |   |
| Total                  |       | 14,022                                      |       | (2,335 | ) | 17,118 |   |
| Income tax provision   |       | $                                           | 15,144     |   | $ | 262 |   | $ | 46,137 |   |

 

The income tax provisionis different from that which would be obtained by applying the statutoryfederal income tax rate (35%) to income before income tax expense.  The items causing this difference for eachperiod are as follows (in thousands):

F-32

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|                                                                     | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                                |       |                                        |       |   |   |   |   |
| Provision at statutory  rate                                        |       | $                                           | 21,201     |   | $ | 16,026 |   | $ | 48,542 |   |
| Foreign provision in  excess of (less than)  federal statutory rate |       | 2,958                                       |       | (1,443 | ) | 3,739 |   |
| State income taxes, net  of federal benefit                         |       | (135                                        | )          | (2,035 | ) | 1,629 |   |
| Extraterritorial income  exclusion benefit                          |       | (7,305                                      | )          | (7,571 | ) | (3,629 | ) |
| U.S. manufacturing  benefit                                         |       | —                                      |       | — |   | (897 | ) |
| Federal tax credits                                                 |       | (1,139                                      | )          | (3,896 | ) | (3,500 | ) |
| Change in cash  surrender value of life insurance                   |       | —                                      |       | (883 | ) | (1,117 | ) |
| Change in valuation  allowance                                      | ** ** | **—**                                  |       | 293 |   | 910 |   |
| Other                                                               |       | (436                                        | )          | (229 | ) | 460 |   |
| Provision at effective tax rate                                     |       | $                                           | 15,144     |   | $ | 262 |   | $ | 46,137 |   |

 

Deferred income taxesreflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. Significant components of our net deferred tax assets are as follows (inthousands):

|                                                                  | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                       | ** ** | **2005**              | ** ** | **2006** | ** ** |
|                                                             |       |                  |       |   |   |
| Deferred tax assets:                                             |       |                  |       |   |   |
| Reserves and accruals  not currently deductible                  |       | $                     | 19,216     |   | $ | 20,731 |   |
| Difference  between book and tax basis of inventory              |       | 5,667                 |       | 6,297 |   |
| Tax  carryforwards                                               |       | 39,363                |       | 26,227 |   |
| Tax effect of  foreign transactions                              |       | 6,192                 |       | 5,950 |   |
| Foreign deferred  tax assets                                     |       | 3,731                 |       | 4,080 |   |
| Total gross  deferred tax assets                                 |       | 74,169                |       | 63,285 |   |
| Valuation  allowance                                             |       | (293                  | )          | (1,203 | ) |
| Net deferred tax  assets                                         |       | 73,876                |       | 62,082 |   |
| Deferred tax  liabilities:                                       |       |                  |       |   |   |
| Difference  between book and tax basis of property and equipment |       | (5,986                | )          | (2,787 | ) |
| Reserves and  accruals not currently taxable                     |       | (123                  | )          | (86 | ) |
| Total deferred  tax liabilities                                  |       | (6,109                | )          | (2,873 | ) |
| Net deferred tax assets                                          |       | $                     | 67,767     |   | $ | 59,209 |   |

 

In assessing therealizability of deferred tax assets, we consider whether it is more likelythan not that some portion or all of the deferred tax assets will not berealized. With regard to certain deferred tax assets related to our TCZ jointventure and French branch operations, we believe there is insufficient evidenceto conclude that realization of the benefit is more likely than not, andtherefore we have provided a full valuation allowance of $1.2 million againstthese assets.  With regard to all otherdeferred tax assets, we believe that it is more likely than not that theresults of future operations will generate sufficient taxable income to realizethe benefit, and therefore no valuation allowance has been provided for theseassets.

At December 31,2006, we had federal tax credit carryforwards of $11.7 million, which begin toexpire in 2018.  At December 31, 2006, wehad state tax credit carryforwards of $14.2 million,  which may be carried forward indefinitely. AtDecember 31, 2006, we had foreign NOL carryforwards of $2.6 million which maybe carried forward indefinitely.

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Our 2004 and 2005U.S. federal income tax returns are under audit by the Internal Revenue Service(“IRS”). The audit has focused primarily on our extraterritorial incomeexclusion for these years.  Noassessments or changes have been proposed to date by the IRS auditors.

We benefit from atax holiday in Korea where we manufacture certain products.  The tax holiday is awarded by Korea’sMinistry of Finance and Economy to promote capital investment in certainqualified high-technology businesses. The holiday is effective for a 10-year period, from 2003 through 2012,and provides exemption from corporate income tax of 100% of eligible incomethrough 2009 and 50% of eligible income from 2010 through 2012.  Since its inception, the tax holiday hasproduced tax benefits to us totaling $3.6 million.

It is our intention to reinvest undistributedearnings of our foreign subsidiaries and thereby indefinitely postpone theirremittance, with the exception of our TCZ joint venture. Accordingly, we havenot provided U.S. federal income and foreign withholding taxes on $58 millionof undistributed earnings from non-U.S. operations as of December 31,2006.  It is not practicable to estimatethe amount of the deferred tax liability on such unremitted earnings.

**12.****      ****CONTINGENCIES AND COMMITMENTS**

***Leases***— We lease certain facilities under non-cancelable operating leases.  The lease terms on these facilities arethrough January 1, 2010 and provide for certain rent abatements and minimumannual increases and options to extend the terms.  In addition, we have a land lease in Koreawith a lease term through December 2020. This land lease is exempt from leasepayments because the building meets certain investment and operational criteriaof the Korean government.  From time totime we lease certain equipment and vehicles under either capital or operatingleases.  We had no capital leaseagreements as of December 31, 2006.

Rentexpense under operating leases net of sublease rental income is recognized on astraight-line basis over the life of the related leases, and totaledapproximately $6,495,000, $679,000 and $334,000 for the years endedDecember 31, 2004, 2005 and 2006, respectively.  Rent expenses for 2004 and 2005 include $3.0million and $384,000 in costs recorded for lease losses associated with oursubleasing activities for our San Diego and Charlestown facilities,respectively.  Sublease rental incometotaled $1,085,000, $4,044,000 and $4,666,000 for the years ended December 31,2004, 2005 and 2006, respectively.

Total future minimum lease commitmentsunder operating leases are as follows (in thousands):

| Years ending December 31, | ** ** | **Operating** | ** ** |
|------------------------------------------|------------|---------------|------------|
|                                     |       |          |       |
| 2007                                     |       | $             | 5,095      |   |
| 2008                                     |       | 4,088         |       |
| 2009                                     |       | 3,393         |       |
| 2010                                     |       | 89            |       |
| 2011 & thereafter                    |       | 18            |       |
| Total                                    |       | $             | 12,683     |   |

 

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The following represents future minimum rentals to beearned under our noncancelable subleases (in thousands). These amounts aredirectly offset to the operating lease amounts above.

|                                              | ** ** | **Sublease** | ** ** |
|----------------------------------------------|------------|--------------|------------|
| **Years ending December 31,** | ** ** | **Payments** | ** ** |
|                                         |       |         |       |
| 2007                                         |       | $            | 3,604      |   |
| 2008                                         |       | 1,526        |       |
| 2009                                         |       | 1,124        |       |
| Total                                        |       | $            | 6,254      |   |

 

***Employee Savings Plan*** — We have a401(k) plan that allows participating employees to contribute a percentage oftheir salary, subject to certain annual IRS limits.  The plan is available to substantially allfull-time U.S. employees and, per the terms of the plan, we are allowed to makea  matching contribution of up to 5% ofeach participating employee’s compensation, not to exceed $5,000 per year.Under the plan, we contributed $2.8 million, $2.4 million and $3.0 million forthe years ended December 31, 2004, 2005 and 2006, respectively.

***Executive Deferred Compensation Plan***— We have an executive deferred compensation plan for certain officers and keyexecutives.  Beginning in 2001, we usedcorporate owned life insurance to finance the plan.  Compensation expense under this plan totaled$182,000, $222,000 and $628,000 for the years ended December 31, 2004, 2005 and2006, respectively.  Our liability fordeferred compensation totaled $4.1 million and $4.5 million as of December 31,2005 and 2006, respectively, and is included in other liabilities.  The cash surrender value of the lifeinsurance policies totaled $2.5 million as of December 31, 2005 and 2006 and isincluded in other assets.

***Executive Option and GroupHealth Coverage Extension Program*** — We have an executive option and health coverage extension program foreligible executives who meet certain minimum service and age requirements.  This program is designed to provide extendedbenefits to eligible executives who retire and cease to serve us on a full-timebasis.  Under the terms of the plan, theexecutive acts as our consultant for a term of four years.  In return for these services, the programallows the executive to continue vesting in his or her stock options after theretirement separation date. The program also provides the executives withspecified health insurance continuation benefits until the age of 65.  We had one former executive who participatedin this program in 2005 and 2006. The cost for this program was not material ineither year.

***Retirement Plans***— Two of our subsidiary offices, Cymer Japan and Cymer Korea, have retirementallowances and pension plans covering a substantial portion of theiremployees.  Benefits under these plansare based upon years of service and compensation levels.   Details on each of these plans are asfollows.

Cymer Japan - Cymer Japan has a Retirement Allowanceand Pension Plan (“pension plan”) for all Cymer Japan employees, as well as aretirement allowance for Japanese directors (“directors’ plan”).  Expense under these plans totaledapproximately $536,000, $321,000 and $248,000 for the years ended December 31,2004, 2005 and 2006, respectively.   Theexpenses for the pension plan are recorded pursuant to the accounting requirementsunder Statements of Financial Standards No. 87, 88 and 132(R). We use November30 as the measurement date. Our liability for both plans totaled approximately$1.4 million and $1.5 million as of December 31, 2005 and 2006, respectively.Although the total expenses and liability balances provided above include bothplans, the directors’ plan is immaterial to all amounts and yearsprovided.  The projected benefitobligation at December 31, 2005 and 2006 was approximately $1.3 million and$1.4 million, respectively.  Theaccumulated benefit obligation at December 31, 2005 and 2006 was approximately$1.0 million for both years. There was an unrecognized actuarial loss ofapproximately $69,000 at December 31, 2005 and an unrecognized actuarial gainof approximately $66,000 at December 31, 2006.

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The pension plan is an unfunded plan and includes noplan assets. The net periodic pension costs for the year 2007 are estimated atapproximately $229,000. Estimated future benefit payments expected under thepension plan from 2007 through 2011, and thereafter are approximately $89,000,$101,000, $115,000, $185,000, $198,000 and $665,000, respectively.  The following assumptions were used in theactuarial calculations for 2005 and 2006. The estimated salary increases were 4% and 3.5% for 2005 and 2006,respectively.  The mortality rates forboth 2005 and 2006 were as announced by the Japanese Ministry of Health andWelfare on October 2004 for use in funding valuation of the Employees PensionFund. The discount rates used in the actuarial calculations were 1.50% and 2%for 2005 and 2006, respectively.

As discussed in Note 1, we adopted SFAS No. 158 forthe year ending December 31, 2006.  Dueto the unrecognized actuarial gain in 2006 for the Cymer Japan pension plan,the adoption of SFAS No. 158 resulted in a decrease of approximately $66,000 inour other liabilities and an increase of approximately $39,000 in ouraccumulated other comprehensive loss for the tax affected portion of theunrecognized actuarial gain. We do not plan to recognize as a component of netperiod benefit cost in 2007 the $39,000 recorded in accumulated othercomprehensive loss for 2006 as the total amount does not exceed 10% of theprojected benefit obligation as of December 31, 2006. There were nounrecognized transition costs or unrecognized prior service costs for either ofthe years ended December 31, 2005 or December 31, 2006 for the Cymer Japanpension plan.

Cymer Korea — Cymer Korea has a government mandatedRetirement Allowance and Pension Plan (“pension plan”) for all Cymer Koreaemployees.  Expense under this plantotaled approximately $279,000, $319,000 and $249,000 for the years endedDecember 31, 2004, 2005 and 2006, respectively. The expenses for the pension plan are recorded pursuant to theaccounting requirements under Statements of Financial Standards No. 87, 88 and132R. We use November 30 as the measurement date. Our liability for the pensionplan totaled approximately $403,000 and $461,000 as of December 31, 2005 and 2006,respectively.  The projected benefitobligation and the accumulated benefit obligation were approximately $1.1million and $795,000 at December 31, 2006, respectively. The unrecognizedactuarial loss was approximately $59,000 at December 31, 2006.

The net periodic pension costs for the year 2007 areestimated at approximately $274,000. Estimated future benefit payments expectedunder the pension plan from 2007 through 2011, and thereafter are approximately$113,000, $117,000, $126,000, $131,000, $133,000 and $734,000,respectively.  We expect to makecontributions of $243,000 to the plan in 2007. The following assumptions wereused in the actuarial calculations for 2006. The estimated salary increase was6%.  The mortality rates were based upondata announced by the Korea Insurance Development Institute as required byKorean regulations for pension plans with less than 300 employees. The discountrate used in the actuarial calculation was 5.06% and the expected rate ofreturn on plan assets was 4.60%.

CymerKorea has an established life insurance trust fund to maintain the pension planassets.  The life insurance fund is aguaranteed investment product and is heavily regulated by the Koreangovernment.  As of December 31, 2006,total plan assets were $655,000.  To developthe expected long-term rate of return on plan assets assumption, we consideredthe current level of expected returns on risk free investments (primarilygovernment bonds), the historical level of the risk premium associated with theother asset classes in which the portfolio is invested and the expectations forfuture returns of each asset class.  Wethen weighted the expected return for each asset class based on the targetasset allocation to develop the expected long-term rate of return on planassets assumption in the portfolio.  Thisresulted in our selection of the 4.60% assumption.

Due to the unrecognized actuarial loss for the CymerKorea pension plan in 2006, the adoption of SFAS No. 158 resulted in anincrease of approximately $59,000 in our other liabilities and a decrease ofapproximately $46,000 in our accumulated other comprehensive loss for the taxaffected portion of the actuarial loss. We do not plan to recognize as acomponent of net period benefit cost in 2007 the $46,000 recorded inaccumulated other comprehensive loss for 2006 as the

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total amount does not exceed 10% of the projectedbenefit obligation as of December 31, 2006. There were no unrecognized transition costs or unrecognized priorservice costs for either of the years ending December 31, 2005 or December 31,2006 for the Cymer Korea pension plan.

***Korea Customs Investigation*****—**In 2002, the****customsagency in Korea had asserted that parts being imported into Korea from ourcorporate office in San Diego were classified improperly for customs and dutiespurposes and some used items, which were returned to San Diego, were valuedimproperly during the period from 1997 through July 2003.  Although we did not agree with these assertions,Korean customs assessed and required us to pay additional duties related toshipments during this time period.  As aresult of these assertions and discussions that we had with the customs agencyin Korea, we recorded an expense of $4.7 million in the cost of product salesfor the year ended December 31, 2003. Payments made to the customs agency in Korea were $2.5 million and $1.9million during 2003 and 2004, respectively. The 2004 payment was net of a$289,000 refund received from the Korea customs agency.  In 2004, we received notification from theKorean customs agency that we would receive a refund of a portion of dutiespreviously paid. As a result, we recorded a $2.3 million reduction to cost ofproduct sales and $100,000 to interest income in the accompanying consolidatedstatements of operations for the year ended December 31, 2004 related to thisrefund.  No balances related to thisrefund were outstanding as of December 31, 2006.

***Contingencies*****— We are party tolegal actions in the normal course of business. Based in part on the advice of legal counsel, our management does notexpect the outcome of legal action in the normal course of business to have amaterial impact on our financial position, liquidity, or results of operations.

Our former Japanesemanufacturing partner, Seiko, and one of our Japanese customers were notifiedin July 1996 that our light source systems in Japan may infringe certainJapanese patents held by another Japanese company.  We have agreed to indemnify our former Japanesemanufacturing partner and our customers against patent infringement claimsunder certain circumstances, even after the termination date of the contractmanufacturing agreement.  We believe,based upon the advice of counsel, that our products do not infringe any validclaim of the asserted patents or that we are entitled to prior use claims inJapan.

**13.****      ****PATENT LICENSE AGREEMENTS**

In May2001, we acquired certain patents for use in our deep ultraviolet (“DUV”) lightsource applications.  The totalconsideration for this transaction was $10.3 million, which included a $6.0million cash payment and the issuance of 200,000 warrants valued at $4.3million. The warrants were valued on the date of issuance using theBlack-Scholes pricing model using the following assumptions: 87% volatility,5.0% risk-free interest rate and 4.6 years expected life.  The total value of these patents are beingamortized over eight years which represents the remaining useful life of thepatents purchased under the agreement. The amortization of these patents isincluded in cost of product sales on the accompanying statements of operationssince they are used in products which are currently being shipped to customers.

In November 2003, we acquired the rights to the samelist of patents as in the May 2001 agreement but for a different field of use,for a total amount of $6.0 million in cash. This license agreement allows us to use the patents for EUV and otherfuture applications.  The total value ofthese patents are being amortized over a period of 5.5 years which representsthe remaining useful life of the patents purchased under the agreement. Theamortization of these patents is included in research and development expenseson the accompanying statements of operations since the field of use involvesapplications which are still in the research and development stages.

Per the terms of the May 2001 and November 2003 patentlicense agreements relating to the above, we are required to pay a minimum$200,000 royalty annually in the event that we do not ship a certain number ofproduction tools to third parties which contain the intellectual property thatwe in-licensed under these agreements. This royalty provision which applies to both agreements, became

F-37

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effective on January 1, 2006. Although this royaltywas not triggered in 2006 for the DUV light source applications that weshipped, it was triggered for the EUV field of use since we did not ship anyEUV systems to third parties in 2006. This $200,000 royalty for 2006 is included in research and developmentexpenses on the accompanying statements of operations.

In November 2005, we acquired certain patents for usein our DUV  light source applications inmask based lithography for a total of $2.5 million in cash.  The total value of these patents are beingamortized over a period of 14.65 years which represents the average remaininguseful life of the patents purchased under the agreement. The amortization ofthese patents is included in cost of product sales on the accompanyingstatements of operations since they are mainly being used in products which arecurrently being shipped to customers.

In June 2006, weacquired certain patent license rights valued at $8.2 million for use in ourcontinuing research and development efforts related to EUV.  The acquisition of these patent licenserights are associated with the Amended Intellectual Property License Agreementwith Intel which is discussed in Note 6 to our consolidated financialstatements. The total value of these patent license rights are being amortizedover a period of 16.29 years which represents the average remaining useful lifeof all of the patents purchased under this amendment. The amortization of thesepatents is included in research and development expenses on the accompanyingstatement of operations since the field of use involves applications which arestill in the research and development stages.

As of December 31, 2005 and 2006, the net carryingamount related to all of these patent license agreements was $10.5 million and$15.9 million, respectively.

**14.**        RELATED PARTY TRANSACTIONS

*CollaborativeArrangement**—* We have a collaborative arrangement with a Japanesecompany that was also a stockholder of ours until 2000.  The arrangement, entered into in August 1992,includes a product license agreement and contract manufacturing agreement. Inearly 2003, we mutually agreed to terminate the contract manufacturingagreement. The general provisions of the product license agreement are asfollows:

We granted to thestockholder the exclusive right in Japan and the non-exclusive right outsideJapan to manufacture and sell one of our products and any subsequentenhancements. We also granted the stockholder the right of first refusal tolicense and fund the development of new technologies not developed with fundingfrom other parties.  In exchange forthese rights, we received up-front license fees and were entitled to royaltiesof 5% on related product sales through September 1999, after which the royaltyrate was subject to renegotiation.  Todate there has been no renegotiation of the royalty rate.  The license agreement also provides thatproduct sales between us and the stockholder will be at a 15% discount from therespective companies’ list price. The agreement terminates in August 2012.  There was no activity under this agreement in2004, 2005 and 2006.

*Joint Venture Agreement**—*  As a result of the formation of our TCZ joint venturein July 2005 and under the terms of the joint venture agreement which wasamended in September 2006, Zeiss is now a related party.  In addition to transactions that occur amongus, Zeiss and TCZ Singapore related to the joint venture, we also purchasecertain optical parts directly from Zeiss and sell our light source systemproducts to Zeiss periodically. We recorded revenue associated with thisrelated party of $400,000 and $7.4 million for the years ended December 31,2005 and 2006, respectively.  As ofDecember 31, 2005 and 2006, we had accounts receivable balances of $588,000 and$834,000, respectively, and accounts payable balances of $5.0 million and $4.9million, respectively, all of which were associated with these related partytransactions with Zeiss.

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**15.   SEGMENT INFORMATION**

Our primary business is to design, manufacture andsell excimer light source systems, replacement parts, and support services foruse in photolithography systems used in the manufacture of semiconductors.  In addition, as discussed in Note 2, weentered into a joint venture agreement in July 2005 with Zeiss and formed TCZ.  On September 12, 2006, we amended the joint ventureagreement to move the location of TCZ from Switzerland to Singapore. As aresult, the geographic information table below reflects that the majority ofTCZ’s assets were located in Europe in 2005 and in Asia in 2006. TCZ iscurrently developing a process tool for use in the manufacture of flat paneldisplays. TCZ is owned 60% by us and 40% by Zeiss and we consolidate thefinancial position and results of operations of TCZ into our consolidatedfinancial statements.

In accordance with Statement of Financial AccountingStandards No. 131 (“SFAS No. 131”), “Disclosure about Segments of an Enterpriseand Related Information”, we determined that our business consists of twooperating segments.  Although the assets and results ofoperations of the TCZ business do not exceed established quantitativethresholds included in SFAS No. 131 for the years ended December 31, 2005and 2006, we have provided the following segment information (information is inthousands and TCZ net income is presented net of minority interest):

|                   | ** ** | **Year ended December 31, 2005** | ** ** |
|-------------------|------------|------------------------------------------------------|------------|
| ** **        | ** ** | **Cymer**                                            | ** ** | **TCZ** | ** ** | **Total** | ** ** |
|              |       |                                                 |       |   |   |   |   |
| Revenue           |       | $                                                    | 383,648    |   | $ | — |   | $ | 383,648 |   |
|              |       |                                                 |       |   |   |   |   |
| Net Income (Loss) |       | $                                                    | 48,574     |   | $ | (2,022 | ) | $ | 46,552 |   |
|              |       |                                                 |       |   |   |   |   |
| Total Assets      |       | $                                                    | 761,859    |   | $ | 29,517 |   | $ | 791,376 |   |

 

|                   | ** ** | **Year ended December 31, 2006** | ** ** |
|-------------------|------------|------------------------------------------------------|------------|
| ** **        | ** ** | **Cymer**                                            | ** ** | **TCZ** | ** ** | **Total** | ** ** |
|              |       |                                                 |       |   |   |   |   |
| Revenue           |       | $                                                    | 543,855    |   | $ | — |   | $ | 543,855 |   |
|              |       |                                                 |       |   |   |   |   |
| Net Income (Loss) |       | $                                                    | 100,094    |   | ($4,446 | ) | $ | 95,648 |   |
|              |       |                                                 |       |   |   |   |   |
| Total Assets      |       | $                                                    | 926,999    |   | $ | 22,095 |   | $ | 949,094 |   |

 

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**Geographic Information**

Sales to unaffiliated customers,long-lived assets, all other identifiable assets and total identifiable assets,classified by operations located in the U.S., Japan, Korea, Taiwan, Singapore,the People’s Republic of China, the Netherlands, and Switzerland are as follows(in thousands):

|                                          | ** ** | **Year ended December 31, 2004** | ** ** |
|------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | **Asia** | ** ** | **Europe** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | **(Korea, Taiwan,** | ** ** | **(the Netherlands and** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **U.S.**                                             | ** ** | **Japan** | ** ** | **Singapore and China)** | ** ** | **Switzerland)** | ** ** | **Consolidated** | ** ** |
|                                     |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Sales to unaffiliated customers  (1)** |       | $                                                    | 212,283    |   | $ | 132,512 |   | $ | 53,623 |   | $ | 19,661 |   | $ | 418,079 |   |
|                                     |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Long lived assets (2)**                |       | 114,134                                              |       | 3,115 |   | 5,249 |   | 1,050 |   | 123,548 |   |
| **All other identifiable assets**        |       | 575,696                                              |       | 52,470 |   | 54,037 |   | 13,085 |   | 695,288 |   |
|                                     |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Total identifiable assets**            |       | $                                                    | 689,830    |   | $ | 55,585 |   | $ | 59,286 |   | $ | 14,135 |   | $ | 818,836 |   |

 

|                                          | ** ** | **Year ended December 31, 2005** | ** ** |
|------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | **Asia** | ** ** | **Europe** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | **(Korea, Taiwan,** | ** ** | **(the Netherlands and** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **U.S.**                                             | ** ** | **Japan** | ** ** | **Singapore and China)** | ** ** | **Switzerland)** | ** ** | **Consolidated** | ** ** |
|                                     |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Sales to unaffiliated customers  (1)** |       | $                                                    | 180,804    |   | $ | 118,563 |   | $ | 63,612 |   | $ | 20,669 |   | $ | 383,648 |   |
|                                     |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Long lived assets (2)**                |       | 108,892                                              |       | 2,231 |   | 5,129 |   | 999 |   | 117,251 |   |
| **All other identifiable assets**        |       | 528,969                                              |       | 49,644 |   | 54,638 |   | 40,874 |   | 674,125 |   |
|                                     |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Total identifiable assets**            |       | $                                                    | 637,861    |   | $ | 51,875 |   | $ | 59,767 |   | $ | 41,873 |   | $ | 791,376 |   |

 

|                                           | ** ** | **Year ended December 31, 2006** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | **Asia** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | **(Korea, Taiwan,** | ** ** | **Europe** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **U.S.**                                             | ** ** | **Japan** | ** ** | **Singapore and China)** | ** ** | **(the Netherlands)** | ** ** | **Consolidated** | ** ** |
|                                      |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Sales to unaffiliated   customers (1)** |       | $                                                    | 292,481    |   | $ | 119,969 |   | $ | 105,336 |   | $ | 26,069 |   | $ | 543,855 |   |
|                                      |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Long lived assets (2)**                 |       | 103,076                                              |       | 1,292 |   | 7,005 |   | 701 |   | 112,074 |   |
| **All other identifiable assets**         |       | 680,511                                              |       | 44,569 |   | 95,936 |   | 16,004 |   | 837,020 |   |
|                                      |       |                                                 |       |   |   |   |   |   |   |   |   |
| **Total identifiable assets**             |       | $                                                    | 783,587    |   | $ | 45,861 |   | $ | 102,941 |   | $ | 16,705 |   | $ | 949,094 |   |

----

 

(1) Sales to unaffiliated customersconsist of sales generated from each of the geographic locations. Allsignificant intercompany balances are eliminated in consolidation.  Intercompany sales to our subsidiaries aregenerally priced between 90% to 95% of the price of products sold to outsidecustomers.

(2) Long-lived assets include netproperty, plant and equipment attributed to the geographic location in whichthey are located.

F-40

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**16.****      ****SELECTEDQUARTERLY FINANCIAL DATA (UNAUDITED)**

Thetable below includes quarterly data for the years ended December 31, 2005 and2006 (in thousands, except per share data):
|                                 | ** ** | **Year ended December 31, 2005** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **1st**                                              | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th **(2) | ** ** |
|                            | ** ** | ** **                                           |       |   |   |   |   |   |   |
| Revenues                        |       | $                                                    | 84,810     |   | $ | 96,392 |   | $ | 99,653 |   | $ | 102,793 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Operating income                |       | $                                                    | 5,077      |   | $ | 8,925 |   | $ | 12,181 |   | $ | 14,493 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Net income                      |       | $                                                    | 5,385      |   | $ | 11,015 |   | $ | 12,684 |   | $ | 17,468 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Basic earnings  per share (1)   |       | $                                                    | 0.15       |   | $ | 0.31 |   | $ | 0.36 |   | $ | 0.49 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Diluted earnings per  share (1) |       | $                                                    | 0.14       |   | $ | 0.30 |   | $ | 0.35 |   | $ | 0.48 |   |

 
|                                 | ** ** | **Year ended December 31, 2006** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **1st**                                              | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th (3)** | ** ** |
|                            | ** ** | ** **                                           |       |   |   |   |   |   |   |
| Revenues                        |       | $                                                    | 127,117    |   | $ | 135,379 |   | $ | 143,918 |   | $ | 137,441 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Operating income                |       | $                                                    | 24,273     |   | $ | 29,023 |   | $ | 34,979 |   | $ | 30,856 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Net income                      |       | $                                                    | 20,603     |   | $ | 22,602 |   | $ | 27,032 |   | $ | 25,411 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Basic earnings  per share (1)   |       | $                                                    | 0.55       |   | $ | 0.58 |   | $ | 0.71 |   | $ | 0.68 |   |
|                            |       |                                                 |       |   |   |   |   |   |   |
| Diluted earnings per  share (1) |       | $                                                    | 0.52       |   | $ | 0.55 |   | $ | 0.68 |   | $ | 0.65 |   |

 

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(1)       Earnings per share arecomputed separately for each quarter and the full year using the respectiveweighted average shares. Therefore, the sum of the quarterly earnings per shareamounts may not equal the annual amounts reported.

(2)      Includes additional net income ofapproximately $804,000 due to thecorrection of our income tax provision for prior periods as a result of ourineffective internal controls over our accounting for income taxes.  These control deficiencies resulted inundetected errors in our consolidated income tax provision.  Such errors were corrected in the fourthquarter of 2005, resulting in a reduction to income tax expense.

(3)      During the fourth quarter of 2006, we corrected unrecorded stock-basedcompensation expense relating to grant date errors for a small number of stockoptions that were granted primarily in 1999. The errors primarily resulted from either not following our formal stockoption approval process or making immaterial accounting clerical errors. Thetotal amount of the unrecorded stock compensation expense was $4.2 million andrelated to fiscal years 1999 through 2003. We analyzed this accounting error and determined that it is immaterialto all prior periods impacted and to the current year financial statements.  As a result of this analysis, we recorded thecorrecting entry related to this unrecorded stock compensation in the quarterended December 31, 2006.  This adjustmentresulted in a $4.2 million decrease in 2006 operating income and a $2.6 milliondecrease in 2006 net income.

 

F-41

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**CYMER, INC.********SCHEDULEII********VALUATIONAND QUALIFYING ACCOUNTS********YearsEnded December 31, 2004, 2005 and 2006********(inthousands)**
| ** **                                              | ** ** | **Balance at** | ** ** | **Additions** | ** ** | ** **     | ** ** | **Balance**      | ** ** |
|---------------------------------------------------------|------------|---------------------|------------|---------------|------------|----------------|------------|------------------|------------|
| ** **                                              | ** ** | **Beginning**       | ** ** | **(net)**     | ** ** | ** **     | ** ** | **at End**  | ** ** |
| ** **                                              | ** ** | **of Year**    | ** ** | **(1)**       | ** ** | **Deductions** | ** ** | **of Year** | ** ** |
|                                                    | ** ** | ** **          |       |          |       |           |       |             |       |
| **Allowance for Doubtful Accounts  Accounts and Notes** |       |                |       |          |       |           |       |             |       |
| ** **                                              |       |                |       |          |       |           |       |             |       |
| Year ended December 31,  2004                           |       | $                   | 1,964      |          | $          | 199            |       | $                | (1,543)    | (2) | $ | 620 |   |
| Year ended December 31,  2005                           |       | $                   | 620        |          | $          | 136            |       | $                | —     |   | $ | 756 |   |
| Year ended December 31,  2006                           |       | $                   | 756        |          | $          | 205            |       | $                | (18)       |   | $ | 943 |   |
|                                                    |       |                |       |          |       |           |       |             |       |
| **Inventory Allowance**                                 |       |                |       |          |       |           |       |             |       |
|                                                    |       |                |       |          |       |           |       |             |       |
| Year ended December 31,  2004                           |       | $                   | 12,028     |          | $          | 9,474          |       | $                | (8,842)    |   | $ | 12,660 |   |
| Year ended December 31,  2005                           |       | $                   | 12,660     |          | $          | 3,221          |       | $                | (5,436)    |   | $ | 10,445 |   |
| Year ended December 31,  2006                           |       | $                   | 10,445     |          | $          | 10,095         |       | $                | (5,430)    |   | $ | 15,110 |   |

 

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(1)  Includes reversal of allowance amountsas deemed necessary.

(2)  Represents write-off of note receivable and accruedinterest.

 

 

See accompanying report of independent registered public accountingfirm.

 

S-1

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